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Why AMD Expects Narrower Gross Margins in Fiscal 2Q17

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AMD’s gross margin

Previously in this series, we saw that Advanced Micro Devices’ (AMD) stock price dropped as its revenue guidance for fiscal 2Q17 fell short of analysts’ bullish estimates. The company guided for moderate revenue growth and a narrower gross margin, which led to some analysts and investors questioning the company’s ability to maintain sustainable profits. Let’s take a closer look at the company’s gross margins and their driving factors.

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Fiscal 1Q17 gross margin

AMD’s non-GAAP (generally accepted accounting principles) gross margin improved from 32% in fiscal 4Q16 to 34% in fiscal 1Q17 due to a richer product mix in the Computing and Graphics segment. The product mix had a higher proportion of high-margin Ryzen 7 desktop CPUs (central processing units) and a lower proportion of low-margin game console processors. The first fiscal quarter generally has the highest gross margin, as low-margin game console processors are at their lowest point.

Fiscal 2Q17 gross margin guidance

However, the company guided for its non-GAAP gross margin to fall to 33% in fiscal 2Q17. Already, AMD is operating at half the gross margin as rivals Intel (INTC) and NVIDIA (NVDA), which are operating at gross margins over 60%. The company’s comeback in the high-end market raised analysts’ and investors’ hope that it would return to profits and report record high profits in fiscal 2017.

AMD is offering its high-end Ryzen CPUs at a lower price than Intel’s similar products to deliver a better price-to-performance ratio. To analysts, the reduction in its gross margin estimates suggests financial weakness in AMD’s new product lineup.

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What’s behind AMD’s gross margin guidance?

In AMD’s fiscal 1Q17 earnings call, CEO Lisa Su clarified that the narrower gross margin guidance is a seasonal effect of an unfavorable product mix. As shown in the above graph, AMD’s gross margin narrows in fiscal 2Q and 3Q as the company ramps up production of low-margin game console processors.

AMD expects to charge higher prices for its new 16-nm (nanometer) game console processors for Sony’s (SNE) PS4 Neo and Microsoft’s (MSFT) Xbox Scorpio. However, the benefit from higher ASPs (average selling prices) would be offset by the higher initial costs of 16-nm processors.

Lisa Su highlighted that even though the gross margin may narrow sequentially, from 34% in fiscal 1Q17 to 33% in fiscal 2Q17, it would be wider than the 31.1% margin reported in fiscal 2Q16. This YoY strengthening indicates that the company has improved its product mix and costs. Next, we’ll look at AMD’s strategy to improve its gross margin.

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