Why AMD shares are coming to life

By Robert Walberg

To paraphrase Mark Twain, the report of AMD's death was greatly exaggerated.

Advanced Micro Devices (AMD, news, msgs), the second-largest maker of microprocessors, posted a second-quarter loss of $600 million. But investors should expect the earnings report to jolt the stock back to life.

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Given the size of the operating loss, combined with the fact that it is the company's third consecutive quarter in the red, you might think it's a stretch to call the report positive.

But Wall Street logic is different from Main Street logic: Earnings reports are more about expectations than reality. AMD scored a big win on that front.

Unlike industry giant Intel (INTC, news, msgs), which reported disappointing profit margins earlier in the week, AMD beat the consensus estimate of 32.1% by a comfy 1.4 percentage points. Gross margins were down from 57% a year ago, but AMD showed that its nasty price war with Intel drew less blood than Wall Street had feared.

Successfully stemming decline

There's a long way to go before investors feel that AMD has the upper hand again, but the company had a crucial success by merely stemming the decline.

Sales also were much stronger than expected, as revenue jumped 12%. The company had guided The Street to expect flat or slightly higher sales. Management cited strong end-user demand and initial sales to Toshiba (TOSBF, news, msgs) -- which just started offering AMD chips -- to explain why total sales beat estimates by nearly 9%. Advanced Micro also noted that it expects sales in the current quarter to increase "in line with seasonality," though it didn't say exactly what that means.

Nevertheless, because 78% of all analysts following the stock rated it neutral or lower heading into the report, indications of better times ahead are bound to trigger upgrades. That should translate into a higher stock price.

Still reasons for concern

Looking a little further out, investors have reason to be optimistic about the fourth quarter as well. Demand for PCs is running stronger than many analysts had expected, and there's reason to believe the upcoming Christmas season will be good for AMD, especially since last year was depressed as consumers awaited the launch of Microsoft's (MSFT, news, msgs) Windows Vista operating system before buying new computers. (Microsoft is the publisher of MSN Money.)

In other words, AMD most likely will deliver a minimum of three straight quarters of sequential sales gains -- not a bad way to start a turnaround.

There are still plenty of reasons for concern. First, Intel remains the 800-pound gorilla in the industry and could squeeze margins more with price cuts. Second, AMD's balance sheet remains mired in debt, and dwindling cash flow means there's no room for product or execution disappointments.

Finally, AMD still hasn't convinced the investment community that it can consistently deliver top-quality products in a timely manner. More R&D investments should help cure that problem, but it will take time and proof of execution before Wall Street is willing to do anything more than grudgingly embrace the stock. Moves to reduce operating costs would also be positive for the stock.

Over the short to intermediate term, investors will want to pounce on the stock in anticipation of a return to gap resistance in the $19.50 area. A move to this ceiling would represent a 23.6% gain from Thursday's close. That's not bad for a company and stock left for dead just a couple of months ago.

At the time of publication, Robert Walberg did not own or control shares of any company mentioned in this article. His clients owned shares of AMD, Intel and Microsoft.