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This article first appeared on SumZero, the world’s largest research community of buyside investment professionals. In some cases Barron’s edits the research for brevity; professional investors can access the full version of this thesis and tens of thousands of others at SumZero.com.

Disclaimer: The author of this idea and the author’s fund had a position in this security at the time of posting and may trade in and out of this position without informing the SumZero community.

Target price: $64.00

Recent price: $34.19

Timeframe: 1-2 years

Thesis

Eagle Point Global focuses on disruptions in the technology space. Often disruptions occur as a result of an innovation that creates a new market or value network which disrupts an existing market. This influential idea was first defined and analyzed by Clayton Christensen in 1995. However, disruptions can also be developed by “old technology” firms such as legacy computer chip design and manufacturing companies. AMD has been and continues to be one of our biggest long positions even after the extraordinary profits we have already generated though its stock appreciation. The market is drastically underestimating the disruptive nature of moving production to Taiwan Semiconductor Manufacturing Company (TSMC) plus the two-year cost and architectural advantage in design using chiplets. We believe AMD is poised to deliver strong server market share growth and thus continued strong stock gains over the next few years.

Advanced Micro Devices (AMD) Background

AMD is a global semiconductor company that sells x86 microprocessors, graphics processing units (GPUs), server processors and embedded processors such as for gaming consoles. Currently, the x86 microprocessor is an integrated circuit which serves as the CPU of a computer and is predominantly the processor of choice for desktop computers, notebooks, and servers worldwide. The semiconductor graphics market addresses the need for improved visual and data processing as an augmentation to the microprocessor in computers. AMD was incorporated on May 1, 1969 and became a public company in 1972.

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Semiconductor Manufacturing

Since its founding, AMD had built and owned its internal fabrication facilities. As founder Jerry Sanders stated, “real men have fabs.” However, times change, and over the past fifteen years AMD has had a difficult time keeping up with the relentless pace of Moore’s law, which asserts the number of transistors on a microchip doubles every two years. Due to its scrappy size, AMD has been underfunded, understaffed, and under-resourced to effectively compete in the race to deliver both on advanced nodes and wafer fabrication. Its internal fabs continuously failed to meet required timelines for advanced node processes. As a result, AMD was relegated to niche markets, while the incumbent Intel was given free rein to accumulate more than 90% market share. AMD has since been working to free itself from this anchor. In 2012 AMD finally eliminated its exclusivity agreement with its internal wafer fabs and separated them into an independent company called GlobalFoundries. Unfortunately, its Wafer Supply agreement with GlobalFoundries stated:

“1. If at any time while AMD may purchase the applicable MPU Products from [TSMC], FoundryCo cannot deliver in a timely manner Qualified Products produced on Qualified Processes that meet the Specifications in accordance with Binding Forecasts, the Partnership Committee shall promptly address the situation, including conducting a prompt review process and implementing a corrective action plan. If, however, such failure to so deliver such Products is causing AMD to fail to meet its material commitments to its customers, and AMD as a result needs to purchase greater MPU Product volumes from [TSMC] than otherwise set forth above, AMD may increase its purchases at [TSMC] for the affected MPU Products above the [redacted]%) maximum to meet such customer requirements. AMD may thereafter continue to purchase MPU Products over the [] percent ([]%) maximum until such time as FoundryCo demonstrates, as mutually agreed upon, that FoundryCo can meet the relevant Specifications and Yields for such MPU Product in a manner reasonably comparable or better than those of [TSMC], as well as meet the applicable supply commitments set forth in this Agreement or as actually required by AMD.”

Although GlobalFoundries was a separate company, AMD was anchored to the agreement and obligated to purchase wafers as a preferred partner until GlobalFoundries failed to deliver on its processes. Finally, AMD’s opportunity to fully break ties came. On August 27, 2018, GlobalFoundries announced its decision to stop all development on leading-edge manufacturing and focus on specialized process technologies. AMD quickly pivoted its manufacturing to TSMC for multiple 7nm products, which are launching this year. Although a seemingly small change, the move in fact was significant and a major disruptive inflection point. While Intel struggles to develop its 10nm advanced node process, TSMC’s 7nm node is mature and TSMC is accelerating its lead as it begins its 5nm production process, now more than one generation ahead of Intel. As we’ve seen with GlobalFoundries, Intel may never catch up to leading manufacturers just as AMD’s competitive position may never have been stronger.

