As the I/O fund looks to position itself for the remainder of 2023. Fundamentally, we’re avoiding ‘Crocodile Jaw’ situations where the stock price is going up but fundamentals are decelerating. This is one of the reasons we greatly reduced our Tesla position for a ~60% gain.
Tesla stock has rallied through most of 2023 during a time when consensus was estimating sales to grow +23% y/y but earnings to decline 15%. The main driver behind the decline in earnings estimates is that Tesla has decided to lower prices to increase volumes at the expense of margins.
Starting in Q322 through Q223, operating margins have declined from 17.2% to 9.6%. Initially, Tesla cited making sure certain models qualified for the EV tax credit and later higher interest rates as the primary reasons for lowering prices.
Higher interest rates are effectively a price hike that increases monthly payments for those who finance their purchases. Tesla recently announced 84 month financing to lower monthly payments. Reducing the sales prices also helps lower monthly payments. Meanwhile, increasing EV inventory at dealerships and discounting at an industry level are likely another contributing factor.
However, the challenge of higher interest rates is not unique to Tesla. All OEMs face the same obstacles. Below are reported operating margins for the major global OEMs from Q322 through Q223. Either they were relatively stable for the Germans and Koreans or bottomed in Q123 and have improved in the case of the Japanese.
Despite this, Tesla is the one OEM whose operating margins have continued to decline.
Source: Y-Charts
It’s Not Just Macro
This highlights that there are other forces at work beyond the macro. We believe it points to Tesla implementing a pricing strategy to gain market share. Taking into consideration the competitive factors at work will help in trying to decipher Tesla’s pricing strategy and how that will impact operating margins for the remainder of 2023. It is through this competitive analysis framework that we will try to parameterize how low Tesla operating margins can go.
For this analysis, we chose to focus on reported group operating margins. Although this metric includes non-EV businesses, we believe it’s the most objective and public measure to provide an apples-to-apples comparison across the auto landscape globally.
At the end of Q422, Tesla's operating margin was 16%. To provide some context, at the time this was greater than the German OEMs. Tesla had firmly positioned itself in the premium segment.
The Germans have been dealing with their own challenges integrating EV offerings, and have been trying to catch-up with Tesla. Perhaps sensing its competitive moat within the premium market was fortified, this gave Tesla an impetus to lower prices further to attack the mass market segment. In Q223, Tesla’s operating margins declined to 9.6% after enacting a series of price cuts.
Currently, this is how Tesla’s operating margins compare to its main competitors. As can be seen below, Tesla’s Q223 reported operating margins are below those of most of the major US, German, Japanese and Korean OEMs.
Source: Y-Charts
How Low Can Operating Margins Go?
Strategically, Tesla will likely continue to lower prices to increase its leading EV market share to stave off competition which will intensify over the next few years. Tesla’s electric market share peaked at 78% in 2018 and stood at 62% in 2022. By 2026, Merrill Lynch estimates it will decline to 18%
Source: Merrill Lynch
In the most recent Q2 call, both Elon Musk and Zachary Kirkhorn, former CFO, signaled Tesla‘s focus will continue to be on volumes.
Musk
“So, I think it’s sort of, it would be — I think it — it does make sense to sacrifice margins in favor of making more vehicles because we think in the not too distant future, they will have a dramatic valuation increase.”
Kirkhorn
“We continue to work towards our goals of maximizing volumes on our vehicle business … in a way that generates the capital to continue our pace of R&D and capital investments.”
Through this competitive analysis framework, we believe Tesla’s Q3 operating margins can decline to a level between Honda and VW. Taking the midpoint, operating margins may go to 7.8% compared to most recent 9.6%. If operating margins were to reach a level closer to — or below GM perhaps — that could be sign they’re close to the bottom. This highlights the broader concern for investors in that Tesla has not provided any parameters nor guidance to assess how low margins may go. It is why we significantly reduced our position.
We have two base cases.
Base Case 1 is that Q3 operating margins are between Honda’s and VW at 7.8%.
Base Case 2 is more bearish in that they reach GM’s at 6.2%. For now, we believe Base Case 1 is the most likely. Consensus opm estimates are higher and consensus will have to revise down their Q3 and Q4 operating profit estimates if either case materializes.
In the medium term, there are reasons to be optimistic that Tesla’s strategic moves may bear fruit and its margins will rebound. In addition to lowering prices, the move from the CSS to Tesla’s NACS EV charging standard may help Tesla take market share away from those who have not yet announced plans to shift to NACS. Namely, Toyota and Honda who together have 25% automotive market share in the US. Meanwhile, Tesla deserves credit for maintaining its premium brand perception despite lowering prices. For now, the Tesla brand is almost synonymous with EVs. The refreshed Model 3 may further strengthen Tesla’s position in the minds of consumers.
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Tesla’s Price Action:
We continue to see a bifurcated market, which has been one of the leading themes in 2023. Some markets/stocks have likely put in tops, while big tech, especially those names perceived to be involved in AI, suggest another high is likely. Tesla falls into this camp, where one more high is still on the table before we have to deal with a bout of extended volatility. You can read more about our broad market analysis here.
The question for Tesla investors is whether the January low was a major low, or do we have one push lower before a major low is struck? There are some stocks, like NVDA and NFLX, for example, that will likely see similar bouts of volatility in the coming months, yet they have a high probability of making a lower high. Tesla could fall into this category.
There are two large counts that I’m tracking based on the current price information that account for these scenarios.
Blue – The big picture here has TSLA making a higher low in the coming period of volatility. The key to this count will be a large pullback that both holds $147 and is a 3-wave retrace. If this happens, it will be setting up a great buying opportunity.
On a shorter-time horizon, TSLA has ended the topping region from $300 – $325. We could see one more swing into the $325 region. This will be very strong resistance to monitor, if we get another push. The August low around $213 will be very important. If we break below this level, then it is likely the top is in.
Red – on a shorter time horizon, the above analysis applies to both counts. Where this one differs will be in the pattern of the larger retrace. Instead of a 3-wave retrace, it will have to be a 5-wave pattern that breaks below $147. If this happens, the odds will be quite high that we will see one more low before a major buying opportunity presents itself.
If you own Tesla stock, or are looking to own Tesla, we encourage you to attend our weekly premium webinars, held every Thursday at 4:30 pm EST. This week, we will discuss Tesla, as well as a handful of other AI plays – what our targets are, where we plan to buy as well as take gains.
We want to put a spotlight on CrowdStrike going into the earnings report tomorrow, and to point out the company was GAAP profitable in the last quarter. This is something that other cloud companies will take years to achieve — if they get there at all.
This was an important accomplishment, yet per management, this will take time to become more consistent: "We also reached GAAP profitability for the first time in company history. While we are very proud of this milestone, we have yet to reach sustained GAAP profitability […] We believe reaching this milestone demonstrates that our financial model will deliver GAAP profitability in due time."we have yet to reach sustained GAAP profitability […] We believe reaching this milestone demonstrates that our financial model will deliver GAAP profitability in due time."
Here’s how CrowdStrike compares to a sample of best-of-breed. For illustrative purposes, much larger companies that have been public for a long time have been omitted (Adobe, Salesforce, Microsoft, etc.). Note that net margin was 0% last quarter while GAAP operating margin was (-2.8%)
CrowdStrike went public in 2019, yet has a cash flow margin of 33% and an operating cash flow margin of 43%. The cash flow margin defies the few, brief years the company has been on the market. Most tech companies are burdened with stock-based compensation or growth tactics that deplete cash, especially in the initial years that follow the IPO. Stock based compensation is at 18.9% in the most recent quarter, and has been trending downward from the 24% range.
One thing to watch for in the upcoming earnings report is the net new ARR, as it had a steep decline last year from a range of 60% growth YoY down to 17% YoY. We covered this in November.
Fast-forward, and net new ARR was down (-8.6%) in the most recent quarter and is expected to be (-11.3%) in the current quarter. The decline pictured below is expected to continue this quarter.
We are interested in this earnings report to see if Crowdstrike bottoms soon in this regard, which would indicate new business is recovering and upgrades are resuming.Per management in the last earnings call: “When we look at our pipeline for the remainder of the year, we expect this trend to continue, giving us confidence in our ability to deliver net-new ARR growth in the back half of the year.”
ARR has been more resilient, but per some comments on various earnings calls, it’s expected to exit FY2024 at “low 30%” growth. I’m curious if this will beat as the year goes on, and if FY2024 is a bottom for ARR, as well.
It will also be interesting to see if RPO bottoms over the next few quarters. It was at 41.2% growth last quarter.
Revenue and EPS:
Crowdstrike is expected to report revenue of $724.4 million in the upcoming earnings report, due on August 30th. This will represent growth of 35.4%.
Next quarter, the company is expected to report revenue of $774.5 million for growth of 33.3%.
Expected adjusted EPS this quarter is $0.56 which is 55% higher than last year’s Q2 at $0.36.
Margins – Reported Last Quarter:
The most important takeaway is that margins are very strong for Crowdstrike compared to its peers.
Last quarter, the gross margin of 76% expanded by 200 basis points compared to the year ago quarter.
The adjusted gross margin of 78% improved by 100 basis points compared to the year ago quarter. Subscription gross margin also improved 100 basis points.
The GAAP operating margin of (-3%) improved from (-4.90%) in the year ago quarter. Although it’s promising that the margin is close to reaching GAAP operating profitability, the quarter ending in April tends to have the better margin profile.
Adjusted operating margin of 17% was flat year-over-year.
GAAP net margin of 0% improved from (-6.5%) in the year ago quarter.
The adjusted GAAP net margin of 20% improved from 15.3% in the year ago quarter.
Margins – In the Upcoming Quarter:
Management guided for $120.1 million at the midpoint in adjusted operating income, which represents an adjusted operating margin of 16.6%.
Management also guided for $133.3 million for net profits, for a margin of 18.4%
If CrowdStrike reports as expected, it’ll be some of the best margins the company has reported.
Cash Flow:
Last quarter, operating cash flow was $300.9 million for a margin of 43%.
The free cash flow was $227.4 million, for a margin of 33%.
There is $1.91 billion on the balance sheet and $739 million in debt.
Conclusion:
This is a brief note to say we are watching CrowdStrike very closely. This is not an earnings call rather it’s a few bullet points prior to earnings to organize our thoughts should there be a strong ER. If it’s a weak ER, we will put the company on hold until next quarter.
This article was originally published on Forbes on Aug 23, 2023,12:30pm EDTForbes Forbes on Aug 23, 2023,12:30pm EDT
You’re probably well aware that last quarter, Nvidia guided fiscal Q2 at $11 billion, which is 53% higher than analyst expectations of $7.2 billion. The stock was up 25% after hours, adding $200 billion to its market cap in the matter of a day. During the earnings call, the stock went from being up 15% after hours to being up 25% after hours when the CFO confirmed H2 would also be strong with visibility on supply.
