Month: October 2023

AMD Q3 Pre-Earnings: With Bated Breath for Q4 Commentary

Posted on by io-fund

Nvidia’s dominance and AMD’s potential are both massive, which is why the battle between these two companies is far more exciting than the Mag 7 combined. Where else can you find the most powerful trend we’ve seen in decades come head-to-head between two companies? The MI300 will ramp in Q4 with El Capitan, but it’s the additional color management provides in terms of Q4 data center commentary that the market will be looking for. It may come in Q4 or the management team may force investors to wait for additional color until early 2024. Regardless, this is a highly anticipated earnings report, not only for the I/O Fund but I suspect many will be watching this report with interest given the catalyst that AMD is sitting on — and most crucially, must execute on.

Revenue and EPS:

Revenue for this quarter is expected to be $5.7 billion, per both management guidance and analyst consensus. This represents growth of 2.3%. This should be the bottom for AMD with revenue consensus at 14% next quarter and accelerating for the next four quarters through September of 2024. When there’s a catalyst on the horizon, I tend to see analyst estimates as a baseline.

EPS also rebounds from here with $0.60 EPS expected this quarter, yet EPS will reach $1.11 EPS by September 2024.

Margins:

GAAP gross margin was 46% last quarter. The last few quarters, GAAP GM was affected by the Xilinx acquisition. Typical range is GM of 45% in 2022 and 48% in 2021. 

AMD’s guidance for Q3 is adjusted gross margin of 51%. This represents 100 basis points improvement from the previous quarter.

The operating margin was 0% last quarter. The CFO has been clear that it will recover when client sales of PCs recover. According to most industry analysts who track PC sales, we have bottomed in Q3 or will bottom in Q4 (see below). The GAAP OM was 5% in 2022 and 25% in 2021.

Adjusted operating margin was 20% last quarter for adjusted operating profit of $1.06 billion.

Net margin was 0% while adjusted net margin was 17.5%.

Cash Flow:

AMD reported operating cash flow of $379 million last quarter. This is low for the company as the last two fiscal years have been $3.6B and $3.5B, respectively.

Free cash flow was $254 million in the most recent quarter, for a margin of 4.70%. This compares to a FCF margin of 13% last year and a FCF margin of 20% in 2021. The company has $6.3 billion on its balance sheet with $2.46 billion in debt.

Key Segments:

Data Center:

The data center segment has been reporting negative growth due to tough comps. Last quarter growth was (-11%) compared to 83% in the year ago quarter.

Investors should expect revenue growth to be flat YoY for Q3 yet is expected to report double digit growth QoQ. For Q4, DC is expected to report 50% sequential growth as there will be sizable revenue from MI300s powering the El Capitan supercomputer that launches in November. We covered this here following the last earnings report. For a deep dive on AMD’s MI300 GPUs and how they compare to Nvidia’s H100 GPUs, reference this analysis here.

According to the earnings call Q&A, the acceleration in the data center between Q3 and Q4 will be about 50% growth. This is exciting, yet the market will want to see more balanced, commercial demand beyond the government-owned supercomputer. I’ve included the transcript that references the 50% growth below as this is what most of the near-term price action will be based on.

In terms of when AMD will show up with broader MI300 GPU sales, it took Nvidia six months from initial shipments in October through the April quarter to see a more obvious impact. That’s a general idea of what to expect. It could be a bit sooner or a bit later.

Per our write-up last quarter, management stated: “In the datacenter market, we see 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 fourth gen EPYC, this is an important series to help AMD resume strength in the data center. Last quarter 4th Gen EPYCs carried the segment as CPU revenue nearly doubled while 3rd Gen inventory levels were high. In September, the company released 4th Gen workload-specific CPUs for edge computing and telcos. This needs to be monitored closely as we want to see 4th Gen strength overtake 3rd Gen weakness. 

Here is the transcript on the discussion around Q4’s 50% revenue impact from El Capitan:

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 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.” 

Per management, El Capitan 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 announces 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.

ONE MORE COMMENT ON THE 50% QoQ RAMP in Q4:

“Aaron Rakers

[…] I think, last quarter, you had alluded to, for the full-year, the expectation is still growing 10% or double digits, I should say, for the full-year the Datacenter business, just confirming that. And what I'm really trying to ask is, given the guidance of flat year-over-year growth in Datacenter in 3Q, it would seem, if my math is correct, you're implying a 50% or so increase sequentially into 4Q. I'm just trying to frame exactly how you're thinking about the cadence of what 4Q looks like, underpinning that expectation?

Jean Hu

Hi, Aaron. Thanks for the question. I think as Lisa just mentioned earlier, it's a very dynamic market. There are puts and takes. We have a tremendously strong momentum with our product portfolio, but there is continued softness in enterprise market, and also call it, the optimization is still ongoing. So, overall on balance, we think year-over-year it's probably more like a high single-digit. It's really strong ramp, not only in Q3, right, sequentially earnings double-digit — strong double-digit. And the Q4, of course we're going to see continued sequential strong ramp.”

Last year, in FY2022, the data center segment reported $6.043B in revenue. This means at high single-digit, or 9% growth, FY2023 DC segment will report $6.586B. This leaves $3.986B for the next two quarters given $2.6B has already been reported in Q1 and Q2 this year.

The CFO is implying $1.6B for this upcoming quarter per the “flat YoY” comment. This also matches the “double digit” QoQ growth. This leaves $2.386B revenue for Q4. These are the approximate numbers to watch in the upcoming quarter.

Client Segment/PCs:

Although data center is where the focus tends to gravitate, the Client Segment is going to be critical in the upcoming report. Last quarter the Client / PC segment was up 35% QoQ yet was down (-54%) YoY. The March quarter should have marked the bottom at $739M in revenue, with the June quarter showing some improvement at $998M in revenue.

Per management in the last earnings call:  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.

Industry analysts at Gartner are targeting Q4 as the rebound quarter for PCs. The CFO of AMD likely has a good idea as to their unique levels of demand, therefore, we are looking for Q3 to be the rebound given the CFO’s comments. Whether it happens in Q3 or Q4, it’s a good supportive segment to the data center ramp that El Capitan will provide, at minimum.

Gartner’s most recent report on PC sales:

  • Worldwide PC shipments totaled 64.3M units in the third quarter of 2023, a 9% decrease from the third quarter of 2022, according to preliminary results by Gartner. 
  • While the third quarter's results mark the eighth consecutive quarter of decline for the global PC market, Gartner is expecting to see growth again starting in the fourth quarter of this year. "There is evidence that the PC market's decline has finally bottomed out.”
  • The good news for PC vendors is that that the worst could be over by the end of 2023,” said Kitagawa. “The business PC market is ready for the next replacement cycle, driven by the Windows 11 upgrades. Consumer PC demand should also begin to recover as PCs purchased during the pandemic are entering the early stages of a refresh cycle.”
  • Gartner is projecting 4.9% growth for the worldwide PC market for 2024, with growth expected in both the business and consumer segments.

An analyst from Citi has September as the rebound, per an analyst note: “Christopher Danely notes that notebook shipments were up 7% month-over-month in September, which was well above the firm's expectation of down 2% month-over-month, driven by stronger seasonal demand and pull-in from Q4. As a result, Q3 notebook shipments were up 6% quarter-over-quarter, which is above the firm's prior expectation of up 3% quarter-over-quarter.”

Gaming:

Gaming is expected to decline again this quarter. We will look for comments on when this segment will bottom. The Radeon 7000 series built on RDNA 3 architecture is still ramping, but the company has been facing tough comps. Last quarter, the segment reported (-4%) YoY revenue of $1.6B.

Embedded:

The embedded segment will be weaker than usual over the next two quarters. Per management: “Embedded segment revenue to decline in the back-half of the year as lead times normalize and some customers reduce their inventory levels.” Embedded has been reporting very high and unusual growth due to the Xilinx acquisition with triple digit growth and even four-digit growth (it was up 1,868% in the Dec quarter). Look for embedded to normalize.

A Note on the Software Platform RocM:

In the deep dive on AMD entitled AMD is Ready to Rival on AI Acceleration, the analysis broke down the differences between CUDA and RocM. There is where Nvidia has the largest lead over AMD. As the two competitors face off, there will be many new developments to track, most recently AMD’s recent acquisition of Nod.ai to (quickly) expand its open AI software capabilities. I imagine analysts will be asking about this acquisition on the call, and our post-ER write-up will cover any Q&A on AMD’s plans with this acquisition.

Conclusion:

AMD is the top earnings report for our firm to watch over the next few quarters. We are not looking for a H100 moment, rather we are looking for a MI300 moment. For AMD, this is characterized by undercutting the competitor on price while bringing the heat on performance. If the performance is there (to be determined by benchmark tests) than AMD will fare well with the hyperscalers. Let’s see how this unfolds.  

Recommended Reading:

Five Stocks (Not Seven) Can Lead to New Highs

Posted on by io-fund

This is a complicated market, and there is really no better image to prove this point than comparing the transportation juggernaut, UPS, to the big tech juggernaut, META. While UPS has broken below its October 2022 lows and is currently in free fall, META’s uptrend is incomplete, and needs one more push higher to at least the $370 level before completing.

united parcel service stock chart

The majority of other sectors are confirming a continuation of the 2022 bear market, meanwhile, a handful of big tech names, with outsized weighting in the major indexes, suggest that they want to go higher. Though this pattern of narrow leadership where the market is held up by 7 stocks is unsustainable and a warning of an unhealthy market, it can continue, and likely will, at least into late 2023/early 2024. 

With markets continuing a nearly 3-month correction, the consensus is now confirming what we have been saying since July.

“We do not believe a recession is priced into equities, and that it is inevitable. However, this doesn’t mean that we can’t see higher levels from here, before a recession hits.”

In other words, bearish sentiment is now accompanied with the mainstream news is calling for an imminent market crash. This is after flooding the market with non-stop narratives about a soft landing.non-stop narratives about a soft landing.

stock market crash warning

However, unlike the consensus, we believe this final swing higher in the markets has one more run in it before the secular bear market that started in 2022 commences again.

Five Stocks (Not Seven) Can Lead to New Highs

Nasdaq had the best first 6 months in the index’s history, and this rally was propped up by seven stocks known as the Magnificent 7: Apple, Amazon, Meta, Tesla, Nvidia, Microsoft and Alphabet. Meanwhile, the rest of the market is struggling. Many argue otherwise, but the picture below is worth a thousand words in terms of illustrating the narrow leadership of this market.

sp500 stock chart

What is most concerning is that the equal weighted S&P 500 (RSP), which gives the same weighting to all 500 stocks in the index, is actually negative for the year. This matters because in a healthy economy, all sectors tend to participate, while mid-caps tend to outperform large caps. So, when the equal weighted S&P 500 is outperforming on a relative basis, it tends to be a good sign for the foundation of a new bull market.

