Month: July 2023

Microsoft FYQ4: Cooling Off Before AI Heats Up

Posted on by io-fund

Let’s be real, the Nasdaq has rallied more than it has in its 52-year history off fairly unimpressive top line growth in the tech industry and minimal to no earnings growth.

Although fellow growth investors have greatly benefited, we shouldn’t be surprised if the buying is exhausted at the moment. The reaction to Microsoft’s earnings is a clue that this could be the case.

Microsoft was in line for this quarter. However, the guide was a tad weak at $52.3 billion compared to $54.5 billion. It’s also important to note that estimates had been coming down going into the ER. We had consensus of $54.9 billion a month ago.

The operating margin of 43.3% is expected to be flat moving forward, which is good news for AI chip investors such as ourselves, because some of the capex is going toward data center buildouts and outsized AI demand. Also, Microsoft has a strong margin right now so flat is certainly acceptable. Part of Microsoft’s strong margins comes from extending the useful life of their servers and equipment, which we’ve covered in the past. 

Psychologically, Azure dipping below Google Cloud revenue growth rate for the first time is not ideal. The reality is that Azure is growing at a similar growth rate on a much higher revenue base, but headlines will take hold of these oversimplified percentages. Within Azure, AI contributed 2% and management stated this is the number to watch moving forward. Regardless, if optimizations end and we see recurring software from AI kick-in, we should see Azure bottom and accelerate in growth in calendar year H1 2024. This is key for MSFT investors. Reference more notes below.

Copilot 365 is among the top reasons to remain invested in Microsoft. For $30/per user per month, enterprises can increase developer productivity by 40% to 50%. It sounded like this will be in general availability by FYH1 with results showing in FYH2 (which is calendar year H1 2024). Having deep pockets to acquire GitHub, and then rolling-out CoPilot 365 is an example of AI being a winner-takes-all market; which is that these acquisitions were carefully placed years ago.

Similar to our note on Google last night, Microsoft’s capex comments spell good things for our particular holdings in the semi-industry. With this level of exposure, these comments are arguably more important for IOF Members than Microsoft’s individual results. The market will go up (and down), but as long as capex increases, we should be in good shape with our current holdings.

There are additional questions from analysts noted below about when optimization will potentially end, when Azure will increase its growth rate, and when AI will start to affect revenue. All of these are important to note, and the pertinent Q&A is highlighted for you below.

Scorecard:

Figures are for FYQ4 ending in June and year-over-year, unless otherwise stated:

Revenue and EPS:

  • Consensus earnings of $2.54 versus $2.70 EPS Reported
  • Midpoint guidance of $55.35B (+7 y/y) and Consensus of $55.42B versus $56.2B Reported
  • FY24 Q1 consensus of $54.53B versus FY24 Q1 Guidance of $54.250B

Microsoft sales guidance by division 

  • Azure & other cloud – +26-27% y/y in constant currency, includes about 1% from AI services versus 26% Reported and 2% from AI Services
  • Productivity & Business Processes – $17.8B to $18.28B, +8.7% midpoint. CC guidance is 10% to 12% versus $18.3B up 10% and 12% on CC Basis
  • Intelligent Cloud – $23.6B to $23.9B up 13.6% midpoint, CC guidance is 15-16% versus $24 billion, up 15% and 17% on CC Basis
  • Personal Computing – $13.35B to 13.75B, (-5.6%) y/y at midpoint versus $13.9 billion (-4%) and (-3%) on CC Basis.

Margins

  • Q4FY23 MSFT gross margin of guidance of 69.5% vs Q323 of 69.5% actual vs Q223 of 67% actual versus 70.1% Reported
  • Q4FY23 MSFT operating margin of guidance of 42.1% vs Q323 of 42.3% actual vs Q223 of 41% actual versus 43.3% reported 

Cash flow + Cash 

  • Q3FY23 operating and free cash flow was $24.5B and $17.8B respectively versus $28.7B and $19.8B
  • Q3FY23 cash stood at $104B and $48B in debt versus $111.3B in cash

Earnings Call:

The number 1 question is this — when will Microsoft begin to realize strong growth from AI? Given AI has been the primary driver in this historic Nasdaq rally, we want to make darn sure there is AI revenue on the way (and soonish). I think some investors are going to get burned by piling AI stocks far too early, for example. But for Microsoft, we are a mere 9-12 months out. I’m including the quote below because this analyst is unfiltered in terms of how exciting the modeling can become:

Karl Keirstead

Okay, great. Amy, if I could double-click a little bit on the exciting news around M365 Copilot as everybody on the line looks to layer that opportunity into our models, I just wanted to get your views. Are there any guardrails you'd offer us to sort of keep us in line? Is there a degree of gross margin pressure in the Office segment? In other words, is it a fairly cost-intensive new product that we should keep in mind? And also, could it pull along Azure in the sense that you need Azure AD and perhaps some of the other cybersecurity products? So a little color there might help everybody with their modeling exercise tonight and in the coming weeks.

Amy Hood

Thanks, Karl. I think maybe I'll first start with the process we have when we release new products. And I absolutely understand we are excited, too, by the demand signal, the customer reaction, really the requests we're getting to be in the paid preview. It's all encouraging. As you know, we've — last week, we announced pricing, then we'll continue to work through the paid preview process get good feedback. Then we'll announce the general availability date, then we'll get to the GA date. Then we'll, of course, be able to sell it and then recognize revenue.

And that is why I continue to say that I am just as excited as everyone else about this, and it should be more H2 weighted. And we've, I think, given you some sizing opportunities. And I think I would use all that. But I do think this is really about pacing. And of course, we've still got to get our Security Copilot and some of the Dynamics workloads priced and released. And we'll continue to work toward that.

My note: this is calendar H2, so within 9-12 months, we should have a decent start on what AI can do for Microsoft on recurring software.

This is a brief comment on when cloud optimizations will end—which should be the perfect storm if we can get cloud to resume growth and then AI layered on top: “I think, in the next couple of quarters, what is the last catch-up optimization.” My note: I imagine this also means 9-12 months out.

Similar to Google, the comments on capex were bullish:

“To support our Microsoft Cloud growth and demand for our AI platform, we will accelerate investment in our cloud infrastructure. We expect capital expenditures to increase sequentially each quarter through the year as we scale to meet demand signals.”

Later, it was also stated: 

“And we do expect, as you asked and Satya talked about, the pace of this adoption curve, we do expect to be faster. So you're seeing the CapEx spend accelerate in Q4 and then again in Q1, and we've talked about what it should look like the rest of the year” and then also: “So it's why I do comment quite often that it's both overall Commercial Cloud demand and building out capacity for AI. It's both.” My note: That’s bullish for AMD, as well, in terms of CPUs.

The CEO also stated this, which I think is interesting for our particular holdings, which is that the rate of investment is higher than the Cloud growth rate right now. “Yes. And I think just for perspective, I think it's sort of always good to think about it, right, where we have, what, 111 [billion] commercial cloud business growing at, what, 22% year-over-year. And then you had a CapEx growth, which is around the same number, 23%, 24%. So in some sense, it's sort of replacement capital plus some new capital that is going to drive new growth.” My note: keep it coming on the capex! ☺

Lastly, Microsoft expressed they believe they are the best data platform on the market. Of course, this is biased but I want to earmark this for as we go along because the argument the CEO is making is important:

“I mean to give you a flavor for it, right, so you have your data in an Azure data lake. You can bring SQL Compute to it. You can bring Spark to it. You can bring Azure AI or Azure OpenAI to it, right? So the fact is you have storage separated from all these compute meters, and they're all interchangeable, right? So you don't have to buy each of these separately. That's the disruptive business model.”

Conclusion:

I chose to cover Google quickly last night because Microsoft (as always) came in as-expected. This is not a dramatic stock to own, rather is a good choice for those who prefer their drama comes elsewhere, and outside of their pocketbook. 

The Nasdaq is due for a breather and I’m kinda hoping for a selloff so we can load up at lower prices in the Fall and Winter. Amy Hood has archery-like skills when she provides guidance – she hits the bullseye on her numbers frequently. Because it’s coming from her, I have it written in ink to expect AI revenue to appear in calendar H1 of 2024. The remaining question of how to best position (and when) will be answered through Knox’s notes and trade alerts on Advanced Market Signals. 

  Recommended Readings:

Alphabet Q2 Earnings: More on the Year of Execution

Posted on by io-fund

Alphabet impressed on the top line with revenue of $74.6 billion compared to estimates of $72.7 billion. This resulted in growth of 7%, or 9% on a constant currency basis, compared to 4% expected.   What is important to note is that Alphabet is rebounding on margins and has now returned to the percentage they were at in Q1 2022.

