Month: April 2024

Super Micro Q3 Pre-Earnings: Puts and Takes for the AI Bullet Train

Posted on by io-fund

In our last write-up, we called Super Micro the “AI Bullet Train” due to neck-breaking growth rates. Last quarter, the company reported a notable 103% year-over-year growth, with revenues surging to $3.66 billion. Management's projections are for nearly double the growth, anticipating Q3 revenues to range between $3.7 billion and $4.1 billion, or growth of 204.7% year-over-year at the midpoint. Consensus estimates are for $3.92 billion, for 206.3% growth expected in tomorrow’s print.

Such predictions underscore a consistent upward revision in earnings guidance, reflecting anticipated strong growth for the remainder of the fiscal year and extending into 2025.

To understand how we got here, it was through multiple analyst revisions. For example, the March quarter started with estimates of $2.1 billion in August for growth of 45% but were revised by 160 points (!) to $3.92 billion for growth of 205.7%. The June quarter was seen upward analyst revisions increase by 92 points, and the September quarter’s numbers revised by 82.7 points in the span of one quarter!

Here's what that looks like:

The takeaway is that Super Micro’s bullet train-like price action is based on upward revisions, which is unique from earnings beat/raise or simply strong estimates. In fact, the stock was down (-12%) following its last earnings report and is now up 80% since that call with gains as high as 135%. This is a stock that does not rely on earnings pops, like most growth stocks, and rather, it requires a bit of tenacity as the intra-quarter changes have been quite profitable.

With that said, below is a deeper look into SuperMicro, including the underlying factors contributing to these impressive figures ahead of tomorrow’s Fiscal Q3 results and the risks that accompany this high beta stock.

Revenue and EPS

Last quarter, the company’s Q2 FY2024 revenue grew by 103% YoY to $3.66 billion. Management Q3 guidance is in the range of $3.7 billion to $4.1 billion, representing YoY growth of 204.7% at the mid-point. The consensus analysts’ estimate is $3.92 billion, representing a YoY growth of 206.3%. The guidance has increased consistently through recent months as strong growth is expected for the remaining quarters of the fiscal year and into 2025.

The drop off in Q2 FY25, which is calendar year Dec 2024, will be key to keep an eye on following this earnings report. It may seem far off but this is a high beta stock that gets slammed on any weakness. The opposite can also happen, which is that we see more revisions which supports the price action extending, as outlined in the introduction above.

Fiscal year estimates were revised upward over the past year by 87.8 points for growth of 105.5% and revenue of $14.6 billion. This is higher than the midpoint of management guidance for revenue of $14.5 billion, at the midpoint. Next fiscal year ending June 2025 has been revised upward 33 points to 44% growth. We will be watching these estimates closely as we manage our position intra-quarter throughout the next few months.

GAAP EPS for December was $5.10 compared to analysts’ consensus of $4.90. This is nearly 80% higher sequentially with $2.85 GAAP EPS in the previous quarter and is 62% growth from the year-ago quarter. Adjusted EPS was $5.59 for similar YoY and QoQ growth.

Looking forward, next quarter’s GAAP EPS is expected to be between $4.79 and $5.64 for over 240% growth from the year-ago quarter. Adjusted EPS of $5.60 at the midpoint will see similar YoY growth.

Note: Normally, we’d be hesitant to see the slowing growth on both top line and bottom line pictured above as moving from hypergrowth to average growth tends to cause a re-rating in valuation. However, we’d like to see if SMCI will continue its pattern of seeing upward revisions given the strength of the AI trend.

Margins

  • Gross margin was 15.4% in Q2 for gross profit of $564.4 million
  • Operating margin was 10.1% for operating profit of $371.5 million and adjusted OPM was 11.3%
  • Net margin was 8% for net profits of $295 million. Adjusted net margin was 9%

Adjusted gross margin was 15.5% for Q2, compared to 17% in Q1 and 18.8% in the same quarter a year ago. On the gross margin declines, management stated: “in order to take market share, we will take opportunities by being more competitive on pricing.”

The gross margins guide for Q3 is expected to be “slightly lower than Q2 levels.” This indicates another YoY and QoQ decline in gross margins if the management’s guide is correct. The goal is that margins will return to baseline once the company is operating at scale. However, it’s worth mentioning that stocks with thin margins tend to underperform in a Fed-driven market. This is one reason we will adhere to stops with SMCI.

Margins on SMCI tend to be thinner than most semiconductors, which is a key topic of analysts’ focus during each earnings call. The CFO has stated the target margin is between 14% and 17%.

Cash Flow and Balance Sheet

Operating cash flow reached (-$595) million, with a margin of (-16.2%). This performance contrasts with the positive margins of +12.8% and +9% reported in the September quarter and the June quarter, respectively.

The CFO explained that the cash outflow in operations for Q2, totaling (-$595) million, was a shift from the $271 million generated in the prior quarter. Despite robust profitability and an increased level of accounts payable, this was counterbalanced by a rise in inventory and accounts receivable, driven by preparations for Q3 and shipment timings in Q2.

Cash flow will be a primary focus on the call as any additional quarters that report negative free cash flow will force investors to price-in future stock dilution and cash raises. This line item can cause the stock to be re-rated should it continue to be weak.

Free cash flow was also negative at (-$610) million, representing a (-16.6%) margin, compared to positive margins of +12.7% last quarter and +8.4% in the corresponding quarter of the previous year.

On its balance sheet, the company reported $726 million in cash and $376 million in debt, up from $543 million in cash and net debt of $146 million in the previous quarter. Consequently, the net cash position stood at $350 million, slightly down from $397 million in the last quarter.

The company boosted its cash reserves with an equity offering. As stated by the CFO, the proceeds from the equity offering will be used to strengthen working capital, continued investments in R&D and expand global capacity.

Key Metrics:

In the latest quarterly financial update, the OEM Appliance and Large Data Center segment led the company's revenue streams, contributing $2.15 billion, which accounts for 59% of total revenue. This segment saw significant growth of 175% year-over-year and 83% quarter-over-quarter.

The Organic (Enterprise & Channel), AI/ML segment followed with $1.48 billion, making up 40% of the revenue and growing by 55% year-over-year, fueled by enterprise AI initiatives and CPU upgrade programs. The 5G, Telco, and Edge/IoT sectors, however, represented just 1% of revenue at $35 million.

In terms of the revenue mix, server and storage systems generated $3.4 billion and comprising 94% of the quarter's revenue, reflecting a year-over-year growth of 107%. Subsystems and Accessories contributed $229 million, accounting for the remaining 6% of revenue and marking a 61% increase from the previous year.

Inventory management improved, with inventory days reducing to 67 from 91 in the previous quarter, indicating a tightening of supply as noted by the management.

What to look for in the earnings report:

1) Declining margins are going to be a key focus of analysts.

Notably, Super Micro has weaker margins than Wall Street prefers and tend to be weaker amongst its peers. It’s no surprise when analysts pick up on this during the call and slide in a question or two on it.

Last quarter, there was a large revenue beat that did not flow through to a higher gross margin or operating margin, and in the following Q&A session, the CFO stated: “And so, at this time we are we are growing really quickly. And in order to do that and in order to take market share, we will take opportunities by being more competitive on pricing.” The CEO followed up with: “The good thing is that when we continue to grow our economies of scale, our operation margin indeed will be still able to keep in healthy position.”

2) Nvidia Relationship – Liquid Cooling Reaches Inflection with Nvidia’s B100s

Super Micro is primarily air cooled right now, yet liquid cooling is growing. Per the CEO in the opening remarks, we can expect major updates in the coming quarters on their progress: “By this June quarter, we will have high volume, dedicated capacity for manufacturing 100 kilowatt to 120 kilowatt racks with liquid-cooling capabilities, providing DLC, direct liquid cooling racks capacity up to 1,500 racks per month and our total rack production capacity will be up to 5,000 racks per month by then.” To read more on liquid cooling, reference our previous Super Micro analysis here.

3) Conservative Commentary by Management

This word, “conservative,” has been continually referenced by management in recent quarters. We hope to continue to hear the twelve-letter C-word from SMCI tomorrow evening!

David Weigand

“[…] And so really as Charles mentioned earlier, our only constraint is supply. However, the good news is, the supply is improving. And so, to your point, we have to be somewhat conservative, because we are constrained still by supply.”

Conclusion:

Despite facing declining gross margins, the firm's substantial year-over-year revenue and EPS growth underscore its product strength and positioning in a fiercely competitive environment. In case it’s not clear, Super Micro is an outlier and it all comes down to product differentiation, which you can read about here.

The stock seems to be on a never-ending winning streak, however, what could be Super Micro’s Achilles heel is the cash issue — as the company must grow capacity to keep up with the revenue growth, yet to do so will require cash.

Due to the high beta nature of Super Micro, I foresee us trying to ride this wave a few more times in the coming years. We will play this one with the understanding that volatility goes both ways, armed with the information that it’s the upward revisions that reward this stock (mainly intra-quarter), and it’ll be negative cash flow margins and/or dilution that penalizes the stock.

Overall, for our risk profile, entries in high beta stocks are accompanied by a strategy and with predetermined stops. You can read more about our line in the sand here along with upper price targets.

Chad Shoop, Equity Analyst for the I/O Fund, contributed to this analysis

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AMD Q1 Earnings Preview: $3.5B GPU Revenue is the Benchmark

Posted on by io-fund

AMD heads into its fiscal Q1 report with rather high expectations, after management raised FY2024 GPU revenue forecast by 75% last quarter to $3.5 billion plus. Earnings reports last week from Microsoft, Meta and Google reaffirmed a bullish outlook on AI infrastructure spending for 2024, with all three combining for at least $135 billion in capex this year, with management commentary signaling a bulk of that spend will go to data center infrastructure and GPUs.

Therefore, data center revenue and GPU commentary are in focus this report. Yet, it’s key to be objective, and to note for our Members that some analysts are toning down estimates on the data center. Given the channel checks that analysts can do on a company like AMD, the polarized nature of the commentary going into the print tomorrow is interesting. We include analyst commentary below.

As a reminder, just last quarter analysts were setting a very high bar with some pushing for a $6 billion GPU revenue guide for the full year. We are seeing as low as $4 billion and as high as $8 billion. This wide of a range on a key metric is highly unusual, — and investors should be aware, it’ll be nearly impossible for AMD to beat the high-end of the FY expectations for the data center in Q1.

Therefore, it’s important we come up with our own expectations, of sorts. Broadcom is in second place with $1.5B in AI revenue, or $6B annual run rate. Due to analysts muddying the water a bit here on what is reasonable for a Q1 discussion on the call tomorrow, I think a decent goal (and win) would be for AMD to have GPU revenue equal to 2023 data center revenue by the time we exit the year, which was $6B. This number is also in line with AVGO’s current AI revenue and is the midpoint of analyst estimates.

Revenue and EPS:

  • Q1 revenue was guided to be $5.4 billion, +/- $300 million, for YoY growth of approximately 0.9% and a QoQ decline of (12.5%). Analysts are expecting slightly higher revenues of $5.45 billion for YoY growth of 1.9%. As you can see above, Q1 should mark the bottom with a strong ramp into Q1 of next year.
  • Q1’s adjusted EPS is estimated to be $0.61, for YoY growth of 1.3%. Adjusted EPS growth is expected to accelerate to 90% by Q1 of next year.

Q2’s guide will be important to track. Susquehanna noted Monday, after lowering its price target, that it is “expecting in-line to slightly weaker guidance as Server/PC/XLNX/Gaming continue to weigh.” Q2 revenue is currently estimated to be $5.69 billion for YoY growth of 6.2%.

Key Segments:

Data Center: AMD guided for Q1 data center revenue to be approximately flat QoQ, implying revenues of $2.3 billion for YoY growth of ~77%. This is due to “a seasonal decline in server sales offset by a strong Data Center GPU ramp.”

Data center revenue, and more importantly, MI300 revenue is likely to be the most critical aspect of Q1’s report and Q2’s guide, as analysts are simultaneously resetting and increasing expectations for MI300 revenues in April. This will be discussed in more detail in the section “MI300 GPU Sales in Focus” below.

For the full year, management said “the largest incremental revenue opportunities are going to come from Data Center between both the server side gaining more share, and Data Center GPU side with the significant ramp up of our MI300.”

Client, Embedded, Gaming: AMD guided for Client, Embedded and Gaming segment sales to “decline sequentially, with semi-custom revenue expected to decline by a significant double-digit percentage.”

Margins:

Adjusted gross margin is guided to be 52% in Q1, a 120 bp QoQ expansion as data center mix increases.

Adjusted operating margin is expected to be 20%, a ~300 bp QoQ contraction and the lowest level in three quarters. However, data center operating margin has expanded significantly over the past two quarters, from 19.1% in Q3 to 29.2% in Q4. For context, DC generated $666 million in operating income in Q4, up 118% QoQ and the most of any of AMD’s segments.

CFO Jean Hu shed more light on both the trajectory of margins and DC margin in Q1 and the rest of the year:

“We guided the Q1, 120 basis points higher than Q4 sequentially, primarily because the higher Data Center contribution actually more than offset the decline of Embedded business in Q1. Going forward, the way to think about it is as you said is the major driver is going to be Data Center business is going to grow much faster than other segment. That mix change will help us to expand the gross margin nicely. I think you also are spot on, the Embedded coming back in second half, which will be a tailwind. With the Data Center GPU, we are at the very early stage of ramp. We are improving testing time yield and continue to expand gross margin and we expect to be accretive to corporate average. So, those are all the tailwinds coming in the second half. I would say the headwinds side continue to be in the first half where we see Embedded business not only Q1 we see sequential decline, Q2 probably are going to be sequentially flattish versus Q1.”higher Data Center contribution actually more than offset the decline of Embedded business in Q1. Going forward, the way to think about it is as you said is the major driver is going to be Data Center business is going to grow much faster than other segment. That mix change will help us to expand the gross margin nicely. I think you also are spot on, the Embedded coming back in second half, which will be a tailwind. With the Data Center GPU, we are at the very early stage of ramp. We are improving testing time yield and continue to expand gross margin and we expect to be accretive to corporate average. So, those are all the tailwinds coming in the second half. I would say the headwinds side continue to be in the first half where we see Embedded business not only Q1 we see sequential decline, Q2 probably are going to be sequentially flattish versus Q1.”

Cash and Debt:

AMD reported operating cash flow of $381 million in Q4 for a margin of 6.1%, and FY23 OCF was $1.67 billion for a 7.4% margin. Free cash flow was $242 million in Q4 for a margin of 4%, and FY23 FCF was $1.12 billion for a 4.9% margin.

Operating cash flow growth is expected to unfold as one of the larger fundamental recoveries in 2024. Current estimates point to nearly 277% YoY growth in OCF to $6.28 billion, or a margin in the 24% range based on current revenue estimates of $25.7 billion for the year.

AMD has $5.77 billion in cash and equivalents on hand, and total debt of $2.47 billion.

MI300 GPU Sales in Focus

As noted earlier, AMD’s MI300 GPU revenue outlook for the full year will be the most important data point coming out of Q1’s report, after AMD increased its outlook by 75% last quarter.

Analysts are hinting towards possible weakness in Q1 due to rumors of Microsoft cutting some orders, though other analysts are expecting full year GPU revenue of $8B, more than double AMD’s guide. This is setting up an interesting scenario in which even if AMD surprises with better-than-expected GPU revenue in Q1, the full year picture may still disappoint against outsized expectations for $4.5B+ all the way to $8B.