The Equal Weighted S&P 500, like many others indexes, has put in a large top, and will likely not see a new all-time high for a long time. Note in the below chart that RSP could not sustain above its February highs, and has now broken through the major trendline in a 5-wave pattern.

invesco chart analysis

If the market is going to continue the bear market that started in 2022 to new lows, it will have to take the form of a 5-wave pattern pointing down. These patterns are fractal, which means that a small one builds into a larger one until we reach our target. So, the fact that the current drop in RSP is taking the shape of a 5-wave pattern is quite concerning, and also confirms that we are likely still in a larger bear market.

However, markets do not drop in straight lines. The current 5-wave pattern is only the first wave (of 5) that should take us much lower. What follows this pattern is always a 3 wave retrace that makes a lower high. So, even though sentiment is prepping for a crash, we still have one more bounce before that happens.

Even with this weakness we are seeing throughout the market, the magnificent 7 stocks account for ~28% of the S&P 500’s total weighting, and nearly ~42% of the NASDAQ-100. It is feasible that even with the broad level of weakness we are seeing, a handful of these stocks can push the bigger markets higher, and even potentially make another high in the NASDAQ-100.

The Macro Backdrop

In late August, we stated that..

“According to the economic trends we are seeing, there is simply no evidence of a recession brewing in Q3 of this year, and this is important for investors to realize this when looking for some type of top.”there is simply no evidence of a recession brewing in Q3 of this year, and this is important for investors to realize this when looking for some type of top.”

This remains true today, as the resilience of the US economy is still chugging along.

macro stocks chart

Not only has retail sales accelerated for the 6th month in a row, but industrial production gave us the strongest 3-month annualized reading since May of 2022. Most importantly, employment is still quite strong. Once we see a sharp rise in the 4 week average for initial jobless claims, we can start to looking for an imminent recession. Until then, we simply see no sign that the economy is heading into a recession right now.

Furthermore, we warned our readers to be cautious of claiming victory over inflation in June of 2023.

“Peak inflation is behind us, but the real battle will be getting these numbers back to the 2% target. In fact, going back in history, there is no instance where core PCE inflation backs off from an inflation impulse without a recession.”Peak inflation is behind us, but the real battle will be getting these numbers back to the 2% target. In fact, going back in history, there is no instance where core PCE inflation backs off from an inflation impulse without a recession.”

This has proven to be true, as we have seen 2 months in a row of reacceleration in CPI numbers. Most importantly, these numbers have bottomed well above the FED’s 2% targets on a YoY basis. In the below chart, core inflation has remained well above the Fed’s target, while the incredible disinflation that we saw in the Spring/Summer was due to decelerating energy prices.

cpi chart

It has been our view that energy prices would make a run back to the highs in the coming months, and this new uptrend has further confirmed this thesis. However, as stated prior, markets do not move in a straight line. Now that we have a completed a full 5-wave move off the low in crude oil, which would be the 1st wave, we are now seeing the 2nd wave pullback.

Sign up for I/O Fund's free newsletter with gains of up to 221% – Click hereSign up for I/O Fund's free newsletter with gains of up to 221% – Click hereClick here

The most likely path is the count presented in green. We are seeing the end of the first leg in a 3 leg correction. This could take us as low as $76/barrel and could last through November/December. If this plays out, this will relieve pressure from the coming CPI prints, and allow equities to make the next leg higher.

light crude oil chart

This is further confirmed when we look at the Japanese Nikkei, which has a strange history of leading the NASDAQ. Japan must import all of their oil. So, if oil is moving higher, companies within the Nikkei will see contracting margins, which is not good for stocks. When we look at the Nikkei, much like many of the magnificent 7, it has an incomplete uptrend.

nikkei 225 stock chart

Note how the correction, so far, has been an overlapping mess of a pattern. This is very common in 4th waves. It also implies that a 5th wave rally is needed to complete the larger pattern. If Japan is going higher, oil is going lower, which should propel equities in the US through the end of the year.

What This Means for S&P 500

In mid-September we laid out 3 potential paths that this bull market would to into a major top. From our assessment, the odds of a recession were very low in Q3, which was proven correct. Because of this, if the July high was the actual top, then it would likely be an event that pulls forward the recession.

Our line in the sand was 4245 SPX, which we breached and have continued lower. Because of this, we have narrowed the potential paths to two, and are leaning into our top-is-in count, in red.

sp500 daily stock chart

This drop in the S&P 500 has gone too low, and lowered the odds of us making a new high. However, at minimum, we are due for a sizable bounce over the coming weeks – months, which we believe will be led by a handful of Big Tech names.

My green count above sees the S&P 500 making one more high, which is not completely off the table. In order for this to happen, we would need to see Microsoft and Apple both present solid reports, and start new uptrends. A lot rides on how the market reacts to Apple’s report. We would also need to see Amazon, Meta, and Nvidia participate, all of which have charts that can allow for one more high. So, it’s not improbable to see the above green count play out with only a handful of stocks leading.

These scenarios are what we are game planning for, while also keeping a cautious eye on the bigger picture – we are likely setting up for a return of the bear market sooner than most think. For this reason we have been quite defensive for most of the year. If we instead see a vertical drop from these levels that takes us below 4000 SPX, we will drop the thesis that we are setting up for a bounce, and assume that we are the central part of this drop.

In conclusion, we have been adamant that we are in a cyclical bull market within a secular bear market. The macro environment as well as weakness outside of the magnificent 7 has only continued to prove this thesis. However, in this environment, we only need 5 stocks to keep the market moving higher. With no recession in sight, and oil relieving inflation fears, the market is setting up for a move higher in the coming weeks/months. Regardless, if we make a new high or a lower high, the next sizable bounce we will use to further de-risk our portfolio

Recommended Reading:

Meta Q3 Earnings Update

Posted on by io-fund

Note: The I/O Fund is covering Big Tech more closely than usual this earnings season given the narrow leadership of the market. The Magnificent 7 is holding the market up with 78% combined YTD returns. Therefore, these particular companies carry importance for all tech investors whether we own them or not. Also, we track capex as a proxy for AMD and Nvidia. You can read our past analysis on this here.here.

Meta Q3 earnings report beat the top-line and bottom-line estimates along with strong ad impressions growth and cash flows. Operating margin rose to the highest level since Q2 2021. However, the mid-point of the revenue guidance missed analysts’ consensus estimates.

Founder and CEO Mark Zuckerberg had earlier this year announced in the Q4 2022 earnings call that 2023 is the ‘Year of Efficiency.’ This was in continuation of the restructuring of teams and capex reduction initiatives undertaken in 2022. This had led to price action of 140% YTD, yet has also set the company up to report perfection as this price action is unusually strong. The bottom line has expanded, yet where the market is a touch nervous is due to comments from the CFO. Primarily, this comment caused the price action to reverse:

"We've reflected the latest trends and advertiser reaction that we've seen into our Q4 outlook, which again, we think, reflects the greater uncertainty and volatility in the landscape ahead.” And later, the CFO said: "Thanks, Doug. We obviously have not shared a 2024 revenue outlook yet. You asked about what are some of the significant puts and takes, and I'd maybe point back to what I said earlier about the Q4 outlook just to highlight what a volatile macro environment we believe we're in. I think that will obviously have a big impact on the advertising market next year, and it's something we'll be keeping a very close eye on. But ultimately, we're very subject to volatility in the macro landscape. […] We'll also be obviously lapping stronger periods, especially in — as you saw with this quarter's results. So all of those factors, I think, will play into the 2024 revenue outlook."

Revenue and EPS

  • The company’s revenue grew by 23% YoY and 21% on constant currency basis to $34.15 billion.
  • EPS rose 168% YoY to $4.39 and beat estimates by 19.1%.            

Margins

  • Operating income rose 143% YoY to $13.75 billion.
  • Operating margin rose to the highest level since Q2 2021, reaching 40.26%. That compares to 29.35% in Q2 and 20.44% in Q3 last year. It was helped by 7% decline in costs and expenses.
  • Net income rose 164% YoY to $11.58 billion. Net margin came at 33.9%, compared to 24.3% in Q2 and 15.9% in Q3 last year.

Cash Flows and Balance Sheet

  • Operating cash flow was strong: +110.5% YoY to $20.4 billion; YTD OCF was up 43.8% YoY to $51.7 billion.
  • Free cash flow also was strong: $13.64 billion for Q3 compared to $0.17 billion a year ago; YTD FCF was up 139.6% YoY to $31.5 billion. The cash flows also benefitted from deferral income taxes that was paid in Q4.
  • The company has cash and marketable securities of $61.1 billion and debt of $18.4 billion. It repurchased $3.7 billion of shares in the recent quarter.

Key Metrics

  • Family Daily Active People (DAP) continue to grow and was 3.14 billion on average for September 2023, up 7% YoY. Family Monthly Active People (MAP) was 3.96 billion as of September 30, 2023, up 7% YoY.
  • Facebook Daily Active Users (DAUs) continue to grow and was up by 5% YoY to 2.09 billion. Monthly Active Users (MAUs) grew by 3% YoY to 3.05 billion.
  • Ad impressions remained strong at 31% YoY growth and recorded a second straight quarter of over 30% growth. Average price per ad decreased by (6%) YoY.

Outlook

The management revenue guidance for the next quarter is $36.5 billion to $40 billion, representing a YoY growth of 18.9% at the midpoint. However, the mid-point missed the analysts’ consensus estimate of 20.95% YoY growth to $38.90 billion. This is why the CFO’s comments about relating Q4 to FY2024 had an outsized reaction — the CFO was basically saying more of the same could continue (what we quoted in the intro of this analysis), which translates to the potential for a miss on revenue in FY2024.

CFO Susan Li replied to an analyst question in the earnings call regarding the recent geopolitical tensions impact on the ad business. “Now in terms of how this translates into impact on the Q4 business, first of all, I should say that coming into Q4, we've been seeing continued strong advertiser demand in key segments, including online commerce and gaming. But having said that, we are also seeing more volatility at the start of the quarter. That's in part why we widened our guidance range to capture that uncertainty. And so for instance, while we don't have material direct revenue exposure to Israel and the Middle East, we have observed softer ad spend in the beginning of the fourth quarter, correlating with the start of the conflict, which is captured in our Q4 revenue outlook.”That's in part why we widened our guidance range to capture that uncertainty. And so for instance, while we don't have material direct revenue exposure to Israel and the Middle East, we have observed softer ad spend in the beginning of the fourth quarter, correlating with the start of the conflict, which is captured in our Q4 revenue outlook.”

