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.
This article was originally published on Forbes on Oct 13, 2023,05:15am EDTForbes Forbes on Oct 13, 2023,05:15am EDT
After Nvidia added $750 billion in value this year on the backs of surging AI chip demand, investors are quickly searching for the next trillion-dollar AI winner. AI is the best investment opportunity of our lifetimes, and although Apple (AAPL) has been relatively overlooked as an AI play, the tech giant could quickly become a force to be reckoned with in the AI space. The reason for this is simple. Apple can bring AI to the consumer’s pocket by the billions, and is rumored to be sitting on one of the best AI models on the market today, with comparable performance to OpenAI’s ChatGPT.
Two Billion Devices to Lever AI
Apple’s installed active device base surpassed 2 billion last February and “reached an all-time high in every geographic segment” at the end of the June quarter, according to CFO Luca Maestri. The iPhone’s installed base also “grew to a new all-time high,” and is estimated to have nearly 1.5 billion active devices worldwide, after adding around 500 million active devices since 2019—an 11.4% compound annual growth rate since then.
Source: I/O FUND
While installed active devices reached a new record, so did Apple’s subscriber base. CEO Tim Cook noted during Apple’s FQ3 report in August that the company hit an “all-time revenue record in Services” with “over 1 billion paid subscriptions,” which are growing at a double-digit rate. Apple has added more than65 million subscribers in the first half of this fiscal year and more than 300 million subscribers over the past two fiscal years heading into its fiscal Q4.
Source: I/O FUND
The opportunity for Apple to capitalize on AI arises from the combination of growth within Apple’s installed device base, along with increased engagement and adoption of paid subscriptions over time. Consumer interest in AI surged earlier in 2023 with ChatGPT garnering over100 million active users and more than 1 billion visits monthly. Apple’s installed base offers the chance to more than 10 times the number of individuals with readily available access to AI.
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Services Is Where AI Can Shine
Apple is witnessing a higher contribution from its services segment to both revenues and margins—the segment is approaching a $100 billion annual run rate, accounting for nearly 26% of revenue with a 70.5% gross margin.
In other words, services is contributing 41.1 cents to each dollar of gross profit, up from 34.6 cents just eight quarters ago. The segment has seen its contribution to gross profit increase steadily, rising 46% from 23.7 cents per dollar in FY18 to 34.6 cents per dollar to date in FY23. It is not out of the picture for services to soon contribute 50 cents of each dollar of gross profit as the segment surpasses $100 billion in annual revenue.
Source: I/O FUND
The importance of services to Apple’s bottom line cannot be overstated—that 70% gross margin level combined with its nearly $100 billion revenue scale has pulled Apple’s margins higher over the past few years and will likely continue to do so in the future as transacting accounts and paid accounts continue to grow to new all-time highs.
This is exactly where AI will have the most profound impact on Apple, and why the tech giant could emerge as a strong AI contender.
Google and Microsoft demonstrate the revenue potential of AI subscriptions at scale—for Microsoft’s Copilot, a 2.5% take rate of the ~382 million commercial Office 365 users would equate to nearly $3.5 billion in annual revenue, while a 10% take rate would see annual revenue reaching $14 billion, according to Macquarie.
In Apple’s case, it has nearly three times the paid subscription base as Microsoft that it could target with an AI product, via a stand-alone service or in one of its three pre-existing service bundles. Regardless of the route that Apple chooses, there remains billions in revenue potential. Offering a stand-alone AI subscription for $2.99 per month could rake in ~$10.8 billion in annual revenue at a 15% attach rate based on Apple’s more than 2 billion active devices, while boosting the prices of its subscription bundles could by $0.50 per month could add more than $5 billion annually.
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Apple Can Bridge the Gap with Mass-Market Consumer AI
Apple is spending millions of dollars per day in a quest to develop a conversational AI model, potentially for Siri, that would allow iPhone and iPad owners to use voice commands for automating multi-step tasks with the voice assistant. As such, Apple is uniquely positioned to both monetize and implement advanced AI in a mass-market consumer application.
Consumers, especially Millennials, are very willing to adopt and pay for such voice assistants that are as smart and as reliable as a human. According to a PYMNTS survey from April, more than 42% are willing to pay $10 or more per month for an assistant.
Although Apple is tight-lipped about the progress of its AI projects, the so-called Apple GPT chatbot is rumored to be more powerful than Open AI’s GPT 3.5 model, according to The Verge. Apple is spending millions of dollars a day training the large language model Ajax on more than 200 billion parameters.
The project could find life integrated within Siri, given the applications within automating multiple tasks and range of capabilities stemming from image and video recognition.
Apple's Apple GPT model is rumored to be more powerful than OpenAl's GPT 3.5, as well as Google's LaMDA, Meta's LLaMA and LLaMA 2, and Anthropic's Claude 2 model. – Source: I/O FUND
Apple noted back in 2020 that Siri had more than 25 billion requests made per month, a figure that could easily be increased with a ChatGPT-like chatbot installed across billions of devices. That is how Apple can be the first big stock in consumer driven AI uptake.
On Real Vision, I previously pointed out that “if you take a consumer-facing company like Google,” that they are in a good position because Google doesn’t “have to go out and try to get lots of consumers to adopt something new, consumers will continue to use Search, it’ll just be improved Search; advertisers will continue to use Google, it’ll just be improved ROI.”
For Apple, it’s the same case – it does not have to try to convert millions of users into a paid subscriber in the way that OpenAI does; rather, it could easily integrate an advanced conversational AI model within Siri for example, and quickly convert already-paying subscribers over to those AI services.
Damien Robbins, Equity Analyst at the I/O Fund, contributed to this article
The I/O Fund was early to AI with a 45% allocation in 2023. For more in-depth research from Beth, including 15-page+ deep dives on the 10 stock positions the I/O Fund owns, subscribe here.
Cloudflare has leveraged its content delivery network footprint to also offer application and website security. The company further innovated with Zero Trust combined with SASE network connectivity, and also eliminated egress fees for object storage to attract developers. What’s quite rare about Cloudflare is that the company is leveraging its global network to offer compute, storage and application services.
That’s a mouthful. There’s a lot of jargon when discussing Cloudflare that cannot be avoided. What’s important to take away from this analysis is that Cloudflare has laid down important stepping stones to becoming a dominant player in AI. Although we have to focus on the what (product), we also want to connect the dots on the why (strategy). This analysis will break down Cloudflare’s visionary approach on bringing AI inference to the edge; an approach that is a decade or more ahead of the competition. That is, if there is any competition among best-of-breed companies.
The analysis below touches base on Cloudflare’s core products as a CDN and best-of-breed leader in cloud-based security and application security. We will also discuss Zero Trust. However, the point of describing these products is so that I/O Fund Members understand how each of these is interconnected, and how these products uniquely position Cloudflare to capture AI inference at the edge. By my estimation, every market Cloudflare has entered over the past 14 years has been leading up to this point.
Product Overview:
Cloudflare references its business units as “Acts” – Act 1, Act 2 and Act 3. The company defines Act 1 as application security, Act 2 as Zero Trust and Act 3 as the Workers Platform. For our purposes as stock investors, it’s Act 3 we are most interested in. The analysis below makes it abundantly clear as to why Act 3 and the Workers platform is where the most explosive moment could occur.
Before we discuss Cloudflare’s positioning to democratize AI development and bring inference to the edge, it’s well worth the time to discuss the stepping stones that can create a moat of sorts. As stated, the most important section of the analysis begins at Act 3: Workers Platform.
CDN: Content Delivery Network
Cloudflare owns a predominant share of the CDN market. Content Delivery Networks are essentially a middleman that sits between the client/users and the origin server. CDNs contain a cached copy of website content on multiple servers located across the world to help improve page loading times.
When a person visits a website, it will provide the content from the server closest to the end-user, which helps increase the delivery speed of the content. When a website is hosted on a server in the United States, the person browsing the website from any part of the globe, like Asia or Europe, will receive the content from the nearest location instead of the server in the USA.
Pictured Above: CDNs are the middleman between origin servers and client devices.
Source: WallarmWallarm
Cloudflare has 300 points of presence (POPs) which are servers that sit at the edge. Hyperscalers, such as Google, Microsoft and Amazon, offer more centralized data centers. These data centers are geographically distributed but are designed for compute intensive workloads more than speed. Content delivery networks, as the name suggests, are designed for speed because their primary function is to deliver content as quickly as possible. This means smaller servers in more locations, with an emphasis on the network, which is why Cloudflare advertises that 95% of the world’s population is within 50 milliseconds with 12,500 network partners. In contrast, cloud data centers are much larger (think football field size) and are designed for a variety of workloads that are not only more compute intensive but also require a lot of storage.
Before I keep going, I want to make it clear that the Big 3 (AWS, Google Cloud and Azure) also have points of presence (POPs) and edge infrastructure. AWS has 400 points of presence (POPs), Azure 192 POPs, and Google Cloud has 120 POPs. The original dot-com CDN is Akamai, and this company has 4,200 POPs. As inference moves more toward the edge network and edge devices, you can expect the Big 3 will increase the number of POPs and strike close partnerships with telecom companies to leverage millions of 5G points-of-presence (POPs) for fast network speeds.
So then, given that Cloudflare is up against tech’s heavyweights who can build POPs with their large cash reserves and partner with telecoms, what is Cloudflare’s competitive advantage? Sitting at the edge is one of many stepping stones for Cloudflare. But this is where the similarities end.
Reverse Proxy and Anycast:
I want to touch base on reverse proxy and Anycast to help illustrate Cloudflare’s leading position as a middleman. This will also help illustrate how Cloudflare has leveraged its position to greatly improve application performance when we discuss Serverless.
Large Market Penetration:
According to data from W3Techs, 79.9% of websites that use a CDN or reverse proxy rely on Cloudflare.
The customer count is high because Cloudflare offers free services. Cloudflare has 1.154 million customers and makes $1.3 billion in revenue whereas Akamai has 143,000 customers and makes $3.8 billion in revenue.