Here’s some recent analyst commentary and updated expectations for GPUs:

  • Susquehanna analyst Christopher Rolland said it is likely that “upward revisions to the MI300 are ‘necessary’ for the stock to move higher, especially as investor sentiment has cooled” following Nvidia’s GTC conference. “Buy-side expectations for the MI300 are as high as $8B, while Rolland estimates revenue from the MI300 for this year at around $5B.”
  • Deutsche Bank “believes the most anticipated aspect of the quarter will be any update to the company's 2024 outlook for MI300 revenues. On this metric, it thinks buy-side expectations have recently fallen on the back of suspected order cancellations by Microsoft, which are yet to be substantiated, but still are likely at a minimum of $4B.”
  • TD Cowen is expecting strength in the data center and “increased its MI300 2024 revenue estimate to $4.5B from $4B, saying ramps at several customers will continue to happen more quickly than typical.”
  • HSBC says that “market expectations for the company's MI300 2024 and 2025 revenue have been reset,” but thinks AMD “has enough supply capacity and demand to surpass management's artificial intelligence revenue guidance” for the year.
  • Baird believes “MI300X orders have been cut by a U.S. hyperscaler recently,” saying that the “magnitude of the initial order suggests it was a multi-year agreement, but it does not know whether the cut is due to market share shift or the hyperscaler scaling down to numbers more in line with shipment expectations.” Baird also “continues to believe there is ‘comfortable upside’ in AMD's artificial intelligence revenue guidance for this year, based on high-bandwidth memory order visibility.”
  • Wells Fargo analyst Aaron Rakers says the “focus on AMD is squarely on upside related to its MI300X accelerator chips,” and sees “a path towards AMD generating $8B in revenue from the MI300 (up from $3.5B to $4B), and wonder if there is a recovery in the traditional server market and an ‘underappreciated’ story in market share gain.” Rakers adds that concerns over Microsoft’s order cuts are “too narrowly cited."

While rumors for Microsoft’s order cuts are yet to be substantiated, there are further notes discussed on the site Tom’s Hardware that Microsoft is reportedly able to purchase MI300 GPUs at a 33% discount, at approximately $10,000 per GPU compared to a $15,000 price tag for other customers. This could present a margin headwind in Q1 should Microsoft account for a majority of GPU shipments in the quarter due to the pricing discrepancies.

In the bigger picture, to meet the lowest end of analysts’ GPU revenue estimates of $4 billion and $4.5 billion, AMD would need to boost its forecast by 15% to 30% — the question here is whether management has enough visibility after one quarter to confidently raise its full-year outlook to that extent after raising it by 75%.

Big Tech Capex Commentary

Capex commentary from Big Tech last week was directionally bullish, with Microsoft, Meta and Alphabet expecting to spend upwards of $135 billion this year, predominantly on AI infrastructure. This sets up a positive long-term picture for AMD to increase market share against Nvidia among the major hyperscalers, given AMD’s GPUs are available, can compete on performance, and undercut on price.

Microsoft increased its capex 80% YoY to $14 billion this quarter, and for the entire fiscal year, capex will increase approximately 50% YoY to more than $50 billion. Demand for Azure’s AI services is outpacing its capacity in the near-term, hence the need for Microsoft to accelerate spending to boost GPU supply.

Meta boosted its full year capex range to $35-40 billion, up from $30-37 billion, to build out AI infrastructure and support its internal AI roadmap. However, Meta’s Q1 capex was only $6.7 billion, implying that the bulk of this spend will hit in the second half of the year and accelerate into 2025. By the end of 2024, Meta is aiming to have 350,000 H100 GPUs and 600,000 total GPUs including H100 equivalents, leaving ~250,000 GPUs split between its custom processors and AMD’s MI300. Assuming AMD can capture 50% of that remaining 250K units, MI300 revenue to Meta may surpass $1.8 billion this year.

Alphabet’s capex rose 91% YoY to $12 billion in Q1, primarily for technical infrastructure – this capex spend was led by servers and followed by data centers. Management is expecting quarterly capex “to be roughly at or above the Q1 level,” implying a full-year capex around $50 billion.

Overall, the planned capex outlays and management commentary from the trio is ultimately bullish. Meta’s Q1 spend declined ~$300 million YoY, and was low compared to its full year forecast, and rumors for Microsoft’s order cuts can’t entirely be shrugged off. As such, there is a chance that Q1’s data center and MI300 sales come in light before finding strength in the back half of the year.

AMD Count and Game Plan

By Knox Ridley

This is the bullish count we’re following, and it’s the best interpretation higher given the price information. Here’s what we would guess based on the current technicals: we get a final drop into the $138 region, which will get bought, and then we push higher. If this is going to happen, we must hold $128. Below here and we could see a bigger drawdown take hold, as the below path higher will get invalidated.

Look at the red arrow in the chart above. That’s indicating a 3-wave bounce, which is usually corrective (suggesting lower). This is happening on momentum making a higher high with price making a lower high (common in downtrends). However, I think that what is missing is the final 5th wave lower before reversing. This is a very stretched downtrend pattern, so we should see a reversal soon.

Look for us to buy around $138 on a pullback or around $174 if we get a breakout. If price breaks below $128, we will risk manage the position. (Note: real-time trade alerts and weekly webinars reviewing IOF positions are offered for Advanced Members)

Insiders Activity

Since February of 2024, we’ve seen about $95M of insider sells. Lisa Su was about $50M of this total. Forrest Norrod and Victor Peng also had sales above $10M. The CTO sold about $8M. This is the largest cluster of sales since December of 2021. The synchronicity of four top tier execs, two on the same day, is not my favorite thing to see. We collect these details to help inform our decision if the stock should break a key level.

Conclusion

AMD’s Q1 report is one of the most highly anticipated reports of the quarter as the company is battling both lowered near-term estimates and heightened long-term expectations for GPU revenue. Analyst estimates on MI300s range from $4 billion to $8 billion.

AMD’s fundamentals are expected to improve throughout the year as data center sales accelerate, with operating cash flow growth of nearly 277% on top of an acceleration in EPS growth to the 90% range by the first quarter next year. We’re continuing to track Big Tech’s capex for signs on AI spending, and so far, there’s indications that spend will continue to increase for multiple quarters, leaving time for AMD to gain share.

Analyst estimates are showing a sizable rebound in H2. Let’s see what management says. Stay tuned for our post-earnings report in your inboxes tomorrow night.

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

Recommended Reading:

We Are Raising Our Bitcoin Targets To $106K – $190K

Posted on by io-fund

Bitcoin is an asset where the bulls pound the table to “buy, buy, buy,” and the bears relentlessly and stubbornly call it a scam. In reality, both are the wrong approach. This is because although Bitcoin is the highest performing asset in the past ten years, it’s also the one of the most volatile. Consider that it was trading at $58,000 in March of 2022, and by December of 2022 had lost 72% of its value. That year, the loud and proud Bitcoin bulls were not your friends.

Timing is everything. When it comes to timing, our firm has a proven track record of navigating the life-changing bull case that crypto offers while minimizing the volatility associated with different coins – we achieve this via a unique approach combining technical and on-chain analysis to identify major lows and major tops in each cycle. For example, we diligently detailed to our readers in December of 2022, when Bitcoin was trading in the $16,000 region, that we are “Bullish on Bitcoin”:

“Though we are in the 4th bear cycle in Bitcoin's history, the prior 3 cycles suggest where we are is a rare buying opportunity. There is ample evidence to support the $15,500 level is either a major low or very close to a major low. Both the technical and on-chain analysis support this. As Bitcoin continues to integrate into the global economy, we expect both the volatility and epic returns to calm down. For now, we are content buying Bitcoin at these lows with a long-term mindset.”

One year later, our most recent Bitcoin article stated that the coming pullback into the $39,000 – $35,000 region would likely be “the last great buying opportunity” in this bull cycle. At the time our upper targets were between $75,000 – $132,000. That correction bottomed around $38,500 then led to 90% rally, which topped less than 2% from our $75,000 target.

If Bitcoin were in the Mag 7, it would be the second strongest performer both YTD and on a 1-year basis, edging out Meta at returns of 133% in 1-year and 52% YTD. Had you bought in the $16,000 region, the returns would be 300% in about 17 months’ time.

bitcoin price % change

Source: YChartsYCharts

Looking forward, an important question to ask is, are we at the end of a bull cycle or do we have more room to run? We believe that there is more room within this uptrend. As a result, we are raising our upper Bitcoin targets, as the current volatility appears to be another correction within a much larger uptrend.

In this article, we will support this thesis through on-chain analysis as well as technical analysis. We will also address how Bitcoin appears to be setting up for higher levels while equities look like they’re topping. The popular narrative is that crypto and stocks – especially tech stocks — are correlated. It’s our stance that these two investments are not as correlated as many believe, which lends credence to this potential divergence.

Updated Bitcoin Game Plan

We have remained steadfast on the long-term pattern for Bitcoin, which you can see was intact as far back as July of 2022. While the 2022 drawdown went lower than we anticipated, once we got signs of a bottom, we maintained this pattern around the $15,000 lows. The implication was that 2022 was a correction within a much larger uptrend, and that we were going to see a new bull cycle into 2023 – 2024.

As of today, we are more than halfway into the current bull cycle, which is the final 5th wave in a very large 5 wave uptrend that started in late 2018. What this means is that as we approach our upper targets, our game plan will shift from accumulation to distribution.

bitcoin weekly chart

Source: I/O Fund

The current drawdown appears to be tracing a bull flag, which is a correction within an uptrend. The $57,000 region is very strong support, which is the upper range of our support zones that need to hold in order for us to push higher. This is over 25% lower than price currently is, which shows the level of strength still in Bitcoin. If we do see another drop, we can go as low as $42,750 without invalidating the larger uptrend in play. So, this ongoing pattern is comfortably intact and has ample room to drop, if we see more volatility.

While the pattern appears to be corrective, and tracing a standard pattern we see within larger uptrends, the momentum oscillator below price is at a major support zone. Note how this support region acted as key lows, especially in the current uptrend that started in late 2022. Also, note how much higher price is compared to other instances where this support was tested. This suggests a low being put in, while also suggesting that we have ample room to push higher in the coming weeks to months.

Because of this development, we are increasing our upper target zone from $75,000 – $130,000 to $106,000 on the low end, and $190,000 on the high end. As long as the $42,750 support region holds on any on-going volatility, then we have no reason to doubt the uptrend in place. That being said, we do not see the same upside within the equity markets, which begs the question – is Bitcoin highly correlated to tech stocks?

Bitcoin vs. Tech

On April 18th, we saw an escalation of the concerning geopolitical conflict between Iran and Israel. As a result, the NASDAQ-100 closed down over 2% the following day, with AI leaders like NVDA giving back 10% in a single day.

There were not many areas of tech that were spared on that day of selling, as investors sought to de-risk at any price. One would think Bitcoin would follow tech on this day, but it was instead up nearly 1%. In fact, many alt-coins shrugged off this news and pushed higher. Granted this is only one day, but it is an intriguing development. This was the first instance of panic selling in over 6 months where we saw investors dumping high risk tech stocks, and Bitcoin not only did not participate, but saw buyers.

If we look back at the long-term correlation to Bitcoin and the heavily focused NASDAQ-100, you will note that the majority of times, these two investments are closer to having minimal to to no correlation. This is in contrast to being highly correlated, as many would believe.

bitcoin & nasdaq comparison chart

Source: I/O Fund

The above chart measures the correlation between these two investments. The best way to read the chart is when the line is moving up, it means the two are correlated and heading in the same direction, while the inverse indicates they are moving in opposite directions. Also, when the cumulative reading is above 0.5 (green), the two investments are highly correlated, between 0.5 and -0.5 (yellow) the two have minimal to no correlation, and when the reading is below -0.5 (red) they have an inverse correlation and are moving in the opposite direction.

Considering the correlation is cumulative on a weekly scale, the two investments have to stay inversely correlated for some time in order to cross below 0. As you can see, there are significant periods where the two have been inversely correlated, which I’ve marked with the gray vertical shades.

For reference, the below chart shows the correlation between the S&P 500 and the NASDAQ-100 through the same period. While there are brief periods where the two indexes have diverged, the cumulative correlation rarely goes below 0.5% (green), and only briefly crossed the 0 line.

sp500 & nasdaq comparison chart

Source: I/O Fund

The point is to show actual data in regards to the popular narrative that Bitcoin is just another tech equity play. The data shows that the cumulative correlation has periods where it is highly correlated to tech, but what is key to understand, is that it also has extended periods where it is inversely correlated. The norm is that the two investments have had a low to no correlation, which supports the inverse move that we saw between Bitcoin and tech stocks on April 19th.

This supports a probable scenario where equities could put in a top while Bitcoin continues to run higher.

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Equities Topping While Bitcoin Goes Higher

In our March report, we showed how the current bull market leaders, the Magnificent 7, were topping, one at a time, while the broad market was continuing to push higher. At the time of the report, only 3 of the Mag 7 were making new highs with the broad market. We then saw the AI leaders within the semiconductor space, including Nvidia, top around early March, while the broad market pushed higher into April.

Seeing the bull market leaders diverge from the broad market is usually a sign of coming weakness, not strength. More times than not, we will see the leaders top first when a meaningful change in trend is about to happen, which we warned our readers about. If we were going to push higher, these leaders needed to breakout to new highs, and until then, we were at risk of a trend change.

This lines up with the potential topping pattern we are seeing within the equity markets, compared to Bitcoin, which appears to have more room to run.

equity markets compared to bitcoin chart

Source: I/O Fund

The above chart shows the NASDAQ-100 has completed a mature 5 wave pattern off the 2022 low, and has broken the first of two major supports – 17,265 and 17,000. Bitcoin, on the other hand, is still in an incomplete 5 wave pattern, which is still tracing the 3rd wave higher. Note the current correction is taking the shape of a bull flag, and is nearly 25% above the first critical support level.

The reason for this could have several explanations. For one, it’s worth noting that the demand for Bitcoin has increased substantially, while its supply has remained the same. Spot Bitcoin ETFs have quickly become a popular investment vehicle, and have seen a surge in net inflows, surpassing more than $30B AUM in mid-April after amassing $17B in funds in less than two months after a launch in mid-January. For example, BlackRock’s iShares Bitcoin ETF recorded 71 consecutive days of net inflows. In addition, trading volume on the ETFs nearly tripled in March, reaching $111 billion – for an asset class that launched only two months prior, that’s a significant figure.

Another explanation is the fact that not all markets top and bottom at the same time. For example, small caps topped in 2021 while the NASDAQ-100 continued higher into 2024. Therefore, Bitcoin could be one of the last assets to put in a larger top, after the NASDAQ-100. This would lead to several lower highs within a large range for the NASDAQ-100, while Bitcoin makes its final series of higher highs. After which, they would align in a potential downtrend.

Another answer could be something more fundamental. Bitcoin was created to answer a specific flaw within the centralized banking system. It is fundamentally different than a tech stock, and has the potential to provide a hedge against various banking and/or currency problems that tech stocks would not be able to address. In this case, Bitcoin could be picking up on some deeper issue within the system, which is causing the potential divergence.

The other scenario is that I could be wrong, and the NASDAQ-100 holds this support region, the Mag 7 and AI Semis find more strength, and push higher with Bitcoin, or vice versa. I’m open to this, but until Bitcoin starts breaking critical support levels in a direct fashion, like most equity markets recently have, there is no reason to pivot away from a more bullish outcome in Bitcoin.

On Chain Analysis

For those that are not familiar with on-chain data, it is the unique fundamental analysis within crypto, and a relatively new field of study. We partnered with WealthUmbrella, a team of Machine Learning engineers and professors, to provide this level of analysis within the crypto space. According to WealthUmbrella, the underlying strength that our technical analysis is picking up on is also being supported within on-chain data. The below section was written by Vincent Duchaine, CEO of WealthUmbrella.

Bitcoin’s recent move to $73,000 created some of the most overbought conditions we have seen throughout Bitcoin’s history. One of the indicators used to gauge these overbought levels measures the value of Bitcoin’s network through the increase/decrease in active users.

At the recent high in Bitcoin, this indicator, which only rose briefly to a historically high value, gave us a reading of 3.3. As you can see below, this reading represents an outlier in Bitcoin history.

MLDP Z-Score Distribution chart

Source: I/O Fund

A reading this high historically leads to a top, of sorts. The good news is that the recent volatility has taken this indicator back to a reading of 0.84, which is in the lower range of what we have seen during a correction in a bull market over the last 6 years. This further confirms our long-standing outlook that the bull cycle in Bitcoin will likely move higher.

bitcoin usd chart from wealth umbrella

Source: I/O Fund

This extreme overbought reading was also picked up by our SOPR Indicator, which stands for the Spent Output Profit Ratio. This indicator measures the daily transactions in Bitcoin and measures if the combined ratio has a profit or loss based on when they were bought. As the indicator moves up, it is signaling that all the majority of daily transactions in Bitcoin were sold for a profit.

