Update with ATI's CEO
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Event: On Aug.17,Dave Orton, ATI’s President and CEO.
The meetings focused on four key points: 1) Late September Launch Date Set for Three R500 Desktop Discrete Chips (R520, RV530, and RV515); 2) Strong Integrated Graphics Chipsets Growth, But Gross Margins (Desktop and Mobile Combined) to Remain in the Low-Teens Range in Q4 (Aug); 3) Inventory Level to Remain Above Target in Q4 and Writedown Risk Remains in Our View; and 4) Consumer Business (Wireless and Digital TV) Falls Well Short of Original Target for 2x Growth in F2005. ATI is in final stages of its F2006 financial planning process, and does not intend to make a significant headcount investment, with plans to keep operating expenses relatively flat for each of the quarters. We believe management’s tone was justifiably conservative, and we do not anticipate a one-quarter snapback in revenue growth or gross margins. We have a higher level of confidence that ATI’s R500 family will launch on time, but weak gross margins and the inventory bloat will likely continue to weigh negatively on the stock. We maintain our HOLD and $12.75/C$15.50 target price on ATI, based on 15x our C2006E EPS of $0.85.
1. Late September Launch Date Set for Three R500 Desktop Discrete Chips (R520, RV530, and RV515): Addressing the rampant rumours surrounding the R520 launch date, ATI stated its plan of record is to launch all three 90nm R500 desktop discrete chips (the enthusiast R520, the performance RV530, and the value RV515) in late September. The shipment dates will likely be staggered for the three chips, based on the delivery cycles from TSMC, with one likely shipping at launch date and the other two within the first half of October. The R520 was originally planned for a June launch, while the RV530 and RV515 launch times are only a few weeks delayed from their original schedule. The R520 had been sampling since Dec/04, and although the architecture and 90nm process were not a problem, ATI was not able to run the clock fast enough due to a “soft ground” issue that was discovered in late July after debugging with several re-spins. Specifically, the R520 and RV530 had functional yields, but could not run at high speeds, while the RV515 and the C1 (the 90nm Xbox graphics chip) did not have any issues. ATI concedes it has lost the OEM designs (primarily Dell) to NVIDIA’s GeForce 7800 GTX for enthusiast desktop PCs for both the back-to-school and holiday season, but believes the retail and channel (add-in-board) markets for the R520 chip remain available (representing over 2/3rds of the enthusiast market). Both ATI and NVIDIA did not refresh their back-to-school product stack for the performance/mainstream/value segments, with ATI indicating it has kept a significant share of design wins awarded in the March to May timeframe, based on its ATI X700, X600, X550, and X300 (competing against NVIDIA’s GeForce 6200 and 6600). In terms of performance, ATI believes the R520 should exceed the GeForce 7800 GTX in benchmark tests if it can get the proper clock speed, but recognizes that NVIDIA has some headroom to overclock the GeForce 7800 clock speeds. We do not expect ATI to launch its R580 (speculated to have 32 pixel pipelines) in C2005 (ATI does not want to stall the channel for the R520), and expect a refresh of the R500 family beginning in spring 2006 with RV560, followed by RV540 and RV505. We expect the R600 (DirectX 10, targeting Microsoft Vista operating system and WGF 2.0, the next generation graphics library) in Q4/F06 or Q1/F07.
2. Strong Integrated Graphics Chipsets Growth, But Gross Margins (Desktop and Mobile Combined) to Remain in the Low-Teens Range in Q4 (Aug): ATI is guiding for its integrated graphics chipset business (desktop and mobile) to represent 15% to 20% of revenue in Q4, up from our estimated 11% in Q3. The corresponding gross margins will remain in the 11% to 15% range in Q4, with desktop chipsets margins of approximately 7% and mobile in the mid-teens range. Top line desktop chipset growth is being driven by both the AMD and Intel platforms. ATI contends that half of all AMD processor shipments now ship with ATI’s integrated chipsets, and indicates it has been bidding successfully for design wins against NVIDIA’s upcoming integrated graphics chipset for the AMD64 (K8) desktop market, codenamed C51, for the last six months (C51 launch date is set for late Sept.). We believe Intel’s decision to leave the low-end (sub-$20) desktop chipset market for roughly the next three quarters, as it focuses its capacity on the mobile chipset and handheld/smartphone market, should translate into Intel platform-based integrated chipset growth for both ATI and SiS. ATI is targeting its desktop integrated chipset volume to reach two to three million units per quarter in the next few quarters. ATI expects its integrated chipset gross margins (desktop and mobile combined) to drive towards the 25%-plus range with its next generation chipsets in Spring 2006. Chipset gross margin improvements are expected to be driven by shrinking the die size (from 0.13u to 0.11u), improving the test yields, and reducing the package costs (50% of the chipset cost is substrate packaging). ATI will focus on the $16 to $20 chipset segment, conceding the $22 to $30 chipset segment to Intel, and ATI may move down market to the $12 to $15 chipset segment targeted by VIA and SiS. The single-digit gross margins associated with ATI’s current desktop chipsets is a result of ATI having to lower its chipset pricing from the initial $25 price target (OEM customers desired a $16 to $20 chipset with equivalent graphics performance to Intel, not a $25 chipset with 2x the graphics performance of Intel’s offering). ATI’s high-end CrossFire chipset is expected to ship in volume in early September and contribute positively to gross margins.
3. Inventory Level to Remain Above Target in Q4 and Writedown Risk Remains in Our View: ATI’s Q3 (May) inventory ballooned to $456 million, up $89 million sequentially and representing 100 days of inventory, with 2/3rds of the PC segment inventory consisting of PCI Express versus 1/3 AGP. ATI contends the AGP-based inventory is not materially at risk, given the demand for these value and mainstream parts (e.g., RADEON 9200 and RADEON 9600). Q4 inventory is expected to drop to the low-$400 million range, but still above ATI’s target of having inventory represent roughly 50% of forward revenue guidance (ATI’s inventory turnover target is 70 to 75 days, considering the current substrate shortage situation which is anticipated to last for the next six months). ATI had underestimated the channel demand for nine consecutive quarters, and decided to add two weeks of supply buffer to its inventory in Q2/Q3, increasing to 10 weeks from 8 weeks, but suffered a slowdown in demand and a slight decrease in channel market share to the mid-30% level. In addition, half of the inventory bloat was due to ATI underestimating the yields on its wafer by a factor of roughly 40% (i.e., the wafers yielded 40% more die than expected), further compounding its inventory glut (under ATI’s die buy model, ATI purchases on a per-die as opposed to per-wafer basis, implying that it has secured the price per die based on theoretical yields from the fab, and has committed to purchase the entire wafer no matter what the yield). ATI is not planning for an inventory writedown, arguing its AGP and PCI Express inventory is not obsolete, but cautions that a fast ramp of the new R500 family should put pricing pressure on the existing generation of products (we do not rule out the possibility of an inventory writedown). Justification of Target Price: ATI trades at 25x our C2005E EPS of $0.48 and 14x our C2006E EPS of $0.85, which compares to NVIDIA at 20x and 16x, and Intel trading at 18x and 16x. We believe ATI’s operational issues (desktop product launch delays and gross margin weakness) justify a relatively discounted target multiple of 15x our C2006E EPS, deriving a target price of $12.75/C$15.50. Key Risks to Target Price: Risks include valuation multiple contraction in the semiconductor industry; a slowdown in PC sales; competition from NVIDIA and Intel; inability to secure PCI Express design wins; timing of the Microsoft Xbox 360 and Nintendo Revolution game console launches, unexpected delays in shipping new products; and the outstanding OSC hearing involving ATI’s Chairman.