AMD has not only unhindered its manufacturing process but also has implemented a chiplet design to massively disrupt their markets, especially servers. Although chiplet technology can be traced to the development of multichip modules (MCMs) in the 1980s, MCMs were relegated to high-end systems such as extremely expensive mainframes. For the rest of the industry, cheap commodity packages were used. Frankly, packaging was an afterthought in the IC market. Historically, server chips have been manufactured as a massive, single piece of silicon. For example Intel’s Skylake SP server chip is a 698mm die for a 28 core server processor. This translates into 78 dies per 300mm wafer. Intel’s design also requires a separate Northbridge chip which is located on the motherboard, which adds additional cost. AMD’s chiplet approach separates the server chip into multiple smaller dies. AMD’s top-of-the-line server package houses eight cores which are connected together using an I/O chip. No separate Northbridge chip is required.

AMD’s approach not only facilitates the ability to easily mix and match cores to form different server skus, e.g., 64 core vs. 32 core chip, but also significantly improves the all-in manufacturing cost. Semiconductor fabrication yield depends on manufacturing defects per wafer, location of wafer defects, and die area. Industry models have been developed to calculate yields based on these inputs. Dr. Hansch’s research at Universitat Munchen for example, shows how as die size increases manufacturers realize an accelerating yield loss and thus accelerating manufacturing cost. Using their model, assuming best-case defect densities, AMD’s small chiplet approach achieves 90% yields vs. Intel’s 30%-40% yields from its large, monolithic die approach.

As yields fall, the chiplet approach significantly broadens cost savings. Based on our cost analysis of Intel’s Skylake and AMD’s Rome product lines, we expect AMD to have a significant cost advantage over Intel.

Even with Intel’s lower internal manufacturing cost of 14nm vs TSM 7nm, yield loss due to Skylake’s large die size significantly impacts the overall manufacturing cost. We estimate Intel’s total server die cost at $162 per good server chip while AMD costs about $108 per good server package. The significant yield improvement with using small 70mm chiplet dies provides significant cost savings. Lower production costs mean AMD can outcompete Intel on price without sacrificing operating margins. Recently leaked benchmarks posted on OpenBenchmarking’s database show AMD’s upcoming EPYC 7742 to be extremely competitive compared to Intel’s top-of-the-line Xeon Platinum 8280 chips. In aggregate, benchmarks showed the EPYC 7742 beat the single and dual Xeon Platinum 8280s by double digits in various performance tests and in some cases up to a 60% performance advantage.

How does this disruption in the server ecosystem translate into earnings power? We can look back to 2005 when AMD was extremely competitive in the server space. AMD had launched dual core Opterons featuring a new class of performance that had never been possible in the past. AMD also had a six-month head start on Intel’s dual core Xeons. Today is eerily similar to 2005, but now Intel is likely two years behind on architecture, and serious doubts exist over whether Intel will ever be competitive again with a leading-edge process node. In two short years, AMD’s server market share exploded 18 percentage points to 24% share by 2007. The server market rapidly embraced AMD’s products for two critically important reasons: a new, highly competitive server chip and a second supplier to reduce Intel’s monopolistic power. We believe today we are reliving this story and expect AMD to show significant revenue growth and earnings power due to rapid server share gain.

The difference today is cloud service providers purchase more than 65% of all server CPUs. As most cloud applications make use of open source software like Apache HTTP Server, Perl, PHP, Ruby, Python, NodeJS, and Java, these applications seamlessly run on multiple processor architectures due to underlying Linux OS support. Case in point: Amazon has dealt a huge blow to Intel’s dominance in the data center. As the largest public cloud services provider, Amazon is a trendsetter for the industry, and Amazon has also started offering EC2 instances powered by AMD EPYC processors, positioned as a lower-cost alternative to Intel Xeon-powered CPUs.

Amazon realizes that AMD servers are providing significant value and is passing on that value in terms of pricing discounts. Developers using open source packages on AWS now have a cheaper alternative with low switching costs likely leading to rapid migration to capture the savings. However, we conservatively assume that migration does not accelerate at a faster pace than 2005.

For the full report, including a valuation discussion, go to SumZero.com.