This is important because margins had contracted about 500 basis points at their trough with a 23.9% operating margin in Q4 and have now returned to a 29% operating margin. This is a QoQ increase of 400 basis points. Operating profit of $21.8 billion matches Q4 of 2021 for record operating income. Cash flow margin was also up 440 basis points.

In our pre-earnings write-up, we highlighted that Alphabet was in the Year of Execution when we said: “One of the reasons the IO Fund has invested in larger cap stocks is that they are in a better position to navigate downturns. Big Tech also has more levers to pull to manage margins such as reducing operating expenses. Importantly, at the same time they have the financial strength to make the investments required to capitalize on the AI opportunity and take market from its weaker competitors. The medium-term bull case is that once top-line begins to meaningfully reaccelerate, the combination of right-sizing costs and efficiencies garnered from technology investments leads to expanding margins.”

Also, per our pre-earnings write-up, the CFO has said in the past they are in “Execution mode” in reducing costs and this will be evident not only in 2023 but “you will see more of it in ‘24.” 

Management comments on the QoQ strength in margins were: “A quick comment on the sequential improvement in operating margins in the second quarter. There are two factors to note. First, the benefit from an acceleration in search advertising revenue growth in the second quarter. Second, the vast majority of the charges related to our workforce reduction and optimization of our global office space were taken in Q1.”

Another highlight we were looking for, per the pre-earnings write-up, was stabilization in YouTube and increased growth in Search revenue. Both materialized with Search up 5% and YouTube up 4%. These numbers are small for growth investors such as ourselves, but they also represent the strongest growth Google has reported in a year. We entered our current position with the idea that  Google has bottomed and will accelerate from here. 

Network advertising was weak at (-5.7%) but this is to be expected as mobile identifiers continue be sorted out and first-party data driven ads are more favored. Other revenues was a bright spot, up 24% and driven by “significant subscriber growth” for YouTube subscriptions plus the Pixel 7A.

Google Cloud was “better than peers” at 27.4% growth for an operating margin of 5%. The operating margin is double what it was last quarter, which was the first quarter to turn a profit. This is a positive on the evening of Microsoft’s report as Azure dipped below Google Cloud’s growth rate at 26%.

The CFO is moving to the new role of President and Chief Investment Officer.

Scorecard:

Stated in YoY growth % unless otherwise stated:

EPS and Revenue:

  • Consensus of $1.34 (+11% y/y) vs $1.45 EPS Reported
  • Consensus of $72.75B (+4.4% y/y) vs $74.6 billion Reported and 7% growth/9% on CC Basis 

Sales by division in Q123 versus Q223:

  • Google Search and other advertising – 2% versus 5% Q2
  • YouTube advertising  – (-3%) versus 4% Q2 
  • Network advertising – (-8%) versus (-5.7%) Q2 
  • Other – +9% versus 24.2% in Q2
  • Google Cloud – +28% versus 27.4% in Q2

Margins: 

  • Q1FY23 gross margin of 56.1%% vs Q422 of 53.5% vs Q323 of 54.9% versus Gross Margin of 57.20% in Q2
  • Q1FY23 operating margin of 25% vs Q422 of 23.9% vs Q322 of 24.6% versus Operating Margin of 29% in Q2

Cash flow + Cash:

  • Q1FY23 operating and free cash flow was $23.5B and $17.2B for a margin of 33.7% and 24.7%, respectively versus 38.40% op cash flow and 29.10% FCF in current quarter

Earnings Call:

Perhaps the most important question is why did Google grow this quarter when other ad-tech players are slowing down (or expected to slow down).

The answer was: “a lot of companies are focused on profitability, driving efficiencies, and they're carefully evaluating the effectiveness of their budgets. And our goal is really to help them maximize efficiency and drive strong ROI. And I think we have the proven AI-powered tools and solutions to actually do it. I called out Search and Other revenues being led by solid growth in the retail vertical. We talked about the DR and brand side on the YouTube side. I think those are the key points I would make.”

There were the obligatory questions about AI, of which this is probably the most important quote:

“It is an exciting moment overall in Cloud because there is definitely a lot of interest from customers on AI, and they definitely are engaging in many more conversations with us. So I would say, without commenting on the short term, but when I think about it long term, I view the AI opportunity as expanding our total addressable market and allows us to win new customers. Scale of investments that we can directly bring to cloud now. As I said earlier, we have over 80 models across Vertex, Enterprise Search and Conversational AI, and we are taking all of them, translating it into deep industry solutions. So, I'm excited about it. Second, it gives us an opportunity to upsell and cross-sell into our installed base.”

As Nvidia, AMD and Marvell investors (as a proxy), we want to keep an eye on capex. The comments were quite bullish in that regard:

“[..] that's why we wanted to be really clear that we do expect elevated levels of investment in our technical infrastructure, and that would be increasing through the back half of 2023, consistent with the comments we've made previously that we expected 2023 to be higher given the slower start at the front half of the year and then continuing to grow into 2024 [..] And the primary driver of this, as you know well, is to support the opportunities we see in AI across the Company, including the investments that we've already talked about, proprietary TPUs, all that we're doing with GPUs as well as data center capacity. And as we continue to see the pace of innovation accelerate, we just want to make sure we're positioned to address the opportunity across Alphabet.”

Conclusion:

We write out a lengthy and thorough pre-earnings report so our Members are aware of what to look for, and what in our eyes constitutes a strong report (or a weak report). It also helps us to eliminate biases. If a company isn’t up to par on the criteria we objectively set forth prior to the call, then we have to trim. Or, if a company clears a bar we set, then we look to add.

Suffice to say, Google has cleared the bar we set forth for our Members on Monday. You can look for us to add to this position soon.

Recommended Readings:

Microsoft Q4FY23 Pre-ER: Looking to build AI momentum into FY24

Posted on by io-fund

We recently wrote about Microsoft’s $100B revenue opportunity in AI and the potential valuation impact of its strategic AI initiatives that go beyond traditional valuation metrics. One approach treated the opportunity as a separate business unit aka Microsoft AI. Using conservative margin assumptions under this approach, we estimated that MSFT AI could earn $4-5 in eps and our bull case price of MSFT + MSFT AI is about $485 (+40%).

As you know, we are incredibly bullish on AI and these are starting points, not ending points. Specifically for Microsoft, we stated that it’s enterprise customer base would propel the company forward as an AI leader because enterprises are the perfect customer for AI. This is because enterprises can drive down costs and increase productivity for immediate ROI whereas consumers may be slower to adopt AI and/or see how it benefits them directly. The ability to directly monetize enterprise customers with AI features faster than peers is materializing with the $30/month CoPilot 365 plan.

MSFT is just beginning to incorporate AI into its core offerings – starting with Microsoft Bing Chat enterprise and Microsoft Co-Pilot 365 – which by its own estimates AI will only contribute 1% to its Azure division in q4. For example, based on an analysis done by Macquarie bank, AI could add $14B to sales in its first full year. 

We anticipate that MSFT will build upon its momentum from Q3 into Q4FY23. Meanwhile, 1hFY24 comps will also be supportive. MSFT’S commentary on the AI potential across its businesses in FY24 will be a clear, key focus. The upcoming quarters will be important to follow the growth and stability in Azure, Productivity and Intelligent Cloud businesses, as well, while looking for signs of the bottom in the Personal Computing division.

Fundamentally, we will monitor the impact on revenues and over time the margin impact on these units.

Here are the Q4 estimates going into earnings announcement on 7/25 (amc).