In addition to covering Nvidia’s AI angle many times since 2018, the I/O Fund holds an outsized Nvidia position at 17% allocation. Going into this year, we broke all of our portfolio management rules by holding a position that was over 10%. From there, we’ve talked consistently about a H2 2023 Semi Rebound to our premium members in webinars and analysis. I was also interviewed by Tier 1 media in August of 2022, and January of 2023about this very high conviction. As you know, Nvidia would later beat in May.
Source: BETH KINDIG
Well, it’s the day of Q2 earnings, so let’s cut to the chase … what should Nvidia investors do now?
Below, we will review why it’s likely Nvidia beats and sees expanding margins, and secondly, we will review our plans for our outsized position. My firm is unique in that we do not simply offer blanket buy recommendations, rather we disclose our trades in real-time to our premium members. Please also note our disclosure below that we cannot guarantee a stock’s performance, but we can tell you how the firm is managing our money.
As a reminder, Super Micro had a sizable beat with management doubling fiscal year guidance three months later from 20% to 40%, yet the market reacted harshly. Therefore, it is the practice of our firm to have an active portfolio stance by combining fundamentals and technicals for risk management.
Nvidia Stock: Will a Beat Be Enough?
It’s not a stretch to say that anticipation within the investment community is on par with the series finale of Game of Thrones. Everyone in the market will be watching this earnings report come market close.
In its Q1 announcement, Nvidia provided a first glimpse into the financial impact AI will have on its businesses with Q2 sales guidance of $11.07b. The sequential increase of +54% vs Q1 surprised the market. We expect Nvidia to only provide guidance into Q3. Although just one quarter, it will be an important data point for the market to assess the appropriate growth rate for the remainder of FY2024 and FY25.
Q2 SALES + Q3 GUIDANCE
Meeting or beating Q2 sales guidance and providing Q3 sales guidance better than consensus will be very important drivers behind Nvidia’s short-term stock performance.
During the earnings call, this was one of the comments that contributed to strong price action after hours:
“Vivek Arya:
Thanks for the question. Could I just wanted to clarify does visibility mean data center sales can continue to grow sequentially in Q3 and Q4 or do they sustain at Q2 levels? […]
Colette Kress:
Yeah, Vivek. Thanks for the question. Let me see if I can add a little bit more color. We believe that the supply that we will have for the second half of the year will be substantially larger than H1. So, we are expecting not only the demand that we just saw in this last quarter, the demand that we have in Q2 for our forecast, but also planning on seeing something in the second half of the year. We just have to be careful here. But we are not here to guide on the second half of that. Yes, we do plan a substantial increase in the second half compared to the first half.
On 6/14/23, Collette Kress, Nvidia CFO held a Q&A at the Jefferies Investor Conference . In particular, there is one question on all investors’ minds.
Question
“You guys gave guidance for the July quarter, which beat everybody’s expectations and 50% sequential growth. And I think there is a concern from investors that this is kind of a one-time spike that will come back down. I know you only guide one quarter at a time. But what do you say to investors who have a concern that it’s a one-time spike? And can you just talk in general terms, what is the visibility typically like with the data center and hyperscale companies?”
Colette Kress
“Yes. What we have seen is certainly an astounding amount of interest worldwide globally from many different types of customer sets […] We have better visibility than what we have seen before and our ability to focus right now on procuring the supply.
As we indicated in our earnings, we have procured the supply to the demand that’s been put in front of us and that visibility that we see. […] So our guidance for Q2 is really building upon years and years of working of the industry on accelerated computing and solutions such as AI. And we continue to see demand and demand visibility for the full year as well that we believe will sustain as we finish in Q2.”
Comparing her response to consensus sales estimates for the remainder of FY24, we come away with a couple of observations.
Source: I/O FUND
For Q2, consensus is in line with Nvidia’s guidance. There’s a chance that Nvidia will exceed their own forecasts
If Nvidia has indeed procured the supply needed to meet demand, we believe that consensus Q2/Q3 growth estimates of +12% is too conservative.
However, the magnitude of the Q3 guidance will be very important given heightened expectations. Assuming Nvidia meets its Q2 guidance, we’ve put together a simple scenario analysis to parameterize the different outcomes we anticipate based on Nvidia’s potential Q3 guidance. +/- indicates anticipated stock positive or negative price performance on the next trading day based on that scenario.
Source: I/O FUND
We’re optimistic that continued strength in AI related demand and stabilization in gaming will allow Nvidia to meet if not exceed their Q2 guidance. According to the Financial Times, “multiple sources close to Nvidia and its manufacturer, Taiwan Semiconductor Manufacturing Company, the chipmaker will ship about 550,000 of its latest H100 chips globally in 2023, primarily to US tech companies. Nvidia declined to comment.”
At $40,000 per H100, that equals $22 billion in H100 sales alone, and when you add the A100 and other data center sales at a current run rate of $14 billion, the data center segment could report a total of $36 billion in 2023. When you equal this out across the upcoming quarters, it looks something like this:
Q2: $3B A100s, $5B H100s = $8B data center, guided
Q3: $2B to $3.5B A100s, $7B H100s = $9B to $10.5B data center
Q4: $2B to $3.5B A100s, $10B H100s = $12B to $13.5B data center
H100s are priced differently depending on where they are sourced. The Information has the H100s at $20,000 yet sourced an analyst that believes we could see over 1M H100s sold in 2023. This arrives at $35 billion in sales. Given these variables, and credible sources, it appears $30 to $40 billion is the range going into Q2 earnings that analysts want to see for full year data center revenue.
We believe the market will react negatively if Nvidia provides Q3 guidance that is in-line with consensus or lower than 12%. On the flip side, Nvidia will likely need to provide guidance of at least greater than 20% for a significant positive reaction. This is because consensus will likely need to make upward revisions to their earnings for the remainder of FY2024 and FY2025. This is critical to support the current valuation.
Our base case assumption is that Nvidia’s Q3 guidance will estimate q/q growth of at least +20%. Remember, H100 was only introduced to the market toward the end of the last calendar year. Q1FY24 was the very first quarter where Nvidia is beginning to see the impact of AI and demand for the H100. Ultimately, we believe Nvidia will close out the year with data center revenue that is 50% higher than Q2.
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Q2 + Q3 MARGIN GUIDANCE
At the same conference, in response to a question of how much of revenue growth is pricing vs units, CFO Kress answered
Question
“I know that you have fielded this question probably 1,000 times since you reported there is kind of this view that all of your growth is driven by ASPs and maybe not as much by units. And how should investors think about the ASP growth versus the unit growth in the quarter past and the quarter outlook?”
Colette Kress
“No. We truly are seeing demand and need across such a wide group of folks. And that’s not just based based on selling a brand new architecture and ramping a new architecture, Hopper architecture. We are still shipping our existing prior architecture. But no, this is not about ASPs, this really is about just the growth that we are seeing in focusing on AI and accelerated computing. I believe more of it is just about sheer volume of companies that are really interested in taking this next step and really leveraging generative AI for all the work that they do. That’s really what it’s about.”
CFO Kress’s answer is important because it indicates further potential for margins to expand not just from pricing. On a three-year basis, Nvidia has just returned to its prior peak of about 65% gross margins (reported). Given the positive pricing and unit demand dynamics, the new normal is perhaps between 65% and 70% gross margins:
Source: I/O FUND
Operating Margin
Given CFO Kress’s comments that it’s both pricing and units, this suggests that there is upside to reported operating margins that still have yet to return to the prior 3-yr peak.
Source: I/O FUND
Net margin
A similar below-peak picture can be seen in reported net margins.
Source: I/O FUND
We likely won’t get answers to all these medium term questions in Q2, but it will help us to assess what the margin potential is in the upcoming quarters.
Outlook for Gaming for FY2024
Gaming is still an important segment and contributed 31% to Q1FY24 sales and has been impacted by the weaker consumer. It appears that gaming bottom in Q1. Although gaming sales were down 38% y/y, they were positive 22% q/q. Critically, in the Q1 call Nvidia stated “We believe the channel inventory correction is behind us.
A resumption of growth in gaming is important for the overall sales and profitability and is probably not quite reflected in consensus estimates. It provides another lever for Nvidia to exceed their Q2 sales guidance and Q3 consensus sales estimates. So, we will look for continued signs of improvement and what growth rate is sustainable.
Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.Learn more here.
Visually, you can see how Nvidia breaks down the $1 trillion opportunity. This was taken from the October 2022 investor presentation.
Source: NVIDIA
How We Plan to Manage our Position
By Knox Ridley, Portfolio Manager
With the cash we raised throughout 2022, NVDA was the primary target of deploying some of this cash once our analysis signaled a bottom was in place. The below is a real-time trade notification we sent to our stock researchmembers on the October 13th.
Source: I/O FUND
The above alert was one out of nine alerts we sent out from 2021 – 2022 to buy NVDA below $200. However, since February of 2023, we have been systematically taking gains at key levels based on technical and macro warnings, while still holding it as our top position today.
In our last free Nvidia report, we identified the $405-$395 region as strong support. This was the buy zone we set up in advance, and were able to grab shares around the $410 region after it bounced from $403. Also, in our last report, we stressed the importance of last quarter’s earnings gap. For those that are not familiar, I’m referring to the rather large gap between closing price before their report and the opening price after the report.
Source: I/O FUND
Gaps are very important markers within price trends, and have many uses. For our purpose, the question we need to answer – is this gap a breakaway gap (the halfway point in a trend), or is it an exhaustion gap (the final bullish push before rolling over)?
There are two general Elliott Wave counts I’m using that represent both of these gap possibilities.
Blue – this count has the 2022 bear market as the first leg in a large degree correction. That would make 2023 the corrective leg, with the final drop on the horizon, which would likely retest the October lows.
Red – this count has us in a 4th wave correction within a larger 5 wave uptrend. This would make this current dip a buying opportunity as we push towards the $560-$590 region next.
Source: I/O FUND
The lowest I would allow this correction to go and still keep the red count valid would be the $340 region. If we break below $340, then the odds shift that the gap from Nvidia’s last earnings call was in fact an exhaustion gap. Our next move would be to set up downward targets to accumulate Nvidia for the long haul.
Micro Analysis
Another point worth mentioning is that the structure of the final leg in a corrective pattern (the C wave) is always a 5 wave drop. Furthermore, these patterns are fractal, so a small 5 wave patterns will morph into a larger one, which turns into an even bigger one. So, if we analyze the structure of the initial drop, we can get clues on what is playing out.
Source: I/O FUND
This pattern appears to be an overlapping and corrective pattern, not a 5-wave pattern. If price can definitely break above the July high at $480, then the odds will shift heavily towards the red count as we push to new highs. The only chance the blue count will have is if we break $405 to make afresh low. If this happens, and it is followed by a 3 wave correction, then the odds will shift towards the blue count, allowing investors ample time to better risk manage this position.
If you own Nvidia stock, or are looking to own NVDA, we encourage you to attend our weekly premium webinars, held every Thursday at 4:30 pm EST. Next week, we will discuss NVDA, as well as a handful of other AI plays – what our targets are, where we plan to buy as well as take gains.
