Throughout most of 2023, the consensus expectation was that the economy would enter a recession in the first half of 2023. Instead, we saw one of the best rallies in the NASDAQ on record, which has now led investors to believe that this FED might actually maneuver a soft landing.
Then, on July 27th, equity markets topped and have been trending sharply lower, while inflation fears have started trending higher. With the amount of cross currents in this market, most investors are now confused as to whether they should buy this dip in stocks, or get out now before the real volatility begins.
On one hand, we are coming off of the first real bear market since 2009 with the S&P 500 up +11% for the year, and the tech-heavy NASDAQ-100 up +30% this year. This is after the S&P 500 has dropped -8% from the July high, while the NASADAQ-100 is down only -9%. Considering that both of these indexes are still up double digits for the year, this appears to be an obvious spot to buy the dip.
On the other hand, most inventors are not aware that the Russell 2000 Index, which is the goal to benchmark for small cap stocks, is down -4% for the year, while the equal weighted S&P 500 is down -1.5% for the year. We’re also seeing the Financial Sector down -4% for the year, while long-dated Treasuries are continuing their downtrend by being down another -13% this year.
Because we believe we are approaching a major inflection point, we thought it would be helpful to share our thesis on both the broad market, which includes levels to monitor, as well as the macro back drop that is unfolding. We hope this will shed some light on the confusing context we are seeing in 2023. While many stocks and markets have topped, we do believe that the S&P 500 and NASDAQ-100, led by choice big tech names, can make one more high into the year-end before putting in a larger top. We also provide clips on the essentials 3 stock portfolio, with levels to monitor, which can help investors better manage risk in the current environment.
Broad Market Scenarios – In this clip, the I/O Fund portfolio manager, Knox Ridley, goes through various markets, including the S&P 500, NASDAQ-100, ARKK, Small Caps, and more. While many of these markets have likely topped, we lay out the path where the S&P 500 and NASDAQ-100 continue higher into late Q4-early Q1. We also lay out what levels must hold in order for this scenario to play out.
Macro – Equities have rallied on stronger than expected economic growth and lower than expected inflation. In order for markets to push higher, this trend needs to continue. We will need to see energy prices pull back soon along with the US dollar in order to provide the necessary backdrop for equities to push higher.
Nvidia (NVDA) – As long as we hold $340, NVDA could easily push into the mid to high $500s in the next rally.
Microsoft (MSFT) – Unlike many stocks, MSFT has the potential for a new high. As long as we hold the $301 – $292 region in this correction, we should see one more high.
Netflix (NFLX) – Though NFLX has pulled back quite a bit, we still do not think it is low enough for us to start buying again. We took ample gains around the highs, and being patient before we start buying again.
What’s Next?
In mid to late July, the I/O Fund warned our premium members of a coming pullback. We locked in gains around the top and began actively hedging our portfolio to mitigate the down moves. We have also started buying specific tech stocks recently based on our broad market analysis. If you are confused on what’s going on in the markets, we encourage you to join us for our weekly webinars, held every Thursday at 5 Pm EST. Next week we will be discussing our strategy with our AI stocks, as well as lay out our game plan to avoid the next bear market, which we believe is closer than most think.
Today, we are looking at Palo Alto Networks’ financials, and will follow-up soon with more analysis on Palo Alto’s platform. What we like about PANW is that it gives you the best of both worlds – it has the potential to accelerate in revenue growth from its platform approachits platform approach to cybersecurity and has an enviable bottom line. The value proposition for the platform approach is similar to Microsoft’s value proposition, which is that a platform consolidates many vendors under one umbrella. As AI begins to automate tasks and transform cybersecurity, Palo Alto Networks stands to benefit as a one-stop-shop. Although nearly every cybersecurity company is attempting to acquire startups to become a platform, Palo Alto Networks has a five-year head start.
In the free editorial we published, we highlight that if cybercrime were a country, it would be the world’s third-largest economy, second to the United States and China. The costs that enterprises dedicate to cybersecurity is expected to increase from $8 trillion to $10.5 trillion by 2025. At 12% of IT budgets, what we want to find is the companies that will drive down these costs for enterprises.
Financials:
Palo Alto Networks is GAAP profitable with expanding margins. This has helped PANW outperform against its peers in 2023.
Revenue and EPS:
Palo Alto’s revenue in the recent quarter ending July grew 26% year-over-year to $1.95 billion. Management guidance in the quarter is in the range of $1.82 billion to $1.85 billion, for growth of 17.4% at the midpoint. This is slightly below consensus of 18%.
Management is targeting 17% to 19% in revenue and billings growth over the next three fiscal years.
Source: Seeking Alpha
Palo Alto’s adjusted EPS grew by 80% YoY to $1.44 in the recent quarter, beating estimates by 12.03%.
Adjusted EPS is expected to grow 40.3% YoY to $1.16 in the next quarter.
Source: Company IR/Seeking Alpha
Margins
Palo Alto is GAAP profitable, which sets it apart from other cloud stocks. Per management: “We are now firmly GAAP profitable with GAAP net income of over $200 million in the quarter.”
The margin expansion below is quite impressive.
In the most recent quarter, the gross margin expanded 590 basis points YoY to 74.1%.
The adjusted gross margin increased by 410 basis points YoY to 77.3% and was primarily helped by a higher software mix. The normalization of supply chain costs also helped to improve margins (PANW has hardware exposure) and there were lower costs associated with combining customer service support efforts across the platform. The company also uses generative AI to lower customer service costs.
The operating margin was 12.98% in the recent quarter compared to 0.99% in the same period last year.
The adjusted operating margin improved by 760 basis points YoY to 28.4% in the recent quarter. The company’s current business mix and focus on efficiency initiatives have helped to improve margins significantly. The efficiency initiatives include resource utilization and streamlining the sales force.
The net margin of 12% compares to 0% in the year ago quarter. The company was also able to deliver more profits by focusing on helping their largest customers to upgrade.
The adjusted net margin of 25% compares to 16% in the year ago quarter.
Looking ahead, management expects adjusted operating margins in the range of 25% for fiscal year 2024, and in the range of 28.5% in fiscal year 2026, with a long-term opportunity to reach the low to mid-30 percentile.
Free Cash Flow:
Operating cash flow margin of 21% for cash flow of $414 million. Notably, the cash flow margin has been unusually high in previous quarters at 79% margin due to lumpy collections. It was particularly high in fiscal Q1 of last year, ending in October. We are making this note for the upcoming earnings season should cash flow be high again.
Adjusted free cash flow of 20% for $387.8 million.
The company has managed to generate consistent adjusted free cash flow margins in the past three years, with 32.6% in FY21, 33.3% in FY22, and 38.8% in FY23. The management guide for FY ending July 2024 is a FCF margin of 37.5%. Dipak Golechha, CFO of the company, stated: “This higher operating profitability, strong bookings growth and interest income form the baseline for our free cash flow at higher levels, as we achieved 39% adjusted free cash flow margins in fiscal year 2023.”
Management also stated they are confident of maintaining a baseline of 37% adjusted FCF over the next three years. Some of this longer-term visibility is helped by deferred payments, which were up 400% over a three-year period in Q4.
The company has cash and investments of $5.4 billion. The company repaid 2023 convertible notes of $1.7 billion in cash in the recent quarter. The next repayment is due in 2025 for $2.0 billion and the company plans to settle this in cash.
Key Metrics:
Remaining Performance Obligation (RPO) grew by 30% YoY in the recent quarter to $10.6 billion. Management expects 25% RPO growth annually through FY26.
This statement was quite bullish: “Additionally, we see about two-thirds of our revenue in fiscal year '26, driven by current RPO entering the year highlighting the increase in predictability of our revenue profile.” Not only does this lay a nice foundation for future beats on revenue, but the market tends to reward predictability while it penalizes uncertainty. This really is one of the most bullish things a management team can say.
It’s been discussed on the earnings call that management believes RPO is a better metric than Bookings since it is not impacted by billing terms, such as customers preferring deferred payments in the current environment. This is a common discussion on earnings calls across the board, at the moment. RPO represents the booked business the company expects to recognize as revenue in future periods, and cannot be canceled. The market tends to reward companies that have RPO growth that is higher than revenue growth as it can be a leading indicator as to the health of future revenue growth percentages.
Source: Company IR
Palo Alto’s billings grew by 18% YoY to $3.2 billion. Billings growth is showing a deceleration, although the market was forgiving with strong price action following the earnings report as the company is up against tough comps. Billings grew 44% in the year ago quarter, and so the 18% reported this quarter was better than feared.
Management guidance for billings is in the range of $2.05 billion to $2.08 billion, representing a YoY growth of 18% at the mid-point for the next quarter. They also expect billings to grow in the range of 17% to 19% for the next three years. The guidance impressed analysts. RBC Capital analyst mentioned in a research note, “The company's Q4 results were generally fine as some metrics were better and some were mixed, but the real highlight was the better-than-expected outlook for billings in FY24 and billings growth through FY26.” , but the real highlight was the better-than-expected outlook for billings in FY24 and billings growth through FY26.”
Source: Company IR
Next-Generation Security (NGS) ARR grew by 56% YoY to $2.96 billion in the recent quarter. For FY24 management expects NGS ARR in the range of $3.95 billion to $4.0 billion, an increase of 34% to 36%.
Source: Company IR
Conclusion:
We will dive deeper into Palo Alto’s products and competitive positioning soon. As of now, the chart is not looking like a buy. Although we do not have plans to buy at the moment, we want to be prepared to buy if the chart affords us a good entry, and thus are doing our due diligence now.
Palo Alto’s financials are nearly flawless given the many stumbles its peers have reported this past year. When you combine the unusual performance with an incoming trend like AI-powered threat prevention that can block attacks as they happen and also transform security operations, it’s only prudent for us to put this stock in our pipeline.
For real-time trade alerts and weekly 1-hour webinars with the portfolio manager of the I/O Fund, sign up here for Advanced Market Signals.sign up here for Advanced Market Signals.
Royston Roche, equity analyst for the I/O Fund, contributed to this analysis
This article was originally published on Forbes on Sep 22, 2023,05:45am EDTForbes Forbes on Sep 22, 2023,05:45am EDT
It is our stance at the I/O Fund that the stock market is not logical, rather it’s sentimental. There is no logical explanation for a stock to go up 100% or more —— only to fall 40% or more in the matter of a couple of months. Fundamentals do not change this quickly, but sentiment does. In the simplest terms, sentiment is driven by how fear and greed interrelate with supply and demand. However, the way to track sentiment to protect capital is much more complex and needs to combine fundamental analysis with technical analysis
This roller coaster ride is most evident in tech stocks, which happens to be our specialty. Therefore, we openly and frequently discuss with our free newsletter readers the importance of layering into a leading position, setting up buy plans ahead of time, and also the importance of taking gains once the technical and fundamentals get stretched.