The management lowered the 2023 total expenses guidance to the range of $87 billion to $89 billion from $88 billion to $91 billion. However, they expect higher 2024 total expenses in the range of $94 billion to $99 billion. The increase in expenses is due to higher depreciation expenses and higher costs to operate larger infrastructure. They also expect payroll expenses to rise as they look to add talent in priority business areas. Reality Labs operating losses are expected to increase YoY due to the ongoing product development efforts.

The management lowered the upper range of the 2023 capex. It is expected to be $27 billion to $29 billion from the earlier estimate of $27 billion to $30 billion, representing a YoY decline of (12.6%) at the mid-point. However, they expect higher capex for the next year in the range of $30 billion to $35 billion, representing a YoY growth of 16.1% at the mid-point. The CFO said in the earnings call, “With growth driven by investments in servers, including both non-AI and AI hardware, and in data centers as we ramp up construction on sites with the new data center architecture we announced late last year.”

Conclusion

The company’s earnings report was good, with the top-line and bottom-line beat, strong ad impressions growth, and cash flows. However, the revenue guidance disappointed, along with the management’s comments on the macro uncertainty that might impact the advertising market next year. If growth normalizes while costs go up, overall, Meta faces a tougher 2024 and was priced to perfection, up 140% YTD.

Royston Roche, Equity Analyst at the I/O Fund, contributed to this analysis.

Recommended Readings:

AEHR Fiscal Q1: More Orders Likely this Fiscal Year

Tesla’s Margins Fall Again

Netflix: Cash is King and Pivot is on Track

CrowdStrike: Steady Growth, Strong Bottom Line

Microsoft Fiscal Q1 Earnings: Operating Leverage from AI

Posted on by io-fund

Microsoft posted strong results with the highlight coming from Azure and the Intelligent Cloud segment. Azure accelerated by 100 basis points on a constant currency basis, meanwhile, Google Cloud decelerated 549 basis points as reported on the same evening.

Azure reported growth of 28% YoY compared to 27% last quarter. Meanwhile, Google Cloud reported growth of 22.5% compared to 28% last quarter. This is important because GCP had finally passed Azure growth quarter, only to fumble in a fairly dramatic deceleration this quarter.

The company reported a fiscal Q1 growth rate of 12.8% for revenue of $56.5 billion versus 8.8% growth expected on revenue of $54.6 billion. Microsoft beat by almost $2 billion. This flowed through to the bottom line, which was also a sizable beat at $2.99 EPS reported compared to $2.65 EPS expected.

Microsoft’s guide for next quarter came in above expectations for 15.5% revenue growth compared to 11% expected. For next quarter, analysts were expecting revenue of $58.6 billion whereas management is guiding for $60.9 billion for a raise of $2.3 billion. The company is clearly seeing the early effects of AI revenue; however, the Activision acquisition is also contributing.

Of the roughly $2B beat this quarter, $850M of the beat is coming from the Intelligent Cloud segment. This segment reported $24.3 billion in revenue for growth of 19% on a CC basis. This is an acceleration from 17% on a CC basis last quarter. Per the CFO, “Higher-than-expected AI consumption contributed to revenue growth in Azure.” Later, the CFO stated something along the same lines in regard to Azure’s beat being AI-driven: “While the trends from prior quarter continued, growth was ahead of expectations, primarily driven by increased GPU capacity and better-than-expected GPU utilization of our AI services as well as slightly higher-than-expected growth in our per-user business,”

Personal Computing also came in better than expected by $1 billion at 3% growth YoY, which beat guidance of (-4.7%). For next quarter, the guide is 13.6% growth which is a considerable rebound from the many declining quarters this segment has been reporting. This is partly due to the Activision acquisition, which will contribute to gaming growth of mid to high 40%.

Although Microsoft guided Azure growth to decelerate 1-2pts for the December quarter and then to be “stable” throughout FY24, analysts were digging to find out if conservatism was baked into the guide, and how much room there is for potential upside in Azure based on new workload starts, mostly driven by AI workloads. In addition to this, optimizations were peaking in H2 of last fiscal year, and so that is technically a tailwind as Microsoft laps those quarters in H2 of this fiscal year.

Although Azure tends to grab the headlines, the margins were also impressive. We detail this and more below.

Revenue and EPS:

As stated, the company beat on the top line and bottom line.

  • Microsoft reported a fiscal Q1 growth rate of 12.8% for revenue of $56.5 billion versus 8.8% growth expected on revenue of $54.6 billion.
  • This flowed through to the bottom line, which was also a sizable beat at $2.99 EPS reported compared to $2.65 EPS expected.
  • Guidance was also strong at 15.5% revenue growth compared to 11% expected. For next quarter, analysts were expecting revenue of $58.6 billion whereas management is guiding for $60.9 billion for a raise of $2.3 billion.

Segment Revenue:

  • Productivity and Business Processes revenue increased to $18.6B (up 13% YoY) which is an acceleration of 300 basis points from last quarter.
  • Intelligent Cloud revenue increased to $24.3B (19% YoY) above guidance of $23.45B or 15.5% YoY and was driven by strength in Azure and other cloud services. This is up from 15% last quarter.
  • More Personal Computing was $13.7B and above guidance of $12.5B – $12.9B, driven by strength in Gaming and Windows, partially offset by a 22% YoY decline in Devices revenue growth

Guidance on Segment Revenue:

  • Productivity and Business expected to decelerate by 150 basis points at the midpoint for growth of 11% to 12% YoY.
  • Intelligent Cloud revenue is expected to decelerate 150 basis points at the midpoint for growth of 17.5%
    undefinedundefined
  • More Personal Computing is expected to show revenue of $16.5B – $16.9B representing 13.6% growth. Gaming is especially expected to be strong next quarter due to Activision, however, devices are still weak.

Margins:

This is where the report really shined.

Regarding gross margins, the company has done a good job of improving gross margins with 71.2% for the current quarter, up 200 basis points YoY. Microsoft Cloud gross margins increased by 200bps Y/Y when excluding the impact of useful lives. There was discussion on the earnings call that there is room for improvement in Cloud GMs as MSFT continues to benefit from the investments in its cloud infrastructure.

Microsoft is showing strong operating margin leverage with 47.6% in the current quarter, up from 43.2% last quarter along with strong operating margin expansion in Intelligent Cloud with 48.4% in the current quarter up from 43.9% last quarter. This flowed through to record net profit of $22.3 billion, up from $20.1 billion in the previous quarter.

There may be more room for operating margin expansion in Intelligent Cloud as the company continues to stay disciplined with OpEx with implementing the AI transition with Azure. Although MSFT maintained FY24 operating margins to be flat Y/Y, there is potential upside to operating margins on better-than-expected integration of the Activision acquisition and Microsoft’s continued efforts to improve Azure and Microsoft 365 gross margins.

  • Gross margin of 71.2% was up from 69.2% in the year ago quarter. The guide is for 68% next quarter.
  • Overall operating margin was 47.6%, expanding 470bps YoY and 440bps QoQ. The guide is for 42.4% next quarter. The guide for next fiscal year is for operating margin to be flat YoY.
  • Net margin of 39.4% will help cement Microsoft as the leading FAAMG in terms of GAAP profit margin again. The guide was for 33.5% next quarter.
  • Productivity and Business operating margin was 53.6%, expanding 310bps YoY and 410bps QoQ due to strength in Office 365.
  • Intelligent Cloud operating margin was 48.4%, expanding 430bps YoY and 460bps QoQ due to strength in Azure and other cloud services. This was the best Intelligent Cloud operating margin in six years.
  • More Personal Computing operating margin was 37.9%, expanding 620bps YoY and 420bps QoQ due to strength in Gaming and Windows, offset by weakness in Devices

Cash Flows:

Operating cash flow of $30.6 billion was up 32% year-over-year due to strong cloud billings and collections. This represents an operating cash flow margin of 54%.

Free cash flow was up 22% year-over-year for $20.7 billion. This compares to the June quarter with 12% YoY growth.

Key Metrics:

Commercial bookings increased 14% and 17% in constant currency in line with expectations, primarily driven by strong execution across our core annuity sales motions with continued growth in the number $10 million-plus contracts for both Azure and Microsoft 365.

GitHub CoPilot is growing rapidly with over 1 million paid copilot users across 37,000 organizations, which is up 40% QoQ. According to Microsoft, GitHub CoPilot increases developer productivity by up to 55%.

CoPilot 365 is one of the more crucial growth trajectories to watch as we move into calendar year 2024. This integrates an AI assistant for Microsoft Office and becomes available Nov 1st.

Azure Open AI Services has been adopted by 18,000 organizations, which allows companies to use OpenAI’s APIs for new development purposes. Ultimately, OpenAI creates more business for Azure even if a startup or company is not directly an Azure customer.

AzureArc is helping Microsoft to expand the meaning of hybrid and multi-cloud, to also include running apps across on-prem, edge and multi-cloud environments. This key metric grew 140% year-over-year.

Earnings Call:

The Microsoft management team is very polished so most questions are answered with fairly uneventful replies, at times. However, one analyst did get more color on future operating margin. The concern is that opex came in so low, where does Microsoft go from here?

Primarily, the CFO believes margins will be flat/stable due to: “improvements we're making in Azure and even Microsoft 365 gross margins, even in the core of the commercial cloud. It speaks to the pace at which we're delivering AI revenue with the increasing cost expense and capital investment ahead with the demand we see.”

And then, another analyst went right for the question on everyone’s minds, which is — can Microsoft sustain double-digit growth? Here is the transcript, which as you can see, the management team is fairly vague. But if you read between the lines, they’re using the word stability a lot, and that would imply no notable acceleration, but more importantly, no notable deceleration either. This could change if AI continues to show up in various segments (Office 365, Search, Security, etc)

“Question – Brent Thill: Thanks. Amy, good to see the 12% growth. Many investors are asking, can you sustain double-digit growth, especially with a stronger AI boost coming in the next several quarters?

Amy Hood: I think, looking at our – as I said, Q1 was a strong start to the year. Q2 certainly implies that we've talked about stability for Azure into the second half of the year looking at the – and in line with what we're seeing for Q2. And so I think we feel good about our ability to execute. But more importantly, our ability to continue to take share.”

