AMD’s balance sheet and shareholders
Advanced Micro Devices (AMD) has improved its balance sheet by reducing its leverage and improving its cash reserves. However, it still has a long way to go toward strengthening its balance sheet and making itself financially flexible like its competitors Intel (INTC) and NVIDIA (NVDA).
From a shareholder’s perspective, the company needs a strong balance sheet to ensure that it’s giving returns on the capital it has invested. However, the ROE (return on equity) of a company, such as AMD, that’s been reporting multiple years of losses is also negative.
ROE is the percentage of net income attributable to the shareholder on the book value of equity. It’s calculated by dividing net income by shareholders’ equity. At the end of 2017, AMD reported GAAP (generally accepted accounting principles) net income of $43 million, which resulted in an ROE of 7%, higher than no returns in 2015 and 2016. AMD’s ROE is far below Intel’s and NVIDIA’s ROEs of 14.2% and 40.8%, respectively.
AMD’s 7% ROE is even lower than its cost of equity of 10.3%, which means the company is paying more for its capital than what it’s generating from that capital. The cost of equity is high because AMD issued new equity worth $600 million in 2016 to repay some of its debt and reduce its interest expenses.
Understanding AMD’s capital structure
A structure in which capital costs are higher than capital returns is not sustainable. AMD has to do everything it can to increase its net profit margins and sustain them. However, its ability to improve profits is limited because of its large debt. AMD’s balance sheet is highly leveraged, as its debt is 228% of its equity. On the other hand, Intel and NVIDIA have debt-to-equity ratios of 38.8% and 26.7%, respectively.
It’s important for AMD to significantly reduce its debt because that’s what’s hindering its profitability and obstructing its financial flexibility to invest in future projects.
What ROE means for shareholders
Investors generally look for stocks with high ROE. However, ROE shouldn’t be considered in isolation, because it can be artificially inflated if a company has high debt and low equity. For instance, AMD’s 7% ROE is artificially inflated because of its high debt. Even then, its ROE is far below those of its rivals.
Investors should look for stocks with high ROEs and strong balance sheets, where debt levels are low. For instance, NVIDIA has an ROE of 40.8%—higher than AMD’s or INTC’s—and debt-to-equity of 26.3%—lower than AMD’s or INTC’s. Even Micron Technology (MU) has an ROE of 33% and a debt-to-equity of 40%.
However, hedge fund managers and institutional investors are optimistic about AMD and are buying stakes in it. We’ll look into this in the next part of the series.