We’ve had unwavering conviction in Nvidia’s AI story since November of 2018. In fact, it was our leading position going into 2023 and our AI allocation of 45% exceeded Stanley Druckenmiller at 29%, meanwhile, Druckenmiller was celebrated for having a leading AI portfolio. The Street is also taking credit for being early to Nvidia, which was a latecomer recommendation in March of 2023. Ark often discusses AI as a leading trend, yet almost missed this AI leader entirely. We point this out because we provided Nvidia as a stock tip for free, repeatedly, with top tier analysis delivered on Forbes and through our free newsletter, with our own capital backing the research.
The I/O Fund is a strong proponent of offering quality information at the free level. We offer top tier analysis every single week in our free newsletter, and we do not know any other top-performing portfolio that offers this at the free level in a consistent mannertop-performing portfolio that offers this at the free level in a consistent manner.
Unfortunately, free information tends to come from those who are unproven and may not be very good investors at all, while those with a proven track record keep trades close to their chest.
Not only do we actively manage every position we own and send real-time trade alerts, but we discuss openly and frequently our thoughts along the way. Our track record on Nvidia over the past 1-2 years looks like this:
Source: I/O FUND
The single biggest issue individual investors face is a lack of quality information that is early, consistent, and comes with ultimate transparency around position sizing, portfolio performance, and how to handle sell-offs.
It is this last point that we’d like to discuss with you today “how to handle sell-offs.” We were considered crazy for buying Nvidia in 2022 and we are considered crazy for trimming in 2023. Yet, in what is rare transparency for the financial world, we are sharing with you our plans with this leading portfolio position.
Sign up for I/O Fund's free newsletter with gains of up to 221% – Click hereClick here
Price Analysis
On August 28th, we put out our price analysis on NVDA. We offered two general scenarios that we see playing out, which are still very much in play today. Here is what we said back then…
“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.
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.”
Also, in the last report, we were looking for a breakout above $480 to signal that a low was in and we were heading towards our first overhead target around $545. We did see a breakout, but it failed to hold, which was a warning of more volatility to come. This coupled with some heavy distribution volume above the $440 price level, had us decide to take more gains in Nvidia.
Real-time trade alert offered by I/O Fund
My prior analysis still holds – as long as we hold $340, Nvidia has the potential for one more swing higher into year-end/early next year. However, we do not believe current prices are ideal for a long-term, buy and hold mindset. Patience will likely pay off in the long run. So, it will be up to each investor to decide if they want to take on the risk of potentially getting one more high.
For the I/O Fund, the reward is not worth the risk which is why we have decided to trim. Our last buy at $410 in July is our last buy and we do not have any more buys planned until we see a resolution. There are two other AI-related stocks that we like better in the near-term, and when we enter these, we will notify our premium members with real-time trade alerts.
This remains my primary perspective as long as we hold the $340 support. Below there, and the top is likely in.
Source: Tech Insider Network
When we Plan to Trim next
Nvidia is a core holding of ours, so we will likely never close the position, as long as the story and tech trend remain intact. However, we do strongly believe in taking gains, reducing risk, and targeting lower levels for a better cost basis. That being said, we believe we are approaching one of these moments. Even though we broke a key trendline today, we expect a bounce to occur soon. If this bounce is a corrective bounce that fails to reclaim key overhead levels, we will trim our position even more.
Source: Tech Insider Network
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.
Insider Selling is Elevated Over the Past Month
There has been an excessive level of insider selling by the CEO, Jensen Huang. So far, he has sold over $110,000,000 worth of shares over the last 3 weeks. Regarding insider activity, there are many reasons insiders sell, which may have nothing to do with the business. However, when you the see executives within a company, like the CEO, it’s worth paying attention to. Since June, we’ve seen about $175,000,000 worth of NVDA sold.
Source: SECFORM4.COM
Conclusion:
In conclusion, our broad market work suggests that a complex topping process is forming. Many sectors and stocks have likely topped while some big tech names look like they have the potential for one more high into the end of the year.
Insider activity and institutional selling point toward another high being less likely. If we do get that second high, our plan is to trim more. Until the $340 support breaks, NVDA still has the potential for that last swing higher. Regardless, we believe being patient will pay off for those looking to buy a great company at a great a price. We are also being patient for when we add back to our position and feel it’s better to be defensive at the moment.
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 two other AI plays that we will likely buy next – what our targets are, where we plan to buy, as well as where we plan to take gains.
I/O Fund Portfolio Manager, Knox Ridley, contributed to this analysis
Enphase is expected to resume growth in the June quarter of 2024, according to analyst estimates. This feels like a long way off to growth investors, yet we’d love nothing more than to enter close to a bottom for this global leader in solar. Interest rates will continue to weigh on the company, yet the difference between Enphase and many other consumer-facing tech stocks is that Enphase is trading at a deep discount. The stock is down (-53%) YTD and is down (-62%) since it’s December high, which was less than a year ago.
The analysis below revisits Enphase given its deep discount. Overall, Enphase is a strong product story, a strong management team, and the fundamentals will (eventually) improve. We are not at an inflection point yet on the financials, they’re still a little messy, but we could be within 1-2 quarters of the inflection point. Also, while the market has been preoccupied with selling Enphase, the margins have been quietly improving. This is not being priced in yet, but once top line growth resumes, Enphase will emerge a stronger company fundamentally.
Interest rates continue to be a headwind, and this is out of Enphase’s control. The systems they provide are pricey in the $10K to $20K range or higher, somewhat similar to an automobile. The overall message from Tesla, Apple, Enphase and others that offer high ticket consumer items is that their products are effectively more expensive when interest rates are high. This results in fewer buyers or results in aggressive price cuts. We outlined this here when a Tesla analysis that stated: “The comment on interest rates is the most important comment from the call as high interest rates mean Tesla must lower prices. In a way, management is agreeing that quite a bit about the current situation is out of management’s control. While some will talk about recurring software revenue from robotaxis as the most important catalyst, the harsh reality is that the FED lowering rates is the most important catalyst for Tesla today.”
The same can be said for Enphase as this company is at the cutting edge of solar technology – but reality is that the FED matters more. This seems simple and straight forward, yet the stock market has rallied in some cases despite a worsening outlook for pricing power. So, it’s important to be really clear about this, and repeat it again, now that tech is trading at high valuations. Except Enphase, which is a rate-sensitive stock that is trading at a 4-year low, hence the reason we are attracted to this stock whereas we are trimming others that have outperformed this year.
Most importantly for Enphase, United States revenue has been declining. Despite Europe reporting hypergrowth, it’s not enough to absorb the losses in the United States. Additionally, the IQ8 microinverter is a steady product in terms of sales, yet battery sales and EV chargers are declining. It’s expected that batteries see a recovery in the second half of the year due to NEM 3.0. We cover this plus more details on IRA, NEM 3.0 and Channel Inventory in the section “Key Metrics” and “Earnings Call Notes” below.
Revenue and EPS:
In the June quarter, Enphase reported revenue of $711 million, for growth of 34%. The company’s growth rate had been decelerating gradually over the past two years from a peak of 97%, and will now enter negative territory.
Next quarter, the company is expected to report revenue of $550 million to $600 million, for a decline of (-9.4%). According to analyst estimates, the revenue decline should bottom in December at (-12.5%). By June, the company will be in positive territory again, and by September, Enphase will see a sizable rebound.
Source: YCharts/Seeking Alpha
The company reported Adjusted EPS of $1.47 compared to estimates of $1.27. Similar to the top line, the bottom line is expected to rebound in H2 2024. In fact, Enphase is expected to go through a period of strong bottom-line growth as the company exits 2024 due to IRA making a substantial impact on the bottom line. By Q4 2024, IRA will be contributing an additional $112.5 million compared to the $157.2 million in net income Enphase reported in the previous quarter, or roughly 58% more income (if we assume all things are equal).
Source: Company IR/Seeking Alpha
Margins:
Overall, the margins are stronger due to reducing component costs and the better margins on IQ8 microinverters. For next quarter, management stated the net IRA benefit will be $15.5 million, at the midpoint, based on estimated shipments of 600,000 units of U.S. manufactured microinverters. So, there is some nominal impact from IRA for next quarter, as well.
Gross margin of 45.5% reflects IRA benefits of $1.6 million. Product mix of increased IQ8 sales also helped the margins, plus negotiations around logistics and pricing for components.
For next quarter, gross margin is expected to be 42.5% before reflecting IRA benefits of between $14.5 million and $16.5 million on estimated shipments of 600,000 units of U.S.-manufactured microinverters.
GAAP operating margin of 24% compares to 17.8% in the year ago quarter. Adjusted operating margin of 32.4% is 365 basis points higher than the year ago quarter.
GAAP net margin of 22% compares to a margin of 14.5% in the year ago quarter.
Adjusted net margin of 28.91% for adjusted profits of $205.6 million reflects stock-based compensation that is 7.6% of revenue. SBC has been ticking downward from the 10% range.
It’s quite rare to expand margins while revenue falls rapidly, which is why I’ve copied the full explanation from the earnings call:
“We have non-GAAP guidance that we gave is 42% to 45%. And like what I said, we – like, for example, I didn't even say this to the gentlemen who asked me the question before. For example, in logistics, last quarter, we saved $8 million. Last quarter. Like we have a lot of initiatives from a world-class cost on saving the cost of a capacitor, resister, parting, semiconductors, ASIC, not only by second source qualification or multisource qualification, but simply, purely by negotiation.For example, in logistics, last quarter, we saved $8 million. Last quarter. Like we have a lot of initiatives from a world-class cost on saving the cost of a capacitor, resister, parting, semiconductors, ASIC, not only by second source qualification or multisource qualification, but simply, purely by negotiation.
So we do that, and we do that on microinverters. We do that on batteries. We do that on combiner buses and accessories. So our world-class cost effort is invaluable and has saved us a lot of dollars. And we are now moving to a higher and higher mix of IQ8, which has got a little bit more gross margin than IQ7.And we are now moving to a higher and higher mix of IQ8, which has got a little bit more gross margin than IQ7.”
It was also mentioned on the call that $1 savings on microinverters leads to $20 million in savings total, assuming 20M microinverters are shipped. This also helps illustrate how Enphase plans to expand margins in the future.
Cash Flow:
Cash flow margins are also strong at 37.9% this quarter for operating cash flow, and 31.7% for the free cash flow margin. Q2 is seasonally higher than other quarters. Free cash flow of $225.2 million reflected $44 million spent on capex for new R&D equipment.
The company has $1.8B in cash and marketable securities with $1.3 billion in debt.
The company recently announced $1 billion additional authorization for share repurchases. Previously, the company had $500 million authorized for repurchases, of which the final $200 million was used in Q2 to repurchase 1.25 million shares at an average price of $159.43.
Key Metrics:
As discussed in the intro, the problem area for Enphase’s earnings reports has been the decline in United States revenue. As a percentage of revenue, the United States has fallen from 80% of revenue in Q2 of last year to 59% of revenue in the most recent quarter. This refers to percentage of revenue, while total revenue in the United States was down 12% QoQ and decreased 1% YoY.