Of the 1.154 million customers, 174,129 have upgraded to Cloudflare’s paid services. This ratio of free to paid is rare. I can’t think of another company offering free enterprise and SMB services at this scale. Customers contributing over $100,000 in revenue have been growing steadily and are now at 2,352. Notably, 31% of the Fortune 1000 use Cloudflare, so it’s not only SMBs that drive revenue.
The benefits of having a free base are that these customers are likely to upgrade to paid services, and free users can be used to test products to eliminate a long quality assurance (QA) process for faster product launches. It also helps illustrate how developer-friendly Cloudflare is, on the core CDN and security products, but also for its Workers platform.but also for its Workers platform.
Reverse Proxy:
Reverse proxy allows for cloud security features by sitting in front of web servers and forwarding client requests to the web servers. By routing through a vendor’s reverse proxy before routing to the server, the vendor has the opportunity to provide cloud-based security. This is important because Cloudflare sits at a critical juncture in the tech stack, to where it can uniquely combine its capabilities as a CDN with application and cloud-based security. Therefore, you can combine fast speeds and better application performance seamlessly with web application firewalls, DDoS protection, API gateways and bot management.
Pictured Above: By being a reverse proxy, Cloudflare can also be a forward proxy for security services. This allows Cloudflare to become a one-stop-shop that combines many application needs. As more developers use Cloudflare for AI purposes, security features will act as an seamless upgrade. Right now, security drives Cloudflare’s revenue.
Anycast is a Material Differentiator:
Being a middleman between internet traffic and servers creates strong positioning for vendor-related products and services. By being a content delivery network that protects against DDoS attacks, Cloudflare was forced to innovate around how to handle incoming requests.
The Anycast network was designed to be resilient for a surge in traffic by routing incoming traffic to the nearest server. Traffic finds the best path to the most available data center rather than overwhelming the origin server where the request was created. In this case, traffic can be spread across the entire network. According to Cloudflare, the network spans 300 cities, 100 countries with over 12,500 network partners that are connected to Cloudflare. Cloudflare has continually innovated its core products with features such as automatic platform optimization which allows websites to cache static HTML on edge servers.
Anycast has a latency in the milliseconds by answering requests from the edge instead of routing to an origin server. This is important for AI inference, which we will touch on later in the analysis.latency in the milliseconds by answering requests from the edge instead of routing to an origin server. This is important for AI inference, which we will touch on later in the analysis.
Over the past ten years, Anycast has increasingly gotten smarter by using routing algorithms. Today, developers also use the Cloudflare network to proxy requests for APIs. This reduces API latency by placing Cloudflare in front of the API, allowing Cloudflare’s DNS resolver to direct the request to the nearest Cloudflare server.
More on Cloud-based Network Security:
Cloudflare has been forced to innovate to handle DDoS-levels of botnet traffic. By being a middleman, Cloudflare answers a few needs combined into one, which is application speed and performance alongside security. This is rare, as usually security vendors do not typically improve application performance, let alone improve application performance to an extent that exceeds the hyperscalers (reference Serverless section below).
Because Cloudflare has a large global presence, it’s particularly well suited for analyzing traffic to determine security risks. The company is able to analyze and detect attacks by running a background program known as a daemon on every server in every data center. The scans are shared as threat intelligence among the servers in each data center without affecting the latency of the CDN.
Cloudflare is able to mitigate at optimal locations in the tech stack, for example at L4 inside the firewall or at L7 inside the reverse proxy with a 403 error page. The company is advanced at preventing L3 DDoS attacks, which targets network equipment and infrastructure. The benefit of having access to more of the stack for security purposes is that CPU consumption and intra-data center bandwidth remains relatively unaffected. It’s also autonomous so Cloudflare is not using manual employees for this process
Distributed denial-of-service (DDoS) attacks are a type of security threat where botnets create a surge of traffic to a network and crash a targeted site. DDoS attacks are essentially bots that send millions of requests to overload servers and to shut down a specific website by targeting its IP address. Often times, these bots are run from devices infected with malware and operated remotely by an attacker. In 2021, Cloudflare detected and mitigated a 17.2 million request-per-second DDoS attack, which was three times larger than any previous DDoS attack on record. This is two-thirds the average rate per second that Cloudflare had served in all of Q2.
These outages are very common, with some of the larger DDoS attacks taking down popular social media sites and consumer applications like Twitter and Spotify (and countless others throughout the years). During 2020, DDoS attacks surged by 300%. During this time, Cloudflare went from 10% penetration across all websites to 19%.
They can also cross-sell security and CDN customers with WAN-as-service, or Magic WAN, which connects office networks through the local area network. The company also offers application delivery controllers located centrally within a customer’s infrastructure for Layer 3 through Layer 7 security for applications and APIs.
Quick Takeaway:
DDoS helped put Cloudflare on the map, and it’s important to discuss this because Cloudflare is capable of protecting against some of the world’s most prevalent cyberattacks. By providing cloud-based security alongside edge serverless at low prices, Cloudflare has added benefits the hyperscalers do not inherently provide.
Zero Trust:
Following Covid, Zero Trust gained acceptance due to rising security threats from hybrid work teams. Secure access service edge (SASE) is a cybersecurity concept that utilizes Zero Trust to identify users and devices to deliver secure access to specific applications or data. The need for this has grown due to remote teams as SASE allows policy-based security no matter where the user, application or device is located.
Zero Trust Security is built on the premise that no one should be trusted within or outside the network. In traditional security systems, it is difficult to obtain access from outside the network while those located inside the network were trusted.
With Zero Trust, these trust assumptions are removed with tools such as multi-factor authentication, giving access for a limited time and to also verify, authorize and to have a continuous check on all the data points that are given access.
In this case, Cloudflare uses the company’s proxy infrastructure for both reverse proxy and forward proxy. The company’s edge network is ideal for SASE because the cloud-driven architecture is meant to secure all applications, data, users and devices. Having a footprint of hundreds of POPs enables a security approach that others SASE vendors cannot duplicate.
Quick takeaway:
Cloudflare’s position as the middleman allowed Cloudflare to skate where the puck was going. The company quickly positioned for the Zero Trust market when Covid drove hybrid work environments by releasing Cloudflare One in October of 2020 — which was an incredible 6-7 month turn around from when shelter-in-place began. The cloud firewall approach was able to overcome issues that traditional firewalls, both hardware and virtualized, could not overcome in terms of capacity planning, managing devices, and needing to apply Zero Trust policies across all traffic rather than centralizing traffic to one, physical location. As stated, the company’s edge network is ideal for SASE because the cloud-driven architecture is meant to secure all applications, data, users and devices – and this will come in handy as AI moves more toward the edge.
Act 3: Workers Platform
Cloudflare is not only a CDN and security company. Rather, Cloudflare is being bold by leveraging its global network to offer compute, storage and application services.
The benefit of serverless is to deploy applications without the customer having to provision the compute infrastructure. The servers for executing the code are deployed by cloud service providers, hence it’s “serverless” for the customer. With serverless, it takes minutes to run code.
Fundamentally, Cloudflare approaches serverless differently than the hyperscalers. Amazon’s (AWS) Lambda functions are executed in containers. When an event triggers the code, a runtime container is started and code is loaded from S3. The container then waits for another execution. If too much time passes, the container is deleted and a new container is required. This is popular because you pay for what you use, and are charged based on the number of requests for your functions. The drawback is that every time a container is spun up, the language runtime is spun up in addition to the code. Moving data centers closer to the edge does not entirely solve this problem because there are fewer machines and less memory, which means cold starts will still occur with a containerized process.
To avoid cold starts, some developers will pay for synthetic requests. This means developers must choose between unreliable execution time with quite a bit of variability (sometimes a few seconds) or they have to pay extra for synthetic requests to keep the function warm.
Cloudflare eliminated cold starts entirely with its Workers platform. There are a few milliseconds where Cloudflare can have Workers runtime load a hostname before a TLS certificate is sent back and the original encrypted request is sent. By the time the HTTPS protocol is ready to send secure data between a browser and a website, Cloudflare has the Worker runtime warm. This means Worker executes code the minute the request is received.
What’s crazy is that Cloudflare rolls out features that exceed hyperscaler performance at minimal cost. It is this combination of competing with the hyperscalers, delivering app performance at faster speeds — while keeping prices low — that is unique to Cloudflare.while keeping prices low — that is unique to Cloudflare.
More on Serverless Cold Starts and Isolates:
Serverless is event-driven, which means when an event is received, it’s spun up and the request is processed. Serverless platforms are free at first but become more expensive as an application scales.
Serverless is billed in two ways:
Number of requests – billed in increments of every million requests per month
Compute time – measured in GB per seconds, higher memory execution costs more than lower memory execution
Data transfer and Storage Costs, this depends on the use case
Cloudflare’s approach to serverless is fundamentally different than the hyperscalers. Amazon’s Lambda is one of the more traditional serverless platforms. As discussed, it works by spinning up a containerized process for code, which if inactive at the time the request is received, leads to “cold starts.” As discussed, a cold start is when a new copy of code is started on a machine, which can cause one to four seconds of lag time.
If an instance is already active, then there is a “warm start” and there is no lag time. You can read about the idle instance lifetimes here in terms of how long an instance can idle before it requires another cold start.
In contrast, the Workers platform uses something called isolates. Isolates allow a single process to run up to thousands of isolates. Although hyperscalers will promote the ability to scale, it can be costly to do so. With Cloudflare’s serverless approach, developers pay for the Javascript runtime once, and then are able to run more scripts without additional costs. The isolate runs faster than a node process, and also uses less memory because isolates do not share or access the memory of another isolate (hence the name isolate). By not sharing memory, there is a security feature to isolates.
Additionally, Cloudflare’s serverless Workers platform does not use containers or virtual machines. This means applications do not require the cold starts that virtual machines require. Instead, code runs close to the “metal” – or in other words, on an edge server. This reduces the request response time compared to serverless platforms offered by hyperscalers such as AWS Lambda, Lambda@Edge, Lambda Native and Google’s Firebase.