As you can see, this indicator also reached a historically high reading when Bitcoin first hit $73,000. However, it has greatly cooled down since and is now slowly curving to the right.

bitcoin usd daily chart from wealth umbrella

Source: I/O Fund

These two metrics were warnings that a correction was likely coming due to being extremely overbought. However, since then, we have seen them cool off to a level that suggests we could be getting close to the bottom of the current correction and resume the uptrend.

This thesis is being supported by other metrics that we track. For example, since the arrival of the new Bitcoin ETF, the amount of Bitcoin that hasn’t moved in more than a year was in a constant drop, implying that long-term holders (hodlers) were finally taking gains, which was increasing supply. This selling by the Bitcoin hodlers has since stopped since April 2nd, which you can see in the chart below.

wealth umbrella bitcoin chart analysis

Source: I/O Fund

Like any asset, Bitcoin's price movements are the result of supply and demand. We are now seeing long-term holders of Bitcoin cease the selling that started in late 2023. This is bullish as it creates a constraint on the supply side of the equation.

Not only are hodlers not selling, but whales have also bought the recent dips in a notable way. The below chart measures large block trades within Bitcoin. The most recent spike happened last Thursday, April 18th, when whales bought 19,700 BTC at an average price of $62.5k.

bitcoin large holders net flows chart

Source: I/O Fund

Regarding the demand for Bitcoin, we have historically measured this through monitoring the number of newly created Bitcoin addresses with a non-$0 balance. As new addresses are created that actively buy Bitcoin, this implies that demand is increasing. However, this is likely not as relevant in light of the new Bitcoin ETFs.

Before the creation of these ETFs, the predominant means to access Bitcoin was through the creation of wallets or personalized crypto exchange accounts. Now, an investor can simply buy an ETF on a public exchange and get access to Bitcoin’s price movements. This has now opened the door to institutional investors as well as investors who want diversification but did not want to deal with the hassle of dealing with crypto exchanges and the safety concerns that come with them. Regarding demand, this development is arguably the most important element in Bitcoin’s history, and we view as quite bullish in regards to the demand side of the price equation. Lead Tech Analyst Beth Kindig went on Fox Business News and discussed how Bitcoin has never had a more fundamentally bullish moment:

Bitcoin has never had a more fundamental bullish moment: Beth Kindig (X.com)

Source: Beth's TwitterBeth's Twitter

In summary, the internals are supporting higher levels, as we are now seeing demand start to catch up with supply. We view the current state of Bitcoin’s pullback as a buying opportunity within a larger uptrend. This is confirmed by one of our most powerful tools, which we call the Kwiatkowski Indicator, named after its creator. This tool is designed to spot tops by looking at the profit of all market participants in an organized way. It is currently indicating a value of around 12, while we don’t expect a cyclical top until 35.

bitcoin bullish trend chart analysis

Source: I/O Fund

Conclusion:

We are seeing evidence that Bitcoin wants to go higher, while equities appear to be setting for a top. Bitcoin has a history of not being correlated with tech stocks, so this scenario is not as improbable as the popular narrative would suggest. Both technical and on-chain analysis support higher levels for Bitcoin, and as long as any further weakness holds $42,750, we view this dip as a buying opportunity.

If you own crypto or are looking to own crypto stocks, consider joining us for our next broad market webinar. 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, manage risk, as well as revealing our various long-term game plans regarding stock and crypto 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.here.

Please note: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. Beth Kindig and the I/O Fund own BTC at the time of writing and may own stocks pictured in the charts.

Recommended Reading:

Microsoft Fiscal Q3 2024 Earnings: 80% YoY Increase in Capex; Azure AI is Hitting Capacity

Posted on by io-fund

Highlights this quarter include Azure’s growth of 31% up from 30% and 28% on CC basis last quarter. Of this, 7 points was from AI compared to 6 points from AI last quarter. The reason that Azure did not see more QoQ growth from AI is due to capacity constraints. In other words, Microsoft has higher demand than they have GPU supply. This is leading Microsoft to grow its capex 80% YoY from $7.8 billion in the year ago quarter to $14 billion this quarter. On a fiscal year basis, capex will grow 50% this year, and what this quarter proves, is that this high growth rate on already high capex spend is only accelerating.

Notably, Microsoft’s report, Tesla report with 130% increase in H100 equivalents, and Meta’s earnings report supports what we discussed in our recent Quarterly Kickoff webinar on capex and AI spend. To understand critical points on how we have structured our AI portfolio, view the Quarterly Kickoff webinar here. Per the webinar, Microsoft’s report was a vote of confidence we are positioned well.

Beyond Azure, management’s focus was on Copilot, which are tools that are not capacity constrained. There were many impressive statistics on Copilot that we share with you below. In addition to Copilot, Microsoft emphasized that security is their number one priority – “over anything else” – which was a good reminder for investors given AI takes up the majority of the time on the call. There were also some initial AI-powered PC stats from this ER that we share below, as well.

Microsoft has a knack for in-line reports. However, bookings and RPO were exceptionally strong this quarter. We detail this and more below.

Microsoft Fiscal Q3 Financials:

Revenue and EPS:

Fiscal Q3 revenue of $61.85 billion beat expectations by $960 million, driven by a 21% increase in Intelligent Cloud revenue and a 17% increase in More Personal Computing revenue. Azure growth was 31%, marking a continuation of the acceleration we’ve seen since the June quarter. Of this, AI drove 7 points. Per the CFO: “Azure and other cloud services revenue grew 31% ahead of expectations, while our AI services contributed 7 points of growth as expected.”

The company guided for Azure growth of 30% to 31% percent next quarter, which represents a management guide of flat growth QoQ.

Revenue and EPS:

  • Revenue of $61.85 billion beat estimates by 1.7%, representing YoY growth of 17% but a QoQ decrease of 0.3%.
  • For next quarter, management guided to $64 billion, which is below analyst estimates of $64.6 billion and lower mainly due to the rising US dollar.
  • GAAP EPS of $2.94 beat estimates by $0.11, representing YoY growth of 20%. Non-GAAP EPS of $2.94 beat estimates by $0.10.

Segment Revenue:

  • Productivity and Business revenue was $19.6 billion, up 12% YoY, driven by 15% growth in Office 365 Commercial. Growth came in 100 bp ahead of the midpoint of the guided range.
  • Intelligent Cloud revenue was $26.7B, up 21% YoY, driven by strong demand for server products and cloud services revenue from Azure and other cloud services revenue growth of 31%. This was a 260 bp acceleration from last quarter.
  • More Personal Computing revenue was $15.6 billion, up 17% YoY. Windows revenue increased 11% with OEM revenue growth of 11%, while devices revenue decreased (17%).

Guidance on Segment Revenue:

  • Productivity and Business revenue guided to $20.05 billion at midpoint for growth of 8.7% to 10.4% YoY. This would be a deceleration of 145 bps in growth rate, at the midpoint.
  • Intelligent Cloud revenue was guided to $28.55 billion at midpoint for growth of 18.3% to 19.6% YoY. This is a deceleration of 205 bps in growth rate, at the midpoint.
  • More Personal Computing revenue was guided to $15.4 billion at midpoint for growth of 9.4% to 12.2% YoY. This would be a deceleration from 17% growth on CC basis this quarter.

Margins:

Margins were strong across the board, topping management’s guide in gross margin, operating margin and net margin. Operating margin for Q3 was 45%, 210 bp above guidance, and a 270 bp increase YoY.

We’ve previously discussed how there may be room for continued operating margin expansion in Intelligent Cloud, but in this report, it was Microsoft’s More Personal Computing segment that experienced strong operating margin expansion, up 610 bp QoQ to 31.6% as the company shifted the sales mix to higher margin businesses.

One of the more bullish comments on the call was the CFO guiding full year operating margin to be up 2 points for FY2024. There was a note it would be down 1 point for FY2025 due to higher capex. Overall, Microsoft has done an excellent job maintaining margin strength.

  • Gross margin of 70.1% was up from 69.5% in the year ago quarter. The guide for next quarter is approximately 69.2%.
  • Operating margin was 45%, up from 42.3% in the year-ago quarter. Operating margin is guided for 42.3% next quarter.
  • Net margin was 35.5%, up from 34.6% in the year-ago quarter. Net margin is guided to decelerate to 33.6%, implying a decrease QoQ.
  • Productivity and Business operating margin was 51.8%, down 160 bp QoQ but expanding 250 bp YoY.
  • Intelligent Cloud operating margin was 46.9%, down 120 bp QoQ but expanding 400 bp YoY due to strength in Azure.
  • More Personal Computing operating margin was 31.6%, up 610 bp QoQ due to a sales mix shift to higher margin businesses.

Cash and Debt:

Operating cash flow was $31.9 billion, up 31% YoY driven by strong cloud billings and collections.

Free cash flow was $21 billion, up 18% YoY reflecting higher capital expenditures to support cloud and AI offerings.

Microsoft returned $8.4 billion to shareholders with $5.6 billion in dividends and $2.8B in share repurchases.

For Q3 2024, the company has $65.44 billion total debt, with $80.02 billion in cash and short-term investments.

Key Metrics:

Bookings increased 29% YoY and 31% on a constant currency basis. This was driven by strength in large, long-term Azure contracts and “strong execution across our core annuity sales motions.” This compares to 17% growth (9% on CC basis) in Bookings last quarter and compares to 11% growth (12% on CC basis) in Bookings in the year ago quarter. This is the highest quarter for bookings since fiscal year 2022.

Commercial RPO grew by 20% YoY to $235 billion. This compares to 17.5% growth last quarter and 26% YoY growth in the year ago quarter.

Last quarter, it was stated that “more than half of the Fortune 500 are using Azure OpenAI Services” and this was updated to “more than 65% of the Fortune 500 now use Azure OpenAI services.” Last quarter, it was stated that “Azure AI customers totaled more than 53,000, with one-third of these being new customers over the past twelve months. This implies customer growth rate of approximately 50% YoY.” This quarter, it was updated to: “The number of $100 million-plus Azure deals increased over 80% year-over-year, while the number of $10 million-plus deals more than doubled.” These aren’t exactly apples-to-apples but seems to imply the trend is up.

According to the opening remarks, over half of Azure AI customers use their data and analytics tools. The next-gen analytics platform, Microsoft Fabric, has over 11,000 paid customers.

Beyond AI, Microsoft stated cloud migrations contributed to Azure growth, as well. Azure Arc has 33,000 customer up 200% YoY as legacy workloads from Oracle and SAP are migrated to Azure.

GitHub commentary certainly showed impressive growth with paying subscribers at 1.8 million, up from 1.3 million last quarter for growth of 35% QoQ up from 30% QoQ. Revenue accelerated 45% YoY and it was stated that “more than 90% of the Fortune 100 are now GitHub customers.”

Copilot for Microsoft 365 was available for its first full quarter with 30,000 organization using Copilot Studio. The low code, no-code Power Platform is being used by “over 330,000 organizations, including over half of Fortune 100 have used AI-powered capabilities in Power Platform, and Power Apps now has over 25 million monthly active users, up over 40% year-over-year.”

There was an important update on CoPilot for Windows provided, which is that it’s now available in 225 million Windows 10 and Windows 11 PCs and is “up 2X quarter-over-quarter.” The company also teased an upcoming event: “And there's much more to come in just a few weeks, we'll hold a special event to talk about our AI vision across Windows and devices.”

Earnings Call:

Well, I won’t be shy about the fact that our firm has been particularly keen to hear capex commentary from this week’s earnings reports. Microsoft’s report was as bullish as it could be on that point.

Capex:

Microsoft stated capex was $14 billion this quarter compared to $7.8 billion in the year ago quarter, up 80% YoY. This compares to $11 billion in the previous quarter, up a whopping 27.2% sequentially.

The way analysts are thinking of this is up 50% YoY on a run rate for this current fiscal year ending in June with whispers this could get to $100 billion.

Keith Weiss (Analysts)

congratulations on the fantastic quarter. a lot of excitement in the marketplace around generative AI and the potential of these technologies. But there's also a lot of investment going on behind them. It looks like Microsoft is on track to ramp CapEx over 50% year-on-year this year to over $50 billion. And there's media speculation of more spending ahead with some reports talking about like $100 billion data center. So obviously, investments are coming well ahead of the revenue contribution. It looks like Microsoft is on track to ramp CapEx over 50% year-on-year this year to over $50 billion. And there's media speculation of more spending ahead with some reports talking about like $100 billion data center. So obviously, investments are coming well ahead of the revenue contribution. 

But what I was hoping for is that you could give us some color on how use as the management team, try to quantify the potential opportunities that underlie these investments because they are getting very big. And maybe if you could give us some hint on whether there's any truth to the potential of like $100 billion data center out there.And maybe if you could give us some hint on whether there's any truth to the potential of like $100 billion data center out there.

There was not a direct answer other than the following tone – but the overall message is key to the I/O Fund’s portfolio allocation, and thus, the question in this case reveals more than the answer in terms of what institutions are expecting: “So this is not the quarter. I realize in the news, it's a lot more in the quarter nowadays. But if you look at it, we have been doing what is essentially capital allocation to be a leader in AI for multiple years now, and we plan to sort of essentially keep taking that forward.”

AI Demand Exceeds Capacity

According to the CFO’s opening remarks: “We expect capital expenditures to increase materially on a sequential basis driven by cloud and AI infrastructure investments. As a reminder, there can be normal quarterly spend variability in the timing of our cloud infrastructure build-outs and the timing of finance leases. We continue to bring capacity online as we scale our AI investments with growing demand. Currently, near-term AI demand is a bit higher than our available capacity.” Currently, near-term AI demand is a bit higher than our available capacity.” It was also stated that growth in Azure next quarter “will be driven by our Azure consumption business and continued contribution from AI with some impact from the AI capacity availability noted earlierwith some impact from the AI capacity availability noted earlier. 

This later led to an important part of the Q&A that helps spell out why Microsoft must increase capex, and how they expect it to flow-through to Azure. Commentary that Azure is hitting capacity due to demand is very bullish for the outlook on GPUs and ASICs this year.

Question
Karl Keirstead (Analysts)

Satya and Amy, congrats on these outstanding Azure results. I'd love to hone in a little bit on the 7-point lift to Azure growth from AI, outstanding number, but it's leveling off a little bit from 6 points in December. I'm wondering if you could unpack that a little bit. To what extent did the capacity issues that you Amy highlighted on the call, impact that number. Is there any seasonality? I wouldn't think so or any other factor that can swing around that number that you'd advise us to keep in mind?

Answer
Amy Hood (Executives)

[…] it is how much capacity we have in play and how much capacity that we have to sell on the inferencing side, in particular. And so that is partially why you see the capital investment in the shape that is, is because right this minute, we do have demand that exceeds our supply by a bit. So it is fair to say that, that could have been an impact on the number for the quarter and it does impact a little bit the number in Q4.it is how much capacity we have in play and how much capacity that we have to sell on the inferencing side, in particular. And so that is partially why you see the capital investment in the shape that is, is because right this minute, we do have demand that exceeds our supply by a bit. So it is fair to say that, that could have been an impact on the number for the quarter and it does impact a little bit the number in Q4.

Security #1 Priority:

I wanted to pull out this quote from the opening remarks as it was a particularly strong statement in terms of how Microsoft thinks of their security products moving forward. It seemed as if this means security is an even bigger priority than AI (although the capex increase communicates otherwise):

“Security underpins every layer of the tech stack and it's our #1 priority. We launched our Secure Future initiative last fall for this reason, bringing together every part of the company to advance cybersecurity protection and we are doubling down on this very important work, putting security about all else before all other features and investmentsSecurity underpins every layer of the tech stack and it's our #1 priority. We launched our Secure Future initiative last fall for this reason, bringing together every part of the company to advance cybersecurity protection and we are doubling down on this very important work, putting security about all else before all other features and investments.”

Conclusion:

For our purposes, Microsoft’s report confirms we are on the right track for 2024 in terms of how we have structured our portfolio for the AI data center (reference the webinar here). Microsoft’s report signals the trend is clearly up for AI in the years to come – both for Microsoft and the many other AI data center stocks we own. We are pleased to have this stock in our portfolio and our goal is to continue to add at key levels. There is no question in my mind that Microsoft will remain in the Mag 7 over the next decade, alongside Nvidia. The only remaining questions are when do we buy and how much. If we are lucky, we will get it lower in the near-term to hold for the long-term.