Source: Earnings Call Transcripts
We tried to get in front of this by closing our position in April when regions outside of California reported a 25% sequential decline. This foreshadowed weak price action as the stock was down (-33%) YTD when we closed it, and it is now down (-54% ) YTD.However, through active management, our combined cost basis for the position was around $215, which means we were able to close it for only a ~17% loss. Without our process, we would instead be dealing with a 44% loss if we held onto it. Notably, management attempted to keep investors hopeful by stating Q1 is seasonally weaker than Q2, yet this did not pan out, as Q2 was weaker than Q1.
Per management, non-California states declined (-6%) QoQ on microinverters and (-11%) year-over-year. This is better than the (-25%) QoQ but is suggesting we do not have evidence of a bottom yet.
California revenue was 20% higher QoQ and 34% higher YoY – yet this comes with uncertainty because the sales are coming from a backlog on NEM 2.0 installation whereas we do not know yet how California will perform under NEM 3.0. Per our research notes below, although NEM 3.0 looks like it’ll be a positive outcome, it’s speculative until we get actual results.
Europe is growing rapidly, and is up 25% QoQ and tripled YoY. However, the United States made up 80% of revenue last year (and is now at 59%), and Europe is not large enough to make up for these losses.
Per management: “The overall U.S. market is experiencing a broad-based slowdown due to high interest rates. As I said earlier, our Q2 sell-through of microinverters in the U.S. was only up 2% compared to Q1 and only up 2% year-on-year. The second quarter is typically stronger than the first quarter that did not happen this year due to the market environment.” We covered this last quarter here.
Additionally, management stated that non-California is not likely to resume growth until interest rates are lower: “Yes. I think to answer your question on sell-through for non-California, I mean it has not changed much in Q1 and Q2. In fact, I said Q2 was a little bit worse compared to Q1, about 6% worse and I think it is expected to probably be at this level until the interest rates take a meaningful turn for the better.That in non-California.”
Enphase’s revenue has become increasingly driven by IQ8 microinverters at 78% of microinverters compared to 65% of microinverters in the previous quarter. The company reported 2121 Megawatts DC of microinverters, which was up 74.8% year over year, and was up 8.4% QoQ.
Other segments, such as IQ Batteries are trending down on megawatt hours at 82.3 MW hours this past quarter compared to 132.4 megawatt hours last quarter, for a decline of (-60.9%). The number of EV chargers shipped is also trending down for a decline of (-25%) with 6,600 U.S. EV Chargers shipped compared to 8,250 chargers shipped in the year ago quarter.
Regarding weakness in batteries, there was a suggestion on the call that Tesla is causing a pricing war. However, NEM 3.0 is expected to help accelerate battery growth as the new provisions favor storage.
Update on Net Energy Metering (NEM) 3.0:
Per our previous write-up on NEM 3.0, last year, California passed controversial solar policies that will initially benefit Enphase and other “solar plus storage” companies because the new policies greatly reward solar systems that have storage.
The new policies introduce high tariffs for high-priced evening power whereas rooftop solar systems with storage will offset these prices and potentially export power back to the grid. This was a controversial policy because it benefits utility companies by also slashing the value of solar returned to the grid by nearly 75%.
Another controversial tariff is the grid participation charge, which is proposed to be $8.00 per kW, or $56 a month and $672 per year.
This will initially benefit Enphase as the company sells storage with its comprehensive systems, and systems installed before the new policy takes effect (mid-April) will be grandfathered into the current rates offered for selling power back to the grid.
As discussed in a previous analysis, Enphase’s microinverters use a proprietary ASIC chip to change loads and grid events, which reduces the required size of battery and battery power. The solution that Enphase designed with IQ8 is that the models are “always on” by combining the inverters, batteries, system controllers and load controllers for a mini grid that can produce power from the sun and efficiently store this power at night.
The small upside to the new policy is that over the next 9 years, residential customers can receive credits by using the Avoided Cost Calculator (ACC) to calculate the cost a utility avoids for each kilowatt-hour that it doesn’t buy from the wholesale market. The extra credits will result in residential customers saving $100 to $136 per month on the average electricity bill. There is an additional $630 million in state funding set aside for low-income housing installations.
The reason I use the word “initially” is because solar installations ultimately fell in Nevada and Hawaii after similar policies.
“Enphase Energy states, ‘Based on data from other states, cutting (the) solar value proposition by more than half — four months from now — will lead to a deluge of installation requests in the first quarter of 2023, followed by a precipitous curtailment. This will not only fail to sustainably grow the solar market, but it also risks debilitating it, exacerbating supply chain issues, disrupting small business cashflows, and jeopardizing roughly 65,000 California solar jobs.”
In December, NEM 3.0 passed with the new policy set to take effect April 13, 2023. Enphase had previously cautioned it will cause a spike in installations because solar + storage that is installed prior to NEM 3.0 can continue to sell to the grid at the higher rate before the policies go into effect.
Fast forward, and today Enphase is saying the following about NEM 3.0 — notably, the tone is more positive today compared to when NEM 3.0 had not passed yet:
“We think NEM 2.0 will continue through Q3. That's what we are hearing from our installers. It will continue through the summer until September. We believe Q4, NEM 3.0 will start. And the anecdotes we are hearing from some of our installers, some of our big installers who say that their battery attach rates are pretty nice, higher than 50% […] So payback comes down from the 7 to 8 years to 5 to 6 years with a high enough battery system. So once the installer has realized that economics, then they are a lot more confident of selling them NEM 3.0.”
Despite these positive comments, I think the reality is that nobody can accurately predict how NEM 3.0 will impact Enphase. Management at one point acquiesced that it’s an unknown right now. I will also add that when we closed the position in Q1, management had provided comments that Q2 will be seasonally stronger but this was not the case. Although management has been reliable in the past, interest rates and consumer behavior is out of their control; this is compounded by the new legislation.
“On NEM 3.0, I mean, we only have anecdotal evidence right now. The channel is still NEM 2.0. And NEM 2.0 installations are happening. Many – some of our distribution partners said that a few installers may even do NEM 2.0 until October or November. We are hearing that for most of Q3, it will be NEM 2.0. And we will start getting data on NEM 3.0 sell-through data only in Q4.”
Takeaway: We are at a speculative juncture for how NEM 3.0 plays out, however, because Enphase is the premiere “solar + storage” company and has been preparing for NEM 3.0 with the third-generation battery (available now) and fourth-generation battery (available soon), the most likely outcome is that Enphase does well. There could be a bumpy transition around Q4, Q1, etc. However, with the stock down 50% YTD and down 60% since the December high, one could argue a bumpy transition is priced in.
Third-Generation and Fourth-Generation Battery:
The third-generation battery was released in the second quarter. This is the battery that is expected to support a softer landing from NEM 3.0. Per management: “The higher charging and discharge rate of our third-generation battery will be uniquely beneficial for NEM 3.0 systems in California through its ability to generate revenue by exporting into the grid at appropriate time.”
The battery has 5KW modularity and 2X the power of the existing battery plus 3X the peak power. Due to this, management has stated “we expect our battery business to perform well in the second half of the year.” Notably, battery sales were weak this quarter as management cut pricing on the second-generation battery during the third-generation battery launch.
The benefit to being modular is that if the battery fails, a homeowner can replace parts that cost about $40 instead of the entire battery, which costs about $3,000. In this case, the third-generation battery allows for only those parts that have failed to be replaced, such as the power electronics.
Enphase will improve margins with the fourth-generation battery by reducing the number of components and costs. The 4th Gen battery is due over the next 9-12 months.
Notably, analysts on the call commented that their channel checks have stated that Enphase is under pricing pressure from Tesla. This is something to monitor as the third-generation rolls out in H2.
Based on an analysis by McKinsey and Company , IRA will direct nearly $400B in federal funding to clean energy, with the goal of substantially lowering the US’s carbon emission by the end of this decade. The funds will be dispersed via a mix of tax incentives, grants and loan guarantees. Clean electricity and transmission will receive the highest funding, followed by clean transportation, including electric-vehicle (EV) incentives.
In the past, the US has generally relied on imports for solar equipment. This law will encourage more production at home with incentives for domestic solar panels and inverter manufacturing. It is also designed to support the construction of renewable electricity plants.
Enphase has been moving its manufacturing over to United States soil in order to capture the IRA credit. Although Q2 impact was nominal at $1.6M, we are starting to see this ramp for Q3. Management expects to ship 600,000 units from United States manufacturing facilities in Q3 for an estimated IRA benefit of $14.5 million to $16.5 million. Calculating per unit comes to about $24.17 to $27.5, with management guiding for $24 to $28 per microinverter sold. The net benefit per unit will differ each quarter as the company manufactures high-power products in certain quarters and low-power products in others, depending on customer demand.
The management expects robust demand of 4.5 million US shipments in Q4 2024. However, this could change depending on the macroeconomic conditions over the next year. Per management: “Well, it all depends. That is why we qualified it with saying pending robust demand. And if that demand is, for example, let us say we go through another recession next year, then I mentioned earlier that we would look at how to balance this out between U.S. and international, and we will give you the appropriate guidance at that time.”
At an average of $25 per unit, they expect a net IRA benefit of $112.5 million in Q4 2024. This has led analyst consensus to see EPS of $1.97 by Q4 of next year. Assuming there are no changes, Enphase will see 76% and 66% growth to its bottom line in Q3 and Q4 of next year. From there, EPS continues to grow.
The management also gave more clarity on how the manufacturing production credit from IRA is reported in the company’s earnings. They expect the production credit to be a reduction in the cost of goods sold. The company’s CFO, Mandy Yang, said in the recent earnings call, “We had originally thought that the production credit will be reflected in income tax expenses. But based on the latest guidelines from the U.S. Treasury, we expect to claim the production credit by direct pay, and therefore, account for the production credit as a reduction in cost of goods sold.”we expect to claim the production credit by direct pay, and therefore, account for the production credit as a reduction in cost of goods sold.”
IQ9 and IQ10 Microinverters:
For the IQ9, Enphase plans to increase the power of the microinverter by 50% from 320 watts to 480 watts DC in the same footprint. This is made possible by gallium nitride (GaN), which has the thermal characteristics to withstand high power. GaN also allows a higher frequency, so what operates at 100 kilohertz today in the IQ8 will operate at 200 to 300 kilohertz on the IQ9 and 1 megahertz in the IQ10.
The other major benefit is that the footprint of the transformer size will be the same despite a much more optimized system. At one point, it was stated the IQ9 would arrive in 2024. There have not been any new comments on the launch date, so we will need to wait for confirmation if 2024 is still on track.
Launching later this year, the small commercial microinverter IQ8P supports 480 watts of AC power, yet has a larger form factor. This will also be used in emerging markets, such as Brazil, Mexico, India and Spain. For the IQ9, gallium nitride makes it possible to shrink the form factor while achieving 480 watts of AC. The IQ8P was discussed on the most recent earnings call and is generally understood to be warm-up for the 480-watt IQ9s.
Channel Inventory:
Enphase’s ideal channel inventory pipeline is 8 to 10 weeks. Europe is currently at the high end of this at 10 weeks. However, management comments on the call that “we are now left with two quarters of inventory that is added on. And meaning two quarters of extra inventory” would imply 34 weeks of inventory in the United States. If ever there was a comment to get a stock to drop, it is a comment like this — that inventory is 3-4 times higher than average.