Later, the CFO explained that by guiding for stable Azure growth, that Microsoft is overcoming optimization headwinds due to new AI workloads. The puts and takes lead to stable growth, and there was an underlying tone that this will ultimately set Microsoft apart: “And at the scale we're talking about being able to have stability in our Azure business does mean that we will have a lot of new workload starts. And primarily, we're expecting those to come from AI workloads, but AI workloads don't just use our AI services. They use data services and they use other things. And so that combination I think looking on a competitive basis, we feel good about our execution, we feel good about taking share, and we feel good about consistent trends. And so I feel good about that guide and what it says about where we are on share.”

If I were to wrap up the call in one word, it would be “leverage.” This was probably the most important statement on the call in terms on why the company may fare better than its peers in a recession (or excuse me, during extended periods of optimization):

“In addition, what Satya mentioned earlier in a question, and I just want to take every chance to reiterate it, if you have a consistent infrastructure from the platform all the way up through its layers, that every capital dollar we spend, if we optimize revenue against it, we will have great leverage. Because wherever demand shows up in the layers, whether it's at the SaaS layer, whether it's at the infrastructure lower, whether it's for training workloads, we're able to quickly put our infrastructure to work generating revenue.”

Conclusion:

At one point, Microsoft was left out of the FAANG acronym. This earnings season, and probably a few more in the near future, will place this profitable powerhouse at the front of the Big Tech train. This company is not messing around when it comes to the one unique advantage it has over its peers, which is simply this: enterprises.

Recommended Reading:

Alphabet: Search Accelerates While Cloud Decelerates

Posted on by io-fund

Alphabet’s Q3 report was strong on the headline: GAAP EPS of $1.55 beat estimates by $0.10, while revenues of $76.79 billion beat estimates by $0.98 billion. Revenue growth accelerated to +11.0% for the quarter, ahead of the expected +9.7% growth figure and much higher than the +7.1% growth in Q2 and the +6.1% growth in Q3 last year.

Operating margin expanded ~300 bp during the quarter to 27.8%, as Google Services’ segment operating margin rose to 35.2% compared to 30.8% in the year-ago quarter. Net margin for the quarter was 25.7%, increasing ~560 bp from 20.1% last year.

We highlighted four key factors back in August that drove our optimism for revenue acceleration with upside for margins through the end of this year:

  1. Resilience in Search
  2. stabilization in YouTube Ads
  3. Market share and profitability gains in Cloud
  4. Growth in Other Google (i.e. YouTube subscription)

Three of those points have panned out this year – Search growth has accelerated tremendously, YouTube Ads growth has picked up its pace, and growth in Other Google also accelerated; Cloud is the only disappointment so far, with revenue decelerating during Q3.

For a deeper dive into Alphabet and how the Search giant is entering its Year of Execution, read more here.here.

Revenue and EPS:

  • Revenue of $76.79 billion beat estimates by 1.3%, representing growth of +11.0% YoY
  • Search revenue of $44.04 billion grew by +11.3% YoY
  • GAAP EPS of $1.55 beat estimates by 6.5%, representing growth of +46.2% YoY

Margins:

  • Gross margin of 56.7% increased ~180 bp YoY from 54.9%, but decreased ~50 bp QoQ from 57.2%
  • Operating margin of 27.8% increased ~300 bp YoY from 24.8%, but decreased ~150 bp QoQ from 29.3%
  • Net margin of 25.7% increased ~560 bp YoY from 20.1% and increased ~110 bp QoQ from 24.6%
  • Operating cash flow margin of 39.9% increased ~610 bp YoY from 33.8% and increased ~150 bp QoQ from 38.4%
  • Free cash flow margin of 29.4% increased ~610 bp YoY from 23.3%

Cash & Debt:

  • Total cash, equivalents and marketable securities of $119.9 billion; cash and equivalents on hand of $30.70 billion increased +40.3% from $21.98 billion
  • Operating cash flow of $30.66 billion increased 31.3% YoY from $23.35 billion; YTD operating cash flow of $82.83 billion increased +22.0% YoY from $67.88 billion
  • Free cash flow of $22.60 billion increased +40.6% YoY from $16.08 billion; YTD free cash flow of $61.60 billion increased +40.0% YoY from $43.99 billion
  • Total debt of $13.78 billion

Segment Results:

  • Search revenue of $44.03 billion increased +11.3% YoY, highest growth rate since Q2 ‘22
  • YouTube Ads revenue of $7.95 billion increased +12.5% YoY, highest growth rate since Q1 ‘22
  • Google Other revenue of $8.34 billion increased +20.9% YoY, second straight quarter with greater than +20% growth
  • Google Cloud revenue of $8.41 billion increased +22.5% YoY

Search Growth Accelerating, Boosting Services Segment Margin

Search’s growth stole the show in Q3, with growth quickly accelerating to a double-digit rate — Search added ~$4.5 billion in revenue YoY and ~$1.4 billion QoQ, reaching a record level. Alphabet sees AI as driving the next ‘major evolution’ of Search, and evidence of that is already surfacing as generative AI tools are being integrated into Search and accelerating revenue growth at scale.

Growth in Search cooled rather quickly through 2022 as a challenging macro environment rapidly replaced a surging ad spending environment in 2021, with revenue growth bottoming out at a (1.6%) YoY decline in Q4 2022. Just three quarters later, Search returned to double-digit growth, accelerating in each quarter this year – rising from a ~$160 billion annualized run rate in Q1 to a ~$176 billion annualized run rate in Q3.

This acceleration in Search revenue alongside strong double-digit growth in YouTube Ads revenue and Google Other (YouTube subscriptions, etc.), significantly boosted margins. Not only is AI helping drive higher ROI and increased engagement for Google’s advertising customers, but it’s also showing an incrementally large boost to Google’s Services segment margin.  Compared to the year-ago quarter, Google’s Services segment added ~$6.6 billion in revenue, and from that ~$5.0 billion in operating income.

A quick note on Search:

I/O Fund said prior to earnings that “Alphabet’s Search ‘has proven resilient because it provides advertisers an attractive ROI on their ad spend. Looking ahead, Search Generative Experience, [Google’s generative AI-powered search tool], will improve advertisers’ ROI and will likely provide Alphabet additional pricing power. This will also improve their retail vertical’ – a trend already surfacing, with Q2’s Search growth driven by retail alongside SGE’s launch.”

The retail vertical again drove growth in Search in Q3, while management was upbeat about SGE and experimenting with new native ad formats in the tool. CEO Sundar Pichai said that “direct user feedback [for SGE] has been positive with strong growth and adoption,” with Google rolling the tool out to India and Japan with more countries and languages to come.

Google Cloud’s Deceleration Continues

Weighing down on strong results in Search and YouTube was Google Cloud, which saw growth decelerate once more to the low-20% range while Microsoft’s Azure saw a marginal acceleration this quarter to 28%.

Cloud’s revenue growth dropped to +22.5%, down from +28.0% in Q2 and +37.6% in the year-ago quarter. Aside from the deceleration, Google Cloud recorded its third-straight consecutive quarter with a positive operating margin; however, its operating margin declined ~170 bp QoQ to 3.2%.

The segment’s deceleration is particularly concerning this quarter, and even more so should it continue again in Q4, given the segment’s size relative to Microsoft’s Intelligent Cloud and Amazon’s AWS.

Google Cloud operates at a ~$34 billion annual run rate, compared to an ~$97 billion run rate to Microsoft’s Intelligent Cloud and ~$88 billion run rate for AWS. At its size, Google Cloud should theoretically be posting higher growth rates based on the law of large numbers, so this sharper deceleration raises red flags that:

  1. AI products are not boosting revenue as much as expected in the near term
  2. Azure is commanding a higher share of AI-based cloud spending, helped by its tie-in with OpenAI via APIs
  3. Cloud spending is shifting away from Google to Azure and AWS

CFO Ruth Porat said Cloud’s “Q3 year-on-year growth rate reflects the impact of customer optimization efforts,” signaling that some cloud customers may still be reining in spending. She added that “Google Workspace also delivered strong revenue growth, primarily driven by increases in average revenue per seat.” Overall, Porat said Alphabet was “pleased with the ongoing customer engagement with GCP and Workspace and the potential benefit of our AI solutions including infrastructure and services such as Vertex AI and Duet.”

Earnings Call:

Alphabet’s earnings call reiterated the fact that the company is “definitely seeing a lot of interest in AI,” as executives highlighted how AI is driving higher ROIs in advertising while discussing the need to continually invest in AI.

On the advertising side, SVP Philipp Schindler said that Alphabet’s “our proven AI-powered solutions like Search and PMax are helping retailers drive reliable, strong ROI and meet customers wherever they are across the funnel.” He added that PMax “gives advertisers really maximum performance across all inventory from, one, really AI-powered campaign, and it's probably the ultimate example of AI in action across our ads product. It's delivering excellent ROI. Those using it achieve like on average, over 18% more conversions at a similar cost per action.” In addition, “AI is helping advertisers find as many people as possible in their ideal audience for the lowest possible price. Early tests are delivering 54% more reach at 42% lower cost.” As Alphabet continues to roll out and improve AI-focused advertising solutions, it can continue to drive ROI and capture larger amounts of advertising spend throughout Search and YouTube.

With that in mind, Porat discussed how Alphabet will “continue to invest meaningfully in the technical infrastructure needed to support the opportunities we see in AI.” She said the company is expecting “elevated levels of investment, increasing in the fourth quarter of 2023 and continuing to grow in 2024,” this 2024’s “aggregate CapEx will be above the full year 2023.”

Conclusion:

Alphabet’s Q3 was a very solid report under the surface, with Search’s rapid reacceleration and Services’ major increase in operating income overshadowed by Google Cloud’s deceleration. Heading into a seasonally strong Q4 for advertising, Alphabet looks poised to reach record Advertising revenues and another record quarter for Search, boosted in part by AI integrations and SGE. Both showed signs of strength in Q3: Search revenue reached a record high, while Ad revenue rose to a seven-quarter high of $59.6 billion.

Moving on to Q4 and 2024, Google Cloud will remain in focus, and if revenue growth can inflect sooner rather than later, given that Azure is showing signs of stabilization shifting towards acceleration. AI’s impact on Search and Ads will also be watched – Alphabet is currently projected to post double-digit revenue growth in each quarter of 2024, driven by Ads and Search.

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.

I/O Fund Equity Analyst Damien Robbins contributed to this report.

Recommended Reading:

Microsoft Fiscal Q1 Earnings: Operating Leverage from AI

Posted on by io-fund

Microsoft posted strong results with the highlight coming from Azure and the Intelligent Cloud segment. Azure accelerated by 100 basis points on a constant currency basis, meanwhile, Google Cloud decelerated 549 basis points as reported on the same evening.

Azure reported growth of 28% YoY compared to 27% last quarter. Meanwhile, Google Cloud reported growth of 22.5% compared to 28% last quarter. This is important because GCP had finally passed Azure growth quarter, only to fumble in a fairly dramatic deceleration this quarter.

