Month: May 2024

Big Tech Q1 Earnings: AI Capex Increases As AI-Related Gains Continue

Posted on by io-fund

This article was originally published on Forbes on May 9, 2024,02:23pm EDTForbes on May 9, 2024,02:23pm EDT

Recent Q1 earnings releases from Microsoft, Amazon, Alphabet and Meta reaffirmed that AI spending is continuing to increase through 2024 as companies seek AI-related revenue gains.

The tech giants are continuing to dedicate tens of billions each towards AI infrastructure, and overall were broadly optimistic over the opportunities that generative AI brings to growth and the value that these AI services provide to end customers. Below, we take a look at Big Tech’s Q1 earnings, AI commentary and capex plans for 2024, and what this means for the broader AI industry.

Q1 Earnings: AI Aids Revenue Gains

Big Tech’s reported revenue growth rates in Q1 were higher than anticipated just over two quarters ago. Meta is seeing one of the largest accelerations at 10 percentage points due to accelerating advertising revenue as ad prices recover. Microsoft is reporting one of the largest AI contributions of 7 points within Azure, which helped raise estimates by 550 bps. Across the board, however, Big Tech is accelerating which is not merely a coincidence.

Big Tech Revenue Growth Acceleration

Source: I/O Fund, Company Filings

Microsoft beat on the top and bottom line with $61.85 billion in revenue, representing a second straight quarter with revenue growth above 17% YoY. This is the first time it’s been above 17% in two years. This was driven by 21% growth in Intelligent Cloud, and in that, an acceleration to 31% growth in Azure, with 7 percentage points from AI.

Recall that in our Big Tech Stocks: Q3 Earnings Preview from October, prior to Microsoft’s September quarter report (which saw AI’s first contributions to Azure’s growth), Microsoft was expected to see 10% to 11.5% revenue growth these past two quarters – at this revenue scale, up to a 6 percentage point acceleration in three quarters marks an inflection point. For a more in-depth look at Microsoft’s recent earnings report, read the analysis: “Microsoft Fiscal Q3: 80% YoY Increase in Capex; Azure AI is Hitting Capacity”Big Tech Stocks: Q3 Earnings Preview from October, prior to Microsoft’s September quarter report (which saw AI’s first contributions to Azure’s growth), Microsoft was expected to see 10% to 11.5% revenue growth these past two quarters – at this revenue scale, up to a 6 percentage point acceleration in three quarters marks an inflection point. For a more in-depth look at Microsoft’s recent earnings report, read the analysis: “Microsoft Fiscal Q3: 80% YoY Increase in Capex; Azure AI is Hitting Capacity”

Alphabet easily beat Q1 revenue and EPS estimates as both Google Cloud (GCP) and Search revenue growth accelerated, combined with strong YouTube revenue growth. Overall revenue growth was 15.4% in Q1, the fastest in two years, and a strong acceleration from just 2.6% growth in the year ago quarter. Similar to Microsoft, increasing contributions from AI in GCP and resilient Search and YouTube ad revenues has resulted in revenue growth that is nearly 4 percentage points higher than Q1’s 11.8% growth estimate from October.

Meta reported 27.3% revenue growth and a solid EPS beat in Q1, as it captured tailwinds from 20% growth in ad impressions combined with 6% growth in ad prices. The ad impressions have cooled from 30% growth in mid 2023. Revenue gains were strongest in Rest of World and Europe at nearly 42% and 34% YoY, as Meta capitalized on double-digit growth in ad prices in those regions. While AI is aiding with improved ROI and automation for advertisers, Meta struck a nerve as it downplayed near-term revenue recognition from increased AI investments and the stock sold off nearly 11% after the earnings report.

Amazon rounded out the double beats from Big Tech as it notched a top and bottom line beat due to a 4-percentage point acceleration in AWS sales to 17% YoY and strong 24% 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.”

Microsoft, Meta, Alphabet and Amazon are reporting significant YoY improvements in operating margin, with Meta recording the largest expansion at 13 percentage points.

Source: Company Filings

We’re also seeing the four Big Tech companies report significant YoY improvements in operating margin, with Meta recording the largest expansion at 13 percentage points. Amazon’s operating margin improved 7 percentage points from an increase in AWS’ operating margin to 38%, which was up 14 percentage points. Cost management efforts combined with improvements in operating leverage, aided by AI growth and efficiency gains, can help the four Big Tech companies maintain and drive full-year operating margin expansion.

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Management Positive About AI’s Potential

Management teams from The Four offered positive commentary about AI’s potential to drive new growth. On the earnings call, it was discussed that AI can help to improve ROI for advertisers, help drive more infrastructure revenue (already seen in beats from Azure, GCP, and AWS), plus AI will help to innovate across customer-facing applications.

Let’s dig in to some of the top quotes and stats shared from each management team.

Microsoft:

Microsoft shared some of the more impressive (and arguably most important) stats around AI, with CEO Satya Nadella providing multiple strong growth rates for AI products and insights into AI demand.

He noted that Azure Arc now has “33,000 customers, up over 2X year-over-year,” while the “number of 100 million dollar-plus Azure deals increased over 80% year-over-year, while the number of 10 million dollar-plus deals more than doubled.”

GitHub Copilot now has “1.8 million paid subscribers, with growth accelerating to over 35% quarter-over-quarter” and revenue growth of 45% YoY. In terms of device penetration, “Copilot in Windows is now available on nearly 225 million Windows 10 and Windows 11 PCs, up 2X quarter-over-quarter.”

However, one of the most important pieces was that Microsoft’s current “near-term AI demand is a bit higher than our available capacity,” meaning its available GPU supply is not enough to meet demand from customers. Read more here.

Meta:

After launching its newest AI assistant powered by its Llama 3 model in mid-April, Meta CEO Mark Zuckerberg said the “initial rollout of Meta AI is going well. Tens of millions of people have already tried it.” He later added that he believes “Meta AI with Llama 3 is now the most intelligent AI assistant that you can freely use.”

Zuckerberg also noted that “about 30% of the posts on Facebook feed are delivered by our AI recommendation system. That's up 2x over the last couple of years. And for the first time ever, more than 50% of the content people see on Instagram is now AI recommended.”

In terms of how AI is aiding revenue, CFO Susan Li explained that “with our core AI work, we continue to have a very ROI-driven approach to investment, and we're still seeing strong returns as improvements to both engagement and ad performance have translated into revenue gains.”

Alphabet:

Alphabet CEO Sundar Pichai said that Google has “already served billions of queries with our generative AI features” while also “seeing an increase in Search usage among people who use the new AI overviews, as well as increased user satisfaction with the results.”

In addition, he added that “more than 60% of funded gen AI startups and nearly 90% of gen AI unicorns are Google Cloud customers,” and “more than one million developers are now using our generative AI across tools including AI Studio and Vertex AI.”

Amazon:

Amazon also shared some impressive stats about AI tool adoption as well as its revenue contribution, with CEO Andy Jassy saying that Amazon sees “considerable momentum on the AI front, where we've accumulated a multi-billion dollar revenue run rate already.” Microsoft is similarly in the multi-billion dollar range in Azure, where the 7% boost to growth is correlating to an approximate $4 billion run rate.

CFO Brian Olsavsky added that AWS has surpassed a $100 billion run rate and that’s “before you even calculate gen AI, most of which will be created over the next 10 to 20 years from scratch and on the cloud.”

Amazon’s managed end-to-end service SageMaker is aiding in LLM training, AI inference, and productivity improvements, with management stating that “Perplexity AI trains models 40% faster in SageMaker [and] Workday reduces inference latency by 80% with SageMaker.”

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Capex Surging More Than 35% YoY In 2024

Big Tech will likely commit upwards of $200 billion, maybe even $210 billion, combined in capex this year, predominantly for AI infrastructure – from data center construction and expansion, to GPU procurement and custom silicon efforts and more.

It’s no wonder the four are boosting capex by more than 35% YoY, given positive outlooks on AI’s potential to drive revenue growth in the billions and how demand continues to outstrip GPU supply. Overall, capex commentary from the four was directionally bullish for AI semiconductors and server manufacturers, though Meta’s vagueness on a timeline to recognize a return on said spend hit shares quite hard.

Microsoft:

Microsoft increased its capex 80% YoY to $14 billion this quarter, and for the entire fiscal year, capex will increase approximately 50% YoY to more than $50 billion. Demand for Azure’s AI services is outpacing its capacity in the near-term, hence the need for Microsoft to accelerate spending to boost GPU supply. It has been reported that Microsoft is seeking to triple its GPU supply this year to 1.8 million GPUs.

Alphabet:

Alphabet’s capex rose 91% YoY to $12 billion in Q1, primarily for technical infrastructure – this capex spend was led by servers and followed by data centers. Management is expecting quarterly capex “to be roughly at or above the Q1 level,” implying a full-year capex around $50 billion, an increase of ~55% YoY. Management said this significant growth in capex “reflects our confidence in the opportunities offered by AI across our business.”

CFO Ruth Porat explained that “as we’re investing in CapEx and applying it across our various businesses, it opens up more service and products, which bring revenue opportunities, and we’re very focused on the monetization opportunity,” which spans Search, Cloud, YouTube, and other services. CEO Sundar Pichai emphasized that Alphabet has “clear paths to AI monetization through Ads and Cloud, as well as subscriptions.”

Meta:

Meta boosted its full year capex range to $35-40 billion, pointing to 33% YoY growth and $4 billion more than previously anticipated, to build out AI infrastructure and support its internal AI roadmap. Meta’s Q1 capex was only $6.7 billion, implying that the bulk of this spend will hit in the second half of the year, possibly accelerating at a ~20% QoQ rate and exiting 2024 above the $11 billion range. However, despite these aggressive investments in AI, Meta was rather vague on its returns, saying it is very early on the return curve:

As we're scaling capex and energy expenses for AI, we'll continue focusing on operating the rest of our company efficiently. But realistically, even with shifting many of our existing resources to focus on AI, we'll still grow our investment envelope meaningfully before we make much revenue from some of these new products.

Once our new AI services reach scale, we have a strong track record of monetizing them effectively. There are several ways to build a massive business here, including scaling business messaging, introducing ads or paid content into AI interactions, and enabling people to pay to use bigger AI models and access more compute.”

Despite the hints of positivity in creating and monetizing new services, the commentary highlights a rather important angle that the market does not like – an unclear timeline to when a return on increased investments will be recognized. This is quite the polar opposite from Microsoft and Amazon, who have multi-billion dollar AI revenue streams that will immediately benefit from increased expenditures on capacity expansion. The difference is that AWS and Azure are more enterprise or startup related whereas Meta is more consumer related. It’s been our contention that AI is an enterprise technology first and foremost when we held a webinar in 2022 when it was stated about AI that: “enterprises are going to drive forward the gains over the next 10 years, it will not be consumer.”

Amazon:

Amazon did not provide a full-year figure for capex, but management said they anticipate capex will “meaningfully increase year-over-year in 2024, primarily driven by higher infrastructure CapEx to support growth in AWS, including generative AI.” In addition, they expected the $14 billion capex sum for Q1 will “be the low quarter for the year,” suggesting capex could easily top $60 billion, exiting the year in the mid-$60 billion range or higher, an increase of at least 24% YoY.

CEO Andy Jassy explained this capex growth is driven by “the combination of AWS' reaccelerating growth and high demand for gen AI, … which given the way the AWS business model works 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.”

Implications For the Broader AI Industry

This increased spending by Big Tech ultimately is flowing to multiple core components for infrastructure expansion and increased GPU capacity. Management teams are talking about more GPU purchases, more custom silicon buildout, data center expansion, and the need for more hardware (networking and switches). For example, since the start of this year, consensus revenue estimates for Nvidia have already risen from $91 billion at the beginning of January to $112 billion at the beginning of May – an increase of $21 billion. This goes hand in hand with its new GPU releases and increased Big Tech spending.

However, AI opportunities extend well past Nvidia. We’ve been closely monitoring Big Tech for years while identifying the top beneficiaries from this blistering AI-driven increase in capex. We routinely share our research with our premium members including how this impacts AI semiconductors such as GPUs and custom silicon, memory players, and AI networking.

If you own AI stocks, or are looking to own AI stocks, we encourage you to attend our weekly premium webinars, held every Thursday at 4:30 pm EST. Next week, we will discuss a handful of AI plays for 2024 – what our targets are, where we plan to buy as well as take gains. Learn more about I/O Fund’s premium services here.

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

Recommended Reading:

Alphabet Q1 2024: Impeccable Earnings Report, GCP Accelerates from AI

Posted on by io-fund

Alphabet’s revenue accelerated for the sixth consecutive quarter. Revenue grew by 15% and clocked the fastest growth since Q1 2022. Google Cloud revenue accelerated for the second consecutive quarter. The company also announced its first dividend and authorized a new $70 billion share repurchase plan. The margin improvement due to the cost reduction initiatives was the icing on the cake. The shares closed 10% higher following strong results and reached the $2 trillion market capitalization milestone.