Recommended Reading:

Microsoft Fiscal Q3 2024 Earnings: 80% YoY Increase in Capex; Azure AI is Hitting Capacity

Posted on by io-fund

Highlights this quarter include Azure’s growth of 31% up from 30% and 28% on CC basis last quarter. Of this, 7 points was from AI compared to 6 points from AI last quarter. The reason that Azure did not see more QoQ growth from AI is due to capacity constraints. In other words, Microsoft has higher demand than they have GPU supply. This is leading Microsoft to grow its capex 80% YoY from $7.8 billion in the year ago quarter to $14 billion this quarter. On a fiscal year basis, capex will grow 50% this year, and what this quarter proves, is that this high growth rate on already high capex spend is only accelerating.

Beyond Azure, management’s focus was on Copilot, which are tools that are not capacity constrained. There were many impressive statistics on Copilot that we share with you below. In addition to Copilot, Microsoft emphasized that security is their number one priority – “over anything else” – which was a good reminder for investors given AI takes up the majority of the time on the call. There were also some initial AI-powered PC stats from this ER that we share below, as well.

Microsoft has a knack for in-line reports. However, bookings and RPO were exceptionally strong this quarter. We detail this and more below.

Microsoft Fiscal Q3 Financials:

Revenue and EPS:

Fiscal Q3 revenue of $61.85 billion beat expectations by $960 million, driven by a 21% increase in Intelligent Cloud revenue and a 17% increase in More Personal Computing revenue. Azure growth was 31%, marking a continuation of the acceleration we’ve seen since the June quarter. Of this, AI drove 7 points. Per the CFO: “Azure and other cloud services revenue grew 31% ahead of expectations, while our AI services contributed 7 points of growth as expected.”

The company guided for Azure growth of 30% to 31% percent next quarter, which represents a management guide of flat growth QoQ.

Revenue and EPS:

  • Revenue of $61.85 billion beat estimates by 1.7%, representing YoY growth of 17% but a QoQ decrease of 0.3%.
  • For next quarter, management guided to $64 billion, which is under analyst estimates of $64.6 billion and lower mainly due to the rising US dollar.
  • GAAP EPS of $2.94 beat estimates by $0.11, representing YoY growth of 20%. Non-GAAP EPS of $2.94 beat estimates by $0.10.

Segment Revenue:

  • Productivity and Business revenue was $19.6 billion, up 12% YoY, driven by 15% growth in Office 365 Commercial. Growth came in 100 bp ahead of the midpoint of the guided range.
  • Intelligent Cloud revenue was $26.7B, up 21% YoY, driven by strong demand for server products and cloud services revenue from Azure and other cloud services revenue growth of 31%. This was a 260 bp acceleration from last quarter.
  • More Personal Computing revenue was $15.6 billion, up 17% YoY. Windows revenue increased 11% with OEM revenue growth of 11%, while devices revenue decreased (17%).

Guidance on Segment Revenue:

  • Productivity and Business revenue guided to $20.05 billion at midpoint for growth of 8.7% to 10.4% YoY. This would be a deceleration of 145 bps in growth rate, at the midpoint.
  • Intelligent Cloud revenue was guided to $28.55 billion at midpoint for growth of 18.3% to 19.6% YoY. This is a deceleration of 205 bps in growth rate, at the midpoint.
  • More Personal Computing revenue was guided to $15.4 billion at midpoint for growth of 9.4% to 12.2% YoY. This would be a deceleration from 17% growth on CC basis this quarter.

Margins:

Margins were strong across the board, topping management’s guide in gross margin, operating margin and net margin. Operating margin for Q3 was 45%, 210 bp above guidance, and a 270 bp increase YoY.

We’ve previously discussed how there may be room for continued operating margin expansion in Intelligent Cloud, but in this report, it was Microsoft’s More Personal Computing segment that experienced strong operating margin expansion, up 610 bp QoQ to 31.6% as the company shifted the sales mix to higher margin businesses.

One of the more bullish comments on the call was the CFO guiding full year operating margin to be up 2 points for FY2024. There was a note it would be down 1 point for FY2025 due to higher capex. Overall, Microsoft has done an excellent job maintaining margin strength.

  • Gross margin of 70.1% was up from 69.5% in the year ago quarter. The guide for next quarter is approximately 69.2%.
  • Operating margin was 45%, up from 42.3% in the year-ago quarter. Operating margin is guided for 42.3% next quarter.
  • Net margin was 35.5%, up from 34.6% in the year-ago quarter. Net margin is guided to decelerate to 33.6%, implying a decrease QoQ.
  • Productivity and Business operating margin was 51.8%, down 160 bp QoQ but expanding 250 bp YoY.
  • Intelligent Cloud operating margin was 46.9%, down 120 bp QoQ but expanding 400 bp YoY due to strength in Azure.
  • More Personal Computing operating margin was 31.6%, up 610 bp QoQ due to a sales mix shift to higher margin businesses.

Cash and Debt:

Operating cash flow was $31.9 billion, up 31% YoY driven by strong cloud billings and collections.

Free cash flow was $21 billion, up 18% YoY reflecting higher capital expenditures to support cloud and AI offerings.

Microsoft returned $8.4 billion to shareholders with $5.6 billion in dividends and $2.8B in share repurchases.

For Q3 2024, the company has $65.44 billion total debt, with $80.02 billion in cash and short-term investments.

Key Metrics:

Bookings increased 29% YoY and 31% on a constant currency basis. This was driven by strength in large, long-term Azure contracts and “strong execution across our core annuity sales motions.” This compares to 17% growth (9% on CC basis) in Bookings last quarter and compares to 11% growth (12% on CC basis) in Bookings in the year ago quarter. This is the highest quarter for bookings since fiscal year 2022.

Commercial RPO grew by 20% YoY to $235 billion. This compares to 17.5% growth last quarter and 26% YoY growth in the year ago quarter.

Last quarter, it was stated that “more than half of the Fortune 500 are using Azure OpenAI Services” and this was updated to “more than 65% of the Fortune 500 now use Azure OpenAI services.” Last quarter, it was stated that “Azure AI customers totaled more than 53,000, with one-third of these being new customers over the past twelve months. This implies customer growth rate of approximately 50% YoY.” This quarter, it was updated to: “The number of $100 million-plus Azure deals increased over 80% year-over-year, while the number of $10 million-plus deals more than doubled.” These aren’t exactly apples-to-apples but seems to imply the trend is up.

According to the opening remarks, over half of Azure AI customers use their data and analytics tools. The next-gen analytics platform, Microsoft Fabric, has over 11,000 paid customers.

Beyond AI, Microsoft stated cloud migrations contributed to Azure growth, as well. Azure Arc has 33,000 customer up 200% YoY as legacy workloads from Oracle and SAP are migrated to Azure.

GitHub commentary certainly showed impressive growth with paying subscribers at 1.8 million, up from 1.3 million last quarter for growth of 35% QoQ up from 30% QoQ. Revenue accelerated 45% YoY and it was stated that “more than 90% of the Fortune 100 are now GitHub customers.”

Copilot for Microsoft 365 was available for its first full quarter with 30,000 organization using Copilot Studio. The low code, no-code Power Platform is being used by “over 330,000 organizations, including over half of Fortune 100 have used AI-powered capabilities in Power Platform, and Power Apps now has over 25 million monthly active users, up over 40% year-over-year.”

There was an important update on CoPilot for Windows provided, which is that it’s now available in 225 million Windows 10 and Windows 11 PCs and is “up 2X quarter-over-quarter.” The company also teased an upcoming event: “And there's much more to come in just a few weeks, we'll hold a special event to talk about our AI vision across Windows and devices.”

Earnings Call:

Well, I won’t be shy about the fact that our firm has been particularly keen to hear capex commentary from this week’s earnings reports. Microsoft’s report was as bullish as it could be on that point.

Capex:

Microsoft stated capex was $14 billion this quarter compared to $7.8 billion in the year ago quarter, up 80% YoY. This compares to $11 billion in the previous quarter, up a whopping 27.2% sequentially.

The way analysts are thinking of this is up 50% YoY on a run rate for this current fiscal year ending in June with whispers this could get to $100 billion.

Keith Weiss (Analysts)

congratulations on the fantastic quarter. a lot of excitement in the marketplace around generative AI and the potential of these technologies. But there's also a lot of investment going on behind them. It looks like Microsoft is on track to ramp CapEx over 50% year-on-year this year to over $50 billion. And there's media speculation of more spending ahead with some reports talking about like $100 billion data center. So obviously, investments are coming well ahead of the revenue contribution. It looks like Microsoft is on track to ramp CapEx over 50% year-on-year this year to over $50 billion. And there's media speculation of more spending ahead with some reports talking about like $100 billion data center. So obviously, investments are coming well ahead of the revenue contribution. 

But what I was hoping for is that you could give us some color on how use as the management team, try to quantify the potential opportunities that underlie these investments because they are getting very big. And maybe if you could give us some hint on whether there's any truth to the potential of like $100 billion data center out there.And maybe if you could give us some hint on whether there's any truth to the potential of like $100 billion data center out there.

There was not a direct answer other than the following tone – but the overall message is key to the I/O Fund’s portfolio allocation, and thus, the question in this case reveals more than the answer in terms of what institutions are expecting: “So this is not the quarter. I realize in the news, it's a lot more in the quarter nowadays. But if you look at it, we have been doing what is essentially capital allocation to be a leader in AI for multiple years now, and we plan to sort of essentially keep taking that forward.”

AI Demand Exceeds Capacity

According to the CFO’s opening remarks: “We expect capital expenditures to increase materially on a sequential basis driven by cloud and AI infrastructure investments. As a reminder, there can be normal quarterly spend variability in the timing of our cloud infrastructure build-outs and the timing of finance leases. We continue to bring capacity online as we scale our AI investments with growing demand. Currently, near-term AI demand is a bit higher than our available capacity.” Currently, near-term AI demand is a bit higher than our available capacity.” It was also stated that growth in Azure next quarter “will be driven by our Azure consumption business and continued contribution from AI with some impact from the AI capacity availability noted earlierwith some impact from the AI capacity availability noted earlier. 

This later led to an important part of the Q&A that helps spell out why Microsoft must increase capex, and how they expect it to flow-through to Azure. Commentary that Azure is hitting capacity due to demand is very bullish for the outlook on GPUs and ASICs this year.

Question
Karl Keirstead (Analysts)

Satya and Amy, congrats on these outstanding Azure results. I'd love to hone in a little bit on the 7-point lift to Azure growth from AI, outstanding number, but it's leveling off a little bit from 6 points in December. I'm wondering if you could unpack that a little bit. To what extent did the capacity issues that you Amy highlighted on the call, impact that number. Is there any seasonality? I wouldn't think so or any other factor that can swing around that number that you'd advise us to keep in mind?

Answer
Amy Hood (Executives)

[…] it is how much capacity we have in play and how much capacity that we have to sell on the inferencing side, in particular. And so that is partially why you see the capital investment in the shape that is, is because right this minute, we do have demand that exceeds our supply by a bit. So it is fair to say that, that could have been an impact on the number for the quarter and it does impact a little bit the number in Q4.it is how much capacity we have in play and how much capacity that we have to sell on the inferencing side, in particular. And so that is partially why you see the capital investment in the shape that is, is because right this minute, we do have demand that exceeds our supply by a bit. So it is fair to say that, that could have been an impact on the number for the quarter and it does impact a little bit the number in Q4.

Security #1 Priority:

I wanted to pull out this quote from the opening remarks as it was a particularly strong statement in terms of how Microsoft thinks of their security products moving forward. It seemed as if this means security is an even bigger priority than AI (although the capex increase communicates otherwise):

“Security underpins every layer of the tech stack and it's our #1 priority. We launched our Secure Future initiative last fall for this reason, bringing together every part of the company to advance cybersecurity protection and we are doubling down on this very important work, putting security about all else before all other features and investmentsSecurity underpins every layer of the tech stack and it's our #1 priority. We launched our Secure Future initiative last fall for this reason, bringing together every part of the company to advance cybersecurity protection and we are doubling down on this very important work, putting security about all else before all other features and investments.”

Conclusion:

For our purposes, Microsoft’s report confirms we are on the right track for 2024 in terms of how we have structured our portfolio for the AI data center (reference the webinar highlights here). Microsoft’s report signals the trend is clearly up for AI in the years to come – both for Microsoft and the many other AI data center stocks we own. We are pleased to have this stock in our portfolio and our goal is to continue to add at key levels. There is no question in my mind that Microsoft will remain in the Mag 7 over the next decade, alongside Nvidia. The only remaining questions are when do we buy and how much. If we are lucky, we will get it lower in the near-term to hold for the long-term.

Recommended Reading:

Lam Research Fiscal Q3 Earnings: A Tad Early to the 2025 Rebound

Posted on by io-fund

Lam’s Q3 report was nothing too spectacular, with a slight revenue beat in the quarter and a solid EPS beat. Q4’s guide pointed to relatively flat revenue and a slight sequential decline in EPS.

We have a 4% placeholder on Lam, which may be a tad early for the material rebound that is expected 2025-ish. Primarily, Lam’s rebound is dependent on NAND recovering. Discussions around the incoming NAND rebound were important, as well as the discussions on DRAM.

China is both an opportunity and a risk for Lam. China’s revenue contribution remained above 40% in the quarter, though Korea’s contribution increased 500 bp sequentially to 24%, suggesting major memory manufacturers may be increasing WFE (wafer fabrication equipment) spend. Given the high exposure to China, there is risk in more customers being added to the banned entity list, which would result in a loss of revenue for Lam.

Overall, this is not the standout quarter for Lam and we didn’t expect it to be. Instead, we were provided important clues as to when the standout quarter might occur. The story is intact, the fundamentals have likely bottomed, yet the stock is overvalued and has been for some time. Therefore, primarily due to valuation concerns, we realize the allocation we currently have is unlikely to be our lowest entry.

Revenue and EPS:

Lam’s revenue peaked in Q2 FY2023, with the current FY2024 Q4 guide pointing to flat revenue for three straight quarters as Lam digests a trough in NAND spending coupled with strong China and DRAM demand. Fiscal Q1 is expected to break this trend with revenues projected to push back to $4 billion and higher.

  • Revenue of $3.79 billion beat estimates by 1.6%, representing a YoY decline of (2.1%) but a QoQ increase of 0.9%.
  • For fiscal Q4 (June 2024 quarter), Lam guided for revenue of $3.8 billion, +/- $300 million, representing YoY growth of 18.5% and approximately flat QoQ growth at midpoint. Prior to earnings, our information shows QoQ growth in the September quarter of 6% and December quarter of 7%.
  • GAAP EPS of $7.34 beat estimates by $0.50, representing YoY growth of 22.1%. Non-GAAP EPS of $7.79 beat estimates by $0.49.
  • Q4’s GAAP EPS was guided at $7.20, +/- $0.75, representing YoY growth of 20.6% and a QoQ decline of (1.9%) at midpoint. Non-GAAP EPS was guided at $7.50, +/- $0.75, implying YoY growth of 25.4% and a QoQ decline of (3.7%). Same as revenue, the September quarter and December quarter is when QoQ growth returns.

Margins:

GAAP operating margin contracted slightly on a QoQ basis despite GAAP margin expanding due to customer mix in China. Q4’s margin outlook was also mixed, pointing to operating margin expansion and gross margin contraction.

It’s important to note that 46% is the normalized gross margin for Lam although customer mix can result in as high as 48% gross margin. Per management: “You're absolutely right, and thanks for mentioning the 46%. That's sort of where gross margin was after we had done some of the Malaysia stuff and before China popped up with those smaller customers. And so the fact that we're above that level is largely customer mix.”

  • Fiscal Q3’s GAAP gross margin was 47.5%, representing a 70 bp QoQ and 600 bp YoY expansion from 41.5%.
  • For fiscal Q4, Lam guided for a GAAP gross margin of 46.7%, representing an 80bp QoQ contraction but a 120 bp YoY expansion.
  • GAAP operating margin was 27.9% up 350 bp YoY from 24.4%.
  • Q4’s GAAP operating margin was guided at 28.3%, for a 40 bp QoQ and 170 bp YoY expansion compared to 26.6% in Q4 of last year.
  • GAAP net margin was 25.4%, essentially flat QoQ and expanding 440 bp YoY.