The company reported a fiscal Q1 growth rate of 12.8% for revenue of $56.5 billion versus 8.8% growth expected on revenue of $54.6 billion. Microsoft beat by almost $2 billion. This flowed through to the bottom line, which was also a sizable beat at $2.99 EPS reported compared to $2.65 EPS expected.

Microsoft’s guide for next quarter came in above expectations for 15.5% revenue growth compared to 11% expected. For next quarter, analysts were expecting revenue of $58.6 billion whereas management is guiding for $60.9 billion for a raise of $2.3 billion. The company is clearly seeing the early effects of AI revenue; however, the Activision acquisition is also contributing.

Of the roughly $2B beat this quarter, $850M of the beat is coming from the Intelligent Cloud segment. This segment reported $24.3 billion in revenue for growth of 19% on a CC basis. This is an acceleration from 17% on a CC basis last quarter. Per the CFO, “Higher-than-expected AI consumption contributed to revenue growth in Azure.” Later, the CFO stated something along the same lines in regard to Azure’s beat being AI-driven: “While the trends from prior quarter continued, growth was ahead of expectations, primarily driven by increased GPU capacity and better-than-expected GPU utilization of our AI services as well as slightly higher-than-expected growth in our per-user business,”

Personal Computing also came in better than expected by $1 billion at 3% growth YoY, which beat guidance of (-4.7%). For next quarter, the guide is 13.6% growth which is a considerable rebound from the many declining quarters this segment has been reporting. This is partly due to the Activision acquisition, which will contribute to gaming growth of mid to high 40%.

Although Microsoft guided Azure growth to decelerate 1-2pts for the December quarter and then to be “stable” throughout FY24, analysts were digging to find out if conservatism was baked into the guide, and how much room there is for potential upside in Azure based on new workload starts, mostly driven by AI workloads. In addition to this, optimizations were peaking in H2 of last fiscal year, and so that is technically a tailwind as Microsoft laps those quarters in H2 of this fiscal year.

Although Azure tends to grab the headlines, the margins were also impressive. We detail this and more below.

Revenue and EPS:

As stated, the company beat on the top line and bottom line.

  • Microsoft reported a fiscal Q1 growth rate of 12.8% for revenue of $56.5 billion versus 8.8% growth expected on revenue of $54.6 billion.
  • This flowed through to the bottom line, which was also a sizable beat at $2.99 EPS reported compared to $2.65 EPS expected.
  • Guidance was also strong at 15.5% revenue growth compared to 11% expected. For next quarter, analysts were expecting revenue of $58.6 billion whereas management is guiding for $60.9 billion for a raise of $2.3 billion.

Segment Revenue:

  • Productivity and Business Processes revenue increased to $18.6B (up 13% YoY) which is an acceleration of 300 basis points from last quarter.
  • Intelligent Cloud revenue increased to $24.3B (19% YoY) above guidance of $23.45B or 15.5% YoY and was driven by strength in Azure and other cloud services. This is up from 15% last quarter.
  • More Personal Computing was $13.7B and above guidance of $12.5B – $12.9B, driven by strength in Gaming and Windows, partially offset by a 22% YoY decline in Devices revenue growth

Guidance on Segment Revenue:

  • Productivity and Business expected to decelerate by 150 basis points at the midpoint for growth of 11% to 12% YoY.
  • Intelligent Cloud revenue is expected to decelerate 150 basis points at the midpoint for growth of 17.5%
    undefinedundefined
  • More Personal Computing is expected to show revenue of $16.5B – $16.9B representing 13.6% growth. Gaming is especially expected to be strong next quarter due to Activision, however, devices are still weak.

Margins:

This is where the report really shined.

Regarding gross margins, the company has done a good job of improving gross margins with 71.2% for the current quarter, up 200 basis points YoY. Microsoft Cloud gross margins increased by 200bps Y/Y when excluding the impact of useful lives. There was discussion on the earnings call that there is room for improvement in Cloud GMs as MSFT continues to benefit from the investments in its cloud infrastructure.

Microsoft is showing strong operating margin leverage with 47.6% in the current quarter, up from 43.2% last quarter along with strong operating margin expansion in Intelligent Cloud with 48.4% in the current quarter up from 43.9% last quarter. This flowed through to record net profit of $22.3 billion, up from $20.1 billion in the previous quarter.

There may be more room for operating margin expansion in Intelligent Cloud as the company continues to stay disciplined with OpEx with implementing the AI transition with Azure. Although MSFT maintained FY24 operating margins to be flat Y/Y, there is potential upside to operating margins on better-than-expected integration of the Activision acquisition and Microsoft’s continued efforts to improve Azure and Microsoft 365 gross margins.

  • Gross margin of 71.2% was up from 69.2% in the year ago quarter. The guide is for 68% next quarter.
  • Overall operating margin was 47.6%, expanding 470bps YoY and 440bps QoQ. The guide is for 42.4% next quarter. The guide for next fiscal year is for operating margin to be flat YoY.
  • Net margin of 39.4% will help cement Microsoft as the leading FAAMG in terms of GAAP profit margin again. The guide was for 33.5% next quarter.
  • Productivity and Business operating margin was 53.6%, expanding 310bps YoY and 410bps QoQ due to strength in Office 365.
  • Intelligent Cloud operating margin was 48.4%, expanding 430bps YoY and 460bps QoQ due to strength in Azure and other cloud services. This was the best Intelligent Cloud operating margin in six years.
  • More Personal Computing operating margin was 37.9%, expanding 620bps YoY and 420bps QoQ due to strength in Gaming and Windows, offset by weakness in Devices

Cash Flows:

Operating cash flow of $30.6 billion was up 32% year-over-year due to strong cloud billings and collections. This represents an operating cash flow margin of 54%.

Free cash flow was up 22% year-over-year for $20.7 billion. This compares to the June quarter with 12% YoY growth.

Key Metrics:

Commercial bookings increased 14% and 17% in constant currency in line with expectations, primarily driven by strong execution across our core annuity sales motions with continued growth in the number $10 million-plus contracts for both Azure and Microsoft 365.

GitHub CoPilot is growing rapidly with over 1 million paid copilot users across 37,000 organizations, which is up 40% QoQ. According to Microsoft, GitHub CoPilot increases developer productivity by up to 55%.

CoPilot 365 is one of the more crucial growth trajectories to watch as we move into calendar year 2024. This integrates an AI assistant for Microsoft Office and becomes available Nov 1st.

Azure Open AI Services has been adopted by 18,000 organizations, which allows companies to use OpenAI’s APIs for new development purposes. Ultimately, OpenAI creates more business for Azure even if a startup or company is not directly an Azure customer.

AzureArc is helping Microsoft to expand the meaning of hybrid and multi-cloud, to also include running apps across on-prem, edge and multi-cloud environments. This key metric grew 140% year-over-year.

Earnings Call:

The Microsoft management team is very polished so most questions are answered with fairly uneventful replies, at times. However, one analyst did get more color on future operating margin. The concern is that opex came in so low, where does Microsoft go from here?

Primarily, the CFO believes margins will be flat/stable due to: “improvements we're making in Azure and even Microsoft 365 gross margins, even in the core of the commercial cloud. It speaks to the pace at which we're delivering AI revenue with the increasing cost expense and capital investment ahead with the demand we see.”

And then, another analyst went right for the question on everyone’s minds, which is — can Microsoft sustain double-digit growth? Here is the transcript, which as you can see, the management team is fairly vague. But if you read between the lines, they’re using the word stability a lot, and that would imply no notable acceleration, but more importantly, no notable deceleration either. This could change if AI continues to show up in various segments (Office 365, Search, Security, etc)

“Question – Brent Thill: Thanks. Amy, good to see the 12% growth. Many investors are asking, can you sustain double-digit growth, especially with a stronger AI boost coming in the next several quarters?

Amy Hood: I think, looking at our – as I said, Q1 was a strong start to the year. Q2 certainly implies that we've talked about stability for Azure into the second half of the year looking at the – and in line with what we're seeing for Q2. And so I think we feel good about our ability to execute. But more importantly, our ability to continue to take share.”

Later, the CFO explained that by guiding for stable Azure growth, that Microsoft is overcoming optimization headwinds due to new AI workloads. The puts and takes lead to stable growth, and there was an underlying tone that this will ultimately set Microsoft apart: “And at the scale we're talking about being able to have stability in our Azure business does mean that we will have a lot of new workload starts. And primarily, we're expecting those to come from AI workloads, but AI workloads don't just use our AI services. They use data services and they use other things. And so that combination I think looking on a competitive basis, we feel good about our execution, we feel good about taking share, and we feel good about consistent trends. And so I feel good about that guide and what it says about where we are on share.”

If I were to wrap up the call in one word, it would be “leverage.” This was probably the most important statement on the call in terms on why the company may fare better than its peers in a recession (or excuse me, during extended periods of optimization):

“In addition, what Satya mentioned earlier in a question, and I just want to take every chance to reiterate it, if you have a consistent infrastructure from the platform all the way up through its layers, that every capital dollar we spend, if we optimize revenue against it, we will have great leverage. Because wherever demand shows up in the layers, whether it's at the SaaS layer, whether it's at the infrastructure lower, whether it's for training workloads, we're able to quickly put our infrastructure to work generating revenue.”

Conclusion:

At one point, Microsoft was left out of the FAANG acronym. This earnings season, and probably a few more in the near future, will place this profitable powerhouse at the front of the Big Tech train. This company is not messing around when it comes to the one unique advantage it has over its peers, which is simply this: enterprises.

Recommended Reading:

Big Tech Stocks: Q3 Earnings Preview

Posted on by io-fund

This article was originally published on Forbes on Forbes Forbes on Oct 19, 2023,10:47pm EDT

Earnings season has officially kicked off, with Big Tech headlining a busy week next week: Microsoft and Google report on Tuesday, followed by Meta on Wednesday, and Amazon on Thursday. Big Tech stocks have seen their dominance over the broader indexes soar this year, with the Magnificent 7 reaching nearly 30% of the S&P 500’s weighting, higher now than at its peak in 2022 and up from 20.0% at the beginning of this year.

In the Nasdaq 100, the combined weighting of Big Tech stocks is even higher, at 44.8%. The Nasdaq 100’s rebalance earlier this year in July dropped the overall weighting of the group from 55% to ~38%, but already, we’ve seen a 6 percentage point increase in just over one quarter.