Revenue

Revenue grew by 15% and 16% in constant currency YoY to $80.54 billion and beat estimates by 2.3%. Revenue accelerated for the sixth consecutive quarter. Analysts expect revenue to grow 12.5% YoY to $83.90 billion in the June quarter. While growth is decelerating, the consensus estimates have moved up 100 basis points compared to the estimates prior to the earnings.

Google Services segment revenue grew by 14% YoY to $70.4 billion. Search and other advertising revenues accelerated  to 14% YoY growth to $46.2 billion from 13% in the December quarter and 11% in the September quarter, which was primarily due to strong growth in retail, particularly from APAC-based retailers. The strong trend in the advertising business from APAC-based retailers began in Q2 2023 last year and continued in the recent quarter.

Management also highlighted tougher comps in the upcoming quarter and headwinds from the strong dollar. “As we look ahead, two points that will affect sequential year-on-year revenue growth comparisons across Alphabet. First, Q1 results reflect the benefit of leap year, which contributed slightly more than one point to our revenue growth rate at the consolidated level in the first quarter. Second, at current spot rates, we expect a larger headwind from foreign exchange in Q2 versus Q1.”

Margins

The company’s cost control initiatives, such as workforce reductions and office space optimizations, have helped the company report very strong margins in the recent quarter. Going forward, management expects operating margin for 2024 to be higher than in 2023. This is from moderating expense growth for higher depreciation and expenses related to higher technical infrastructure investments.

  • Gross margin expanded 200 basis points YoY and 160 basis points QoQ to 58.1%.
  • Operating margin expanded 660 basis points YoY and 410 basis points sequentially to 31.6%. Non-GAAP operating margin, which excludes severance and related office space charges, came in at 32.5% compared to 28.6% in the same period last year.
  • The operating margin was the second highest in the previous 10 years, and if we exclude the non-recurring charges in the recent quarter, it is the highest in the last decade.

Ruth Porat, CFO of the company said in the earnings call:

“Turning to margins, our efforts to durably re-engineer our cost base are reflected in a 400 basis point expansion of our Alphabet operating margin year-on-year, excluding the impact of restructuring and severance charges in both periods. You can also see the impact in the quarter-on-quarter decline in headcount in Q1, which reflects both actions we have taken over the past few months and a much slower pace of hiring. As we have discussed previously, we are continuing to invest in top engineering and technical talent, particularly in Cloud, Google DeepMind, and technical infrastructure. Looking ahead, we remain focused on our efforts to moderate the pace of expense growth in order to create capacity for the increases in depreciation and expenses associated with the higher levels of investment in our technical infrastructure. We believe these efforts will enable us to deliver full-year 2024 Alphabet operating margin expansion relative to 2023.”

–End Quote

Net margin improved 780 basis points YoY and 540 basis points sequentially to 29.4%. GAAP EPS came in at $1.89, up 61.5% YoY and beat estimates by 25%. It partly benefitted from a net gain on equity securities of $2.2 billion, and the $104 million reversal of previously accrued performance fees related to some of these investments, which increased net income by $1.9 billion and EPS by $0.15.

Analysts expect the company to report GAAP EPS of $1.83 in the next quarter, up from expectations of $1.69 prior to the earnings report.

Cash Flows and Balance Sheet

Operating cash flow was $28.85 billion or 35.8% of revenue compared to $23.51 billion or 33.7% in the same period last year. Free cash flow was $16.84 billion or 20.9% of revenue compared to $17.22 billion or 24.7% in the same period last year. Free cash flow was lower than the previous year as capex increased 91% YoY to $12 billion due to AI.

The CFO said in the earnings call, “With respect to CapEx, our reported CapEx in the first quarter was $12 billion, once again driven overwhelmingly by investment in our technical infrastructure with the largest component for servers followed by data centers. The significant year-on-year growth in CapEx in recent quarters reflects our confidence in the opportunities offered by AI across our business. Looking ahead, we expect quarterly CapEx throughout the year to be roughly at or above the Q1 level, keeping in mind that the timing of cash payments can cause variability in quarterly reported CapEx.”

This means that capex is expected to rise about 49% YoY to $48 billion in 2024.

Cash and marketable securities were $108.09 billion compared to $110.92 billion in the December quarter. Debt was also largely unchanged at $13.23 billion compared to $13.25 billion in the December quarter.

Another key highlight in the report was the announcement of the first quarterly dividend of $0.20 and the authorization of an additional $70 billion share repurchase plan. The company repurchased shares worth $15.7 billion in the recent quarter.

Key Metrics:

Google Cloud Revenue

Google Cloud revenue grew by 28% YoY to $9.6 billion, helped by increasing contributions from AI and strong Workspace growth, which is productivity apps. The revenue growth accelerated for the second consecutive quarter from 26% in the previous quarter and 22% in the September quarter. The strong growth also further helped to narrow the gap with Microsoft Azure’s growth of 31%. Google Cloud now only trails Microsoft Azure by 3 percentage points compared to 4 points and 7 points in the previous two quarters.

The operating margin for Google Cloud came in at 9% compared to 3% in the same period last year and 9% in the December quarter.

Google Advertising Revenue

Google Advertising revenue accelerated for the fifth consecutive quarter. Revenue grew by 13% YoY to $61.7 billion, compared to 11% growth in the December quarter, and was flat in the same period last year.

  • Google Search and other advertising revenues grew by 14% YoY to $46.2 billion. It was up from 13% growth in the previous quarter and 2% in the same period last year.
  • YouTube ads revenue grew by 21% YoY to $8.09 billion, helped primarily by direct response marketing and brand advertising. It was up from 16% growth in the previous quarter and a decline of (-3%) in the same period last year.
  • Networking advertising revenue declined by (-1%) YoY to $7.41 billion. It was better than the (-2%) decline in the previous quarter and (-8%) decline in the same period last year.

Earnings Call:

Capex

Big Tech capex has surged over the past few quarters and Google is no exception.

Capex grew 91% YoY to $12 billion; this is up from 45% growth and $11 billion last quarter. As stated, this means that capex is expected to rise about 49% YoY to $48 billion in 2024.

The CFO stated less than 10% was going to office with the rest going toward infrastructure (or AI basically).

Per the earnings call:

Ruth Porat:

“And then in terms of CapEx, as I said in opening comments, we do expect the quarterly CapEx throughout the year to be roughly at or above the $12 billion cash CapEx we had here in Q1. As I said, you can always have variability in the reported quarterly CapEx just due to the timing of cash payments, but roughly at or above this level. And it really goes to Sundar's comment, opening comment, that we're very committed to making the investments required to keep us at the leading edge in technical infrastructure to support the growth in Cloud, all the innovation and search that he and Philip have spoken about and our lead with Gemini. I will note that most nearly all, I should say, of the CapEx was in our technical infrastructure. We expect that our investment in office facilities will be about less than 10% of the total CapEx in 2024, roughly flat with our CapEx in 2023, but is still there […]

Clear Path to Monetization

In the call, the CEO highlighted six points as to why the company is positioned to tap the AI opportunity.

  1. Leadership position in R&D
  2. Infrastructure leadership including Google Cloud
  3. The company invests in developing new AI models; custom TPUs power AI projects which are in the 5th generation and this powers Search
  4. Global product footprint
  5. Velocity in execution (my note: this one can lag at times)
  6. Monetization paths

Of these, the last one on monetization paths interests us the most.

Regarding #4, the global product footprint combined with infrastructure leadership (#2) will help with data sovereignty in the medium-term as AI will become required to have data residency in the country the data is produced. This isn’t unique necessarily as all hyperscalers offer this, but it’s notable and supports our thesis that Big Tech will get Bigger.

The clear path to monetization that Google speaks about is through Google Cloud, which accelerated this quarter and is closing the gap with juggernaut Azure. Secondly, it’s through Search revenue and ad revenue on YouTube and its advertising network. As stated above, Google Cloud accelerated to 28% growth, up from 26% growth in the previous quarter. Search also accelerated to 14% growth this quarter for revenue of $46.2 billion, compared to growth of 13% and revenue of $48 billion last quarter (seasonal high due to being Q4). These are record quarters for Search revenue.

Per the opening remarks – note, SGE refers to Google Search Generative Experience (SGE) which uses gen AI to provide brief overviews of web pages.

“We have clear paths to AI monetization through ads and cloud, as well as subscriptions. Philip will talk more about new AI features that are helping advertisers, including bringing Gemini models into Performance Max. Our Cloud business continues to grow as we bring the best of Google AI to enterprise customers and organizations around the world. And Google One now has crossed 100 million paid subscribers. And in Q1, we introduced a new AI premium plan with Gemini Advanced […]

“You can see that from the increases in our capital expenditures. This will fuel growth in cloud, help us push the frontiers of AI models, and enable innovation across our services, especially in Search. AI innovations and Search are the third and perhaps the most important point I want to make. We have been through technology shifts before, to the web, to mobile, and even to voice technology. Each shift expanded what people can do with Search and led to new growth. We are seeing a similar shift happening now with generative AI. For nearly a year, we have been experimenting with SGE and Search labs across a wide range of queries. And now we are starting to bring AI overviews to the main Search results page. We are being measured in how we do this, focusing on areas where gen AI can improve the Search experience, while also prioritizing traffic to websites and merchants.

We have already served billions of queries with our generative AI features. It's enabling people to access new information, to ask questions in new ways, and to ask more complex questions. Most notably, based on our testing, we are encouraged that we are seeing an increase in Search usage among people who use the new AI overviews as well as increased user satisfaction with the results.”

–End Quote

Later, the CFO added: “We're continuing to experiment with new ad formats, including search and shopping ads alongside search results in SGE. And we shared in March how folks are finding ads either above or below the SGE results helpful. We're excited to have a solid baseline to keep innovating on and confident in the role SGE, including ads, will play in delighting users and expanding opportunities to meet user needs.”

Toward the end of the call, an analyst asked the CEO to quantify the monetization. He did not provide specifics, rather stated: “There are questions about monetization, and based on our testing so far, I am comfortable and confident that we'll be able to manage the monetization transition here well as well.”

My note: there is a lot of corporate-speak on these calls to wade through. However, to keep it brief and direct, areas where Google can continue to monetize Search is on mobile with rumours that Apple may partner with Google’s Gemini to power AI apps on iPhones in the future. Android also currently has 3 billion users that Gemini can reach.

60% of Funded Gen AI Startups use Google Cloud

Google Cloud has the majority of funded AI startups building on Google Cloud. Although this is too small to make a revenue impact, the message is that Google Cloud is at the cutting edge for AI workloads training on Nvidia’s GPUs and its own TPUs. Google also recently announced Axion CPUs.

 “Today, more than 60% of funded Gen AI startups and nearly 90% of Gen AI unicorns are Google Cloud customers […] We also announced Axion, our new Google design and ARM-based CPU. In benchmark testing, it has performed up to 50% better than compatible x86-based systems. On top of our infrastructure, we offer more than 130 models, including our own models, open source models, and third-party models. We made Gemini 1.5 Pro available to customers, as well as Imagine 2.0 at Cloud Next.”

It was also stated that over 1 million developers use Google’s generative AI tools.

Google Third-Party Cookie Deprecation

Google has delayed the third-party cookie deprecation on its browser for the third time with plans to now phase them out in 2025. As of now, it has restricted third-party cookies to only 1% of Chrome users. The delay is due to concerns from the regulatory authorities, particularly the UK’s Competition and Markets Authority (CMA) and the ad industry. The recent release said, “It's also critical that the CMA has sufficient time to review all evidence including results from industry tests, which the CMA has asked market participants to provide by the end of June.”

Regulators like the UK’s Competition and Markets Authority (CMA) have previously raised concerns that Google’s plan to replace third-party cookies with its Privacy Sandbox initiative will give Google an unfair advantage in the ad market. According to eMarketer and 33Across, cookies were used in 78% or more of programmatic ad buys. Google’s Privacy Sandbox replaces cookies with 20 different APIs for “Measurement and Relevance” and also “Other APIs” to help advertisers target users based on topics and cohorts without tracking individual behavior. For users and advertisers, this is an improvement from cookies. For competitors like The Trade Desk, this poses a threat as Google own major properties across the web, and theoretically, eliminating cookies can limit the effectiveness of a platform like The Trade Desk. This is because cookies leak a lot of data to third parties like The Trade Desk, whereas what Google seeks to do is stop those leaks to outside parties on their own properties (Chrome for now, Android soon after). 

Despite Google being the target for alleged monopolistic control over Search and its ad network, Apple and Mozilla have already phased out identifiers on their browsers, and Apple has also done this on iOS. We covered this extensively, including here. According to Google, Privacy Sandbox will use the same Android API solutions, and no one (including Google) will have a privileged position (given the recent allegations in the DOJ lawsuit, I’d take that with a grain of salt).

Ad-tech companies like The Trade Desk have been critical of Google’s Privacy Sandbox. We previously discussed this here. The Trade Desk is a solid resource on discussing the downside to deprecating cookies, as they are one of Google’s fiercest opponents in that regard. The Trade Desk has famously created an alternative for a consortium of first parties and third parties called Unified Ad ID or UID2.0. There is a long and impressive list of collaborators that have adopted UID2.0.