Cash and Debt:

  • Operating cash flow was $1.38 billion in Q3, compared to $1.76 billion in the year ago quarter. Lam’s OCF margin contracted from 44.6% a year ago to 36.5%.
  • Free cash flow was $1.28 billion, compared to $1.61 billion in the year ago quarter. FCF margin contracted from 41.5% a year ago to 33.7%.
  • Cash and equivalents totaled $5.67 billion.
  • Debt and finance leases totaled $4.98 billion.

The company allocated $860 million to share repurchases and paid $263 million in dividends in the March quarter. Management also added: “And I would just mention, we continue to track towards our long-term capital return plans of returning 75% to 100% of our free cash flow.”

Key Metrics:

DRAM Revenue Dips QoQ:

We highlighted DRAM as one of the primary growth drivers for Lam coming out of this memory trough over the course of the next few quarters as Samsung, SK Hynix, and Micron work to significantly boost HBM3 and HBM3e production to meet elevated demand from Nvidia and AMD’s GPUs.

However, DRAM contributed only 23% of systems revenue in fiscal Q3, or ~$551 million, compared to 31% of revenue, or ~$713 million, last quarter.  Through the first three quarters of FY24, DRAM revenue totaled ~$1.737 billion, an increase of ~73% YoY.

Management stated the following about the sequential weakness in DRAM: “I do just want to mention one thing. We are characterizing 1 customer's investment in specialty DRAM as a nonvolatile investment since it has a nonvolatile component to the device.”

The weakness is also relative as during peak revenue in the Q2 FY2023 quarter, DRAM was 11% of revenue. So, even with this sequential weakness, it’s more than doubled in percentage of revenue from what it was at the cyclical top.

Non-Volatile Memory (NVM) Sales Pick Up:

Though DRAM’s contribution dipped sequentially, NVM sales offset much of this, rising from 17% of systems sales last quarter to 21% in Q3. Overall, memory accounted for 44% of Lam’s total systems sales in the quarter, down from 48% last quarter but up from 32% in the year-ago quarter.

Overall, systems sales rose to a ~63% contribution to total revenue, up from 61% in the prior quarter and marking a third consecutive quarter of increasing contribution. This suggests demand remains healthy.

Earnings Call:

Key Product Commentary and Timing for 2025-ish:

HBM and DRAM:

Our thesis is two-fold and management explained both points nicely in the call. The first is that we want to participate in the high bandwidth memory (HBM) boom being driven forth by AI acceleration. Our Members are quite aware of this trend as we’ve been hammering on it for a few quarters.

Here is what management stated about how Lam participates in this trend: “With respect to DRAM, AI servers use high-bandwidth memory or HBM to increase read write speed and reduce server power consumption. HBM stacks multiple DRAM dies using TSVs enabling 15x more data throughput than standard DRAM. However, HBM also requires an approximately threefold increase in wafers per bit compared to conventional memory. With this in mind, it's important that our SABRE 3D and Syndion tools not only provide best-in-class plating and etch capabilities, but also deliver industry-leading throughput and productivity to keep overall costs low for our customers. We are the leading player in TSV applications for HBM and expect our HBM related shipments to grow more than 3x in calendar year 2024.”

It was stated on the call that HBM is only 1-2 points of overall bit demand, and thus it’s “small today but growing quite rapidly.”

In terms of timing, especially as it relates to the CHIPS Act, which in turn will drive more equipment sales, the following was stated:

“And so we've always said these are more of a 25, 26, 27 time frame for — from the equipment side, especially the shorter lead time tools like we provide. So you see the fab coming up a lot of construction connectivity, you see long lead time tools go in. And then we know that our time will come. I mean — and so I think it's still a '25, '26, '27 opportunity for us. more of a 25, 26, 27 time frame for — from the equipment side, especially the shorter lead time tools like we provide. So you see the fab coming up a lot of construction connectivity, you see long lead time tools go in. And then we know that our time will come. I mean — and so I think it's still a '25, '26, '27 opportunity for us. 

But the important thing is, while that's a lot of extra money maybe what's really exciting about is most of that is targeted towards to the leading-edge nodes […], but it's at nodes where we believe that we will actually do better from a SAM and market share perspective. And so we're patiently waiting. But we know it's going to come. You can go visit the sites, the fab buildings are there, and they're feverishly working to get them ready for equipment.”that we will actually do better from a SAM and market share perspective. And so we're patiently waiting. But we know it's going to come. You can go visit the sites, the fab buildings are there, and they're feverishly working to get them ready for equipment.”

The bigger picture at full utilization is that GPUs and AI servers will drive 8X DRAM and 3X NAND, which will equal “$1 billion to $1.5 billion incremental WFE” for every 1% server penetration, according to Lam.

NAND/Storage:

Non-volatile memory’s (NVM) acceleration this quarter could imply that the NAND uptick is already beginning, with a greater contribution expected in 2025. Since Korea commands a significant global share in both DRAM and NAND, its increased revenue share, at 24% in Q3 (up from 19% last quarter and 16% two quarters ago), hints at NAND spending and utilization resuming given that DRAM sales were weaker. 

According to management, “More advanced AI applications need faster, more power-efficient and higher-density NAND storage. NAND-based enterprise solid-state drives or eSSDs, are 50x faster in read write capability, 2 to 5x more power efficient and use 50% less space at the system level compared to hard disk drives or HDDs. Today, over 80% of enterprise data is stored on HDDs. And we expect this mix to shift in favor of SSDs as NAND capability and cost continues to improve.”

In terms of timing and the 2025 rebound that is expected industry-wide, Lam stated the following:

“I mean, clearly, we all know that the NAND spending has been incredibly weak for the last 12 to 18 months. And so we're in the very early stages of starting to see that recover. And I think if you look at what most of our — we rely on our customer commentary that they make publicly for a lot of this, but they talk about the fact that maybe 90% of the bits they're shipping are at the leading edge. 

But when we look at the installed base of our systems, that was my comment. I believe that there is still going to be a large portion of the installed base that will move forward to the next technology nodes. It's the most efficient way for our customers to to do that is to upgrade what they already have. And I think you'll see that move forward and therefore, NAND WFE move up in '25. But because it comes through a large — to a large degree, through upgrades, Lam's capture rate of every dollar of WFE spend will be much higher than in a greenfield capacity added. So when I think about Lam's opportunity to outperform in 2025, in NAND, I think it is obviously with high confidence because of the type of spending we would expect to be seen in 2025. And in the other market segments, it's also pretty high because of the — as I mentioned, the technology inflections that are occurring […] And so I just feel like there are a number of growth drivers for the company besides the one that is the most obvious, which is a NAND recovery in 2025.”And I think you'll see that move forward and therefore, NAND WFE move up in '25. But because it comes through a large — to a large degree, through upgrades, Lam's capture rate of every dollar of WFE spend will be much higher than in a greenfield capacity added. So when I think about Lam's opportunity to outperform in 2025, in NAND, I think it is obviously with high confidence because of the type of spending we would expect to be seen in 2025. And in the other market segments, it's also pretty high because of the — as I mentioned, the technology inflections that are occurring […] And so I just feel like there are a number of growth drivers for the company besides the one that is the most obvious, which is a NAND recovery in 2025.”

Gate All Around Technology Nodes:

In August, our deep dive discussed how gate-all-around transistors are replacing FinFET transistors. The company stated that shipments for gate-all-around nodes will exceed $1 billion this year. Per management, this is just starting:

“we're really just starting at gate-all-around. Our comment was $1 billion of shipments into the gate-all-around nodes this year. And it's across all of our types of products that help enable gate-all-around smaller technology nodes. And so what we've said is that every technology node, etch and depth intensity grows and our SAM opportunity expands.”

Utilization is Improving, Further Supports 2025 Recovery

Lam offered a lucid discussion around how utilization rates are showing signs the 2025 recovery is on track.

In the opening remarks it was stated: “In NAND, we continue to expect year-on-year growth in WFE spending in calendar 2024. Encouragingly, we have seen an uptick in fab utilization. And in the March quarter, this has translated into double-digit percent growth quarter-over-quarter in our spares revenues. As supply and demand continues to normalize through the remainder of the year, we see a strong setup developing for 2025 NAND spending. As supply and demand continues to normalize through the remainder of the year, we see a strong setup developing for 2025 NAND spending.”

There was follow-up on this in the Q&A:

However, through this downturn, the cuts in fab utilization were so severe that we actually saw spares revenue come down, which surprised us a bit, so maybe to your point of expectations.

We knew that as soon as customers started to utilize the fabs and bring some of the tools back online, we would see spares increase. We said that would be the first sign that the end market was really starting to improve. And so the reason we called it out was that, obviously, it's — it further confirms, I think, what you're hearing from our customers, which is that utilization is starting to improve.it further confirms, I think, what you're hearing from our customers, which is that utilization is starting to improve.

It doesn't tie to WFE because utilization of what you have is one issue. When you choose to spend more to either upgrade technology or add capacity is a second decision. We've said that, that is likely still more of a 2025 event on the equipment spend side. But you have to get the first indication, which is utilization improvement, spares improving and then the rest would comeWhen you choose to spend more to either upgrade technology or add capacity is a second decision. We've said that, that is likely still more of a 2025 event on the equipment spend side. But you have to get the first indication, which is utilization improvement, spares improving and then the rest would come.

China Sales Remain High

It was discussed in-depth that China is first-half weighted and revenue from this region is expected to declining as the year progresses.

In the Q&A, it was brought up that perhaps management is expecting more weakness as the year progresses due to customers being added to the blacklist. It was not confirmed directly but also was not denied.

Question
Timothy Arcuri (Analysts)Question
Timothy Arcuri (Analysts)

So I wanted to ask about China. So it's going to modulate through the year, the mix, but it sounds like it's still going to be up year-over-year for domestic China this year. So I guess my question is, we've seen some headlines on a few entities being potentially added to the entity list. And I'm wondering if these comments reflect the potential addition of these entities? Or does it basically say, hey, if the status quo remains, this is what your assumption is, meaning that if there were entities added that, that would be downside to these comments?And I'm wondering if these comments reflect the potential addition of these entities? Or does it basically say, hey, if the status quo remains, this is what your assumption is, meaning that if there were entities added that, that would be downside to these comments?

Answer
Timothy Archer (Executives)Answer
Timothy Archer (Executives)

Yes. Tim, I mean, obviously, we can't forecast changes in U.S. trade policy with respect to China that we don't know about. And so we're basically giving you our best view of what we think our China business will be through the rest of the year and recognizing that there could be changes that we don't foresee. And so we're basically giving you our best view of what we think our China business will be through the rest of the year and recognizing that there could be changes that we don't foresee. 

Well, what I will say is we — obviously, we've built up what we believe is a strong government affairs team were plugged into all the relevant discussions. And I think over the last couple of years, you've seen we have a pretty strong track record of working with the U.S. government responding to export control policy and that's just what we plan to do going on into the future.

Conclusion:

Lam has broken key support and it’s likely we trim some of the position with the goal of adding back at lower levels. Across the board, Lam is trading about 2X higher than its median top line and bottom-line valuations. The PE Ratio is 34 compared to a 3-year median of 19. The forward PE Ratio of 30 is easily the highest it’s traded in three years. It’s the same scenario for the top line. This report may not be enough to justify these valuations in the near-term. Therefore, you can expect us to actively manage this position as we try to seek whatever alpha we can find in the current market.

For reasons clearly outlined above, we expect this will be a high allocation for 2025. The company carries a level of complexity that we are comfortable navigating, and it’s to our benefit that management is being quite clear on when to expect their largest segments to rebound. Therefore, whatever we trim will be added back at lower levels.

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

Recommended Reading:

Tencent: China AI Momentum Play with Technicals

Posted on by io-fund

Tencent stands out for its dividend, buybacks, strong margin expansion, increased cash, and plus WeChat in mainland China was quite strong this past quarter. However, we want to emphasize that any trades on Tencent or Baidu are momentum trades only. These are not shared with Pro or Essentials Members and are more like crypto, where technicals not only lead but are roughly 90% of the decisions we make around the position.

Below is research into Tencent’s financials with the gentle reminder that the technical analysis section below is the ultimate determining factor in how we manage the momentum position.

Revenue and EPS:

In the last earnings report, the conversion rate was stated to be based on USD1 to RMB7.0827. The currency rates may fluctuate in the upcoming earnings report and thus any USD numbers will not be exact.

Tencent is expected to report growth of 2% this quarter for revenue of $21.9 billion USD. This compares to $21.98 USD or RMB 155.2B in the previous quarter for growth of 7%. The company is expected to report growth of roughly 10% the next three quarters with the March quarter expected to be the bottom.

On an annual basis, 2023 reported growth of 10% for RMB 609B or $86B USD compared to a decline of (-1%) for RMB 554.6B or $79.6B USD for the full year 2022. Looking forward, Tencent is expected to report growth of 8.9% for USD $92.2B. The company is expected to report roughly 10% growth over the next few fiscal years with 2022 expected to be the bottom on an annual basis.

This quarter, the company is expected to report EPS of USD $0.64, or calculated to be RMB $4.53 EPS. This is flat from RMB $4.50 EPS reported last quarter yet the estimates represent growth on a year-over-year basis of 33%, up from RMB $3.10. Next quarter, Tencent is expected to report EPS of $0.64 or RMB $4.53 to be flat QoQ yet up 21% year-over-year.

On an annual basis, adjusted EPS is expected to grow 23.4% for USD $2.80, calculated to be RMB $19.9 EPS. This is up from RMB $16.3 adjusted EPS in FY2023. EPS is expected to grow 16% in FY2025 and 29% in FY2026.

Tencent focuses closely on Profit Attributable to Shareholders on a Non-IFRS basis (which is Non-GAAP adjusted net income for our reporting standards). In the most recent quarter, this was RMB $42.7B or USD $6B and was up 44% YoY.

EBITDA of $54B RMB or $7.6B USD was up 22.7% from $44B RMB in the year ago quarter. Adjusted EBITDA of $59.5B RMB or $8.4B USD was up from $49.6B RMB in the year ago quarter. The adjusted EBITDA margin increased to 38% up from 34% in the year ago quarter.

Margins:

Tencent is seeing expanding margins and this is a key piece as to why Tencent could see favorable price action.

Last quarter, the gross margin of 50.2% expanded from 43% in the year ago quarter and was up 120 basis points QoQ. Gross profit was up 25% from $61.8 RMB to $77.68 RMB or USD $11B.

Per management: “Importantly, our gross profit growth has consistently surpassed revenue growth due to the margins of our incremental revenue being significantly higher than the 50% overall gross margins for the entire company. This incremental revenue is generated predominantly from our leading social and payment platforms, which have already been built and had their costs covered. We now consider gross profit growth as a key proxy and, frankly, a better proxy than revenue growth for our organic growth given this shift in terms of the revenue mix.”

Last quarter, the operating margin of 27% increased from OPM of 20% in the year ago quarter yet decreased 400 bps from the previous quarter. The operating profits were $41.4B RMB or $5.8B USD.

The adjusted operating margin of 32% was up from 27% in the year ago quarter and is up 11-points in two years. This is down QoQ 400 basis points.

Per management regarding this efficiency: “We further enhanced our operating profit growth from gross profit growth through operating leverage. First, we streamlined operations and prudently reduced aggressive marketing expenditures. We perceive these measures as a less recurring strategy. Second and more importantly, we are committed to operational efficiency and disciplined resource allocation, which includes thoughtful staff distribution and effective marketing expense management. This approach ensures a focused organization and a lean cost structure moving forward.”

  • The net margin of 18% for profits of 27.9 RMB doesn’t comp well against a one-time event in the year ago quarter, which had led to a net margin of 74%, but the 18% is in line with previous quarters. 
  • The adjusted net margin of 28% compares to an adjusted net margin of 21% in the year ago quarter. This is down 200 basis points QoQ.

Cash Flow:

Operating cash flow last quarter was RMB $54 billion or USD $7.6B, up 52% YoY. This represents an operating cash flow margin of 35% up from a margin of 25% in the year ago quarter.