Because of some of these fundamental differences, Cloudflare claims to cold start applications within five milliseconds. Per Cloudflare: “Any given isolate can start around a hundred times faster than a Node process on a container or virtual machine.” The company also states: “on startup, isolates consume an order of magnitude less memory.”
Out the gate, the Workers platform was designed to compete with AWS’s Lambda and Lambda@Edge by being faster. According to Cloudflare, Workers was 441% faster than a Lambda function and 192% faster than Lambda@Edge. The speed is possible because Cloudflare offers serverless through its edge network, which is distributed and decentralized.
The Workers Platform is on fire in terms of growth. Per the most recent earnings call: “Our developer platform, Cloudflare Workers, continues its explosive growth. We reached 10 million active Workers applications in Q2, up 250% since December and 490% year-over-year.” These applications were at 2.2 million less than a year ago in Q3, and were at 4.9 million last quarter.
Pictured Above: Cloudflare Workers Platform has seen applications surge. Source: Cloudflare Investor Relations
It’s not clear how much the 10 million is contributing to revenue. Per management: “But I would say that we have been very pleasantly surprised at how quickly the Workers' platform is taking off. But we are not, at this time, optimizing that platform for how can we bring as many dollars out of it as possible.”
However, this is where the magic of a developer moat often starts – a platform that advocates for developers, offers something of value (lower costs, higher performance, more accessibility), and then patiently waits for the tide to come in.
Quick takeaway:
Cloudflare combines executing runtime for an application close to the user and removes cold starts by running isolates that create an advantage at the edge. This is distinct from pushing compute from a centralized data center to the edge. It’s also distinct from containerized processes that require cold starts.
R2 Object Storage
Cloudflare’s R2 storage allows unstructured data to be stored without egress bandwidth fees, which are charged when developers retrieve data from a cloud provider like AWS. This was a bold move by Cloudflare to prove it can compete against a hyperscaler on cloud storage.
The egress fees that Cloudflare is disrupting are essentially a tax without any value. Markups are as high as 7900% in the United States region when calculating what AWS charges. This is an 80X bandwidth markup and was detailed here by Cloudflare’s management. Eliminating egress fees with R2 Storage places Cloudflare in direct competition with Amazon’s S3.
Cloudflare’s motivation is to win over developers and their loyalty. Per the CEO: “We want developers to keep developing, not worrying about their storage bill. Our aim is to make R2 Storage the least expensive, most reliable option for storing data, with no egress charges. I’m constantly amazed by what developers are building on our platform, and look forward to continued innovation as we expand the tools they have access to.”
Primarily, Cloudflare is hoping to attract developers for its Workers platform by eliminating unnecessary fees on cloud storage. R2 Storage will help Cloudflare grow its addressable market and will help the company compete as a best-of-breed player in of multi-cloud.
In response, Amazon lowered prices by up to 31% but this may not be enough if Cloudflare removes egress fees entirely. When Cloudflare announced R2 storage, the company’s co-founder and CEO, Matthew Prince, tweeted, “Why R2? Because it’s S3 minus the one most annoying thing: egregious egress.”
It is interesting to note that Amazon successfully grew by targeting companies that had good margins with a famous quote from Jeff Bezos, “Your margin is my opportunity.” Now, companies like Cloudflare are doing what Amazon did in its early days by toughening the competition. Amazon’s AWS is a profitable powerhouse, and if Cloudflare can attract even a small share of AWS customers, it could be a game-changer for Cloudflare. Per management on the most recent call: “Cloudflare is the most commonly used cloud provider across the leading AI startups. They're using R2 to help arbitrage the lowest GPU cost to train their models.”
R2 Object Storage is growing quickly. Management stated in the last earnings call: “R2 continues to grow and now stores over 13 petabytes of customer data, up 85% quarter-over-quarter. We have 44,000 distinct paying customers with R2 subscription, and brand name customers are beginning to adopt it as their primary object storage solution.”
Inference at the Edge:
There are two primary steps to AI/ML: training and inference. Training is the learning phase and is compute intensive. GPT-3 had 175 billion parameters and required 300 zettaflops and 300,000 billion math operations across it’s training cycle. For the most part, training is done by high performance computing systems and is often done in the cloud instead of on-prem.
However, inference is a different matter entirely. Cloud computing through the hyperscalers has a long transmission delay. What inference needs is speed so it can retain the learning from the training phase, while quickly applying data it’s never seen before. Inference takes batches of real-world data and quickly comes back with an answer or prediction. This is best done at the edge, which includes the edge network that Cloudflare provides, and edge devices, such as smartphones and laptops.
In the inference stage, the compute intensive neural networks are modified for speed and to improve latency. In order to do this, inference is optimized for runtime performance. This allows the computation tasks to be as close to the data source as possible. In many cases, data is produced at the edge, and it’s more efficient and faster to run inferencing at the edge.
For many inferencing tasks, Cloudflare’s distributed edge servers will handle tasks without needing to exchange data with the cloud. This helps to optimize the traffic load. For other tasks, the cloud will act as a backup not only for processing but also for scalable storage. So, it’s important to understand that Cloudflare is not a direct competitor in the traditional sense, but in some cases, compliments the Big 3. Look Cloudflare to play up its multi-cloud approach and the common goal of increasing the number of AI applications and improving accessibility to developers.
It’s true that hyperscalers will increase their edge footprint, and will partner with telecoms for fast speeds. However, AI developers need an advocate, and because Cloudflare owns their infrastructure, their strategy of driving down costs and improving GPU accessibility makes a lot of sense.
There are more details that we will visit later down the line, such as ONNX runtime, which allows Cloudflare to be the middleman as a routing layer between cloud data centers, the edge network and devices – and AI gateways, which allow developers to cache AI responses and monitor performance to mitigate AI costs.
Connecting the Dots:
If we connect the dots, then it becomes clear Cloudflare has a few distinct advantages as the platform of choice for AI developers. Here’s a summary of what’s been discussed:
Does not rely on Big 3 infrastructure and can drive down costs
Is faster on performance because of its position at the edge; this lowers costs and latency for AI inference and keeps data as close to the user as possible
Geographically equipped to handle compliance issues that will inevitably result from using training data for inference. You can read more about ChatGPT running into issues in Italy here.
The company has moved diligently into compute, storage and application services. Combined with its global network, this positions the company for AI inference as-a-service. There is no other company doing both edge network plus compute and storage except the hyperscalers. However, in some cases such as serverless, Cloudflare exceeds the performance of the hyperscalers
CDN as a core product and security as a seamless upgrade shows the importance of being a middleman, helping to position Cloudflare to innovate around Serverless in ways that outperform even AWS.
Training models is prohibitively expensive by requiring upfront costs, Nvidia GPUs are hard to obtain, and AI development is not democratized for developers with proprietary, blackbox APIs that run counter to an open-source movement (GPT-4 versus Llama). Cloudflare aims to solve these problems by allowing popular models to run closer to the user, which is the next logical step for AI.
Ultimately, the bigger and the faster a network is, the more it’s capable of providing “as a service.” AI can create a fortuitous moment for Cloudflare because the company is positioned to offer AI inference-as-a-service.
Last month, there was an important announcement with Cloudflare launching Workers AI. This new platform is the sum of the parts we discussed in this analysis.
Financials:
Cloudflare is strong on revenue growth with analysts expecting consistency over the next few quarters. This kind of consistency is rare in the cloud and security category. However, Cloudflare is not GAAP profitable and the AI story will take a back seat if there is a FED-related selloff, or if for any other reason we enter a risk-off market for growth stocks.
Revenue and EPS
All numbers are for the current Q2 quarter ending in June and are year-over-year comps unless otherwise stated.
Revenue grew 31.5% to $308.5 million and was in line with expectations. Next quarter the company is expected to grow 30% to $330.5 million in revenue.
Full year revenue guidance for 2023 is $1.283 billion to $1.287 billion, representing growth of 31.8% at the mid-point.
Pictured Above: Cloudflare is expected to report consistent growth
Source: YCharts/Seeking Alpha
Adjusted EPS of $0.10 is up from $0.00 in the year ago quarter. The consensus for next quarter is $0.10. However, on a GAAP basis, the company is unprofitable with GAAP EPS of ($-0.28) reported compared to ($-0.13) expected. The miss in GAAP EPS is due to a $50.3 million loss on extinguishment of debt for a negative impact of $0.15 EPS.
Pictured Above: Bottom line growth on an adjusted basis is expected to slow
Margins:
Cloudflare has a strong gross margin yet stock-based compensation weighs on the GAAP operating margin.
Gross margin of 75.6% is strong and necessary for this company to expand.
The operating margin of (-18.20%) compared to (-27.50%) a year ago. However, it got worse QoQ and has remained flat this year with no improvement.
· Stock based compensation is high at 22.2% of revenue.
Adjusted operating margin improved by 700 basis points YoY to 6.6%.
· Sales and marketing expenses decreased as a percentage of revenue by 300 basis points YoY to 41%.
· R&D expenses decreased by 300 basis points YoY to 17%
· G&A expenses decreased by 200 basis points YoY to 13%.
Adjusted operating income guidance for the next quarter ranges from $20 million to $21 million or 6.2% of revenue.
Net margin of (-30.60%) with the net loss increasing last quarter primarily due to the loss on extinguishment of debt of ($50.3 million) due to early repurchase of 2025 convertible senior notes. Per the 10-Q: “In May 2023, the Company repurchased $123.0 million principal amount of the 2025 Notes (the 2025 Notes Repurchases) for $172.7 million in cash, including accrued interest payable of $0.5 million.”
Adjusted net margin of 10.9% compared to 0.1% in the same period last year.
Source: Cloudflare Investor Relations
Cash Flow and Balance Sheet:
Compared to its peers, Cloudflare’s cash flows are a bright spot. The operating cash flow margin was 21% compared to 16% in the same period last year. Free cash flow improved to 6% from (-2%) in the same period last year and was up 1% sequentially. Previously, management had guided to being breakeven on cash flows in H1 2023.