So, who better to turn to than Jeff Green for the most recent, unfiltered commentary from one of Google’s opponents. Here is what was stated on the most recent earnings call:

Brian Fitzgerald (Analyst)

Thanks. Jeff, it looks like third-party cookies won't be going away now for at least until '25. What are your thoughts on the cookie deprecation delay once again and how, if at all, it impacts the industry? And then, maybe secondarily, could you — could the continued delays have any impacts, positive or negative on UID2.0 adoption?

Jeff Green (CEO, The Trade Desk)

[…] I think it is a strategic mistake for Google to deprecate cookies. I don't think the risk/reward is worth it for them. And I would not be surprised to see them delay this again and again as they continue to buy more time. I think that's exactly what we saw because we weren't surprised by this, we predicted this. We have just been sort of quick to move on. I do want to give Google a little bit of credit though. I mean, Apple took away cookies and said nothing, gave no announcement, offered no alternatives. Google said we're going to take away cookies, they gave some head start. Now, they moved the date a bunch, both forward and backward, which to me didn't make any sense. But they did at least try to propose something else, which was a privacy sandbox. The unfortunate thing was what they proposed was half-fake and not a valid solution. And so, the industry has just been criticizing it, us included, for the better part of the year because those criticisms, I think, were pretty unanimous even from industry bodies like the IAB that I never expected to take such a strong position on privacy sandbox. I think it forced Google's hand to delay cookie deprecation. So we were not surprised by it. The net effect of that is that it gives the open Internet a bit more runway to adopt things like UID2 and come up with authentication and identity strategies so that they can thrive in an environment outside of cookies.  […]

And so, I think the average publisher is saying exactly what we were saying four or five years ago that while we think it's a strategic mistake for Google to get rid of cookies, we also think it's a strategic mistake for all the rest of us to do nothing.”

–End Quote

Google’s Antitrust Lawsuit to be Decided in Q3

We’ve covered the antitrust lawsuit in the past here when we stated: “Therein lies the issue. Google undisputedly has the world’s best consumer data, but did this grow to become part and parcel with operating a monopoly? The Department of Justice has asserted anti-trust violations against Google with the trial beginning in September 2023 […]  This is not a headline to simply dismiss. It’s the first time the DOJ has brought a case of this kind against a technology company since Microsoft. If there are even minor cracks in Google’s monopoly, there could stand to be a stock or two that starts a new trajectory.”

Of course, the stock that starts the new trajectory could be Google if the DOJ rules in their favour. The trial is now concluded, and in his closing arguments, U.S. District Judge Amit Mehta questioned whether another company could rival Google’s search due to the cash and data that the company possesses, especially with Google’s 90% market share as a search engine in the crosshairs. The company pays $20 billion to make its search engine the default across Apple and Mozilla browsers and devices. Google argues they are widely used because of large R&D investments, which has made their technology superior. In cases where other search engines were the default, users complained or manually switched on their own.

The decision is expected to be announced in late summer or early fall.

Conclusion

Alphabet delivered a perfect earnings report. It beat the top line and bottom line; plus important key metrics are accelerating. Google Cloud revenue accelerated for the second consecutive quarter, narrowing the gap with Microsoft Azure. The dividend announcement was welcomed to help Google meet pressures from the Street.  

Meanwhile, Alphabet has a tough year ahead with pushback from the deprecation of cookies in the early part of 2025 (assuming there are no further delays), and the looming decision from the DOJ on the antitrust trial. We continue to believe this is a landmark case for a tech company, and requires a bit of a gamble on how it will turn out for Google.

We’ve covered Alphabet extensively on AI, as well. You can find previous analysis here:

Broadcom: $10B in AI Revenue This Year Plus Software is Rapidly Accelerating

Posted on by io-fund

Broadcom has greatly outperformed the FAANGs over the past decade yet is rarely discussed as one of the market’s top-performing stocks. The ticker certainly does not participate in a catchy acronym. Half the battle with Broadcom is there are many revenue segments to analyze, some go through harsh cyclical downturns, and it acquires companies hand over fist. To put it plainly, this is not an easy stock to cover; there are no pithy ways to summarize the products and it doesn’t offer growth stock qualities.

We have revamped the Essentials Portfolio by including Broadcom. Stay tuned for trade alerts sent directly to your inbox, keeping you up-to-date with any adjustments to three key holdings.

Broadcom has many departments that have been strung together through acquisitions with a vision of consolidating Ethernet, ASICs and now virtualization under one company. The reason this company is sitting in plain sight is because it was a major winner from the mobile era, is partnered with Big Tech as we move in the AI era, and is putting together the pieces to participate in AI strategically by not needing to compete on GPUs.

Broadcom Financials

Broadcom is firing on all cylinders and the Q1 earnings report cemented the company as number two in terms of AI revenue. It’s not only the AI revenue that sets Broadcom apart, but also its developing software strategy with VMWare.

The headline numbers don’t help to translate underlying AI strength as Broadcom reiterated its full year guidance yet raised AI revenue. This is because some of Broadcom’s segments are coming in lower than expected, while AI is coming in higher than previously guided.

This comment kicked off the tone of the call: “I know we told you in December, our revenue from AI would be 25% of our full year semiconductor revenue. We now expect revenue from AI to be much stronger, representing some 35% of semiconductor revenue at over $10 billion.” This is up from $7.5 billion expected this year, and also up from a $6 billion run rate last quarter ($1.5B per quarter). The AI revenue is roughly 70% ASICs and 30% AI Networking.

In addition to stronger-than-expected AI revenue, Broadcom is expecting dramatic, sequential growth in software bookings, which are expected to grow about 70% QoQ. We need another quarter or two to verify if the rapid growth from VMWare Cloud Foundation will continue, but management implies it will continue to be strong. If so, Broadcom is quickly asserting itself as a leader in AI software as consolidated bookings are expected to add $1.2 billion QoQ from $1.8 billion this quarter to $3 billion next quarter. 

Revenue and EPS:

  • Q1 revenue was $11.96 billion, beating estimates by $240 million, and representing YoY growth of 34%. Excluding VMWare, revenue growth was 11% for a 7 percentage point acceleration over the past two quarters, at 4% in the October quarter and 4.9% growth in the July quarter.
  • Q1 adjusted EPS was $10.99, beating estimates by $0.57. GAAP EPS was $2.84, compared to $8.80 in the year ago quarter.
  • Broadcom reiterated its fiscal year revenue guide of $50 billion and full year EBITDA guidance of 60%. This compares to an EBITDA margin of 63% to 65% in previous quarters.

 Margins:

  • Q1 GAAP gross margin was 61.7%, compared to 67.4% in the year ago quarter. Amortization of acquisition-related intangible assets adversely impacted gross margin by ~1150bp in the quarter. Adjusted gross margin was 75.4%, compared to 73.8% in the year ago quarter.
  • Q1 GAAP operating margin was 17.4%, compared to 46% in the year ago quarter. The operating margin was mainly lower due to the increase of amortization of acquisition-related intangible assets, restructuring charges, and stock-based compensation. Adjusted operating margin was 57.1%, compared to 60.9% in the year ago quarter.
  • Q1 GAAP net margin was 11.1%, compared to 42.3% in the year ago quarter. The net margin was mainly lower due to the increase of amortization of acquisition-related intangible assets, restructuring charges, and stock-based compensation. Adjusted net margin was 43.9%, compared to 50.3% in the year ago quarter.

Cash Flows and Balance Sheet:

  • Q1 operating cash flow was $4.82 billion, representing a 40.3% margin.
  • Q1 free cash flow was $4.69 billion, representing a 39.2% margin. Excluding restructuring and integration spend of $658 million, free cash flow was 45% of revenue.
  • Cash, equivalents and short-term investments totaled $11.9 billion.
  • Debt totaled $75.9 billion. The debt increased from the $39.2 billion in the previous quarter due to the additional debt taken to finance the VMware purchase and the company also assumed $8.3 billion VMware’s debt. The average coupon-rate and years to maturity of fixed rate debt of $48 billion is 3.5% and 8.4 years, respectively. The average coupon-rate and years to maturity of floating rate debt of $30 billion is 6.6% and 3 years, respectively. In early March, the company repaid $2 billion of floating rate debt and intends to maintain this quarterly repayment throughout FY2024.

In Q1, Broadcom paid stockholders $2.4 billion of cash dividends based on a quarterly common dividend of $5.25 per share. The company repurchased $7.2 billion of common stock and eliminated $1.1 billion of common stock for taxes due on vesting of employee equity, resulting in the repurchase and elimination of approximately 7.7 million AVGO shares. The Q2 non-GAAP diluted share count is expected to increase to approximately 492 million as the shares issued including VMWare.

Days sales outstanding were 41 days in the first quarter compared to 31 days in the fourth quarter on higher accounts receivable due to the VMware acquisition. This is due to the accounts receivable from VMware having payment terms of 60 days compared to Broadcom’s 30 days.

The company ended the first quarter with inventory of $1.9 billion, up 1% sequentially.

Key Segments:

Software Revenue:

Management reiterated their software revenue guidance of $20 billion this year.

  • Q1 Software segment revenue of $4.6 billion was up 156% year-on-year and included $2.1 billion in revenue contribution from VMware. In the previous quarter, software was $1.97 billion. This implies 27% QoQ growth in software after stripping out VMWare. When asked about this, management said to not get too excited about this particular growth as it’s due to strong contract renewals. Instead, the CEO explicitly stated: “Yes, don't get too excited over that. So that has also accelerated, but that's not the star of this show, Stacy. Star this show is the accelerating bookings and backlog we are accumulating on VMware.” In fact, it was indicated that some of this could fall off in future quarters given the software guide was not raised.  
  • What the CEO is referring to as the star of the show is the consolidated bookings in software, which grew sequentially from less than $600 million to $1.8 billion in Q1 and is expected to grow to over $3 billion in Q2. Per management: “Revenue from VMware will grow double-digit percentage. Sequentially, quarter-over-quarter, through the rest of the fiscal year.”

Management stated the rapid growth from the VMWare segment is because: “We are focused on upselling customers, particularly those who are already running their compute workloads with vSphere virtualization tools to upgrade to VMware Cloud Foundation, otherwise branded as VCF […] VMware and NVIDIA entered into a partnership called VMware Private AI Foundation, which enables VCF to run GPUs. This allows customers to deploy their AI models on-prem. And wherever they do business without having to compromise on privacy and data — in control of their data. And we are seeing this capability drive strong demand for VCF, from enterprises seeking to run their growing AI workloads on-prem.”

Semiconductor Revenue:

Semiconductor solution sales increased 4% YoY to $7.39 billion, a slight uptick from 3.3% growth in the prior quarter. Stronger-than-expected growth from AI more than offsetting the cyclical weakness in broadband and server storage. According to Bloomberg, this was a bit shy of expectations for $7.7 billion in revenue. This was most likely due to weak wireless, broadband, and server storage segments.

  • Q1 networking revenue of $3.3 billion grew 46% year-on-year, representing 45% of semiconductor revenue. Management stated the following: “For fiscal 2024, given continued strength of AI NAND working demand, we now expect networking revenue to grow over 35% year-on-year compared to our prior guidance for 30% annual growth.”
  • Q1 wireless revenue of $2 billion decreased 1% sequentially and declined 4% year-on-year representing 27% of semiconductor revenue. Wireless is expected to be flat YoY for FY2024.
  • Q1 server storage connectivity revenue was $887 million or 12% of semiconductor revenue, down 29% year-on-year. The company revised its server storage revenue to decline in the mid-20 percentage range compared to prior guidance for a decline in the high teens.
  • Broadband Q1 revenue declined 23% year-on-year to $940 million and represented 13% of semiconductor revenue. Broadcom revised its outlook for fiscal '24 broadband revenue to be down 30% year-on-year from prior guidance of down mid-teens year-on-year.
  • Q1 industrial resales of $215 million declined 6% year-on-year. Management stated that industrial resales will be down high single digits this year.

Broadcom’s Switch Products and Switch Fabric

Broadcom has a dominant market share of switching and routing semiconductors for hyperscalers and is seeking to maintain its market share, most especially as AI changes networking requirements. The Jericho3-AI launch was last April, which is a redesign intended to compete with Nvidia’s InfiniBand.

Broadcom has three switch products. The Tomahawk is the high-bandwidth switch platform, Trident is the platform with more features, and the new Jericho line combines the Jericho switch with routing ASICs. The Jerico3 was redesigned with deep packet buffers. Tomahawk and Trident are used in data centers yet are not optimized for AI workloads, especially when compared to InfiniBand.

Jericho has 160 switch ports dedicated to switch fabric, which allows multiple ASICs to be stitched together to support GPU clusters. The asymmetric split helps the chip overcome network congestion and network failures. According to Broadcom, Jericho3-AI performed 10% better than “alternative network solutions” — which is a clear reference to InfiniBand.

A few specs before we go deeper into how Broadcom’s solutions compare to Nvidia’s. As you’ll note, the specs for InfiniBand are superior with support for 64X 400Gbp or 128 200 GB/s ports compared to Jericho’s 36X 400 GbE and 72X 200GbE network-facing ports.