Marvell reported in line with expectations. There was a miss on GAAP margin and GAAP EPS, yet the guide was in line. We had written in our pre-earnings writeup that GAAP margins were depressed due to the amortization of acquired intangible assets, and that management expected further challenges due to increased product mix of 5G and ASICs.
What’s exciting is that Marvell doubled its AI revenue from $400 million to $800 million. This means AI is now 14.4% of revenue, up from roughly 7% (on an annual run rate). This is bullish for our CY2024 thesis, and was not expected so soon. The most important statement on the call was this:
“Based on our latest demand outlook for our electro-optics products, we now expect revenue from AI to exit this year at over a $200 million quarterly revenue run rate or $800 million annualized. This is well above what we had outlined last quarter. Put this in perspective, this would put us at the run rate we had previously communicated for all of next year.”
Where the report is concerning is the increasing net debt to EBITDA ratio, which has increased from 1.6X to 1.8X. You can expect us to risk manage this position depending on FED actions. It was stated in the call: “we will opportunistically explore accessing the debt capital markets to refinance our upcoming debt maturities.”
Please note, we covered Marvell more in-depth yesterday heading into earnings, so this will be a brief update. Read more here.
Revenue and EPS:
Revenue of $1.34 billion was in line. This represents a year-over-year decline of (-11.60%).
Guide of $1.4 billion was in line. This represents a year-over-year decline of (-8.9%)
GAAP EPS missed at (-$0.24) reported versus (-$0.15) EPS expected
Adjusted EPS was in line at $0.40
Going into the report, we had said:
Margins:
GAAP Gross Margin missed, hence the miss on GAAP EPS. The company reported 38.9% versus 45.6% guided, at the midpoint for a miss of 670 basis points.
Adjusted gross margin was in line with guidance at 60.3%
GAAP operating margin missed, coming in at (-15.3%) versus (-6.6%) expected. This resulted in an operating loss of (-$205.7) million
Adjusted operating margin was marginally above expectations at 26.9% compared to 26.3% guided. This resulted in $360.1 million in adjusted operating profits
The net margin was (-15.5%) and adjusted net margin was 21.6%
Cash:
The operating cash flow was $112.5 million compared to $208.4 million in Q1 and $332 million in the same quarter last year. The operating cash flow was low primarily due to an increase in DSO (days sales outstanding) and severance-related cash restructuring charges. Management mentioned that they expect DSO to improve in the next quarter.
The CFO, Willem Meintjes, replied to an analyst’s question.
“Yes, so this quarter certainly DSO was impacted somewhat by linearity. We do expect a nice back — bounce-back in Q3 and some normalization.”
It is crucial the company to improves its cash flows in the coming quarter. The free cash flow dropped to $1.2 million compared to $105.8 million in Q1 and $256.3 million in the same period last year. The lower operating cash flows and higher capex of $111 million led to the drop in the free cash flow.
Debt:
The company has cash of $423.4 million compared to $1.03 billion at the end of Q1. Debt is $4.15 billion, which includes short-term debt of $1.02 billion.
The company used $572 million to repay debt in the recent quarter. Due to the lower cash flows, the company had to repay its debt from the cash balance. This was in contrary to what management had indicated in the Q1 earnings call when they stated they would repay debt from free cash flow and cash balance.
They have resumed buybacks as indicated in the last earnings call and it doesn’t seem ideal the company would take this route when the net debt to EBITDA ratio has increased from 1.6x in Q1 to 1.83 in Q2.
Per the earnings call, “we will opportunistically explore accessing the debt capital markets to refinance our upcoming debt maturities.”we will opportunistically explore accessing the debt capital markets to refinance our upcoming debt maturities.”
We had highlighted this risk in our pre-earnings coverage that this is a stock we will be cautious with depending on the FED’s actions due to higher interest rate environment.highlighted this risk in our pre-earnings coverage that this is a stock we will be cautious with depending on the FED’s actions due to higher interest rate environment. If we close the position, it will be due to this as we foresee AI revenue becoming meaningful in the second half of calendar year 2024, and the FED becoming more meaningful than AI much sooner.
Also note, we were on high alert for comments around this per our pre-ER writeup, and the report did not satisfy the criteria of being able to pay the debt from cash flow.
Key Metrics:
Data center revenue was down (-29%) and was up 6% QoQ, which should be marking a bottom, as long as the storage recovery doesn’t get pushed out further. This compares to being down (-32%) YoY last quarter and (-12%) QoQ decline. This exceeded guidance of 0% QoQ growth. The beat was due to the AI networking products.
On a QoQ basis, data center is expected to accelerate to “mid-teens” growth. Per management: “Demand for our AI products continues to grow at an extraordinary rate and we are working very closely with our customers to meet the rapidly evolving needs. On the other hand, enterprise on-premise is expected to continue to trend down. As a result, we are projecting overall data center revenue in the third quarter to grow in the mid-teens sequentially on a percentage basis.”
This additional color was also shared: “Our overall revenue from cloud grew over 20% sequentially. Notably, revenue from both cloud AI and standard cloud infrastructure grew sequentially, with AI growing faster. As expected, revenue from the enterprise on-premise portion of our data center end market declined significantly on a sequential basis in the second quarter, reflecting a weakening enterprise market.”
Carrier infrastructure segment was down (-3%) YoY and down (-5%) QoQ due to wired networks whereas 5G was strong at 25% QoQ growth.
Enterprise networking declined (-4%) YoY and (-10%) QoQ. This is expected to decline further into the low teens QoQ next quarter. Per management, enterprise networking will take a few quarters to normalize: “We expect this inventory re-normalization to take a few quarters to resolve as customer balance sheets get worked down over time.”
Automotive was up 32% YoY and 23% QoQ driven by increased adoption of Ethernet in cars. This segment is expected to be up 30% YoY and flat sequentially.
Consumer end market is up 2% YoY and up 18% QoQ. Revenue is expected to grow sequentially next in the low teens next quarter.
Notes on AI Revenue:
Per our pre-earnings notes regarding AI revenue: “However, up until FY2023 ending in January, the revenue was $200 million. This revenue is expected to double in the current fiscal year 2024 to $400 million.”
Notably, the company is at a $800 million run rate now with this earnings report. So, this means AI revenue has already doubled from the last call. Yes, it’s doubling on small numbers but it looks like we will be crossing $1 billion soon, and where can we then reasonably assume Marvell will end next fiscal year 2025 (calendar year 2024)?
This is why AI is tricky – it moves very rapidly – so we went from 7% of revenue exiting the year at $400M in the last call to 14.4% of revenue exiting the year within three months. If Marvell adds $400 million again next one or two quarters, we will be at 18.3% of revenue based on the FY guide for FY2025.
What will the market do once we reach 30% or even 50% and how quickly will this happen. If we double between FY2024 to FY2025 (ending in calendar January 2025) then we will be at 25% of revenue by end of next year, or 18 quick months. This is based off adding another $800 million by end of year next year, which is a reasonable assumption since Marvell added $400 million annual run rate in a quarter. I’m sure you know where I’m going with this. Due to the rapid move in AI revenue this quarter, 25% in AI revenue exiting next year is probably too low.
Earnings Call:
Marvell said something on the call that has been my contention for some time, which is that there are “scarce few” companies that will enable AI. I believe this is a winner-takes-most market. This is why I like Marvell very much as a stock, it’s showing us in the very early innings that it can be one of the few contenders to enable AI.
“As you heard in detail last quarter, AI infrastructure requires a staggering amount of high-bandwidth connectivity, best provided by an optically connected infrastructure operating at the highest available speeds. Marvell is enabling AI with a broad range of solutions, which include: PAM4-based optical DSPs and AECs for connecting accelerator clusters inside AI data centers; DCI products for connectivity between regional data centers; low-latency high-capacity Ethernet switches for fabric connectivity inside data centers; and custom silicon for compute acceleration. We are confident that the breadth of Marvell's technology positions us as one of a scarce few semiconductor companies that can enable the industry to capitalize on the rapid growth in AI.”.
Also, per the call, the following was stated on the margins: “We're targeting to get back to that 64% exiting this year and then to maintain that through next year. But clearly, it's sort of early to decide exactly how big the ASIC ramp is next year. Now if we do show outsized growth there, that would negatively impact our gross margin, but certainly our view is that, that would be very accretive to operating income and to EPS.”
Of course, my focus is on the “how big the ASIC ramp is next year” — the market will likely be forgiving on margins if we get a nice surprise in this regard.
Conclusion:
As a gentle reminder, covering semis is not easy. It was one year ago to the month that Nvidia missed $2.5B in revenue and it was expected to take years for the company to overcome the crypto mining selloff from Ethereum’s merge to PoS.
Nvidia looks easy now that the company is reporting triple digit data center revenue growth, yet its gaming segment was a cyclical, black eye to the company in prior quarters. Thus, if you’re looking at this report and wondering if it’s worth sorting through all these moving pars, the answer (for me) is absolutely yes. The edge in investing is not found in regurgitating what everyone else already knows. Even if the Street is aware that Marvell has AI revenue, the company is greatly underestimated due to the rising importance of custom silicon.
In fact, the intense focus on Nvidia is perhaps to our favor as we will continue to dig up lesser-known stocks and AI angles. Marvell is a stock we’ve owned and covered for many years (about 3-4 years now), and it’ll take just a touch more patience before this research pays off on a company that is quite complex.
However, I don’t want to overlook the debt issue that Marvell faces. This simply doesn’t match our investing criteria and so in that regard we want to emphasize risk management around any FED decisions. If we were to close/trim, we will add back at appropriate technical levels. We are ignoring this discipline for now and remaining invested, but want to give our Members a heads up that this is a risk we are tracking.
& p.s. sorry for any typos – we are closing out a long week and a long earnings season at the I/O Fund! See you Monday.
Note: This write-up includes notes on the earnings report that will come after market close plus the Post-Earnings write-up from last quarter — which was posted on the forum. the Post-Earnings write-up from last quarter — which was posted on the forum.
We expect Marvell to be a late bloomer in AI acceleration compared to Nvidia and AMD. There’s been discussion on the forum lately about Marvell’s AI thesis, and admittedly, it carries some speculation at this point in time. I do think ASICs will take market share from GPUs once the market is more mature, yet who specifically serves the market requires speculation. We think it’s worth the gamble to have a placeholder on Marvell right now. Given the runup in AI, we will use technical analysis to risk manage, as needed.
Revenue and EPS:
Marvell is expected to report revenue of $1.33 billion, representing a decline of (-12.3%). This should mark the bottom with revenue expected to decline (-9.2%) next quarter for $1.4B in revenue. From there, Marvell is expected to return to positive revenue growth with 2024 showing a meaningful rebound by H2.
One thing to note is the company saw some fairly large downward revisions despite the stock rallying in price this year. At the end of last year, the growth was expected to be 15% for FY 2024 ending in January and it’s now at (-7%). This is true for a few semiconductor companies that have exposure to consumers. FY 2025 estimates are improved 200 to 300 basis points to 18% growth.
