Advanced Micro Devices (AMD) reported fiscal third-quarter results that missed already-lowered expectations after the closing bell Tuesday. The stock initially dropped in after-hours trading before reversing and rising 4%.

• Revenue in AMD’s third-quarter increased 29% to $5.57 billion, missing estimates of $5.62 billion.

• Adjusted gross margin expanded 150 basis points to 50%, largely in line with expectations.

• Adjusted earnings per share fell 8% to 67 cents, missing analyst expectations of 68 cents.

Q3 companywide results

As a reminder, AMD reports results through four segments: (1) Data Center, which includes server central processing units (CPUs), data center graphics processing units (GPUs), Pensando and Xilinx data center products; (2) Client, which is desktop and notebook PC processors and chipsets; (3) Gaming, which is discrete graphics processors and semi-custom game console products that go into Microsoft’s (MSFT) Xbox and Sony’s PlayStation); and (4) the Embedded segment, which includes AMD and Xilinx embedded products.

Data Center revenue increased 45% to $1.6 billion, in line with expectations and marking the 10th straight quarter of record server processor sales thanks to strong sales of EPYC server processors. Operating income in the segment was $505 million, representing 31% of revenue. That’s up from $308 million and 28% of revenue, one year ago.

• While enterprise OEM (original equipment manufacturer) revenue was down sequentially as customers slowed purchases due to macroeconomic uncertainty, cloud was up sequentially and more than doubled versus the year ago period.

• Driving the segment, management said that the EPYC generation 3 is the highest performing and most energy efficient server CPU in the market today, and the team expects to further extend that lead next week with the public launch of their generation 4. That’s a 5 nanometer EPYC CPU, which is expected to deliver significant performance enhancements and increased energy efficiency. 

• Outside of CPUs, management called out record sales of Xilinx FPGA and network Data Center products and said, “The addition of Pensando DPUs [data processing units] to our product portfolio has been very well received by customers highlighted by our Enterprise customer pipeline doubling in the few months since the acquisition closed.”

• With AMD now in position to address more customer data center needs than ever before thanks to past acquisitions of Xilinx and Pensando, management expects long-term growth and market share gains to continue.

Client revenue was $1 billion, a decrease of 40% year over year, however, on par with consensus estimates.

• Sales were hurt by weak PC demand and a focus channel partners on reducing inventory, which resulted in AMD shipping below consumption. Essentially, AMD is shipping below consumer demand in order to help resellers clear out their inventory.

• Operating losses came in at $26 million, down from income of $490 million in the year ago period. 

Gaming revenue was $1.6 billion, up 14% year over year and also in line with estimates driven by higher semi-custom product sales. It was partially offset by a decline in gaming graphics revenue.

• This marks the sixth straight quarter of record semi-custom sales thanks to resilient demand for next-gen gaming consoles — PlayStation 5 and Xbox Series X|S — ahead of the holiday season.

• Gaming graphics took a hit due to soft consumer demand and management’s efforts to reduce channel inventory ahead of the next-gen GPU launch later this week.

• Operating income in the segment was $142 million, representing 9% of revenue. That’s down from $231 million and 16% of revenue, one year ago.

Embedded revenue were up significantly year over year at a record $1.3 billion, also in line with expectations.

• Growth was primarily driven by the inclusion of Xilinx’s business. On the call, management called out record sales to aerospace and defense, automotive, and communications customers.

• Operating income in the segment was $635 million, representing 49% of revenue. That’s up from $23 million and 30% of revenue, one year ago, with the large annual jump due mainly to the inclusion of Xilinx embedded product revenue.

Guidance

For the full year, AMD now expect approximately $23.5 billion in revenue plus or minus $300 million, representing growth of 43% year over year. That was a tad light versus the $23.9 billion expected. The company also reduced gross margin guidance to about 52%, roughly in line with expectations. 

For its fiscal fourth quarter, AMD expects revenue of approximately $5.5 billion, plus or minus $300 million, representing an increase of approximately 14% year over year, with growth from Data Center and Embedded being offset by declines in Client and Gaming. This outlook is below estimates of $5.85 billion at the midpoint. Non-GAAP gross margins are expected to be approximately 51%, which is slightly below estimates of about 52.4%. (GAAP stands for general accounting principles.)

Cash flow, capital allocation 

In the quarter, AMD generated $965 million of operating cash flow, below estimates of $1.18 billion. Free cash flow was also lighter than expected at $849 million compared to estimates of $937 million. The company repurchased $617 million worth of stock, and it has $6.8 billion remaining in its current authorization, representing about 7% of shares outstanding at current levels. It is worth noting that management spent close to 10% of its authorized power to repurchase stocks during the third quarter, suggesting a slimmer of hope that even management believes this is a good stock price to buy. 

Bottom line 

There were no major surprises as management preannounced the quarter in early October. Given that the issues plaguing the industry are well-understood at this point — primarily weak personal computer demand and U.S. export restrictions on certain high-end chips to China — investors appear to have been managing their expectations and forgiving AMD’s slightly weaker than expected guidance, which again was tempered due to weak PC and video gaming demand.

While AMD has been taking advantage of consistent missteps at Intel (INTC), management is executing effectively on their stated roadmap and appear to be effectively navigating the difficult operating environment. Data center revenue remains resilient thanks to strong North American cloud demand, where AMD is strongest, while Embedded segment sales benefited from strong end market demand. Gaming and Client will remain weak into year end, but AMD is taking its medicine and working diligently to clear out elevated inventory levels by the end of the year. That sets the company up in a better position heading into 2023.

While the long-term drivers of growth — cloud computing, gaming, and digitization — appear fully intact, the near-term issues must be resolved. Channel inventories must flush out. We need more clarity on the macroeconomic front as it is causing enterprise customers to understandably slow the pace of spending. 

Unfortunately, we will need to get through these more immediate issues before investors can focus on future growth drivers. Given that (1) the inventory glut appears to last at least through year end, (2) enterprise spending will depend on economic conditions, and (3) the state of semiconductor sales into China remains in question, we find it hard to prioritize the semiconductor sector as a place to commit additional funds in this environment.