  • Jericho has 144X SerDes lanes and 106Gpbs PAM4 supporting 18X 800Gbe, 36X 400 GbE and 72X 200GbE network-facing ports. The Jericho3-AI allows for more than 32,000 GPUs to be linked for a massive AI training system and links directly to GPUs without the need for a server bus.
  • Tomahawk5 runs at 100 GB/second with PAM4 with aggregate bandwidth of 51.2 Tb/s
  • Compare this to Nvidia’s Quantum-2 InfiniBand which has support for 64X 400Gbp or 128 200 GB/s ports with 51.2 Tb/s and 66.5 billion packets per second.
  • Nvidia’s new Spectrum X Platform is an Ethernet solution that delivers 1.6X better networking performance than traditional Ethernet with 256X 200 Gbe ports or 16,000 ports for larger training systems.

On a similar note, and while we are on the topic, Marvell has some skin in the game too by offering a 51.2T switch called Teralynx 10 that offers ultra-low-latency at 80% cost savings. According to Moor Insight Strategy, Marvell is the supplier for AWS for “electro-optics, networking, security, storage, and custom-designed solutions.”

Marvell’s Nova 1.6 Tbps PAM4 electro-optics have eight 200G lanes that “double the networking bandwidth while reducing power and cost per bit by 30%.” According to the press release, “by doubling the bandwidth per lambda, the Nova-based modules reduce the number of lasers and related optical components by 50%.”

Marvell hopes to help data centers transition to 51.2 Tbps networking architectures by offering a platform that needs 32 optical modules instead of 64 optical modules.

AI Networking

A few years back, we discussed that Nvidia acquired Mellanox for the strategic synergy that InfiniBand and Ethernet can provide in boosting GPU performance. Without proper interconnection, GPU performance could be limited, and so Nvidia strategically wanted to create the best-case scenario of owning both markets for AI accelerators — and their fabric and interconnects. 

Mellanox supports Virtual Protocol Interconnect (VPI), which allows the ubiquitous Ethernet to provide bandwidth as cheap as possible, and InfiniBand to deliver higher throughput and fewer bottlenecks during high loads. In 2019, the split in Mellanox’s revenue was about 40% InfiniBand and 60% Ethernet. By leveraging a hybrid of Ethernet and InfiniBand, Mellanox was able to take market share from Ethernet incumbents.

The acquisition went under review in China, with officials believing Mellanox’s market share at the time was about 55% to 60% of the global interconnect market and 80% to 85% of the Chinese market. This illustrates how popular Mellanox was before Nvidia acquired the company.

The outcome of the review was that Nvidia was required to decouple the sale of InfiniBand from the sale of its GPUs to where a customer could buy one but not the other at no penalty. Even if a customer can buy them separately, there are many cases where it’s not practical to do so, such as with the DGX and HGX systems which achieve optimal performance with the A100s/H100s and InfiniBand.

Nvidia has stated that InfiniBand increase the effectiveness of AI infrastructure by 20% to 30%. Remote Direct Memory Access (RDMA) reduces CPU overhead by offloading data movement to network adaptors. In addition, Ethernet has quality of service (QoS) flow control and advanced error handling mechanisms that increase its network efficiency capabilities.

Ethernet Vs InfiniBand

I wish I could make networking more conversational, but it’s pretty challenging to do that! Here are some bullet points on how the two compare; I’ve bolded the more important takeaways:

Benefits of Ethernet:

  • Raw bandwidth is a benefit with Ethernet hitting 51.2 Tb/s two years ago with support for 800 Gb/s port speeds. InfiniBand lags by topping out at 51.2 TB/s with 400 Gb/s port speeds. Although typical server nodes do no need the extra bandwidth, AI clusters come with 400 Gb/s NIC per GPU with some nodes having four to eight GPUs. By 2025, Dell’Oro believes switch ports for AI networks will be operating at 800 Gb/s and will further double to 1600 GB/s by 2027.Dell’Oro believes switch ports for AI networks will be operating at 800 Gb/s and will further double to 1600 GB/s by 2027.
  • smartNICs and AI-optimized switch ASICs help to reduce packet loss
  • Large pool of vendors whereas InfiniBand increases dependency on Nvidia. For this reason, AWS and Google Cloud have remained on Ethernet as they prioritize custom silicon.
  • Ethernet is the incumbent networking standard and most cloud providers have invested heavily here already. With Ethernet, providers don’t have to manage a new network stack.
  • Ethernet switching has evolved to where a new term has been coined “lossless” Ethernet. Even Nvidia is moving in this direction with their Spectrum X platform.

Benefits of InfiniBand:

  • Outperforms for AI/ML workloads due to low latency and by reducing packet loss. Data packets are sent in a serial approach so multiple channels of data can be sent simultaneously. This is much better for AI/ML than a parallel approach for internal data flow, which creates bottlenecks.
  • Has 3X to 4X lower latency than traditional Ethernet switches based on ASICs
  • Highly scalable, can support tens of thousands of nodes per subnet. InfiniBand is also cheaper as it requires fewer connections for reliability.
  • Its QoS and failover capabilities are a reason it’s adopted for high-performance computing environments.
  • Reduces CPU resources

So, why is Ethernet Making a Comeback?

Broadcom’s Jericho3-AI has some promising benchmarks that could help shift the dominant market share InfiniBand has in AI networking (or at least prevent a monopoly). These benchmarks showed the Jericho3-AI outperforming InfiniBand by 10%, which is substantial when dealing with AI systems as it’s enough to increase the collective operations of the system.

“Leveraging this unique functionality, the Jericho3-AI fabric provides at least 10 percent shorter job completion times versus alternative networking solutions for key AI benchmarks such as All-to-All. This performance improvement has a multiplicative effect on decreasing the cost of running AI workloads since it implies that expensive AI accelerators are used 10 percent more efficiently. The network, in effect, pays for itself.” — You can read the press release here.

This means bare metal can work more effectively. Per Broadcom: “because it can handle 800Gbps port speed (for PCIe Gen6 servers) and more, it is a better choice [than InfiniBand.” At high price points, all hyperscalers want to see their investments working at maximum clock times. This is achieved by better load balancing and congestion control to improve network latency, whereas InfiniBand reduces port and hop latency inside the switch. Broadcom calls their product differentiation “Perfect Load Balancing” and “Congestion-Free Operation.”

A note on PCIe

The maximum bandwidth supported by PCIe 5.0 is 400Gbps per port. By using 106Gbps PAM4 SerDes, ASICs can be tuned to support 100, 200 and 400 Gbps port speeds. To work around this, and to achieve 800Gbps, chip makers are building NICs directly into the accelerator.

Jericho3-AI supports 36 ports at 400 Gbps speed, and this can support Nvidia’s powerful DGX H100, which have 8 ports of 400 Gbps speed. In this case, four node racks are within Jericho’s capabilities. However, the Quantum-2 InfiniBand can handle 64 ports of 400Gbps, and so for Nvidia’s GPUs, it outperforms. Broadcom’s answer to this is that AWS and Google still prefer to not have vendor lock-in with Nvidia and use the Jericho3-AI to make use of their extensive Ethernet systems.

Overview of Custom Silicon (ASICs):

In addition to AI networking, Broadcom participates in the custom silicon market. ASICs are application-specific integrated circuits that are customized to perform a specific function for a specific application, hence the term “application-specific.” This is in contrast to GPUs which are more general-purpose. ASICs are expensive at the onset, yet become cheaper with volume production. We first published this graph in 2019 but the comparison still applies:

For now, custom silicon only makes sense for a company with deep coffers that has immensely popular applications – such as Google, Meta, Amazon. These companies use custom silicon to drive down costs on GPUs for their most popular applications. Across ASICs, the most well-known is Google’s tensor processing unit (TPU).

Google was one of the first to require low-power machine learning workloads for Search, YouTube and Google Maps. The compute intensive workloads were running on Nvidia’s GPUs for both training and inferencing until Google made their own processing unit, TPUs, to perform workloads at a lower cost and higher performance.

Performance between TPUs and GPUs is often debated depending on the current release (A100 versus fourth-generation TPU, for example). In some cases, TPUs have better performance per watt for power-constrained applications. Notably, some of this comes with the territory of being an ASIC, which is designed to do one specific application very well whereas GPUs can be programmed as a more general-purpose accelerator. In this case, the benchmarks where TPUs compete are object detection, image classification, natural language processing and machine translation — all areas where Google’s product portfolio of Search, YouTube, AI assistants, and Google Maps, for example, excels.

Notably, TPUs are used internally at Google to help drive down the costs and capex of its own AI and ML portfolio and they are also available to users of Google’s AI cloud services. For example, eBay adopted TPUs to build a machine learning solution that could recognize millions of product images.

Unless Google releases an internal technology as open-source, it won’t be adopted by the competitors. This is where Nvidia’s neutral position as traditionally a hardware company becomes a positive as it’s universally used by Amazon, Microsoft, Google — — and Alibaba, Baidu, Tencent, IBM and Oracle. Meanwhile, TPUs create vendor lock in (with a direct competitor) which most companies want to avoid. eBay is the exception here as the company needs Google-level object detection and image classification.

Why ASICs are Not a Near-Term Threat to GPUs

AI investors will need to get comfortable hearing about the battle between ASICs and GPUs. This debate has been going on since at least 2018, when Nvidia’s biggest threat was thought to be Google’s custom TPUs. There is some merit to these concerns as the largest customers for Nvidia’s GPUs have enough cash to make custom chips. There’s roughly $35B to $40B per Big Tech company per year that executives will naturally want to optimize to drive down costs.

To program ASICs is difficult, and they are application-specific, which means they cannot be reconfigured. Nvidia is wildly popular because GPUs are easy to program and are the best choice for a wide range of applications. Developers create the moat, which was our original Nvidia thesis. Therefore, I don’t believe there is much risk that Big Tech commercializes AI accelerators.

However, it’s quite plausible that someday Big Tech will reallocate capex toward more ASICs and fewer GPUs to where it will impact Nvidia. For now, demand outstrips supply, and there are long lead times for Nvidia’s GPUs. If a company like Google reallocates to more TPUs, another enterprise will certainly step up to fill those orders.

VMWare –Software-Defined Networks and Data Centers

In November, Broadcom closed its acquisition of VMware for $69 billion. VMWare is virtualization software that virtualizes compute and data centers. The software creates an abstraction layer, or a “hypervisor” which is the technical term for a computer or server that runs virtual machines called ESX. VMWare was the first company to virtualize x86 machines and was founded in 1998. Operating systems, such as Linux, Windows and MacOS, can share the same, virtualized resources by running on a x86 machine.

Over the past decade, VMware pivoted to offer a software-defined data center. On the Q4 earnings call, Broadcom discussed building essentially a private cloud on-premise, which has some advantages, such as lowering capex by pooling memory, security, networking and server resources. “Our strategy going forward is simply to enable global enterprises to run their applications across the other data centers as well as on public clouds by consuming VMware’s higher-value software stack.”

Later it was stated: “We are creating with VMware, the same experience of virtualization of the data center on-prem for those companies, which has workloads, by the way, that are already running VMware products that application that’s already written on VMware Cloud Foundation. This is then giving these enterprises the opportunity to have a hyperscaler on-prem. That’s the plan we’re doing, plain and simple.”

Where software defined networks have seen quite a bit of success is with 5G networks. SDNs separate the control plane on embedded switching systems. This allows the networks to be managed remotely. Products from different suppliers can be used without incompatibility issues. By using open APIs, the 5G market has benefited from a more neutral ecosystem by allowing products from different suppliers. This is because SDNs allow network functions to be programmed by APIs instead of proprietary interfaces.

In 2012, VMWare acquired Nicera to create VMware NSX, virtual networking and security software that virtualizes network components. The NSX products, including NSX-T data center, programmatically creates and manages virtual networks from Layer 2 to Layer 7, which is defined as switching, routing, access control, firewall and QoS. NSX Manager and transport nodes can be assembled in seconds for proof-of-concept deployments, deployments with up to 64 hosts, or large-scale environments. Software-defined networks have a natural synergy with Broadcom, the leader in networking hardware.

A few years ago, VMWare expanded to virtualize containerized workloads for Kubernetes clusters. This product is referred to as Tanzu. This was a necessary evolution to keep cloud native customers. Many Kubernetes clusters use something called a multi-tenancy solution, which is to have non-connected “tenants” use a common pool of resources. This can be hard to implement correctly, and also has limited functionality once it’s set up. Virtualized containers are similar to a single-tenancy solution by having its own API server, controller manager and storage for data. Yet, it’s similar to a multi-tenancy solution by using a common pool of resources. Per the Broadcom Q4 earnings call: “And to attract and keep these workloads across the environment, we are investing in a rich catalog of microservices tools. This will be our focus. And the noncore businesses of end-user computing and Carbon Black will be divested.”

All of this sounds good, but virtualization is not a wild success. The software defined data center market at one time was expected to reach $77 billion by 2020 but instead has only reached $28 billion as of 2023. There are many vendors in the space, which creates pricing wars.