Marvell is not GAAP profitable, and is expected to report (-$0.16) EPS this quarter. Adjusted EPS for Q2 is expected to be $0.32. The company is expected to return to EPS growth when it returns to revenue growth in the January quarter, with considerable growth on the bottom line beginning in the April quarter.
Per our last write-up: “In summary, as we move forward through this fiscal year, we project our revenue to continue to grow sequentially, gross margin to improve significantly in the fourth quarter, and operating expenses to continue to step down. Our DSO and inventory have already shown signs of improvement. As a result, we are looking forward to driving tremendous operating leverage and significant improvement in cash flow generation over this year, while setting up a strong platform for growth next year.”
Margins:
Numbers stated are from management’s guide for the current quarter unless otherwise indicated.
Overall, we are hoping Marvell is at a bottom this quarter with margins that are not ideal, but are expected to improve over the next few quarters.
The guide on GAAP gross margin is lower than usual at 45.5% at the midpoint. This compares to a GM of 51% in the year ago quarter. This will lead to GAAP gross profits also being down at $605M compared to $786M in the year ago quarter.
Adjusted gross margin of 60.5% guided this quarter is 450 basis points lower than year ago quarter.
GAAP Operating margin of (-6.6%) compares to OPM of +2.60% in the year ago quarter. Note that even the year ago quarter is still quite low compared to semi peers.
Adjusted operating margin of 26.3% compares to Adjusted OM of 36.5% in the year ago quarter.
Net margin last quarter was (-13%) for a net loss of ($170 million).
The reason for the lower GAAP margins is due to the amortization of acquired intangible assets. (Marvell acquired Inphi and Innovium in 2021). In the recent quarter amortization of acquired intangible assets that was included in the cost of goods sold was $183.7 million (13.9% of revenue). This led to a 14% difference in the GAAP gross margin and non-GAAP gross margin.
The management expects challenging margins in the near term due to the product mix.
The company’s CEO Matt Murphy mentioned in the Q4 2023 earnings call, “At the same time, we are forecasting very strong sequential growth in revenue from 5G and a number of custom ASICs, but these have gross margins well below Marvell's corporate average. As a result, we expect a challenging gross margin outlook for the next few quarters.” strong sequential growth in revenue from 5G and a number of custom ASICs, but these have gross margins well below Marvell's corporate average. As a result, we expect a challenging gross margin outlook for the next few quarters.” He further said that once the inventory correction situation improves the margins will improve. “However, we are confident that once we emerge from the inventory digestion phase into a more normalized environment, we will be well positioned for our gross margins to recover.”we are confident that once we emerge from the inventory digestion phase into a more normalized environment, we will be well positioned for our gross margins to recover.”
In a further update in the recent Q1 earnings call he said that inventory corrections will be resolved by the end of the year. “We anticipate that inventory corrections will be mostly behind us by the end of this year, and we are excited about the resumption of revenue growth driven by Marvell's specific product ramps. We have been laser focused on a number of cost improvement actions to improve gross margin. As a result, we have confidence in our forecast for our non-GAAP gross margin to return to at least the low-end of our target range in the fourth quarter of this fiscal year.”We anticipate that inventory corrections will be mostly behind us by the end of this year, and we are excited about the resumption of revenue growth driven by Marvell's specific product ramps. We have been laser focused on a number of cost improvement actions to improve gross margin. As a result, we have confidence in our forecast for our non-GAAP gross margin to return to at least the low-end of our target range in the fourth quarter of this fiscal year.”
The company’s CFO, Willem Meintjes said, “We have also put in place multiple cost reduction efforts to improve gross margin. Internally, we are optimizing headcount and further streamlining operations. Externally, we continue to partner with our strategic suppliers to drive more efficiency in the supply chain. We are confident that as a result of mix improvement and our cost reduction efforts, our non-GAAP gross margin will start to improve.”
Higher R&D and SG&A:
Marvell has higher R&D expenses and SG&A expenses compared to some of its peers like Broadcom, Microchip, and Analog Devices.
Marvell had R&D expenses as a percentage of revenue of 30.14% for the year ending Jan 2023 compared to:
14.81% for Broadcom for the year ending Oct 2022
13.25% for Microchip for the year ending Mar 2023
14.15% for Analog Devices for the year ending Oct 2022.
Marvell had SG&A expenses as a percentage of revenue of 14.25% for the year ending Jan 2023 compared to:
4.16% for Broadcom for the year ending Oct 2022
9.45% for Microchip for the year ending Mar 2023
10.54% for Analog Devices for the year ending Oct 2022
Marvell also has slightly higher stock-based compensation than its peers at 9.33% compared to:
4.62% for Broadcom for the year ending Oct 2022
2.02% for Microchip for the year ending Mar 2023
2.69% for Analog Devices for the year ending Oct 2022
Cash Flow:
Last quarter, operating cash flow of $208.4 million was up on a year-over basis but down quite a bit sequentially. Last year, OCF was $195 million and was $351 million in the previous quarter.
Last quarter, free cash flow of $105.8M compared to $156M in the year ago quarter.
Marvell is also different from its peers in that the company is highly leveraged with $1B in cash and $4.7B in debt. This should garner a lower valuation, and it’s also likely Marvell sees more volatile price action depending on the FED’s actions.
Marvell has to repay $1.5B in debt over the next year and has $1B in cash. Of this, $500M was just repaid and Marvell is expecting to resume buybacks in Q3. This is a line item we need an update on in the upcoming earnings call.
The operating cash flow included $40 million for a long-term capacity payment. Management expects minimal additional payments for FY2024 and beyond. Capex was also higher in the recent quarter as it was $102.6 million compared to $56 million in the January quarter and $38.50 million in the same quarter last year.
Key Metrics:
The following numbers are for the previous quarter YoY, ending in April:
Data center was down (-32%) to $436M – The sequential decline was due to storage and the management expects the storage business to grow sequentially in the next quarter and grow in the second half of the year. The data center revenue is expected to be flat sequentially in the next quarter (more below).
Carrier infrastructure was up 15% to $290M — helped by strong demand for wireless products due to 5G adoption. The management expects revenue to decline mid-single digits sequentially due to the ongoing inventory digestion in the wired end market.
Enterprise networking was up 27% to $365M — Management expects revenue to decline more than 10% sequentially in the next quarter due to the ongoing inventory corrections that also negatively impacted the recent quarter.
Consumer was down (-20%) for $142M — Management expects revenue to grow mid-30% range sequentially due to the strong seasonal growth expected for custom SSD controllers.
Automotive/Industrial – (Flat) for $89M — Due to the weakness in the industrial business. The management expects the automotive and industrial end market to grow sequentially in the low teens in the next quarter.
Storage:
Marvell’s data center segment has exposure to the deep trough in storage. We recently covered Lam Research’s exposure to NAND. This is not unique to Marvell, and many quality companies are affected. We ultimately think it’ll lead to a buying opportunity for FY2024.
Here was a question on the call about where storage might stabilize in terms of revenue:
Toshiya Hari:
Good point. Maybe one last question on data center, and then I’ll certainly open it up to the crowd. On your storage business and you gave great context in your prior comments. But I think pre-pandemic you were doing $200 millionish in storage revenue within data center. I think at the peak, you were closer to $300 million?
Ashish Saran:
Higher – it’s a lot higher.
Toshiya Hari:
And now you’re sub $100 million. And I think you talked about ultimately getting back to $200 millionish. Is that sort of the steady state if there is such a thing in this business?
Willem Meintjes:
Yes. I think – when you look at it – yes, so exiting this year, we don’t think we get all the way back to $200 million, maybe three quarters of the way.
According to management, they are returning to growth soon. Per the last earnings call:
“As expected, storage was responsible for the majority of the overall sequential decline in our data center revenue in the first quarter, although we are forecasting sequential growth to start in the second quarter and our data center storage business continue to grow in the second half.
Looking ahead to the second quarter for our overall data center end market, we expect cloud revenue to grow over 10% sequentially. However, we are expecting the enterprise on-premise portion of our data center end market to decline an offset growth from cloud. As a result, we expect revenue from our overall data center end market to be flat sequentially in the second quarter.”
AI-related Revenue:
Below are excerpts from the forum post following last quarter’s earnings results. excerpts from the forum post following last quarter’s earnings results.
If you listen closely to Marvell’s call, you’ll see there was a slight pivot to how management pitched AI and the data center. This pivot is important to understand.
In the past, the company’s data center segment was benefiting from the Inphi acquisition. We’ve written many times about this acquisition, and in fact, we owned both Inphi and Marvell when it was acquired by Marvell.
The COLORZ silicon photonics technology from Inphi allows data centers located in the same region to function like a mega data center. This helped Marvell become a critical supplier for data center interconnects. At one point, following the Inphi acquisition, the COLORZ 400-gig ZR datacenter interconnect products were driving data center revenue growth of 100%.
On the call, management is referring to networking and connectivity products when they stated:
“We created the industry's first pluggable module for DCI, and we are now providing 400 gigabits per second in our latest DCI product line. We already seen that AI cloud data centers are driving a significant increase in demand for 400 ZR solution. Another demand driver for our DCI products is that the next generation AI implementations are planning on clustering accelerators across different sites.”
Networking and connectivity are not to be underestimated in terms of growing importance, especially as AI will drive a need for more bandwidth. However, up until FY2023 ending in January, the revenue was $200 million. This revenue is expected to double in the current fiscal year 2024 to $400 million. Compare this to Marvell’s overall revenue of $5.52 billion. That’s only 7% of revenue from AI – a far cry from Nvidia’s $4 billion data center beat & raise for one quarter for a data center segment that will be $8 billion per quarter, purely from GPUs and AI acceleration.
Maybe Marvell is an AI bubble stock? I don’t think so … instead, Marvell is a serious contender.
Here’s why.
What Marvell later communicated is quite important, which is that the company plans to compete against GPUs with custom silicon. To be clear, this is a leap from relying on network connectivity to now relying more heavily on compute to drive AI revenue. This will be done through ASICs, which stands for application-specific integrated circuit (ASIC). As soon as Marvell started talking compute, the revenue for networking and connectivity is no longer the driver for AI revenue.
Here is what management said:
“Today, we see cloud customers enhancing their AI offerings by building custom accelerators of their own designed to address their specific needs. This is a core part of Marvell's cloud optimized silicon strategy, and we now see a much larger and faster growing opportunity for custom compute and AI infrastructure. When we previously discussed our cloud optimized silicon opportunities and revenue ramp expectations at our Investor Day in October 2021, we projected revenue from the first set of design wins to grow to $800 million annually once all the programs were in production.”
Management indicated $800M is a starting point when the CEO stated: “The continuing increase in demand from AI, we see annual revenue from those same set of cloud optimized design wins, well exceeding the prior 800 million projection as these programs ramp over time. In fact, we have a number of custom silicon products tied to AI expected to ramp into volume production next year. As an example for one of these programs, initial samples are already up and running at our customer's lab and qualification is proceeding well. And in other case, we expect to take out this quarter and deliver first silicon before the end of the calendar year.”