Julien Dumoulin-Smith
Excellent. Thank you. Good afternoon, team. I appreciate it. Can you talk a little bit more about the inventory levels and any write-down risk here? Can you talk a little bit about just the backdrop on that front? And more importantly, just the normalizing functions as you think about these different inventory levels across geographies, especially thinking to continued European growth, what might be implied by inventory levels, et cetera?
Badri Kothandaraman
Yes. I just now answered the question for Europe. The inventory level in Europe is a little bit normal, although it's on the higher side at about approximately 10 weeks. And that is why we said Q3 is a seasonally down quarter in Europe, and we expect to be slightly down in revenue as compared to Q2. But then I talked about we are introducing several new products […] Our sell-through rate was the highest, and our channel inventory was very healthy at the end of Q4. What happened is the sell-through rates declined overall in the U.S., 20%, with respect to Q4, for Q1 and for Q2.
And therefore – and in response to that, we did throttle our shipments into the channel, but we didn't throttle it enough because we assumed Q2 will be a seasonally good quarter, which turned out to not be the case.
So therefore, we are now left with two quarters of inventory that is added on. And meaning two quarters of extra inventory. And we are also assuming, going forward, we are not making any aggressive assumptions. We are saying the demand will be at the same level as it is today. And therefore, we are taking a onetime correction for shipments into the channel. And that is why our guide is light for Q3.”
Valuation:
Enphase is cheap right now. While other tech stocks have participated in the rally this year, Enphase has not. What is pictured below is a time stamp that shows the last time Enphase traded this cheap was at the end of 2019.
With earnings, it was during Covid that Enphase traded this cheap.
Conclusion:
If we do enter Enphase, it’s not because the fundamentals have bottomed, as the next one to two quarters could show further sequential decline. Rather, it’s based on a combination of getting a solid company at a deep discount with the idea that the fundamentals will be much better in time, as well as technicals.
According to the I/O Fund Portfolio Manager, Knox: “We are seeing very bullish momentum patterns, while ENPH is basing in price. It is setting up for a nice bounce, which could signal the low. My base case is that this bounce will fail and we will make one more low; however, if the bounce breaks above $167, the odds will favor a low being in.”
If you own ENPH or are looking to own ENPH, please join us on our weekly webinar where the Portfolio Manager goes into great detail about our positions and buy plans for each stock. On the Advanced premium plan, we offer real-time trade alerts for every buy/sell or add/trim. Learn more about Advanced Market Signals here.Learn more about Advanced Market Signals here.
In last week’s article, we discussed the general path the SPX will likely take into the end of the year. In brief, we are expecting volatility to continue with a test of the 4275 SPX region, then a final push to new highs, which could take us into Q1 of 2024. The current macro environment is not signaling a near-term recession in the US now, so absent of an unforeseen event, we do not see the July top as anything more than a correction.
However, markets do not move in a vacuum. There is always a market ahead of the one you are tracking, and seemingly unrelated markets often drive the very one you are most exposed to. Our portfolio management discipline is to track various key markets, as it’s quite evident that tangential markets are inter-related. When doing so, the picture that emerges is not one that supports an uninterrupted bull market.
The two most important markets that are driving the S&P 500 is oil and the US dollar. Both are suggesting a continuation of the equity rally for another leg higher, but then the also suggest a return to volatility over a longer time horizon. In this article, we will examine the levels that must hold, as well as introduce the important supporting markets to track right now so that one can maneuver any further upside in the markets as well as the coming volatility that may follow.
Growth, Inflation and Recessions
Markets do not crash randomly. They crash as a result of economic growth decelerating below expectations, which simply cannot support equity valuations at the time. With the FED wrapping up one of the most aggressive rate hike campaigns in modern market history, investors are now left wondering if those rate hikes will filter into the economy enough to cause an unexpected decline in economic growth. We believe the lag effect on these rate hikes is giving the illusion of safety, with the effects of this campaign most likely to show up in late Q4 of 2023 – Q1 of 2024. When economic growth decelerates too much, that is usually the environment that we see deep market declines.
That being said, investors betting on a crash now will likely be disappointed. If we examine the trend in US growth, there is simply no evidence of an impending recession. The below graph looks at the 3-month annualized trend in various metrics ranging from the consumer’s health to employment. Simply put, this is not what you see going into a recession, nor do they signal a recession is just over the horizon.
Furthermore, we tend to see initial unemployment claims spike relatively close to market tops. As of now, this metric is signaling that the July top is likely nothing more than a correction within a larger trend higher. Employment is not weak enough, nor is the consumer weak enough to suggest that a recession is just over the immediate horizon.
While the US economy has remained resilient for most of 2023, we have also seen a high level of disinflation, as well. While the YoY CPI numbers are still a far cry from the FED’s 2% target, coming in recently at 3.7%, the 3-month annualized trend is an encouraging step towards that goal. Keep in mind, in order to get to the YoY target, you need to see several months in a row of the 3-month annualized trend come in at, or below your target. So, this trend is encouraging.
However, when you dig under the surface of what’s driving the current level of disinflation, a concerning picture emerges. There are only three general drivers within the CPI print – energy, food, core inflation.
The 3-month annualized trend in core inflation has remained within the 4% – 5% for over a year, with our first move towards 3% – 2% in the last print two prints. While this is a move in the right direction, keep in mind that the YoY print for Core CPI is 4.3%. This is still more than double the FED’s target.
This falls in line with what market history has taught us about inflation and recessions. Once core inflation gets out of control and moves well above the FED’s target for that business cycle, it requires a recession to get it back in line. More importantly, there is no instance in modern market history where core inflation has naturally gone back to the FED’s target without the help of a recession. The last two shoes to drop in the business cycle are always employment, then inflation, which is exactly what we are seeing right now.
So, while the trend in core inflation is promising, a current YoY reading of 4.3% is still too far away from the FED’s target of 2%. This means that energy has been the primary driver of the current disinflation trend, which is obvious in the graph above. For this reason, oil prices are crucial right now in confirming what equity prices have priced in – the FED pausing further rate hikes. If oil continues higher, inflation will certainly come back, forcing the FED to continue raising higher than equity valuations are currently priced.
Oil
From its high just under $130/barrel in March of 2022, to its low just above $63/barrel on May of 2023, crude oil has seen a +50% drawdown over 14 months. This deceleration in oil caused the disinflation that equity prices are celebrating, as core inflation remained virtually unchanged during that time
However, since the May low, crude oil is up over 30%, making its first series of higher highs and higher lows in over a year. What this means for future inflation readings is that energy will actually hurt the disinflation narrative, meaning that core inflation will have to decelerate to pick up the slack. Considering the health of the consumer, coupled with the lessons in history, we find this to be unlikely.
However, it’s important for investors to understand that equities are forward looking. As oil prices broke out to a new high in early August, equities topped one week prior, causing the drawdown we are currently in. Technically, the odds favor a larger uptrend in oil prices over the coming year; however, we just completed a 5-wave pattern off the May low. What follows this pattern is usually a 3-wave retrace of the same degree.
In other words, the 5-wave uptrend took about 4 months to complete. So, I’d expect at least a 2-3-2 month retrace over the coming months. If oil gives us a proper pullback, which it seems likely, expect equities, especially tech, to continue higher.This sets us up for that final push higher into early 2024.
The US Dollar
My favorite means of tracking the US dollar (USD) is through the dollar index (DXY). This is simply an index of popular currency pairs to the USD that has a lot of price history to analyze. What is undeniable in this market is the inverse relationship between DXY and US equities.
The reason for this relationship is based on the abundance of global debt denominated in the US dollar. Some estimates claim that $12 Trillion of global debt is denominated in the US Dollar, while others have claimed its even as high as $65 Trillion. This would be debt in US dollars coming from non-US banks and shadow banks. These figures are in relation to a global GDP of $104 Trillion.
Regardless of the actual denomination, with so much global debt priced denominated in dollars, when the dollar goes up in value, compared to a country’s own currency, the cost to service this debt is also going up. This drains liquidity from that foreign economy, which is less money to spend on stocks. Adversely, the opposite is true, which is one of the reasons why we have seen such a sharp increase in US equities. As the dollar has dropped sharply from its high, global liquidity has also bottomed and slowly trended up.
If we analyze DXY, it appears to be in the final stages of the corrective rally within a larger correction. It hit the lower target around $105; however, the structure looks like it can extend towards $107 in the coming weeks.
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As long as DXY goes up, expect volatility to continue in the markets. However, what is encouraging is that once this corrective rally terminates, we should see a final leg lower in DXY, which will also support another rally in equities.
Broad Market Levels
It is our belief that we are about to start the final leg higher in equities before topping. This is supported by two of the most important markets that have a significant effect on equity prices. The catalyst for a larger top will likely be a recession. Absent of an unforeseen event, our timing of this recession is November 2023 – March of 2024. The above supporting markets also line up with this thesis – Oil and DXY should see a multi-month decline, which will support equities moving higher. However, these moves will be a correction in much larger trends.
Regarding price levels, our belief is that the broad market is in a correction, which should make another move lower into late fall/early winter. Confirmation of this move will be a break below 4430 SPX, and our targets for the last leg in this correction will be around 4275 SPX. This is laid out in the green count below.
However, I cannot ignore that the bears have, so far, been unable to take advantage of the setup pointing us lower. For this reason, I’ve added the red count to the chart, which suggests a direct push towards 4700 – 4800 SPX. If we see the market breakout above 4516 SPX, this will become my primary expectation.
The final alternative count is in blue. This will not be considered until we see a break below 4245 SPX. If this does happen, it will make the probabilities of a major top being in, and we will risk manage accordingly. As I do not see any evidence of a recession brewing now, this blue count would likely be the market picking up on some type of event.
In conclusion, there are three broad market levels investors need to focus on in order to best risk manage their portfolios into the end of the year. We do believe that we are marching towards a recession, but that recession is not in the data now, which favors higher levels. But, based on the trends in oil and the US dollar, which are key markets driving equity returns, any additional upside should be met with caution until the macro environment changes.
Due to these dynamics, we believe the odds of a final swing higher are quite high. If we get confirmation of this move, we will target 4700 – 4800. Our plan is to trim substantially when we get to this region, and play defense until the market and economy proves otherwise. If we see a continuation of the current correction we are in, we consider it to be a buying opportunity as long as we stay above 4245 SPX. Below this level, and a major top is likely in.
What’s Next
If you want to track the potential top in equities, join I/O Fund next Thursday, September 21st at 4:30 pm EST, for our premium webinar. We will go over in detail all possible scenarios, plus the levels that need to hold that can confirm what is likely playing out. We will also go over the specific AI stocks we are targeting for this final run higher, as well as our game plan for when we confirm a top.join I/O Fund next Thursday, September 21st at 4:30 pm EST, for our premium webinar. We will go over in detail all possible scenarios, plus the levels that need to hold that can confirm what is likely playing out. We will also go over the specific AI stocks we are targeting for this final run higher, as well as our game plan for when we confirm a top.
Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
CrowdStrike is becoming a strong candidate for the I/O Fund portfolio for the following reasons:
Larger revenue base than its peers at about $3 billion per year, yet often stronger growth than peers that have half the revenue
Stronger bottom line than the majority of the 5-year cohort of IPOs that went public around 2018-2020. CrowdStrike is stronger on GAAP earnings and free cash flow.
CrowdStrike is GAAP profitable for two quarters, although we prefer the company be GAAP profitable from operations. If GAAP operating margin continues on the same trajectory, this could happen soon.
Below, we go into a brief overview of CrowdStrike’s core business, plus a few ways the Falcon Platform has expanded since we last covered the stock. The analysis also discusses the impact AI will have on cybersecurity companies.
CrowdStrike’s Falcon Platform:
CrowdStrike’s Falcon platform delivers comprehensive breach protection against sophisticated attacks on endpoints. Due to the sheer number of endpoints in a corporate network, this is where the majority of attacks are made. Compromised credentials across desktops, laptops, and mobile devices are often the hardest points of access to secure.
Endpoint security refers to protecting the endpoints or entry points of the end-user devices such as desktop PCs, laptops, mobile devices, and servers from being exploited. Originally, CrowdStrike was a EDR platform (endpoint detection and response) until it expanded and adopted the XDR acronym in 2022, which stands for extended, as it includes more data points than a EDR platform. As part of moving from EDR to XDR, CrowdStrike added cloud security to its platform.
Extended detection and response (XDR) is cross-layered detection and response. XDR collects and automatically correlates data across multiple security layers – email, server, cloud workloads, and network – so threats are detected faster and security analysts improve investigation and response times.
CrowdStrike’s AI based security model is focused on collecting large amounts of data, centrally storing it in a single model, and continuously training its algorithms with vast amounts of data. The more data that the Falcon Platform collects, the more intelligent the platform becomes in detecting and stopping breaches.
The company’s cloud-native Falcon platform was built to provide automated protection to stop sophisticated cyber-attacks. It is capable of protecting workloads across servers, laptops, virtual machines, mobile, cloud, and the Internet of Things (IoT). With hybrid deployments, and the internet of things, the risk of cyber-attacks has increased, and the need to protect digital assets has increased.
The Falcon platform has 22 modules offered via a subscription-based model under various categories like cloud security, endpoint security, Crowd XDR, Security & IT Operations, Managed Services, Threat Intelligence, Identity Protection, and Log Management. These modules can be easily deployed on the customer’s endpoints and workloads and can be easily scaled depending on the needs of each customer.
One of the most popular upgrades is Falcon Complete, CrowdStrike’s fully managed detection and response solution that offers Fusion no-code security automation to proactively remediate issues. This helps less technical employees work alongside Falcon Complete throughout IT and security departments. This is important due to a cybersecurity training gap between the small talent pool and the dire need for larger security teams.
The upgrade process for modules within the Falcon Complete tier is driving CrowdStrike’s ongoing growth. For example, the company has been accelerating its growth in subscription customers that adopt five or more modules, six or more modules and seven or more modules. We discuss this more in the Financials Overview below.
This includes modules such as Discover, Spotlight, Identity Protection and Log Management. At one point, the company reported on four or more modules, yet retired this key metric as it became commonplace to upgrade to four. Users download a lightweight agent on each endpoint and cloud workload with only a single agent required to upgrade to more modules.
The agent also protects workloads when offline and sends data to the Falcon platform. The data from workloads are analyzed by machine learning models and are capable of preventing future attacks. The events are sent to the Threat Graph in real-time to be further analyzed.
The Threat Graph is a proprietary and a dynamic graph database. It continuously looks for malicious activity by using Artificial Intelligence. The data needs to be collected only once and can be used to analyze how to prevent future attacks. It also enables the company to introduce new products by using the same data and this is one of the reasons that CrowdStrike was able to rapidly introduce new modules.
The company has a smart filtering system that helps filter enormous amounts of data. The company estimates that a typical endpoint generates 100 GB of unfiltered system event data daily. A typical corporation will have several endpoints. The company’s smart filtering helps reduce the noise, and the Falcon agent only sends the crucial data required for detecting, preventing, and investigating attacks. It thereby improves the performance and allows for efficiently analyzing large volumes of data.
The Threat Graph is a powerful product in preventing breaches as it predicts and prevents modern threats in real-time through endpoint telemetry, threat intelligence and AI-powered analytics. This works alongside the modules to offer a best-of-breed endpoint security solution that offers a combination of agent-based and agentless solutions on one dashboard across public cloud, multi-cloud, and hybrid deployments.
The company feels that agent-based is still essential to offer pre-runtime and runtime protection, whereas according to CrowdStrike, agentless-only solutions offer partial visibility and lack remediation capabilities (i.e., the company is referring to SentinelOne which we’ve covered here and also here). With that said, CrowdStrike has recently enhanced it’s agentless offering with a virtual analyst with generative AI features.
The company has three graphs: Threat Graph, Intel Graph and the Asset Graph.
Threat Graph: As discussed, takes trillions of data points from millions of sensors and enriches the threat intelligence from third-party sources (hence “crowd” strike). This offers full visibility and provides automated threat prevention.
Intel Graph: Offers threat intelligence by correlating massive amounts of data and provides insights into any shifts in tactics or techniques
Asset Graph: Launched last year to increase protection across attack vectors such as cloud, on-premise systems, mobile, IoT and connects them into a unified, visual graph rather than a list.
CrowdStrike’s Land and Expand Strategy:
One of the company’s primary strategies is to use its strong, defensible position on endpoints and expand to other layers in the security stack. As enterprises look to lower budgets, the goal is to have them tap CrowdStrike as a replacement for the fragmented list of security vendors that enterprises currently use. This is a normal cycle for tech innovation to where it can become vertical and fragmented before more horizontal, consolidated platforms emerge.
Endpoints are arguably the most difficult to protect, therefore, it stands that an endpoint security company could expand into other turf by combining endpoint with other products. The company’s most recent expansion includes: cloud security, identity protection and LogScale SIEM.
The most important point for investors to take away from the section below is that the company’s total addressable market (TAM) is growing. It was $25 billion during the company’s IPO in 2019 and is expected to reach $126 billion in 2025 with planned new offerings. expected to reach $126 billion in 2025 with planned new offerings. The TAM is expected to be $71 billion in 2024 with the current portfolio offering.
Of CrowdStrike’s $2.9 billion in ending ARR, nearly $600 million came from cloud security, identity protection and SIEM. We want to highlight these three because they are the fastest growing components within the Falcon platform. As you’ll see, they will also help contribute to an inflection point in net new ARR.
Cloud Security:
According to Checkpoint, cloud-based environments are the second most popular targets for hackers, following corporate and internal networks as the number one. According to Frost & Sullivan, the global cloud workload protection platform market (CWPP) recorded revenue of $3.05 billion, representing growth of 47.9%. The market is expected to grow at a CAGR of 26.3% through 2027 due to “the increasing demand for runtime protection and automated threat response.” The forecast below predicts cloud security will grow at a CAGR of 22.5% through 2032.
Cloud is a growth lever for CrowdStrike as the company leverages a microservices architecture for rapid and frequent updates. The company offers support for Kubernetes workloads with additional runtime protection and simplified deployment. Kubernetes is automation orchestration for containers and allows for scaling of a container rather than an entire application. Kubernetes was created by Google and is used by 78% of companies managing containers with this open-source system.
Agentless is important for cloud security in order to reduce friction for developers. Instead of requiring an agent for workloads, developers can adopt agentless workload protection that is built into cloud-native applications for total coverage including runtime, plus full automation, including features such as zero trust.
CNAPP, or cloud native application protection platform, is a term coined by Gartner in 2021. Due to Zero Trust being an important component for CNAPP, CrowdStrike competes with Zscaler and Cloudflare in Cloud Security.
Management was recently asked on the earnings call what the benefit is to offering CNAAP from an endpoint security company instead of a Zero Trust company. This is a good question to ask because Zero Trust manages perimeter-less security architectures, and cloud is certainly perimeter-less. Workloads that include both containers and serverless also spin up and down based on demand, and this could also be best served by a Zero Trust company as permissions are more complex given the dynamic quality of cloud workloads.
The primary difference is that Zscaler and Cloudflare will protect the environment by controlling access, whereas CrowdStrike is trained in detecting and responding to threats. Another primary difference is that CrowdStrike only recently began to offer cloud security as it’s traditionally an endpoint company that launched cloud security in 2020, whereas Zscaler and Cloudflare are predominately cloud security companies that grew in prominence by helping companies migrate to the cloud by replacing their traditional VPNs and networking solutions. In contrast, about 10% of endpoints secured by a typical endpoint security company are cloud related. However, over time, cloud security could surpass the endpoint market, and thus, you can expect CrowdStrike to make an outsized effort here.
As to why CrowdStrike would be used for cloud security over ZS and NET, management answered with this: “It's not just around the cloud workload protection, but it's also around the cloud security posture management and everything really from code to cloud.”
Cloud security posture management refers to a comprehensive view of a security landscape to help identify misconfiguration issues or compliance risks. An example of “code to cloud,” is to secure the development pipeline as applications are built from open-source code, libraries, and APIs. CrowdStrike’s management is also stating that workload protection is also important, which refers to real-time threat detection and vulnerability management.
Another interpretation is this – Zscaler and Cloudflare may have been first, but CrowdStrike is better because it consolidates what other best-of-breed companies do while offering more comprehensive coverage. That’s CrowdStrike’s perspective although I’m sure ZS and NET would argue that an endpoint company with $300 million in cloud security revenue does not compare to a company that specializes in cloud migrations and has $1 to $2 billion in revenue.
Notably, in July, it was rumored that CrowdStrike was in negotiations to acquire a startup called Bionic.AI for about $300 million. If this acquisition is officially announced, it would grow CrowdStrike’s cloud security footprint to become more specialized in application visibility. The company uses an AI domain because the solution is agentless.
Identity Protection:
This quarter, identity protection reported $200 million in ending annual recurring revenue, which is up 194% year-over-year. The identity protection adoption rate for new customers grew over 100% year-over-year and the total number of deals tied to identity increased 200%.
According to management, “identity-based attacks represented 62% of all interactive intrusions we observed in the last 12 months.” Also, according to CrowdStrike, 80% of breaches are identity-driven. These attacks are particularly difficult to identify because they mimic typical user behavior. Examples include stolen credentials that are used on other systems, accessing user data stored in Microsoft Active Directory, or man-in-the-middle attack where an attacker intercepts passwords or banking details.
The Falcon Identity Platform offers threat detection and threat protection (that’s a tongue twister!) through behavioral analysis and looks for anomalies across accounts and users, while also tracking authentications for elevated risk. The platform offers authentication protection end-to-end.