Broadcom Technical Analysis

By Portfolio Manager Knox Ridley

We still believe AVGO is in a large uptrend, so the recent volatility was used to layer into this position.  Even though we are seeing a bounce, there is a chance that AVGO’s correction is not over. This setup would see the current bounce fail, and then a breakdown below $1200. If this happens, we will look to add to AVGO between the $1150 – $1000 region. On the other hand, if we hold the $1200 level, we can keep pushing higher into the $1600 region. A breakout over $1365 would signal this scenario is likely playing out, which we would also use as a signal to buy into strength.

Conclusion

Broadcom belongs to our AI portfolio. Over the next few years, Big Tech is likely to diversify away from Nvidia’s GPUs, plus Ethernet networking continues to be upgraded for AI purposes, which means Broadcom should be on our radar. It’s not only the AI revenue that sets Broadcom apart, but also its developing software strategy with VMWare makes it an ideal choice.

Pro premium members receive deep-dive research on all the stocks in the portfolio and quarterly earnings kickoff webinars. In addition, the Advanced Market Signals Members receive regular technical and broad market analysis and weekly webinars from our Portfolio Manager, Knox Ridley. Learn more here.here.

Recommended Reading:

Cloudflare Q1: H2 Deceleration to 26.5%, CEO Spooked by Macro

Posted on by io-fund

Cloudflare reported a razor-thin beat in Q1, with revenues increasing 30.5% YoY to $378.6 million, marginally ahead of the company’s guide for $373 million by $5.6 million. The guide next quarter is for $394 million at the midpoint. Analysts were expecting $393.5 million. The stock is selling off because although Cloudflare beat for two quarters, management is not raising full year guidance.

If you do the math, the current guide implies a growth rate in the second half of 26.5%. The growth rate for H1 was:

  • Q1 actual of $373M
  • Q2 guide for $394M
  • H1 of $767M compared to H1 revenue last year of $598.7 for H1 2024 growth of 28.1%
  • H2 will be revenue of $883M compared to H2 revenue last year of $698M for H2 2024 growth of 26.5%. Notably, H1 2023 had higher comps (53% both qtrs) than H2 2023 (47% and 41%) so that doesn’t help explain the deceleration, in fact, it would make the decel stand out more.

The interesting part is that Cloudflare’s key metrics are not throwing any major flags as to what is causing the deceleration. Paying customers accelerated by 20 basis points from 17% to 17.2%. Customers above $100K were up 33.5% compared to 35% in the prior quarter. RPO increased 8% QoQ from $1.245 billion to $1.343 billion for growth of 40% YoY. This is an acceleration from growth of 37% YoY in the previous quarter. 

When asked why management didn’t raise full year guidance, the answer was macro concerns. Essentially, what this earnings report is communicating is that Cloudflare is quite strong, but the macro environment is not, per signals Cloudflare is seeing from their vantage point as a company that has visibility into many industries.

Revenue and EPS:

Management said Q1’s results were “fueled by a record number of net-new customers year-over-year spending more than $100,000, $500,000, and $1 million with Cloudflare on an annualized basis.”

Although adjusted EPS increased 100% to $0.16 and beat estimates by 23%, Cloudflare struggled to make improvements down the line on a GAAP basis, with GAAP operating loss widening YoY and GAAP net loss showing little improvement. Cloudflare has stubbornly high SBC expense, at $69.7 million in Q1. This is about 18.4% of revenue, meaning that Cloudflare’s path to GAAP profitability will rely on continual improvements in gross profit growth and minimizing SBC growth.

  • For Q1, Cloudflare reported revenue of $378.6 million, increasing 30% YoY and beating estimates by 1.4%.
  • Adjusted EPS of $0.16 increased by 100% YoY, and beat estimates by 23.1%. GAAP EPS was ($0.10), an increase of 16.6% YoY.
  • For Q2, Cloudflare guided revenue of $393.5 million to $394.5 million, representing YoY growth of 27.7%.
  • For Q2, Cloudflare guided adjusted EPS to be $0.14, a slight sequential decline but a YoY increase of 40%.
  • For FY24, Cloudflare maintained its revenue guidance for $1.648 to $1.652 billion, for YoY growth of 27.3%. Management increased its adjusted EPS forecast by $0.02, now seeing full-year adjusted EPS of $0.60 to $0.61.

Margins:

A higher mix of Zero Trust and SASE revenue contributes to the gross margin expansion. Zero Trust and SASE are discussed in more detail here.

A closer look at Cloudflare’s report shows that as revenues increased $88 million YoY, operating expenses increased $81 million, more than offsetting improvements in gross margin. However, Cloudflare reported a one-time sales & marketing compensation expense of $15 million, which was likely the primary reason for a ~41.6% YoY increase in sales & marketing spend. Stripping out this one-time expense would see GAAP operating loss improve by nearly $8 million YoY, from ($47.3 million) in Q1 of last year to ($39.5 million), instead of slipping deeper into the red at ($54.6 million).

  • GAAP gross margin in Q1 was 77.5% for profit of $293.6 million, a 180 bp YoY and 50 bp QoQ expansion.
  • Adjusted gross margin was 79.5%, a 170 bp YoY and 60 bp QoQ expansion for $301.1 million.
  • GAAP operating margin was (14.4%), a 190 bp YoY improvement but a 260 bp QoQ contraction from (11.8%) in Q4 2023 for operating losses of (-$54.6) million. As stated, stock-based compensation is $69.7 million which drags down GAAP profits into the red.
  • Adjusted operating margin was 11.2%, a 450 bp YoY and 20 bp QoQ expansion for adjusted operating income of $42.4 million.
  • GAAP net margin was (9.4%), a 370 bp YoY improvement but a 170 bp QoQ contraction to ($35.5) million.
  • Adjusted net margin was 15.4%, a 500 bp YoY and 80 bp QoQ improvement for $58.2 million.
  • For Q2, based on management’s guidance, adjusted operating margin is expected to be ~9%, a 220 bp QoQ contraction. They expect FY adjusted operating margin of 9.8%.

Cash and Debt:

Free cash flow decelerated from 14% last quarter to 9% this quarter for a total of $35.6 million. Operating cash flow of $73.6 million had a margin of 19.4% down from 24% last quarter. On a YoY basis, Cloudflare is trending up on cash flows but the market is sensitive right now on this line item. Despite the QoQ deceleration, the CFO stated on the call that cash would increase in H2: “We expect free cash flow to be relatively consistent with operating profit for the full year 2024 with the first half lower and the second half higher compared with operating profit.”

Network capex is expected was 8% this quarter and is expected to be 10% to 12% for FY2024, which is in line with prior comments, yet will be up from FY2023 by 200 basis points, at the midpoint.

Essentially, the 10,000-foot view is that Cloudflare is competing with hyperscalers who have very large capex budgets. The concern is that Cloudflare may not be able to keep up — where will the cash come from to build a larger footprint given the cash flow margins are fairly thin with $1.7 billion on the balance sheet although net cash is $432 million when you consider the $1.28B in debt.

The CFO pointed out why capex should remain reasonable: “We were at 8% to 9% of revenue with network CapEx in the first quarter. We said the year will be close in the range of 10 to 12, and this includes the rollout of GPU capacity pretty much to every server and every location we have.”

The CEO said something similar later in the call – that capex will remain reasonable as a percentage of revenue: “If we have to — we — so it may be that we — on a just pure dollars basis, end up spending more on GPUs. But as a percentage of revenue, we feel very comfortable that we can service these applications very well at the percentage of revenues that it is in our forecast going forward.”But as a percentage of revenue, we feel very comfortable that we can service these applications very well at the percentage of revenues that it is in our forecast going forward.” There was additional discussion from the CEO on the call quoted below.

  • Operating cash flow was $73.6 million in Q1, or 19% of revenue, compared to $85.4 million or 24% of revenue in Q4.
  • Free cash flow was $35.6 million, or 9% of revenue, compared to $50.7 million or 14% of revenue in Q4.
  • Cash and equivalents totaled $1.72 billion.
  • Debt totaled $1.28 billion.

Key Metrics:

RPO increased 8% QoQ from $1.245 billion to $1.343 billion for growth of 40% YoY. This is an acceleration from growth of 37% YoY in the previous quarter. 

DBNRR was 115% in Q1, flat QoQ but down from 117% in the year ago quarter.

  • Customers with ARR of >$100K grew 33.5% YoY to 2,878. This customer cohort accounted for 67% of revenue in Q1, compared to 66% in Q4 and 62% a year ago.
  • This is down from last quarter with 35% YoY growth.
  • This is down from the year ago quarter with 40% YoY growth.
  • Paying customers of 197,138 accelerated both YoY and QoQ
  • This is up 20 basis points from 17% growth last quarter
  • This is up from 13% growth in the year ago quarter

Cloudflare is reporting 2 million developers on their Workers platform. This is up from “more than a million” in a press release in November of 2023 and is up from 450K developers in May of 2022 per a corporate blog. Per the opening remarks: “The last few months were incredible for the entire workers' ecosystem. First, we crossed over 2 million active developers building applications on Cloudflare Workers. Second, in April, we GA-ed a number of key products like DY, our serverless SQL database; hyperdrive, which makes any traditional database perform like it's globally distributed; and Workers AI, which allows developers to run and tune AI models across our global network.”

Earnings Call:

The earnings call can be boiled down into two key discussions. The first was on capex, which was a very important discussion for the longer-term thesis of AI inference at the Edge and the Workers Platform, which we discussed here.

The second important discussion was analysts grilling management on why they didn’t raise guidance for the back half of the year. The brief answer is macro reasons, but the discussion addresses the primary reason the stock is down after hours.

Network Capex:

Today, for this report, network capex is not an issue. However, we did recently note that Super Micro has a fundamental problem where the company must raise cash to grow. Investors should pencil-in that Cloudflare could be in a similar issue someday. The management team is pulling a lot of levers to make sure this isn’t a serious concern, and ultimately if they can time their need to scale to when cash is cheap, then all will be well.

Here is what management said regarding why their approach is different from the hefty cash approach the hyperscalers take.

Answer
Matthew Prince (Executives)

[…] the thing which is really magical about Cloudflare's business, which is really elegant is that it all fits together so well. So for instance, as we sell more of our Zero Trust and SASE products, those are extremely high-margin products, and they don't require a significant additional amount of CapEx. That then frees up our ability to invest that CapEx in other areas, including in the AI space.

[…] That means that as we deploy CapEx, it's literally not shipping an entire server to support AI, but shipping just the GPU cards that go into existing servers that are in the field. That reduces the amount of CapEx that has to be deployed. And again, it works because it is all running on 1 unified network. The fact that every server across Cloudflare's entire platform is capable of performing any function that we need. That has allowed us an enormous amount of flexibility in how we can deploy things and has helped us. 

[…] But in the average hyperscaler, if they're getting maybe 20% utilization out of a CPU or GPU resources that they've deployed, we can often be many times that in terms of the utilization where in CPUs we're seeing almost 80% utilization. So that efficiency allows us to get more out of every CapEx dollar. Finally, I would say that inference is different than training. And so you need different resources for that. You don't mean necessarily the most cutting-edge GPUs in order to do inference tasks. And so that has meant that we haven't had to chase down what is a — GPUs that have limited quantity. It's also meant that we can be much smarter about picking and choosing between different GPU vendors and matching workloads to whoever it is that can provide the best service. And I think over time, that gives us a significant advantage over people who are just trying to rent 1 particular type of GPU or rent that and let their customers figure out how to be as efficient as possible.

–End Quote

Workers Platform:

As we likely face some turbulence in the near-term (defined as next couple quarters) due to cloud valuations being quite high, it’s important to remember the medium-term thesis (next 1-2 years). When asked what was special about the Workers Platform, the CEO stated the following, some of which we described in detail in the October deep dive.

Answer
Matthew Prince (Executive)

In terms of why, what is it about Cloudflare that's unique? I think there are sort of 3 things that stand out to me about it. The first is just the performance of Cloudflare Workers AI because we are distributed around the world and today, over 150 locations globally, as we serve customers that serve a global audience, we can just give them a much better experience in having to ship all of your code back to some central location. 

The second is that we can actually be significantly more cost effective. If you're using one of the big hyperscale cloud in order to do any sort of AI task, it's up to you to manage efficiency. You have to make sure that you're getting the most out of the GPU that you're renting whereas what we do is much more of a serverless AI model where you only pay for the task that you actually run. So especially in a lot of the start-ups, they're finding that they can just get significant better efficiency, significant better cost if they use our platform in order to deliver that AI experience. And then the third thing is that because we got it distributed globally and because of the fact that we have such a rich ecosystem that we've built, where you can get a AI experience that's allowing people to actually fine-tune their models […] We can actually correspond all of the local and regional differences all around the world. That's something that you don't get anywhere else. 

—End Quote

Macro Concerns:

The tone on this particular call was that macro is providing early signals of a H2 slowdown. This was not your typical “oh, macro is hard to predict” discussion. When they discussed the H2 slowdown, it was not Cloudflare specific at all, rather that Cloudflare would have better visibility than other companies due to where they sit in terms of the internet.