EPS

  • Q4FY23 consensus earnings of $2.54
  • Q1FY24 consensus of $2.60

Group Sales

  • Q4FY23 MSFT midpoint guidance of $55.35B (+7 y/y) vs Consensus of $55.42B
  • Q1FY24 consensus of $54.9 – we will want commentary on FY2024 in the call, not sure if CFO will provide as recently MSFT has pulled full year guidance given uncertainty in PCs

Microsoft sales guidance by division

  • Azure & other cloud – +26-27% y/y in constant currency, includes about 1% from AI services
  • Productivity & Business Processes – $17.8B to $18.28B, +8.7 y/y at the midpoint. CC guidance is 10% to 12% 
  • Intelligent Cloud – $23.6B to $23.9B up 13.6% y/y at the midpoint, CC guidance is 15-16%
  • Personal Computing – $13.35B to 13.75B, (-5.6%) y/y at midpoint

Margins

  • Q4FY23 MSFT gross margin of guidance of 69.5% vs Q323 of 69.5% actual vs Q223 of 67% actual
  • Q4FY23 MSFT operating margin of guidance of 42.1% vs Q323 of 42.3% actual vs Q223 of 41% actual

Cash flow + Cash

  • Q3FY23 operating and free cash flow was $24.5B and $17.8B for a margin of 46% and 34%, respectively
  • Q3FY23 cash stood at $104B and $48B in debt

Here are the things we’ll be looking for:

  • Microsoft Bing Chat and Microsoft Co-Pilot 365 – further insights into AI products, how it expects to impact sales, how it may evolve and the “domino” effect it may have on its other businesses
  • Big Tech has prioritized higher ROI capex (i.e., AI infrastructure) in 2023 calendar year. Analysts may ask CFO about FY2024 capex.
  • FY24 and Q124 guidance – MSFT will likely provide qualitative 2024 FY and financial Q1FY24 guidance. Meanwhile consensus is estimating a decline in sales in q4/q1. Anything better will be viewed positively. Consensus is forecasting FY2024 sales and eps growth 11.8% and 14.2%, respectively. Neither of which appear to be demanding given the underlying secular demand drivers.
  • FY2024 profitability outlook – In FY2023, MSFT pulled several levers to manage its margins from corporate restructurings to accounting change to equipment useful life. We will look for the key drivers that will drive FY2024 margins.  
  • Azure and cloud competitive dynamics and growth – is MSFT taking market share in its Azure cloud related businesses and what is the growth outlook. Plus, comments on the overall corporate IT spending environment.
  • Current PC environment, the channel inventory situation and if it’s closer to the bottom. Macro and how it’s impacting its consumer related businesses
  • Update on Activision merger – recently Microsoft and Activision Blizzard jointly agreed to extend the merger agreement deadline from July 18, 2023, to October 18, 2023, to allow for additional time to resolve remaining regulatory concerns.

Here’s what analysts are saying

Stifel raised the firm's price target on Microsoft to $380 from $320 and keeps a Buy rating on the shares. The firm believes Azure should post "solid upside" to management's 26%-27% year-over-year constant currency growth guidance given strong enterprise checks, management's commentary that implied optimization activity should begin to abate as customers lap initial efforts and the firm's expectation of greater than expected AI contribution. The firm expects new Cloud project go-live growth to stabilize as customer's return to reinvesting into cloud migrations

Citi raised the firm's price target on Microsoft to $425 from $340 and keeps a Buy rating on the shares. The analyst remains positive on the shares into the company's fiscal Q4 results. Citi's reseller survey shows improving target achievement levels and an expected acceleration in growth into fiscal 2024, the analyst tells investors in a research note. To reflect signs of improving channel partner inputs and generative artificial intelligence tailwinds, the firm raised estimates "more substantially" across Office 365 Commercial and Azure.

Mizuho analyst Gregg Moskowitz raised the firm's price target on Microsoft to $420 from $390 and keeps a Buy rating on the shares. The big news from day one of Microsoft Inspire came in the form of a $30 per user per month add-on for Microsoft 365 Copilot, the analyst tells investors in a research note. The firm estimates the cumulative incremental revenue from Microsoft 365 Copilot by the end of fiscal 2025 could exceed $9B using a 20% attach rate, and approach $19B using a 40% attach rate. It remains confident that Microsoft's growth opportunities over the medium term and beyond are "greater than many realize."

JPMorgan raised the firm's price target on Microsoft to $385 from $350 and keeps an Overweight rating on the shares. The analyst left the company's Inspire conference "incrementally positive" on its category leadership in artificial intelligence. The announced M365 Copilot pricing of $30 per user per month is an "upside shocker" versus investor expectations closer to $10, the analyst tells investors in a research note. The price point aligns with the perspective that Copilots are far exceeding expectations in the private preview stage

BofA analyst Brad Sills raised the firm's price target on Microsoft to $405 from $340 and keeps a Buy rating on the shares. BofA expects Microsoft to report "healthy 1% upside" to the firm's Q4 revenue estimate of $55.45B, based on Azure and O365 strength. The firm also expects upside to its Azure estimate of 27% year-over-year constant currency growth due to better AI/ML workloads and baseline migration strength, the analyst tells investors in an earnings preview note. BofA forecasts double digit constant currency FY24 revenue growth guidance, assuming "conservative" low 20s percentage Azure growth, low/mid-teens O365 growth and Windows OEM growth of 2%.

Bernstein analyst Mark Moerdler notes that Microsoft announced Bing Chat Enterprise and Microsoft 365 Copilot pricing earlier, which is higher than the firm expected, at $30 per user per month for Microsoft 365 E3, E5, Business Standard, and Business Premium editions. This is a price uplift of 53% to 240%, to list price of these SKUs, depending on what Microsoft 365 edition being used. The price lift is similar to that of Microsoft GitHub Copilot. It is important to note that this announcement is only for Microsoft 365 and not Office 365, Bernstein notes. While Microsoft offers Office 365, their go-to-market focus has been in driving the Microsoft 365 bundle, Bernstein has an Outperform rating and a price target of $380.

The I/O Fund Analyst Team contributed to this analysis

Recommended Readings:

Google Q2 2023 – Year of Execution

Posted on by io-fund

As the women’s world cup commences, perhaps it’s apropos that both Microsoft and Google will report on 7/25 (amc). It will be a Big Tech “battle” of who can generate the most excitement on the AI opportunity and how that may impact their businesses in the future.

Given its cyclical exposure to advertising, Google’s valuation declined until it bottomed in early 2023, and has since increased due to the resilience of Search and optimism that AI will help strengthen it. Meanwhile,  there are hopes that YouTube and the Network advertising businesses will stabilize. An aggressive focus on the stabilizing costs was another catalyst.

We recently initiated a position and we’ll discuss a few things we’ll be looking for in order to add to the position.

Here are the Q2FY23 estimates going into earnings announcement on 7/25 (amc).

EPS

  • Q2FY23 consensus earnings of vs $1.34 (+11% y/y) vs Q123 $1.17 actual
  • Q3FY23 consensus of $1.34

Group Sales

  • Q2FY23 consensus of $72.75B (+4.4% y/y)
  • Q3FY23 consensus of $74.3B

Sales by division in Q123

  • Google Search and other advertising  – $40.4B, +2% y/y
  • YouTube advertising  – $6.7B (-3%) y/y  
  • Network advertising – $7.5B (-8%) y/y
  • Other – $7.4B +9% y/y
  • Google Cloud – $7.5B, +28% y/y

Margins –

  • Q1FY23 gross margin of 56.1%% vs Q422 of 53.5% vs Q323 of 54.9%
  • Q1FY23 operating margin of 25% vs Q422 of 23.9% vs Q322 of 24.6%

Cash flow + Cash

  • Q1FY23 operating and free cash flow was $23.5B and $17.2B for a margin of 33.7% and 24.7%, respectively
  • Q1FY23 cash stood at $115B and $14B in debt

One of the reasons the IO Fund has invested in larger cap stocks is that they are in a better position to navigate downturns. Big Tech also has more levers to pull to manage margins such as reducing operating expenses. Importantly, at the same time they have the financial strength to make the investments required to capitalize on the AI opportunity and take market from its weaker competitors. The medium term bull case is that once top-line begins to meaningfully reaccelerate, the combination of right-sizing costs and efficiencies garnered from technology investments leads to expanding margins. 

In Q123, this is how Ruth Porat, Google CFO, characterized the impact of focusing on opex that began in late 2022.

Question

“And then, Ruth, backing out the one-time charges, it looks like OpEx growth is now 8%, so real progress there. Could you give us a flavor of where you are, you think in your optimization cycle?”

Ruth Porat

“We remain extremely focused on these various work streams that we have talked about. It starts with the pace of hiring. It goes to the various work streams that both Sundar and I referenced around using AI and automation to improve productivity, all that we are doing with suppliers and vendors to be as efficient as possible, all that we are doing around optimizing how and where we work. You have seen some of those announcements this quarter beyond the workforce reduction, things that we are doing in, for example, office services, and we are executing against each of these various work streams. So, our view is that there is more to do. And as we try to be clear, we are in execution mode. You will see some of the benefit in ‘23. You will see more of it in ‘24, and we are going to continue building against it beyond.”

Meta has described 2023 as the Year of Efficiency. We’ll refer to Google’s 2023 as the Year of Execution.

Here are the things we’ll be looking for:

  • Google AI integration and impact across its business – This year Google introduced its chatbot BARD. Organizations are using large language models integrated within Google’s Search, Cloud, Workspace and Cybersecurity platforms.