LogScale SIEM:
“The number of customers using LogScale grew more than 3x year-over-year. LogScale ending ARR grew over 200% year-over-year and is quickly approaching the $100 million ARR milestone, which we expect to achieve in Q3.” –Q2 2023 Earnings Call
SIEM combines security information and security events into one management tool. SIEM systems log data from many sources to identify deviations and alert the security team. The system is either rules-based or correlates to event log entries. The goal is to find the priorities within a large volume of security data through incident detection.
For example, a user that attempts to login 10 times but fails would be a lower priority event, whereas a user that attempts to login 100 times would be a high priority event as it’s likely a brute-force attack.
SOAR is another acronym used in advanced SIEM, and it stands for security orchestration, automation and response. SOAR platforms ingest alert data, and then automate response workflows. Overall, SOARs are more efficient than SIEM systems by adding in automation through automated playbooks and by using AI to learn pattern behaviors with the goal of predicting threats before they happen. Human analysts are needed to sort through events to determine which ones require prioritizing, while AI learns pattern behaviors to help flag which anomalies are most urgent.
Splunk is a heavyweight in SIEM with $3.7 billion in revenue last year. About two years ago, CrowdStrike acquired a leading SIEM provider called Humio. As stated above, the $100 million does not compare to Splunk, but CrowdStrike’s goal is that those looking to consolidate endpoint protection with SIEM will choose CrowdStrike to drive down costs compared to stringing together many vendors.
Cybersecurity and AI:
Combining cybersecurity with AI has a natural affinity as cyberattacks are computer generated, and in turn, computers are uniquely capable of finding computer-generated threats. For example, Chat-GPT heightens security risks as generative AI is capable of writing malicious code or acting as a sidekick to the human hacker writing malicious code. To level the playing field, the best defense will also be self-learning, generative AI tools.
This is early days, so I don’t want to get too far ahead of ourselves, yet the point is that CrowdStrike already has a strong foundation. Now, we may be layering in a new trend that can drive further growth, which is to protect against the risks that large language models pose. By offering agentless, theoretically, fewer human agents will be needed.
Charlotte AI uses generative artificial intelligence as an agent, or a security analyst. Security professionals can ask the AI assistant questions about threat vectors and receive responses, such as “Which threat actors target us?” It also reduces repetitive tasks by automating them. Rather than relying on existing data sets, generative AI is able to create net-new outputs that are based on patterns and structures inherent to the training data. According to management, a virtual analyst that automates tasks can complete eight hours of work in 10 minutes.to management, a virtual analyst that automates tasks can complete eight hours of work in 10 minutes. Pricing information will become available later this month at the Fal.Con conference.
There will be competitors with generative AI agentless solutions. However, CrowdStrike’s contention is that their data is more valuable, and this is the most important element to AI-related outcomes. The statement that CrowdStrike’s data is more valuable is based on the vast number of threats their platform has already detected. Essentially, the argument is that their XDR platform is better than competitors, and therefore, their data is better than competitors, which results in smarter and more accurate AI output. Here is how management spoke about it: “we actually have a very well-defined training set that's annotated based upon all the threat hunting that we've done over the last 10 years.”
Automation reduces the number of false positives. Instead of getting every piece of telemetry that requires the security team to investigate, AI-assisted endpoint detection and response solutions eliminates the noise so that the security team is only responding to those that have the potential to be critical. Fundamentally, cybersecurity is a data problem. CrowdStrike’s Falcon platform ingests, correlates, and queries petabytes of structured and unstructured data from ever-expanding disparate external and internal sources in real-time. It builds rich context and delivers greater visibility by constructing a dynamic representation of data across an organization. As a result, the company’s AI models are often highly accurate in triggering a response.
What matters to customers is that every threat is detected very quickly, and CrowdStrike proposes a solution that is able to do both because automation and AI is best done at the data level rather than by only managing thousands of user endpoints to mitigate attacks.
Financials:
CrowdStrike’s revenue growth was in the 60% range this time last year, and will exit the year at a 30% growth rate over the span of 18 months. For our purposes, this deceleration is not ideal. However, we are willing to overlook this for two reasons:
The bottom line has been growing, and this is what separates a cloud company from the long list of cloud companies that are years away from becoming GAAP profitable. In our opinion, to own companies that are not GAAP profitable is to gamble the Fed is done raising rates, which is a complicated gamble as it’s entirely outside of a company’s control.
CrowdStrike’s key metrics may be pointing toward an acceleration, or at least, an improvement in the growth profile.
In the most recent quarter, CrowdStrike reported revenue of $731.6 million, for growth of 36.7%. For the next quarter, CrowdStrike is guiding for revenue of $775.4M to $778M, for growth of 33.7% at the midpoint.
The company reported adjusted EPS of $0.74 and GAAP EPS of $0.03. This beat estimates of $0.56 and ($0.06). Next quarter, CrowdStrike is expected to report adjusted EPS of $0.74.
This quarter, CrowdStrike earned $36.6 million in interest income, which offset losses from operations at (-$15.4) million. The outcome was a net profit of $8.5 million. Operating losses have improved from (-$48.3) million in the year ago quarter. Ideally, this time next year, CrowdStrike reports GAAP operating profits. The company is certainly on that trajectory.
Margins:
In the most recent quarter, CrowdStrike reported a gross margin of 75%, which has improved one to two basis points over the past few quarters. The adjusted gross margin has also improved one or two basis points to 78%.
The GAAP operating margin reported quite a bit of improvement at (-2%) up from (-9%) in the year ago quarter.
In Q2, there was a sizable beat on adjusted operating profit at $155.7 million, compared to management’s guidance of $120.1M, at the midpoint. Adjusted operating profits have nearly doubled YoY from $87.4M in the year ago quarter. There was also strong growth QoQ of 34.2%. The last time CrowdStrike grew its adjusted operating margin by four basis points QoQ was in CY 2021. Management has guided flat for fiscal Q3 for $155.4M at the midpoint. The same is true for the adjusted net margin at 25%, which added five basis points QoQ.
As discussed, the GAAP net profits were $8.5 million for a margin of 1%.
Stock based compensation weighs on CrowdStrike’s GAAP operating margin, although less so compared to other cloud companies. In the current quarter, SBC was 22.5% of revenue. This is higher than last quarter at 18.9% of revenue. An analyst asked about this in the call, with management replying with this:
“So, number one, we are going to continue to invest as aggressively as we can while keeping to our commitment to our profitability metrics. And for us, I think that the key here, you had mentioned on the stock-based compensation, a lot of that is based on timing of grants and I think that for us, we're going to continue to use grants to attract and retain. Having said that, we think that we are going to continue to show low dilution, less than 2% this year and strive to keep it under 3% for next year.”
In Q1, the company had stated the following: "Third evolution is GAAP profit which we will continue to focus on and drive towards achieving sustainability. Of course, SBC is the biggest piece of that. We continued to manage SBC and we are going to be mindful balanced with retaining the best and the brightest talent that's paramount for us."
Key Metrics:
There were two key metrics that are worth pointing out. The first was management’s comments about an inflection in net new ARR in the second half of the year. We had highlighted the importance of this key metric going into the call: “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.”
This statement was quite important in terms of confirming what we wanted to see.
“Heading into the second half of the year, we see increased momentum in the business, driven by record levels of new logo and upsell pipeline, record deal registrations from our market-leading partner ecosystem and record levels of customers proudly trusting CrowdStrike to be their long-term security platform consolidator of choice. We are also observing substantial changes in the competitive landscape, uniquely benefiting CrowdStrike. With the business momentum we see and competitive market dynamics, we believe our second half performance will yield double-digit net new ARR growth.”
In the current quarter, net new ARR growth hopefully bottomed at (-10%) decline YoY for $196.2 million. This compares to 44.8% growth in the year ago quarter. The steep difference, and the risk of going double-digit negative, is ultimately why we stepped aside from this company. If we take the current quarter’s results coupled with management’s comments at face value, it appears net new ARR is at an inflection point.
Pictured Above: Net new ARR is showing signs of bottoming in this quarter, and when coupled with CrowdStrike’s guide that net new ARR will “yield double-digit net new ARR growth”
When providing full year guidance, the company’s CFO, Burt Podbere stated: “We are raising our revenue guidance for the fiscal year and maintaining our net new ARR assumptions for the second half and fiscal year, which call for in line to modestly up net new ARR for the full year.” Using this guidance, we calculate that net new ARR in the 2H 2023 will be around $460 million, representing about 10% YoY growth. The ending ARR is expected to grow 32% YoY to $3.4 billion.
ARR in the current quarter was $2.93 billion for growth of 37% YoY, compared to 42% YoY last quarter. This is a deceleration from the 59% growth in the year ago quarter.
One thing to note is that the company used to report number of subscription customers, and has dropped this key metric from its coverage. Typically, this means the growth rate was undesirable.
However, the number of modules per customer is increasing, and the company has seen a steady acceleration of one basis points or more per quarter in customers adopting 7 or more modules, 6 or more modules, and 5 or more modules.
The second highlight in key metrics was remaining performance obligation (RPO) of $3.6 billion, which was up 43% year-over-year and up 8% QoQ. This accelerated from Q1, which was up 41% YoY and flat QoQ. In the year ago quarter, RPO decelerated in growth from Q1-Q2 from 60% growth in Q1 to 49% growth in Q2. In an effort to find an inflection point, RPO could also be signaling that this quarter might be the bottom.
Per our write-up going into the earnings report, this was a key metric we were watching closely: “It will also be interesting to see if RPO bottoms over the next few quarters. It was at 41.2% growth last quarter.”
Dollar based net retention rate of 120% was lower than last year by five to seven basis points.
Cash Flow:
Operating cash flow of $244.8 million is up from $210 million in the year ago quarter. This represents an op cash flow margin of 33%.
Free cash flow of $188.7 million is up from $2.32M in the year ago quarter. This represents a free cash flow margin of 26%. The company has $3.2 billion in cash and $742M in debt.
After the first two quarters in FY2024, the free cash flow margin is at 29% of revenue, representing 42% YoY growth. As stated in the earnings call, management is on track to reach its goal of a 30% free cash flow margin in FY2024.
A Note on Microsoft:
Big Tech is formidable when it comes to AI because it has the cash reserves coupled with a strong motivation to not only succeed, but rather to “rule them all.” We are talking about companies that have been cash flow positive for decades up against a company that is a fraction of its size. As enamored as we may be with a smaller company taking on Big Tech, Microsoft’s cybersecurity revenue stands 6X-7X larger than CrowdStrike’s revenue today, and there is plenty of cash reserves and adjacent products that can fuel Microsoft’s growth. The reason customers choose Microsoft is because it drives down costs to consolidate cybersecurity with their suite of enterprise software. As a lead investor in OpenAI and ChatGPT, Microsoft is likely years ahead of CrowdStrike when it comes to AI capabilities – especially generative AI.
Conclusion:
We’d like to add cybersecurity to our portfolio on the next pullback. This is one strong candidate and we will cover another strong candidate over the next week or so. Advanced Market Signals members receive real-time trade alerts when we enter a position, along with a 1 hour webinar every week with the I/O Fund Portfolio Manager who discusses what positions he is looking to trim, add, buy or sell. Learn more here.