This was a sample of the opening remarks:

“In the short term, however, my crystal ball is less clear. We see a lot of signals based on our privileged position running a good chunk of the Internet […] The short term is uncertain, the long term is bright, and so in the medium term, we're going to keep our hands firmly on the levers of our business […]”

Here’s an additional glimpse into the tone on the call, at times:

Question
Jonathan Ho (Analysts)

Excellent. And just a quick follow-up. Is there something specific in the macro that's maybe causing you a little bit of pause? Anything that you can sort of point to in terms of that additional concern on the outlook.

Answer
Matthew Prince (Executives)

I think that we we get a lot of signal based on where we sit on the Internet. And what I would say right now is that it's not any one thing pointing in any one clear direction. But there's a lot of noise pointing in a number of different directions that give us, I think, reason to be cautious and I think that, that is in our very nature is always taking as much signal being data-driven and making sure that we're making investments in a responsible way. And so I think the obvious thing is the geopolitical uncertainty around the world. That absolutely causes changes in buying behavior. On the other hand, some of that — those changes in buying behavior have been positive for us as we're seeing, especially in our government business, pick up because of that uncertainty. 

So there are puts and takes that are out there. What we want to do is just make sure that we are being prudent and responsible and thoughtful as we make investments and as we think through how to handle the responsibility that we have with investors capital and that they've trusted us with.

–End Quote

Additional discussions on macro had a similar tone, such as this one from the CEO: “We can make investments and we can think through what that future looks like in part because we just get much more signal than I think the average enterprise SaaS company gets. And I think that, that has served us well. And I think we try not to be surprising in any way. And so as we see — I would say that there is certainly an uptick in uncertainty and sort of potential downside this quarter over last quarter.”I would say that there is certainly an uptick in uncertainty and sort of potential downside this quarter over last quarter.”

Here is more along those lines: “I think my level of concern is not at the same level that it was in Q1 of 2022, but it is definitely heightened over a lot of what we've seen in more recent quarters.”

However, one analyst didn’t let them off the hook so easily, and so to really drive home the tone of the call, I’m quoting in full one of the last questions where the analyst pushed for management to be crystal clear.

Question
Alex Henderson (Analysts)

So if nothing is really spooking you here, I'm still struggling with the guidance and the outlook for the back half of the year. You've given guidance that — or commentary that you're seeing significant strengthening of your pipeline, you're saying you're duration stable. You're seeing solid closure rates. You're adding more sales capacity, you're winning large customer deals at an accelerating rate. You’re spending more on hiring people and productivity in your sales force is significantly improving. Yet your guidance implies with the first quarter beat and the second quarter are above the Street, the back half is much more conservative. So I guess the question is, is that a function of specific weakness in a particular geography or due to political issues? Or is it just trying to feather in more opportunity for the sales organization to be realigned as Mark comes on and drives things because ultimately, it sounds like the mechanics imply an acceleration, not a deceleration.

Answer
Matthew Prince (Executives)

Yes. Alex, I'll start and then Thomas can give a little bit more color. I would push back on your initial statement, which was that nothing spooks me, a lot spooks me right now. So just because just — and I want to make it clear, we are in a much more uncertain environment and the signal that we're seeing is that uncertainty is up. In addition to that, I think you're correct that whenever you have a sales leadership change, there is risk that comes with it. And so there's a bit of that. But the primary factor here is that as we look at the signals in the overall macro economy, it is — it feels like a much more — it feels like there's much more reason to worry in Q1 than there was in Q4. But that doesn't mean that it was the same, just sound the alarm bells that we were seeing back in Q1 of 2022.

–End Quote

Conclusion:

Cloudflare’s valuation at 18x forward sales is hovering at the 20x forward PS level that ‘best-of-breed’ cloud stocks struggle to maintain. If macro does weaken, cloud stocks will get slammed for their thin FCF margins (far majority have negative FCF) and lack of GAAP profitability. Remember, I’m simply the messenger here. The reality is that cloud gets hit hard. We trimmed the position over the past quarter or so because cloud simply doesn’t sustain well at certain valuations. Had we not already trimmed Cloudflare, we would be doing so today – primarily based on valuation, secondly due to this management team being better than most at giving investors a heads-up when something is off. Meaning, management stated their crystal ball was “cloudy,” but in reality, if you’re listening, they’re being crystal clear.

With that said, Cloudflare is one of our favorite choices for the medium-term. The company sits in an enviable position for AI inference at the Edge. The key metrics are strong incl an acceleration in RPO, and I suspect that won’t be the case with most cloud peers this quarter. The developer growth on Workers to 2M is fire. I liked management’s response on network capex as it shows they have a strategy, and it’s showing up today with cash flows remaining at an acceptable percentage of revenue – although, notably, we do want to stay neutral here in terms of what the network capex reports in the future and also continue to scrutinize cash flow margins.

Recommended Reading:

The Risk is Higher in the Market than it Feels

Posted on by io-fund

Our last broad market report entitled “The Magnificent 7 are Falling Like Dominoes; Only 3 Remain” warned investors that risk was building in the markets. Specifically, it was discussed that the current market leaders, deemed the indestructible “Magnificent 7,” were putting in tops one leader at a time. First Tesla put in a top, then Apple, Google and Microsoft, all started making lower highs, while the broad market kept trending higher.  As we stated in that report, “When these cycle leaders start underperforming, it usually marks the start of a trend change.”

Just days later, the AI powerhouse and market leader, Nvidia, put in a top on March 8th, while the S&P 500 continued higher. This left only Amazon and Meta from the original Magnificent 7 pushing higher with the S&P 500.

sp500 & mag7 chart analysis

Source: I/O Fund

Sure enough, on March 28th, the S&P 500 followed the Mag 7 down, as we are now seeing volatility pick up for the first time in over 5 months. Now, investors are wondering if this is a buying opportunity in a larger uptrend or the start of something more severe?

In this report, we will show that the sentiment readings over the last several months suggest investors should be cautious. This is backed up by our broad market analysis, which indicates that risk is more elevated than most investors may think. This doesn’t mean we can’t push marginally higher. Instead, it is suggesting that the downside is greater than any additional upside. Interestingly, the last two standing from the Mag 7, Meta and Amazon, appear to be giving the strongest clues that we could see more volatility over the coming weeks to months.

Historic Sentiment

The below graph measures the percentile rankings of the weekly AAII Investor Sentiment Survey going back to 1987. The survey simply asks a group of investors where they believe the market will be going over the next 6 months.

Based on the answers, it provides a percentage of those surveyed that have a bullish or bearish outlook about the markets. It then measures the spread between the bulls and bears to provide a comprehensive reading regarding market sentiment.

It is best used as a contrarian indicator. The idea is that the more extreme the readings become, the closer we are to trend change.

naaim & aaii investor sentiment

Source: I/O Fund

Based on recent volatility, the participants are starting to get more concerned about the future markets, as you can see the increased number of bears over the last 2 weeks. However, look at the highlighted period November 2023 – April 2024. The spread between the bulls vs. the bears during this 22 week period stayed in the 70th percentile of all bullish readings going back to 1987. Out of these 22 weeks, 13 weeks were in the 90th percentile of all bullish readings.

We have not seen a consistent streak of exuberance that lasted this long within the history of this survey. The closest period was December of 1999 – February of 2000, where we had 18 weeks where the spread between bulls and bears were in the 70th percentile, with 14 of these weeks above the 90% threshold.

This level of exuberance warrants cation based on historic readings. Sentiment is a powerful measurement, as investing is not a zero-sum game. For every buyer, there must be a seller, and when everyone piles into the same side of a trade, willing to pay any price to get more gains, there is only one way for the market to go.

Broad Market

The extreme sentiment readings are coinciding with a potential top, of sorts, unfolding in the broader market. The S&P 500 broke out to new all-time highs earlier this year, which means that the 2022 bear market was just a deep correction within a larger uptrend.

The pattern that has unfolded in this new bull cycle has taken the shape of a common technical pattern called an ending diagonal. This is a choppy, and narrow pattern that traces within a channel and always consists of five waves. Most importantly, these patterns only show up in the final 5th wave, which is the end of a trend.

sp500 chart analysis

Source: I/O Fund

Note how we are very far along in the 5th wave pattern, and touching the lower boundary of our 5th wave topping zone. We are pushing higher on fading momentum, which is a typical sign that we see in the final 5th wave of an uptrend.

The breakdown, so far, has made a push into the upper regions of the 5th wave target box less likely. However, until we break below 4950, there is a chance we could push higher before rolling over. It would require the market not making a new low, and then breaking out above the 5225 level.

sp500 daily chart

Source: I/O Fund

Based on the current price information, I believe we are still in a downtrend, which is bets shown in the chart below.  The below path in blue shows an overlapping bounce off the recent lows. We can still push higher from here, but as long as we do not see a vertical breakout above 5225, I expect this bounce to fail as we push lower. A break below 5015 will be the first warning, and the final support will be 4950. If we do break below 4950, what my particular style of analysis tells me, is that there is not a path to new highs within the ending diagonal pattern that started in October of 2022. We will need to see a sizable correction, at best, in order to start a new pattern pointing higher. For this reason, it is likely that we see volatility pick up.

sp500 weekly chart analysis

Source: I/O Fund

The Mag 2

The final two Mag 7 stocks appear to be supporting the conclusion that a top is in place. Meta, for example, has been tracing the final 5th wave off the November 2022 low. Note how this final move higher has happened on lower momentum. This is common in the final 5th wave of a trend.

meta stock chart analysis

Source: I/O Fund

There is a low probability that we hold $406 and turn higher for one more high. However, I find this to be unlikely based on the additional clues within the chart.

The choppy consolidation after their Q4 results resembles a distribution top, which is where we see large institutional trades sell to an eager retail crowd. This was confirmed by the recent earnings report resulting in a large gap below the major trend line, which happened on heavy volume.

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Also, it’s worth noting the importance of gaps within an uptrend. These are literal gaps between the closing price and opening price, usually on heavy volume. They are key markers within a trend and tend to unfold in 3s: the breakaway gap is the 1st indication that a new uptrend has started, the runaway gap typically happens around the halfway point of the larger uptrend, and the final gap is the exhaustion gap, which tends to happen around the end of the trend. So far, this is exactly what we have seen, and was confirmed with the recent selling gap, which tends to signal a trend reversal.

meta stock chart

Source: I/O Fund

Amazon is another Mag 7 stock that is signaling a larger pullback is likely underway. Note the clear 5 wave uptrend off the 2022 low. Just like in Meta, the final 5th wave in Amazon was happening on weaker momentum, signaling that the strength in the uptrend was fading.

amazon stock chart analysis

Source: I/O Fund

What follows a five wave uptrend is a correction of the same degree. We are unfortunately dealing with a 1.5 year five wave uptrend. If this is what is playing out, this means we should see a multi-month correction, which should retrace most of the final push off the October 2023 low.

Amazon’s pattern is an ending diagonal, which is another piece of evidence supporting the final push will be a top for Amazon. As stated earlier, these patterns are tight, with choppy moves higher that trace a trend channel. They happen as the final 5th wave of a move, and when they end, we tend to see a swift drop back to the start of the pattern.

amazon chart analysis

Source: I/O Fund

The above ending diagonal pattern took 21 days to complete and only 6 days to retrace the entire pattern, which further confirms that this is likely an ending diagonal. Since these patterns only occur at the end of a move, we are likely setting up for more volatility into the coming weeks – months. If the current bounce can break above $190, then we could see an extension of this final 5th wave higher before rolling over.

A Note on Google

The divergences discussed in our last report regarding the Magnificent 7 was the clearest signal that a correction was building. Google was the 3rd of the seven to start making lower highs against the market pushing higher. This was the right call, as the market is now in a clear correction.

However, GOOGL recently pushed to new highs in their last earnings report. I believe this push was the final 5th wave within a pattern called an expanding diagonal. This patter is common in 5th waves, and also lines up with the rest of the market. Note below how the  final 5 waves each moved respected the expanding trend channel. If GOOGL closes the recent gap around $157, this will be the first signal that this pattern is in play.

alphabet stock chart analysis

Source: I/O Fund

Regardless, future market leaders will emerge from volatility. They will go down less than the broad market and tend to bottom before the broad market. It is too soon to tell, but this move in GOOGL is one we are watching as a potential market leader when this volatility ends. 

Conclusion:

The last six months have been a historic, and nearly vertical move higher. From November 2023 to March 2024, we have not seen even a shallow pullback — which is uncommon. With that came a level of exuberance that has not been recorded before in the AAII Investor Sentiment Survey. The level of greed in the market has not only created extreme valuations with stocks, but it created a tight rope that the broad market had to walk in order to keep pushing higher.

Once the recent volatility broke below the 5080 – 5055 support zone, the odds tilted in favor of a top being in. As long as we hold 4950 and break back above the 5225 region, we can extend this move higher. However, if 4950 breaks, we will have full confirmation that a top is in as the next move tests the 4800 – 4600 region. Because of this, we believe this market warrants caution.

If you own Tech stocks or are looking to own Tech stocks, consider joining us for our next broad market webinar. Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, manage risk, as well as revealing our various long-term game plans regarding stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.