This outsized influence that the Magnificent 7 has over the indexes is just one of the many reasons that Big Tech earnings reports next week will be some of the most closely watched this season. EPS estimates for the group will be in focus – estimates have all pushed higher during Q3, with Amazon, Meta, and Nvidia seeing some of the largest increases, and investors will likely be assessing how the group stacks up against heightened expectations.

Beth Kindig Big Tech Earnings Twitter Post

View Post: Click HereView Post: Click HereClick Here

Sign up for I/O Fund's free newsletter with gains of up to 221% – Click hereClick hereClick here

Microsoft: AI to Help Drive A ‘Noticeable Acceleration’ This Year

For Microsoft, a noticeable acceleration is expected this year, with revenue growth accelerating back to the low-double digits through FY25. For the quarter, revenue growth is estimated to be about +8.8% YoY to $54.5 billion, with EPS forecast to grow +12.6% to $2.65. Revenue growth is currently forecast to return to +10% to +12% growth over the next three quarters through calendar Q2 2024.

Microsoft Quarterly Revenue

Source: SEEKING ALPHA

Azure and AI will be two of the key areas to watch, given the overlap between the two. Microsoft is devoting 13% of Capex to AI in 2023, the most among the top cloud service providers.

Azure’s growth in the prior quarter was 27% in constant currency, including about 1% from AI services, a decline from 31% two quarters ago. Excluding currency impacts, growth slowed to 26% from 27%, hinting at a possible inflection point back to higher growth.

Azure's Quarterly Revenue Growth, YoY

Source: MICROSOFT

Microsoft also stands to benefit from its consumption pricing model for OpenAI’s APIs, given that the APIs are all new workloads for Azure this year. Microsoft said last quarter that it had “great momentum across Azure OpenAI Service” with around 100 customers added each day, bringing total customers to more than 11,000.

In addition, commercial subscriptions for Office 365’s Copilot AI assistant are expected to start on November 1, at a $30 per month per user price point, opening up a potential multibillion-dollar revenue opportunity over the next few years, with the first insights likely to come next quarter.

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 hereLearn more here.

Alphabet: Search & Cloud Momentum to Continue

Like Microsoft, Alphabet is expected to see revenues reaccelerate to the low double-digits through Q2 2024, a marked acceleration from forecasts at the beginning of the year. Revenue for Q3 is forecast to rise +9.6% YoY to $75.7 billion, with EPS growing +36.0% YoY to $1.44.

Alphabet Quarterly Revenue/EPS Growth, YoY

Source: SEEKING ALPHA

The combination of resilient Search growth, strong Cloud performance, and the integration of AI into Alphabet’s services is driving revenue growth expectations higher. Forward revenue growth rates for the next two quarters have risen upwards of 2 percentage points since the beginning of the year.

Alphabet Revenue Growth Forecast Change, Q1 to Q3

Source: SEEKING ALPHA

Search and Other advertising growth is picking up, rising 5.4% QoQ to $42.6 billion, as Google begins “building the next major evolution in Search” with AI integrations driving a higher ROI. As the I/O Fund highlighted previously, Alphabet’s Search “has proven resilient because it provides advertisers an attractive ROI on their ad spend. Looking ahead, Search Generative Experience, [Google’s generative AI-powered search tool], will improve advertisers’ ROI and will likely provide Alphabet additional pricing power. This will also improve their retail vertical” – a trend already surfacing, with Q2’s Search growth driven by retail alongside SGE’s launch.

Google Cloud will also be under the microscope, after posting two consecutive quarters of operating profitability, with operating margin reaching almost 5% last quarter. Revenue for Cloud stabilized at 28% growth YoY in both Q1 and Q2, as the platform remains a leading choice for training generative AI models. As enterprises start to think more deeply about AI and integrating AI across their organizations, Google Cloud stands to benefit in multiple ways – via its large language models such as Bard, its generative AI offerings including the recently launched Duet AI, offering AI model training with multiple AI supercomputers, and by “expanding our total addressable market and winning new customers,” according to CEO Sundar Pichai.

However, Google is in the midst of its antitrust trial, with regulators concerned that Google has been keeping an illegal monopoly on search. Google is reportedly paying Apple nearly $20 billion per year to remain the default search engine on Apple’s devices, are at the forefront of the case.

For a deeper dive into Alphabet and how the Search giant is entering its Year of Execution, read more here.here.

Meta: Ad Impressions to Drive Revenue Growth

Meta’s Q3 EPS estimate surged during the quarter, rising $0.60 from an estimate of $2.98 on June 30 to $3.58 by September 30. Meta returned to positive growth in Q1 this year, with revenues up +2.6%, and has since seen revenue growth accelerate – Q3 and Q4 are both expected to see YoY revenue growth up more than +20%.

Meta also has seen improvements in operating efficiency this year. Operating margin has expanded 9 percentage points in just two quarters, from 20% in Q4 to 29% in Q2. Revenue growth reaccelerating to more than +20% through the end of the year is set to drive EPS growth in the triple-digits as operating margin expands further.

Meta Quarterly Revenue/EPS Growth, YoY

Source: SEEKING ALPHA

Q3 is expected to be a banner quarter setting Meta up for a strong end-of-year finish: Meta is estimated to post 119% EPS growth to $3.58, with revenues expected to rise 20.6% to $33.4 billion. As an advertising-driven company, with more than 98% of revenues coming from ads, the mix of ad impressions and ad pricing will determine growth. So far this year, ad impressions have served as the primary driver, rising 26% YoY in Q1 and 34% YoY in Q2, offsetting weak pricing, which declined 17% YoY in Q1 and 16% YoY in Q2.

Meta Ad Impression and Ad Pricing Growth, YoY

Source: I/O FUND

Over the past four quarters, advertising spend looks to have bottomed out, recovering from Q4’s (-22%) decline, while ad impressions continue to accelerate past 30%. Impression growth has been driven by APAC and Rest of World, which, as lower monetizing regions, have contributed to that decline in pricing. AI is only just beginning to scratch the surface in optimizing ads and increasing ROI for advertisers, and Meta is seeing “strong advertiser demand,” with almost all of its advertisers “using at least one of [its] AI driven products.” Meta is continuing to release new AI advertising products, such as Meta Lattice for predicting ad performance and AI Sandbox for generative AI-powered ad generation.

Amazon: AWS Growth in Focus

Amazon is expected to see a slight acceleration in revenue growth through the end of the year, with Q3 and Q4 forecast to see revenues increase 11.4% and 11.7% respectively, following Q2’s 10.9% growth. EPS estimates for Q3 point to +114% growth to $0.60, as operating margins for North America are expected to continue a 5-quarter streak of improvement.

Amazon Quarterly Revenue Growth, YoY

Source: SEEKING ALPHA

AWS will also be a major focus of the upcoming report, as its revenue growth rate has declined for 7 straight quarters, from 40% growth in Q4 2021 to just12% growth in Q22023. Operating income has declined for three consecutive quarters but is on the verge of inflecting back to growth.

AWS Revenue/Operating Income Growth, YoY

Source: AMAZON

While AWS generates just ~17% of Amazon’s total sales, its influence down the line is increasingly large. In Q2, AWS contributed nearly 70% of Amazon’s $7.7 billion of operating income; on a TTM basis, AWS generated $21.1 billion in operating income, or 119% of Amazon’s total $17.7 billion, weighed down by losses on the e-commerce side.

Given that outsized impact on Amazon’s bottom line, an inflection in both AWS’ revenue growth and a pivot back to growth in operating income will help drive more confidence in Amazon’s high EPS growth rates over the next couple years – earnings are forecast to grow 43% and 41% in FY24 and FY25, respectively. However, should AWS fail to show that inflection in revenue growth and post a fourth consecutive quarter of declining operating income, higher EPS estimates over the next three to four quarters could come under pressure.

Beth Kindig Twitter Post

Watch the Video: Click HereWatch the Video: Click HereClick Here

Conclusion:

Heightened expectations stemming in part from surging AI interest and cloud spend stabilizing are the major theme heading into Big Tech’s earnings week next week. Meta and Google are forecast to see the strongest revenue accelerations over the next two to three quarters, while Amazon is expected to see a small bump up with AWS’ growth a prime factor. Microsoft’s AI initiatives are expected to drive revenue acceleration over the next four quarters as the company devotes more than 13% of its Capex to AI.

We have buy levels we are targeting for Big Tech, which we share with our premium research members each week as the stocks progress. We believe our target buy levels will set us up for gains in FAANG stocks when the next bull cycle begins. We provide in-depth macro and individual stock analysis so that readers can better understand why we buy/sell. In this market, we frequently take gains. You can learn more here including information on our weekly webinar series, where we review our positions live and discuss some of the top stocks of the week.

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.

I/O Fund Equity Analyst Damien Robbins contributed to this report.

Recommended Reading:

TSM Results: Recovery in sight but technicals look weak

Posted on by io-fund

Taiwan Semiconductor Manufacturing delivered a strong earnings report that beat top-line and bottom-line estimates. The company's Q4 revenue guide was also higher than analyst estimates. However, the chart is not looking good, and this may be a situation where technicals are providing a heads up that TSM has too much geopolitical risk for buyers to step in. We cover the earnings report below, and as a courtesy to Pro Members, we are relaying the technical setup we are tracking. Advanced Members will receive real-time trade alerts regarding any final decisions on this position.

TSM expects healthy growth in 2024. Management mentioned in the earnings call that they see early signs of demand stabilization in the PC and smartphone markets. Along with this, due to technological leadership, it can capture a significant portion of AI business.

Revenue & EPS

Revenue declined by (-14.6%) YoY and up 10.2% QoQ to $17.28 billion. Revenue came at the higher end of the guidance of $16.7 billion to $17.5 billion and beat the analysts estimate by 1.48%.

Wendell Huang, CFO of the company, said, “Our third quarter business was supported by the strong ramp of our industry-leading 3-nanometer technology and higher demand for 5-nanometer technologies, partially offset by customers’ ongoing inventory adjustment,”strong ramp of our industry-leading 3-nanometer technology and higher demand for 5-nanometer technologies, partially offset by customers’ ongoing inventory adjustment,” he further added, “Moving into fourth quarter 2023, we expect our business to be supported by the continued strong ramp of our 3-nanomenter technology, partially offset by customers’ continued inventory adjustment.”continued strong ramp of our 3-nanomenter technology, partially offset by customers’ continued inventory adjustment.”

Management guidance for the next quarter is $18.8 billion to $19.6 billion, representing a YoY decline of (-3.66%) at the mid-point, which came in about 5% higher than estimates, primarily due to the strong ramp up of 3-nanometer technology.

EPS came at $1.29 and beat estimates by 11.2%.