Free cash flow of RMB $34.2B or $4.8B was up 48% YoY and represents a free cash flow margin of 22% up from 16% in the year ago quarter. Some quarters have a higher FCF margin than others, with Q3 and Q1 reporting a FCF margin of 33% and 35%, respectively.

The company has RMB 403.3B or USD at $56.9B in cash. This is up from USD 45.9 in the year ago quarter. The company has debt of RMB 348.6B or USD 49.2B for net cash of RMB 54.7B, which calculates to net cash of $7.72B USD.

Last quarter, the company spent RMB 7.5B in capex, which was up 33% YoY.

The fair value of shareholding in listed investee companies was RMB 550.7B or USD $77.8 billion. This has been trending upward but is a risk to have this much exposure to other companies.

The carrying book value of unlisted investee companies was RMB 337.3B or USD $47.6 billion. This has been flat over the past few quarters.

Dividends and Buybacks

Tencent pays an annual dividend and recently increased this by 42% to HKD 3.40 per share, which has a current exchange rate of $1 = $7.84. This would equal USD $0.43. Also, according to the last earnings report: “we intend to at least double the size of our share repurchases, from approximately HKD49 billion in 2023 to over HKD100 billion in 2024.” This equals roughly USD $12.7 billion.

Per the earnings call: “We believe this commitment to return at least HKD 132 billion or US $16.9 billion to shareholders during the year is well supported by our free cash flow, which was US $24 billion for the full year of ’23, along with our gross cash position of US $57 billion and our investment portfolio of US $126 billion.”

Key Metrics:

The Online advertising revenue segment reported RMB 39.8B up 21% YoY. This compares to 15% growth in the year ago quarter. This represents 19% of revenue with a gross margin of 56.8%. The gross margin was up 12.6 points year-over-year.

Fintech and Business services were up 15% YoY for RMB 54.4B compared to a decline of (-1%) YoY to RMB 47.2 billion in the year ago quarter. This represents 35% of revenue. Gross margin in fintech and business services is at 43.9% which was up 10.3 points year-over-year.

Revenue from value-added services (VAS) which includes international games, domestic games, communication and social, and also digital content, was down 2% YoY to RMB 69 billion and was also down 2% in the year ago quarter. Revenue from music-related and game-related livestreaming services decreased while revenue from the video accounts streaming service, music subscriptions and mini-games increased. This segment has a gross margin of 53.7% and was up 3.9 points YoY.

Despite the puts and takes in the segment, management stated the following highlights: “Our mini-games platform increased gross receipts by over 50% year-on-year. Our number of major hit games in China achieving both high DAU and substantial monetization increased from six in 2022 to eight in 2023 and in connection with games achieved double digit revenue growth and rose to 30% of games revenue.”

Management also stated they expect games to improve “from the second quarter of 2024.” There is also a popular game on desktop expected to launch on mobile in the second quarter called DnF mobile.

  • Combined MAU of Weixin (mainland China) and Wechat (global app) is 1.343B up 2% YoY
  • Mobile Device MAU was down (-3%) YoY to 554
  • Fee-based VAS registered subscriptions was up 6% YoY to 248

Additional metrics:

  • Tencent Video had 117 million paid subs. Long form video subscription revenue increased 1% year-on-year, driven by higher ARPU, while their video subscriptions declined slightly to RMB 117 million.
  • Tencent Music had 107 million paid subs. Music subscription revenue increased 45% year-on-year on 21% growth in subscription count and 20% growth in ARPU.

Some highlights this past quarter include management stating: “Weixin Search has now achieved over 100 million DAU, up over 20% year-on-year, and Weixin Search content QV grew over 30% year-on-year. Our search revenue grew multiple times year-on-year in 2023 as we ramped up monetization on this under-monetized asset.”

Later it was also stated: “Weixin video accounts on the content consumption side, time spent increased over 80% year-on-year in the fourth quarter driven partly by DAU and mostly by time spent per user.”

Risks:

There are some risks associated with Tencent stock that are important to keep in mind, especially since United States stocks do not carry the same level of risk. The first is United States-China tensions, the second is that Tencent’s financials are unaudited, and third that Tencent is an over-the-counter stock which means the stock is not traded on an exchange.

Valuation:

Tencent trades at a PS ratio of 4.5 and a 4 EV/Sales which is in line with three year averages yet is low on a 5-year average basis. The 3-year median is 5 and the 5-year median is 6-8 EV/Sales

The company trades at a Fwd PE Ratio of 12 based on next year’s earnings compared to a 15 Fwd PE Ratio on a 3-year basis. However, the forward PE Ratio on a 5-year median is 30.

Price to FCF is 28.7 and has primarily traded higher except in 2022. The stock has traded as high as a 50 Price to FCF, but this is the absolute max it’s traded in the last few years.

Earnings Call:

AI driving Ad Revenue increase:

Per the earnings call:

“Moving to online advertising, our ad revenue was RMB 30 billion in the fourth quarter, up 21% year-on-year, benefiting from upgrades to our ad tech platform and more advertising revenue and video accounts. We generated increased ad revenue from all major categories except automotive with notable step-ups in revenue from internet services, healthcare and consumer goods categories. We refined our ad targeting by utilizing more real-time data in the AI powering our ad tech, enabling us to match target users with more relevant ads in a more timely manner across both our owned and our ad network properties.We refined our ad targeting by utilizing more real-time data in the AI powering our ad tech, enabling us to match target users with more relevant ads in a more timely manner across both our owned and our ad network properties.

Our video accounts ad revenue more than doubled year-on-year despite maintaining a very low ad load, due to increased video views and upgraded ad targeting. Weixin Search increased its revenue several-fold year-on-year in the quarter on growth on commercial queries and RPM.”

Later it was also stated:

Moving to communications and social networks, for Weixin video accounts on the content consumption side, time spent increased over 80% year-on-year in the fourth quarter driven partly by DAU and mostly by time spent per user, benefiting from our enhanced content recommendation engine […] Our video accounts ad revenue more than doubled year-on-year despite maintaining a very low ad load, due to increased video views and upgraded ad targeting. Weixin Search increased its revenue several-fold year-on-year in the quarter on growth on commercial queries and RPM.”

More on Artificial Intelligence

“Our Tencent Hunyuan foundation model is now among the top tier of large language models in China with notable strength in advanced logical reasoning. Our upgraded advertising AI model enables us to deliver better ad targeting and higher revenue.”

“In 2023, we also made notable progress in core technologies, especially those involving AI that will serve as our growth multiplier going forward. After deploying leading edge technologies such as the mixture of experts, or MoE architecture, our foundation model Tencent Hunyuan is now achieving top tier Chinese language performance among large language models in China and worldwide. The enhanced Hunyuan excels particularly in multi-turn conversations, logical inference, and numerical reasoning, areas which have been challenging for large language models. We have scaled the model up to the trillion parameter mark leveraging the MoE architecture to enhance performance and reducing [indiscernible] costs, and we are rapidly improving the model’s text-to-picture and text-to-video capabilities.

We are increasingly integrating Hunyuan to provide copilot services for our enterprise SaaS products, including Tencent Meeting and Tencent Docs, and we are also developing new gen-AI tools for effective content production internally. More generally, deploying AI technology in our existing businesses has begun to deliver significant revenue benefits. This is most obvious in our advertising business where our AI-powered ad tech platform is contributing to more accurate ad targeting, higher ad click-through rates and thus faster advertising revenue growth rates. We also see earlier stage business opportunities from providing AI services to Tencent Cloud customers.”

Technical Analysis

If we analyze the bigger trend in Tencent (TCEHY), there are two interpretations on the pattern in play.

  • The Blue Count has the large correction that started in February of 2021 was actually a correction within a larger uptrend. This pattern would be playing out in 5 waves, and the current breakout would be the start of the final 5th wave higher. If this is in play, we will push past the $72 resistance, breakout to new all-time highs and then target the $115 – $140 region.
  • The Red Count has the larger 5 wave pattern ending in February of 2021. This would imply that we are in a larger degree corrective bounce, which should take us to the $58 – $72 region, and potentially higher. We would be in the final push of a B wave, which is a 3 wave move.

If we zoom in on this move, what is worth noting is that both counts suggest a move to the $58 – $72 region.

From current levels, this is a 35% – 65% move. How TCEHY reacts in this region will determine if the more bullish blue count is in play. For any immediate entry, our stops would be between $39 – $36. If we catch the trend correctly, these stops would move higher with price.

Conclusion:

Similar to our analysis on Baidu, we foresee China’s push for domestic tech to be a force to contend with when it comes to AI. We could not be clearer that United States stocks are richly valued at the moment, and it’s quite difficult to find a good deal on tech in this market. Should we look toward China for alpha, it would be brief and a decision based on technicals. This means a position ranging from 1 day (should the setup fail) to a couple of months maximum. The weekly webinars and trade alerts are especially informative in this case, which is why the analysis is not shared with subscription tiers that do not have access to these Premium benefits. China is risky, Tencent is not audited, and is an OTC stock, and there are geopolitical tensions to navigate. With that said, the likelihood is high that we will attempt this half-court shot, so keep an eye out for the trade alert.

Knox Ridley, Beth Kindig, and the I/O Fund Analysts, contributed to this analysis

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ServiceNow Overview: Key Metrics are Strong

Posted on by io-fund

ServiceNow’s upcoming earnings report is of high interest to us. There are many key metrics to highlight, including the company’s ability to re-accelerate subscription revenues to 27% YoY in the previous quarter, up from 22% a year ago. RPO also accelerated nicely to 29% YoY growth up from 22% in the year ago quarter. Net New ACV (NNACV) was up 33% YoY compared to 30% in the year ago quarter with the number of transactions over $1M in NNACV more than doubling QoQ from 83 to 168 transactions.

The CFO stated that the company’s generative AI product, Now Assist, contributed to the recent raise for FY2024 guidance of $165 million. However, gen AI’s contribution is very new and not too impactful yet, per management.

ServiceNow is the rare cloud company that is GAAP profitable and has a strong free cash flow margin of 30% for FY2023.

This report dives deeper into the elements that underpin ServiceNow’s optimism, including an examination of its financial health, strategic initiatives, and the anticipated impact of its AI-driven products on the market.

Key Points:

  • Q4 2023 Revenue Performance: ServiceNow reported a 25.62% increase in Q4 revenue, reaching $2.44 billion. QoQ growth improved by 6.6%, with expected Q1 revenue of $2.59 billion, marking a 23.5% year-over-year increase.
  • Robust Subscription Growth: ServiceNow's subscription revenues reached $2.37 billion, growing 27% YoY and exceeding revenue guidance of $2.32 billion and growth of 24.75% at the mid-point and $2.32 billion, while professional services declined by 10% YoY in Q4 and 18% for the year.
  • Expansion and Strategic Alliances: ServiceNow enhanced its OT management capabilities with acquisitions of 4Industry and Smart Daily Management, collaborated with Hugging Face and NVIDIA on the StarCoder2 LLM, expanded its partnership with NVIDIA for telco-specific AI solutions, deepened its alliance with EY for AI compliance, and launched new payment and AI-powered solutions through strategic alliances with Visa and AWS.
  • Mixed Margin Performance: ServiceNow experienced mixed margins year-over-year, with improvements in operating and net margins, while gross and subscription margins saw slight declines.
  • Operational Efficiency and Investment Strategy: The company is raising its full-year operating margin target from 28% to 29% due to continued operational efficiencies. Investments are focused on innovation in AI, particularly Gen AI, with significant hiring in R&D to drive these initiatives.
  • Strong Growth Outlook with GenAI Focus: According to management, the newly launched Gen AI product, Now Assist is contributing to the company’s largest net new ACV. This segment saw 168 deals greater than $1 million, up 33% YoY.
  • Strategic Gains Across Segments: Despite challenges in the market environment, ServiceNow closed numerous large deals globally, including a record number of new $1 million+ deals and major wins in the public sector such as with the US Army and Australian Department of Defense.

Revenue and Earnings:

ServiceNow reported fiscal Q4 revenue of $2.44 billion for an increase of 25.62% YoY. This is a 6.6% improvement QoQ from $2.29 billion in revenue. The growth rate was 24.96% in the September quarter, and thus, December marked a slight acceleration. In terms of being seasonal or not, this did not occur last year, rather the December 2022 quarter decelerated by 90 basis points in growth rate.

ServiceNow is expected to see slightly slower growth next quarter at 23.5% for revenue of $2.59 billion. For the full year, analysts are expecting growth of 21.4% for revenue of $10.89 billion.

The performance in Q4 was packed with milestones for ServiceNow, spanning the full breadth of their portfolio. Each of their workflow businesses, technology, customer, and creator, are over $1 billion in annual contract value (ACV). And the company has 11 individual product lines with north of $250 million in ACV.

ServiceNow ended Q4 with 1,897 customers paying over $1 million in ACV adding 108 customers compared to the prior quarter. This is the addition in $1M customers in the past five quarters.  

The company closed 168 deals greater than $1 million in net new ACV (NNACV) in the quarter, a 33% increase year-over-year, that includes five deals over $10 million. Interestingly, this was over 100% growth QoQ.

For the full year 2023, ServiceNow saw an approximate 30% increase in deals greater than $1 million in net new ACV.

Despite this, total ACV only increased 15% in Q4 2023 compared to the prior year period. This is down from 17% growth in the previous quarter and down from 22% in the year ago quarter.

Remaining Performance Obligations (RPO) and current Remaining Performance Obligations (cRPO) are two popular metrics to track for ServiceNow.

RPO ended the quarter at approximately $18 billion representing an acceleration to 29% YoY. This compares to growth of 26% in the previous quarter and compared to growth of 22% in the year ago quarter.

cRPO was $8.6 billion, representing 24% YoY which was down from 27% in the previous quarter although was up from 22% in the year ago quarter.

Gen AI products, via Now Assist, drove the largest net new ACV contribution for the first full quarter of any of ServiceNow’s new product family releases ever, including the original Pro SKU.

ServiceNow topped analyst estimates on both the top line and bottom line. Analysts were expecting GAAP EPS of $1.43, non-GAAP EPS at $2.78 and revenue of $2.4B, while the company reported GAAP EPS at $1.46, non-GAAP EPS at $3.11and revenue at $2.44B. Even though the company’s earnings growth is expected to slow in 2024, management is still anticipating solid double-digit growth for the year.

Revenue Segments:

In Q4, subscription revenues were $2.37 billion, growing 27% YoY, exceeding the high end of the company’s guidance. ServiceNow closed out 2023 with $8.68 billion in subscription revenues, also representing 27% growth compared to fiscal 2022 subscription revenues. The CFO Gina Mastantuono had this to add on subscription revenues, “All organic at a scale that hasn't been accomplished by any other enterprise software company.”

Professional services and other revenues were $72 million for Q4, a (-10%) decrease YoY. For the full year of fiscal 2023, professional services and other revenues amounted to $291 million, representing an (-18%) decline YoY.

With regards to ServiceNow’s total addressable market (TAM), the CFO commented on a major milestone: “For the first time in a decade, IT services will become bigger than communication services in 2024. Gartner estimates that by 2027, nearly all of the growth in worldwide IT spending will come from software and IT services. And when you drill deeper into the Gartner forecast between 2023 and 2027, $3 trillion will be spent on AI.” This speaks to size and growth of the total addressable market for ServiceNow.

Margins:

Margins were mixed YoY as the company's focus on low-margin AI products is evident in its financial outcomes. Operating margin and net margin improved, while gross margin and subscription margin declined slightly YoY.

Non-GAAP subscription gross margin dipped to 84% in Q4 2023, flat QoQ but a decrease from 86% in Q4 2022. The company expects this margin to improve slightly to 84.5% in 2024, reflecting investments in data centers and emerging growth opportunities, partially offset by a change in useful life in data center equipment from four to five years. ServiceNow is also raising its full year non-GAAP operating margin target from 28% to 29% driven by continued operational expenses efficiencies.

Margins were a topic in the conference call with one analyst congratulating the company on the performance in 2023, with the CFO adding the expectation those margins will continue to expand in 2024.

Cash Flow:

Operating cash flow of $1.61 billion in fiscal Q4 represented a margin of 66%. Free cash flow of $1.34 billion represented a FCF margin of 55%.