In terms of trying to quantify it further, management also stated: “In other words, we are forecasting an AI revenue growth CAGR over 100% over the fiscal 2023 to 2025 time frame.”
Later, it was stated: “And then what I updated on the call was that that peak revenue was actually going to exceed the 800 million, just given that the total lifetime volume now of those same design wins has actually increased pretty significantly. And then the percentage of those has moved meaningfully towards AI.”
What are ASICs?
I’ve written about ASICs a few times in the past, including in this article about Google. Google is well known for TPUs, which is customized silicon, known as ASICs. The two companies that supply leading edge ASICs are Broadcom and Marvell. The reason it makes sense to outsource custom chips is because a Big Tech company trying to tackle too many things can often work against them, especially with hardware of complexity.
“Just as Google was one of the first to need automated orchestration for containerization of cloud-native apps, the company was also one of the first to require low-power machine learning workloads. The compute intensive workloads were running on Nvidia’s GPUs for both training and inferencing until Google made their own processing unit called Tensorflow (TPUs) to perform the workload at a lower cost and higher performance.
Performance between TPUs and GPUs is often debated depending on the current release (A100 versus fourth-generation TPUs is the current battle). However, the TPU does have an undisputed better performance per watt for power-constrained applications. Notably, some of this comes with the territory of being an ASIC, which is designed to do one specific application very well whereas GPUs can be programmed as a more general-purpose accelerator. In this case, the benchmarks where TPUs compete are object detection, image classification, natural language processing and machine translation – all areas where Google’s product portfolio of Search, YouTube, AI assistants, and Google Maps, for example, excels.
Notably, TPUs are used internally at Google to help drive down the costs and capex of its own AI and ML portfolio and they are also available to users of Google’s AI cloud services. For example, eBay adopted TPUs to build a machine learning solution that could recognize millions of product images.”
In May, Marvell announced plans to acquire Avera Semiconductor for $650 million in cash plus $90 million if the business does well within the next 15 months. The deal is expected to close at the end of fiscal year 2020. Avera is a player in the ASIC market, which will help diversify Marvell as 5G has begun to favor ASICs over FPGAs due to costs and power consumption. ASICs, which stands for application-specific integrated circuit, are customized to perform one very specific function repeatedly rather than general-purpose chips – hence the “application specific.” Broadcom could potentially be challenged by this acquisition. Avera will add $300 million per year to Marvell’s top line.
In contrast to ASICs, the traditional FPGA chips are high in cost and power consumption, according to critics. Marvell is attempting to offer end-to-end network infrastructure with baseband DSPs, Arm multi-core SoCs (system on chips), purpose-built hardware accelerators, Ethernet connectivity engines and system-level security solutions. Although Marvell aims to offer specific-use ASICs and semi-custom ASICs, the 5G platform that Marvell offers will be adaptable for many use cases to expand on any ASIC limitations.
The primary SoC competitor is Broadcom. NXP Semiconductors and Qualcomm also compete with Marvell. Xilinx is a competitor on FPGAs.”
AWS Potential Customer on ASICs:
There was a report out of Taiwan that Marvell and Amazon may be working together on custom silicon for AWS. Since then, the report has been questioned but this is certainly the size and type of customer that would contract Marvell for a custom design.
Per the report:
“Marvell Technology (NASDAQ:MRVL) shares trade nearly 5% higher in pre-open Wednesday after Taiwan-based media outlet Liberty Times reported the chipmaker won Amazon’s (NASDAQ:AMZN) second-gen ASIC chip design. The production will begin in the second half of 2023, according to the report.
Some had speculated MSFT would be a leading MRVL ASIC customer. AMZN would make sense as they have some of the biggest custom in-house silicon development (Gravitron). And NVDA CEO has oddly NEVER INCLUDED AMZN as a direct GPU / AI partner in recent presentations, only MSFT, ORCL, GOOG,” they added.”
Conclusion:
The timing for custom silicon to show up in Marvell’s financials is 9 to 12 months out, and reaching full potential in two years. Many of our Members have been patiently waiting for our other semiconductor stocks to play out, what’s another two years? 😀
Maybe then, we will be needing to reallocate Nvidia anyways away from being such a large position! This stuff takes a LONG time to play out. I'm writing this Marvell post right now about custom silicon for a 24-month outlook, minimum.
Here is what management said:
“I mean – and those are the projects now that are coming to fruition. But I mean, just to be very clear, since that time, we have layered in a significant number of incremental new design wins. And those are – many of those are now underway, probably not as much revenue from those next year, but then those would be, sort of the year after. And I would just also add that our design win funnel, and this is data I was just reviewing at the company level, who's just expanded dramatically with the biggest portion of that coming from our cloud design win funnel.”
I didn’t address CXL in this post but this is an added bonus should Marvell be a frontrunner with CXL Memory. You can read about this new product line here.
The price action was more muted, yet the earnings report was quite spectacular. Primarily, the guide for Q3 implies data center growth of 226%, an acceleration from the 171% year-over-year reported in Q1. We had been posting on the forum that channel checks published by The Financial Times and The Information,plus China were pointing toward analysts/sources expecting between $30B to $40B in data center revenue growth. We are going to now easily clear the $40B number. If we assume an incremental $3B in Q4 (which is a reasonable assumption), then we will be at $42.6B.
The $42.6B is now probably too low if we factor in that Nvidia just beat 28% on data center in this quarter and 30% for overall revenue in Q3.
$8B in data center expected versus $10.3B reported = 28% beat
Q3 revenue expected of $12.35B versus $16B reported = 29.5% beat
Should the trend continue, it will lead to a $20B revenue quarter for Q4 and overall data center revenue for FY2024 of $48 billion, up from $15 billion last year for growth of 220%. These are hypothetical, but in line with what Nvidia has been reporting.
What I’m trying to describe here is that myself and the analysts covering this stock cannot keep up with the large beats and raises — even when you think you’ve provided a reasonable estimate, Nvidia blows right past it.
Financials Scorecard:
Revenue and EPS:
Revenue of $13.5B beat estimates of $11.1B for growth of 101.5%
Q3 Revenue of $12.35B beat estimates of $16B for growth of 169% estimated
Look for FY2024 estimates to go up, although hopefully they aren’t too aggressive to help secure a beat next quarter. A beat is very important for Nvidia next quarter given the spotlight on this company.
Adjusted EPS of $2.09 was expected versus $2.70 reported
The company announced a $25 billion buyback with $4 billion remaining
Margins:
Similar to revenue, this was a blowout quarter on the margins. Although pricing power may not sustain, as software revenue grows, it will continue to help the margins. The strong margin is likely due to a mix from software and also higher average sales prices.
70% gross margin is also bonkers. This is the best gross margin in Nvidia’s history (typically in the mid-50%) and this marks the turning point of Nvidia becoming a software company.and this marks the turning point of Nvidia becoming a software company.
Adjusted gross margin of 71.2% beat guidance of 70%
Operating margin of 50% beat guidance of 44%. On a year-over-year basis, operating income was up an incredible 1,263% from $499 million last year Q2 to $6.8B this year and was up 218% QoQ.
Adjusted operating margin of 57.6% beat guidance of 52.7%
Net margin of 45.9% compares to net margin of 28% last quarter
Net profits were $6.2B compared to $656 million in the year ago quarter – yes, 8-9X higher!
Earnings Call:
The CFO said the following in her opening comments about supply:
“We expect supply to increase each quarter through next year” and she also said “Demand for our Data Center platform where AI is tremendous and broad-based across industries on customers. Our demand visibility extends into next year. Our supply over the next several quarters will continue to ramp as we lower cycle times and work with our supply partners to add capacity.”
This is an indirect way of implying sales will increase each quarter through next year as Nvidia has plenty of demand.
The call was not as exciting this quarter. Per our notes last quarter, management said the following, which led to the stock action moving from 15% AH to 25% AH.
“Let me see if I can add a little bit more color. We believe that the supply that we will have for the second half of the year will be substantially larger than H1 […] Yes, we do plan a substantial increase in the second half compared to the first half.” -CFO Collette Kress, Q1 call
Considering the analyst was able to get this important color on the last call, the same analyst, Vivek Arya, thought he’d give it a go again by asking about supply. This time, the CFO declined to comment, and the price action AH softened from 9% to 6.5%.
Vivek Arya
Thank you. Just had a quick clarification and a question. Colette, if you could please clarify how much incremental supply do you expect to come online in the next year? You think it's up 20%, 30%, 40%, 50%? So just any sense of how much supply because you said it's growing every quarter […]
Colette Kress
So thanks for that question regarding our supply. Yes, we do expect to continue increasing ramping our supply over the next quarters as well as into next fiscal year. In terms of percent, it's not something that we have here […]
Speaking of demand, the CFO confirmed that cloud service providers (CSPs) are “a little bit more than 50% of revenue” in the data center followed by consumer internet companies.
Regarding software revenue, which is what leads to higher margins, the CFO said the following:
“Colette Kress
And let's see if I can answer your question regarding our software revenue. In part of our opening remarks that we made as well, remember, software is a part of almost all of our products, whether they're our Data Center products, GPU systems or any of our products within gaming and our future automotive products. You're correct, we're also selling it in a standalone business. And that stand-alone software continues to grow where we are providing both the software services, upgrades across there as well.
Now we're seeing, at this point, probably hundreds of millions of dollars annually for our software business, and we are looking at NVIDIA AI enterprise to be included with many of the products that we're selling, such as our DGX, such as our PCIe versions of our H100.”
Conclusion
I took the opportunity to make a plug for technical analysis after SMCI dropped as it was a strong report that received a harsh reaction. I want to make another plug for technical analysis because our last entry at $410 was bold given the stock was up 200% this year. We used technical analysis for this, not fundamentals. Our hope is that we can take gains in the mid-$500s to low $600s per this July Positions Report. When we do, you will be alerted via real-time trade alerts. Keep an eye out for the webinar invite for tomorrow, as well, where Knox will be discussing the I/O Fund’s Nvidia position.
Risk:
It may seem like Nvidia stock will keep climbing forever, but the words “China ban” can and will rock this stock. There is 20% to 25% exposure to China in the data center. We assume this risk by owning the stock and will use technicals to risk manage when appropriate.
The price action was more muted, yet the earnings report was quite spectacular. Primarily, the guide for Q3 implies data center growth of 226%, an acceleration from the 171% year-over-year reported in Q1. Our research based on the channel checks published by The Financial Times and The Information were pointing toward analysts/sources expecting between $30B to $40B in data center revenue growth. We are going to now easily clear the $40B number. If we assume an incremental $3B in Q4 (which is a reasonable assumption), then we will be at $42.6B.
The $42.6B is now probably too low if we factor in that Nvidia just beat 28% on data center in this quarter and 30% for overall revenue in Q3.
· $8B in data center expected versus $10.3B reported = 28% beat
· Q3 revenue expected of $12.35B versus $16B reported = 29.5% beat
Should the trend continue, it will lead to a $20B revenue quarter for Q4 and overall data center revenue for FY2024 of $48 billion, up from $15 billion last year for growth of 220%. These are hypothetical, but in line with what Nvidia has been reporting.