Cybersecurity was a wild ride this earnings season with stocks such as Fortinet down (25%) after its report, yet stocks like Palo Alto Networks up 15% following its report. This is important to dissect as Palo Alto is the leader YTD in gains while Fortinet is the laggard (see chart below).
Source: YCharts
We think the market is more forward-looking than ever when it comes to the cybersecurity space as the key metrics is what separates these names. Below, we look into the key metrics to help predict where the market will go next.
Revenue and EPS
Before we go into key metrics, let's first review top line and bottom-line numbers. Here is how the leading cybersecurity stocks stack up on revenue. Zscaler and CrowdStrike are leading in revenue growth in the recent quarter with YoY growth of 43.1% and 36.7%, respectively.
Zscaler’s revenue grew by 43.1% YoY to $455 million and CrowdStrike’s revenue grew by 36.7% YoY to $731.6 million in the recent quarter.
Forward looking, CrowdStrike leads highest revenue growth rates in the next two quarters and yet Cloudflare edges out CrowdStrike in the early part of next year – per analyst consensus.
CrowdStrike’s revenue is expected to grow 33.8% YoY in Q3 2023 and 31.3% YoY in Q4 2023.
Cloudflare’s revenue is expected to grow 29.6% YoY in Q1 2024 and 30.2% YoY in Q2 2024.
Source: Seeking Alpha
CrowdStrike’s adjusted EPS is expected to grow the fastest in the next three quarters with 85.6%, 66.3%, and 36.6% YoY growth. Zscaler beats CrowdStrike in Q2 2024 with 21.1% YoY growth while CrowdStrike’s EPS is expected to grow 15.1% YoY in that particular quarter.
Source: Seeking Alpha
Margins
We'd also like to discuss margins as a group before we break the stocks down individually. For brevity’s sake, we are placing the most importance on GAAP operating margin. This highlights why Palo Alto Network has led cybersecurity stocks this year, as the company’s growth profile is balanced with operational efficiency.
Source: YCharts and Company IR
Palo Alto’s operating margin improved to 13% from 1% in the same period last year. CrowdStrike and Zscaler are also improving as can be seen in the below chart.
CrowdStrike improved to (2%) from (9%) in the same period last year.
Zscaler improved to (10%) from (26%) in the same period last year.
Source: YCharts
Key Metrics
Below, we look at key metrics among cybersecurity stocks to help determine which companies may be stronger than they seem, or the opposite, weaker than they first appear.
CrowdStrike
For CrowdStrike ending ARR and net new ARR are two important key metrics. Per CrowdStrike’s management: “And as you know, the business is focused on ARR, as opposed to billings, which can be — which can have whipsaw effects and the focus on ARR, just gives you an idea about the overall health of the business.”
Ending ARR grew by 37% YoY in the recent quarter to $2.93 billion. This was partly helped by the rapid growth in cloud security, identity protection, and LogScale Next-gen SIEM, which together surpassed $550 million in ARR with very high growth rates:
LogScale SIEM ending ARR grew by over 200% YoY in the recent quarter and is approaching $100 million and the management expects to achieve in Q3.
Falcon modules deployed in public cloud grew by 70% YoY to $296 million.
Identity Protection ending ARR grew by 194% YoY to over $200 million.
Source: Company IR
Net new ARR declined by (10%) YoY to $196.2 million yet was better than management’s guidance of a decline of (11%). In the earnings call, management pointed toward net new ARR returning to growth in the second half of the year: “With the business momentum we see and competitive market dynamics, we believe our second half performance will yield double-digit net new ARR growth.”
Source: Company IR
Palo Alto
For Palo Alto, billings and RPO are the two key indicators. Palo Alto’s billings grew by 18% YoY to $3.2 billion. Despite billings growth showing a deceleration, it’s actually quite strong due to the tough comps as billings grew by 44% YoY in the same period last year.
The management guided billings to grow in the range of 17% to 19% for the next quarter. They also expect billings to grow in the range of 17% to 19% for the next three years. Dipak Golechha, CFO of the company said in the earnings call, “We have the product portfolio that makes us an attractive partner to these players, along with the scale to make the investments to support the success of these partners. Bringing this together on the top line, as Nikesh noted, we're targeting growth of 17% to 19% in revenue and billings over the next three years, which is ahead of the cybersecurity market growth rates.”we're targeting growth of 17% to 19% in revenue and billings over the next three years, which is ahead of the cybersecurity market growth rates.”
Source: Company IR
Remaining Performance Obligation (RPO) grew by 30% YoY in the recent quarter to $10.6 billion. The management believes RPO is a better metric than billings since it is not impacted by billing terms that impacted billings due to customers preferring deferred payments in the current environment. Per the earnings call: “The percent of bookings that included deferred payments increased approximately 45% year-over-year […] and also: “RPO is becoming a more important leading indicator for our business as it's not impacted by billing terms [..] As a reminder, RPO represents the booked business we expect to recognize as revenue in future periods. Also, all customers' purchases, including in RPO, are noncancelable.”
Source: Investor Presentation
Fortinet
Billings grew by 18% YoY to $1.54 billion in the recent quarter, which was a disappointment to the market. Ken Xie, CEO and Founder of the company, said in the earnings call, “Billings growth of 18%, led to more normalized product revenue growth of 18%. We believe our billing performance reflects large enterprises’ concerns with the macro environment, in addition to some inventory digestion after two years of elevated 30%+ of product billing growth during the supply chain shortage.”product revenue growth of 18%. We believe our billing performance reflects large enterprises’ concerns with the macro environment, in addition to some inventory digestion after two years of elevated 30%+ of product billing growth during the supply chain shortage.”
The management cited macro uncertainty led to shorter contract duration and enterprise deals getting pushed out to future quarters for the slower billing’s growth of 18%. Keith Jensen, CFO of the company, said, “We saw shorter contract duration with the average term decreasing 1.5 months to 28 months, creating a 4 to 5-point billings headwind year over year. Normalizing billings growth for the change in contract duration, yields billings growth in the low 20% range. Having some level of enterprise deals push to future quarters is not unusual. In Q2’23, however, an unusually large volume of deals that we expected to close in June, instead pushed to future periods.”
The above explanation from the management was not convincing as it lowered the company’s revenue guidance to $5.35 billion to $5.45 billion, representing a YoY growth of 22.3% at the mid-point from an earlier estimate of $5.425 billion to $5.485 billion.
Revenue for Q3 is expected to be $1.315 billion to $1.375 billion, representing a YoY growth of 17% at the midpoint.
Billings in the range of $1.56 billion to $1.62 billion, representing a YoY growth of 12.8% at the mid-point.
Source: Company IR
Cloudflare
The company’s paying customers grew by 15% YoY yet large customers (> $100,000 annualized revenue) grew by 34% YoY to 2,352.
Thomas Seifert, CFO of the company said in the earnings call, “Turning to our customer metrics. In the second quarter, we had 174,129 paying customers, representing an increase of 15% year-over-year. We ended the quarter with 2,352 large customers, representing an increase of 34% year-over-year and an addition of 196 large customers in the quarter. In fact, we added a record number of customers spending more than $500,000 on an annualized basis with Cloudflare. And the second quarter was also one of our highest quarterly additions of customers, spending more than $1 million annually, including our largest Zero Trust contract to date.”
The dollar-based net retention rate was 115% compared to 117% in Q1 23 and 126% in the same period last year. He further said,
“Importantly, renewal rates in the second quarter were consistent with the quarterly average in 2022, which was an all-time high for the company. Instead, similar to the last two quarters, the decline in DNR was again primarily driven by slower expansion in our larger customer cohort. We calculate DNR by comparing the analyzed revenue from paying customers four quarters prior to the annualized revenue from the same set of customers in the most recent quarter. As a result, this will be a lagging indicator of Cloudflare’s underlying business trends. Based on our visibility, we believe the deceleration in DNR is nearing a bottom.”Based on our visibility, we believe the deceleration in DNR is nearing a bottom.”
Source: Company IR
Zscaler
Customers with over $100,000 in ARR grew by 25% YoY to 2,609.
Calculated billings grew by 38% YoY and up 49% QoQ to $719 million. The total billings benefitted from $20 million upfront billing on a multiyear deal. The calculated billings grew 40% YoY in Q1 and 57% YoY in the same period last year.
Source: Company IR
Conclusion
We are currently looking to add cybersecurity exposure to our portfolio, ideally on a pullback, to position into 2024. There are many strong candidates highlighted here that are performing better than other cloud cohorts. In particular, there are many mentions throughout of the key metrics listed above bottoming. Should these key metrics bottom on any particular stock, the market will likely reward that stock. Our plan is to front-run this bottom with a small allocation and then layer-once the bottom has been confirmed.
September is widely known to be the worst month for tech as it’s the only month to see negative average returns for the past decade for the Nasdaq 100. Meanwhile, the index is entering September up 42.5% YTD, setting up investors who are sitting on paper gains for potentially a large disappointment.
There are many cross currents driving the markets in 2023, which can make positioning challenging for investors right now.
On the positive side, the economy grew at a 2.4% annualized rate in Q2, with an early projection for Q3 to be a stunning 5.8% annualized, This is accompanied with a strengthening consumer, and a resilient employment market with room to grow. If there was ever an environment for the Central Bank to pull off a soft-landing, this would be it.
On the other hand, the track record for the FOMC’s ability to pull off a soft landing is not very good. There have been previous instances where low inflation environments allowed them to rescue equities with injections of liquidity, such as the mid-1990s, 2016, 2020. However, there is no instance in market history where they were able to pull off a soft-landing in an environment with heightened inflation. This coupled with the most inverted yield curve in decades, and the Money Supply going negative for the first time since the 1930s, it makes sense to give up some additional gains in any further swing higher, just to be prepared for the coming crash.
With this many cross currents, there is no shortage of well-supported narratives. For this reason, we believe the best means to navigate the current markets is by focusing on price. If we are going to see a major pullback, this will show up in specific price patterns breaking through critical support. Until then, we believe it wise to not fight the current trend, even with the high probability of a recession manifesting within the next six months.
It is our belief that inflation will likely start surprising to the upside in the next three months. We’ve been talking about the strong economy = strong inflation theme for several months, and with energy and food prices in sustained uptrends, this theme will likely start to manifest soon. We also believe the US will enter a recession within the November 2023 to March 2024 time frame. This will cause a top in equities, which is showing up in the charts. The only question is if this top will coincide with a recession, which we will use technical analysis to help guide us.
We have a solid history of using these techniques to identify turning points. For example, between October 12 – November 9th of 2022, we put all of our cash to work in the markets. On October 12th, we timed the bottom perfectly, buying companies like NVDA at $108.October 12 – November 9th of 2022, we put all of our cash to work in the markets. On October 12th, we timed the bottom perfectly, buying companies like NVDA at $108.