Thomas Seifert, CFO of the company, had said in the Q4 2022 earnings call, “While we expect free cash flow to trend upward on an ongoing basis, for modeling purposes we anticipate near-term variability in our cash flow generation with the first half of 2023 expected to be relatively breakeven.”
One of the differences between operating cash flow and free cash flow is network capex of 11% in the most recent quarter. Network capex is expected to be 10% to 12% of revenue in FY2023. This is a primary reason as to why FCF can be minimal at times.
The company has cash and available-for-sale securities of $1.59 billion. It repurchased $123 million convertible senior notes in the recent quarter and had an outstanding $1.32 billion.
Key Metrics
Remaining performance obligation (RPO) is declining yet is still above revenue growth. In the recent quarter, RPO grew by 36% YoY and was up 8% QoQ to $1 billion. The deceleration pictured below is quite apparent and RPO will need to accelerate when the AI story plays out.
Source: Cloudflare Investor Relations
The dollar-based net retention rate was 115% in the recent quarter. Management believes that the deceleration in DBNRR is nearing a bottom.
This is very important for Cloudflare to prove to investors as we move through the next few quarters. Thus, we’ve provided the full statement below.
Thomas Seifert said in the recent earnings call, “Our dollar-based net retention rate was 115% during the second quarter, representing a decrease of 200 basis points sequentially. Importantly, renewal rates in the second quarter were consistent with the quarterly average in 2022, which was an all-time high for the company. Instead, similar to the last two quarters, the decline in DNR was again primarily driven by slower expansion in our larger customer cohort. We calculate DNR by comparing the analyzed revenue from paying customers four quarters prior to the annualized revenue from the same set of customers in the most recent quarter. As a result, this will be a lagging indicator of Cloudflare’s underlying business trends. Based on our visibility, we believe the deceleration in DNR is nearing a bottom.”Importantly, renewal rates in the second quarter were consistent with the quarterly average in 2022, which was an all-time high for the company. Instead, similar to the last two quarters, the decline in DNR was again primarily driven by slower expansion in our larger customer cohort. We calculate DNR by comparing the analyzed revenue from paying customers four quarters prior to the annualized revenue from the same set of customers in the most recent quarter. As a result, this will be a lagging indicator of Cloudflare’s underlying business trends. Based on our visibility, we believe the deceleration in DNR is nearing a bottom.”
Source: Cloudflare Investor Relations
Total paying customers grew by 15% YoY to 174,129.
Large customers (greater than $100,000 annualized revenue) have declined considerably and is at nearly half the growth rate of 34% YoY compared to last year. This needs to accelerate when the AI story plays out.
Source: Cloudflare Investor Relations
Conclusion:
The goal of the analysis is to make it clear why Act 3 is what we are interested in, and how Cloudflare is uniquely positioned to bring inference to the edge. The Big 3 will also do this with an ever-expanding edge footprint, yet Cloudflare is grassroots enough to attract a large developer following. The company states there are 1 million active developers with 10 million active applications for Workers. This puts Cloudflare well on its way to become a leading developer platform. Five years ago, we pointed toward CUDA being Nvidia’s moat. Cloudflare does not have a moat right now but it certainly could over the next few years. Because of Workers, Cloudflare is at the top of our list for building a position.
There are some caveats — if only investing were so simple that all we had to do was find a great product and a strong management team with a history of executing in new markets. Cloudflare’s financials are not FED-proof. This company is not GAAP profitable and won’t be in the near future. The company is cash flow positive, but it’s minimal and subject to network infrastructure capex.
The FED has the power to overshadow even a multi-generational investment opportunity such as AI. Tech is the most sensitive sector to the FED because tech stocks are long duration assets that are priced according to future cash flows. The longer rates stay elevated, the more likely valuations recede and tech stocks get rerated.
This is why we put risk management in the drivers’ seat by carefully and patiently timing our entriesby carefully and patiently timing our entries. Buying Nvidia at the top last year means you would have to sit through a (-60%) drawdown. This drawdown was steepest the month the H100 shipped. However, buying Nvidia in October means you are sitting on 300% returns. This helps illustrate why identifying a great product is secondary to risk management tools. We expect something similar for Cloudflare — to where timing will be everything.
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Royston Roche, Equity Analyst for the I/O Fund, contributed to this analysis.
The I/O Fund was early to publishing stock analysis that stated AI would be an explosive opportunity. Beth went on record to say that Nvidia will surpass the valuation of Apple, and it has been her stance since November 2018 that AI will bring us a new set of FAANGs, one of which will be Nvidia. Since her callout, Nvidia shares have risen nearly 1,000%, with surging AI demand sending data center revenues to a projected $31 billion in FY24, an impressive 58.8% CAGR from 2018’s $1.93 billion.
In January, Beth was on Real Vision’s 3 Ideas and stated it would take World War 3 to get her to sell her Nvidia position. This was a strong statement at the time, yet Nvidia later led a historic 6-month performance for the Nasdaq with over 200% gains in 2023. Real Vision invited Beth Kindig back for a candid interview with Raoul Pal for a one-hour discussion on how to position for AI. Listen here for the full discussion on why AI is the best investment opportunity of our lifetime.here for the full discussion on why AI is the best investment opportunity of our lifetime.
Watch the full-length 1 hour video on RealVision here.here.
AI’s Potential Impact on The Economy Will Be Unrivaled
The reason that AI will be the best investment opportunity of our lifetime is because of the impact it will have on GDP. As discussed in the 1-hour interview, the potential of AI to revolutionize nearly every sector, boost productivity, reduce costs, and significantly influence GDP is unparalleled. To be exact, AI is estimated to add up to $15.7 trillion to the global economy by 2030, and drive a market 5x the size of tech’s current global spend.
Later, McKinsey highlighted in June that AI’s total economic impact could be as high as $25 trillion combined, when spanning ML, advanced analytics, generative AI and AI-related worker productivity gains.
Beth points out that the contribution to GDP around the world will be “unlike any technology in modern times” and “infinitely higher than something like mobile.” AI is expected to more than double the GDP of developed countries in Europe, Asia, and the United States, and drive worker productivity as much as 35% higher across those regions.
It’s a trend that will be “4-5x larger than the FAANGs,” and one that will result in massive winners.
To watch the full 1-hour video, click here.click here.
Beth explained to Raoul that “given the numbers we have today, because people like to think of AI as a hype, what I would encourage people to realize is that in 2010, mobile was not a hype, and we’re probably more like 2008 or 2009 right now, in terms of where we are with the vintage of AI and where it’s going to. So just keep all that in mind — if you believe that mobile would've been the right way to position, then AI certainly will be because it is so much more massive in terms of its contribution.”
Big Tech is Cornering AI, Edging out Startups
In the past, nearly all innovation came from the private markets and smaller teams. There is certainly a lot of innovation in AI still occurring in the private markets, yet AI will not be as democratized as mobile or the internet boom. This is due to the cost of training models, and Big Tech’s 10+ year head start on AI.
Google, Facebook, Amazon, and Microsoft have invested billions into AI development for years and can quickly and effortlessly integrate AI into their established business models. For example, Beth explored in June how AI could drive $100B in revenue for Microsoft by 2027, from OpenAI’s APIs running on Azure, to AI integrations and partnerships via Bing, and the rollout of Copilot, among other drivers.
Beth points out that AI “will be very enterprise driven,” with some consumer overlay, as opposed to mobile’s consumer-driven nature. In that context, “what is really ideal for a stock is if you take a consumer-facing company like Google, and they can inject their AI technology into the ads machine, or Google Search. So they don’t have to go out and try to get lots of consumers to adopt something new, consumers will continue to use Search, it’ll just be improved Search; advertisers will continue to use Google, it’ll just be improved ROI.”
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To watch the full 1-hour video, click here.click here.
Powering nearly every aspect of Big Tech’s AI ambitions is the semiconductor universe, and at the moment, that’s spearheaded by Nvidia’s AI GPUs. Beth has taken the stance for multiple years that “AI will bring us a new set of FAANGs, one of which will be Nvidia,” pointing out five years ago that “when artificial intelligence matures, you can expect data center revenue to be Nvidia’s top revenue segment.” Demand for Nvidia’s GPUs has soared through the roof, with data center revenues projected to triple from FY22’s levels to around $31B in FY24, as Nvidia is reportedly looking to triple shipments of its H100 GPUs from ~550,000 this year to 1.5 million to 2.0 million next year.
Nvidia’s H100 “has now opened up such an ecosystem of software development, that it’s a very special moment in time. People do call it the ‘iPhone moment’” for Nvidia, because of the significant increase in performance offered combined with the transformer engine on the chip. However, with the ‘iPhone moment’ comes an Android – watch the video below to find out who Beth thinks will take second place on AI acceleration. For more in-depth research from Beth, including 15-page deep dives on the 10 stock positions the I/O Fund owns, subscribe heresubscribe here.
To watch the full 1-hour video, click here.click here.
Profiting From AI Takes a Thematic Approach
Beth does not believe in going “all-in” on a thematic approach. Rather, the I/O Fund is quite strict on what companies they add to the portfolio. Simply put, a great company should be disruptive and innovative, but should also be cash efficient and profitable. Criteria for the portfolio is discussed in detail every quarter on the I/O Fund team’s portfolio reviews.
To watch the full 1-hour video, click here.click here.
Some of the key components for I/O Fund portfolio companies include ensuring companies remain on track with their product roadmap, ensuring that they are not overpromising and under-delivering, and not giving any leniency to the company’s financials in terms of weaknesses that may be present in margins or growth.
An example of a company that does not fitdoes not fit the I/O Fund’s portfolio criteria despite being branded as an AI stock is C3.ai (NASDAQ: AI) – shares rallied nearly 34% after topping estimates with its fiscal Q3 results in March, before rising another 34% to $44 at the end of May on product roadmap updates with its Generative AI product release on AWS’ Marketplace.
However, in just the span of 4 months, shares have fallen nearly 50% to $24, as fiscal Q1 results in September highlighted exactly why investors should offer zero leniency for weak financials. From FQ4 to FQ1, revenues remained flat, GAAP gross margins shrunk 10 percentage points to 56%, while GAAP RPO declined by $47M.