What I’m trying to describe here is that myself and the analysts covering this stock cannot keep up with the large beats and raises — even when you think you’ve provided a reasonable estimate, Nvidia blows right past it.
Financials Scorecard:
Revenue and EPS:
· Revenue of $13.5B beat estimates of $11.1B for growth of 101.5%
· Q3 Revenue of $12.35B beat estimates of $16B for growth of 169% estimated
· Look for FY2024 estimates to go up, although hopefully they aren’t too aggressive to help secure a beat next quarter. A beat is very important for Nvidia next quarter given the spotlight on this company.
· Adjusted EPS of $2.09 was expected versus $2.70 reported
· The company announced a $25 billion buyback with $4 billion remaining
Margins:
Similar to revenue, this was a blowout quarter on the margins. Although pricing power may not sustain, as software revenue grows, it will continue to help the margins. The strong margin is likely due to a mix from software and also higher average sales prices.
· 70% gross margin is also bonkers. This is the best gross margin in Nvidia’s history (typically in the mid-50%) and this marks the turning point of Nvidia becoming a software company.and this marks the turning point of Nvidia becoming a software company.
· Adjusted gross margin of 71.2% beat guidance of 70%
· Operating margin of 50% beat guidance of 44%. On a year-over-year basis, operating income was up an incredible 1,263% from $499 million last year Q2 to $6.8B this year and was up 218% QoQ.
· Adjusted operating margin of 57.6% beat guidance of 52.7%
· Net margin of 45.9% compares to net margin of 28% last quarter
· Net profits were $6.2B compared to $656 million in the year ago quarter – yes, 8-9X higher!
Earnings Call:
The CFO said the following in her opening comments about supply:
“We expect supply to increase each quarter through next year” and she also said “Demand for our Data Center platform where AI is tremendous and broad-based across industries on customers. Our demand visibility extends into next year. Our supply over the next several quarters will continue to ramp as we lower cycle times and work with our supply partners to add capacity.”
This is an indirect way of implying sales will increase each quarter through next year as Nvidia has plenty of demand.
The call was not as exciting this quarter. Per our notes last quarter, management said the following, which led to the stock action moving from 15% AH to 25% AH.
“Let me see if I can add a little bit more color. We believe that the supply that we will have for the second half of the year will be substantially larger than H1 […] Yes, we do plan a substantial increase in the second half compared to the first half.” -CFO Collette Kress, Q1 call
Considering the analyst was able to get this important color on the last call, the same analyst, Vivek Arya, thought he’d give it a go again by asking about supply. This time, the CFO declined to comment, and the price action AH softened from 9% to 6.5%.
Vivek Arya
Thank you. Just had a quick clarification and a question. Colette, if you could please clarify how much incremental supply do you expect to come online in the next year? You think it's up 20%, 30%, 40%, 50%? So just any sense of how much supply because you said it's growing every quarter […]
Colette Kress
So thanks for that question regarding our supply. Yes, we do expect to continue increasing ramping our supply over the next quarters as well as into next fiscal year. In terms of percent, it's not something that we have here […]
Speaking of demand, the CFO confirmed that cloud service providers (CSPs) are “a little bit more than 50% of revenue” in the data center followed by consumer internet companies.
Regarding software revenue, which is what leads to higher margins, the CFO said the following:
“Colette Kress
And let's see if I can answer your question regarding our software revenue. In part of our opening remarks that we made as well, remember, software is a part of almost all of our products, whether they're our Data Center products, GPU systems or any of our products within gaming and our future automotive products. You're correct, we're also selling it in a standalone business. And that stand-alone software continues to grow where we are providing both the software services, upgrades across there as well.
Now we're seeing, at this point, probably hundreds of millions of dollars annually for our software business, and we are looking at NVIDIA AI enterprise to be included with many of the products that we're selling, such as our DGX, such as our PCIe versions of our H100.”
Conclusion
I took the opportunity to make a plug for technical analysis after SMCI dropped as it was a strong report that received a harsh reaction. I want to make another plug for technical analysis because our last entry at $410 was bold given the stock was up 200% this year. We used technical analysis for this, not fundamentals. Our hope is that we can take gains in the mid-$500s to low $600s per this Forbes article. When we do, we will update our 3-position Portfolio found here on the Dashboard
Risk:
It may seem like Nvidia stock will keep climbing forever, but the words “China ban” can and will rock this stock. There is 20% to 25% exposure to China in the data center. We assume this risk by owning the stock and will use technicals to risk manage when appropriate.
Regarding the horizontal lines, black lines represent strong support/resistance, while dark red lines mark very strong support/resistance.
Elliott Wave count are meant to provide context. There is a pattern unfolding in real-time, one of which will play out. By monitoring price levels that are held/broken, it will help us figure out which one is in play.
Big Picture
Below is a weekly chart for the S&P 500, so each bar represents one full week of price action. From this larger perspective, there are three general paths that we are tracking.
Blue – The bull market that began at the COVID low completed in early 2022. What has followed has been the start of a secular bear market with one more leg lower. This would make the current bull market a cyclical bull uptrend, within a secular bear downtrend.
Green – This is a variation of the Blue count above. This count has us making one more swing higher in a larger B wave.
Red – The 2022 bear market was a large correction in an on-going uptrend that started at the COVID low. This pattern would have us around the halfway point in the final 5th wave, which should take us to new highs into 2024.
Where we are now is determining whether this correction is the start of something much worse than most expect (blue), or an excellent buying opportunity (red, green). There are two determining criteria I am looking out for in order to position our portfolio correctly:
Is the structure of this drop a 5-wave pattern or a 3-wave pattern? A 5-wave pattern will be more vertical and direct in nature. If so, it will support our blue count. If it is a 3-wave pattern, it will have many overlaps and appear to be quite messy. If this manifests, it will support our red or green counts.
Will the drop hold our critical support at 4315-4275? If we break below this pivot, it will strongly support our blue count. On the other hand, if we are in a minor correction within a larger uptrend to new highs, this level needs to hold.
Positions Report of Nvidia, Microsoft, and Netflix
Nvidia (NVDA)Nvidia (NVDA)
As long as NVDA stays above $340 on any further weakness, the green count remains my primary. This supports the green count in the broader market, suggesting another push higher into the fall/early winter. Furthermore, the drop from the recent high looks to be corrective – 3 waves. We will want to see a 5-wave rally off of this low – or a future low above $340 – to support the next swing to new highs.
It's also worth noting that NVDA is trending down into a time factor, which tends to mark the end of a swing. It’s doing so with the downward momentum at a rare extreme. This, at minimum, leads to a notable bounce.
Microsoft (MSFT)Microsoft (MSFT)
The daily RSI is below the bull market support zone. This supports any bounce in MSFT should be sold, with at least one more low to come. The critical support is $280 for the green count and holding this is critical for any chance at one more high.
Note: We added to MSFT today in the $313 target zone. We believe the evidence still supports one more swing higher. If this changes, we will stop out of this attempt.
Netflix (NFLX)Netflix (NFLX)
Looks like NFLX has a high probability to move down into the $380s. If that next drop breaks below $376, then the Blue count will be my primary, and we will start setting up downside buy zones. If it can hold $376, then I’d expect another high.
Advanced Signals Members receive real-time trade alerts for our entries and in-depth technical analysis from the Portfolio Manager, Knox Ridley. Learn more here.Learn more here.
Semiconductors have outperformed every other sector in technology this year, and I believe this is for good reason. Our site has been stated (consistently) for many years that the semiconductor industry is at the forefront of AI – and this is different than previous tech booms that were led by software. Although it’ll be a mix of hardware and software that drives the next leg up for artificial intelligence, we are firmly in the hardware stage of the hype cycle to where the competitive advantage for both data centers and enterprises is concentrated on the hardware, for now. In turn, this need for leading-edge hardware is contributing to high capital intensity.
Lam serves the memory market, and the cyclicality in memory is steep. DRAM is expected to decline (-39.4%) in 2023. Yet in 2024, DRAM will grow by “as much as 87 percent” according to Gartner. NAND flash memory is projected to decline by (-32.9%) and then “bounce back to grow by about 60 percent” in 2024. For semiconductor manufacturing equipment, the market is expected to decline (-22%) in 2023 and then rebound 21% in 2024. This is a remarkable turnaround, but one that should be approached carefully, as the rebound also represents a remarkable oversupply.
Ideally, we will enter Lam much lower than where it’s currently trading. The memory rebound is expected to ramp in June of 2024, so there is time. Micron is also showing evidence it will heavily participate in this rebound, although Lam is (typically) lower risk due to being diversified across the top 3 memory customers. As a reminder, Micron is #3 behind Samsung and SK Hynix, whereas Lam is tied for #1 on WFE with Tokyo Electron. The company also does quite well at disrupting the wafer fabrication equipment market with strong R&D spend and a rapid product cycle.
Over the past decade or so, Lam was considered lower risk because it was expected that memory manufacturers would continue to buy from Lam even during a low point in the cycle. This happened in 2015, when Lam was insulated from the last deep memory trough. However, due to the China ban, Lam did not escape the memory trough this time around.
The fundamentals are pointing toward either a bottom already occurring last quarter, or the bottom occurring this quarter. Fundamentals can always change – which is why we cover each earnings report for our core positions twice. However, as of now, the early part of 2024 is looking strong for Lam. We review these important key metrics below, and will ultimately wait for technicals to align before we consider an entry.
Water fabrication equipment (WFE) is a primary segment for Lam Research, specifically for memory and storage chips. The deposition process creates layers of insulating and conducting materials with techniques like chemical vapor deposition or atomic layer deposition, which allows for thin films of atomic layers to be coated onto surfaces. The excess material is then etched away.
Deposition and etch are processes that require complex machines for wafers to be built into integrated circuits.
3D NAND moves memory from a 2D plane to a 3D plane, which dramatically improves the storage capacity. Storage was reaching the end of its physical limits yet applications were requiring higher density and lower cost-per-bit. Due to data hungry applications – today in AI but also elsewhere, current NAND designs have been reaching the limits of monolithic die-level maximum capacity.
In 2013, Lam was at the forefront of this change by providing the equipment to manufacture 3D NAND. The advanced deposition and etch systems solved important manufacturing challenges for stacking film layers. Planar NAND has aspect ratios of 1:10 whereas 3D NAND has aspect ratios of 1:40. Going vertical makes it hard to maintain a uniform hole diameter.
Even more challenging is the need to fill narrow, horizontal features with a lateral deposition process. This is especially important for replacement-gate designs, which have replacement layers in the stack. We’ve detailed these differences in a Micron write-up here.
Cryogenic etch is a technology introduced a few years back where the etch removes the material in devices at cold temperatures below 100 degrees Celsius for high-aspect ratios with 200+ layers. The cold temperatures are achieved with liquefied nitrogen gas. You can click here for an article that describes this process.
There is competition in this space for Lam, especially from Tokyo Electron, who released a third generation cryogenic etch solution that lowers the temperature to increase the gas, which in turn, improves dimensions and depth over conventional cryogenic etch. This leads to a 53% reduction in etch time and is enabling 300-layer single-stack NAND by etching a 25% longer hole.
Lam has many highly technical processes for deposition and etch, here are a few. I won’t go into the details of each one, but rather have detailed the products most likely to drive forward growth below (advanced packaging, HBM/DRAM, and gate all around).
Kiyo and Flex process modules for the Sense.i platform, which increases output with a smaller warehouse footprint.
Coronus plasma bevel clean systems and Corvus etch for leading-edge node manufacturing
The company also supports Gallium Nitride manufacturing with “atomic level precision” and is porting it’s 300mm etch solutions to a 200mm process.
Additionally, advanced packaging is a segment where generative AI applications may drive more revenue for Lam. The company’s SABRE 3D copper electroplating and Syndion etch system is one of Lam’s solutions used for packaging advanced 3D stacking.
Lam’s Reliant Equipment is driving growth by providing a lower cost of ownership for non-traditional chip markets, such as micro electromechnical systems (MEMS), power chips, radio frequency (RF) filters and CMOS image sensors for better connectivity and more powerful imaging. This particular segment refers to trailing edge nodes, which means larger nodes, such as 24nm, 28nm or 90nm processes. Although we have written quite a bit about leading edge nodes, Lam has also found success in supplying equipment for larger nodes as these are used in automotive and medical equipment.
Lastly, Lam is a leader in plasma simulation, which allows engineers to model and simulate wafer builds to drive down costs and increase production time compared to the traditional method of building many wafer tests. In this case, engineers are testing virtual wafers, and this is expected to be popular for advanced nodes. Recently, Lam announced an initiative to train 60,000 engineers in India on its simulation software, Semiverse.
HBM/3D-Stacked DRAM
HBM and/or 3D-stacked DRAM and/or 3D DRAM are terms often used interchangeably, and are strong drivers for Lam given the company has an opportunity to supply the market with greater etch and deposition intensity to reverse DRAM’s slowing cost/bit declines.
The impetus is AI acceleration, which is in a stage where it’s fiercely competing on memory (see below excerpts from our AMD deep dive). In fact, according to Lam, AI servers use 8X DRAM and 3X NAND compared to an enterprise class server.
High bandwidth memory (HBM) offers higher bandwidth and lower power by vertically stacking memory chips to shorten how far data has to travel, while also allowing for smaller form factors. Stacked memory chips are connected through something called “through silicon vias” or TSVs.
TSVs are spoken about on Lam’s earnings calls, per the most recent comment: “we haven't exactly sized this business externally, but we — it is growing and, it’s in certain areas, especially as I highlighted things like etch for TSVs, copper plating for filling of those TSVs, pretty much anything related to the building of that advanced packaging structure through etch and deposition.”
Nvidia’s H100 utilizes HBM3 memory, supplied by both SK Hynix and soon Samsung will also supply the H100s. AMD’s MI300s are leverage HBM3 memory and 2.5D packaging, supplied by Samsung. Lam states the company has 50% market share in deposition and etch solutions in 3D stacking for high bandwidth memory.
The focus of our recent AMD deep dive in July helped emphasize how memory has become a point of fierce competition among AI accelerators. Here is what was stated in our report – I’ve bolded what’s important for this report on Lam:
“According to AMD, the MI300X will have 2.4X the memory density of the H100 and 1.6X the memory bandwidth. The reason that the MI300X was able to run the popular Falcon-40B large language model (LLM) with 40 parameters is because the neural network was ran entirely in memory without the need to move data back-and-forth with the external memory. AMD also stated the MI300X will be able to run up to 80B parameters on a single chip.
(8) 5nm GPUs and (4) 6nm base dies
153 billion transistors
192GB of HMB3 memory. 5TB/second of memory bandwidth
Ran a 40B parameter large language model (LLM) on a single GPU (unprecedented)
Can scale up to 8 accelerators in a single package for cutting-edge generative AI LLMs
The MI300X requires more power than its predecessor MI250X at 750 watts, and this is higher than Nvidia’s H100 at 700 watts. However, it’s not an apples-to-apples because what the MI300X promises to deliver is running compute-intensive large language models with fewer GPUs than is required with the H100s due to offering roughly double the memory.”
This month, Nvidia announced the GH200 super chip, which combines the H100 GPU with Grace 72-core Arm CPUs for an increase of memory capacity by 3.5X and memory bandwidth by 3X. Per the press release: “HBM3e memory, which is 50% faster than current HBM3, delivers a total of 10TB/sec of combined bandwidth, allowing the new platform to run models 3.5x larger than the previous version, while improving performance with 3x faster memory bandwidth.” This new generation of HBM3 memory is likely being supplied by SK Hynix.
Point being, memory is becoming an important component in the AI arms race, and Lam is a major equipment supplier and beneficiary of capital intensity that follows each new generation of HBM. Although Tokyo Electron is a notable and equal-sized competitor, Lam’s not to be underestimated on its ability to innovate quickly and serve the growing demands of the insatiable high-performance computing market.
Advanced Packaging
HBM3 and HBM3e require advanced 2.5D CoWoS packaging. Lam serves this market, and it’s expected to be an important growth driver over time. Per Lam’s management team: “I mean when you look at the importance of things like CoWoS-2 and AI packaged system, our exposure there even broadens further to the types of tools that we sell in there.”
Especially for AI purposes, chiplets are replacing monolithic circuits, where the overall system is divided into smaller parts so that 3nm or 5nm nodes can be replaced when needed. This avoids having to replace all of the components nodes shrink and design companies otherwise battle Moore’s Law.
With chiplets, AI platforms can scale by adding computing power and reduce total cost of ownership. Here is a whitepaper that discusses how chiplets are the way forward “Chiplet Cloud: Building AI Supercomputers for Serving Large Generative Language Models.” This whitepaper lays out some important arguments about the future of designs for AI acceleration. In most all cases, chiplets will be the desired architecture, and companies like Lam will provide these advanced packaging solutions.
Last year, Lam acquired SEMSYSCO to further its advanced packaging offerings for leading-edge logic chips and chiplet-based technologies. These solutions are needed for high-performance computing, AI and data-intensive applications. By cutting the chips or chiplets from a substrate sheet, chipmakers can increase yield and reduce waste.
Here are some of the stats shared on the most recent earnings call about advanced packaging:
“Customers are increasingly adopting a wide variety of packaging schemes to enable logic and memory integration. Some of these schemes enable up to 50% improved memory density, 10 times improvement in bandwidth and 60% gain in power efficiency. Lam has a track record of excellence in the advanced packaging segment with a strong set of manufacturing proven products.”
Gate All Around (GAA) Transistors
Lam supplies equipment for gate-all-around transistors, which are replacing replace FinFET transistors. Chipmakers such as TSM, Samsung and Intel produce GAA transistor designs.
FinFET transistors have a vertical geometry that helps to reduce the effects of Moore’s Law. This leads to more current flow with less leakage, leading to a lower gate voltage for operating the transistor. FinFET has been popular over the past decade as it resulted in better performance and lower power consumption.
Due to advanced nodes, FinFETS are reaching their limits in both height and how many can be stacked side-by-side. The vertical geometry is being replaced with horizontal nanosheets. This allows the gate to surround the channel on all four sides, reducing leakage and current. The result is better chip performance from the electrical signal that passes through the transistors.
A Few Reminders:
Given Lam’s highly technical product line, we should review the pros and cons for Lam so that the driving forces for this company does not get lost in the jargon.
There is a glut of supply in both NAND and DRAM, but especially NAND that must become absorbed. As you are all aware, the weak consumer market of PCs and mobile are weighing on otherwise strong companies (Apple, Microsoft, AMD, Broadcom, you name it). Memory is deeply feeling the effects of a weak consumer market. As a result, there is low production and low utilization rates in the industry right now, which will later lead to a shortage.
Lam’s advantage is the company’s ability to innovate at a fast clip to keep its equipment in high demand. Therefore, one could argue that even though memory has become commoditized, the equipment market can be leveraged within this competition for improved processes. The company’s customers include TSM, Intel, Samsung, SK Hynix and Micron. By serving the top 3 companies in memory, Lam has greatly outperformed the more well-known memory stock, Micron, over the past 10 years.
Lam’s production facilities are located in the United States, which is a positive as the CHIPS Act will benefit Lam. On the flip side, Lam is also exposed to the China ban, which has hurt Lam this year, and strengthened its competitors. The puts and takes to the geographical AI arms race have to be considered with Lam – and for all semiconductor companies really incl NVDA, AMD, MRVL — as this will only intensify as time goes on.
A Note on AI-related Revenue
The CEO of Lam stated that for “every incremental 1% penetration of AI servers and data centers is expected to drive $1B to $1.5B of additional WFE investment.” This is exciting but an analyst asked management to double click on this statement, as in this case, that 1:1 or 1:1.5 should be showing up by now given the surge in demand for AI servers and data centers.
This was an important part of the call, so I’ve included the transcript for you:
Atif Malik
“[…] When I listened to the major foundry in Taiwan, they talked about 50% AI semi growth rate in the next few years but we did not really raise any CapEx this year. And we believe AI server adoption is probably like high single digit, 8%, 9%.
So what explains the discrepancy in terms of not seeing a lift in leading-edge investments from the higher server adoption? Maybe it's just underutilization in other end markets.
Doug Bettinger
I guess what I think about, Atif, is these are longer-term statements we're making. I think you're right about the composition of AI servers. In the short term, you're not really going to see a meaningful uptick in WFE, frankly. This is going to occur over the next several years. As more of — and you're right, I think server volumes largely, I don't know, mid- to, I'd call it, mid-single digit percent of total servers. I think that grows over time. But in the short term, it doesn't really show up as quickly as you might think. It requires sort of capital investments to occur for future demand. That doesn't really happen in a meaningful way in the short term.”
Financials
Lam Research saw as high as 49% revenue growth in 2021 when we owned the stock and will now bottom at (-32.7%) growth in the upcoming September quarter. Assuming analyst estimates are correct, Lam will then rebound to 20% growth by the June 2024 quarter, and will remain at this growth rate into the foreseeable future.
This rebound is seen across a few semiconductors with consumer exposure, such as Taiwan Semi and Micron. Lam has an exceptional bottom line, and this is a large part of our consideration. As stated in the intro, fiscal year EPS is eye-watering at $27.05 expected for FY2024 and will grow to $55.13 EPS by FY2028. This is not a typo with the decimal point.
Analysts were positive on Lam’s gross margins as they bottomed in the March quarter at 41.5% and are now at 45% and 46%.
Even during the downturn, Lam maintained a strong GAAP operating margin of 26.6% last quarter, this is down about 500 basis points from its peak. The low on operating margin is likely behind us, at a 24.4% margin in the March quarter. Current guide for this upcoming quarter is an operating margin of 27%.