Two Scenarios for Potential Tops
There are three general counts I'm tracking into Q1 of 2024. The Green count, or some variation of it, is the most likely. This suggests that we see one more swing into the 4680 – 4730 region after a drop into the 4275 region, which is likely playing out now. The red count will mimic the Green count with the possibility of a larger swing higher into Q1 of 2024. The targets here are 4890 – 5000 SPX. The Blue count has us topping. We would need to see a break below 4245 SPX for confirmation of the Blue count.
I believe that we are marching towards a recession, which will cause a top in equities. This view has become contrarian, as the consensus is now calling for a soft-landing.
Even though this is my thesis, as a portfolio manager, I cannot be too attached to a thesis and must be willing to pivot. This is the reason I put so much weight on price. It is because it is the only metric that ultimately matters, and it will be the final arbiter of what narrative will win out in this market. Price can help you pivot when you are wrong, and also confirm an unexpected scenario is starting to play out.
The reason I say this is because of the Blue count, which suggests a top has already happened. There is no evidence in the macro data suggesting a Q3 recession is underway. However, if we see price break below 4245 SPX, I'll have no choice but to make this the primary count. So, that is the ultimate bail-out for the Green and Red counts.
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If we zoom into the cyclical bull market that started in October of 2022, we can get some more clarity on where this trend can go. Let's start with the push higher that started two weeks ago. With price breaking below 4478 SPX, it appears that we are starting the next leg lower in this correction, which we have 4275 as a strong target.
In conclusion, as stated earlier, as long as this drop stays above 4245 SPX, we are expecting a push higher into Q4/Q1. This will likely set up a nice buying opportunity for those looking to capture the final swing in the large uptrend that started in October of 2022.
This is the most likely outcome, considering the resilience of the US economy, which is not in threat of going into recession right now. Also, we expect the new uptrend in energy prices to hit CPI data in October. If we start seeing a return to upside surprises in inflation data, it will likely trigger a risk-off environment for equities that is worth monitoring. We will update you as we go along.
Next week we’ll discuss the most important markets to track for a continued push higher in equities.
If you want to track the potential top in equities, join I/O Fund next Thursday, September 14th at 4:30 pm EST, for our premium webinar. We will go over in detail all possible scenarios, plus the levels that need to hold that can confirm what is likely playing out. We will also go over the specific AI stocks we are targeting for this final run higher, as well as our game plan for when we confirm a top.join I/O Fund next Thursday, September 14th at 4:30 pm EST, for our premium webinar. We will go over in detail all possible scenarios, plus the levels that need to hold that can confirm what is likely playing out. We will also go over the specific AI stocks we are targeting for this final run higher, as well as our game plan for when we confirm a top.
Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
AMD has been referencing a ramp for the data center in H2. Given that Q3 revenue growth is below expectations, this would imply that Q4 will have to really deliver.
AMD’s management reiterated “we do have that confidence” that there will be an “aggressive ramp in Q4 and 2024.” This was not the only statement on the topic, rather the quote from the last earnings call where management confirmed “50% year-over-year growth in the second half” was by and far the main focus of the call.
Notably, a large portion of the sales in Q4 will come from the El Capitan supercomputer, a highly anticipated launch that we discussed recently in our premium AMD Deep Dive, “This year, AMD will be powering the launch of a new and highly anticipated supercomputer called El Capitan located in Livermore, California. The ambitious goal for El Capitan is to exceed 2 exaFLOPS of “double-precision” processing power. This supercomputer is powered by AMD EPYC Genoa CPUs and AMD’s MI300A GPUs. El Capitan will also feature AMD’s ROCm open compute software platform.”
The analysts that dug into the “50% year-over-year growth in second half” comment were trying to ascertain the following:
· Is the 50% still valid despite the Q3 miss? If so, this implies +$700 million sequential revenue for Q4
· Of this roughly $700 million for Q4, what’s the product mix between EPYC processors and MI300 GPUs
· If El Capitan contributes “several hundred million” for Q4 then when will Tier 1 hyperscalers begin to drive sales for MI300 GPUs
In addition to these questions, which we outline below, the pertinent Q&A was on how much of a slowdown AMD is seeing for general purpose CPUs (Gen 3) as hyperscalers and the enterprise go through an optimization period. Here is what was specifically stated: “In the datacenter market, wesee a mixed environment as AI deployments are expanding. However, cloud customers continue optimizing their datacenter compute and enterprise customers remain cautious with new deployments. Against this backdrop, we expect strong growth driven by higher fourth gen EPYC and Ryzen 7000 processor sales and initial shipments of our Instinct MI300 accelerators in the fourth quarter.”
Regarding Bergamo and Genoa-X specifically, management stated that Microsoft Azure is seeing “5X higher performance in technical computing workloads compared to their prior generation” and that Bergamo is delivering “more than double the performance than competitive offerings for cloud-native applications, while offering full x86 software compatibility.” As a reminder, Gen 4 CPUs went into production this quarter.
We had also discussed in our previous article that AMD is expected to increase its CPU market share.
“AMD’s Zen architecture was introduced in 2017. The company proved it wasn’t down for the count by offering a chipset-free design, resulting in energy-efficient processors capable of executing more tasks per cycle and more cores than Intel.
AMD’s first-gen Zen architecture helped prove AMD had a pulse and a heartbeat— however faint it may have been with a tiny 2% CPU market share— but it was circa 2020 when the company found its wings again. In that phase, it grew by 400%, catapulting to 8% of the CPU market. Today, its share stands at an estimated 20%-24% and while the company is unlikely to increase six times over again, with continued excellent management, market dominance of 50% market share or greater is very much in the real realm of possibilities. This is the move we want to capture in 2023/2024.”market dominance of 50% market share or greater is very much in the real realm of possibilities. This is the move we want to capture in 2023/2024.”
The MI300s will ship in Q4 with the competitive edge of more memory bandwidth and memory storage. This is ideal for the inference phase, which is used heavily by large language models. We wrote a premium note about the MI300s:
“The El Capitan Supercomputer is expected to launch this Fall. When it launches, El Capitan is expected to follow a similar system as Frontier which is (1) AMD Epyc CPU with (4) MI300 GPUs with Infinity Fabric. The “A” in the MI300 stands for APU, which refers to a CPU being combined with a GPU. Nvidia has only recently attempted this at the HPC level with the Grace CPU and H100 GPU, but this is technically two discrete devices with separate memories.
By having a fully shared, coherent memory, the MI300A architecture reduces latency while enabling high bandwidth. The high-speed, low-latency unified memory helps improve speed while allowing the CPU and GPU to do what they do best. By allowing both processor types to access shared memory, HPC programming is more efficient.”
“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.”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.”
On the Client side, AMD has officially bottomed (barring any new, unforeseen circumstances). Management stated that “client segment will grow in the seasonally stronger second half of the year” including a launch of a dedicated AI engine for the mobile 7040 Ryzen CPUs. When discussing AMD’s AI opportunity, it is vitally important that we not lose sight of the opportunity AMD will have to expand its AI portfolio to the Client Segment. Hybrid AI architectures are coming (which means AI is going to go beyond the data center and expand toward the edge), and AMD will be at the forefront. As long as dollar content per chip is higher (which it will be), then AMD will benefit nicely in the next replacement cycle (and beyond). That is a record for parentheses in a paragraph!
For gaming, AMD has yet to bottom. The embedded segment will be weaker than usual over the next two quarters. This segment has been unusually strong post-Xilinx acquisition but is coming up on sky-high comps, so will be cooling off in the medium-term. Due to the M&A with Xilinx, AMD was posting 1,000% to 2,000% growth in the 2022 quarters.
Quick Earnings Glimpse
Overall, everything was in line except the forward guide for Q3 was a miss. This is important because it means the pressure is on Q4 to deliver the H2 growth management had referenced in the prior Q1 earnings call.
In addition to this, we want to see margins rebound quickly after Client and Gaming stabilize. In the past, the CFO has stated that the margins will return to normal when these two segments return to normal. The gross margin of 51% is in good shape but the operating margin of 0% is below AMD’s GAAP operating margin of 20% to 25% in the boom years of 2020/2021. Net margin of 0% compares the net margin of 15% to 20% in the boom years.
Although a tad vague, the CFO stated the following when pressed about the margins: “The model we leverage to generate profitability, we should be able to get back to 20%.”
Earnings Q&A
As stated in the intro, there were many questions about the 50% growth in the second half comment from Q1. Here were a few of the more important discussions.
Matt Ramsay
“Last quarter, you had given us some metrics around potentially being able to grow your datacenter business by 50% in the second-half of the year versus the first-half. And maybe you could give us a little bit of an update on how you're thinking about that milestone and the drivers of growth across CPU and accelerator for the back-half? Thanks.”
Lisa Su
“And we are still looking at a zip code of, let's call it, 50% plus or minus second-half to first-half. So, it's a big ramp, but when we look at all the components, I think that the customer pull is certainly there. And it's exciting to be in this part of the industry.”
When asked again about Q4, and whether the company has the supply to meet the demand, the CFO stated: “We feel that we have ample supply for an aggressive ramp in the fourth quarter and into 2024. But this is certainly one of the areas that we spent quite a bit of time to ensure that we do have that confidence.”
As stated in our AMD deep dive, El Capitan launches in November. Per management, this will contribute “several hundred million” in revenue for Q4. Of the obstacles that AMD must overcome, our analysis made it quite clear it was the software part of the equation that AMD must solve.
Per management: “There is a sort of large, call it, lumpy supercomputer win, so our El Capitan win will be in the fourth quarter primarily, with a little bit in the first quarter” and later it was stated by management: “You can assume that the El Capitan is several hundred million” of the Q4 data center revenue. Ideally, AMD will announce commercial customers soon. I’m sure Meta will be one of the first customers, considering the company has been ordering Bergamo from AMD, was on stage at AMD’s conference recently in June, and PyTorch is optimizing its framework for AMD’s software stack RocM. It’s just a guess at this point, but that’s a lot of collaboration.
Conclusion:
AMD has high institutional ownership of +70%, which exceeds many of the FAANGs. The reason is that it’s a tough company to cover and retail investors avoid AMD for this reason. There are many moving pieces with exposure to a handful of major markets, a wide variety of customers, deceivingly lumpy revenue, known to be in second place against 800-pound gorillas, plus trying to figure out where AMD fits requires understanding of both hardware and software.
While some are offput by AMD’s complexity compared to Nvidia’s simple, straightforward thesis, this company has all of the ingredients to be a major AI player. As you’ve probably heard already on the quarterly webinars, my stance is there will be fewer winners in AI compared to other microtrends, and so to find a company like AMD will be quite rare.
Also, as a gentle reminder, Nvidia’s H100 started shipping in Q4 of last year and it took until April for there to be a “wow” moment. I can’t guarantee a “wow” moment will happen (my personal speculation is that it will happen), but this provides investors a minimum time frame of what to expect for Tier 1 hyperscalers to ramp orders after qualifying the two new accelerators.
Rather than pinpoint an exact month or quarter, let’s just say that 2024 should be the year that AMD puts up notable AI revenue. Those are my words. Here is management’s way of saying it: “So, we would expect early deployments as we go into the first-half of 2024, and then we would expect more volume in the second-half of '24 as those things fully qualify.”
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