This is why thematic investing alone can result in losses – companies must do more than just state they are an AI company to have a place in the portfolio. Their financials must prove they are doing something disruptive, and that they have found true product-market fit.
AI Is Not A Trend To Miss
Per Beth’s interview with Raoul: “we all know that [with] the FAANGs, if you could have invested 10, 15 years ago in the FAANGs, you would have,” because of that multi-trillion-dollar potential of the mobile economy. In 2022, the mobile economy contributed around $5.2 trillion to global GDP, per GSMA, while AI is currently forecast to contribute three to five times that amount over the course of the next decade and beyond.
While many are quick to say that AI is merely just a ‘buzzword’, those who are in the know were able to get in front of 2023’s big move. AI is not a trend to miss, and as a leading portfolio in AI, the I/O Fund is preparing to capitalize on this once-in-a-lifetime trend.
If you own AI stocks, or are looking to own AI stocks, we encourage you to attend our weekly premium webinars, held every Thursday at 4:30 pm EST. Next week, we will discuss a new AI stock to our site that we think will be hot in 2024 – what our targets are, where we plan to buy, as well as where we plan to take gains. Learn more here.
Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
AEHR came in as expected and beat in some cases. Management reiterated guidance of at least $100 million for 50% year-over-year growth. Given the company added its sixth customer this quarter, the market may have wanted a raise. If we are patient, it’s likely AEHR will see a raise over the next two to three quarters. Management alluded to more orders likely being placed and delivered this fiscal year. This is detailed in the earnings notes below.
AEHR has a large and obtainable TAM relative to its market cap, which we’ve covered in the past when we stated: “SiC wafer market is expected to grow 35X by 2030 – that’s not a typo. “Forecast from William Blair estimate that the silicon carbide market for devices in electric vehicles alone, such as traction inverters and onboard chargers is expected to grow from 119,000 6-inch equivalent silicon carbide wafers for EVs in 2021 to more than 4.1 million 6-inch equivalent wafers in 2030, representing a compound annual growth rate of 48.4%. This equates to almost 35 times larger in 2030 than in 2021.”
As industrial uses for SiC ramp, the TAM could be closer to 6 million wafers needed every year by 2030. This was discussed on the call as the past two customers were not EV related. Batteries were also discussed on the call, and we’ve included these notes below.
Revenue:
Revenue of 93.3% beat estimates of 80.4%. These beats are easier on small numbers. The difference was about $1 million in revenue at $20.6M reported compared to $19.25M expected.
Product revenue declined $1.7M QoQ to $19.4M in revenue. Services was flat at $1.27M in revenue.
Management went out of their way to remind investors that this is the strongest first quarter they’ve ever reported, and that first quarter is typically seasonally weak. We also reminded our Members going into the earnings call that AEHR’s revenue can be lumpy.
EPS:
EPS was in line:
GAAP EPS of $0.16 is up from $0.02 in the year ago quarter.
The adjusted EPS of $0.18 beat estimates of $0.16 EPS.
Margins:
The gross margin this quarter is weak at 48.4%, and this is the lowest gross margin since Q1 of last year. The Fox-XP system’s automated WaferPak aligner caused the decrease in margin. The automated aligners are built externally. Per the CEO: “the first units have a higher incremental cost to us than the ones going forward.” When the CFO was asked if the gross margin would return to 50%, he affirmed this by saying “So we're still targeting 50% above the margin for the year, and that's what we're looking at.”
Operating margin was also softer than it’s been in previous quarters at 20%. The CFO stated opex was higher due to “increased headcount related expense and R&D programs.”
Gross margin of 48.4% compares to 51.5% last quarter and 42% in the year ago quarter
Operating margin of 20% compares to 25.3% last quarter and 4.3% in the year ago quarter. This resulted in operating income of $4.12 million.
Net margin of 22.6% was also softer on a sequential basis but up nearly 700% year-over-year (due to small numbers).
Cash Flows:
The operating cash flow of $3.9 million was down 28.6% year-over-year. However, cash on the balance sheet of $51 million is up from $36.2 million in the year ago quarter and up 6.5% sequentially.
Key Metrics:
I suspect the key metrics is why we are seeing the weak price action after hours. Inventory is higher than usual at $31.56 million, up $7.6 million QoQ. Often, this can be a flag for a semiconductor stock yet management has stated their plan is to increase inventory to meet upcoming demand. Per the CEO: “ I mean we are able to ship more than anybody else. We literally can ship up to, call it, 50, 80, 100 testers, call it, wafers or blades of capacity a month, we are shipping more per month than the combined number of installed base of every other competing alternative has ever shipped.”
Bookings in Q1 of $18.4 million declined (-3.7%) year-over-year. Bookings were up from $15.2 million last quarter. Backlog of $22.3 million was up 14.4% year-over-year yet was down sequentially. We had discussed that these are lumpy in our pre-earnings report. The effective backlog of $24 million was a bit lackluster given management had stated they received $15 million in effective backlog for Q1 three months ago.
Earnings Call:
AEHR’s key metrics matter, but the stock tends to move intra-quarter with new order announcements. If AEHR gets more orders in the next two quarters, it will be very positive for the stock as we are hovering at a baseline guide of $100 million this year. As investors, we are already sold on the product’s potential but I do include a few more notes on that regard, as well.
Comments on Upcoming Orders, New Customers and Q2 Revenue Recognition
In the opening comments, the CEO stated the following: “Acceptance and production release of these FOX XPs with the integrated aligners and the associated revenue recognition provide a solid start to our second quarter revenue and pave the path for revenue recognition immediately upon all future shipments of these products to this customer and forecasted shipments to additional customers this fiscal year.”
An analyst asked for more clarification and AEHR stated that $8 million in revenue was being recognized in September due to a deferred situation on two aligners.
Separate from this $8M, this was also a bullish statement on the call: “We continue to feel confident that this customer will move forward with us using the FOX-XP multi-wafer solution for their high-volume needs, including initial purchase orders and system shipments this fiscal year.”
And management hinted again they may see more order than what is currently being forecast:
“Our meetings also included face-to-face meetings with potential new silicon carbide companies who have now told us that they intend to place their first purchase orders with us over the next several months, including some that want us to ship systems, WaferPaks and aligners to them this fiscal year.”
New Customers:
AEHR announced their sixth customer for silicon carbide this quarter. Customer #5 and Customer #6 are not EV customers, which is generally seen as a positive because it increases TAM by 2.8 million wafers in addition to the 4.5 million wafers estimated for the EV market.
“These additional applications expand our market opportunity beyond the 4.5 million 6-inch equivalent silicon carbide wafers that William Blair forecast will be needed per year by 2030 just for electric vehicles. These new applications are driving an additional 2.8 million 6-inch equivalent wafers annually by 2030 to address industrial, solar, electric trains, energy conversion and other applications.”
With that said, ON Semi is 88% of revenue, and thus it’s quite apparent EV-related customers have a larger need for AEHR’s testing equipment as new customers have not been able to shake ON’s large customer share. ON was 79% last quarter so this is increasing – although, as stated, AEHR is lumpy and so this could decrease again next quarter.
More on 800-volt Batteries:
In the call, management elaborated on the need for silicon carbide by 2025 to 2026. Specifically management stated it was due to 800 volt EV batteries. Management stated: “Per UBS in 2023, 91% of the batteries sold in electric vehicles are forecasted to be 400 volts and only 9% are 800 volts. But by 2026, UBS expects a percentage of 800-volt battery cars to be above 30%, which is why it appears so many silicon carbide suppliers are timing their major ramps to be in the 2025 to 2026 time frame.”
The 800-volt battery needs to be tested up to 1,200 volts AC. AEHR’s WaferPaks are able to test and burn-in wafers up to 2,000 volts whereas competitive systems spark and create damage at 900 volts. We’ve covered AEHR’s product extensively (see recommended reading below) yet this was another mention of AEHR’s competitive advantage that is notable.
This was also a big statement on the call product-wise: “In fact, we've never lost a head-to-head evaluation to a competitive product since introducing our FOX-NP and XP configured with the silicon carbide and gallium nitride test resources.”
Conclusion:
Overall, AEHR has a bright future but small caps are very volatile. This is where technical analysis helps quite a bit. For example, we moved to the sidelines during a drawdown in H1 2022 and then re-entered the stock and captured a 151% move from the August 2022 low. We will continue to use technical analysis especially for small caps, which carry much more risk than a large cap stock.
Interesting enough, Knox had stated last week that the $37 to $38 level is what he’s expecting to see. This level needs to hold for the earnings report to be a buy.
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For reference to terminology used, please look at technical analysis under our resources section here. Regarding the horizontal lines, black lines represent strong support/resistance, while dark red lines mark very strong support/resistance.here. Regarding the horizontal lines, black lines represent strong support/resistance, while dark red lines mark very strong support/resistance.
Elliott Wave counts are meant to provide context. Each colored count represents the most probable paths given the current price data. There is a pattern unfolding in real-time, one of which will play out. By monitoring price levels that are held/broken, it will help us figure out which one is in play, so that we can better manage risk.
Broad Market Analysis
The Larger Trend
The below image is a weekly chart of the S&P 500 (SPX). So, each price bar represents one week of price data. The weekly chart provides a great snapshot of the larger trend in play. There are currently two scenarios/counts that I am tracking, as of now.
Green – This is the primary scenario that I am game-planning for. In this count, we completed a large 5-wave pattern off of the COVID low, which topped in January 2022. This also completes the even larger 5-wave pattern that started on March of 2009, which, if true, would suggest a larger bear market is in play than just the 2022 drop.
What has followed the 2022 top has been the start of a secular bear market. That would make this year a cyclical bull market within the larger secular bear market. In Elliott Wave speak, 2022 was the (A) wave down, 2023 is the (B) wave up, and 2024 should be the final (C) wave down.
Where this puts us now is that we should see one more multi-month swing high before the larger (B) wave tops. As long as the current correction that we are in can hold 4163 SPX, I am viewing this volatility as a correction within a larger uptrend.