Margins

  • Gross margin came in at 54.3% compared to 60.4% in the same period last year and 54.1% in Q2. This beat was management guidance of 51.5% to 53.5%. The sequential improvement of 20 basis points was due to a higher capacity utilization rate and more favourable foreign exchange rate, and was partially offset by the initial ramp-up of the 3-nanometer technology.
  • Management guidance for gross margin next quarter is 51.5% to 53.5%
  • The operating margin of 41.7% compared to 50.6% in the same period last year and was lower by 30 basis points QoQ.
  • Net margin of 38.6% compared to 45.8% in the same period last year and 37.8% in Q2.

Cash Flow and Balance Sheet

Overall, cash flow is improving and returning to normal levels.

  • Operating cash flow of $9.31 billion or 54% of revenue compared to $13.61 billion or 67% of revenue in Q3 of last year, yet is up from 35% of revenue in Q2. 
  • Free cash flow of $2.15 billion or 12% of revenue compares to a FCF margin last year of 24% of revenue, yet is a marked improvement from last quarter at (-17%) of revenue.

Capex was down (-18.9%) YoY to $7.1 billion. Management confirmed in the earnings call that capex will be $32 billion for 2023. In the last earnings call, they mentioned that due to the uncertainty in the business environment, capex would be at the lower end of their range of $32 billion to $36 billion.

Looking forward, the management expects capex to cool off in the next few years, which is a positive if revenue accelerates. Wendell Huang said in the earnings call. “Now in terms of CapEx, what we can see now is that we, in the past few years, have invested very heavily to capture the growth in the next few years. And as we begin to harvest those investments, we expect our — the increase of our CapEx to be leveling off in the next few years. That doesn't mean the dollar amount is going to reduce. But the capital intensity is expected to decline in the next few years.”have invested very heavily to capture the growth in the next few years. And as we begin to harvest those investments, we expect our — the increase of our CapEx to be leveling off in the next few years. That doesn't mean the dollar amount is going to reduce. But the capital intensity is expected to decline in the next few years.”

The company has cash and marketable securities of $48.06 billion and debt of $29.1 billion.

Key Metrics 

The 3-nanometer process technology is seeing a strong ramp in the second half of the year supported by both HPC and smartphones. CEO Dr. C.C. Wei, said in the earnings call. “N3 is already involving production with good yield, and we are seeing a strong ramp in the second half of this year, supported by both HPC and smartphone applications. We reaffirm N3 will contribute a mid-single-digit percentage of our total wafer revenue in 2023, and we expect a much higher percentage in 2024 supported by robust demand for multiple customers.”with good yield, and we are seeing a strong ramp in the second half of this year, supported by both HPC and smartphone applications. We reaffirm N3 will contribute a mid-single-digit percentage of our total wafer revenue in 2023, and we expect a much higher percentage in 2024 supported by robust demand for multiple customers.”

  • Smartphone grew by 33% QoQ compared to a decline of (9%) QoQ in Q2
  • High-performance computing grew by 6% QoQ compared to a decline of (5%) QoQ in Q2
  • IoT grew by 24% QoQ compared to a decline of (11%) QoQ in Q2
  • Automotive declined by (24%) QoQ compared to a growth of 3% QoQ in Q2
  • Digital Consumer Electronics declined by (1%) QoQ compared to an increase of 25% QoQ in Q2.
  • Others declined by (2%) QoQ compared to a decline of (5%) QoQ in Q2

Conclusion 

The signs of stabilization of demand in PC and smartphone markets, and the potential to capture the AI business due to technological leadership, lay a strong foundation for growth in 2024. However, the technical chart is at odds with this conclusion.  

Technical Analysis

By Knox Ridley

TSM, like many stocks off the October low, has not been a vertical pattern. In fact, as you can see below, it has many overlaps, marked with large swings in both directions. The pattern into the June high best fits as a large degree corrective rally (B wave). In other words, the 2022 decline was the A wave down, 2023 was the B wave up, and the pattern requires one more down move to new lows before completing, which would be called the C wave.

What gives me caution is that C waves are always 5-wave patterns. Now, look at the shape of the pattern from the June high. It’s clearly 5 waves down. The other issue I have is that TSM has broken the major trend channel pointing up. This is rarely a good sign and further supports the above analysis. The retrace up is currently testing the lower end of the channel, and unable to break back in.

In conclusion, this bounce is likely a reasonable place to exit/trim. We will be look to much lower levels to build a long-term position in this company.

Royston Roche, Equity Analyst at the I/O Fund, contributed to this analysis.

Recommended Readings:

Netflix: Cash is King and Pivot is on Track

Posted on by io-fund

Five quarters ago, we took a chance on entering Netflix in 2022 based on two things:

1.     The upcoming pivot to monetize through ads and by cutting off password sharing. In the June quarter of 2022, Netflix reported negative net additions QoQ. This quarter, Netflix reported some of the best growth in recent quarters. Notably, ads are not contributing meaningfully. Password sharing is helping the company drive growth in paid memberships both YoY and QoQ following the December quarter. 

Per management: “The cancel reaction continues to be low, exceeding our expectations, and borrower households converting into full paying memberships are demonstrating healthy retention. As a result, we’re revenue positive in every region when accounting for additional spin off accounts and extra members, churn and changes to our plan mix.”

2.     Improved cash profile from negative (-$3.3B) in 2019 to a positive $1.6B in 2022. We had noted that management stated there would be substantial FCF growth in 2023. At the time, we had hoped for $3B to $4B in 2023. By raising FCF guidance every quarter this year, FCF will now come in at $6.5B. This is a phenomenal beat, although roughly $1 billion is from the Writer’s Strike. When adjusting for this, FCF is at $5.5 billion, which more realistically sets expectations for 2024 when content spend will be higher than 2023.

The weak spot in the report was average revenue per member, which declined (1%). Ideally, this improves with the price hikes the company announced today. This is reflected by a net paid addition beat that does not result in a revenue beat. With management guiding for similar net paid adds as Q3 (implying 9M) plus higher prices, the market is rewarding the stock because it’s assumed ARM will be higher next quarter. Netflix investors should continue to monitor lower ARM countries as time goes on as outsized growth here can potentially weigh on revenue growth. Last quarter, ARM was (-3%) and (-1%) on a CC basis.

Revenue and EPS:

  • Netflix reported revenue of $8.5 billion in line with management guidance and analyst consensus. This represents growth of 7.8% and 8% on a constant currency basis (CC). This is an acceleration QoQ from the 2.7% growth and 6% on CC basis last quarter. However, this is not an acceleration from the year ago quarter on a CC basis, which grew 13%.
  • Next quarter, Netflix guided in line for revenue of $8.7 billion for growth of 11% and 12% on CC basis. This will be an acceleration both QoQ (to be expected due to seasonality) and year-over-year with 10% growth on a CC basis in the year ago quarter.
  • Overall, Netflix’s revenue growth is expected to trend upward over the next few quarters.
  • The analyst consensus for adjusted EPS was $3.48 compared to $3.73 reported.

Operating Margin: A Bit of Confusion Following CFO Commentary Last Month

Analysts were expressing concerns going into this call about the FY2024 operating margin following a Bank of America conference when Spencer Neumann, CFO of the company, said:

“So I don't think given our scale now that we're at roughly 20% operating margins, I don't think it's really prudent for us to keep growing at 3 percentage points of margin per year. I think that would probably constrain the business too much on the growth opportunity. So, we'll grow margins more gradually. At some point, there's probably some peak margin where it's a good balance between peak margin and growth potential of the business. I just don't think we're anywhere near that yet. So we're going to gradually go into it.”I don't think it's really prudent for us to keep growing at 3 percentage points of margin per year. I think that would probably constrain the business too much on the growth opportunity. So, we'll grow margins more gradually. At some point, there's probably some peak margin where it's a good balance between peak margin and growth potential of the business. I just don't think we're anywhere near that yet. So we're going to gradually go into it.”

This caused analysts to scramble and lower their price targets as some had a 279 bps estimate for next quarter.

For example, published on September 28th: “JPMorgan lowered the firm's price target on Netflix to $455 from $505 and keeps an Overweight rating on the shares ahead of the Q3 report. The firm's overall view on Netflix shares remains positive, but it lowered estimates to reflect recent comments from management around margin expansion. Investor conversations suggest increased concerns that paid sharing is less impactful than expected and providing less lift in Q4, while 2024 margin expansion could be less robust than anticipated, the analyst tells investors in a research note.”

Here's another one from September 22nd:

“Oppenheimer lowered the firm's price target on Netflix to $470 from $515 and keeps an Outperform rating on the shares following the CFO's comments at a conference. The CFO said he was "not expecting future operating leverage of 300bps" going forward, and while the comments are likely not intended to be guidance, the firm took notice, given its prior view of 279bps improvement, the analyst tells investors in a research note.

There are quite a few like this. The interesting part is that Netflix actually guided operating margin for FY2024 growth of 200 bps to 300 bps, or 250 bps at the midpoint. Therefore, the comments may have been taken out of context to mean future years (?) as the guide was strong all things considered.

  • Gross margin of 42.3% was in line
  • Operating margin of 22.4% was in line. Management stated the FY2023 operating margin would be 20%, which was at the high end of previous guidance of 18% to 20%.
  • Net profit of $1.68 billion was up 19.6%
  • For full year 2024, management stated they are expecting full year operating margin of 22% to 23%.

Cash:

Netflix repurchased $2.5B in shares and increased the buyback authorization by $10B.

The company’s cash flow margins are a highlight of the report. Operating cash flow of $1.992 billion represents a cash flow margin of 23.3%. Free cash flow of $1.888B represents a FCF margin of 22.1%. This is up from a FCF margin of 6% in the year ago quarter. This is outsized due to the writer’s strike.

Overall, Netflix has substantial long-term debt and always will. We’ve covered this extensively in the past as their business model requires high content spend. The gross debt is $14 billion and the net debt is $6.5 billion.

Per management: “expect FCF of $6.5B up from $5B prior forecast. The company repurchased $2.5B shares in Q3 and increased buyback authorization by $10B. As a result, we expect 2023 cash content spend of around $13B and, assuming the SAG-AFTRA strike is resolved in the near future, we are currently expecting cash content spend of up to ~$17B in 2024.

As we said last quarter, the strikes will create some lumpiness in FCF over the 2023/2024 period, but we still plan to deliver very substantial positive FCF in 2024.”

Key Metrics:

Netflix reported 8.7M net paid adds for a total of 247.2 million paid memberships. This is the highest number of paid net adds in recent quarters. Analyst consensus was between 6.5M and 6.9M. Per management, this was due to: “the roll out of paid sharing, strong, steady programming and the ongoing expansion of streaming globally"

Across the regions, ARM in APAC had the biggest decline at (-9%). The United States region technically declined (Netflix reporting this as 0%) from $16.37 ARM a year ago to $16.29 ARM in the most recent quarter. All regions added paid net additions.