    To improve targeting in Core Search, Google has updated search keyword relevance using the latest natural language processing from MUM models to improve the relevance and performance of shown ads. Smart Bidding uses machine learning tools to optimize the bid of the advertisers. ML tools can analyze millions of data signals and can better predict future ad conversions.

    We wrote about the potential impact AI may have here.
    here.

  • Google Search – Q1 results demonstrated the resilience of search with its unique ability to surface demand and deliver measurable ROI. We will look for signs of accelerating growth.
  • YouTube – look for continued signs of stabilization in its advertising exposed businesses and growth in its subscription based services. This is how Ruth Porat described it:

    “YouTube, we saw signs of stabilization in ad spend on a sequential basis.”

  • Network advertising – look for signs of stabilization and improvement. According to the CFO, investors can expect YouTube to be somewhat stabilized whereas Network is still decelerating: “And I would contrast that last quarter, we talked about both a pullback in YouTube and Network, and we were pleased that we saw the stabilization in ad spend on a sequential basis in YouTube. We still saw an ongoing pullback in Network, which tends to be a mix of businesses, as you know well.”
  • Continued momentum in its Cloud business – for the first time Google had an operating profit in its cloud division. Q123 operating margins were 2.6% and represented 11% of sales. This is how Ruth Porat described it (which is bullish for AI accelerators from NVDA and potentially AMD and MRVL in the future):

    “At the same time, I think at the core of your question, and what we were trying to convey is we will continue to invest to support long-term growth, in particular, given the opportunities we see delivering AI capabilities to our customers.”

    However, the 28% growth rate may not be the bottom for Google Cloud:

    “That being said, in Q1, we continued to see slower growth of consumption as customers optimized GCP costs reflecting the macro backdrop, which remains uncertain. In terms of operating performance, we remain focused on driving long-term profitable growth in Cloud, while continuing to invest given the substantial opportunity.”

  • Capex outlook for FY 2023 – in Q1 Google raised their capex outlook and stated:

    “Finally, as it relates to CapEx, for 2023, we now expect total CapEx to be modestly higher than in 2022. As discussed last quarter, CapEx this year will include a meaningful increase in technical infrastructure versus a decline in office facilities.”

    This was reiterated later: “And then as we talked about last quarter, the increase in CapEx for the full year 2023 reflects the sizable increase in technical infrastructure investment, on the flip side, a decline in office facilities relative to last year.”

  • FY2023 profitability and beyond – Now that Google is half way through their Year of Execution, we will look for any indications on this how may improve profitability once Network and YouTube advertising begin to improve.
  • September 2023 anti-trust trial – We don’t expect anything from the call but wanted to remind our Members as that date is fast approaching. We wrote about the possible ramifications here.

Here’s what analysts are saying:

Stifel raised the firm's price target on Alphabet to $135 from $130 and keeps a Buy rating on the shares ahead of the company's upcoming earnings report. The firm is "slightly" revising higher its digital advertising growth forecasts for 2023 and 2024, though it is only expecting "slightly better results" for ad-based names relative to the top-line outperformance witnessed in Q1 

BofA raised the firm's price target on Alphabet to $142 from $128 and keeps a Buy rating on the shares ahead of the company's Q2 report due on July 25. BofA forecasts revenue and GAAP EPS at $60.7B and $1.42 versus the Street at $60.4B and $1.34, respectively. The firm is constructive on stable search share trends, which it thinks will enable Google to control the pace of large language model integration

Jefferies said the firm's checks indicate overall higher ad spend growth in Q2 for larger platforms after a cautious start to the year due to economic uncertainties and core Google search holding up, "albeit still at muted growth rates." Alphabet is up 41% year-to-date and the firm notes higher expectations, but argues the valuation is "still low" and it believes the stock "could work" into the second half thanks to improved ad checks in Q2 and the advertiser outlook for the second half. The firm, which expects a beat from Alphabet and has a $150 price target on the shares. 

KeyBanc analyst Justin Patterson raised the firm's price target on Alphabet to $140 from $122 and keeps an Overweight rating on the shares ahead of quarterly results. The firm believes Q2 is largely improved and growth should re-accelerate. In its conversations, investors perceive Alphabet as a "grind higher" stock given there is likely more limited upside to revenue from Search's vertical exposures and a theoretical ceiling on the multiple due to AI risk. That said, most investors acknowledge Street EPS forecasts appear conservative and that re-accelerating revenue growth provides some near-term reasons for optimism 

Credit Suisse analyst Stephen Ju raised the firm's price target on Alphabet to $150 from $135 and keeps an Outperform rating on the shares ahead of quarterly results. Conservatively assuming ongoing headwinds in 2024 and normalization in 2025, the takeaway for Alphabet's shares is that even leaving upside potential from improving monetization potential for YouTube, Maps, and other non-Search surfaces off the table, the firm arrives at a positive investment conclusion. Switching focus to the more near-term, Credit Suisse's checks suggest an acceleration of year-over-year Search budget growth for Q2, as would be expected given easing comparisons. As for YouTube, the firm has received improving advertiser feedback quarter-over-quarter of increasing ad budgets, as CPG vertical spend recovers coinciding with what looks to be increasing ad loads.

Jefferies said the firm's checks indicate overall higher ad spend growth in Q2 for larger platforms after a cautious start to the year due to economic uncertainties and core Google search holding up, "albeit still at muted growth rates." Alphabet is up 41% year-to-date and the firm notes higher expectations, but argues the valuation is "still low" and it believes the stock "could work" into the second half thanks to improved ad checks in Q2 and the advertiser outlook for the second half. The firm, which expects a beat from Alphabet, maintains a Buy rating and $150 price target on the shares.

The I/O Fund Analyst Team contributed to this analysis

Recommended Readings:

Tesla Q2 Earnings – It’s About Margins

Posted on by io-fund

This article was originally published on Forbes on Forbes Forbes on Jul 21, 2023,08:15am EDT

After the strong rally, it appears the market is taking profits on commentary around the outlook for margins. It’s not only that they were lower quarter-over-quarter (QoQ), but also Tesla provided zero insight as to how much lower margins can go. The market does not like uncertainty. It’s somewhat ironic that during the call Musk can wax poetic about the complexities of AI, neural net training, the 6-million dollar man, and robotic taxis yet when it comes to basic profitability drivers, he can’t say anything. The former drove the price post Q123 and the latter is driving the price today.

Did reported automotive gross margins bottom?

Likely not.

Telsa had a reported Q223 automotive gross margin of 19.2% vs Q123 of 21.10% vs Q422 of 25.90%. Meanwhile, Q223 group operating margins were of 9.6% vs Q123 of 11% vs Q422 of 16%.

Reported automotive gross margins and operating margins peaked in Q222 at 32.9% and 19.3% respectively. Since then, both have been steadily declining downward. The stock is weaker today because the market does not know where or when these two metrics will ultimately bottom.

Looking ahead, Tesla will continue to focus on volumes through lower prices and at the expense of margins. Here’s what Zachary Kirkhorn, CFO said:

“Second, we continue to work towards our goals of maximizing volumes on both, our vehicle and energy business, but most importantly, doing so in a way that generates the capital to continue our pace of R&D and capital investments. This requires a strong focus on per unit COGS reductions in each of our key businesses, as well as working capital improvements on raw materials, work in process inventory and customer AR, all of which progressed appropriately in Q2.

If we look specifically at our automotive business, our gross margin showed a modest reduction and remained healthy, despite action taken to further improve vehicle affordability early in the quarter. We recognized – we realized per unit cost improvements in nearly every category, including material cost and commodities, manufacturing costs and logistics”

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In response to a question on pricing, Tesla continues the point that the company is having to lower prices due to the higher interest rate environment

Question:

“How has the order intake trended relatively to production levels during Q2? And how has it trended in the quarter-to-date period? Conceptually, how does Tesla decide when is it appropriate to reduce prices or at other sales incentives to increase demand?”

Elon Musk

“[…] Buying a new car is a big decision for vast majority of people. So, any time there’s economic uncertainty, people generally pause on new car buying at least to see what happens. And then obviously, another challenge is the interest rate environment. As interest rates rise, the affordability of anything bought with debt decreases, so effectively increasing the price of the car.

So when interest rates rise dramatically, we actually have to reduce the price of the car because the interest payments increase the price of the car. And this is — at least up until recently, it was, I believe, the sharpest interest rate rise in history. So, we had to do something about that […]

When asked again about automotive margins, management did not provide a direct answer. For our purposes, we prefer management teams to answer directly as it increases uncertainty to not provide visibility into contracting margins.

Question:

“With the emphasis of price cuts to drive volume growth eating into automotive gross margin, can investors expect to see automotive gross margin stabilize or even rise due to efficiencies outpacing the cuts? And if so, when?”

Elon Musk:

“Where’s that crystal ball, again? If I may, look, the short-term variances in gross margin and profitability really are minor relative to the long-term picture. Autonomy will make all of these numbers look silly.

Zachary Kirkhorn

“I fully agree with you. I mean, I think the only thing in the short term that matters is what I said in my opening remarks, which is are we generating enough money to continue to invest. And the portfolio of products and technologies that the technical teams are investing in right now, this is intense. It’s intense in terms of investment; it’s intense in terms of potential.”

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Conclusion:

The sentiment post Q223 isn’t much different than in Q123. As we all know, Tesla rallied after Q1. This time around, given the stock is at higher levels, there may be less AI sentiment to support it in the short term. Q3 won’t be a catalyst and analysts will likely reduce numbers.

While many will argue that Tesla is one of the most advanced AI companies in the world, my response is “sure” but Tesla is also heavily exposed to consumer spending — and this is entirely out of their control. The comment on interest rates is the most important comment from the call as high interest rates mean Tesla must lower prices. In a way, management is agreeing that quite a bit about the current situation is out of management’s control. While some will talk about recurring software revenue from robotaxis as the most important catalyst, the harsh reality is that the FED lowering rates is the most important catalyst for Tesla today. That may not be as exciting as AI, but Tesla is one of many tech stocks whose revenue growth and profitability is on borrowed time until the Fed instills a more dovish policy.

The I/O Fund Analyst Team contributed to this analysis.

Recommended Readings:

Tesla Q2 2023 Earnings – It’s About Margins

Posted on by io-fund

After the strong rally, it appears the market is taking profits on commentary around the outlook for margins. It’s not only that they were lower q/q, but also Tesla provided zero insight as to how much lower margins can go. The market does not like uncertainty. It’s somewhat ironic that during the call Musk can wax poetic about the complexities of AI, neural net training, the 6-million dollar man, and robotic taxis yet when it comes to basic profitability drivers, he can’t say anything. The former drove the price post Q123 and the latter is driving the price today.

Earnings estimates had been steadily reduced since Q123 so the hurdle to beat was not very high.

Revenue and EPS both beat in the current quarter:

  • Q2 revenue of $24.97B vs $24.6B consensus
  • Q2 adjusted of  $0.91 vs $0.85 consensus

Margins contracted, which you’ve likely heard by now:

  • Q223 gross margins of 18.2% vs Q123 of 19.3% vs Q422 of 23.8%  
  • Q223 reported automotive gross margin of 19.2% vs  Q123 of 21.10% vs Q422 of 25.90%   
  • Q223 opm of 9.6% vs Q123 of 11% vs Q422 of 16%

Cash Flow was strong:

  • Q223 operating cash flow of $3.1B vs Q123 of $2.5B
  • Q223 free cash flow of $1B vs Q123 of $441
  • Q223 cash of 23.1B vs Q123 of  $22.4B in cash

Production and deliveries are strong and in line with management’s FY guidance of 1.8 million electric vehicles:

  • Q123 produced 440,808k vehicles (+44%) and delivered 422,875 (+36%)
  • Q223, TSLA produced 479,700 vehicles (+83%) and delivered 466,140 (83%)

What were we watching for and what happened?

We outlined what we were watching for in this write-up here. Our portfolio criteria is sensitive to contracting margins. We stated the following: “After guiding to a minimum of gross automotive margins ex-credits of at least 20% in 2023 during their q422 call. Tesla did a 180 in q123 and said that they had decided to lower prices to sell more vehicles and sacrifice margins. We wrote about this about this here and here. In addition, Tesla signaled that automotive gross margins may continue to go lower in the short term. From a longer term perspective, this shift from a pricing to market share focus does have its strategic merits but TSLA has not communicated the profitability impact.”

Did reported automotive gross margins bottom?

Likely not. 

Telsa had a reported Q223 automotive gross margin of 19.2% vs Q123 of 21.10% vs Q422 of 25.90%. Meanwhile, Q223 group operating margins were of 9.6% vs Q123 of 11% vs Q422 of 16%.

Reported automotive gross margins and operating margins peaked in Q222 at 32.9% and 19.3% respectively.  Since then, both have been steadily declining downward. The stock is weaker today because the market does not know where or when these two metrics will ultimately bottom.

Looking ahead, Tesla will continue to focus on volumes through lower prices and at the expense of margins. Here’s what Zachary Kirkhorn, CFO said:

“Second, we continue to work towards our goals of maximizing volumes on both, our vehicle and energy business, but most importantly, doing so in a way that generates the capital to continue our pace of R&D and capital investments. This requires a strong focus on per unit COGS reductions in each of our key businesses, as well as working capital improvements on raw materials, work in process inventory and customer AR, all of which progressed appropriately in Q2.

If we look specifically at our automotive business, our gross margin showed a modest reduction and remained healthy, despite action taken to further improve vehicle affordability early in the quarter. We recognized – we realized per unit cost improvements in nearly every category, including material cost and commodities, manufacturing costs and logistics”

In response to a question on pricing, Tesla continues the point that the company is having to lower prices due to the higher interest rate environment

Question:

“How has the order intake trended relatively to production levels during Q2? And how has it trended in the quarter-to-date period? Conceptually, how does Tesla decide when is it appropriate to reduce prices or at other sales incentives to increase demand?”

Elon Musk

“[…] Buying a new car is a big decision for vast majority of people. So, any time there’s economic uncertainty, people generally pause on new car buying at least to see what happens. And then obviously, another challenge is the interest rate environment. As interest rates rise, the affordability of anything bought with debt decreases, so effectively increasing the price of the car.

So when interest rates rise dramatically, we actually have to reduce the price of the car because the interest payments increase the price of the car. And this is — at least up until recently, it was, I believe, the sharpest interest rate rise in history. So, we had to do something about that […]

When asked again about automotive margins, management did not provide a direct answer. For our purposes, we prefer management teams to answer directly as it increases uncertainty to not provide visibility into contracting margins. 

Question:

“With the emphasis of price cuts to drive volume growth eating into automotive gross margin, can investors expect to see automotive gross margin stabilize or even rise due to efficiencies outpacing the cuts? And if so, when?”

Elon Musk:

“Where’s that crystal ball, again? If I may, look, the short-term variances in gross margin and profitability really are minor relative to the long-term picture. Autonomy will make all of these numbers look silly.

Zachary Kirkhorn

“I fully agree with you. I mean, I think the only thing in the short term that matters is what I said in my opening remarks, which is are we generating enough money to continue to invest. And the portfolio of products and technologies that the technical teams are investing in right now, this is intense. It’s intense in terms of investment; it’s intense in terms of potential.”

Additionally, management discussed that there will be factory downtime related to upgrades. This will have a cost impact.

“As we look forward to the rest of the year, I want to reiterate Elon’s comments on Q3 volumes driven by planned downtimes for factory upgrades. These upgrades will also carry some amount of factory idle cost. However, we are working to minimize as much as possible.”

Our take:Our take:

If Tesla has a pricing strategy, they aren’t sharing it. The take-away is that Tesla will continue to lower prices to offset higher interest rates and focus on volume price over to take in cashflow. And Tesla will tell you that any short-term margin variability is not a big deal because the margins on autonomy will be much bigger in the future.

Taking this all together, we believe the reported automotive gross margins and operating margin will be lower in Q323 vs Q223. Consensus will likely reduce their estimates as well.

Did they benefit from the IRATC and lower commodity prices?

Yes, they did.

Question

“Could you quantify the benefits to COGS per unit from the IRA battery manufacturing incentives; and secondly, battery raw material declines year-to-date?”

Zachary Kirkhorn

“All right. I can take that. On the first part of the question for IRA manufacturing incentives, we provided previous guidance that we expect these to be for the course of this year in the range of $150 million to $250 million per quarter. […] Lithium is the most notable improvement so far. I think I commented on this on the last call, because typically, we see this coming about a quarter before it actually is realized in our financials. […] We’re also seeing benefits in aluminum and steel, which I think is great. Not as large as the lithium impacts, but they contribute nonetheless. So, if we add up the total impact of this in Q2 relative to prior quarter, it’s about the same size and magnitude as the IRA benefits that we also received.”

Our take:Our take:

Tesla has and will likely use these benefits as ammunition to lower prices.

Free Cash Flow and Inventory Improved

Q223 free cash flow was $1B vs Q123 of $441.

Inventory days although higher, went from 15 to 16 days. A deceleration compared to prior quarters.