Red – This count is the alternative/secondary count that I’m tracking. The only difference between this and the green count is when the (B) wave will top. Green says it will top after we see one more swing higher. The red count says July was the (B) wave top and we are in the very early stages of the final (C) wave that is pointing towards 3000 SPX. If we break below 4163 SPX in the coming weeks, I will have no choice but to abandon the above green count, and shift into the red count as my primary.
I’d like to also point out the RSI on the above weekly chart. The RSI is a momentum indicator, and provides excellent clues on the strength or weakness of current trends. Note how the weekly RSI held that red trend line from the COVID low. The green arrows mark bottoms in a bull market.
Then note how that trendline, which was bull market support, became bear market resistance in 2022. We had a brief period where we reclaimed this key trend line, but we are well below that trendline now, which suggests that we are still in a bear market momentum pattern. Furthermore, note how the 2023 uptrend held the black trendline until recently, further supporting internal weakness in the market that is not seen in bull markets.
These are weekly charts, which means that we can still see a push higher. However, I would fully expect any push higher in price will be met with weaker momentum. What this means is that the market is on thin ice, and simply does not have the needed strength to keep pushing higher well into 2024, as of now. If we do hold the 4163 SPX pivot and turn back up for one more push higher, that red trend line will likely be the key resistance for tracking the top.
Cyclical Bull within a Secular Bear
If we zoom in on the 2022 top through today, you can see where I believe we are within this secular bear market. I have the first leg down (A) ending at the June low. This would put the move off of the October low as the C wave within a large (B) wave.
All C waves are 5-wave patterns, and the current structure looks incomplete. If accurate, the current period of volatility is a 4th wave suggesting a 5th wave push higher to complete the larger structure. This means that the larger trend is still pointing down, and the current “bull market” that we are in is a correction within this larger downtrend.
What would invalidate this scenario is if we drop directly through the 4163 SPX pivot. Below this level and the green count gets too stretched to be valid, which would put us directly into the red count. This would mean that the July top was actually the (B) wave top, and we are in the early stages of the final (C) wave within the secular bear market.
Since C waves are always 5-wave patterns, a drop through the 4165 pivot would suggest that we are in the 1st wave of a larger 5-wave pattern pointing us towards 3000 SPX. This 1st wave would target around 4000 SPX, which would then be followed by a large bounce back to, at least, 4200 SPX. If this plays out, the 2nd wave bounce is the last chance investors have to manage risk.
In conclusion, as long as any additional volatility stays above 4165 SPX, we expect a final swing higher to take us to new 2023 highs in SPX and NDX. Below this level, and the odds of a new high diminish greatly.
Another key point, which is also a warning, is that even though SPX and NDX suggest another high is probable, it’s important for investors to understand that most indexes/markets/stocks appear to have already topped. So, while SPX and NDX could make another high, many stocks will simply make a lower high.
Supporting Markets
NASDAQ-100 (NDX)
The tech-heavy NASDAQ-100 (NDX) appears to need one more drop to complete the current correction we are in. But, unlike the S&P 500, the NASDAQ-100 is in a more bullish posture. This correction, unlike in SPX, has not retraced a significant portion of the large breakout we saw earlier this year, unlike in SPX. So, it has higher probabilities to push to new highs even if the 4163 SPX pivot does not hold. If this plays out, I still view NDX in a larger (B) wave. So, expect us to continue to sell into any further push higher from here.
The Equal-Weighted S&P 500 (RSP)
It is important to track the equal weighted S&P 500 (RSP) vs. the market cap weighted S&P 500 (SPX). An equal weighted index gives the same percentage weighting to Apple as it does, say, Under Armour. In an expanding and healthy economy, we tend to see mid-caps outperform, as well as expansive growth in all stocks and sectors. So, when RSP is outperforming SPX, it tends to signal a healthy economy.
In the normal S&P 500, which is organized according to a stock’s market cap, the higher the price goes for a stock, the more of a weighting it takes up within the index. This is how you can have an index of 500 stocks being held up by a handful of mega cap stocks, as we are seeing right now.
The below chart compares the S&P 500, equal weighted S&P 500, and the top 7 stocks in S&P 500. As you can see, when you don’t allow for these 7 stocks to take up an outsized portion of the index, you get negative returns for the year, signaling broad weakness in the markets.
If we look at RSP alone, it has just broken the uptrend support that started at the October low. This is usually not a good sign, especially following such a weak and messy uptrend pattern. I believe RSP is leading SPX, and it is only a matter of time before Big Tech follows.
Ark Invest (ARKK)
We have nothing but respect for Ark and their research. The reason I am tracking ARKK is not to pick on them, but because they are a great benchmark for high beta tech, which I believe is also leading the broader market.
The bounce from the January low in 2023 is a perfect corrective pattern. Note how symmetrical it is, as it took the shape of a 3-wave pattern. This suggests that 2023, so far, has been a correction within a larger downtrend.
If accurate, keep in mind, that the larger downtrend is a 5-wave pattern. This means that the final drop will also be a 5-wave pattern. Note what pattern has just developed off the 2023 high. You can clearly see a 5-wave drop that is coming to an end. What this suggests is that the next rally will provide a lower high for ARKK, while SPX and NDX make a higher high. If this happens, it will be a big warning, and further confirm our green scenario.
Small Caps (IWM)
No matter how you count the current structure, IWM will not likely see an all-time-high (ATH) for some time. I have been tracking the structure since the 2022 low. It is definitely a triangle pattern, which only shows up in B waves and in 4th waves.
The question is – what direction is this triangle pointing? If SPX is in the red count, then IWM will likely lead with a sustained break down below $167. If SPX bottoms and begins tracing the green count that I laid out, then I expect IWM to also follow. This would have IWM make one more high in a direct fashion before topping out.
Financials
We’ve continued to warn about something brewing within the larger banks. Some of these charts do not look healthy, and suggest the red count in SPX should not be completely ignored. Below are the charts of two major banks in the US – Citigroup (C) and Bank of America (BAC).
They have both broken the major trend line that has been in place since 2009. These patterns look like 10 – 12 year bear flags. C is on the doorstep of confirming a head and shoulder topping pattern that has taken 3 years to play out.
There’s just no interpretation of the above charts that is not concerning. However, these are large patterns that have taken years to develop. So, they can allow for the green count in SPX to play out before letting go. If SPX and NDX make a new high in the green path, I’d look for these banks to trade sideways or make a muted lower high.
Regional Banks are also pointing lower after providing us with a similar pattern as ARKK. After completing a corrective looking bounce, we got a fresh 5-wave drop from the 2023 high. This is likely the 1st of 5 waves that will take us to the final target for this drop.
Note the divergence in momentum. This means the selling pressure is fading, which is common after completing a 5-wave drop. What should follow is a multi-week to month 2nd wave that will give us another lower high in the coming rally.
In conclusion, we are not seeing the type of breadth and leadership that accompanies a new bull market. Many economically sensitive stocks and sectors have put in a larger top, and are likely leading the broad market lower. However, the patterns in SPX and NDX both can allow for one more large rally to end the year. As long as SPX holds our 4163 pivot, we will be looking for this to play out. This means SPX and NDX will make a fresh high, while many of the other indexes and stocks discussed make a lower high.
Macro – The Two Most Important Markets
Once banks began to fail in Q1 of 2023, we saw a panic into cash and short positions in preparation for the next leg lower. This sentiment only fueled the next leg higher, as April saw its first of many upward surprises in economic growth. This was accompanied with a strong disinflation trend that has surprised to the downside for most of the year.
When we see growth accelerating and inflation decelerating, it creates the type of economic environment where high beta/risk-on investments tend to outperform. This is what we have seen since April through late July of 2023.
However, as early as July, we warned our readers not to celebrate a permanent victory over inflation. With history as our guide, we stated in our July Positions Report, “It is likely inflation starts to surprise to the upside again in the second half of 2023, further supporting the need for continued tightening until the economy enters a recession in Q4/Q1.”
We have been beating the drum each month that inflation will likely return, which could derail a richly valued market that is pricing in a FED pause. In the last CPI report we saw a bottom in inflation and reacceleration of the headline CPI print.
While the market tracks the YoY number, we prefer to track the 3-month annualized reading. The reason for this is because it provides better insight into the actual trend in play. Also, in order for the YoY number to reach the FED’s 2% target, we will need to see several readings at or below the YoY target. So, it is a measure that can help you see the developing trend.
From this perspective, the 3-month annualized CPI print bottomed at 1.9% and has reaccelerated to 3.9%. Though we have seen a nice deceleration in core inflation from its 5% range to 2.4%, this is nowhere near enough to get us to the FED’s 2% YoY target, and it wasn’t enough to offset the move higher in oil.
What we are dealing with now is a return to an uptrend in crude oil prices. After a very long and complex correction, crude oil has given us several higher highs, while reclaiming key levels from the prior downtrend. What’s even more concerning is that we have a very clear 5-wave bounce from the May low. This implies that a new uptrend is underway, which, if accurate, should target new highs.
How this lines up with the green count in SPX, suggesting one more multi-month swing high, is that oil is due for a reasonable pullback in both time and price, which is currently underway. The first 5-wave pattern off the low took ~4 months to complete. I would expect the coming 2nd wave retrace to be about 1.5 – 2.5 months long. This will relieve inflation concerns, rates, and also provide a path higher for equities.
The other key market to track is the US Dollar. I track the Dollar Index (DXY), which is a basket of currency pairs against the dollar. What is undeniable in this market is the inverse relationship between DXY and US equities.
The reason for this relationship is based on the abundance of global debt denominated in the US dollar. Some estimates claim that $12 Trillion of global debt is denominated in the US Dollar, while others have claimed its even as high as $65 Trillion. This would be debt in US dollars coming from non-US banks and shadow banks. These figures are in relation to a global GDP of $104 Trillion.