There is $8.1 billion in cash and investments on the balance sheet and $1.49 billion in debt. Debt has remained constant since Q4 2022 with no amounts due in the next twelve months.

ServiceNow announced that the company repurchased 400,000 shares of its common stock for $256 million as part of its share repurchase program.

Earnings Call:

ServiceNow is expecting strong growth yet again in 2024 with GenAI being a central part of the bullish view for the stock. Analysts had a lot of questions on the topic.

GenAI

ServiceNow’s new Gen AI product, Now Assist, was stated to have “drove the largest net new ACV contribution for our first full quarter of any of our new product family releases ever.” Therefore, it’s not surprising to see it as a key topic during the Q&A.

And despite the very strong performance in Q4 and fiscal year 2023, it brought out a few interesting takes from management, specifically on the environment they face as we head into 2024.

Here is what the CEO stated when asked about the Gen AI product driving the largest net new ACV contribution:

“What's really happening and I can say this after 186 CEO meetings in the last six months, the CEOs are now getting very involved with the Gen AI revolution. They realize there has to be architectural adjustments to their environment and the manner in which they manage their data and the platforms they're beholden to actually take advantage of Gen AI.

 And if you think about the half a century mess that exists out there with legacy systems, in many cases, multiples of the same system, we have one unifying force in these conversations, which is the Now platform because we cooperate with the complexity of this landscape without putting people in a position to rip and replace […]

As I said, that SKU has outsold any other new introduction we put into the marketplace. So, there's a real appetite to invest in Gen AI, and there's no price sensitivity around it because the business cases are so unbelievable. I mean if you're improving productivity, 40%, 50%, it just sells itself.”

Overall, this is an encouraging note on the sales environment along with the potential of the Gen AI segment for ServiceNow. It’s not a huge revenue driver at the moment, but the trajectory means it could become a key driver of growth in 2024 and beyond.

Here’s what Gina had to add about Gen AI during the call.

I get the question often, do we see the adoption curve to be steeper for our Pro Plus than our Pro. Certainly, in the first full quarter of launch, it absolutely has shown that.

That being said, it's very early days. And so from a revenue contribution perspective, it's not going to be huge, but it's certainly helped when I thought about my guide for 2024 and that increase of $165 million at the midpoint, right? So Gen AI, early days, but the adoption curve so far is steeper than the original Pro. We will keep an eye on it.but it's certainly helped when I thought about my guide for 2024 and that increase of $165 million at the midpoint, right? So Gen AI, early days, but the adoption curve so far is steeper than the original Pro. We will keep an eye on it.

Net New ACV

ServiceNow’s new logo count continued to accelerate in Q4, with a record 10 new customers signing deals over $1 million in NNACV, including a $10 million win with a very large global financial services firm, which is their largest new customer logo in history.

Chipotle, Air France, TIAA, NTT, Data Group Corporation, and Busch are some of the brands that are utilizing ServiceNow to enhance their operations.

Additionally, in Q4 ServiceNow built on a record Q3 with the public sector, with key wins including in the United States Army, US Postal Service, and Australian Department of Defense Digital Delivery Group.

During the call, one analyst wanted more details on the drivers of the momentum in ACV.

Bill McDermott:

Just a couple of statistics on the customer workflows, 18 of our top 20 deals, what we're seeing is there's a tremendous opportunity to really take ServiceNow and squarely place it on the Customer Relationship Management category.

When you think about front, mid and back office and the fact that we can align all three of those things, and nobody has to lose for us to win. We could fill in all the blanks for what the current participants don't do, especially with their integration problems. It's just a fantastic opportunity for our customers.

And I think it's important to note, when I gave the Field Service Management example, our net new ACV in Field Service Management, specifically was up over 50% and year-over-year.

So, I think it's important to recognize that we have a whole list of new logos in this space. And employee workflows, nine of our top 20 deals and was kind of interesting. Every single CEO now is looking to make the people packed far more productive than it is and with natural language to have your employees seek the data and the information they want and have it reported back to them in just a very nice paragraph of content and data so they can do their jobs better, is kind of like in the no-brainer category.

RPO and cRPO

RPO and cRPO are key indicators of growth and future projections for ServiceNow. Analysts were zeroing in on what the upside is for the current quarter, Q1 2024, and how much is due to Gen AI adoption.

Gina Mastantuono:

So, we beat our Q4 cRPO growth guidance by 200 basis points as you know. And I would say it's driven probably half and half by net new ACV outperformance and certainly, Gen AI is in there, but it's not all Gen AI.

So, our core business is also doing well. And then we also did see higher early renewals than we had assumed in our guidance. And I would say it's about half and half of the total beat.

Government:

The government is a very strong potential growth area for ServiceNow. A few analysts wanted more details.

They asked about cyclical spending at the public sector and what their AI adoption cadence is going to look like.

Here’s Bill’s take:

Our federal business is really outstanding. And for the benefit of our shareholders, I think that there's a tremendous opportunity to replicate what we're doing in the United States federal and many other governments around the world. That is clearly an ambition that we have, and we have many use cases and many references to back that up.

Recent AI Announcements:

On March 18, 2024, ServiceNow announced it has signed an agreement to acquire 4Industry, a Netherlands‑based partner whose manufacturing technology application is built on the Now Platform, and has completed the acquisition of  Smart Daily Management, a connected digital worker application from EY. Together, the deals augment ServiceNow’s existing operational technology (OT) management capabilities, adding Connected Worker solutions and enhancing expertise across key industrial markets such as manufacturing, energy and transport & logistics.

On February 28, 2024, ServiceNow, Hugging Face, and NVIDIA, announced the release of StarCoder2, a family of open‑access large language models (LLMs) for code generation that sets new standards for performance, transparency, and cost‑effectiveness.

On February 26, 2024, ServiceNow and NVIDIA announced that they are broadening their relationship with the introduction of telco‑specific generative AI solutions to elevate service experiences.

On January 24, 2024, ServiceNow announced a broader strategic alliance with EY to empower responsible AI use for enterprise customers, deliver unified solutions for AI compliance and governance, and bring AI‑enhanced experiences to EY employees and clients with ServiceNow Now Assist.

Additionally, ServiceNow and Visa announced a five‑year strategic alliance to transform payment services experiences. The initial phase includes the launch of ServiceNow Disputes Management, Built with Visa–– a single, connected solution for disputes resolution.

ServiceNow also announced a five‑year Strategic Collaboration Agreement with Amazon Web Services (AWS) to offer the ServiceNow Platform and full suite of solutions in the AWS Marketplace. The two companies will also co‑develop and launch industry‑specific, AI powered applications.

Conclusion:

The key metrics on ServiceNow help to create a picture that something special is going on at this company compared to many cloud peers. As with nearly every stock in the market right now, investors must contend with valuations. This is one thing if you’ve owned a stock for some time and are sitting on gains, but is a bigger risk if you’re wanting to enter now for the initial entry. We’d like to keep ServiceNow in our pipeline to buy at lower levels, while also keeping an eye on the upcoming earnings report to see if any new information changes that decision. As always, each investor must determine their own unique risk profile for themselves. For our purposes, we view ServiceNow as fairly valued at 17 PS ratio compared to a 17 PS ratio 5-year median and 15.5 PS ratio 3-year median. The bottom line is only recently GAAP profitable and trades at a 88.6 PE Ratio compared to 5-year median of 1826 (noisy signal). Price to free cash flow is at 56 compared to a 5-year median of 52.6. Therefore, for our purposes, it makes sense to try and get the stock lower since the probability it can stretch higher (and sustain a higher valuation) is low. 

Chad Shoop, Equity Analyst for the I/O Fund, contributed to this analysis

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Lam Research: Eyeing Strong 2024 Exit Boosted by Memory Rebound

Posted on by io-fund

We’re seeing early shoots of the memory market rebound unfolding a bit earlier than expected, with strong results from Micron and a positive outlook from Samsung on its HBM output this year due to GPU growth.

This is following a rather steep cyclical downturn in NAND and DRAM in 2023, and this rapid recovery offers a growth opportunity for both memory chip makers and WFE suppliers including Lam Research, though it should be approached carefully with a chance for oversupply in 2025.

Despite a rather soft guide for the March 2024 quarter, Lam’s management alluded to multiple pockets of strength arising through the back half of the year, with positive commentary on HBM and DRAM as well as a brighter outlook for WFE spend. Memory is a mission-critical component for AI accelerators and the newest battleground in the market, and Lam is a major equipment supplier and beneficiary of capital intensity that follows each new generation of HBM.

This memory ‘arms race’ is forecast to translate into strong revenue growth to potentially a record level, improved leverage and >35% EPS growth in fiscal 2025 (June 2024 to June 2025) From there, growth is expected to continue at a high-teens, low 20% rate through fiscal 2026. We look at this and more below.

For a deeper overview of Lam and its products and segments, refer to our August 2023 deep dive here.August 2023 deep dive here.

DRAM Market Overview: Rebound Unfolding

The DRAM market is exhibiting signs of rebounding from 2022 and 2023’s steep decline:

  • Industry revenues declined more than (35%) YoY from $80.1 billion in 2022 to $51.9 billion, according to TrendForce.
  • DRAM industry revenue in the fourth quarter rose 29.6% to nearly $17.5 billion, setting the stage for growth throughout 2024 as prices rise.
  • DRAM prices were projected to rise 13% to 18% QoQ in Q1, followed by a more modest 3% to 8% QoQ projected increase for Q2.

Micron is expecting DRAM pricing to increase throughout the calendar year, as surging HBM and DDR5 demand tightens leading-edge DRAM supply.

These strong pricing trends and a surge in HBM revenue, from 8.4% in 2023 to 20.1% this year, are expected to aid DRAM revenue growth for the full year, with growth estimated at over 62% YoY to $84.2 billion – this is 5% higher than 2022’s level.

HBM Shipments to Surge in 2024 and 2025

With a surge in demand for GPUs, the HBM market is poised to grow at a rapid pace in 2024, and then extend this growth into 2025. HBM bit shipments are estimated to rise 147% YoY to 1.18 billion GB, leading to a projected 156% YoY increase in HBM revenues to $14.1 billion. This follows a 93% YoY increase in bit shipments and a ~104% increase in revenue in 2023.

Commentary and outlook from the three major players in the market demonstrate just how strong this growth is that we’re beginning to see.

Micron’s management expressed how strong AI server demand was “driving rapid growth in HBM, DDR5 (D5) and data center SSDs,” adding that its “2024 volume as well as pricing is all locked up.” For 2025, HBM volumes “are largely allocated. A vast majority of our production supply is allocated, and some of the pricing is already firmed up. Keep in mind, this has never happened before, right, that we are talking about 2025, and we are sitting in CQ1, and we already have so much discussion around supply and pricing for 2025 getting locked up here as we speak.”

Micron also raised a crucial point, with comments regarding Nvidia’s new Blackwell GPU lineup – the architecture “provides a 33% increase in HBM3E content, continuing a trend of steadily increasing HBM content per GPU.” This trend for higher memory content to support larger and faster GPUs is likely to continue especially as chipmakers such as AMD work quickly to encroach on Nvidia’s share with comparable or faster GPUs.

Samsung is planning a “2.9-fold increase in HBM chip production volume this year, up from the 2.5-fold projection previously announced at CES 2024,” and is “projecting a 13.8-fold surge in HBM shipments by 2026 compared to 2023.”

Lam Well Positioned to Capture HBM and DRAM Growth

Lam is well positioned to capitalize on this growth in HBM and DRAM, as Samsung, Micron and SK Hynix work to significantly boost HBM TSV capacity this year.

The trio combined for an estimated capacity of ~93K units per month at the end of 2023, and are estimated to boost HBM TSV capacity to 270K to 275K units per month by the end of 2024. As a result, Lam is expecting its “HBM-related DRAM and packaging shipments to more than triple year-on-year and outpace WFE growth in this segment by a significant margin” in 2024.

CEO Timothy Archer added that in HBM, Lam is seeing “very, very strong demand. I think that whether or not at some point, it's shipping above peak, I think that this AI market is continuing to evolve at a very, very fast rate. And all we're focused on right now is ensuring we are building out our own capacity and capabilities. And ensuring that we maintain that technology leadership that's allowing us to hold 100% market share of the TSV formation in HBM.”

We had pointed out in our August 2023 deep dive that while all three segments are important to monitor for forward growth, for a true recovery, we would need to see memory and DRAM bottom as it’s a substantial part of Lam’s business.

HBM capacity expansion, the shift to DDR5, and shipments to China have kickstarted a strong rebound in DRAM sales – in the December quarter, memory systems revenue reached 48%, a 10-percentage point increase from 38% in the September quarter. Lam noted that DRAM reached “record levels on a dollar basis, coming in at 31% of systems revenue compared with 23% in the September quarter.”

Non-volatile memory (NVM) ticked up to 17% of systems revenue in the December quarter, up from 15% in the prior quarter, though this remained significantly lower than the ~40% the segment contributed through the end of 2022 as NAND customers aggressively cut capacity in response to oversupply and elevated inventory levels. Lam noted that this was at “historic lows” for NVM, and the “slight growth was predominantly related to investments in certain technology projects.”

This has marked a pretty significant mix shift over the past four, even six, quarters – in the first half of 2023, DRAM was at just 9% of systems revenue, before rising to 31% in the December quarter.

In dollar terms, here’s what this growth in DRAM looks like:

Essentially, in two quarters – June 2023 to December 2023 – Lam has seen DRAM revenues rise 363%.

As noted earlier, management is expecting “HBM-related DRAM and packaging shipments to more than triple” this year, suggesting that DRAM systems sales could push past $1 billion by the end of FY24 (June 2024 quarter). Such growth can help offset the near-term weakness in NVM until NAND spending and upgrades resume.

Positive WFE Spending Outlook

Lam’s management shared a rather cautious view on its WFE spending outlook for the first part of the year, but expressed optimism on a recovery and strong exit to 2024 leading to a “robust” setup for the WFE market.

Here’s what CEO Timothy Archer said in the December quarter earnings call:

“As we enter 2024, the business environment remains muted. However, we expect a modest recovery in memory spending to drive a stronger exit to the year. Our early view of WFE spending for calendar 2024 is in the mid- to high $80 billion range. Growth in DRAM will be driven by capacity additions for high-bandwidth memory as well as node conversions. NAND spending increases will largely come from technology upgrades. We see foundry logic spend growing in 2024 with higher leading-edge investment, offset in part by declines in mature node investment outside of China. Overall, we believe domestic China spending will be stable in 2024.early view of WFE spending for calendar 2024 is in the mid- to high $80 billion range. Growth in DRAM will be driven by capacity additions for high-bandwidth memory as well as node conversions. NAND spending increases will largely come from technology upgrades. We see foundry logic spend growing in 2024 with higher leading-edge investment, offset in part by declines in mature node investment outside of China. Overall, we believe domestic China spending will be stable in 2024.

Longer term, the setup for WFE investment is robust. With semiconductor revenues widely expected to reach $1 trillion around the end of the decade and device manufacturing complexity continuing to rise, we believe WFE spending will need to roughly double from today's levels. Lam's served markets of etch and deposition should outpace growth in WFE overall.”the setup for WFE investment is robust. With semiconductor revenues widely expected to reach $1 trillion around the end of the decade and device manufacturing complexity continuing to rise, we believe WFE spending will need to roughly double from today's levels. Lam's served markets of etch and deposition should outpace growth in WFE overall.”

Lam’s early view for the mid to high $80 billion range represents just single digit growth YoY, with a majority of the growth being driven by HBM, which we are seeing signs of within DRAM systems sales. NAND spending cuts are likely weighing down on WFE spend, as management noted that memory WFE fell nearly 40% in 2023 on greater than 75% spending cuts in NAND.

NAND Upgrades to Aid Beyond 2024

While 2023 was extremely tough for NAND and in turn the broader memory WFE market, Lam sees a rather large opportunity to capitalize as NAND capacity comes back online due to the fact that there will be a high percentage of technology upgrades this cycle. Archer was hard-pressed for details on how this NAND recovery would unfold in the December quarter earnings call, and his comments alluded to Lam being able to capture these tech upgrades.

Archer explained in response to Cantor analyst C.J. Muse about NAND’s recovery and timeline for normalization that “as we see NAND growing — recovering and growing at a certain percentage rate, Lam will actually significantly outperform that rate because of the fact that most of that is coming from upgrades.”

And in response to BofA analyst Vivek Arya about current NAND demand and the outlook for H2 this year, Archer said that there is “a tremendous amount of capacity that [has] been offline and we've said in the past that needs to be brought back online. And I think the question and the discussions we're having is [at] what technology node should that capacity be restarted. And in many cases, there is a very high likelihood that technology upgrade certainly will occur as that equipment is brought back into service.

And so in that case, we would actually begin to see a restart of some of the utilization driven revenue that we get from things like spares and services, as well as, at the same time, a restart of technology upgrade revenues. And that's why I think that from a NAND perspective this year, we think that will effectively represent the majority of the spend that occurs in this segment.”

These technological upgrades and resumed spending in NAND will help cement in a recovery to potentially record revenues in fiscal 2025 – while the near-term rebound is more DRAM-centered, NAND’s rebound may unfold as the bigger story, given that NAND’s best-ever quarter was larger than NAND revenue in all of last year.

Double Digit Revenue Growth Through FY26 to Drive Strong Earnings Leverage

While the March quarter guide (fiscal Q3) was soft, pointing to a ~(4.4%) YoY decline at midpoint, fiscal 2025’s outlook (beginning in July of 2024) is much brighter, boosted by DRAM’s surge and NAND’s recovery.

Fiscal 2024 is expected to see a (15.2%) revenue decline to just under $14.8 billion as a result of this sharp memory WFE decline in calendar year 2023. Fiscal 2025 (beginning in July of 2024) is expected to see an 18.7% increase to a record $17.55 billion on DRAM-fueled tailwinds.

Fiscal 2026 is projected to see revenues top $20.2 billion, representing an increase of 15.6% YoY; NAND technological upgrades and continued DRAM spending are likely the main drivers of this growth.

We noted in our August deep dive that an inflection in Systems’ revenue contribution would offer further evidence that Lam had bottomed — during periods of strong demand, the breakdown is about 65%/35% between Systems and CSBG. This reflects strong sales of new hardware and the steady growth of the aftermarket that follows. During periods of weaker demand, the percentage of hardware sales decreases and aftermarket increases because there are fewer new systems sales and the aftermarket is primarily done on existing capacity.

Systems inflected in September, contributing 59% of revenue before rising to 61% of revenue in the December quarter, likely aided by this strength in DRAM sales.

In addition, we’re seeing evidence that CSBG revenue may have bottomed in the September quarter, rising 2.3% QoQ in the December quarter. Reaching this inflection point serves as an early sign that customers are planning to increase utilization. Increased utilization and higher systems sales go hand in hand, as customers boost both to capture growth in periods of higher memory chip demand.

This path to possible record revenues in FY25 and $20B+ in FY26 sets the stage for strong EPS growth. Lam has demonstrated a tremendous ability to grow earnings in the past. For example, from fiscal 2019 to fiscal 2023, Lam grew its EPS from $13.70 to $33.21.

Despite a hit to EPS in fiscal 2024 from the revenue decline and margin pressure Lam is experiencing, earnings growth in fiscal 2025 and fiscal 2026 is expected to be robust, at 22% and 26% YoY – this is faster than Lam’s earnings growth in fiscal 2022. Fiscal 2026 is estimated to see Lam generate nearly $43 in GAAP EPS, almost 54% higher than its $28 estimate for fiscal 2024.

In addition, Lam said that its new Malaysian manufacturing facility is “poised to fully scale in the coming WFE upturn, providing us the capability to nearly triple the percentage revenue contribution from our lower cost manufacturing locations versus a few years ago.” Bringing more lower cost manufacturing online provides room for operating margin expansion, which paves the way for increased operating leverage as revenue accelerates over the next two fiscal years.

However, one thing to watch is whether we see a ‘V’ or ‘U’ shaped rebound for margins. In the last memory downturn in 2019, operating margin recovered in a U-shaped fashion, taking five quarters to reclaim its 2018 levels after bottoming in December 2019. We’ve seen a rather swift contraction in TTM operating margin through 2023, and subdued revenue growth in FY24 is likely to remain a headwind on this margin rebound.

China Risks

China presents a rather real risk to Lam, not only due to rising geopolitical tensions and export restrictions, but also because the country is a primary revenue driver, contributing 40% of revenue in the December quarter, up from 26% in the June quarter.

Lam’s China revenue increased nearly 14% YoY in the first half of fiscal 2024 to $3.18 billion, while sales to Lam’s second largest segment, Korea, declined almost (35%) to $1.26 billion. It’s not necessarily that Lam is driving much higher revenue from China, as revenues are well within historical norms, but rather than China’s strong demand in the first half of the fiscal year is offsetting global weakness – the revenue trough has been significantly minimized by China. Should Lam face increased difficulties selling to China in the remainder of FY24 and into FY25 due to export restrictions, the revenue recovery may be at risk. 

However, this is not solely isolated to Lam, as peers are also seeing increasing China contributions. ASML’s China systems sales reached 49% in its first quarter, versus a single-digit percentage just a year ago, while KLA’s China sales reached 41% in the December quarter, versus 23% in the prior December quarter.

Fiscal Q3 Earnings Preview

Lam’s fiscal Q3 (March 2024 quarter) is expected to be the last quarter of its revenue trough, with revenue expected to inflect back to YoY and QoQ growth in the June 2024 quarter. Sentiment in semis was weak last week heading in to Lam’s report this week. Primarily, the lackluster response to TSMC’s solid top and bottom line beat, the selloff following ASML’s weak bookings and a sharp industry-wide selloff to end last week.

Here are our notes for the upcoming earnings report:

Revenue and EPS:

  • Lam guided for $3.7 billion, +/- $300 million in revenue for the March quarter, pointing to a YoY decline of (4.4%) at midpoint.
  • GAAP EPS was guided  at $6.90, +/- $0.75, representing YoY growth of 14.8% at midpoint. Non-GAAP EPS was guided at $7.25, +/- $0.75, representing YoY growth of 3.7% at midpoint.
  • Analysts expect revenue of $3.73 billion and non-GAAP EPS of $7.30, slightly above the midpoint of both figures. The EPS figure has been revised 9.32% higher over the last 3 months, revised 9.32% higher over the last 3 months, suggesting analysts are looking for improved operating leverage aiding bottom line growth.

Margins

  • Lam guided for GAAP gross margin of 47.2%, +/- 1%, and non-GAAP gross margin of 48.0%, +/- 1%. This would represent a 570 bp expansion for the GAAP margin and a 400 bp YoY expansion for the non-GAAP margin at midpoint.
  • am guided for a GAAP operating margin of 28.1%, +/- 1%, and non-GAAP operating margin of 29.5%, +/- 1%. This would represent a 370 bp YoY expansion for the GAAP margin and a 120 bp expansion for the non-GAAP margin.

This YoY improvement in GAAP margins is aiding the earnings leverage that Lam is seeing, calling for double-digit YoY GAAP EPS growth on a decline in revenue. GAAP operating margin is approximately flat QoQ, hinting that the margin recovery may take more of a U-shaped pattern.

What to Watch:

Systems sales mix: Systems sales have steadily increased from 53% of revenue in the June quarter to 61% of revenue in the December quarter, suggesting healthy demand for new hardware in the market. Ideally, systems sales will maintain this 61% mix or increase it slightly in the March quarter.

DRAM systems revenue: Given management’s commentary about tripling HBM-related DRAM and packaging revenue this year and DRAM’s surge from 9% to 31% of systems revenue, we’re watching for continued growth here. DRAM systems sales have increased by $550 million, from $155 million to $718 million, and while a $1 billion quarter in Q3 is unlikely, strong double-digit sequential growth further supports the story that we will see a $1B+ DRAM systems revenue quarter in the next couple of quarters.

Q4 guide: Though this is rather obvious, Q3’s guide will ultimately be one of the more important pieces of the report, as Lam is expected to shift back to double-digit YoY revenue and EPS growth in fiscal Q4 (the June quarter) – however, QoQ growth is minimal, estimated at less than $60 million, so ideally we would like to see Q4’s revenue guide pointing to a QoQ increase. Analyst estimates are projecting 17.9% YoY revenue growth to $3.78 billion and 22.2% YoY EPS growth to $7.31, just $0.01 higher than the $7.30 estimate for Q3.

Conclusion

Lam is a primary beneficiary of this memory upcycle driven by GPU upgrades, with memory being the current battleground rather than computing power. Q3 is expected to be the inflection point for revenue and EPS growth before Lam returns to double-digit growth rates. DRAM systems sales have been surging as memory chipmakers work to rapidly expand HBM3 and HBM3e production, while NAND sales have been sluggish over the past couple quarters as spending has not yet resumed.

Lam Research reports after the bell on Wednesday.  This research helps us get ready regardless of what’s reported. Our goal over the next few quarters is to build a bigger position in Lam Research. However, we need to see what comes from this report before we determine when to layer-in. As you know, we initiated a starter position this past quarter. This refreshes our analysis from August and we look forward to updating you post-earnings Wednesday evening.

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

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Investing In AI with Beth Kindig: 1-Hour Video Interview

Posted on by io-fund

The rise of AI marks a transformative technological, economic, and societal inflection point — one with extreme implications for how we live and invest. So, how can investors take advantage of the trend? Jordi Visser, CIO and Chairman of Weiss Multi-Strategy Advisers, spoke to Beth Kindig on the Real Vision podcast on March 20th, to dive deep into AI’s potential for explosive economic growth, how to find winners in this theme, sectors that benefit from AI, the potential for crypto to decentralize AI, and more.

Watch the full interview on Real Vision here: Real Vision Video: AI Opportunity (youtube.com)

AI’s Impact Much Larger Than Mobile

The multi-trillion dollar impact to global GDP is the reason AI will shape up to be such a transformative and explosive trend – much like smartphones, which revolutionized countless facets of our lives, added trillions to the global economy, and created multiple trillion-dollar companies and billion dollar industries.

AI is shaping up to be multiple times larger than mobile – to the tune of 3x to 5x larger over the course of the next decade. Beth explains to Jordi that for AI’s impact on GDP, she has “seen $15 trillion, but McKinsey and others are now raising it to a $25 trillion impact on GDP. You can assume mobile is $3 to $4 trillion, maybe $4 to $5 [trillion], depending on how you chop up smartphones, applications, app stores, things like that. Let’s just give it the highest estimate of $5 trillion – [for AI], we’re looking at 3x minimum, 5x right now and these estimates keep getting raised […].”

Al's Potential Impact on the Global Economy, $ Trillion

Source: I/O Fund

This profound economic growth opportunity from AI is “something we’ve never seen before.” It stems from AI’s product-market fit — solving clear problems, driving down costs for enterprises and boosting worker productivity — and when you “match it with the right product, what you have is this hockey stick explosive growth.”

A Cautionary Tale of Consolidation

Even with such an explosive growth forecast for AI, it may still face a similar hype cycle trajectory as many other facets of tech do.

Just as with other innovative technologies, for AI, it’s likely that we will “go through a lot of innovation that is absolutely necessary… but then over time, the hype phase on the user side [fades] and those businesses don’t last.” This has happened in all facets of tech, from mobile to gaming to one of the most notable for tech investors, the dot-com bubble.

Beth cautions that you can “expect something similar to happen with AI as what we’ve seen in mobile, [and] maybe even at a higher rate.” For context, “a wave of innovation such as mobile will often put on the market 2 million apps, but in the long run, fast forward 10 years, most people use about 10 [apps].”

According to Crunchbase data, there are nearly 10,000 AI startups, while a more specific look in generative AI shows nearly 800 startups. Of that 800, 67% are still early stage, while only 2% are late stage. This comes despite a 5x surge in generative AI investments to almost $22 billion in 2023, with funding concentrated in OpenAI, Anthropic, and Inflection AI.

This sort of proliferation of companies creating different AI apps and use cases is definitely a positive outcome, but it’s extremely unlikely that all 10,000 companies participating in the AI economy survive, with consolidation occurring via acquisitions to even bankruptcies for the smaller bootstrapped startups.

Generative AI Startups by Stage

Source: CB Insights

There will ultimately be winners in AI, and there’s one critical piece that sets these companies apart: data.

Data Will Create the Winners

For AI, data will separate the winners from the rest of the pack, due to the high costs of training AI models and the need for high-quality data sets to train said models.

Google, Meta, Amazon, and Microsoft have all invested tens of billions into AI development for years, and can quickly and effortlessly integrate AI into their established business models.  For example, Beth explored in June 2023 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.

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What sets Big Tech, and these four companies apart, is that they have huge proprietary data sets that they can use to train AI models for various different purposes. Beth points out that “now we have an issue where, if you are a startup or small company, do you even have the data set to train these models? A lot of people have followed Tesla for a long time, what are the chances that Tesla would ever give away the data set that their fleet has created and generated over the last however many years. They’re going to protect that with everything they have, not only because of the costs that it required to create that data set, but because it’s really their secret sauce.”

Small companies not only will struggle to build out AI infrastructure due to the substantial costs with building out physical data center infrastructure and acquiring GPUs, but will also struggle with developing and fine-tuning high-quality AI models due to the challenges and costs associated with having a large enough proprietary data set. In this sense, large proprietary data sets create a ‘winner takes all’ or ‘winner takes most’ market, led currently by the Magnificent 7. Open-source movements could change this but how/when is speculative at this time.

Show Love to the Semiconductors

Jordi asked Beth what sectors she likes in AI, and her response was: “get comfortable with semiconductors.” She has done exactly that — of the I/O Fund’s more than 45% allocation to AI stocks in 2023, 40% of that was semiconductors, helping the fund power to a 57% annual return last year.

Semiconductors are powering Big Tech’s AI aspirations, and Beth explained that these companies are “50% of the AI market; that’s up from 20% or 30% of the mobile market, and they will be, for us, the right way to participate in AI in the near term.” She added that one of the main takeaways that she hopes for investors to get from the interview is that “these semiconductors will become the AI software players.”

This is evident with Nvidia – not only is it monetizing hardware sales via its Enterprise software suite for $4,500 per GPU per year, but also some of its biggest announcements at GTC were software, with its Omniverse Cloud APIs and Omniverse integration with Apple’s Vision Pro headset.

Preparing for the Next Phase of AI

While semiconductors have dominated in hardware – the data center – as the first explosive phase of AI, will expand beyond them to the edge. The forthcoming upgrade cycles for smartphones and PCs will see Edge AI rise as the second wave of AI. Beth explained that “there’s only so much AI can do in the data center. Inference has to run close to the user.”

We’re already seeing signs of this unfolding – Samsung is partnering with Baidu to use the Chinese tech giant’s AI chatbot Ernie in its S24 smartphones, while Apple is in discussions to also use Ernie in its Chinese devices. AMD, Apple, Qualcomm and Intel are all releasing new PC chips to boost AI computing power two to four-fold from prior generations in an effort to facilitate AI inference on these local devices.

The I/O Fund is currently preparing to capitalize on edge AI as it will be an important trend that has yet to emerge. We have been sharing in-depth research on the next stocks poised to capitalize on edge AI with our premium members and we discuss potential entries and exits every week in a one-hour webinar on Thursdays. We also 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.

AI Is Not a Trend to Ignore

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 or ignore, and it offers investors a rare opportunity to get onboard in the early stages of one of the largest economic and transformational trends in tech.

The $3 trillion to $5 trillion mobile economy sprouted the FAANGs of today, and if you could’ve invested in the FAANGs 10 to 15 years ago, you would have, given that multi-trillion dollar potential. Today’s estimates put AI at 3x to 5x larger than mobile in terms of overall impact to GDP, and  we’re only in the first of multiple powerful AI waves. And as a leading portfolio in AI, the I/O Fund is preparing to capitalize on this once-in-a-lifetime trend.

Watch the full 1-hour interview for the in-depth view on AI’s potential, what sectors will benefit and which will be a “hot potato” to avoid, crypto and AI, and more.

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 handful of AI plays for 2024 – what our targets are, where we plan to buy as well as take gains. Learn more about I/O Fund’s premium services here.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

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