The I/O Fund’s Plans:

The sentiment post Q223 isn’t much different than in Q123. As we all know, Tesla rallied after Q1. This time around, given the stock is at higher levels, there may be less AI sentiment to support it in the short term. Q3 won’t be a catalyst and analysts will likely reduce numbers.

We will review if we have the right allocation given the current environment. I’m guessing we will trim when Knox finds the appropriate moment. While many will argue that Tesla is one of the most advanced AI companies in the world, my response is “sure” but Tesla is also heavily exposed to consumer spending — and this is entirely out of their control. The comment on interest rates is the most important comment from the call as high interest rates mean Tesla must lower prices. In a way, management is agreeing that quite a bit about the current situation is out of management’s control. While some will talk about recurring software revenue from robotaxis as the most important catalyst, the harsh reality is that the FED lowering rates is the most important catalyst for Tesla today. That may not be as exciting as AI, but Tesla is one of many tech stocks whose revenue growth and profitability is on borrowed time until the Fed instills a more dovish policy.

The I/O Fund Analyst Team contributed to this analysis.

Recommended Readings:

Netflix Q2 2023 Earnings: UCAN Region Flat on Revenue

Posted on by io-fund

Netflix’s report had some puts and takes.

Positives:

EPS was a beat at $3.29 versus $2.86 expected. The previous free cash flow guide for FY2023 was at $3.5 billion, and the full year guide is now raised to $5 billion this year. The company beat on paid net adds at 5.9 million compared to 2.1 million expected. Notably, the beat on net adds is coming from paid sharing, to where you can pay a lower fee to be added to someone’s account. The beat is not coming from the ad tier.

There was a marginal miss on revenue at $8.18 billion compared to $8.29 billion expected. There was also a marginal miss on forward revenue at $8.52 billion management guidance versus $8.68 billion expected. These things may seem insignificant, but most tech stocks are priced to perfection right now. 

The question is why did Netflix have such a big beat on net adds but not on revenue? 

Negatives: 

This is a blemish because in the past, the region grew 10% in revenue with similar net paid adds (reference Dec 2022 quarter), or there were no new net adds and still grew 9% in revenue (reference September 2022 quarter). Notably, even when Netflix lost 1.3 million subscribers, the company grew UCAN by 10% YoY on CC Basis. Therefore, it is unusual that Netflix did not grow revenue YoY in UCAN region, especially given the net adds.

Almost half of Netflix’s revenue comes from UCAN and so it’s watched closely. According to management, the UCAN region had benefited from increased pricing and is now only reflecting paid sharing plans. The UCAN region resulted in overall ARM being down 1%.

Today, separate from the earnings report, Netflix removed the basic, ad-free option for new subscribers in the United States and United Kingdom. New subscribers will have to pay $6.99 with ads or $15.49 without ads, eliminating the $9.99 tier.

On a side note, the ads ARM is expected to be $8.50, per management comments in the call.

Margins:

Margins were strong. Gross margin was flat yet operating margin was a beat by 330 basis points for an operating margin of 22.3% and operating income of $1.827 billion. Net margin also surpassed expectations by 260 basis points, which flowed to the beat on EPS.

Cash:

As stated, cash was quite strong at $1.44 billion in the quarter, up from $103 million a year ago. Management raised guidance from $3.5 billion in FCF for the fiscal year to $5 billion in the current fiscal year.

Earnings Call:

As stated, the primary blemish is related to UCAN. In the call, management emphasized overall revenue will accelerate yet could have been more clear about UCAN specifically.

This was stated at one point regarding ARM being down next quarter, as well: “But if you think about the drivers of average revenue per member, starting with the revenue drivers that we spoke about a moment ago, you can see our FX neutral, ARM is — it was down 1%, FX neutral in Q2 and we expect similar in Q3, flat to slightly down. That's mostly due to the limited price adjustments we mentioned over the past year in our big revenue markets in advance of rolling out paid sharing.”

Jessica Reif Ehrlich:

“Well, maybe you can help us think through like in UCAN, how much of the ARM growth is a function of add-on members to existing accounts versus new subs signing up to higher priced plans. And it sounds like from your letter that ARM will accelerate in the second half as you get further along in password sharing. Is that correct?”

Spencer Neumann:

“Yeah. Maybe just broadly thinking about our kind of revenue in Q2 and going forward. Jessica, the key is that we delivered revenue in line in Q2 with our expectations and we're on track to accelerate that revenue in Q3 and further accelerated in Q4. That's really our primary objective around revenue acceleration and we're set to deliver on it. But if we step back on thinking about our revenue growth and components overall or within a given region, it's driven by a combination of pricing, volume and new revenue streams like ads.

So if we think about each one of those, so we're now more than a year out from any price adjustments in our big revenue countries. We largely paused them during paid sharing rollout and so that's to be expected. For ads, that new revenue stream, we've expected a gradual revenue build and so that's not expected to be a big contributor this year. So continues to be on target. So most of our revenue growth this year is from growth in volume through new paid memberships and that's largely driven by our paid sharing rollout.”

The Hollywood strike is also a concern although management was bit vague about the implications other than saying: “These strikes, this strike is not an outcome that we wanted” and did not answer the question directly as to how much content they have in the pipeline before they run out. My takeaway was that Netflix’s stock will be impacted the longer the strike continues.

Conclusion:

Having a large beat on paid net adds but not translating that to revenue is not ideal. The company is being clear about revenue acceleration into the back half of the year, which means investors are being asked to be patient. We will likely be patient to some extent, but probably not at this allocation and with these gains. Overall, I imagine we will trim on this report. The stock has done quite well and we’d like to keep some of those gains given the weaker-than-expected quarterly report.

Recommended Readings:

Netflix Q2 2023 Earnings: UCAN Region Flat on Revenue

Posted on by io-fund

Netflix’s report had some puts and takes.

Positives:

EPS was a beat at $3.29 versus $2.86 expected. The previous free cash flow guide for FY2023 was at $3.5 billion, and the full year guide is now raised to $5 billion this year. The company beat on paid net adds at 5.9 million compared to 2.1 million expected. Notably, the beat on net adds is coming from paid sharing, to where you can pay a lower fee to be added to someone’s account. The beat is not coming from the ad tier.

There was a marginal miss on revenue at $8.18 billion compared to $8.29 billion expected. There was also a marginal miss on forward revenue at $8.52 billion management guidance versus $8.68 billion expected. These things may seem insignificant, but most tech stocks are priced to perfection right now. 

The question is why did Netflix have such a big beat on net adds but not on revenue? 

Negatives: 

This is a blemish because in the past, the region grew 10% in revenue with similar net paid adds (reference Dec 2022 quarter), or there were no new net adds and still grew 9% in revenue (reference September 2022 quarter). Notably, even when Netflix lost 1.3 million subscribers, the company grew UCAN by 10% YoY on CC Basis. Therefore, it is unusual that Netflix did not grow revenue YoY in UCAN region, especially given the net adds.

Almost half of Netflix’s revenue comes from UCAN and so it’s watched closely. According to management, the UCAN region had benefited from increased pricing and is now only reflecting paid sharing plans. The UCAN region resulted in overall ARM being down 1%.

Today, separate from the earnings report, Netflix removed the basic, ad-free option for new subscribers in the United States and United Kingdom. New subscribers will have to pay $6.99 with ads or $15.49 without ads, eliminating the $9.99 tier.

On a side note, the ads ARM is expected to be $8.50, per management comments in the call.

Margins:

Margins were strong. Gross margin was flat yet operating margin was a beat by 330 basis points for an operating margin of 22.3% and operating income of $1.827 billion. Net margin also surpassed expectations by 260 basis points, which flowed to the beat on EPS.

Cash:

As stated, cash was quite strong at $1.44 billion in the quarter, up from $103 million a year ago. Management raised guidance from $3.5 billion in FCF for the fiscal year to $5 billion in the current fiscal year.

Earnings Call:

As stated, the primary blemish is related to UCAN. In the call, management emphasized overall revenue will accelerate yet could have been more clear about UCAN specifically.

This was stated at one point regarding ARM being down next quarter, as well: “But if you think about the drivers of average revenue per member, starting with the revenue drivers that we spoke about a moment ago, you can see our FX neutral, ARM is — it was down 1%, FX neutral in Q2 and we expect similar in Q3, flat to slightly down. That's mostly due to the limited price adjustments we mentioned over the past year in our big revenue markets in advance of rolling out paid sharing.”

Jessica Reif Ehrlich:

“Well, maybe you can help us think through like in UCAN, how much of the ARM growth is a function of add-on members to existing accounts versus new subs signing up to higher priced plans. And it sounds like from your letter that ARM will accelerate in the second half as you get further along in password sharing. Is that correct?”

Spencer Neumann:

“Yeah. Maybe just broadly thinking about our kind of revenue in Q2 and going forward. Jessica, the key is that we delivered revenue in line in Q2 with our expectations and we're on track to accelerate that revenue in Q3 and further accelerated in Q4. That's really our primary objective around revenue acceleration and we're set to deliver on it. But if we step back on thinking about our revenue growth and components overall or within a given region, it's driven by a combination of pricing, volume and new revenue streams like ads.

So if we think about each one of those, so we're now more than a year out from any price adjustments in our big revenue countries. We largely paused them during paid sharing rollout and so that's to be expected. For ads, that new revenue stream, we've expected a gradual revenue build and so that's not expected to be a big contributor this year. So continues to be on target. So most of our revenue growth this year is from growth in volume through new paid memberships and that's largely driven by our paid sharing rollout.”

The Hollywood strike is also a concern although management was bit vague about the implications other than saying: “These strikes, this strike is not an outcome that we wanted” and did not answer the question directly as to how much content they have in the pipeline before they run out. My takeaway was that Netflix’s stock will be impacted the longer the strike continues.

Conclusion:

Having a large beat on paid net adds but not translating that to revenue is not ideal. The company is being clear about revenue acceleration into the back half of the year, which means investors are being asked to be patient. We will likely be patient to some extent, but probably not at this allocation and with these gains. Overall, I imagine we will trim on this report. The stock has done quite well and we’d like to keep some of those gains given the weaker-than-expected quarterly report.

Recommended Readings:

Semiconductor Stocks: Q2 Sector Overview

Posted on by io-fund

This article was originally published on Forbes on Jul 13, 2023,07:05pm EDTForbes Forbes on Jul 13, 2023,07:05pm EDT

Semiconductors are the common denominator across the burgeoning technology trends of the next decade. Artificial Intelligence, 5G, high-performance computing, Internet-of-Things, gaming, electric vehicles, and robotics, among others, all require semiconductors to power them. These trends make semiconductor stocks an ideal investment and perhaps the most important space for tech investors to monitor.

For years now, we have published on semiconductors as leaders in tech– even when cloud, e-commerce, connected TV and others were more favored. In fact, we have been pointing out quite clearly that semiconductors are the sector that has provided the most returns in the past decade.

Beth Kindig's Twitter Post

Source: Beth Kindig

Below, we update our semiconductor sector analysis to look at which companies have performed well in the most recent quarter, and also which companies stand out on a forward-basis with revenue growth estimates, profits, cash flows, earnings surprises, and we also look into management insights.

Top Semiconductor Stocks with the highest revenue growth rates in Q1

Quarterly YoY Revenue

Source: YCHARTS

Navitas Semiconductor had the highest revenue growth among semiconductor stocks in the recent quarter. The company’s revenue grew by 98% YoY to $13.4 million. Management’s revenue guidance for next quarter is $16 million to $17 million, representing YoY growth of 92% at the mid-point.

Ron Shelton, CFO of the company, said in the earnings call, “Our guidance is based on robust strength in EV, solar, appliance/industrial, and the beginnings of a recovery in the mobile and consumer market, all further evidenced by a more than 50% increase in backlog during the quarter.”

The company acquired GeneSiC Semiconductor in August last year and helped to diversify into the fast-growing Silicon Carbide market. Navitas has a strong pipeline of $760 million with $432 million of this recognized by fiscal year 2026.

Analysts expect revenue in the next quarter to grow 92% YoY to $16.51 million and robust revenue growth close to or over 100% on a YoY basis for the next several quarters. The risk to consider is that the bottom line is weak. Analysts don’t expect Navitas to be profitable on an adjusted basis until Q1 2025 and GAAP profitable roughly around 2027.

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Semi Stocks Q1 Revenue Surprise

Quarterly Revenue Surprise

Source: YCHARTS

Nvidia crushed analysts’ revenue estimates by 10.4%. The company’s revenue declined by (13%) YoY and is up 19% QoQ to $7.19 billion.

The strong sequential growth was led by record data center revenue, primarily helped by accelerated computing. The company’s CFO, Colette Kress, said in the earnings call, “Generative AI drove significant upside in demand for our products, creating opportunities and broad-based global growth across our markets.” Gaming and professional visualization segments also witnessed improvement from the inventory correction.

If Nvidia is adding roughly $4 billion in revenue, primarily driven by the data center, then Q2’s data center growth will accelerate to an incredible 100% growth rate, up from $3.8 billion in the year ago quarter. It also means the data center will roughly double from the first quarter (sequentially) as the segment was $4.28B in the current quarter.

Put another way, this means Nvidia’s data center segment in the upcoming quarter will be as large as the company’s entire revenue this quarter – if we assume $7.75B in the data center compared to $7.2B total revenue this quarter.

We have highlighted in the past that AI will add $15 trillion to GDP compared to mobile’s $4.4 trillion. Mobile brought us three FAANGs: Apple, Google, and Facebook. It has been my stance for years that AI will bring us a new set of FAANGs, one of which will be Nvidia.

The company’s revenue guidance for the next quarter is $11 billion, representing YoY growth of 64% at the midpoint. The Q2 guidance was 53% higher than consensus. The historic beat in estimates is driven by data center revenue doubling from $4.28 billion in revenue in Q1 to $8 billion in revenue in Q2.

Semiconductor Stocks Q2 Revenue Growth Estimates

Revenue Growth Estimate for Q2

Source: YCHARTS

Indie Semiconductor has the highest expected revenue growth rate for Q2. The company’s recent quarter revenue grew by 84% YoY to $40.5 million. The company has guided for 102% YoY revenue growth in the next quarter.

Analysts expect revenue to grow 102% YoY to $51.97 million. The company is benefiting from growth trends in advanced-driver assistance systems (ADAS) and electric vehicles. indie has a large Serviceable Addressable Market (SAM) of $56 billion by 2028. The company is on track to be profitable on an adjusted basis this year.

Donald McClymont, indie’s co-founder and CEO, said, “Our growth trajectory reflects continued design win momentum spanning ADAS, vehicle electrification and user experience applications. At the same time, our deeper R&D investments and targeted acquisitions are beginning to contribute, enabling us to sharply outpace our peer group. Accordingly, today we are even better positioned to capitalize on the 2025 Autotech market opportunity of $42 billion.”

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Revenue Growth Estimates for Current Fiscal Year: Navitas and indie Semiconductor

Revenue Growth Estimate for Current Fiscal Year

Source: YCHARTS

For the current fiscal year, analysts expect indie Semiconductor to have the highest revenue growth estimate among the semiconductor stocks. It is followed by Navitas Semiconductor, which analysts expect to grow 100%. Among more established players, Nvidia leads and is expected to grow by 59%.

Semiconductor equipment provider ACM Research ranks fourth and is expected to grow 40% in the current fiscal year. The company’s revenue in the recent quarter grew by 76% YoY to $74.3 million. The management’s FY23 revenue guidance is in the range of $515 million to $585 million, representing YoY growth of 41% at the midpoint.

Needham Analyst Quinn Bolton mentioned in his note, “As the fastest growing SemiCap stock in our coverage with ~$400MM in cash and very little debt, we believe a 12.5x multiple is more than fair. The stock is currently receiving little attention from investors due to its high-exposure to China. However, we believe this ACMR sentiment will change over time as its growth proves too difficult to ignore.”

Semiconductor Top Line Valuations

P/S Ratio (Forward)

Source: YCHARTS

Nvidia has the highest forward P/S ratio of 24.4 among the semiconductor stocks. The company has commanded a premium valuation due to its unrivaled position on GPUs. It is followed by Navitas, which has a forward P/S ratio of 22.4.

Per our analysis, Navitas is expected to have strong revenue growth in the next several quarters.

Free Cash Flow Margin

Free Cash Flow Margin (Qly)

Source: YCHARTS

The majority of semiconductor stocks have positive free cash flow margins. Among the semiconductor stocks we track, 16 companies have more than 20% free cash flow margin. During times of macro uncertainty, stocks with strong free cash flows are considered a safer bet.

Broadcom leads the semiconductor sector with a free cash flow margin of 50%, followed by 47% for Synopsys and 47% for Monolithic Power Systems. Broadcom’s free cash flow in the recent quarter grew by 5% YoY to $4.4 billion. The management also expects cash flows to be strong in the next quarter.

Operating Margin

Operating Margin (Qly)

Source: YCHARTS

Broadcom leads the semiconductor stocks with an operating margin of 46%, followed by 45.5% for Taiwan Semiconductor Manufacturing and 44.2% for Texas Instruments.

TSM’s operating margin of 45.5% was higher than management’s guidance of 41.5% to 43.5%. The company’s cost control efforts led to a reduction in operating expenses.

Wendell Huang, CFO of the company, said in the earnings call, “Total operating expenses accounted for 10.8% of net revenue, which is lower than the 12% implied in our first quarter guidance mainly due to stringent expense control and lower employee profit sharing”. Management guidance for Q2 is 39.5% to 41.5%.

Due to its leadership position in manufacturing advanced chips, TSM is able to negotiate better prices with its customers. Cost improvements also help the company to maintain strong margins.

Conclusion:

Nvidia is a well-known semiconductor stock at the moment, yet there are others in the semiconductor space that are outperforming, as well. Broadcom and Taiwan Semiconductor continue to be defensive stocks with strong bottom lines. Navitas and indie Semiconductor are high beta stocks that are putting up nearly triple digit growth (notably, their margins are in the red until they reach scale). 

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AEHR: Strong Top Line & Strong Bottom Line – Fiscal Q4 2023 Earnings

Posted on by io-fund

AEHR is the rare small cap that has top line growth coupled with bottom line strength. We recently discussed what comprises a defensible portfolio in tech in our recent Q3 Kickoff webinar. AEHR fits the criteria we outlined in the webinar, and is one of our largest holdings because of how many boxes it ticks.

It’s both the consistent revenue growth andand the bottom-line growth that causes this stock to defy the odds. The FY2024 guide is for 50% growth on the top line and 90% growth on the bottom line. In addition to this fiscal year 2023 cash flow grew over 500% from $1.51 million in FY2022 to $10M in FY2023.

In our pre-earnings write-up we had stated: “Aehr is within $1m of last year’s entire GAAP earnings by the end of Q3, so with the forecasted revenues for fiscal Q4 conservative net profit on revenue, Aehr will clearly grow net profit and GAAP earnings at a higher percentage than revenue growth.”

The revenue growth can be seasonal, which is why we had said “All Eyes on FY2024 Guide” in our last earnings review. The fiscal year guide in July tends to be a baseline as it’s likely the company receives more orders in the next few months and fills these in FY2024.

I believe management is doing the responsible thing – guiding to what they know today. Because the company has a small amount of revenue, a minor miss can be substantial. To avoid this, they lean “conservative.” This was discussed in the earnings call (see below).

Financials:

FY2023 and Q4 revenue were both in line at $65 million and $22.3 million, respectively. This represents FY revenue growth of 28% and quarterly revenue growth of 9.9%. EPS also came in as expected at $0.59 and $0.23, on an adjusted basis.

The FY2024 guide represents growth of 50% for revenue of $100 million. The two analysts covering the stock had a consensus of $102.5 million for growth of 58%. The FY2024 guide on the bottom line is for GAAP net income of $28 million and at least 90% in earnings growth. 

Margins were flat to slightly contracted. 51.5% on gross margin was flat from a year ago. Operating margin of 25.2% was slightly lower compared to 28.7% a year ago. Net margin of 27.3% was also lower compared to 28.6% last year.

Regarding the margins, management pointed toward R&D as a primary reason the margins were down, plus product mix, material and transportation costs. At the current FY2024 guide, management is implying flat margins YoY and that’s a positive given the GAAP margins are very strong (i.e., opposite of “growth at any cost”, this is growth while maintaining a strong bottom line). G&A will increase this year as AEHR is a $1 billion market cap and auditing costs are expected to increase.

The company has $47.9 million in cash, up from $31.5 million a year ago and up from $4.6M two years ago. Operating cash flow of $5.8 million in Q4 was up considerably from (-$0.77) million a year ago. For AEHR, the exact cash flow figures are available when the company files their 10-Q/10-K. Since it's the end of a fiscal year, AEHR will be filing a 10-K.

Last quarter, AEHR had reported $33.3 million, the highest bookings in company history. The fiscal year-to-date was $72.5 million, exceeding full prior fiscal year of $62.2 million. The current effective backlog is $40 million with $15 million added in the first six weeks of the fiscal year, which started June 1st.

Earnings Call:

The main questions to focus on from the earnings call was regarding number of customers and customer concentration, hints toward if the guide was purposely low, plus product optionality with gallium nitride, higher power voltages and silicon photonics.

Number of Customers and Customer Concentration:

AEHR’s top risk remains its high customer concentration. When asked about this on the forum, I’ve stated it’s different from semiconductor companies compared to cloud software or fintech, for example. For a semiconductor company like Aehr, the supply chain limits the number of customers they have to probably a dozen or so for its total addressable market. This is different than a software company that will have thousands of customers at scale. 

Regardless, it’s a risk and one we’ve covered many times. In the call, it was discussed that the primary customer (which is generally known to be ON Semiconductor) represents 79% of revenue. When we first covered AEHR, ON was about 100% of revenue.

In FY2023, the customer concentration improved to three customers representing: 79%/10%/10%. In other words, AEHR had two 10% customers. In FY2024, the company is expected to have “three or four” 10% customers.

Overall, the discussions around AEHR’s customer growth are quite bullish and likely contributed to the positive price action. For example, this was stated:

“With the addition of this latest new customer, we've significantly expanded our customer base by adding a total of four new silicon carbide customers this year. Each of these new customers is already ramping or plans to ramp our products into high volume production using our multi-wafer test and burn-in systems.

We believe this customer who serves several significant markets that include the electric vehicle industry as well as other industrial applications will purchase a large number of our FOX-XP systems to meet their publicly announced significant increase in plant capacity and revenue growth over the next several years and through the end of the decade and longer.”

Questions on FY2024 Guidance:

It was discussed (by an analyst) that the guide should be particularly easy to hit given the customer mix. The analyst felt the $40 million in backlog was especially where the guide/current information is too low.

“And specifically, if we look at this past year and your largest customer being 52 million based on the 79% and their targets of growing 300% over the next few years. I would assume that creates a solid base for your business. So, as you look at already having 8 million to 10 million booked on that, number two, you're really talking about a 30 million incremental number to hit that minimum threshold and you've already got three customers.” 

Management’s response was “I felt like you were going to end it with why we're such sandbaggers but anyhow” and then went on to state that timing orders is too difficult for their business in order to guide aggressively: “It's interesting even with current customers candidly their ability to forecast is all over the map. And so, I think we've taken a conservative stance here. But it provides us with confidence to be able to hit that number. And we don't need any miracles to happen, if you will.

Total Addressable Market:

AEHR is a company where a few different TAMs are thrown around in the earnings calls. All of them are sizable, and perhaps the highest TAMs of any company we cover relative to AEHR’s size, and the products being in a unique niche with virtually no competitors.

We’ve discussed the TAM many times but here is what was most recently stated:

“William Blair forecast total demand for silicon carbide wafer is just for electric vehicles, which include EV, inverters onboard and offboard chargers to grow from 220,000 wafers in 2022 to over 4.5 million six-inch equivalent wafers in 2030, a greater than 45% compound annual growth rate and over 20 times larger in 2030 than in 2022.

In addition, William Blair expects demand for industrial applications, trains, energy conversion and RF amplifiers of silicon carbide to drive another 2.8 million wafers in 2030. This expands our silicon carbide test and burn-in market even more.”

Combined, the market for AEHR could be as large as 7.3 million wafers, up from 220,000. This is 33.2X growth. Notably, this assumes AEHR takes the entire market, which is not likely to happen even with a superior product. The product is superior because wafer level testing is up to 9 times faster than competitors as customers can test and burn-in/stabilize nine 300mm wafers at the same time compared to one wafer with competitors at 3.5 kilowatts of power per wafer.

Product Optionality:

There were discussions about AEHR’s next two major markets, silicon photonics and gallium nitride. For background on these two new markets, which would extend AEHR’s total addressable market beyond silicon carbide, please read this analysis here.

Per the earnings call, AEHR has officially received their first silicon photonics order whereas gallium nitride is in the more nascent phase of “customer inquiries.”

This system can test new high power density devices that can be used in new optical I/O or heterogeneous integrated packages. This customer is one of the world's largest semiconductor manufacturers and we expect to receive orders for additional production systems as they have increased production of these devices.”

Conclusion:

With AEHR, we broke a few of our portfolio rules. First, we have held a small cap at a high allocation. Secondly, we are holding it beyond the 10% allocation limit most portfolios (including the I/O Fund) adhere to for risk management purposes. Third, we bought close to earnings. It’s not ideal to break this many portfolio rules unless the stock is special. Clearly, we think AEHR is special. To reiterate, it’s special not only for its top line growth but primarily for its bottom-line growth, total addressable market and product optionality.

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