Similar to operating margins, cash flow margins have maintained quite well. Operating cash flow margin last quarter was 35% and free cash flow margin was 32.5% for a little over $1 billion in FCF. The company has $5B in cash and $5B in debt on the balance sheet. This has been consistent for many quarters.
Gross margins reached a 5 and 10 year low in March 2023. Operating margins reached 5-year lows and you can see where Lam improved operational efficiency.
Meanwhile, based on company September quarterly guidance. Quarterly sales also appeared to have bottomed out in the June 2023 quarter.
Consensus has revised eps mainly due to better-than-expected profitability from self-help and bottoming in sales. Lam has also been buying back shares to lift EPS.
Key Segments:
To drive forward growth, all three segments from Lam are important to monitor. Foundry is where we will see growth from leading-edge devices and Logic/other is where advanced packaging revenue will be recognized. However, for a true recovery, we need Memory and DRAM to bottom as it’s a substantial part of Lam’s business. You can see the blue arrow below is pointing toward Memory/DRAM declining from 40% of revenue and 14% of revenue, respectively, to 18% and 9% of revenue in the most recent quarter.
Combined Memory was at 27%, which per management, is the “lowest concentration percentage for this segment in the last decade.” Management also stated they expect “NAND spending to remain at low levels for the remainder of the 2023 calendar year” and is the lowest they’ve seen since the 3D NAND entered the market circa 2013.
Given Lam’s strong performance over the past decade, coupled with its strong bottom line and penchant for innovation, a 10-year trough may be a buying opportunity – provided we can get the stock at the right price.
When Will Lam Bottom?
Canary in the coal mine
Given the financial metrics we’ve outlined, most point to signs Lam is getting closer to the bottom in the “cycle”. The section below answers what will we be focusing on to give us confidence that the 2024 growth rates that Gartner has estimated are realistic?
Lam breaks down their sales between two business units – Systems and Customer Support Business Group (CSBG). The Systems business sells the hardware. CSBG is the aftermarket business that provides services and parts to its clients after they’ve installed Lam’s hardware.
This is a recent breakdown in sales between these two businesses. We’ve estimated the September quarter breakdown based on management’s guidance of $3.4b in total sales.
During periods of strong demand, the breakdown between the two is about 65%/35% between Systems and CSBG. This reflects strong sales of new hardware and the steady growth of the aftermarket that follows. During periods of weaker demand, the percentage of hardware sales decreases and aftermarket increases because there are fewer new systems sales and the aftermarket is primarily done on existing capacity.
As can be seen above, this ratio peaked at 67/33 in the December 2022 quarter and since then has steadily declined to 53/47 in the June 2023 quarter, which is primarily a function of the decline in Systems sales. The 47% CSBG contribution is the highest ever.
Looking ahead we see signs we’re closer to the bottom. Firstly, based on Lam’s September guidance, we believe that the June quarter marked the bottom in Systems sales and that September will show sequential positive growth. Secondly, we believe CSBG will bottom in the September quarter if not the December quarter.
The focus on when the CSBG segment has bottomed is important because it is an early indicator that Lam’s clients are planning to increase utilization. This is how Lam described its importance when asked in the recent June quarterly call as to what investors should focus on for signs that the environment is getting better.
Pricing
An important catalyst for an increase in utilization and capex will be higher DRAM and NAND prices. A chart by the Yole Group shows the recent history and estimated Q/Q price changes. Lam’s fab clients will begin to increase utilization if Q/Q pricing begins to improve.
In the most recent call, Lam indicated that NAND capex has declined the most and management has heard of recent, additional cuts: “And again, just listening to our customers and talking to them, we've heard some customers talk about further cuts in NAND just in the last 24 hours.” Management also stated that DRAM will be the first to recover as they are optimistic around HBM.
China exposure
Lam’s China exposure is both a blessing and a curse. The former in that it comprises 26% percent or $4.5b of Lam’s FY2023 sales. The latter in that it is at center of the export restrictions targets that the US government has aimed at China in the name of IP security. In the most recent call, Lam stated that they had lost about $2b in sales due to these restrictions. In response, Lam has focused on areas that aren’t subject to these restrictions. The risk is that these restrictions will spread to those areas and will continue to meaningfully impact Lam’s China business. This risk is quantifiable. Although highly unlikely, in the worst-case scenario Lam could lose 26% of its sales overnight.
From June 2021 to June 2022 to June 2023, Lam’s China revenue has gone from 37% to 31% to 26%. A reasonable base case is to assume this downward trend will continue over time.
Delay in Capex
If pricing does not improve, WFE capex may take longer to resume and WFE sales may take longer to resume.
Based on estimates from semi.org, 2023 WFE sales are expected to be about $75b. And if WFE sales have bottomed, Lam 5.1 p/sales (1 yr. fwrd) vs its 4.6 avg, is not yet pricing in a significant improvement.
Interestingly, despite the sharp decline in sales in q3 and q4 in FY2023, the FY2023 annual sales were flat y/y. Lam expects a slight pick-up from China and HBM. If Systems sales are beginning to improve and CSBG is close to bottoming, consensus estimates of 14% decline in Lam’s FY2024 sales appears a bit pessimistic.
In the most recent June quarter, deferred revenue was $1.8B vs $2.B in March. Regarding the deferred revenue, Lam made the following comment.
“We've got all the deferred revenue related to outstanding back order parts completely back to normal levels. As we discussed last quarter though, our deferred revenue balance is currently still at higher than historic levels.”
VALUATION:
Due to the tech rally, which was led by semiconductors this year, Lam Research is trading at a 1-year high and 3-year high of 5.9 forward P/S ratio. The PE Ratio is the same, it’s trading at a 1-year and 3-year high of 24X.
TA will be important as the stock is close to 2022 all-time highs. Lam tested first support level at $644 and bounced to $662. Next support is at $587.
Advanced Signals Members receive real-time trade alerts for our entries and in-depth technical analysis from the Portfolio Manager, Knox Ridley. Learn more here.Learn more here.
Conclusion:
The pummeled consumer market is deceiving as eventually hybrid AI will bring AI processing capabilities to the edge, including consumer devices. Memory is a key component in the competitive AI race both inside and outside the data center.
Our goal is to identify an AI-related memory stock by mid-2024 that we can own into the foreseeable future. We’ve tracked Big Tech capex as a proxy for AI acceleration in the data center, and we are forming new proxies now for the consumer device AI boom. Apple will always be Apple, but their margins will likely be lower with semiconductor companies benefiting from higher dollar chip content per device. This will take time to play out, but if we are lucky, then the consumer weakness will depress the very stocks that will most benefit from AI moving toward the edge.
This article was originally published on Forbes on Aug 10, 2023,07:15 am EDTForbes Forbes on Aug 10, 2023,07:15 am EDT
Given the macro headwinds, not many investors expected the magnitude of the Nasdaq-100’s rally through the first six months of 2023. Going into this year, we were positioned for bottom-line focused investment themes that we felt would be able to deliver earnings growth due to secular demand for its products, and in some cases, be able to reduce costs to maintain profitability.
Big Tech versus Tech Sector earnings
Below is an analysis of consensus earnings estimates from Zack’s on Q2 Technology Sector earnings trends through July 26 plus expectations for the next three calendar quarters.
For the past three quarters, sales and earnings have declined on a year-over-year basis. However, there appears to be stabilization as year-over-year comps get easier and the market is estimating a modest resumption of growth in Q3 and an acceleration in Q4 to Q124.
Meanwhile, Zack’s looked at the earnings picture for the “Big 7 Tech Players” – Microsoft, Alphabet, Meta, Nvidia, Apple, Tesla and Amazon. The earnings profile for the Big 7 is estimated to be more robust compared to the overall technology sector.
In addition to a better earnings profile, Big Tech prices and valuations have benefited from other factors that investors are seeking
Focus on their AI capability and having the financial resources to make the required investments so that they make a positive contribution to future earnings.
Company size (i.e. large cap) and the ability to manage margins in the face of macro headwinds by meaningfully reducing costs but not at the expense of critical high ROI investments.
Credit quality – following Fitch Ratings’ downgrade of U.S. government debt to AA+. Big Tech Credit worthiness is on par if not greater than US debt. For example, Alphabet has the same AA+ rating.
Amongst the Big 7, we believe Alphabet stands out for several reasons:
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Year of Execution – Alphabet
Beginning in mid-2022, IO Fund began to transition allocation toward larger cap tech stocks because we felt they are in a better position to navigate a macro downturn. Big Tech has levers at its disposal to manage its margins by rightsizing its cost base. Importantly, at the same time they have the financial strength to make the investments required to capitalize on the AI opportunity and take market share from its weaker competitors. The medium-term bull case is that once revenue begins to meaningfully reaccelerate helped by its AI offerings, the combination of optimizing its cost structure and efficiencies garnered from technology investments leads to expanding margins. This is similar to Meta and its “Year of Efficiency”.
At the moment we prefer Alphabet (GOOGL) over Meta (META). We see a similar story playing out for Alphabet and its “Year of Execution”. We believe it’s in an earlier stage than Meta in its self-help process and its core business areas are just now showing signs of stabilization. Alphabet’s margins are beginning to rebound and have now returned to the percentage they were at in Q1 2022. Meanwhile 1) Resilience in Search, 2) stabilization in YouTube Ads, 3) Market share and profitability gains in Cloud and 4) Growth in Other Google (i.e. YouTube subscription) make us optimistic that revenue will accelerate and there is upside to margins for the remainder of the year.
In the recent Q223 earnings call, management commented on the QoQ strength in margins: “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.”
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Search moat is strong
For all the hoopla surrounding ChatGPT and the belief that it will provide MSFT an opportunity to take share from Alphabet’s core search business, it has yet to happen according to Search Engine. According to their analysis, Microsoft is losing market share. It peaked at 9.92% in October 2022 and is now at 7.14%. With its market position firmly entrenched, Alphabet has the audience to roll out its Search Generative Experience (SGE). On its own, the Search business has proved resilient because it provides advertisers an attractive ROI on their ad spend. Looking ahead, SGE will improve advertisers’ ROI and will likely provide Alphabet additional pricing power. This will also improve their retail vertical. Meanwhile, consumer interest will further strengthen Alphabet’s dominant market position in Search.
However, let’s not forget about anti-trust trial
One of the reason we’re very positive on the AI potential for Google’s businesses is that it is sitting on the world’s very best consumer data, which is not an exaggeration in the least bit. Its ability to lead in artificial intelligence and large language models should not be underestimated.
Therein lies the issue. Google undisputedly has the world’s best consumer data, but did this grow to become part and parcel with operating a monopoly? The Department of Justice has asserted anti-trust violations against Google with the trial beginning in September 2023.
We anticipate two outcomes. The antitrust outcome will be mild, and Google will be empowered to continue to dominate. Or, the outcome will require the ad properties to be broken up, leading to a weaker stance for Google. This could benefit smaller ad-tech players, which we have identified and are monitoring closely.
The I/O Fund Analyst Team contributed to this analysis