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

Recommended Reading:

AMD Q1 Earnings: GPU Revenue Outlook Raised to $4B

Posted on by io-fund

AMD reported an in-line quarter on both revenue and EPS, with data center revenue coming in just above $2.3 billion for 80% YoY growth and a slight 2% QoQ increase. Margins were stable, with management guiding for a slight 100 bp QoQ expansion in adjusted gross margin. Cash flows improved sequentially, with AMD posting strong double-digit QoQ growth in both operating and free cash flow.

AMD’s GPU revenue forecast was boosted by ~14%, with management now seeing full year revenues at $4 billion, compared to its prior view for $3.5 billion plus. However, analyst expectations were largely pointing to $4 billion as the ‘minimum’ figure, with some looking for GPU revenue as high as $8 billion. The raise is welcomed with MI300 cumulative sales surpassing $1 billion since the launch in Q4, however, it’s not enough to meet a wide range of heightened expectations.

Below, we breakdown the glass half-full or glass-half empty psychology that is overshadowing AMD’s accomplishments right now (and which side of the proverbial debate we are on, and why).

Revenue and EPS:

  • Q1 revenue was $5.47 billion, marginally ahead of expectations for $5.45 billion and representing YoY growth of 2.2%.
  • Q2 revenue was guided at $5.7 billion, +/- $300 million for YoY growth of approximately 6% and QoQ growth of 4%. This was in line with consensus estimates for $5.69 billion.
  • Q1’s adjusted EPS was $0.62 in line with estimates for $0.61, representing YoY growth of 3%. GAAP EPS was $0.07 which missed estimates of $0.17 EPS.
  • Q2 estimates from analysts are for $0.69 EPS in the June quarter and $1.00 in the September quarter.

Key Segments:

Data Center:

AMD had guided for Q1 data center revenue to be approximately flat QoQ, implying revenues around $2.3 billion for YoY growth of ~77%. The company reported data center revenue of $2.34 billion, up 80% YoY.

AMD says the YoY growth was “driven by growth in both AMD Instinct™ GPUs and 4th Gen AMD EPYC™ CPUs,” and the sequential growth was “driven by the first full quarter of AMD Instinct GPU sales, partially offset by a seasonal decline in server CPU sales.” AMD added that MI300 cumulative revenues have surpassed $1 billion since launching in Q4 2023, signaling strong initial adoption and an ability to quickly ramp production.

The CFO guided for next quarter: “Sequentially, we expect data center segment revenue to increase by double-digit percentage, primarily driven by the data center GPU ramp.” Later it was stated: “In the second quarter, we expect overall data center to be up strong double digits.”

An analyst offered verbal math of $900 million for GPU sales next quarter, to which the CFO simply stated she was not guiding to those details. For our purposes, this is a good number to go with. The company called out Microsoft, Meta and Oracle as customers.

Regarding EPYC CPUs, on the call, an analyst stated that his math points toward AMD’s CPU server sales declining 5-6% which is considered strong compared to a competitor (likely Intel). “It looks like your server CPU business was also down at the lower end of the seasonal range. By my math, it was down like 5%, 6% sequentially. Is that right? And that's less than half the decline of your competitor?”

Per the opening remarks: “Given our high core count and energy efficiency, we can deliver the same amount of compute with 45% fewer servers compared to the competition, cutting initial CapEx by up to half and lowering annual OpEx by more than 40%” and also: “We believe we gained server CPU revenue share in the seasonally down first quarter led by growth in enterprise adoption and expanded cloud deployments.”

Client, Embedded, Gaming:

Client segment revenue increased 85% YoY to $1.37 billion, driven predominantly by Ryzen 8000 series processor sales. Revenues declined just (6%) sequentially for the segment.

For Q2, it was stated that Client revenue would increase QoQ.

Per the opening remarks: “Looking forward, we believe the market is on track to return to annual growth in 2024, driven by the start of an enterprise refresh cycle and AI PC adoption. We see AI as the biggest inflection point in PC since the Internet with the ability to deliver unprecedented productivity and usability gains.”

Embedded segment revenue was $846 million, declining (46%) YoY and (20%) QoQ as customer inventory management continued.

For next quarter, the CFO stated Embedded would be flat QoQ, which implies a (47%) decline in Q2. The weakness is coming from automotive, which is widespread.

Gaming revenue was $922 million, declining (48%) YoY and (33%) QoQ “due to due to a decrease in semi-custom revenue and lower AMD Radeon GPU sales.” Looking forward, gaming is expected to decline by a “revenue to decline by significant double-digit percentage.” It was later stated on the call that gaming would be down a “similar zip code” as Q1. In the Q&A, it sounded like this won’t improve this year.

Per the CFO:

“If you look at the gaming, the demand has been quite weak, that's quite very well known and also their inventory level. So based on the visibility we have, the first half both Q1, Q2, we guided down sequentially more than 30%. We actually think the second half will be lower than first half that's basically how we're looking at this year for the gaming business.”

Margins:

Margins for the first quarter were in line with management’s expectations, while Q2’s guide implied a 1 percentage point expansion in adjusted gross margin, driven by an increase in data center mix and lower gaming revenue as gaming has a lower margin than DC.

  • GAAP gross margin was 47%, unchanged from Q4 but up 300 bp from 44% in the year ago quarter. Adjusted gross margin was 52%, in line with management’s guidance, and representing a 100 bp QoQ and 200 bp YoY expansion. Increased data center and client revenues and lower gaming revenue aided the margin expansion.
  • GAAP operating margin was 1% in Q1, an improvement from (-3%) in the year ago quarter but down from 6% in Q4. Adjusted operating margin was 21%, flat YoY and down 200 bp QoQ.
  • On a segment view, data center operating margin was 23.1%, an 1170 bp YoY expansion but a 620 bp QoQ contraction, likely driven by efforts to ramp up MI300 GPU production.
  • Notably, the MI300s are lower than the “corporate gross margin” right now but is expected to be above corporate gross margin over time. For full year 2021, the gross margin was 48%, so that’s a good benchmark for a best-case scenario GM.  Per the CFO: “It's the GPU gross margin right now is below the data center gross margin level. I think there are 2 reasons — actually, the major reason is we actually increased the investment quite significantly to, as Lisa mentioned, to expand and accelerating our road map in the AI side, that's one of the major drivers for the operating income coming down slightly. On the gross margin side, going back to your question, we said in the past and we continue to believe the case is. Data center GPU gross margin over time will be accretive to corporate average, but it will take a while to get to the server level for gross margin.”
  • GAAP net margin was 2%, an improvement from (1%) in the year ago quarter but down from 11% in Q4. Adjusted net margin was 19%, unchanged from Q4 and up slightly from 18% in the year ago quarter.
  • For Q2, management guided adjusted gross margin of 53%, implying a 100 bp QoQ and 300 bp YoY expansion.
  • For Q2, adjusted operating margin is expected to be ~21% given management’s guidance for $1.8 billion in operating expenses.

Cash and Debt:

AMD’s cash flow improvements stood out in Q1’s in line report, as the company drove significant double-digit sequential growth in cash flows and margin improvements.

  • Operating cash flow was $521 million in Q1, an increase of 7.2% YoY and 36.7% QoQ. Operating cash flow margin was 10%, a 300 bp sequential improvement.
  • Free cash flow was $379 million in Q1, an increase of 15.5% YoY and 56.6% QoQ. Free cash flow margin was 7%, a 300 bp sequential improvement.
  • AMD reported cash and equivalents of $6.04 billion.
  • Debt was unchanged at $2.47 billion.

Earnings Call:

AMD’s AI Revenue Ramp: Glass Half-Full or Glass Half-Empty

AMD is an interesting case of is the glass half-full or is the glass half-empty. Interviews like this one, from an analyst that closely follows the stock, would cause you to believe the glass is half-empty. From the reaction after hours, it would be hard to tell that the primary segment reported 80% YoY growth and is expected to grow strong double digits sequentially.

My take is that the glass is 30% full and will likely exit the year half-full. Per the call, one analyst’s math is for $900M in GPUs next quarter. If we take $2.4 billion for the DC segment this quarter and assume strong double-digit growth, that puts us at a $3B data center segment next quarter (roughly). If this analyst’s math is correct, this means within two quarters of shipping; GPUs will be 30% of DC segment in Q2. I can’t think of another company that has ramped this fast outside of Nvidia. Broadcom has had ASICs revenue for years from Google’s TPUs (maybe 2018-ish) so we aren’t looking at as fast of a ramp there.

AMD is in Nvidia’s shadow with GPU revenue, and understandably so, given Nvidia is commanding a $80B annual data center segment (on its way to a $100B segment). Therefore, AMD stock is up against some hefty investor psychology with its tiny $10B segment (roughly).

However, if we zoom-out, sometime in 2025, CPU revenue will be eclipsed by GPU revenue. We were looking at about a $1.7B-ish segment on CPUs prior to the MI300 release for the Frontier supercomputer in Q4. Whenever GPUs exceed $7B in revenue, they will have officially passed up AMD’s CPUs, which took almost 10 years to build that kind of revenue (first gen EPYC was released in 2014). Meanwhile, AMD’s CPU trajectory resulted in 1700% gains in stock price due to flawless execution against Intel. Meaning, that was a breathtaking 10 years.

Now, I’m not saying this will translate to the exact same gains as the CPU comeback story — but by my estimation, doing what took 10 years in as brief as 2 years (with a long runway to go) should translate to something.

$4B in AI Revenue but Vague as To the Exit Rate

Management left room for a higher exit rate this year in terms of AI revenue. There was nothing said concretely but there were some subtle hints that we will hear a higher exit rate in the coming quarters. This was the most pointed discussion in that regard:

Question
Vivek Arya (Analysts)

Lisa, I just wanted to go back to the supply question and the $4 billion outlook for this year. I think at some point, there was a suggestion that the $4 billion number, right, that there are still supply constraints. But I think at resent point, you said that you have supply visibility significantly beyond that. Given that we are almost at the middle of the year, I would have thought that you would have much better visibility about the back half. So is the $4 billion number of supply constrained number? Or is it a demand constrained number? Or relatively, if you could give us some sense of what the exit rate of your GPU sales could be. I think on the last call, $1.5 billion was suggested. Could it be a lot more than that in terms of your exit rate of MI for this year?

Answer
Lisa Su (Executives)

Yes. Vivek, let me try to make sure that we answered this question clearly. From a full year standpoint, our $4 billion number is not supply capped — I'm sorry, yes, it's not supply cup. It is — we do have supply capability above that. It is more back half weighted. So if you're looking at sort of the near term, I would say, for example, in the second quarter, we do have more demand than we have supply right now, and we're continuing to work on pulling in some of that supply. By the way, I think this is an overall industry issue. This is not at all related to AMD. I think overall, AI demand has exceeded anyone's expectations in 2024. So you've heard it from the memory guys. You've heard it from the foundry guys. We're all ramping capacity as we go through the year. 

And as it relates to visibility, we do have good visibility into what's happening. As I said, we have great customer engagements that are going forward. My goal is to make sure that we pass all of the milestones as we're ramping products. And as we pass those milestones, we put that into the overall full year guidance for AI. But in terms of how customer progression things are going, they're actually going quite well, and we continue to bring new customers on and we continue to expand workloads with our current customers. And so hopefully, that clarifies the question, Vivek.

The Concerning Rumor about Microsoft:

No doubt, the main thing that needed to be cleared was the Microsoft rumor that we detailed in our pre-earnings report. I agree and appreciate the tone of this question, as there is never-ending noise with AMD, and am quoting it in full:

Question
Matthew Ramsay (Analysts)

I appreciate that, Lisa. As my follow-up, a little bit shorter term. And I guess having followed the company super closely for a long time. I think there's been — there's always been noise in the system from whether the stock price is $2 a share or $200, there's been kind of always consistent noise with the other. But the last 1.5 months has been extreme in that sense. And so I wanted to just — I got random reports by inbox about changes in demand from some of your MI300 customers or planned demand for consuming your product. I think you answered earlier about the supply situation and how you're working with your partners there. But has there been any change from the customers that you're in ramp with now or that you soon will be of what their intention is for demand? Or in fact, has that maybe strengthened rather than gone down in recent periods because I keep getting questions about it?

Answer
Lisa Su (Executives)

Sure, Matt. Look, I think I might have said it earlier, but maybe I'll repeat it again. I think the demand side is actually really strong. And what we see with our customers and what we are tracking very closely is customers moving from, let's call it, initial POCs to pilots to full-scale production to deployment across multiple workloads. And we're moving through that sequence very well. I feel very good about the deployments and ramps that we have ongoing right now. And I also feel very good about new customers who are sort of earlier on in that process. So from a demand standpoint, we continue to build backlog as well as build engagements going forward. And similarly, on the supply standpoint, we're continuing to build supply momentum. But from a speed of ramp standpoint, I'm actually really pleased with the progress.

–End quote

My take is that all corporate executives are trained to smooth things over, so we can’t tell from this answer if Microsoft truly canceled orders to some effect or not. But the overall message is that demand outstrips supply.

Conclusion:

If I were to guess, we are hitting up against valuation concerns which are being waved off with conversations on CNBC and elsewhere that AI revenue isn’t materializing fast enough. This simply isn’t true.

However, AMD is expensive — all semis are expensive — and we’ve been here before. This is not our first rodeo when the market doubts a company and comes up with outlandish narratives when it simply hits a valuation ceiling.