Across all regions, ARM was down (-1%). As stated, look for ARM to resume growth following the price hikes that were announced today.

Management stated that “ads plan membership is up 70% QoQ.” This is not meaningfully contributing to revenue. According to the Investor Letter: “It’s been less than a year since launch. It takes time to build a new business from scratch, which is why we have said ad revenue would not be material to our business in 2023.

Regarding engagement, Netflix had the most watched Series for 37 out of the first 38 weeks of the year. Share of screen time was 8% and second only to YouTube.

Earnings Call:

This was an important statement in terms of Netflix’s expectations for future revenue growth based on cutting off password sharing. I’m liking the word “incremental” here:

“So we're going to continue the rollout for the next couple of quarters. I think folks are trying to figure out how much juice is left there. And I would say we anticipate that we will have incremental acquisition, incremental adds for the next several quarters. We've seen that in the last couple of quarters. I think also worth noting that, that was on top of also very healthy organic, meaning not driven by paid sharing growth. So we anticipate seeing that for the next several quarters to come.”

There was a lot of discussion on the ads business, but the main takeaway is that the ads business has not taken off yet. However, management seems to think by 2024 it will begin to affect net paid adds and ARM:

“So I would say just generally, when we think about 2024 and beyond, think about it as our revenue growth profile in general. And we talked about this recently. We expect a more balanced mix of membership and ARM growth in 2024 and beyond 2024. So just looking at 2024 specifically, as Ted talked about, we expect to have a great slate to drive the business forward. And we expect to continue to do things like add extra members, grow our advertising revenue, as Greg discussed.”

Conclusion:

Netflix is exactly where we hoped it would be in terms of its product story and fundamentals. There has been ongoing uncertainty around whether the company would do well with the pivot. The writer’s strike and new management team has added to this uncertainty. This quarter helped provide the market with more visibility that the juggernaut is right on track. The only blemish in the report is ARM, which is being addressed in the upcoming pricing increases. We are very early in the earnings season, yet as more companies report, I think Netflix will stand out as company handling a challenging macro environment with ease.

Recommended Reading:

Tesla’s Margins Fall Again

Posted on by io-fund

Tesla reported Q3 earnings that missed on both the top and bottom lines. Revenue of $23.35 billion missed by $0.79 billion, while non-GAAP EPS of $0.66 missed by $0.07. Margins continued to slide, with gross margin declining ~30 bp QoQ and ~720 bp YoY to 17.9%, and operating margins falling ~210 bp QoQ and ~960 bp YoY to 7.6%. A shift in product mix and price cuts led to a lower ASP during the quarter.

We wrote at the end of August that Tesla’s Q3 operating margins can decline to a level between Honda and VW – between 7.0% to 8.5%, with Q3’s actual 7.6% coming in just shy of the midpoint there. If operating margins were to reach a level closer to 6.0%, like GM, that could be a sign they’re close to the bottom. The continual decline in margins highlights the broader concern for investors that Tesla still not provided any guidance to assess how low margins may fall. The OEM’s Q3 update stated the goal remains unchanged: “reducing cost per vehicle… while maximizing delivery volumes.”

In that regard, Tesla kicked off October with another price cut in the US after Q3 deliveries missed expectations. The cuts, for certain Model 3 and Model Y versions, took the base Model 3 price down approximately -3.1% to $38,990. Another cut to spur demand signals that the bottom still may not be in yet for margins, given that the base Model 3’s latest price point sits just ~4% above Tesla’s average COGS of $37,500 in Q3.

Revenue and EPS:

  • Revenue of $23.35 billion missed expectations by (3.3%). This represented YoY growth of +8.9%.
  • Automotive revenue of $19.625 billion grew by +5.0% YoY.
  • GAAP EPS of $0.53 declined (44.2%) YoY, driven by the decline in gross and operating margins.
  • Non-GAAP EPS of $0.66 missed expectations for $0.73, representing a YoY decline of (37.1%).

Margins:

  • Gross margin of 17.9% missed expectations for 18.0%.
  • Operating margin declined for a fourth straight quarter to 7.6%.
  • Automotive margin (excl. leasing & regulatory credits) was 15.75%, declining from 17.52% in Q2 and 26.35% in the year-ago quarter.
  • Adjusted EBITDA margin declined ~260 bp QoQ and ~710 bp YoY to 16.1%, as adjusted EBITDA fell (24.2%) YoY.
  • GAAP net margin of 7.9% represented a decline of ~290 bp QoQ and ~740 bp YoY.

Cash & Debt:

Tesla’s cash and investments rose by ~$3.0 billion from Q2 to reach $26.08 billion, driven by ~$2.19 billion in net borrowing for vehicle and energy system financing and ~$0.85 billion in free cash flow. Free cash flow declined (74.3%) YoY from $3.30 billion in the same quarter last year, impacted by a $1.79 billion decline in operating cash flow and a $0.66 billion increase in CAPEX. TTM free cash flow of $3.71 billion was at the lowest level since Q4 2020.

Operating cash flow of $3.30 billion declined (35.1%) from $5.10 billion in the same quarter last year but improved +7.9% sequentially from Q2. TTM operating cash flow of $12.16 billion reached the lowest level since Q4 2021.

Tesla reported ~$4.39 billion in total debt and finance leases, up from $2.33 billion in Q2, driven by the $2.19 billion surge in net borrowings under vehicle and energy financing.

Other Key Metrics:

Energy storage revenues increased +39.6% YoY to $1.56 billion as deployments rose +90% YoY to 4.0 GWh, and services and other revenue increased +31.7% to $2.17 billion. Energy storage posted a gross profit margin of 24.4%, while services saw a gross profit margin of 6.0%. Tesla said that “pay-per-use Supercharging remains a profitable business for the company, even as we scale capital expenditures” to expand the network further. Supercharger connector deployments increased +31.4% YoY to 51,105.

Despite the top and bottom-line misses and a miss on Q3 deliveries, Tesla critically kept its 1.8 million delivery target unchanged. That suggests at least 475,000 deliveries in Q4, a new high for Tesla and approximately +1.9% higher than Q2’s 466,140 tally. Tesla has more than 2.23 million installed annual capacity, excluding the Cybertruck in pilot production; there should be no issue on the production side to reach the 1.8 million target. Price cuts continuing already in Q4 suggest that demand may remain weak throughout Q4.

A Closer Look at Margin Troubles:

Automotive revenues increased +5.0% YoY, as weaker pricing offset a +28% YoY rise in deliveries to 435,059 vehicles. On a sequential basis, automotive revenues declined (7.1%), as deliveries declined (6.7%) from Q2. Weaker ASPs in the quarter, at approximately (3.1%) lower than Q2, contributed to that sequential decline.

A worrisome trend is emerging in both ASPs and automotive gross margins as Tesla continues to cut vehicle prices. Automotive gross margins (excluding vehicles subject to leases) fell below 16% in Q3, dropping from 17.52% in Q2 and down from 28.46% in Q3 2021, with little relief along the way down.

CFO Zachary Kirkhorn stated back in January this year that that “Tesla would not go below margins of 20% [including leasing and regulatory credits] and an average selling price of $47,000 across models.” Automotive gross margin including leasing and credits declined to 18.7% in Q3, down from 19.2% in Q2 and 21.1% in Q1. 

ASPs have fallen (16.7%) YoY and (20.1%) from a peak in Q2 2022 at ~$55,690 per vehicle to reach ~$44,493. That represented a decline of ($1,469) from Q2’s ~$45,962, more than offsetting the $421 reduction in COGS per vehicle during the quarter.

Looking forward to Q4, should an improved mix offset price cuts to leave ASPs virtually unchanged, Tesla more than likely will have to bring COGS per vehicle lower by at least ~1.5%, to reach point below $37,000, to bring automotive gross margins back above 17%. If COGS per vehicle does not fall to that degree, ASPs will need to rise by at least 1% in the face of price cuts to bring that inflection in margins.

Earnings Call:

Tesla’s earnings call highlighted the difficulties in finding a concrete bottom for margins, as the OEM continues to “invest significantly in AI,” while noting that “there will be enormous challenges in reaching volume production with the Cybertruck, and then in making a Cybertruck cash flow positive.” Therefore, “R&D expenses continued to rise due to Cybertruck prototype bills and pilot production testing combined with spend on AI technologies like full self-driving, Optimus and Dojo.” Increased CAPEX has been detrimental to free cash flow metrics, while heightened R&D will also drag on operating margins – which Tesla inadvertently signaled have yet to bottom.

Tesla said that its “Q3 operational and financial performance was impacted by planned downtimes for our factory upgrades. This was necessary to allow for further factory improvements and production rate increases. Despite such factory shutdowns, our cost per vehicle decreased to approximately $37,500. We saw sequential decreases in material cost and freight. Reducing the cost of our vehicles is our top priority.”

While cost reductions can help prop up margins, Tesla also signaled that price adjustments may continue over the next months to quarters: “as interest costs in the U.S. have risen substantially, it has required us to adjust the price of our vehicles to keep the monthly cost in parity. We’ve tried to offset such adjustments via focus on reducing costs. However, there is an inherent lag in cost reductions, which in turn impacts margins.” Elon Musk added later in the call, “if interest rates remain high or if they go even higher, it’s that much harder for people to buy the car, they simply cannot afford it.” Rates advancing higher would likely force more price reductions to keep those monthly payments relatively close to parity, while higher rates for longer could keep vehicle prices depressed for longer, thereby weighing down on margins.

Conclusion:

Margins were the major story heading into Q3’s earnings and remain the major story moving forward, as Q3’s weaker operating margin print at 7.6%, combined with declining ASPs and automotive gross margins, signal that Tesla is still not much closer to finding a bottom.

Q3’s earnings call supported that view, as Tesla pointed out that reducing vehicle costs remains a key focus but emphasized that affordability is driving price reductions as interest rates rise. Given that there has been no relief in rates, Q4 started with a ~3.1% price cut to the base Model 3 in the US alongside other price cuts.

Tesla did reiterate its 1.8 million target for the year, pointing to a possible record Q4 for production and deliveries, with more than enough installed capacity to reach that goal. While a resumption of sequential delivery growth will be a positive, the question again comes down to how many price adjustments will occur during Q4 and if margins can withstand such adjustments to find a bottom soon.

Damien Robbins, Equity Analyst for the I/O Fund, contributed to this analysis.

Recommended Reading: