Dell posted strong AI server order revenue of $2.6 billion with shipments of $1.7 billion, representing growth of 113% QoQ from $800 million last quarter. The backlog of $3.8 billion grew 31% QoQ, which is slower growth than we saw last quarter of 81% QoQ.
Margins contracted and this was a main focus in the Q&A. The company reported a gross margin of 21.63% down 219 basis points. This is the lowest gross margin in two years, dating back to July of 2022. The operating margin is slim at 4.14% down 254 basis points from last quarter. This is the lowest operating margin dating back to January 2021.
Revenue beat this quarter for growth of 6.2%. There was a marginal raise for next quarter revenue that also flowed through to a marginal raise for the fiscal year. GAAP EPS beat whereas adjusted EPS missed by $0.02. The guide for adjusted EPS missed at $1.65 guided versus $1.86 expected for Q2.
The AI server revenue is more than we could ask for. As long as this is the bottom for margins, we are good to go with this position. Most roads point toward Dell being a stronger 2025-2026 story due to the timing of the AI PC upgrade cycle and its core server strength being in enterprise. This is why our last write-up was called “Early AI Shoots.” With that said, we are also seeing evidence the AI story is already unfolding. With a little extra effort on technicals, we think Dell will be well worth the effort in 2024, as well.
Revenue and EPS:
Revenue of $22.3 billion beat estimates of $21.7 billion for growth of 6.22%. The company guided for revenue at the midpoint of $24 billion, representing growth of 5%. This is higher than expectations for Q2 of $23.2 billion. The company also raised fiscal year guidance to a midpoint of $95.5 billion, up from a midpoint of $93 billion. Analysts were expecting $94 billion for FY2025.
Per current estimates, we should be at the bottom for Dell.
GAAP EPS of $1.32 beat estimates of $0.77. Adjusted EPS missed by 1.55% with $1.27 EPS reported versus $1.29 expected. Looking forward, management is guiding for adjusted EPS of $1.65 +/- $0.10. This is a miss as analysts were expecting adjusted EPS of $1.86. This miss also led to the Q&A being predominately about margins.
This is the bottom for Dell on adjusted EPS with H2 expected to see over $2.00 adjusted EPS.
Margins:
The bulk of the negative price action after hours is coming from weaker margins. This is because analysts are not convinced that the AI server revenue will be accretive. Management was quite clear that the ISG segment (where AI revenue is recognized) will end the year between 11% and 14% operating margin. This quarter, the ISG segment operating margin was 8% of revenue.
Per our pre-earnings writeup: “The company is not expected to continue this trend of improving profit margins for a few reasons. First, the high-growth AI market is generating lower margins than the company’s other leading products. In addition, the company expects input costs to increase further in FY25, driven by anticipated inflation for component costs as the year progresses. Management also anticipates the pricing environment to be more competitive in FY25.”
Gross margin of 21.6% is down 238 basis points from 23.98% in Q1 of last year and is down 219 basis points QoQ. The gross profit was $4.8 billion. Per the opening remarks: “Given inflationary input costs, the competitive environment and the higher mix of AI optimized servers, we do expect our gross margin rate to decline roughly 150 basis points.”
Adjusted gross margin of 22.2% is down 230 basis points QoQ and is down 250 basis points YoY.
The operating margin of 4.14% is down from 6.68% last quarter. This also marks a 97 basis points decline YoY. This led to operating profits of $920 million.
Adjusted operating margin of 6.6% was down 300 basis points QoQ and down 100 basis points YoY. This led to adjusted operating income of $1.47 billion.
Net margin of 4.3% was down 90 basis points QoQ yet was up 151 basis points YoY. This led to net profit of $955 million.
Key Segments:
Infrastructure Solutions grew 22% YoY yet declined (1%) QoQ to $9.2 billion. The segment reported $9.3 billion last quarter. Server and networking revenue was $5.5 billion, up 42%
AI-optimized server order revenue increased to $2.6 billion, with shipments up more than 113% to $1.7 billion. This is up from $800 million last quarter for a 40% QoQ acceleration in Q4. The AI server backlog of $3.8 billion represents growth of 31% QoQ, down from 81% QoQ growth last quarter. AI now represents 7.6% of Dell’s revenue, up from about 5% last quarter.
For FY2025, per the CFO: “We expect ISG to grow in excess of 20%, fueled by AI.”
Client Solutions was flat YoY yet increased 2% QoQ to $12 billion. This is up from $11.7 billion last quarter. Commercial rebounded to 3% growth while consumer was down 15%. For FY2025, the CFO stated she expects “CSG business to grow in the low single digits for the year.”
The flat YoY and 2% QoQ may seem nominal but it’s quite important to see this segment bottom finally as it’s been declining for two years (!). Here is what management stated about what to look forward to in this segment: “We remain optimistic about the coming PC refresh cycle driven by multiple factors. The PC installed base continues to age, Windows 10 will reach end of life later next year, and the industry is making significant advancements in AI-enabled architectures and applications. We will continue to focus on commercial PCs, high end of consumer, and gaming, driving a strong attach motion, a strategy that has served us well across various economic cycles.”
For the full year, the company expects: “the combined ISG and CSG business to grow 11% at the midpoint, and our other business to decline, as previously discussed on the Q4 call.”
Cash and Debt:
Dell has operating cash flow of $1.04 billion for a margin of 4.69% in the most recent quarter. Free cash flow of $457 million represents a margin of 2%. This is slim margins for Dell, which can report a FCF margin >10%.
The company has $7.12 billion on the balance sheet with $25.4 billion in debt.
Dell returned $1.1 billion to shareholders through share repurchases and dividends.
Earnings Call:
Margins:
The Q&A was essentially analysts attempting to come up with creative ways to ask how much AI servers are impacting the margins. To cut to the chase, this is what analysts are concerned about:
Question Toni Sacconaghi (Analysts)
Yes. If I just look year-over-year at the ISG business, storage was perfectly flat. AI servers went from 0 to $1.7 billion, which sort of suggests that traditional servers were flat. So really, the only thing that changed was you added $1.7 billion in AI servers, and operating profit was flat. So does that suggest that operating margins for AI servers were effectively 0? And if that's not the case, how do you square the circle with what I just outlined?
Answer Yvonne McGill (CFO):
Toni, I'll take that one. So when I look at the overall ISG performance from an operating income standpoint, storage — I'll start with storage, right? Operating income was low in storage. You know that Q1 is seasonally our lowest revenue quarter from a storage perspective. When the revenue declines, the business de-scales. And so we saw that evidenced in the Q1 results. And while OpEx remains unchanged, to the point you're making, the OpInc rates decline.
In traditional servers, we saw strength in large enterprise and large bid mix. So a shift there a bit, which, as you know, that drives lower margin rates. When I look into Q2 and FY '25 though, I'd tell you that we expect ISG OpInc rates to improve as we talked about in the guide over the year, and really deliver against our long-term framework that 11% to 14%. So I think what we saw in the first quarter was multifaceted, but we do continue to expect recovery as the year goes on. And those AI-optimized servers, we've talked about being margin rate dilutive, but margin dollar accretive. And so you'll continue to see that evidenced in the results also.
–End Quote
Since this is a such an important topic, I’m going to copy and paste another part of the Q&A on this topic that goes over the same question. I’m cutting down the response to the most succinct answer from the CFO.
Question Erik Woodring (Analysts)
I'm going to kind of hit on a similar topic that everyone has. But Yvonne, you're talking about improving ISG operating margins through the year. Obviously, it seems like the strength and momentum you have in AI servers means that will continue to become an increasing mix of revenue. You also have commodity cost headwinds to contend with.
And so again, I know we've kind of talked about this topic, but maybe on a bit more detailed level, can you just help us understand what are the most significant factors that we should be thinking about that would support ISG operating margin expansion as we work through the year? Is that pricing? Is that mix? Is that storage mix? Just help us understand what are the most important factors there, again, as we look through the year.
[…]
Answer Yvonne McGill (Executives)
Yes. And the one thing, I don't think I called out specifically, the storage margins will continue to improve also because we will scale, right? We talked about the OpEx, we talked about that level of spend that we have. But as we scale that business, we will get that. And I'll reiterate that we do expect ISG Op Inc [operating income] to finish FY '25 within our long-term framework, so 11% to 14%.
–End Quote
The read-through is there could be a 0% operating margin on servers but storage will make up for it. Per previous comments: “for every $1 of AI server, there's $2 of services, storage and other higher-margin things that come.”
Conclusion:
Dell’s management is confident they will exit the year at a higher margin. Typically, we do close positions with contracting margins. We are making an exception to this rule because Dell is at a bottom both on revenue and earnings. That is key to understanding why we stick with a company or not, which is that a bottom is meant to mark an inflection point.
There are a few irons in the fire: AI servers for cloud service providers and enterprises which includes networking and storage, and then separately, the new upgrade cycle coming for PCs.
Per the trading plan, key levels have to hold for Dell. However, Knox was expecting this pullback and he has a buy plan in mind depending on how the price action plays out. You can reference the webinar from earlier today or the upcoming Positions Report due out early next week to learn more. Technicals are important especially for this position because Dell has rivaled Nvidia on YTD returns. Thus, we want to stay diligent in the event this is a breather before the next leg higher.
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Dell will report its Q1 earnings tomorrow at market close. The market will want to see strong QoQ AI revenue growth. Last quarter, the growth was 40% sequentially in Q4 to $800 million in AI optimized server revenue with a $2.9B backlog. The backlog grew 81% QoQ from $1.6B. Super Micro is hitting capacity, and building quickly to increase that capacity. In the meantime, it appears Dell is stepping in to fill AI server demand as a runner-up to SMCI.
For example, recently an analyst stated that Tesla is filling the bulk of its AI server order with Dell. Per the article, Amit Daryanani of Evercore stated: “While our impression is that SMCI has won some of the Tesla AI server business as well, allocations are heavily skewing towards Dell.”
It is not terribly difficult to imagine Dell as #2 for AI servers as it’s been #1 globally across all servers for some time. It’s estimated that SMCI will have about $25 billion in production capacity, which we discussed here. Current estimates are for an AI server market of $40 billion by end of 2024. Whether it’s the near-term TAM or if we simply look at Nvidia’s beat/raises, the conclusion is that more than just Super Micro will be needed to build AI servers.
Revenue
The management guide for the next quarter is $21 billion to $22 billion, representing YoY growth of 2.8% at the midpoint. Analysts are forecasting 3.3% growth for $21.61 billion. The company is expected to return to growth after six quarters of negative growth with a full recovery by H2.
Operating Segments
Revenue is rebounding as the Infrastructure Solutions Group(ISG) is expected to grow in the mid-to-high teens in Q1, led by traditional and AI server growth. ISG revenue declined for the fourth consecutive quarter in Q4. The revenue decreased by (-6%) YoY but grew by 10% sequentially to $9.3 billion. The main highlight of the last earnings report was that AI-optimized orders grew sequentially by 40%. The company reported AI revenue of $800 million, up from $500 million in Q3. Despite now being around only 4% of the total Q4 revenue, analysts expect strong AI revenue growth. Morgan Stanley analyst Erik Woodring expects AI revenue to reach $10 billion in the current FY 2025. This would represent fairly dramatic growth between now and calendar January 2025, yet lines up with the 2024 TAM of $40 billion and the delta of what SMCI is producing.
Management highlighted in the earnings call that the recovery in the PC market has been pushed to the second half of the year. However, there are favorable spots as the Q1 guide calls for a decline of (-3%) YoY in the Client Solutions Group (CSG), which is better than the decline of (-12%) YoY to $11.7 billion and a decline of (-23%) YoY in the same period last year.
Jeff Clarke, COO of the company, said in the earnings call, “In CSG, we remain optimistic about the coming PC refresh cycle as the PC install base continues to age, Windows 10 reaches end of life later next year, and the industry makes advances in AI-enabled architectures and software applications.”
We discussed the AI PC opportunity more in our previous write-up on Dell with a statement from management that the AI PC market will “absolutely” be bigger in H2 2024 than it was in H1 2024.
Margins
In the last quarter, margins improved YoY as the company juggles margin contraction and margin expansion in varied segments. The company is not expected to continue this trend of improving profit margins for a few reasons. First, the high-growth AI market is generating lower margins than the company’s other leading products. In addition, the company expects input costs to increase further in FY25, driven by anticipated inflation for component costs as the year progresses. Management also anticipates the pricing environment to be more competitive in FY25.
Q4 gross margin increased 70 bps sequentially and 80 bps YoY to 23.8%.
Adjusted gross margin improved 80 bps sequentially and 70 bps YoY to 24.5%, partly helped by the higher revenue mix of ISG revenue.
The company also witnessed pricing pressures in PCs and servers, however, remained focused on profitable opportunities and expects this discipline to go forward.
Adjusted gross margin guide for the next quarter is 22.5%, down 200 bps sequentially and 220 bps YoY. The decline in gross margin is due to the seasonally lower storage revenue mix, higher AI-optimized server revenue mix, pricing pressures, and higher inflationary cost components.
Operating margin remained flat sequentially and improved 190 bps YoY to 6.7%.
Adjusted operating margin improved 80 bps sequentially and 90 bps YoY to 9.6%.
The improvement in the margins was due to higher gross margins and cost-cutting initiatives. The company also announced a reduction of staff in the recent quarter. Management expects the adjusted operating margin to trend lower sequentially in Q1 due to the factors discussed in the previous paragraph. Management expects improved performance as the year progresses.
Net margin of 5.2% was up 270 bps from the year-ago quarter.
The adjusted net margin improved 190 bps YoY to 7.2%.
Adjusted EPS came at $2.20 and beat estimates by 27.9%.
Management expects Q1 adjusted EPS to be $1.15 at the midpoint and is lower due to the factors already discussed above. The analysts expect Q1 adjusted EPS of $1.25, representing a YoY decline of (-4.7%).
Cash Flow and Balance Sheet
Last quarter, Dell announced a 20% hike in the annual dividend to $1.78 per share and substantial share buyback program reflects Dell's confidence in sustained cash flow generation and long-term value creation.
Operating cash flow of $1.53 billion in Q4 represented a margin of 6.9% compared to $2.71 billion or 10.8% of revenue in the same period last year.
Adjusted free cash flow for Q4 was $1.01 billion or 4.5% of revenue compared to $2.27 billion or 9.1% in the same period last year. However, for FY2024, the operating cash flows grew 143% YoY to $8.7 billion. Management has been focused on improving cash and working capital.
The company had $8.7 billion in cash and investments and $26 billion in debt. Debt is down from $26.6 billion in the September quarter as the company is focused on deleveraging. The company also reached its core leverage target of 1.5x, down from 1.6x in Q3 and 1.8x in the same quarter last year.
What to Watch
AI-Optimized Server and Backlog:
AI-optimized server backlog increased from $1.6 billion in Q3 to $2.9 billion in Q4. This is a five-quarter backlog. Jeff Clarke also mentioned the strong demand in the earnings call and how they are helping their customers who are in the early stages of AI.
“AI-optimized server orders increased by nearly 40% sequentially. We shipped $800 million of AI-optimized servers, and our backlog nearly doubled sequentially, exiting the fiscal year at $2.9 billion. Demand continues to outpace GPU supply, though we are seeing H100 lead times improving. We are also seeing strong interest in orders for AI-optimized servers equipped with the next generation of AI GPUs, including the H200 and the MI300X….”
Management also said that they will ship more in Q1 than in Q4 and any guide on the AI revenue is to be watched.
There are reports that lead times for servers powered by Nvidia’s H100 GPUs have come down eight to 12 weeks from the earlier 39 weeks, which should help to increase the AI revenues in coming quarters.
Dell’s Nvidia partnership and enterprise opportunity
At the Nvidia GTC event, Jensen Huang spoke iabout Dell AI servers for enterprises. "Everybody who is building these chatbots and Generative AI, when you are ready to run it, you need an AI factory and nobody is better at building end-end systems of very large scale for the enterprise than Dell. Any company and every company needs to build AI factory and it turns out Michael (Dell) is here he would happy to take orders.” you need an AI factory and nobody is better at building end-end systems of very large scale for the enterprise than Dell. Any company and every company needs to build AI factory and it turns out Michael (Dell) is here he would happy to take orders.” The company also recently announced Dell servers that support the latest Blackwell chips. The new servers offer liquid cooling technology that is expected to consume lower power.
We covered the enterprise opportunity more thoroughly in our last write-up.
Storage recovery
Storage revenue declined by (-10%) YoY and up sequentially by 16% to $4.5 billion. Management mentioned that Q1 is seasonally low for storage revenue, and that storage recovery typically lags servers by a couple of quarters. They mentioned that their storage business is expected to have strong growth opportunities in unstructured data. They are also optimistic about tapping the opportunity on-premises or at the edge network.
Per the last earnings call: “I need to mention we got a storage opportunity in there, that we have a networking opportunity in there, and we have a services opportunity in there and to go for the last of the bunch of financing opportunities. So those — how could you not be excited about that given the demand environment?”
AI PCs
During the last earnings call, management said that PC recovery was pushed to the second half of the year. However, they were positive on the coming PC refresh cycle and longer-term impact from AI. The company also recently announced new AI-PCs during the Dell Technologies World. According to Morgan Stanley, 64% of the new PCs in 2028 are expected to be AI PCs, of which Dell will be a large beneficiary.
Conclusion
Dell has done quite well recently. The stock is up 69.2% since the company reported Q4 results and has outperformed Nvidia, Super Micro, and the Nasdaq-100 index during this period. In our last write-up, we focused on Dell’s valuation as a primary part of the thesis. This was similar to our Super Micro thesis, which centers around the pivotal moment that a commoditized hardware company becomes valued like an AI stock. Dell is trading about one-third what SMCI is trading at on sales, and is trading at about two-thirds what Super Micro is trading at on PE ratio. Dell has about 5% AI revenue compared to Super Micro’s 50%. The company may end the year with 10% of revenue from AI. With that said, Dell is a cash cow with a dividend while Super Micro has to raise cash. So, this is not exactly apples-to-apples, but for those who are patient, we think Dell will close its valuation gap with SMCI.
Let’s see what happens tomorrow night. You’ll get a post-earnings writeup from the fundamentals team after market close. Knox will also address his trading plan for Dell in the weekly Advanced Market Signals webinar held Thursday at 4:30 p.m. Eastern.
This article was originally published on Forbes onForbesForbes on May 22, 2024,05:58am EDT
Nvidia’s management team will focus on the H200 in the upcoming earnings call, but make no mistake, we will end this year in full-on Blackwell territory. The new architecture is at the forefront of training and inference for trillion+ parameter models. More than five years ago, I called CUDA the moat for Nvidia’s AI data center story, yet should that moat become breached, the company’s rapid product road maprapid product road map is the first line of defense.
Nvidia is the world’s leading GPU design company, which bears reminding since such little emphasis in Wall Street is placed on what the designs intend to solve. For those paying close attention, there are clues that the company’s fast and furious data center growth will see a second wind with Blackwell.
Nvidia is Hitting Peak Growth: The Hopper Impact
Last quarter in fiscal Q4, Nvidia reported growth of 265%. Last quarter is likely to be peak growth for the company. We pointed this out three months ago when our analysis stated: “Even if we see a beat and raise, the slowing growth in the second half will be hard to overcome due to high comps. As mentioned in the introduction, Nvidia will begin to lap some stellar quarters come the October CY2024 quarter as the growth in October of CY2023 was 205.5% YoY.”
At time of writing, the revenue estimates for Nvidia point to growth of 242%. A beat/raise this quarter is not likely to flow through to a higher growth rate in H2 compared to what we saw in Q4 and what we will see in Q1. Therefore, even if Q1 inches slightly past fiscal Q4 tomorrow evening, we have hit peak growth.
Typically, a growth investor should be cautious when a company hits its peak growth rate after a drastic rise in the stock price. Here is a chart we published three months ago updated with current estimates:
Source: I/O Fund
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Organic Growth
However, Nvidia’s margins and earnings expansion are creating an outlier of a stock. There are rumors Blackwell GPUs will be priced starting at $30,000 to $40,000 but will have more expensive memory components with HBM3e. As long as margins remain within range, this will not be consequential considering Nvidia is posting organic growth.
This is drastically different than a stock that relies on growth at any cost, growth at any cost, which is where rapid growth is bought rather than earned. The quality of Nvidia’s growth is much better than what tech investors are used to, and this is predominately why Nvidia stock is resilient (within reason; there will always be selloffs in the market). As supply/demand becomes more balanced, it will be Nvidia’s aggressive product road map, which in many cases is designed to compete with themselves, that will keep pricing power stable, starting with Blackwell.
For example, there are recent reports that AWS is pausing orders on Hopper GPUs in anticipation of Blackwell GPUs. The market may interpret this as weakness, but this is actually a sign of immense strength. Nvidia needs to pass the baton from the H100s and H200s to the Blackwell architecture for the stock price to extend. We are less concerned with what happens in the immediate-term, and in fact, the I/O Fund has stated a few times that Nvidia is a buy on dips, implying the stock won’t go up forever. Instead, we are encouraged to see early signs of a careful transition to the next architecture to help inform our next buy.
Nvidia’s $150B to $200B Data Center: The Blackwell Effect
There is nothing quite like rapid earnings revisions intra-quarter to determine the quality of a position. For example, consider that Nvidia sold off directly after the November report, yet has gone up a rapid 91% since. The earnings revisions are why Nvidia is so strong intra-quarter:
This upcoming quarter is expected to report growth of 242%. Last August, the growth for the April quarter was expected to be 91.6%. Only three months ago, the estimates for the April quarter were for growth of 197.5%. Stated in terms of revenue, this quarter’s revisions have doubled from $13.8 billion in August to $24.5 billion.
Next quarter, the company is expected to report growth of 98.7%. This was expected to be growth of 44.6% last November. Stated in terms of revenue, next quarter’s revenue has gone up $7 billion from $19.5 billion in November to $26.7 billion in May. In the past three months alone, the estimates went up $4 billion.
Below, we discuss why margins, cash flow and strong earnings support our decision to buy on dips. However, equally as important, there is also a decent probability that FY2026 and FY2027 revenue estimates are too low. The most bullish analyst from KeyBanc is calling for a $200 billion data center segment by 2025. HSBC believes Nvidia’s FY26 revenue could be as high as $196 billion, which implies about a $192 billion data center segment. Loop Capital foresees a $150 billion data center segment as soon as this year, while Wells Fargo has estimates for a $150 billion data center segment by 2027. The exact timing from these analysts has a range, but the conclusion is very similar.
Let’s breakdown the weight of those comments with some back-of-the-napkin math, which shows that analysts are currently estimating about $122.4B in data center revenue for FY2026 (calendar year 2025). This is about 65% lower than the more bullish analyst estimates of $200 billion in data center revenue.
Q1 FY25: $20.75B
Q2 FY25: $23B
Q3 FY25: $25.5B
Q4 FY25: $27.7B
Q1 FY26: $27.87B
Q2 FY26: $29.7B
Q3 FY26: $31.51B
Q4 FY26: $33.25B
Source: I/O Fund
These are the current estimates, yet if the analysts are correct, then the far right of the graph will end in $50B quarterly revenue. The difference between the current consensus and this much higher trajectory can be summarized in one word: Blackwell.
There are additional data points in the supply chain and on the demand side that support Blackwell seeing an increase in orders over Hopper. For example, Taiwan Semi’s CoWos capacity, which is essential for Blackwell’s architecture, is estimated to rise to 40,000 units/month by the end of 2024, which is more than a 150% YoY increase from ~15,000 units/month at the end of 2023. Applied Materials has boosted its forecast for HBM packaging revenue from a prior view for 4X growth to 6X growth this year. According to Wells Fargo, Taiwanese export data rose 360% year-over-year and 33% quarter-over-quarter, and is often correlated to Nvidia data center revenue.
Note: It’s important to remember this is not earnings call on what will happen tomorrow evening as the revenue will be reported when it ships to the customer. However, it helps to consider there are directionally bullish data points should the market sell off following the report and provide us a lower entry.
Notably, the premiere component for the H200 and Blackwell is HBM3e memory, which is currently supply constrained. Samsung and SK Hynix are both re-allocating ~20% of DRAM production capacity to HBM to meet high demand, while HBM4 roadmaps are being accelerated.
CEOs of major companies in AI acceleration are in agreement the total addressable market is much, much larger than today’s market size. Lisa Su of AMD has stated the AI chip market will reach $400B by 2027. Intel’s CEO has stated AI chips will become a $1T opportunity by 2030, which is almost twice the size of the entire chip industry in 2023.
Big Tech capex is supporting this growth. Our firm has been especially strong on correlating capex to AI investments for our paid research members, where we held a 1-hour webinar in April discussing our expectations that capex increases in support of AI stocks. We followed this up with free analysis in our newsletter that tracked a 35% YoY increase to $200 billion across Big Tech companies. A disproportionate amount of this will go to Nvidia.
We’re closely tracking Big Tech’s capex plans for 2024 and how this will flow downstream to AI hardware companies. The I/O Fund had a 45% allocation to AI going into 2023, one of the highest on record. Today, the AI allocation is higher with many lesser-known names. Learn more here.here.
China:
A curveball in the report could be higher than expected China revenue due to China-specific GPUs, such as the H20. Similar to Big Tech in the United States, China’s main players are stockpiling GPUs to secure their lead in AI.
Regarding China, last quarter, the following was stated: “Growth was strong across all regions except for China, where our Data Center revenue declined significantly following the U.S. government export control regulations imposed in October. Although we have not received licenses from the U.S. government to ship restricted products to China, we have started shipping alternatives that don't require a license for the China market. China represented a mid-single-digit percentage of our Data Center revenue in Q4, and we expect it to stay in a similar range in the first quarter.”. Although we have not received licenses from the U.S. government to ship restricted products to China, we have started shipping alternatives that don't require a license for the China market. China represented a mid-single-digit percentage of our Data Center revenue in Q4, and we expect it to stay in a similar range in the first quarter.”
Nvidia’s Blackwell will Answer to Hopper’s Excellence
The product road map is the single most important thing investors should be focused on. A good chunk of the AI accelerator story is understood at this point. What is not understood is how aggressive Nvidia is becoming by speeding up to a one-year release cycle for its next generation of GPUs instead of a two-year release cycle.
This means Nvidia is competing with itself by putting Blackwell dangerously close to Hopper’s product cycle. This move is bold, it’s daring, and it’s absolutely necessary.
Here is the very ambitious eight month schedule Nvidia has set for itself:
The H200 with HBM3e is shipping now.
The B100 and GB200 are shipping in late 2024.
The B200 will be released in early 2025.
The Blackwell architecture remains on 4nm dies, similar to the Hopper architecture. What is different is that Blackwell has 2 reticle-sized GPU dies. Reticle size refers to the limit in the chip surface that can be exposed by a single mask. The limit is set by the lithography equipment. At one point it was expected Blackwell would be on 3nm dies, yet due to reasons unknown, Nvidia is moving forward with 4nm. Since Nvidia is not able to offer a more advanced process node, the company is instead doubling the silicon. The Blackwell architecture is rumored to be priced between $30,000 to $40,000, which is higher than the H100’s reported $25,000 cost. This is competitive considering B200 will offer nearly 30X better performance (benchmarks are provided by Nvidia).
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B100 & B200
The B100 is a replacement chip, which means customers can remove the H100 and place the B100 in the same rack. The B100 is air-cooled and doubles NVLink speeds from the H100 and H200. The B100 is will ship in Q3 and provide upgrades to memory from 80GB in the H100, 141GB in the H200 to 192GB in the B100.
The B200 GPU chipset due in Q1 of next year will deliver a 2.5X training improvement and 5X inference improvement over the H100. This is due to the B200 having 208 billion transistors compared to the H100’s 80 billion transistors.
The B200 will also have 20 petaflops of FP4 compared to the H100’s 4 petaflops of FP8 reaching 32 petaflops of FP8 in the DGX H100 systems. The difference is that the smaller bit size allows for an economical way to achieve more speed when giving up a small amount of accuracy doesn’t make a critical difference. This also helps in the face of a slowing Moore’s Law. Following the release of the Hopper H100, Intel released Gaudi2 which supports FP8. About two years back, chip makers Graphcore, AMD and Qualcomm pushed for an industry-standard for floating point format FP8. However, the recent B200 will have a second-generation transformer engine that supports 4-bit floating point (FP4) with the goal of doubling the performance and size of models the memory can support while maintaining accuracy.
Part of the secret sauce of the H100 is the transformer engine. The A100 lacked support for FP8 compute at default whereas the H100 leveraged a transformer engine to switch between FP8 and FP16, depending on the workload. The second-generation transformer engine in the Blackwell architecture will offer FP4. This is helpful because AI models are moving toward neural nets that lean on the lowest precision and yet still yields an accurate result. In this case, 4 bits double the throughput of 8-bit units, compute faster and more efficiently, and they require less memory and memory bandwidth.
The main feature from the Transformer Engine is the ability to choose what precision is needed for each layer in the neural network at each step, transitioning between 4-bits, 8-bits, 16-bits, or 32-bits. The H100 is able to do matrix math with two forms of 8-bit numbers with either 5-bits as the exponent or 4-bits as the exponent: E5M2 and E4M3. This is important because the E4M3 may be favored for back propagation while E5M2 may be favored for inferencing.
Building on the first-gen transformer engine, the B200’s second-gen transformer engine will support double the compute and model sizes with new 4-bit floating point AI inference capabilities.
GB200 NVL72 Systems:
According to the current product road map, the GB200 will be released before the B200 GPUs. The real fireworks will begin with the GB200 NVL36/NVL72 systems in late 2024 and then continue with the B200 GPUs in early 2025.
The GB200 Grace Blackwell chip connects two Blackwell Tensor core GPUs with the Nvidia Grace CPU. The GB200 NVL 72 rack-scale exascale supercomputer, connects 36 Grace CPUs with 72 Blackwell GPUs in a rack-scale design with liquid cooling. We’ve written in-depth about liquid cooling for our premium research members, learn more here.about liquid cooling for our premium research members, learn more here.
According to HSBC, the average sales price of NVL36/NVL72 server rack will be $1.8 million and $3 million, respectively. Notably, its expected the GB200 systems will have strong margins due to using an in-house CPU.
Source: Nvidia, the GB200 System due to ship in Q4 this year
The GB200 will provide 4X faster training performance than the H100 HGX systems and will include a second-generation transformer engine with FP4/FP6 Tensor core. As stated above, the 4nm process integrates two GPU dies connected with 10 TB/s NVLink with 208 billion transistors.
NVLink Switch is a major component to the Blackwell upgrade. Fifth-generation NVLink enables multi-GPU communication at high speed, reaching 1.8 TB/s bidirectional throughput or 14X the bandwidth of PCIe for a single GPU.
For the NVL72 systems, NVLink Switch can reach 130 TB/second, which is “more than the aggregate bandwidth of the internet.” Therefore, it’s the compute and the communication capabilities of the upcoming GB200 release that are important to consider. The 72 GPUs in the NVL72 can be used as a single accelerator for 1.4 exaflops of AI compute power.
Why GB200s and B200s will Drive more Demand:
To scale up a model, AI departments utilize a Mixture of Experts (MoE) approach. MoE distributes a computational load across “multiple experts” (or neural networks) and trains across thousands of GPUs using what is called model and pipeline parallelism. This enables more compute-efficient pretraining yet the parameters still need to be loaded in RAM, so the memory requirements remain high.
For inference, GB200 will deliver “a 30X speedup” for 1 trillion+ parameter models by leveraging FP4 precision and fifth-generation NVLink. This is what that the leap in real-time throughput for inference looks like for a 1.8 trillion parameter model:
Blackwell is for the trillion+ parameter era of generative AI. The architecture is designed to support the largest language models today and is future-proofed with the GB200 NVL72 rack-scale solution, which is an exascale computer that contains up to 5,000 NVLink cables that total 2 miles. You also have to consider that AMD was coming to market in the first release with nearly 2X memory as the H100. Nvidia is remaining competitive with HBM3e and soon HBM4 to help models run in memory.
The GB200 also has a new decompression engine that allows GPUs to process and decompress compressed data sets to speed up database queries. Coupled with 8 TB/s of high memory bandwidth and high speed NVLink, the GB200 systems deliver up to 18X faster database queries. In addition to this, there is up to 13X faster physics-based simulations compared to CPUs and 22X faster simulations for computational fluid dynamics (CFD).
More on Memory:
High bandwidth memory (HBM) offers higher bandwidth, capacity, performance, and lower power by vertically stacking up to twelve DRAM memory chips to shorten how far data has to travel, while also allowing for smaller form factors. Stacked memory chips are connected through something called “through silicon vias” or TSVs. HBM is increasingly being used to power machine learning, high performance data centers, and more recently, generative AI models.
CoWoS (chip-on-wafer-on-substrate) architecture refers to 3D stacking of memory and processor modules layer by layer to create chiplets. The architecture leverages through-silicon vias (TSVs) and micro-bumps for shorter interconnect length and reduced power consumption compared to 2D packaging.
The advanced CoWoS packaging that is needed to combine logic system-on-chip (SoC) with high bandwidth will take longer, and thus, it’s expected that Blackwell will be able to fully ship by Q4 this year or Q1 next year. How management guides for this will be up to them, but commentary should be fairly informative by Q3 time frame.
GPUs will move from 8Hi configurations to 12Hi HBM3e configurations by 2025. These upgrades are needed to train and deploy large models with trillions of parameters in the near future. What Nvidia’s product road map intends to accomplish is a way forward for real-time inference that is computationally efficient, cost-effective and energy efficient.
The recent surge in generative AI and AI GPUs, spurred by the success of OpenAI’s ChatGPT and development of hundreds of other large language models, are forecast to bring about a new DRAM market, underpinned by high-bandwidth memory (HBM) and DDR5
[…] HBM3 and HBM3e are becoming the next battleground for memory chip manufacturers as well as AI chip design companies, especially Nvidia and AMD, who are pushing the boundaries with the amount of memory bandwidth in each GPU.
AMD’s competing GPUs, the MI300 series, substantially boosted memory and bandwidth relative to the H100, utilizing Samsung’s HBM3. The MI300A is shipping with 128GB HBM3 memory while the MI300x ships with 192GB memory and 5.2 TB/s of bandwidth – that’s 1.6x more bandwidth and 2.4x more HBM3 density than Nvidia’s H100.
Nvidia is rapidly moving forward with its GPU roadmap, as it aims to launch its next-gen H200 and B100 GPUs next year followed by the X100 GPU in 2025 – each GPU will accelerate AI inference times along an exponential curve, thus creating a need for more memory and more bandwidth.”
Nvidia’s Fiscal Q1 Report Card: What You Need to Know
Now that we’ve touched base on the importance of Blackwell, let’s get prepped for this evening. Here is what analysts are expecting:
Revenue:
For Q1, Nvidia is expected to report revenue of $24.6 billion, for growth of 242%. Management guided for revenue of $24 billion +/- 2%, for a growth rate of 233.7%, at the midpoint.
Next quarter, the company is expected to report revenue of $26.8 billion for growth of 98.7%.
On a fiscal year basis, the company is expected to report revenue of $113.2 billion for growth of 85.8%. These estimates have doubled since August.
The FY2026 growth rate of 26.1% for revenue of $142.8 billion, and then FY2027 growth rate of 17.7% for revenue of $168 billion, is where estimates are too low if there is a $200 billion data center segment in the medium-term.
EPS:
In Nvidia’s case, top line growth is flowing through to bottom line growth disproportionately.
For Q1, Nvidia is expected to report adjusted EPS of $5.58 for growth of 411.9%.
Next quarter, Nvidia is expected to report adjusted EPS of $6.00 for growth of 122.1%.
For FY2025, adjusted EPS is expected to be $25.4 for growth of 96%. FY2026 adjusted EPS is expected to be $32.2 for growth of 26.6%.
Margins:
As the story for Nvidia unfolds over the next few years, keep an eye on margins as software will begin to positively impact the company with higher margins. The company is expected to end the year with $2 billion in software revenue.
In the near-term, and especially for this earnings report, it’s likely that analysts ask about the costs associated with HBM3e as memory components are increasing in costs. TrendForce has reported that HBM3 prices have risen 5-fold since 2023. HBM3e prices will be even higher than HBM3. Analysts may also ask about the yield issues that major memory suppliers SK Hynix, Micron, and Samsung are reported to be facing, given the complexities in the manufacturing process for HBM3e and its longer production cycle. For our premium members, we’ve discussed what stocks will benefit from this leading trend in 2024.our premium members, we’ve discussed what stocks will benefit from this leading trend in 2024.
Management guided for gross margin of 76.3% for gross profit of $18.3 billion. If reported in line, this will represent flat growth QoQ and 1170 bps expansion from 64.6% in the year ago quarter.
Management guide for adjusted gross margin is 77%. If reported, it will represent 30 bps QoQ expansion and 1020 bps expansion YoY.
Operating margin was guided to be 61.7% for operating profit of $14.8 billion. If reported, this will be flat QoQ yet up a whopping 32-points from 29.76%. This is the most rapid operating margin expansion that I have personally witnessed. It is rare, even with a hyper growth company to report a 32-point expansion on this line item.
Adjusted operating margin of 66.6% will be flat QoQ and up from 42.4% in the year ago quarter.
Net margin guide is 52.1%. If reported, it will be down (3.5%) sequentially. However, a remarkable 23.7% expansion on a YoY basis.
Cash and Debt:
Last quarter, Nvidia reported operating cash flow of $11.5 billion for a margin of 52%. The free cash flow of $11.2 billion represents a margin of 50.7%. The fiscal year free cash flow of $26.9 billion was more than 7 times higher than the fiscal year 2023 free cash flow of $3.75 billion.
Key Segments:
The data center segment reported revenue of $18.4 billion for growth of 409% YoY and was up 29% QoQ. Nvidia’s tough comps kick in with the Q2 July quarter when the company reported DC revenue of $10.3 billion for growth of 171%, and thus the guide is key. Management will not guide to DC specifically but it’ll be easy enough for analysts to read through the lines that any beat/raise on Q2 is likely coming from the DC segment.
The CFO mentioned in the earnings call that 40% of the revenue came from inference in the past year. “Fourth quarter data center growth was driven by both training and inference of generative AI and large language models across a broad set of industries, use cases and regions. The versatility and leading performance of our data center platform enables a high return on investment for many use cases, including AI training and inference, data processing and a broad range of CUDA accelerated workloads. We estimate in the past year approximately 40% of data center revenue was for AI inference.”
Gaming revenue of $2.8 billion was up 56% YoY and was flat QoQ. Nvidia has fared better than gaming peers due to the timing of the RTX 4000 Series, which I covered in a previous editorial: “Nvidia Stock: Evidence Gaming has Bottomed and Why It’s Important.”Nvidia Stock: Evidence Gaming has Bottomed and Why It’s Important.” With that said, management guided for a seasonal decline in gaming.
Professional Visualization reported revenue of $463 million for growth of 105% YoY and 11% QoQ.
Automotive reported revenue of $281 million, down 4% YoY but up 8% QoQ.
OEM & Other reported revenue of $90 million, up 7% YoY and 23% QoQ.
Conclusion:
As stated on Making Money with Charles Payne today, the upcoming earnings report is only one piece to the story, whereas the ultimate fireworks will be when the Blackwell architecture begins to ship Q3-Q4. The product road map is communicating that AI accelerators are secular; not cyclical.
We will see peak growth this quarter – even if we get that beat that Nvidia is becoming known for, H2 will certainly see a slowdown. This is normally a great jumping off point for investors but those who stick with Nvidia will be rewarded for a few reasons:
This is an organic growth company, which is very rare in tech where most growth is bought. That means Nvidia is likely to remain strong on margins and EPS, even in the face of slowing revenue growth.
The supply chain is providing hints that analyst estimates for the data center are too low – there could be up to 65% upside on those estimates in the next 6-7 quarters.
The reason I side with Keybanc, Loop and others in thinking the estimates are too low – and this last point is critical – is because Nvidia is speeding up its product road map and introducing the Blackwell architecture to address the trillion+ parameter models that Big Tech will compete to create and train.
Nvidia has sold off 10% or greater about 9 times since the 2022 low. We see any dips as buying opportunities as we brace for Blackwell toward the end of this year.
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 shares in NVDA at the time of writing and may own stocks pictured in the charts.
Nvidia impressed again with a beat this quarter and a raise next quarter. However, that wasn’t enough to move the stock price. It was during the earnings call that we saw the stronger price action when management discussed the Blackwell architecture. The first question on the call was a direct question on when Blackwell will be in production:
Q: “So this year, we will see Blackwell revenue, it sounds like?”
A: The CEO offered one, simple sentence in a measured tone: “We will see a lot of Blackwell revenue this year.”
The call could have probably ended there as that one simple sentence shed light on what has been the predominant concern — can Blackwell keep up with Hopper. If you read my analysis published in Forbes this morning, then you know that the I/O Fund thinks a $200 billion data center segment is in sight by the end of CY2025.
There were other bullish comments about Blackwell ramping this year, such as “We will be shipping [Blackwell]. Well, we've been in production for a little bit of time. But our production shipments will start in Q2 and ramp in Q3, and customers should have data centers stood up in Q4.” This was strong language to use as it’s quite clear that Hopper has runway left given the beat/raises we saw in this quarter. To have the two architectures merge seamlessly in terms of timing in H2 is quite ideal.
Revenue and EPS:
Revenue of $26 billion is up 18% QoQ and up 262% from the year ago quarter. This means Q4 was officially the peak quarter for revenue growth, which we covered previously. Revenue beat expectations by 5.9% with analysts expecting $24.6 billion in revenue for growth of 242% YoY.
Nvidia will now face tougher comps as it laps Hopper’s impact from last year. The company is off to a decent start by forecasting next quarter revenue of $28 billion. Analysts were expecting $26.84 billion. This represents growth of 107% up from growth of 98.8% expected.
The intra-quarter revisions are particularly strong. However, regardless of ongoing upward revisions, it’s unlikely we return to the peak growth we saw in Q4 and Q1 (current quarter).
GAAP EPS of $5.98 compares EPS of $4.93 last quarter. This represents QoQ earnings growth of 21.3% and YoY earnings growth of 629%.
Adjusted EPS of $6.12 beat estimates of $5.58. This represents growth of 18.6% QoQ and 461% growth YoY.
Margins:
As expected, margins have expanded across the board.
GAAP gross margin of 78.4% compares to 64.6% in the year ago quarter, up 13.8 points YoY and up 240 bps from last quarter. This represents gross profit of $20.94 billion.
We will see a softening in gross margin due to a deceleration from peak revenue. Management is guiding for GAAP gross margin of 74.8% for next quarter with added color that the full year gross margins “are expected to be in the mid-70% range.”
Adjusted gross margin of 78.9% compares to 66.8% in the year ago quarter, up 12.1 points YoY and 220 bps from last quarter. Management is guiding for adjusted gross margin of 75.5%. This represents adjusted gross profit of $21.1 billion.
GAAP operating margin of 64.9% compares to 50.3% in the year ago quarter. This represents operating profit of $16.9 billion.
For next quarter, GAAP OPM is expected to soften to 60.5%, according to management’s guidance.
Adjusted operating margin of 69.3% was reported for Q1, representing adjusted operating profit of $18.05 billion.
For next quarter, adjusted operating margin is expected to soften to 65.5%.
Net margin this quarter was 57.1% compared to 28.4% in the year ago quarter, and was up 150 basis points QoQ. This represents net profit of $14.9 billion. The adjusted net margin this quarter was 58.5%.
Cash Flow:
Cash flow was strong (unsurprisingly) with some of the highest free cash flow margins among the Mag 7:
Operating cash flow of $15.35 billion represents a margin of 58.9% which expanded 690 bps QoQ from 52% and expanded 18.4 points in the year ago quarter.
Free cash flow of $14.94 billion represents a margin of 57.3%, which was up 660 bps and is up 20.5 points YoY.
The company has $31.4 billion in cash and $9.71 billion in debt.
Nvidia announced a ten-for-one stock split, which will be effective June 6th, 2024. Trading will commence on a split-adjusted basis at market open Monday, June 10th, 2024.
Nvidia is increasing its cash dividend by 150% from $0.04 per share to $0.10 per share of common stock. The increased dividend is equivalent to $0.01 per share on a post-split basis. This quarter, the company utilized cash of $7.8 billion towards shareholder returns, including $7.7 billion in share repurchases and $98 million in cash dividends.
Key Segments:
Data center revenue of $22.6 billion, was up 427% YoY and up 23% QoQ. This marks an annualized run rate of $90 billion. We made the argument in today’s Forbes analysis that we could see a $200 billion data center segment by the close of FY2026 based on the strength of the Blackwell architecture, which would represent 65% upside from current analyst data center estimates. This requires speculation, of course, but management did state this in the call: “Blackwell will be available in over 100 OEMs at launch nearly double compared to Hopper, and will support broad and fast deployments.”
Management’s Q2 guide implies data center revenue of about $24 billion next quarter. This is assuming $4 billion from the other four segments, which reported a combined $3.5 billion this quarter. The CFO stated all segments would be up in Q2 on QoQ basis: “We expect sequential growth in all market platforms.”
Gaming reported revenue of $2.65 billion, which was up 18% YoY yet is down 8% QoQ. The company said the following in the opening remarks: “GeForce RTX GPUs, now with over 100 million installed base, gamers, creators and AI enthusiasts, unmatched performance for Gen AI on PCs.”
ProViz revenue of $427 million, was up 45% YoY and down 8% QoQ
Automotive was up 11% YoY and up 17% QoQ
OEM and other revenue of $78 million was up 1% YoY but down 13% QoQ.
Earnings Call:
One of the key points in the earnings call was the ROI that cloud service providers will see from renting GPUs. This may have been provided to help shine some light on why capex budgets continue to grow.
“For every $1 spent on NVIDIA AI infrastructure, cloud providers have an opportunity to earn $5 in GPU instant hosting revenue over four years. NVIDIA's rich software stack and ecosystem and tight integration with cloud providers makes it easy for end customers up and running on NVIDIA GPU instances in the public cloud.”For every $1 spent on NVIDIA AI infrastructure, cloud providers have an opportunity to earn $5 in GPU instant hosting revenue over four years. NVIDIA's rich software stack and ecosystem and tight integration with cloud providers makes it easy for end customers up and running on NVIDIA GPU instances in the public cloud.”
“For example, using Llama 3 with 700 billion parameters, a single NVIDIA HGX H200 server can deliver 24,000 tokens per second, supporting more than 2,400 users at the same time. That means for every $1 spent on NVIDIA HGX H200 servers at current prices per token, an API provider serving Llama 3 tokens can generate $7 in revenue over four years.”That means for every $1 spent on NVIDIA HGX H200 servers at current prices per token, an API provider serving Llama 3 tokens can generate $7 in revenue over four years.”
The company also went out of its way to highlight that they are well diversified beyond major cloud providers by pointing out that: “Large cloud providers continue to drive strong growth as they deploy and ramp NVIDIA AI infrastructure at scale and represented the mid-40s as a percentage of our Data Center revenue.” They highlighted that enterprises like Tesla and consumer internet companies like Meta are also strong growth verticals. Management also emphasized that it’s not only companies they have as customers, but also countries like Singapore and Japan.
When asked about why customers would continue to buy Hopper (if Blackwell is going to deliver 4X faster training and 30X faster inference), the answer was stated quite well:
Jensen Huang (CEO):
“If you're 5% into the build-out versus if you're 95% into the build out, you're going to feel very differently. And because you're only 5% into the build-out anyhow, you build as fast as you can. And when Blackwell comes, it's going to be terrific. And then after Blackwell, as you mentioned, we have other Blackwells coming. And then there's a short — we're in a one-year rhythm as we've explained to the world. And we want our customers to see our road map for as far as they like, but they're early in their build-out anyways and so they had to just keep on building, okay. And so there's going to be a whole bunch of chips coming at them, and they just got to keep on building and just, if you will, performance average your way into it. So that's the smart thing to do. They need to make money today. They want to save money today. And time is really, really valuable to them. Let me give you an example of time being really valuable, why this idea of standing up a data center instantaneously is so valuable and getting this thing called time to train is so valuable. The reason for that is because the next company who reaches the next major plateau gets to announce a groundbreaking AI. And the second one after that gets to announce something that's 0.3% better. And so the question is, do you want to be repeatedly the company delivering groundbreaking AI or the company delivering 0.3% better? And that's the reason why this race, as in all technology races, the race is so important.”
Conclusion:
Over the past three days I’ve written 6,000 words on Nvidia. The goal was to get us prepared no matter the reaction to the earnings report. Rather than write a new conclusion, I will simply restate the one I published this morning, which is that Nvidia has sold off 10% or greater about 9 times since the 2022 low. We see any dips as buying opportunities as we brace for Blackwell toward the end of this year.
Alpha and Omega Semiconductor manufactures power IC semiconductors, MOSFETs, intelligent power modules, high voltage gate drivers, and other power management module products. AOSL’s primary end market is PCs and graphic cards, with around 40% or more of quarterly revenue stemming from this end market, on average. The company is low-growth and is not GAAP profitable. There are indications it will become profitable on an adjusted basis soon. In the most recent quarter, the company turned cash flow positive. Inventory corrections in the consumer and industrial markets have created headwinds to revenue, yet management expects both segments to see strong sequential growth as inventory corrections are expected to end soon.
Where AOSL could become a promising stock is that it has been shipping on Intel’s Raptor Lake and Meteor Lake, alongside AMD’s FP8 platform. AOSL is in development and sampling for AMD’s FP11 platform, which is expected to underpin its next-generation high-end Ryzen Strix Halo APUs offering 70 TOPS of AI performance, up to a 75% increase to current chips from AMD’s rivals Qualcomm and Apple currently on the market. AOSL is also sampling to Intel’s Panther Lake platform, which is expected to be released in mid-2025, rumored to bring a 5x increase in AI performance versus Meteor Lake.
Despite the promising tie-ins to Intel and AMD, we are putting AOSL in the high-risk bucket due to it being a small-cap, and because it requires speculation that there will be a shift in the fundamentals. The stock will be reserved for the Advanced tier’s momentum portfolio for now, until we see more fundamental strength. This means technical analysis plays a primary role. We will close the position quickly (as soon as one day) if the setup fails. Or, we will hold for many months and increase its allocation if we see the stock shift to meet more of our criteria.
Overview of AI PCs and AI Mobile:
Given its high contribution to revenue combined with a strong outlook in AI PCs over the next six to eight quarters, we’re watching the Computing segment closely to drive growth through the September quarter and through 2025.
Management has been quite transparent throughout the inventory corrections in the PC space in 2022 as well as the growth opportunities it sees in the computing segment, not just in PCs but also extending to graphics and AI accelerators.
In May 2022, management pointed out that they were beginning to “see early signs that the PC market is beginning to soften,” and then later in December 2022, management said that “demand dropped off rapidly in December quarter as our customers aggressively reduced inventories,” though customers were anticipating order resumption in the June 2023 quarter. Not only was management fairly open throughout the downturn, it also was a testament to AOSL’s strength in the market — despite that sharp 20% YoY decline in PC shipments in 2022, AOSL’s full year PC revenue increased 3% YoY due to share gains, increasing bill of materials (BOM) content and product mix shift towards premium products.
Overall, the PC downturn significantly impacted Computing revenue, going from a near peak $89 million to $38 million in just two quarters, from fiscal Q1 2023 (Sept 2022) to fiscal Q3 2023 (Mar 2023). Prior to this macro-induced demand slowdown and subsequent inventory correction in PCs, computing revenue approached $360 million in TTM revenue.
Management had noted in February this year that the “inventory correction in graphic cards is coming to an end,” resolving one headwind to Computing growth.
In fiscal Q3 2024, computing revenue was ~$68.7 million, and management’s guide for mid- to high-single digit QoQ growth implies AOSL exits fiscal 2024 with computing revenue in the mid-$280 million range, or just over 20% below peak. AOSL saw “an increase in demand for newer applications such as graphics cards and AI applications,” and for fiscal Q4, management is forecasting “a rebound in gaming and continued strength from tablets, graphics cards, and AI,” and anticipates PC strength through the September quarter on new product launches.
Moving through the rest of 2024 and into 2025, Computing segment’s growth is likely to be driven by two primary factors – AI PC growth aided by Intel’s Meteor Lake platforms and AMD’s FP8 and FP11 next-gen chips, as well as a rather robust server and AI accelerator point-of-load (POL) roadmap.
For example, AOSL’s power delivery content is increasing significantly on Intel’s Meteor Lake chips, compared to the Arrow Lake predecessor, which should translate into a healthy BOM increase. Intel is targeting a significant 8x increase in Core Ultra AI PC chip shipments (across its Arrow Lake, Meteor Lake and Lunar Lake platforms) — from 5 million since December 2023 to at least 40 million by year-end 2024. This is estimated to grow 50% in 2025 to 60 million Core Ultra chip shipments.
Source: Intel
For Meteor Lake specifically, Intel is rumored to be targeting 20 million unit shipments in 2024, with 300 million units for Meteor Lake’s life-cycle; if correct, this provides a large long-term runway for AOSL on a single chip generation.
Analysts pressed management about this opportunity, though management was vague in terms of specificities stemming from Intel and cautious about how the PC rebound will unfold:
Q, Craig Ellis: “if Intel is on track to ship 40 million Meteor Lake units this year in the back half for their target. And then I think its 60 million next year. Is that where you are getting some content gain and are we seeing some of that in the guidance for fiscal 4Q? And then the broader question beyond just compute, I think three months ago when you talked about mid-year and the second-half of the year, you saw the potential for there to be a seasonal rise in the business that looks like we are starting to see that. Can you just talk about how your expectation for the back half of the year, or the fiscal first half of ‘25 has changed in the last three months. What’s gotten better and is anything tick lower?
A, CEO Stephen Chang: “Sure, regarding PCs in the first half calendar versus second half calendar year, we do think that the second half will be stronger than the first half. But it’s hard to see how strong it will be going beyond the peak season in September. We do believe that the seasonal patterns are already coming back. But we are hesitating to call a full recovery and then we will know better once we are into that second half in terms of how, whether it will persist going into this December quarter. Overall, I think – we think it will probably take a little longer to get to the full recovery for PCs. I think an Intel transition to Meteor Lake will help. We are hoping that some of these new platforms in general from the OEMs will also start to trigger more end demand for PCs. But overall, yes, we are expecting that to see PCs be stronger going into the September quarter. But we are going to be careful watching out for that.”we do think that the second half will be stronger than the first half.But it’s hard to see how strong it will be going beyond the peak season in September. We do believe that the seasonal patterns are already coming back. But we are hesitating to call a full recovery and then we will know better once we are into that second half in terms of how, whether it will persist going into this December quarter. Overall, I think – we think it will probably take a little longer to get to the full recovery for PCs. I think an Intel transition to Meteor Lake will help. We are hoping that some of these new platforms in general from the OEMs will also start to trigger more end demand for PCs. But overall, yes, we are expecting that to see PCs be stronger going into the September quarter. But we are going to be careful watching out for that.”
Bill of Materials (BOM) Increasing from $2 to $3
Management also shared a rather positive long-term outlook in terms of how it will work towards increasing BOM ($ content per product) and enter new markets:
“So, with that, we are seeing BOM content grow. It used to be in the $2 range is going into the $3range. And depending upon the configuration can push harder than that. But that’s helping us in general because with the latest power maps being used that the CPUs are being used, we are seeing more driver mass is lowered, more phases, which basically means more content for us and going into powering the CPU. Now – and so that’s what’s going on the client side. The other thing that we are seeing in general is that we are expanding more not only from the client PC side, but also going into advanced computing. And you guys and we have been sharing about our success in general into the graphics market, we are seeing in a return into growth for the graphics side. So, we feel a little more confident that the inventory correction there is behind us and we are seeing growth is specifically for the graphics side.” which basically means more content for us and going into powering the CPU. Now – and so that’s what’s going on the client side. The other thing that we are seeing in general is that we are expanding more not only from the client PC side, but also going into advanced computing. And you guys and we have been sharing about our success in general into the graphics market, we are seeing in a return into growth for the graphics side. So, we feel a little more confident that the inventory correction there is behind us and we are seeing growth is specifically for the graphics side.”
The company is also sampling or in development for a handful of upcoming next-generation platforms from AMD and Intel.
AOSL has been shipping on Intel’s Raptor Lake and Meteor Lake, alongside AMD’s FP8 platform. AOSL is in development and sampling for AMD’s FP11 platform, which is expected to underpin its next-generation high-end Ryzen Strix Halo APUs offering 70 TOPS of AI performance, up to a 75% increase to current chips from AMD’s rivals Qualcomm and Apple currently on the market. AOSL is also sampling to Intel’s Panther Lake platform, which is expected to be released in mid-2025, rumored to bring a 5x increase in AI performance versus Meteor Lake.
AOSL’s server and HPC/AI accelerator product portfolio is expected to increase significantly, with more than half a dozen new products planned for development through 2025 and beyond. The following was stated on the call: “And the other new area that I would say that’s in the computing space is AI. And over there we are starting to get some business because of our success in graphics cards. One of our customers is basically using a similar solution in their AI accelerators. So, we are still seeing some contribution coming there, going into AI accelerators.”
Fiscal Q3 Financials Recap
AOSL reported fiscal Q3 earnings (quarter ending March 2024) in early May, reporting revenue in line with estimates and EPS above estimates. As you can see below, AOSL is coming off a deep trough. There is commentary that suggests the fundamentals are bottoming, which aligns with our understanding of PCs and mobile rebounding in H2 of this year. However, as stated in the introduction, until fundamentals are actually reported, a rebound requires speculation.
Revenue and EPS:
Revenue in the quarter was $150.1 million, an increase of 13.2% YoY but a decrease of (9.2%) QoQ. This was in-line with analyst estimates. Management expanded on seasonality, saying that while the “March quarter is historically our seasonally lowest revenue quarter due to the technicality of consumer spending, the year-over-year growth indicated the strength of our recovery from the inventory corrections.”
Days sales outstanding was 15 days for Q1 compared to 18 days for the prior quarter, and 30 days for the year ago quarter.
Adjusted EPS was ($0.04), beating the consensus estimate for ($0.14). GAAP EPS was ($0.39), beating estimates for ($0.48). The goal is to see this company become profitable on an adjusted basis next quarter.
Fiscal Q4 revenue was guided to be $160 million, +/- $10 million, for a (1%) YoY decline and a 6.6% QoQ increase at midpoint. Management said that “starting from the June quarter, we forecast a rebound in gaming and continued strength from tablets, graphics cards and AI. Looking beyond, we anticipate the second half of this year will be stronger than the first half as customers gear up for new product launches in smartphones as well as PCs.” Management also added that “inventory corrections across the majority of our end markets are now approaching their conclusion, positioning us for a gradual rebound as we move forward into the rest of calendar year 2024.”
Based on management’s guidance for margins and operating expenses, adjusted EPS is expected to be approximately $0.04 in Q4. GAAP EPS is expected to be approximately ($0.30), as GAAP operating expenses are expected to be around 20% higher than non-GAAP. Moving forward, adjusted EPS is expected to increase sequentially in fiscal Q1 and remain flat QoQ in Q2; however, there are only three analyst estimates for revenue and EPS, which opens the door to large EPS beats or misses.
Margins:
GAAP gross margin was 23.7% in Q3, a 50 bp YoY improvement but a sequential decline of 290 bp. Adjusted gross margin was 25.2%, a 10 bp YoY improvement but a sequential decline of 280 bp. Management explained that the sequential decline in margins were “mainly driven by lower utilization and ASP erosion, partially offset by better mix.”
GAAP operating margin was (7.0%) in Q3, a 390 bp YoY improvement from (10.9%) in the year ago quarter, but a 630 bp sequential decline from (0.7%) last quarter. Adjusted operating margin was (0.7%), a 480 bp YoY improvement from (5.5%) in the year ago quarter but a 290 bp sequential decline from 2.2% last quarter.
GAAP net margin was (7.5%) in Q3, a 680 bp YoY improvement. Adjusted net margin was (0.8%), a 360 bp YoY improvement.
Over the longer term, management remains optimistic about a return to 30% margins as it works towards hitting its $1 billion revenue goal:
Q, Analyst Craig Ellis: “What are some of the bigger gives and takes that we should be aware of for gross margin and really the pace of expansion and what do you need to see to be confident that gross margins can move back to that 30% level and then at some point higher? Thank you.
A, CFO Yifan Lang: At this point and I mean we still think on our mid-term target model and when we reach the $1 billion in revenue, we expect to get to 30% gross margin on the non-GAAP basis level.”
Cash and Debt:
Operating cash flow was $28.2 million in Q3, including $9.9 million in repayments of customer deposits. Operating cash flow margin was 18.8%, compared to 8.8% in the year ago quarter.
Free cash flow was $20.2 million, for a margin of 13.7%, compared to (-8.3%) in the year ago quarter. Given that we’re in a high rate environment that is not ideal for companies undergoing capital raises, having positive operating and free cash flow with margins in the double digits is a positive for AOSL, suggesting that it should be able to fund operations organically.
Cash and equivalents totaled $174.4 million.
Debt totaled $41.2 million.
Key Segments:
Computing:
The Computing segment accounted for 45.8% of AOSL’s revenue in Q3, increasing 80.4% YoY on a weak comp due to a sharp inventory correction and downturn in the PC market in the same quarter last year. Sequentially, computing revenue declined 4.3%, as March is typically AOSL’s seasonally weakest quarter.
Management said Computing’s revenue was “in line with our original expectation for a mid-single digit decline sequentially due to seasonality and the impact of Chinese New Year,” and that “sequential growth in graphics cards, tablets and A.I. accelerators helped partially offset the seasonal decline that was mostly from notebooks.”
Consumer:
The Consumer segment accounted for 15.7% of revenue, declining (47.1%) YoY but increasing 0.3% QoQ. Management said the “inventory correction in gaming continued in the March quarter,” but they see “opportunities to increase BOM [bill of materials] content within the current console platform as part of a product refresh coming very soon.” Consumer segment revenue exceeded management’s expectations for a single-digit sequential decline due to strength in LCD TVs and home appliances.
Communications:
The Communications segment accounted for 17.9% of revenue, increasing 39.2% YoY but declining (7.4%) QoQ. Management noted that segment growth was below expectations as “continued strength in March quarter shipments to the Korea and China-based smartphone OEMs were offset by a seasonal decline in shipments to the Tier 1 U.S. smartphone customer, as well as a slowdown in networking.”
Looking forward, the segment is expected to see flat QoQ growth in the June quarter, as increasing BOM and increased shipments from its US smartphone customer in preparation for a fall launch will be offset by a sequential decline in Korea and China OEMs. Management said that “even with a sequential decline, our China OEM businessremains strong and up significantly year-over-year. Overall, we estimate the Communication segment will be flat sequentially in the June quarter, which is notably higher year-over-year, because of our BOM content and market share increases.”
Power Supply & Industrial:
The Power Supply and Industrial segment accounted for 16.5% of total revenue, decreasing (6.5%) YoY and (29.0%) QoQ on continued inventory corrections in quick chargers in addition to sequential declines in AC-DC power supplies, power tools and solar. Looking ahead to the June quarter, management expects sequential growth in the mid- to high-single digits as the quick charger inventory correction ends alongside strength in e-mobility.
Valuation
In terms of valuation, AOSL trades just slightly above 1x sales and below book, making it one of the cheapest stocks in the semiconductor industry on these two metrics.
At the moment, AOSL is trading about in line with its 5-year average PS ratio of 1.1x, falling from a peak multiple of 2.5x in early 2022 when revenue was approaching its peak above $200 million and EPS was surpassing $1.00 per quarter. AOSL’s forward PS ratio is nearly identical at nearly 1.2x, given that revenue growth is expected to be approximately (1%) this year before accelerating to 5.4% in fiscal 2025, based on current analyst estimates.
Because AOSL is not a hypergrowth stock at the moment, with revenue expected to accelerate to the double digits in late fiscal 2025 (calendar Q1 2025), the focus shifts to the bottom line, which has been weakening as margins slip on lower utilization rates and some ASP declines. Currently, gross margins are hovering in the 25% range, lower than AOSL’s long-term target of 30% and below peak margins in the 35% range in fiscal 2022; at that range, AOSL was delivering $1.00+ in EPS, or annualized earnings power above $4/ per share.
At the moment, AOSL trades at an ~47x forward PE ratio, weighed down by weaker margins. This is more expensive than the 36x forward multiple from November 2023 and significantly more expensive than the 15x ratio from a year ago, when gross margins were closer to the 30% level and the bottom line was a bit stronger.
Essentially, AOSL would need to drive net margin towards the high-single digit, low-double digit range to realize this earnings power, but that is likely entirely reliant on gross margin expanding beyond the 30% range. Finding ways to increase content per chip in the PC space should aid in higher margins, unless that is driven by increasingly expensive components. Notably, the margin recovery is likely to be more gradual due to weakness in other end markets, such as solar and consumer segments.
Technicals Appear Bullish
By Knox Ridley
The developing, larger trend in AOSL appears to be quite bullish. So far, there are two patterns within this larger trend: first, is a near vertical move higher; second, a corrective retrace that is making higher lows.
This first pattern starts off the COVID low in 2020, and is a clear 5 waves that stretches into the March 2022 high. Five wave moves are nearly vertical with minor pullbacks along the way. They tend to signal the start of a trend. There is simply no other interpretation of this pattern in AOSL, which suggests higher prices on the horizon.
The 2nd pattern in the larger trend, which further confirms this thesis higher, is how we have corrected since the March 2022 high. The correction since the March 2022 top has been an overlapping, corrective pullback, which is commonly called a “bull flag.” This pattern tends to be a correction within a larger uptrend.
The internals and volume patterns during this pullback further support the developing uptrend. Look at the MACD, which is a way to measure momentum within trends. Note how the MACD bottomed in July of 2022 and has since made a series of higher highs while price made a series of lower lows. This implies that the selling momentum has been fading, which is common to see close to bottoms.
Furthermore, note the large green volume patterns that have been developing since June of 2023. This is indicating accumulation, which is also a common pattern to see close to bottoms.
Our game plan is to wait for a breakout above $30.50. Once we get this signal, ideally on expanding buying volume, we would enter this position with a stop in the $24 range. If this larger pattern is playing out, we would then buy the dips of AOSL along the way.
Conclusion
We believe AI PCs may emerge as one of the stronger growth trends in consumer AI devices over the next few years, with AI PC shipments projected to surge at a 44% CAGR through 2028 to take over 70% share of PC shipments. AOSL’s tie-ins to Intel’s Meteor Lake CPU and possible launch on its upcoming Panther Lake platform, as well as its position in development stages for AMD’s FP11 platform, position it for strong growth in this space.
Computing revenue growth for AOSL has been strong and is a primary driver of overall growth, accounting for more than 45% share of total revenue. While AOSL’s top line valuation is much cheaper than many leading AI stocks, the bottom line is weak currently as margins remain depressed; however, the technicals are leaning bullish, and as we know, AI small caps can move quickly (in both directions!), so we believe it’s worth keeping AOSL on our radar with a buy plan (and a sell plan!) in place.
Damien Robbins, Equity Analyst for the I/O Fund, contributed to this analysis
Nvidia impressed again with a beat this quarter and a raise next quarter. However, that wasn’t enough to move the stock price. It was during the earnings call that we saw the stronger price action when management discussed the Blackwell architecture. The first question on the call was a direct question on when Blackwell will be in production:
Q: “So this year, we will see Blackwell revenue, it sounds like?”
A: The CEO offered one, simple sentence in a measured tone: “We will see a lot of Blackwell revenue this year.”
The call could have probably ended there as that one simple sentence shed light on what has been the predominant concern — can Blackwell keep up with Hopper. If you read my analysis published in Forbes this morning, then you know that the I/O Fund thinks a $200 billion data center segment is in sight by the end of CY2025.
There were other bullish comments about Blackwell ramping this year, such as “We will be shipping [Blackwell]. Well, we've been in production for a little bit of time. But our production shipments will start in Q2 and ramp in Q3, and customers should have data centers stood up in Q4.” This was strong language to use as it’s quite clear that Hopper has runway left given the beat/raises we saw in this quarter. To have the two architectures merge seamlessly in terms of timing in H2 is quite ideal.
Revenue and EPS:
Revenue of $26 billion is up 18% QoQ and up 262% from the year ago quarter. This means Q4 was officially the peak quarter for revenue growth, which we covered previously. Revenue beat expectations by 5.9% with analysts expecting $24.6 billion in revenue for growth of 242% YoY.
Nvidia will now face tougher comps as it laps Hopper’s impact from last year. The company is off to a decent start by forecasting next quarter revenue of $28 billion. Analysts were expecting $26.84 billion. This represents growth of 107% up from growth of 98.8% expected.
The intra-quarter revisions are particularly strong. However, regardless of ongoing upward revisions, it’s unlikely we return to the peak growth we saw in Q4 and Q1 (current quarter).
GAAP EPS of $5.98 compares EPS of $4.93 last quarter. This represents QoQ earnings growth of 21.3% and YoY earnings growth of 629%.
Adjusted EPS of $6.12 beat estimates of $5.58. This represents growth of 18.6% QoQ and 461% growth YoY.
Margins:
As expected, margins have expanded across the board.
GAAP gross margin of 78.4% compares to 64.6% in the year ago quarter, up 13.8 points YoY and up 240 bps from last quarter. This represents gross profit of $20.94 billion.
We will see a softening in gross margin due to a deceleration from peak revenue. Management is guiding for GAAP gross margin of 74.8% for next quarter with added color that the full year gross margins “are expected to be in the mid-70% range.”
Adjusted gross margin of 78.9% compares to 66.8% in the year ago quarter, up 12.1 points YoY and 220 bps from last quarter. Management is guiding for adjusted gross margin of 75.5%. This represents adjusted gross profit of $21.1 billion.
GAAP operating margin of 64.9% compares to 50.3% in the year ago quarter. This represents operating profit of $16.9 billion.
For next quarter, GAAP OPM is expected to soften to 60.5%, according to management’s guidance.
Adjusted operating margin of 69.3% was reported for Q1, representing adjusted operating profit of $18.05 billion.
For next quarter, adjusted operating margin is expected to soften to 65.5%.
Net margin this quarter was 57.1% compared to 28.4% in the year ago quarter, and was up 150 basis points QoQ. This represents net profit of $14.9 billion. The adjusted net margin this quarter was 58.5%.
Cash Flow:
Cash flow was strong (unsurprisingly) with some of the highest free cash flow margins among the Mag 7:
Operating cash flow of $15.35 billion represents a margin of 58.9% which expanded 690 bps QoQ from 52% and expanded 18.4 points in the year ago quarter.
Free cash flow of $14.94 billion represents a margin of 57.3%, which was up 660 bps and is up 20.5 points YoY.
The company has $31.4 billion in cash and $9.71 billion in debt.
Nvidia announced a ten-for-one stock split, which will be effective June 6th, 2024. Trading will commence on a split-adjusted basis at market open Monday, June 10th, 2024.
Nvidia is increasing its cash dividend by 150% from $0.04 per share to $0.10 per share of common stock. The increased dividend is equivalent to $0.01 per share on a post-split basis. This quarter, the company utilized cash of $7.8 billion towards shareholder returns, including $7.7 billion in share repurchases and $98 million in cash dividends.
Key Segments:
Data center revenue of $22.6 billion, was up 427% YoY and up 23% QoQ. This marks an annualized run rate of $90 billion. We made the argument in today’s Forbes analysis that we could see a $200 billion data center segment by the close of FY2026 based on the strength of the Blackwell architecture, which would represent 65% upside from current analyst data center estimates. This requires speculation, of course, but management did state this in the call: “Blackwell will be available in over 100 OEMs at launch nearly double compared to Hopper, and will support broad and fast deployments.”
Management’s Q2 guide implies data center revenue of about $24 billion next quarter. This is assuming $4 billion from the other four segments, which reported a combined $3.5 billion this quarter. The CFO stated all segments would be up in Q2 on QoQ basis: “We expect sequential growth in all market platforms.”
Gaming reported revenue of $2.65 billion, which was up 18% YoY yet is down 8% QoQ. The company said the following in the opening remarks: “GeForce RTX GPUs, now with over 100 million installed base, gamers, creators and AI enthusiasts, unmatched performance for Gen AI on PCs.”
ProViz revenue of $427 million, was up 45% YoY and down 8% QoQ
Automotive was up 11% YoY and up 17% QoQ
OEM and other revenue of $78 million was up 1% YoY but down 13% QoQ.
Earnings Call:
One of the key points in the earnings call was the ROI that cloud service providers will see from renting GPUs. This may have been provided to help shine some light on why capex budgets continue to grow.
“For every $1 spent on NVIDIA AI infrastructure, cloud providers have an opportunity to earn $5 in GPU instant hosting revenue over four years. NVIDIA's rich software stack and ecosystem and tight integration with cloud providers makes it easy for end customers up and running on NVIDIA GPU instances in the public cloud.”For every $1 spent on NVIDIA AI infrastructure, cloud providers have an opportunity to earn $5 in GPU instant hosting revenue over four years. NVIDIA's rich software stack and ecosystem and tight integration with cloud providers makes it easy for end customers up and running on NVIDIA GPU instances in the public cloud.”
“For example, using Llama 3 with 700 billion parameters, a single NVIDIA HGX H200 server can deliver 24,000 tokens per second, supporting more than 2,400 users at the same time. That means for every $1 spent on NVIDIA HGX H200 servers at current prices per token, an API provider serving Llama 3 tokens can generate $7 in revenue over four years.”That means for every $1 spent on NVIDIA HGX H200 servers at current prices per token, an API provider serving Llama 3 tokens can generate $7 in revenue over four years.”
The company also went out of its way to highlight that they are well diversified beyond major cloud providers by pointing out that: “Large cloud providers continue to drive strong growth as they deploy and ramp NVIDIA AI infrastructure at scale and represented the mid-40s as a percentage of our Data Center revenue.” They highlighted that enterprises like Tesla and consumer internet companies like Meta are also strong growth verticals. Management also emphasized that it’s not only companies they have as customers, but also countries like Singapore and Japan.
When asked about why customers would continue to buy Hopper (if Blackwell is going to deliver 4X faster training and 30X faster inference), the answer was stated quite well:
Jensen Huang (CEO):
“If you're 5% into the build-out versus if you're 95% into the build out, you're going to feel very differently. And because you're only 5% into the build-out anyhow, you build as fast as you can. And when Blackwell comes, it's going to be terrific. And then after Blackwell, as you mentioned, we have other Blackwells coming. And then there's a short — we're in a one-year rhythm as we've explained to the world. And we want our customers to see our road map for as far as they like, but they're early in their build-out anyways and so they had to just keep on building, okay. And so there's going to be a whole bunch of chips coming at them, and they just got to keep on building and just, if you will, performance average your way into it. So that's the smart thing to do. They need to make money today. They want to save money today. And time is really, really valuable to them. Let me give you an example of time being really valuable, why this idea of standing up a data center instantaneously is so valuable and getting this thing called time to train is so valuable. The reason for that is because the next company who reaches the next major plateau gets to announce a groundbreaking AI. And the second one after that gets to announce something that's 0.3% better. And so the question is, do you want to be repeatedly the company delivering groundbreaking AI or the company delivering 0.3% better? And that's the reason why this race, as in all technology races, the race is so important.”
Conclusion:
Over the past three days I’ve written 6,000 words on Nvidia. The goal was to get us prepared no matter the reaction to the earnings report. Rather than write a new conclusion, I will simply restate the one I published this morning, which is that Nvidia has sold off 10% or greater about 9 times since the 2022 low. We see any dips as buying opportunities as we brace for Blackwell toward the end of this year.
This article was originally published on Forbes on May 17, 2024,09:37am EDTForbesForbes on May 17, 2024,09:37am EDT
Amazon shares have climbed to fresh all-time highs following a double beat in the last earnings report. The company is on the verge of joining the $2 Trillion Club, driven by a 4-percentage point accelerating in AWS to 17% YoY growth combined with strong 25% growth in advertising revenue. AWS surpassed a $100 billion annualized run rate in the first quarter, with management noting that they “see more absolute dollar growth again quarter-over-quarter in AWS than we can see elsewhere.”
E-commerce is what Amazon is famous for, however, it’s AWS and advertising that are the core growth engines. This past quarter, the two combined for $37 billion in high-margin revenue. Analyst estimates point toward AWS and advertising exiting 2024 at a combined $160 billion revenue run rate. If this materializes, these segments will combine for one-quarter of Amazon’s total revenue while helping to drive 221% YoY growth in operating income.
The synergies from strong double-digit advertising growth, an AI-driven acceleration in AWS, and an increasing cash flow margin support Amazon’s push to all-time highs. Plus, there are hints that the acceleration could continue as more GPU supply comes online, and as Amazon Prime implements ads in Prime Video.
Q1 Recap
Revenue of $143.3 billion beat estimates by $0.8 billion, marking the fourth consecutive quarter of double-digit growth as Amazon’s revenue growth rate accelerated 310 bp YoY to 12.5%. EPS increased 216% YoY to $0.98, as Amazon continued to realize gains from improved operating leverage, with gross profit rising more than 53% YoY and operating income surging 221% YoY to $15.3 billion.
Amazon’s North America segment and AWS both contributed to this operating income growth. North America operating income increased more 500% to $5.0 billion, from $0.9 billion last year; AWS generated $9.4 billion in operating income, up 84% YoY (and a 37.6% margin). Put another way, AWS contributed more than 61% of Amazon’s total operating income in the quarter despite contributing less than 18% of Amazon’s revenue.
Not only is Amazon showing an ability to expand its gross margin from less than 15% towards 20% in 4 quarters, but it’s also driving more pronounced growth in operating margin, reaching double-digits for the first time.
Pictured Above: Amazon reaches double digit operating margin for the first time. Source: I/O Fund
The tangible improvements to the bottom line are evident as the growth story unfolds. High-margin AWS and advertising revenues are also Amazon’s two fastest growing segments.
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AWS Seeing AI-Powered Growth
AWS re-accelerated 4 percentage points to 17% YoY growth in the quarter, as CEO Andy Jassy attributed it partly due to the “combination of companies renewing their infrastructure modernization efforts and the appeal of AWS’s AI capabilities.”
Growth has cooled rather dramatically since early 2022, where AWS was reporting growth rates above 30%, but at a $100B+ scale, AWS is driving the largest absolute dollar growth across the entirety of Amazon’s businesses.
Amazon is not providing a distinct breakout of AI’s contribution like Microsoft Azure, yet CEO Jassy commented that AWS is seeing “considerable momentum on the AI front, where we've accumulated a multi-billion-dollar revenue run rate already.”
AWS re-accelerated 4 percentage points to 17% YoY growth in the quarter, while operating income grew 84% YoY. Source: I/O Fund
In Q1, we saw evidence that AWS is benefiting from strong demand for generative AI offerings with management optimistic that increased capex will continue to bear fruit in terms of growth. Interestingly, operating expenses for AWS declined YoY, from $16.2 billion to $15.6 billion, aiding this growth in operating income.
In addition, rival Microsoft explicitly pointed out that Azure does not have the GPU capacity to meet demand, Amazon also implied that demand is possibly higher than capacity of both third-party GPUs from Nvidia as well as for its custom silicon. Management noted that in the quarter, they “continued to meet growing demand for AWS Trainium and Inferentia chips,” and explained that a “meaningful” YoY increase in capex in 2024 is being driven by high generative AI demand.
One comment in particular hints at possible capacity constraints: “given the way the AWS business model works, [the capex increase] is a positive sign of the future growth. The more demand AWS has, the more we have to procure new data centers, power, and hardware.”
Reading between the lines here implies that Amazon is working to improve availability of its in-house Trainium and Inferentia chips while also expanding its data center infrastructure and purchasing more GPUs to continue to meet high demand gen AI demand. The end result is that AWS will likely accelerate again in future quarters as supply comes online.
A Note on Capex
Amazon did not provide a full-year figure for capex, but management is anticipating a meaningful YoY increase this year, primarily to support AWS’ growth. Q1’s capex was $14 billion, which management expects will also “be the low quarter for the year.” This suggests 2024’s capex could easily top $60 billion, exiting the year in the mid-$60 billion range or higher, representing a YoY increase of at least 24%.
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Advertising Revenue Growth Remains Strong
Advertising is Amazon’s fastest growing segment with 24% YoY growth to $11.8 billion in revenue in Q1 and its rapidly scaling. Amazon recorded its first $10B ad revenue quarter in Q4 2022, and now has reported four quarters in a row above $10B.
On a TTM basis, advertising revenue was just shy of $50 billion, a 51% increase from $32 billion just two years ago. At this rate, Amazon is set to exit 2024 with ad revenues approaching $58 billion annually. Though Amazon does not break out advertising’s operating income like it does other segments, it says it “remains an important contributor to profitability in North America and International segments.” This is primarily made from sponsored ads on Amazon’s e-commerce site and the recent addition of sponsored TV ads, including on Thursday Night Football.
It’s also worth noting that ad-tech typically has some of the best margins in the tech industry, exceeding cloud or e-commerce.
Source: I/O Fund
Analysts are already quite optimistic about the revenue trajectory and potential for Prime Video ads which launched in January of this year. For reference, Netflix reported 23 million monthly active users (MAUs) globally a little over one year after it launched. Amazon is taking a different approach to SVOD ads than Netflix, Disney and others – instead of offering a cheaper, ad-supported tier, Amazon is adding ads to all Prime Video members, and offering an ad-free plan for an additional $3/mo.
By putting ads directly in front of an estimated 150+ million viewers, Amazon can benefit both from ad revenue and incremental revenue from subscribers who pay the ad-free upcharge. Bank of America analysts estimate that Amazon could rake in $3 billion in advertising revenue this year from Prime Video, potentially up to $5 billion when including those users who pay the additional charge. Morgan Stanley is a bit more optimistic about Amazon’s new initiative forecasting $3.3 billion this year, $5.2 billion in 2025 and $7.1 billion in 2026, generating an additional $2.3 billion in EBITDA in 2024. We see a more conservative take from MoffetNathanson, which projects just $1.3 billion in ad revenue this year before rising to $2.3 billion in 2025, with ~$500 million from users paying the ad-free upcharge.
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Unlocking Value via AWS, Ads
AWS and advertising are poised to exit 2024 at a combined $160 billion annualized run rate, or ~25% of Amazon’s estimated FY24 revenue. The two segments may help unlock more value for Amazon, given the gross and operating margin expansion the two segments are driving.
Take AWS – at $100 billion plus ARR, it’s the largest cloud provider compared to Azure at $76 billion ARR, Google Cloud at $38 billion and Oracle at $20 billion. Though AWS’ growth is lower at 17% versus >25% for rivals, it has one of the strongest margin profiles, with a 37.6% operating margin in Q1 and a 30.6% TTM operating margin.
AWS has one of the strongest margin profiles among rival hyperscalers, with a 37.6% operating margin in Q1 and a 30.6% TTM operating margin. Source: I/O Fund
In a sum-of-the-parts view, AWS could be worth $900 billion: this assumes a fair ~9x sales multiple, or a 30x earnings multiple, given that AWS may potentially generate a ~50% YoY increase to ~$30 billion in net income on a 75% YoY increase in operating income towards $40 billion. These multiples are conservatively in-line with current market valuations in cloud and AI – Microsoft trades at 13x forward sales and 33x forward earnings for 17% company wide growth, and Oracle at 6x forward sales and 21x forward earnings for single-digit growth.
Turning to ads, as the segment approaches a $60 billion run rate by the end of the year, it could fetch a $360 billion value in a similar sum-of-the-parts look. With growth likely remaining above 20%, this is again a conservatively fair market multiple of 6x forward sales, compared to a 7.6x forward sales multiple for Meta and a 6x forward sales multiple for Google.
Combined, Amazon’s two fastest growing segments could be viewed as worth at least $1.26 trillion, while also driving significant gross margin and operating margin expansion. When combined with Amazon’s remaining e-commerce and subscription businesses, which could be worth $1.2 trillion at a 2.5x multiple (a 30% discount to Amazon’s 5-year average 3.3x multiple) on an estimated ~$480 billion in revenue in 2024, there is room for Amazon’s valuation to expand towards the $2.5 trillion threshold. However, this outlook is reliant on AWS maintaining this revenue acceleration, as well as ads & AWS driving continual margin expansion.
Valuation Intact, Strong Cash Flow Growth
Amazon’s valuation is not at peak levels, with shares trading far below historical highs, unlike Microsoft which is trading at ‘Mount Everest’ valuations in regards to historical valuation multiples.
Amazon currently trades in line with its 5-year average PS ratio of nearly 3.4x, and at about 3.1x forward PS — although this is a significant increase from the 1.6x multiples at the start of 2023, Amazon’s forward PS ratio is 10% lower than early 2022.
Due to strong growth on the bottom line, Amazon is cheap on PE basis for this stock. The current PE Ratio of 52 is one of the lowest we’ve seen in the past few years, and is comfortably below the 3-year median of 67 and the 5-year median of 78. In fact, Amazon is cheaper now than it was in October 2023, despite a nearly 60% rally in shares since then.
Due to strong growth on the bottom line, Amazon is cheap on a PE basis for this stock. Source: YCharts
Earnings growth and operating cash flow growth are both expected to be strong in 2024 and extend into 2025. Amazon is estimated to report more than 56% growth in EPS this year to $4.52 before rising another 27% to $5.74 in 2025. Operating cash flow is projected to increase 45.5% to $123.6 billion in 2024 before rising another 19% to $147.4 billion in 2025.
Conclusion
In a 2022 webinar entitled “The New Kings of Tech,” our firm discussed that the first wave of AI gains will be realized in the enterprise space. We also recently debated on Real Vision that Big Tech has an undeniable advantage in AI due to possessing the capital to make the required hardware investments, and having an immediate product-market fit with their current in-house segments. Meanwhile, mid cap companies and small startups have to find customers for their AI products, and those SMB customers must be willing to absorb the high costs of AI. Meanwhile, Amazon is well positioned to capitalize on surging generative AI demand quickly with a multi-billion dollar run rate in AWS from AI products already. Combined with advertising, the two are driving strong margin expansion and aiding in both top and bottom-line growth; and in turn, this growth is creating an attractive valuation on the bottom line.
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Last month, Aljazeera reported that Ernie Bot has 200 million users compared to Chat-GPT’s 180 million users. In the earnings call, Baidu management stated Ernie Bot handles 200 million queries per day, up from 50 million in December. According to the call: “This considerable growth indicates that increasing adoption of ERNIE can point to strong future revenue potential from model inferencing […] We believe ERNIE ecosystem will over time contain millions of applications […]”
On the fundamentals, Baidu reported 1.2% growth in RMB yet this translates to a YoY revenue decline of (-3.75%) USD on a weaker exchange rate. AI cloud revenue increased 12% as Ernie Bot users and API requests continue to rise. Margins improved sequentially, with Baidu’s management emphasizing a near-term focus on optimizing operational efficiency while maintaining AI-related growth.
Revenue and EPS:
FX exchange rates between the RMB and dollar require nuanced approach for Baidu’s growth rates – the company reported YoY growth in local currency, but given that the RMB has weakened more than 5% against the dollar, US$ revenue declined.
Revenue in Q1 was $4.37 billion, representing growth of 1.2% for RMB 31.51 billion. This represents a YoY decline of (3.7%).
Baidu Core revenue was RMB 23.80 billion for an increase of 3.5% YoY. This equals $3.30 billion USD for a decline of (1.5%) YoY.
GAAP EPS was $2.07 in Q1, a YoY decline of (10.8%). Adjusted EPS of $2.76 increased 17.9% YoY.
Adjusted EBITDA was $1.14B for a margin of 26%. This represents a nominal decline from $1.19B in the year ago quarter.
Margins:
Margins improved sequentially, as Baidu reiterated a focus on maintaining a healthy operating margin while still investing in its AI growth engine.
Gross margin of 51.5% was flat YoY yet up 130 basis points QoQ
Operating margin of 17.4% was up 140 basis points YoY and up 200 basis points QoQ from 15.4%. This equals operating profit of $760 million. Adjusted operating margin was 21.2%, up from 20.6% in the year ago quarter.
Net margin of 17.3% was down 140 basis points YoY yet is up 990 basis points QoQ from 7.4%. This equals a net profit of $755 million. Adjusted net margin was 22.3% up from 18.4% last year and flat QoQ. According to the call, weighing on overall net margin, Other Income was down 52% to RMB 2 billion due to “a decrease in favorable gain from long term investments, partially offset by the increase in net foreign exchange gain.”
Cash Flow and Debt:
Cash flow is in line YoY yet down QoQ.
Operating cash flow of $861 million this quarter for a margin of 19.70% is up 100 basis points YoY yet is down considerably QoQ from 30.4% in Q4.
Free cash flow of $579 million this quarter for a margin of 13.3% was down 130 bps from last year and down 660 bps QoQ.
The company has $26.6 billion in cash and $11.3 billion in debt.
Stock based compensation was 3.6% of revenue. Baidu returned US$229 million to shareholders since the beginning of Q1 2024, bringing the cumulative repurchase to US$898 million under the 2023 share repurchase program. Per management: “we have consistently repurchased our shares on the market over the past four years, averaging around $1 billion annually. In total, we have allocated around 37% of our free cash flow towards the share buyback progress.”
Key Segments:
Revenue from Baidu Core grew 4% YoY to RMB 23.8B, which equals USD $3.3 billion. In March of 2024, Baidu’s monthly active users (MAU) on the search engine reached 676 million, up 3% YoY. This compares to 4% growth last year and was up 1.3% QoQ. Revenue from QiYi declined (-5%) YoY to RMB 7.9B, which equals $1.1 billion.
AI Cloud Revenue grew 12% YoY to RMB 4.7 billion and delivered “operating profit on a Non-GAAP basis.” AI cloud revenue has accelerated from a YoY decline in the third quarter of (-2%) to an increase of 11% in the fourth quarter, to a 100 bps acceleration QoQ to 12% this quarter. As stated, the revenue growth was “mainly driven by gen-AI and foundation models. In the first quarter, such revenue accounted for 6.9% of total AI Cloud revenue.”
Regarding scarcity of GPUs, the company stated they are creating GPU clusters of hundreds or even thousands of GPUs across various vendors into a unified computing cluster to train LLMs.
Online marketing revenue grew 3% YoY to RMB 17B, which equals USD $2.36 billion. According to management, this will eventually accelerate with AI: “we have been pushing hard to transform the user experience from a traditional mobile product to a generative-AI experience. This transition is ongoing and monetization has not yet started.” It was also stated macro weighed on the results: “In the first quarter, advertiser sentiment in some verticals, such as real estate and franchising, remained weak. Specifically in the real estate industry, not only was ad spending from developers and agencies muted, but the impact also extended to both upstream and downstream sectors.”
Perhaps most importantly, it was stated this will remain soft in the near-term: “As we enter the second quarter, we have not seen improvement in advertiser sentiment. Given the limited visibility for sentiment improvement and paired with tough comps in Q2, our online marketing revenue should remain fundamentally solid but from a growth perspective soft over the next few quarters.”
Non-online marketing revenue grew 6% YoY to RMB 6.8B for USD $935 million.
Apollo Go Rides were up 25% YoY to 826,000 rides. According to a recent statement, the AV unit will be break even by the end of this year and profitable next year. The robotaxis go for $27,697 USD and operating costs will be reduced by 30% once a robotaxi network is established.
For the outlook across key segments, management stated the following: “We expect our cloud business to accelerate and the loss of our robotaxi business to narrow for the rest of the year. We expect mobile business to be soft in the near term and start to recover when gen-AI becomes the new core of our existing products next year.”
More on ERNIE:
Similar to Chat-GPT, ERNIE has a family of models with the flagship models being ERNIE 3.5 and 4.0. Since March of last year, ERNIE’s training efficiency has improved 5X and the inference cost has been lowered drastically to 1% compared to the March 2023 models. The company offers a set of tools, such as AppBuilder and ModelBuilder, to entice developers to use Baidu’s models. Most recently, the company has released AgentBuilder, which helps developers create AI agents, which by using natural language programming, even those who can’t code can build an AI agent. The long-term goal for ERNIE (and Chat-GPT) is that millions of applications are built on top of these foundational models, ultimately locking AI development into the ecosystem. To do so, these companies will have to create very affordable models to compete with open-source models. Baidu discussed the following efforts: “In addition, our mixture of experts, or MOE approach can partition a user query into distinct tasks, assigning the most suitable models to handle each task and use ERNIE 3.5 or 4.0 only for the most complex tasks. This approach allows for faster responses and lower inferencing cost while maintaining similar performance levels to using more advanced models.”This approach allows for faster responses and lower inferencing cost while maintaining similar performance levels to using more advanced models.”
Being the largest search engine in China, Baidu Search with ERNIE improves search results similar to Chat-GPT/Bing and Gemini/Google. ERNIE will launch across Samsung, Oppo, Vivo and Xiaomi smartphones. APIs are also used across PCs and electric vehicles including Nio. The company has saw “double-digit YoY increase in paying users in the first quarter” for Baidu Wenku, which helps with document creation.
Brand advertisers and SMEs (small to medium sized enterprises) are also adopting ERNIE agents to serve as virtual storefronts, service desks and 24/7 assistance.
China’s GPU Restrictions:
Export controls prevent China from buying Nvidia’s most powerful GPUs. The company has created less powerful GPUs specifically to export to China, such as the A800 and H800. According to SemiAnalysis, Nvidia is also exporting the H20, L20 and L2 GPUs. Naturally, this brings up questions around Baidu’s ability to progress it’s ERNIE family models if the GPUs are less powerful than what’s available globally.
According to Baidu: “For the AI infrastructure layer, a key factor contributing to our high efficiency in model training and inference is our superior capability in GPU cluster management. We have recently made a breakthrough by integrating GPUs from different vendors into one large scale, unified computing cluster, allowing us to use less advanced chips for highly effective model training and inference. Our deep learning framework, PaddlePaddle, has through continuous innovation and enhancement helped reduce the cost of model training and inferencing on a constant basis. PaddlePaddle is compatible with over 50 different chips, many domestically designed, and the developer community has grown to 13 million […]”
“In the long run, I think China will form an ecosystem of its own, probably with less powerful chips but most efficient home grown software stack. There is ample room for innovation in the application layer, model layer, and framework layer […] We believe that the chips we have in hand are sufficient to support earnings for the next one or two years, and because of an ability of high performance chips in China in this year, 2024, we expect our capex to be smaller versus last year.”
Conclusion:
Per our last write-up, the I/O Fund team believes that Baidu could make for an interesting momentum play. We define a momentum position as one where technicals lead, where we respect the stops, and where the fundamentals may not be perfect for one reason or another. For Baidu, risk from China is too high for the stock to be considered for anything more than momentum. Given the emphasis on AI in the markets combined with China pushing for its domestic tech to be the predominant tech used by its citizens, we foresee a scenario where Baidu emerges as a decent choice for those who want to participate in lower valuations.
Tencent reported before market open and beat estimates today, with the advertising segment accelerating nicely year-over-year by 9-points. Where Tencent is stronger than it appears is on the margins, which we had outlined in our analysis last month.
The beat on revenue was marginal at 159.5 billion Chinese yuan (RMB) reported ($22.5 billion USD) compared to 158.4 billion yuan (RMB) expected. However, the beat on the bottom line was more than double digits. On a Non-IFRS basis, the company reported 50.3 billion RMB, which was up 54% YoY. On a IFRS basis, CNBC is reporting a 14% beat on the bottom line. Due to currency conversion differences, USD estimates are not as reliable as the RMB expectations.
Across the board, we have strong margin expansion. Despite strength in advertising, Fintech and Business services posted weaker growth YoY as did Revenues from VAS (gaming) and social networks. Overall, gaming is weighing on the revenue whereas AI is helping to drive the acceleration we are seeing in advertising. We break this down for you below with key points from management commentary.
Revenue and EPS:
As stated, gaming is weighing on Tencent’s revenue yet the bottom line is expanding.
Revenue:
Revenue growth of 6% compares to growth of 11% in the year ago quarter. This is also a 100-bps contraction from last quarter, although it’s common to see seasonality in consumer facing companies.
The 6% RMB revenue growth and 3% USD revenue growth should mark a near-term bottom for Tencent. Estimates for the next three quarters show growth sustaining at 9% to 10%. These are rough approximations due to fluctuations in currency exchange.
Earnings and EPS:
The company reported GAAP EPS of 4.39 RMB compared to 2.64 RMB last year, up 66% YoY.
The company reported non-GAAP EPS of 5.26 RMB compared to 3.35 RMB last year, up 57% YoY.
Profit attributable to shareholders, non-IFRS basis was at RMB 50.3 billion or US$ 7.1 billion, up 54% YoY. Profit attributable to shareholders on a IFRS basis was RMB 41.9 billion or US$ 5.9 billion, up 62% YoY.
EBITDA was $9.2B USD. Adjusted EBITDA margin was 43% for RMB 69.3B (USD $9.8 billion) compared to a margin of 39% in the year ago quarter.
Margins:
The margin expansion in the earnings report shines, and has been steadily improving since 2021.
Gross margin of 53% expanded 800 bps from 45% in the year ago quarter. This equals gross profit of RMB 83.9B or USD 11.8B, up 23% YoY.
Operating margin of 33% was also up 800 bps from 25% in the year ago quarter. This equals RMB 52.6 billion or USD 7.4 billion, up 38% YoY. Adjusted operating margin was up 700 bps for RMB 58.6 billion or $8.3 billion.
Net margin of 27% was up 900 bps from 18% in the year ago quarter for net income of RMB 42.7 billion or US$6 billion. Adjusted net margin was up 1000 bps for RMB 51.3 billion or USD of $7.2 billion.
Cash and Debt:
The company reported very strong cash flows with margin expansion. There is net cash of $13 billion although the company is a large shareholder in other companies with a portfolio value of USD $73.6 billion. United States investors may recall a company like Shopify that sees drastic fluctuations in cash depending on the value of their investments (Affirm, etc). However, due to the sheer size of Tencent’s holdings, there is considerable value to this portfolio at the current moment, which was discussed on the call and is detailed more below.
Operating cash flow of RMB 72.3 billion or USD $10.2 billion reported a margin of 45%.
Free cash flow of RMB 51.9 billion or USD $7.3 billion for a margin of 33%. This represents “stable” growth YoY and was up 52% QoQ. Stock based compensation was 3.8% of revenue.
There is USD $62.8 billion in cash on the balance sheet and debt of USD $49.7 billion for net cash of $13 billion.
Operating Capex of 6.6 RMB was up 557% YoY and Non-Operating Capex of RMB 7.8B is up 127% YoY. Total Capex was up 226% YoY to RMB 14.4B, up from RMB 4.0B in capex in the year ago quarter. The rise in capex was mainly due to the increase in investments in AI. The CFO said in the earnings call, “Operating capex was RMB 6.6 billion, up 557% year-on-year from a low base quarter last year, mainly driven by investment in GPUs and servers to support our Hunyuan and AI recommendation algorithms. On a quarter-on-quarter basis, operating capex was down 1%. Non-operating capex was RMB 7.8 billion, up 127% year-on-year due to acquisition of land use rights during the quarter. As a result, total capex was RMB 14.4 billion, up 226% year-on-year.”
The fair value of shareholdings in listed investee companies is at USD $73.6 billion, up from USD $68.8 billion in the year ago quarter. As you can imagine, this depends on the health of the Chinese stock market. The book value of unlisted investments was a $46.3 billion USD, which is flat YoY and fluctuates less due to infrequent reporting on private valuations.
During the quarter, the company repurchased 51 million shares on the Hong Kong stock exchange for HKD 14.8 billion. The company also made 3.7B RMB in payments for media content and lease liabilities of 1.5B RMB.
Key Metrics:
VAS or value-added services is comprised of gaming and social networks. This segment is 49% of revenue and declined 0.9% YoY to RMB 78.6B compared to RMB 79.3B. However, this was up 14% QoQ from RMB 69.1B. In. In that regard, Q4 could be the bottom for gaming. VAS gross profit increased 5% year-on-year to RMB 45 billion, representing 54% of total gross profit.
International gaming revenue was up 3% due to a “lengthy revenue deferral cycle for Supercell’s games.” This compares to 25% growth in the year ago quarter.
Domestic games receipts “returned to growth” and was up 3% YoY. However, domestic games revenue declined 2% YoY to RMB 34.5B “due to revenue deferral.” As stated, the receipts returning to growth may be indicating the early signs of a bottom for gaming (we will see).
Social networks revenue declined (-2%) by RMB 30.5B. This compares to 6% growth in the year ago quarter. Music subscription revenue increased 39% year-on-year, reflecting growth in subscriptions and ARPU. According to management: “Revenue from music subscriptions, video accounts live streaming, mini games and video subscriptions increased, while revenue from music and games related to live streaming services declined sharp.”
Fintech and Business Services is 33% of revenue and decelerated YoY with 7% growth reported this quarter compared to 14% growth last quarter. Fintech and business services gross profit increased 42% year-on-year to RMB 24 billion, contributing 28% of total gross profit. Fintech and business services gross margin increased to 46%, up 11 percentage points year-on-year. This is being driven by wealth management services, which translates to money market accounts where users are holding their cash, plus ecommerce technology fees and monetization of business services.
Online advertising is 17% of revenue and was up 26% YoY for RMB 26.5 billion, which is a 900 bps acceleration from 17% growth in the year ago quarter. The highlights were Weixin video accounts growing over 100% YoY and mini programs revenue growing 40% YoY. Online advertising gross profit increased 66% year-on-year to RMB 15 billion, contributing 17% of total gross profit. Online advertising gross margin increased to 55%, up 13 percentage points year-on-year driven by growth in video accounts and Weixin Search.
Overall, this segment has been accelerating on a YoY basis over the past few quarters, although can be lumpy on a QoQ basis. Per management: “The first quarter for us is a slightly unusual quarter because it’s a small quarter for advertising due to the Chinese New Year effect, and so sometimes the accelerations or the decelerations get magnified as a result. We would expect our advertising growth to be less rapid in subsequent quarters of the year than it was in the first quarter, more similar to consensus expectations for our advertising revenue growth for the rest of the year.”
AI is showing initial signs of impacting advertising revenue growth. According to the earnings call: “Ad spend from all major categories except automotive increased year-on-year, particularly from games, internet services, and consumer goods sectors. During the quarter, we upgraded our adtech platform to help advertisers manage ad campaigns more effectively and we made generative AI-powered ad creation tools available to all advertisers.”
There are additional, smaller segments that are too small to breakout in terms of revenue: business services “grew at a teens rate year-over-year,” Tencent Cloud Media grew “over 50% YoY,” and within business services “WeCom revenue tripled” and “Tencent Meeting also doubled.”
Risks:
The risks are plentiful with this stock, and thus we use technical analysis fully to determine our entries and exits. The setup could fail in as soon as 1 day or it could remain intact for a few months. The fundamental analysis helps to identify the probability of a technical setup remaining in tact. In this case, we think the margin story helps support the risk of entering while adhering to all stops.
As a reminder, United States stocks have less risk than Chinese stocks. The first risk to consider 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.
Earnings Call:
How AI Can Help Social Networks:
Since are in the first inning for how AI will impact Big Tech, and we have many innings to go on how AI will impact all industries, it’s worth our time listening to a broad range of management teams on the subject. Here are a few comments from Tencent’s vantage point on how AI can provide a lift to social networks:
[…] historically as a social media platform, our click-thru rates were low, and so starting from that lower base, we have seen we can double or triple click-thru rates in a way that’s not possible for ad services that are starting from much higher click-thru rates.”, we have seen we can double or triple click-thru rates in a way that’s not possible for ad services that are starting from much higher click-thru rates.”
“[…] We believe that tools like Advantage Plus are extremely important in terms of helping social media companies, whether it’s Meta or ourselves, grow into being all that they can be on the advertising front, because they simplify and automate the advertising buying and advertising targeting processes so that the social media companies can deliver experiences to advertisers that are more competitive with those that had already been delivered by search engines and by ecommerce platforms.so that the social media companies can deliver experiences to advertisers that are more competitive with those that had already been delivered by search engines and by ecommerce platforms.
But with the advantage that the social media platforms have much greater time spent, user engagement than search engines or ecommerce platforms, and so to the second part of your question around–a number of competitors are obviously applying AI as well, and we believe that all of them will benefit from AI too, but we think that the biggest beneficiaries will be those companies, of which we are one, that have very substantial under-monetized time spent and are now able to monetize that time spent more effectively by deploying AI, because the deployment of AI enables an upward structural shift in click-thru rates, and that shift is most pronounced for those inventories where the click-thru rates were lower to begin with, such as the social media inventory.”the social media platforms have much greater time spent, user engagement than search engines or ecommerce platforms, and so to the second part of your question around–a number of competitors are obviously applying AI as well, and we believe that all of them will benefit from AI too, but we think that the biggest beneficiaries will be those companies, of which we are one, that have very substantial under-monetized time spent and are now able to monetize that time spent more effectively by deploying AI, because the deployment of AI enables an upward structural shift in click-thru rates, and that shift is most pronounced for those inventories where the click-thru rates were lower to begin with, such as the social media inventory.”
The Value of Tencent’s Portfolio:
Below is a discussion on how Tencent’s holding are valued according to the non-IFRS associate income and the stocks current multiple. If PE Ratios are based on GAAP earnings, then one could argue that Tencent is undervalued given the “several hundred billion renminbi” in profits its holdings contribute.
Ronald Keung (Goldman Sachs)
Okay, and then my follow-up question is on our investment portfolio. Given it’s very sizeable, nearly US $130 billion in value, do we have any thinking on consistent or any distribution policies after the JV and Meituan distributions in the past? I’m thinking about any predictable policies so that the market will more actively value this part of the value, given the substantial market value within Tencent. Thank you.
James Mitchell (Chief Strategy Officer)
On that front, we have been working with some of our investee companies, and many of them have been working unprompted by themselves to enhance their profitability, and so if you look at the non-IFRS associate income that we reported this quarter of a little over RMB 5 billion, that’s up very sharply year-on-year and it annualizes to a number in the 20s of billions renminbi. To the extent that investors are valuing Tencent’s overall earnings at a certain multiple, then implicitly they’re now valuing our investment portfolio at several hundred billion renminbi.
There is still a gap between that implicit valuation through our multiple and the associate income contributing to our multiple of several hundred billion renminbi, versus the intrinsic value or the market value of the portfolio, which is substantially higher, but as the associates–you know, as companies like Pinduoduo become steadily more profitable, then more and more that gap will narrow itself as the profitability of the associates gets directly reflected in our own net income.
Conclusion:
Tencent came in as expected with notable strengths within the report. Margins are expanded, there is promising signs of AI-powered advertising, and key metrics point toward a bottom in gaming (needs to be confirmed). Our most recent technical analysis can be found here. Advanced Members can expect to hear more in the weekly webinar and also in Knox’s next Positions Report ETA last week of May or first week of June.
Royston Roche, Equity Analyst for the I/O Fund, contributed to this analysis