Seeing the forest through the trees is important because we need to put our ducks in a row on how to manage our portfolio given these valuations are high, yet these stocks are driving forward a massive market unlike anything we’ve seen before (compare EPYC CPUs ramp to Instinct GPUs ramp — it’s very clear we are in unchartered territory with the growth of AI).

A few weeks ago (and again after hours), AMD retested and broke support for the bullish count of $158. We are looking for AMD to hold $138 and will likely add here. Notably, a break below $128 is more concerning but this report should be enough to avoid that scenario. We will keep you updated in our weekly webinars and with real-time trade alerts as we carefully manage this high-conviction position.

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Super Micro FYQ3: Cash is the Achilles Heel

Posted on by io-fund

This quarter, Super Micro reported revenue of $3.85 billion, reflecting a staggering growth rate of 200.7% YoY. This technically missed estimates by 1.3%. Management increased guidance to between $5.1 billion to $5.5 billion, up from $4.9 billion, indicating year-over-year growth of 142.6% at the midpoint.

The company's GAAP EPS of $6.56, surpassed analyst expectations of $5.16. Next quarter, the expected GAAP EPS ranges from $7.20 to $8.05 compared to analyst expectations of $6.87 EPS.

What lies beneath this phenomenal growth rate is the need to raise cash to fund operations, which for Super Micro means buying excess inventory to prepare for future growth, especially as it relates to liquid cooling. Inventory of $4.1 billion amounts to 85% of revenue, whereas SMCI held closer to 70% of revenue in the past.

This quarter, the operating cash flow margin was (-39.5%) and the free cash flow margin was (-42%). This is a material change to the story given the current macro environment, and management did not indicate it will get better in the near-term as it’s related to components for liquid cooling systems. Per management: “We continue to face some supply chain challenges due to newer products that require new key components, especially, specifically, DLC related components, and believe this situation will gradually improve in the coming quarters.”

Revenue and EPS

For the third quarter of fiscal year 2024, Super Micro reported revenue of $3.85 billion, up $2.57 billion, or 200.7%, compared to $1.28 billion for the same quarter in the previous year. This growth was slightly under the projected midpoint based on management’s previous guidance of revenue in the range of $3.7 billion to $4.1 billion.

For Q4 FY24, management is guiding for revenue in the range of $5.1 billion to $5.5 billion, representing YoY growth of 142.6% at the midpoint. This compares to analyst estimates for $4.9 billion and growth of 124% going into the print.

There is a drop off in Q2 FY25, which is calendar year Dec 2024, and hopefully revisions flow through to increase this growth rate. It may seem far off, but this is a high beta stock that sees volatile price action based on signs of weakness or strength.

Management raised full year revenue growth to 109.3% for revenue of $14.9 billion. This is up from guidance for revenue of $14.5 billion last quarter.

SMCI also established full year GAAP EPS and non-GAAP EPS guidance for FY24. GAAP EPS is guided to $21.61 to $22.46, compared to GAAP EPS of $11.43 for FY23. This would mark a 92.9% increase YoY at the midpoint of guidance. Management expects non-GAAP EPS to be in the range of $23.29 and $24.09 for FY24. This would be YoY growth of 100.6% at the midpoint compared to FY23 non-GAAP EPS of $11.81.

GAAP EPS for March was $6.56 compared to analysts’ consensus of $5.16. This is 28.6% higher sequentially with $5.1 GAAP EPS in the previous quarter and is 328.8% growth from the year-ago quarter. Adjusted EPS was $6.65 for similar YoY and QoQ growth.

Looking forward, next quarter’s GAAP EPS is expected to be between $7.20 and $8.05 for over 122.3% growth from the year-ago quarter. Adjusted EPS of $8.02 at the midpoint will see similar YoY growth. This compares to analyst estimates of $7.16.

Margins

  • Gross margin was 15.5% in Q3 for gross profit of $597.4 million. The company is guiding to a lower gross margin next quarter. An analyst on the call implied it would be 13.5% to 14% next quarter.
  • Operating margin was 9.8% for operating profit of $378.3 million and adjusted OPM was 11.3%.
  • Net margin was 10.5% for net profits of $402.5 million. Adjusted net margin was 10.7%.

Adjusted gross margin was 15.6% for Q3, improved slightly QoQ from 15.5%, however, adjusted gross margin was down 210 bps YoY compared to 17.7% in the same quarter a year ago. On the adjusted gross margin declines, management stated it is due to product/customer mix and focus on market share gains.

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

Cash Flow and Balance Sheet

Cash flow used in operations for Q3 was $1.5 billion compared to cash flow usage of $595 million during the previous quarter as the company grew inventory and accounts receivable for higher levels of business.

Cash flows from strong profitability was offset by higher Inventory, a large portion of which was received late in Q3, and higher Accounts Receivable from increasing revenues. The Q3 closing inventory was $4.1 billion, which increased by 67% QoQ from $2.5 billion in Q2 due to the purchase of key components. Capex was $93 million for Q3 resulting in negative free cash flow of $1.6 billion for the quarter.

On its balance sheet, the company reported $2.12 billion in cash and cash equivalents and $1.86 billion in debt, up from $726 million in cash and debt of $376 million in the previous quarter. Consequently, the net cash position stood at $260 million, declining from $350 million in the last quarter.

During the quarter, SMCI announced a $1.5 billion principal amount of convertible senior notes that will be due in 2029. The company also announced a public offering of common stock as SMCI raises capital to support operations, including purchases of inventory and other working capital needs, manufacturing capacity expansion and increased R&D investments.

Key Metrics:

Server and Storage Systems & Subsystems

  • Server and storage systems were $3.7 billion in revenue for growth of 218% YoY and was 96% of Q3 revenue.
  • Subsystems and Accessories were $152 million, up 27% YoY and was 4% of Q3 revenue.

Vertical Markets

  • OEM Appliance & Large DC: 50% of total revenues, down from 59% last quarter and up from 47% a year ago.
  • Organic (Enterprise & Channel), AI/ML: 49% of revenues, increasing from 40% of revenues last quarter, and slightly down from 50% of revenues a year ago.
  • 5G, Telco & Edge/IoT: 1% of revenues, flat compared to last quarter and down from 3% of total revenues a year ago.

According to the CFO: “One existing CSP large data center customer represented 21% of Q3 revenues and one existing enterprise channel customer represented 17% of revenues.” This compares to last quarter’s customer concentration of 26% and 11%, respectively.

Inventory:

Inventory days increased to 92 days compared to 67 days in the previous quarter. The company’s Q3 closing inventory was $4.1 billion, which increased by 67% quarter-over-quarter from $2.5 billion in Q2 due to the purchase of key components.

This was asked about on the call and we detail it for you below. It’s also reflected in the steep, negative operating cash flow reported this quarter.

Geography:

All revenues were up by a wide margin QoQ.

  • United States was 70% of revenue, and increased 242% YoY and 3% QoQ.
  • Asia was 20% of revenue, and increased 257% YoY and 17% QoQ.
  • Europe was 7%, and increased 30% YoY and 3% QoQ
  • ROW was 3%, and was up 87% YoY and was down 11% QoQ
  • China accounted for 1% of total revenue.

Earnings Call:

Inventory increase:

The inventory days increasing doesn’t entirely explain the steep $4.1 billion in inventory. Rather, the company has to hold more inventory while waiting for key components related to liquid cooling. This is out of character for Super Micro to hold this much inventory and this will not be comfortable for the Street to accept given the company has diluted shareholders and raised debt in the past quarter.

Question
Aaron Rakers (Analysts)

Yes. I'll try and slip in 2 here, if I can. So I guess one of the just kind of housekeeping questions is a very significant increase in inventory this quarter. I know you said that it came in towards the end of the quarter. How do we think about the trajectory of inventory as the supply comes on? Do you expect inventory to stay at this level? Do you expect it to start to come down? I'm just kind of curious how we think that flow through kind of looks as you take on more supply […]

Answer
Charles Liang (Executives)

Two reasons we had to increase inventory: One is because Q4, I mean, June quarter, we will have a strong revenue growth; a second reason because we're preparing for high-volume liquid cooling. Again, we have more than 1,000 of 100k watt, I mean, liquid cooling rack we have to ship to customers in Q4. And liquid cooling as you know, is pretty new. So we had to prepare enough inventory so that we can deliver liquid cooling rack scale product to customer on time or with minimal lead time. So both factor, indeed, is a positive factor. And with our economic scale continuing to grow, indeed, our inventory average [ daily ], indeed, will slightly improve.

Answer
David Weigand (Executives)

Yes. So Aaron, my take on that is I hope that our inventory continues to grow because that means there's a reason behind it, so — and it's tied to sales. 

–End quote

Here was another discussion around the inventory levels:

Question
Nehal Chokshi (Analysts)

Congrats on a strong guide here. Talk about the guide here. Inventory increased $1.5 billion Q-over-Q. And Dave, as you mentioned, you'd like to see inventory increase. I do too because it's a strong indicator of things to come. And you guided June quarter to increase by $1.6 billion Q-over-Q. If I do this math, where I'm looking at the inventory at the quarter end and then the [ fourth ] quarter revenue, typically, it's around 60% to 70% of revenue. But with your March Q ending inventory and your current [ June, too, ] guidance, that equates to about 85% of projected revenue. So can you just explain what seems to be a little bit more usual inventory buildup given the revenue guidance range?

Answer
David Weigand (Executives)

Sure. Absolutely. That's a fair question. So we actually got a substantial amount of inventory in the last week of the quarter, okay, which obviously, we're not going to be able to ship, but we took in $700 million in the last week of the quarter. So that's not something — that's something that has to do with when inventory arrives. And so we — it hurts our cash flow, but you know what, it doesn't matter, because we need that inventory for Q4 shipments.

Answer
Charles Liang (Executives)

Yes. Again, 2 reasons, right? Q4, we will have a strong revenue, so we had to prepare for Q4. And also, I mean, liquid cooling, I mean, it's new. So we had to prepare enough safety inventory for liquid cooling demand for June quarter and September quarter as well. So that's another reason why we have a slightly higher inventory now.

Answer
David Weigand (Executives)

Yes. And I want to add, Nehal, that, that's exactly why we did capital raises, too, is to prepare for these Q4 shipments, and — so that we could make those large purchases, and we hope to continue that.

–End Quote

Sequential Growth is the New Normal

My ears perked up on this comment, when the CEO was asked if they are capable of future sequential growth:

Answer
Charles Liang (Executives)

Yes. As you know, traditionally, in the last 10 years, right, I mean, the September quarter and March quarter, always our soft quarter. But now with AI, we've been growing so strong. So we basically are able to grow sequentially. So although March and September be a little weak, but basically, because of strong AI growth and our market share growing, so the sequential growth will become the normal. And basically, I mean, we have even better technologies than before ever, and now economic scale become much bigger. Malaysia campus production will be ready by end of this calendar year, so we see a lot of positive factors to grow our business.

–End Quote

SMCI Likely to Raise more Capital

This is likely the comment that caused the stock to go down 10% AH despite the strong beat and raise. An analyst asked the CFO if he foresaw a need to raise more capital. Here was his reply:

Answer
David Weigand (Executives)

Yes. So the way I would answer that is, is that I hope that I have — I need more capital, Jon, because that means that we're booking — that we're growing revenues even faster. So we've got capital adequate to get us through the current market, which means today. But in a week, that — we hope that, that changes, and we hope that we've got orders that require even more capital. So all I can say is I hope that — I'm hoping for the need for more capital.

Answer
Charles Liang (Executives)

Yes. We believe our revenue will continue to grow strong. And that's why we need more capital to grow faster. If we grow 20%, 30%, we may have enough capital now, but it will grow much faster. Then for sure, we need more capital to grow stronger.

–End Quote

My comment: this is not what the market wants to hear right now, which is that you have to raise capital to fund growth. Supermicro is an incredible company situated perfectly between hyperscalers and the world’s best design companies. However, this is not the right macro environment to need to raise capital. Not even an AI bullet train can change those facts.

Conclusion:

There is no doubt, we rode a phenomenal wave with Supermicro over the past few months. The comment that sequential growth will be the new norm is music to our ears, as growth investors. However, we can’t fight the Fed. This is a good time to put the surf board down for a little while and let the next wave gather strength before we attempt Supermicro again.

In our pre-earnings writeup, I had stated: “it’ll be negative cash flow margins and/or dilution that penalizes the stock,” as well as: “The stock seems to be on a never-ending winning streak, however, what could be Super Micro’s Achilles heel is the cash issue — as the company must grow capacity to keep up with the revenue growth, yet to do so will require cash.”

If it were just about inventory, to where the shipments came in late in the quarter but was spoken for the following quarter, then that would not be an issue. From this report, the concern is the large appetite the company has to raise more cash to support growth. The tie-up on inventory for the direct liquid cooling components is an additional concern but it’s the primary issue around having to raise more cash that ultimately doesn’t meet our criteria at this time.

As you are aware, Super Micro is a high beta stock and we plan to adhere to our line in the sand. The good news is that we’ve made sizable profits and plan to put those to work at lower levels.

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