Regardless of the actual denomination, with so much global debt priced denominated in dollars, when the dollar goes up in value, compared to a country’s own currency, the cost to service this debt is also going up. This drains liquidity from that foreign economy, which is less money to spend on stocks. Adversely, the opposite is true, which is one of the reasons why we have seen such a sharp increase in US equities. As the dollar has dropped sharply from its high, global liquidity has also bottomed and slowly trended up.
If we analyze DXY, it appears to be in the final stages of the corrective rally within a larger correction. It hit the middle target around $107; however, the structure looks like it can extend towards $108 in the coming days/weeks. It could even extend a bit higher, but the bigger picture has DXY, and the US Dollar, continuing its downtrend once this corrective rally is over, which should be good for US equities.
In conclusion, we believe the body of evidence supports one more push higher in equities that could take us into early 2024. However, in order for this to pan-out, we need oil to pullback along with the US Dollar. This will open up global liquidity while relieving pressure on inflation concerns, and therefore rising rates.
We do not believe the growth data in the US supports a Q3 recession, which lines up with a Q4/Q1 top due to an inevitable recession. With the US growth story remaining resilient, and sentiment approaching extreme bearishness, again, the setup is there for this final swing higher.
I/O Fund Portfolio
We remain in a defensive posture due to the on-going macro risks that have yet to be resolved. We do believe a recession is inevitable, and continue to target Q4-Q1 for this timeline. Until then, we do not see the FED starting a new liquidity cycle, which has been a necessary ingredient for lasting bull markets.
However, the next swing higher, if it manifests, could take us into Q1 of 2024. So, we have been adding to our longs by building a large position in Crowdstrike, starting a new position in Enphase, and adding to existing positions, like AMD.
We do not believe this environment nor these prices are good long-term positions. We also believe the risk is quite high without a nimble exit plan. Our intension is to raise more cash if/when we reach our target for the green count.
Advanced Micro Devices (AMD)
The drop from the June high in AMD looks corrective. In other words, the red count suggests a top in June and the start of a C wave to new lows. However, the structure of this drop does not look like a 5-wave pattern, which we would expect to see in a C wave drop. So, I’m leaning towards a low in our bottoming area, and a push to new 2023 highs, which will complete this pattern. We need to hold the $89 support on any further weakness, or the count that can take us higher is likely over.
Nvidia (NVDA)
There are 3 potential counts I’m tracking with NVDA. The green count has put in a bottom in the 4th wave, and we should see a direct trend towards $545 – $575. The blue count is a variation of the green count, which still should see a push towards $545 – $575. The only difference is the 4th wave decline we are in. This count would have us push towards the $355 level before finding a bottom. The red count would have us break below the $340 critical support zone. If we do this, then the top is in, and we will start developing a new buying plan, targeting much lower levels.
Aehr Test Systems (AEHR)
My confidence in AEHR’s chart is not high. The structure has become so complicated that I went back and re-worked the entire count from scratch. I would like to see AEHR drop and hold around $37. If this happens, I will likely buy. If we break below $37, that’s not a good sign, but it still leaves a path higher. From every count that I can create with the current price data, none can go below $23 and still suggest another push higher. So, that is the critical support level to monitor.
Bitcoin (BTCUSD)
BTCUSD has been stuck since April. With its failure to breakout over $32,000, it keeps the door open that we could push lower to make a new low. As long as we stay above $20,000, I’m leaning towards a continued consolidation with one more push lower, followed by a breakout over $32,000. If we instead breakout over $32,000 directly, then the low is in, and we can shift towards buying the breakouts.
Microsoft (MSFT)
MSFT can make a push lower towards $307 or $301 and still allow for a new 2023 high. There is a lot of support in this region. If MSFT breaks below $293, then the green count will be taken off the board, and the red count will become my primary. Considering how important MSFT is to the market, this would have implications across the board.
Crowdstrike (CRWD)
Unlike many stocks, CRWD has a clear path to go much higher from here. This does not mean that it will take this path, but it is notable that it is present. Most stock that I track do not have a path with this much upside in them. Crowdstrike can suffer a drop as low as $118 and still hold this upside potential. Below this level and we are heading towards $75.
Ethereum (ETHUSD)
ETHUSD has the same setup as BTCUSD. I’d allow a 2nd wave retrace to $1265, but below this level and the larger breakout setup is in question. The confirmation price for the larger breakout is above $2285.
Netflix (NFLX)
With NFLX going below $382, the odds of a new high, as shown in the green count, are diminishing. It needs to reclaim that trend line and break above $395 very soon to negate the breakdown setup. We took heavy gains at $408 and $448 due to this potential setup playing out. We will continue to trim NFLX on any extended bounce from here.
Marvell (MRVL)
MRVL’s break below $52 has made the possibility of a new 2023 high less likely. I’m not liking this count, and struggling to make sense of what’s next. We like MRVL as an AI play, but we are likely early. If we do sell out of this one, expect us to get back in at lower prices. We will wait to see what kind of bounce we get from here. If we instead go directly below $48, we may stop out.
Supermicro (SMCI)
SMCI went from being the perfect setup to buy, to becoming a mess. My best interpretation has us making another leg lower towards $205-$195 from here. However, this runs counter to what I’m seeing in a lot of other stocks. So, if we do see another leg towards our target, we will buy. On the other hand, if we see a breakout above $305, I’ll consider the low in for a very ugly correction, and we will setup new overhead targets.
Chainlink (LINKUSD)
LINK’s range-bound consolidation has been nothing short of epic. After looking back at various exotic Elliott Wave patterns, I’m convinced that LINK’s consolidation is what’s called a barrier triangle. This is an extended consolidation that stays on a horizontal plane. It is almost always seen as a 4th wave, meaning we should see a final drop towards $3.5 to complete this large degree correction. This is where we will heavily buy. If we do not get that low, for me to consider the low as in, I’ll need to see a break above $11.
Enphase (ENPH)
Enphase has gotten hammered this year, moving in the exact opposite direction of big tech. We are seeing signs of selling exhaustion while we approach the final parts of this very large corrective pattern. I’m expecting a bounce soon, which should take us to $145, at minimum.
Taiwan Semiconductor (TSM)
TSM has topped. After giving us a complete 3-waves up off its low, it has broken the trend channel in an obvious 5-wave pattern pointing down. We will look to close it on the next larger bounce.
For those new to AEHR, please reference Recommended Reading for product thesis, previous earnings coverage and more. All of our Must-Read Theses for the I/O Fund Portfolio are located here.are located here.
AEHR is the rare small cap that has top line growth coupled with bottom line strength. We recently discussed what comprises a defensible portfolio in tech in our Q3 Kickoff webinar. AEHR fits the criteria we outlined in the webinar, and has seen a high allocation at times in our portfolio because of how many boxes it ticks. It’s both the consistent revenue growth andand the bottom-line growth that causes this stock to defy the odds.
AEHR has seen a ramp in demand over the past three years because silicon carbide is replacing silicon in electric vehicles. Tesla was the first to adopt silicon carbide for the 2018 Model 3 by working with ST Microelectronics to add SiC MOSFETs to an inverter design. The result was a more compact, lighter inverter at 4.8Kg compared to Si IGBT inverters that weigh 2-3X more (8kg to 12kg). SiC inverters offer 97% efficiency, resulting in more range, and this is achieved without the need to increase battery capacity.
As also pointed out in our previous write-up, by withstanding higher temperatures combined with lower switching losses and lower thermal resistance, silicon carbide (SiC) can handle more power while using less energy. SiC reduces the power consumption and reduces the size of power supply systems that require high-voltage conversion, which makes SiC especially compatible with electric vehicle (EV) on-board chargers and solar photovoltaic power systems.
Financials:
AEHR will be going through a few quarters of rapid growth.
Revenue:
This quarter, the company is expected to report revenue of $19.3 million, for growth of 80.4%. The next few quarters are also expected to be strong on growth (see below).
Fiscal year estimates have remained unchanged since the last earnings report at 58.4% growth for $102.9 million in revenue. Management provided guidance for at least $100 million in revenue, or 50% YoY growth.
Notably, the next two years look stable for AEHR at 55% growth expected in FY2025 and 42% growth in FY2026. There are only two analysts covering the stock for FY2025, and only one analyst covering the stock in FY2026. However, it helps to see there isn’t a sudden drop off in growth expected (as of now). There was a downward revision of 17% over the last month for the upcoming quarter, however, with fiscal year estimates remaining steady, it’s a matter of this revenue being recognized later in the year.
Pictured Above: AEHR is approaching a few quarters of rapid growth
EPS:
EPS of $0.23 in the last quarter beat expectations by 7%. In the upcoming quarter, the company is expected to report EPS of $0.16. Overall, earnings will nearly double in FY2024, per management guidance of “GAAP net income of $28 million for at least 90% earnings growth.” As growth investors who want defensible companies this is music to our ears.
Margins:
As stated, AEHR is one-of-a-kind in terms of being a small cap tech stock with strong margins.
Gross margin last quarter of 51.5%. This can be impacted by 1-2% based on product mix and freight costs. Overall, it’s been ticking upward and has been in the low 40% and mid 40% range a few times over the past eight quarters.
Operating margin last year of 20.6% has seen stellar margin expansion from 15.4% for the previous fiscal year. The operating margin last quarter was 25.3%.
The company pays stock-based compensation of 3% for an adjusted operating margin of 27.4%.
Net margin grew 380 basis points last fiscal year to 22.4%. The net margin for the quarter was 27.4%.
Cash Flow:
Operating cash flow has been lumpy overall but was very strong last quarter for 800% growth to $5.87 million. This led to a cash flow margin of 26.4%. However, this is unusual. The previous op cash flow margins were 3% and 15.4% in FY2022 and FY2023, respectively.
Similarly, the free cash flow margin last quarter of 21% was higher than usual. For previous fiscal years, the FCF margin trended at 2% in FY2022 and 13.3% in FY2023.
This helped the company’s cash position grow 52% in the most recent quarter to $47.9 million. The company has no debt.
The company has also been exercising at the market (ATM) offerings. The company sold $7.9 million worth of shares in the third quarter and expects to sell shares worth $17.7 million in the upcoming fiscal year.
Key Metrics:
The company has been increasing its inventory in anticipation of heightened demand. The inventory stood at $23.9 million last quarter, for an increase of $2.3 million. Per the January earnings call: “We are increasing inventory to support our expected growth in the second half of fiscal 2023, and we continue to purchase inventory to ensure adequate supply to meet current customer and future customer market demand.”
Bookings in the fourth quarter were $15.2 million, up from $4.4 million in the year ago quarter. These are lumpy but can cause the stock to move quite a bit during a good quarter. What we want to see is FY2024 exceed FY2023, which was at $87.7 million. The highest quarter in company history was fiscal Q3 ending in February at $33.3 million.
Last earnings call, management stated there was more than $15 million in bookings received in the first six weeks of Q1. Let’s see if this quarter can meet or exceed the company’s previous record of $33.3 million. This has led to an effective backlog of $40 million.
Backlog is also lumpy at $24.5 million, up 121% last quarter. As long as these trend upward, the lumpiness is to be expected. In the previous quarter ending in February, the backlog was $31.6 million.
What to Watch For:
Bookings and Backlog are important for this stock. As stated, these can be lumpy but have been trending at historical highs for the company.
AEHR received an order on September 18th that will likely be discussed on the call. The order will be filled by end of calendar 2023. According to the press release, this is an initial order from a new customer. The customer is “a US-based multibillion-dollar semiconductor supplier serving several markets including automotive, computing, consumer, energy, industrial, and medical.”
Look for AEHR to increase its number of customers as we move along over the next few quarters. According to a Craig-Hallum analyst, AEHR may be engaged “with up to two dozen” potential SiC customers.
We’ve been reporting for quite a few quarters that H2 2023 is expected to be strong for the automotive supply chain. Let’s hope this materializes. In the January call, this was stated: “And as we had — if you look at the amount of capacity that everybody’s talking about to hit in 2025 calendar-wise, most people are just really focused on second half 2023 and into 2024 is where just a lot of capacity is coming online and so it may be less to do with the timing of us as the timing of that silicon carbide ramp. And our goal is to get qualified before that ramp happens and have a ton of capacity and material on hand to be able to address it.”
Additional catalysts are silicon photonics and gallium nitride, which have been covered in the recommended reading below.
Our next quarterly webinar with analyst Beth Kindig will be held the week of October 16th. Details will be sent via email.
Portfolio Manager Knox Ridley’s next Positions Report will hit your inboxes October 5th. Keep an eye out for his thoughts on AEHR and other positions the I/O Fund owns headed into earnings. In this webinar replay from last week, he also discusses AEHR.webinar replay from last week, he also discusses AEHR.
This article was originally published on Forbes on Forbes Forbes on Sep 29, 2023,12:05am EDT
Cybersecurity is one of the highest costs that enterprises face at 12% of IT budgets on average, and this cost is rapidly rising. While a company can lay off staff or reduce marketing and R&D expenses during a period of lower growth, enterprises cannot compromise on cybersecurity. The rise in the number of attacks and the increased sophistication of attacks means this expense will continue to grow, yet AI and automation can help.
According to Cybercrime Magazine, if cybercrime were a country, it would be the world’s third-largest economy, second to the United States and China. The costs that enterprises dedicate to cybersecurity are expected to increase from $8 trillion to $10.5 trillion by 2025. Statista agrees with Cybercrime Magazine’s estimates, stating the cost of cybercrime will reach $10.3 trillion by 2025 and $13.8 trillion by 2028.
At the I/O Fund, we are positioning for AI and automation to play an important role in this critical, no-compromise industry. There are 560,000 new pieces of malware detected every day, and software systems cannot keep up with this. AI is already assisting human teams in identifying which threats require more analysis, and in the near-term, this will meaningfully lower cybersecurity costs. There is also a shortage of cybersecurity talent, with a 2022 survey stating 59% of companies have a shortage in this department and may not be able to effectively handle a cybersecurity attack.
Below, we look at how AI is set to disrupt cybersecurity next and what is being said on the topic.
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How AI Can Improve Incident Response and Threat Detection
Combining cybersecurity with AI has a natural affinity as cyberattacks are computer generated, and in turn, computers are uniquely capable of finding computer-generated threats. Automation reduces the number of false positives. Instead of getting every piece of telemetry that requires the security team to investigate, AI-assisted endpoint detection and response solutions eliminates the noise so that the security team is only responding to those that have the potential to be critical.
Fundamentally, cybersecurity is a data problem. Cybersecurity platforms ingest, correlate, and query petabytes of structured and unstructured data from disparate external and internal sources in real-time. Cybersecurity platforms then build rich context and deliver greater visibility by constructing a dynamic representation of data across an organization.As a result, AI-driven cybersecurity platforms are often highly accurate in triggering a response.
The number of endpoints in a corporate network are exponentially growing with 27 billion endpoints expected to be connected by 2025. There have been staggering studies done that show 68% of enterprises have experienced a compromised endpoint. Compromised credentials across desktops, laptops, and mobile devices are often the hardest points of access to secure. Algorithms can detect new malware on endpoints based on the attributes of known malware. Unauthorized access, data breaches and cyber threats from endpoints will also help to drive demand for edge-based, decentralized AI cybersecurity solutions.
The network security market is a large contributor to cybersecurity spend. Machine learning algorithms help systems to learn by experience, which helps to identify malware in encrypted traffic and find insider threats. Machine learning algorithms do not need to decrypt, rather can spot the malicious patterns and find threats hidden with encryption.
Cloud security is the fastest growing segment within cybersecurity. AI/ML can help to identify suspicious cloud app logins, detect location-based anomalies, and quickly identify threats through IP reputation analysis. Threat prevention is possible through ingesting cloud telemetry with AI systems, foregoing the need for expert rule engineering. Attack path simulation is also made possible with AI, to help simulate the path an attacker would take to reduce coverage gaps. Egress web traffic can be monitored without the need to configure virtual machines by focusing on limiting egress based on source, identity, destination and request types. Machine learning models can also detect new API threats based on large training data sets. These are a few examples of how AI/ML is improving cloud security.
Chat-GPT heightens security risks as generative AI is capable of writing malicious code or acting as a sidekick to the human hacker writing malicious code. To level the playing field, the best defense will also be self-learning, generative AI tools. The downloads for Chat-GPT have plateaued considerably among consumers. Meanwhile, the use of Chat-GPT among hackers is rising on an exponential curve. This helps illustrate why the adoption curve for AI may be healthier among enterprises (rather than consumers) in the medium-term.
According to Mackenzie Jackson, a developer advocate with GitGuardian, Chat-GPT is likely to give rise to a greater number of hackers. This new generation is called “AI Hackers” because previously they could not hack on their own, but are now able to hack with generative AI as their sidekick.
Source: RAPID7: BAIN & COMPANY
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.
What the C-Suite is Saying About AI & Cybersecurity
McKinsey released a recent report where 53 percent of organizations believe generative-AI is driving new risks in cybersecurity. Not only can AI help enterprises expedite threat detection, but hackers can also expedite the end-to-end attack life cycle. In another survey, 38 percent of enterprises stated they are mitigating AI-related cybersecurity risks compared to 32 percent who are mitigating inaccuracies, indicating cybersecurity is the top risk that is AI-related at this time.
According to Forbes, 56% of enterprises ranked governance, security and auditability issues as their highest-priority concern with AI/ML spend. This survey was completed in 2021, and it’s likely this number is higher today.
What Public Company CEOs are Saying
Microsoft has one of the largest cybersecurity businesses in the world at $20 billion. This is larger than six best-of-breed companies combined. The company has been working for years on new automation features called CoPilot, which was released to the public this month. Although it’s being marketed for Windows, Office 365 and the browsers Bing and Edge, yet will also become an AI companion for it’s cybersecurity business. Per the CEO in the most recent earnings call: “our Security Copilot, the first product to apply this next generation of AI to SecOps will be available to customers via paid early access program this fall.”
Source: BETH KINDIG'S TWITTER
Palo Alto Networks is a company that has outsized returns this year of up to 78% following the most recent earnings call. It’s currently trading at 66% gains YTD. The CEO stated in the most recent earnings call: “I think what's important to understand is that over the last five years, cybersecurity TAM has continued to rise. It has grown at approximately 14%, and it has grown twice the pace at which the IT market has grown […] and possibly now with the sort of arrival of AI as a mainstream opportunity, every one of us is trying to make sure we grab that with both hands. So, we will continue to see the pace of technology spend go sort of up or forward.”
Source: YCHARTS
Cloudflare is a stock that is up 35% YTD and is edging out the Nasdaq-100 this year, which is no small feat given the rally Big Tech has seen. The CEO recently stated that his company is seeing an uptick in business on their R2 product: “And by our estimates, Cloudflare is the most commonly used cloud provider across the leading AI startups. They're using R2 to help arbitrage the lowest GPU cost to train their models.”
Conclusion:
Using AI to identify threats and for pattern recognition and anomaly detection is not new by any means. Rather what is rapidly coming to market are platforms enabled with generative AI and automation that is self-learning, so that a threat is detected before it occurs rather than after the cyberattack. Rather than threat detection, the ultimate goal is threat prevention.
AI will not entirely replace security professionals anytime soon, but it can contribute to efficiency by automating threat detection, analyzing data sets, and by continuously learning to identify anomalies and new attacks before they occur. By offering agentless solutions, theoretically, fewer human agents will be needed. For new technologies, the adoption curve can be challenging (go ask virtual reality enthusiasts how that’s going). But for industries where AI can offer a value proposition that can predictably lower costs at a reasonable price, a market will form. We think one of the next markets to be disrupted by AI will be cybersecurity.
If you own cybersecurity stocks, or are looking to own cybersecurity stocks, we encourage you to attend our weekly premium webinars, held every Thursday at 5:00 pm EST. Next week, we will discuss a cybersecurity stock we recently entered and one that we are eyeing closely – what our targets are, where we plan to buy, as well as where we plan to take gains.
I/O Fund Equity analyst, Royston Roche, contributed to this analysis.
