AMD confirmed a fundamental bottom with a beat this quarter and a beat for next quarter. Analysts were expecting revenue growth of 6.8% and AMD reported growth of 8.9%. Adjusted EPS marginally beat at $0.69 versus $0.68 expected. The results were aided by data center revenue reaching a record as growth accelerated to the triple digit range, at 115% YoY for $2.84 billion, marking a 35-percentage point acceleration from 80% in Q1. CEO Lisa Su said AMD’s “AI business continued accelerating and we are well positioned to deliver strong revenue growth in the second half of the year led by demand for Instinct, EPYC and Ryzen processors.”
We had stated on our most recent webinar and in the write-up AMD’s Future Looks Bright that we want to give AMD the space to fill the very big shoes an Nvidia contender has to fill. Data center growth in Q2 of 115% is a clue that AMD is a serious contender on AI accelerators. The only other companies that have posted triple digit growth from AI in a standalone segment are Nvidia and Super Micro. To be fair, some of the revenue is from EPYC CPU processors, but the majority of the growth is coming from Instinct GPUs. We can sparse out the growth as Instinct drove $1B in revenue this past quarter, with EPYC contributing $1.84 billion. Without Instinct, data center revenue would have grown 41.5% versus 115% with Instinct.
With AMD down (-6%) YTD while Nvidia is up 109%, the market continues to communicate “not good enough.” Yet, what makes these numbers intriguing is we are at the bottom for this company (not a top – this is key), with fundamentals improving and accelerating from here.
Revenue and EPS:
AMD’s revenue accelerated to 8.9% YoY in Q2, up from 2.2% last quarter due to data center revenue accelerating significantly this quarter.
Q2 revenue was $5.84 billion, up 8.9% YoY and 6.6% QoQ from $5.47 billion last quarter.
Adjusted EPS of $0.69 beat estimates by $0.01, representing YoY growth of 19% and QoQ growth of 11%.
GAAP EPS of $0.16 missed estimates by $0.02 but represents 700% YoY growth and 129% QoQ growth as margins bottomed and turned up this quarter (this high growth is due to
For Q3, AMD guided revenue to be $6.7 billion, +/- $300 million, for YoY growth of approximately 15.5% at midpoint. Analysts were expecting Q3 revenue to be $6.61 billion, for YoY growth of approximately 14.1%, so Q2 and Q3 beat/raised by 1 to 2 percentage points.
Key Segments:
AMD reported record data center revenue in Q2, with growth accelerating to the triple digits on strong CPU and GPU demand and the “steep ramp” of Instinct GPUs. The company stated it’s AI accelerator the MI300 contributed $1 billion in revenue.
Data center revenue was $2.83 billion, up 115% YoY and 21% QoQ. For reference, in Q1, AMD reported data center revenue growth of 80% YoY and 2.4% QoQ, so this is a rather sharp acceleration in just one quarter. Per management this was “driven by the steep ramp of Instinct MI300 GPU shipments and a strong double-digit percentage increase in EPYC CPU sales.” There is expected to be strong growth next quarter in the DC segment.
Client revenue was $1.49 billion, up 49% YoY and 9% QoQ, driven by sales of Ryzen processors. This was a solid print, as Client rebounded from a (6%) QoQ decline in Q1. This was “driven by strong demand for our prior generation Ryzen processors and initial shipments of our next-generation Zen 5 processors.” There is expected to be strong growth next quarter in the Client segment.
Gaming revenue was $648 million, down (59%) YoY and (30%) QoQ as the segment continues to weigh on growth. Management stated the gaming market remains soft and sales will decline further in the second half of the year, and will decline double-digit percentage next quarter.
Embedded revenue was $861 million, down (41%) YoY but up 2% QoQ as inventory levels normalize. Management guided last quarter for Embedded revenue growth to be flat, so the 2% sequential increase is slightly better than expected. Management expects Embedded to gradually recover in H2, and this segment will be up next quarter.
Margins:
AMD’s margins improved throughout, with data center driving a sequential improvement in GAAP operating margin.
GAAP gross margin was 49% in Q2, up from 46% last year and 47% in Q1. Adjusted gross margin was 53%, in line with management’s guidance and up from 50% last year and 52% in Q1. Management said higher data center revenue was a primary driver of the gross margin expansion in the quarter.
For Q3, AMD guided for adjusted gross margin of 53.5%, a slight 50 bp QoQ expansion; management has previously pointed to increasing data center mix as a gross margin tailwind.
GAAP operating margin was 5% in Q2, up from 0% last year and 1% in Q1.
This was driven largely by data center, which saw operating income rise more than 37% QoQ and 405% YoY to $743 million, for a 26.2% segment operating margin (up from 23.1% in Q1).
Adjusted operating margin was 22%, up from 20% last year and 21% in Q1.
Based on management’s expenses guide, adjusted operating margin is expected to come in just above 25% in Q3, a 300 bp QoQ expansion.
GAAP net margin was 5%, up from 1% last year and 2% in Q1. Adjusted net margin was 19%, up from 18% last year but flat with Q1.
Cash and Debt:
Operating cash flow was $597 million in Q2, a 10% margin. OCF rose more than 14% QoQ and 56% YoY.
Free cash flow was $439 million, an 8% margin. FCF rose nearly 16% QoQ and 73% YoY as a result of higher operating cash flow generation.
Inventory was $4.99 billion, an increase of 7.3% QoQ.
Cash and equivalents totaled $5.43 billion, while debt totaled $1.72 billion. The company retired $750 million in debt with existing cash this quarter. The company will close Silo AI next quarter for $665 million in cash.
The company returned $352 million to shareholders, repurchased 2.3 million shares with $5.2 billion in share authorization remaining.
Earnings Call:
$4.5B in AI Revenue for FY2024, up from $4B
AMD’s AI accelerator, the MI300, is the fastest ramping product in AMD’s history. I said previously that this is saying a lot as it’s ramping faster than EPYC CPUs, which took a shocking amount of market share from Intel in the data center.
Per a previous write-up:
“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.”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.”
This quarter, AMD seconded this by shrugging off rumors there may be issues with qualifying the MI300: “I think there's a lot of noise in the system. I wouldn't really pay attention to all that noise in the system. I mean this has been an incredible ramp. And I'm actually really proud of what the team has done in terms of just definitely fastest product ramp that we've ever done to $1 billion here in the — over $1 billion in the second quarter and then ramping each quarter in Q3 and Q4.”
EPYC took about 10 years to reach $1.7B in quarterly revenue. AMD will likely reach this quarterly revenue by 2025, or in less than two years with Instinct 300 Series GPUs.
The next MI300 Series release will be the MI325 due out this year with double the memory, and the highly anticipated MI350 will be out early next year to compete with Nvidia’s Blackwell. From there, AMD will continue with a one-year product road map. Look for rack scale systems in the MI350 release next year, which is critical for AMD to keep pace with Nvidia on Blackwell at the hyperscaler and Tier 2 OEM level.
AI Software
The Silo AI acquisition is big news as it will boost AMD’s ability to compete with Nvidia at the enterprise level. We covered the acquisition on our pre-earnings writeup here. Per management: “It's a great acquisition for us. 300 scientists and engineers. These are engineers that have experience with AMD hardware and are very, very good at helping customers get up and running on AMD hardware. And so we view this as the opportunity to expand the customer base with talent like Silo AI, like Nod.ai, which brought a lot of compiler talent. And then we continue to hire quite a bit organically.”
At the Big Tech level, AMD announced that Microsoft has announced the general availability of the MI300X instances. The Azure virtual machines combine AMD’s RocM software platform for “leadership-inferencing price performance.” Hugging Face has adopted the Azure instances “to deploy hundreds of thousands of models on MI300X GPUs with one click.”
On the developer side, Meta’s Llama 3.1 model is supported by MI300 accelerators, Stable Fusion announced they are working with MI300s for their image generation LLM, and AMD supports Flash Attention-2, an algorithm used to enhance efficiency for Transformer models.
RocM is AMD’s attempt to remove the CUDA roadblock the company faces in competing with Nvidia. We’ve covered this here in AMD is Ready to Rival on AI Acceleration. The following update was shared in terms of the progress that’s being made: “the exciting part of this is that the ROCm capability has really gotten substantially better because so many customers have been using it. And with that, what we look at is out-of-box performance, how long does it take a customer to get up and running on MI300. And we've seen, depending on the software that companies are using, particularly if you're based on some of the higher-level frameworks like PyTorch, we can be out-of-the-box running very well in a very short amount of time, like, let's call it, very small number of weeks. And that's great because that's expanding the overall portfolio.”
UALink: Standardizing GPU Interconnects
AMD is being tapped by a consortium of AI acceleration companies, such as Broadcom, Intel, Cisco and Big Tech to assist in creating an Ultra Acceleration Link (UALink) open standard for GPU interconnects to reduce dependency on Nvidia’s NVLink. NVLink is a GPU interconnect that scales GPUs into pods with their own data and computational domain. AMD is being tasked to create an open standard that will serve as an alternative to Nvidia’s NVLink based on AMD’s Infinity Fabric.
The takeaway is AMD is not only viewed as a runner-up to Nvidia, but is actively sought after by the industry to stave off its monopoly. If you read between the lines, this is an important nod to AMD’s capabilities. Look for more updates in Q3.
AI PCs and Zen 5 EPYC Processors
A major part to AMD’s AI story is laptops, desktops and edge devices. I can’t emphasize this enough!
The Ryzen AI 300 laptops and the Ryzen 9000 series for desktops are powered by the 5th generation of the Zen architecture. The Ryzen AI 300 laptop has a XDNA 2 neural processing unit (NPU) that is designed for Microsoft Copilot+ AI software. This will deliver 50 TOPS of AI performance. To put this into perspective, the Macbooks with the M4 chip from Apple – considered the most advanced AI laptop on the market – is capable of 38 TOPS of AI performance.
The laptops are already on the market as of now and the desktops will hit the market in August. Management stated investors can expect a strong H2: “As we go into the second half of the year, I think we have better seasonality in general, and we think we can do, let's call it, above-typical seasonality given the strength of our product launches and when we're launching. And then into 2025, you're going to see AI PCs across sort of a larger set of price points, which will also open up more opportunities.”
AMD’s Zen 5 architecture will have 128 cores and 256 thread count and will double the chiplets from eight to 16. The cache is getting a massive upgrade to 512 MB, which was not possible on the Zen 4 architecture at this core and thread count.
In the data center, Turin EPYC processors will have 192 cores and 384 threads. Per the opening remarks: “We publicly previewed Turin for the first time in June, demonstrating our significant performance advantages in multiple compute-intensive workloads. We also passed a major milestone in the second quarter as we started Turin production shipments to lead cloud customers. Production is ramping now ahead of launch, and we expect broad OEM and cloud availability later this year.” Management stated they believe Turin will help them “continue to grow market share” in the second half of the year.
Conclusion:
At the close of the opening remarks, Lisa Su stated the company is “well positioned to grow revenue significantly in the second half of the year” and “our data center business is on a steep growth trajectory.” These are the words of a company at a fundamental bottom.
There is no doubt, this company ticked every box we have on our checklist this evening. We don’t chase price, rather we look for quality companies. This often means we are early to a move in either direction. You can expect this to be a leading position of ours into the foreseeable future as we patiently wait to see how this bottom unfolds, especially come 2025 for AMD.
Damien Robbins, Equity Analyst for the I/O Fund, contributed to this analysis.
Hewlett Packard Enterprise (HPE) has quietly undergone a business transformation over the last few years to position itself as a beneficiary in AI servers, networking, hybrid cloud and AI software. Last quarter, HPE’s AI systems revenue doubled sequentially to $900 million with a backlog of $3.1 billion. Compare this to Dell with AI server order revenue of $2.6 billion and AI server shipments of $1.7 billion. Super Micro has total revenue of $3.85 billion with “more than 50%” of this from AI or about $2 billion.
As a percentage of revenue, SMCI is certainly in the lead as a pure play. However, HPE is ahead of Dell in terms of percentage of revenue at 12.5% for HPE and 7% for Dell.
We’ve identified liquid cooling as a leading trend for the back half of 2024. Of those at the cross-section of servers and liquid cooling, HPE has the lowest valuation to the tune of being priced up to 67% lower.
HPE Overview:
HPE has over 13,000 patents, with 300 of these in particular in liquid cooling systems for data centers, and is the owner of four of the world’s top 10 fastest supercomputers. It has also made a number of partnerships, such as with Microsoft Azure, Google Cloud, SAP, and Nvidia to offer seamless cloud experiences or more powerful compute capabilities. HPE operates globally with over 700 channel partners giving it a unique edge in go-to-market capabilities.
HPE has five business segments:
1. Server (53% of revenue in Q2’24): HPE sells servers for general-purpose use through their ProLiant line and more compute-intensive applications such as their Cray line, which is used in supercomputers.
2. Hybrid Cloud (17% of revenue): HPE offers cloud-native and hybrid solutions for customers that would prefer not to host their own servers on-premise. This includes data storage and management, hybrid and cloud-native services through HPE GreenLake, and AI infrastructure as a service.
3. Intelligent Edge (15% of revenue): HPE provides solutions that enable faster data transfer and improved data analytics through edge computing. AI workloads will eventually move to the edge. Intelligent Edge also offers security features like Zero Trust. This segment includes HPE Aruba which is a subsidiary focused on networking capabilities supported by HPE’s planned $14B merger with Juniper Networks, announced in January 2024.
4. Financial Services (12% of revenue): HPE provides investment solutions to allow businesses to deploy technology models and acquire IT solutions.
5. Corporate Investments and Other (3% of revenue): HPE provides consulting and implementation services.
HPE Cray’s supercomputers are high performance computing servers for AI workloads. They are available with both Nvidia and AMD GPUs, and currently rank as the world’s fastest and largest supercomputers. Cray was a supercomputer manufacturer founded in 1972 before it was acquired by HPE in 2019. Cray is roughly 80% government and agency contracts and 20% commercial, with the bulk of the line being used such for supercomputers for research labs within the Department of Energy, among others.
The ProLiant servers accelerate workloads from the data center to the edge, and are used by corporations for hybrid AI. The AI rack servers offer memory intensive AI inferencing and scalable GPU acceleration for enterprise AI. There are SKUs for virtualized workloads for edge applications that offer balanced bandwidth and memory, data intensive workloads for apps that require large storage capacity and high bandwidth, and compute and data storage demanding workloads that require a maximum core count, among others.
GreenLake cloud is a hybrid architecture that allows enterprises to maintain control of sensitive data, while leveraging the benefits of public and private clouds. HPE calls this an edge-to-cloud platform, which offers software-as-a-service for storage, a data control plane to have a complete view of data assets, data analytics, and the ability to scale AI pilots and large language models. The software platform offers the ability to create a private cloud alongside on-premise servers, which may become quite popular as it allows enterprises to balance the security and data sovereignty that on-premise offers with the agility and scalability of the cloud. Among other things, HPE GreenLake lets customer privately train and tune large language models.
HPE Edgeline offers edge computing and processing power in a compact server that is located close to where data is generated. Edgeline servers are important for edge computing where data is quickly turned into intelligence with AI, and to manage AI/ML applications while protecting and governing data.
Aruba ensures reliable and secure connectivity from the edge back to the servers at the datacenter. The most recent Juniper Networks acquisition expands HPE into ethernet networking and switches. HPE’s $14B merger with Juniper Networks is expected to close in late 2024 or early 2025 and will strengthen HPE’s portfolio in AI networking.
Financials:
Hewlett Packard Enterprise (HPE) surprised in its latest earnings report, posting revenue and non-GAAP EPS that both exceeded outlook in Q2 as AI systems revenue more than doubled sequentially. Management also raised full year revenue and non-GAAP EPS guidance, signaling confidence in their ability to convert the current backlog orders to revenue.
Revenue and EPS:
HPE is a low growth company that has promising, initial signs of AI demand.
The company reported $7.2B in revenue, representing 3.3% YoY growth (5.45% beat), which was the biggest revenue surprise in the last 6 quarters. The company guided for $7.6B in revenue at the midpoint for this upcoming quarter, representing 8.5% YoY growth (2.1% beat).
The company reported ARR of $1.5 billion, up 37% from the prior-year period and 39% in constant currency. Last quarter, ARR grew 41% year-over-year to more than $1.4 billion in Q1, with the company stating to expect ARR growth of 35% to 45%.
GAAP EPS of $0.24 was down 25% YoY and down 17% QoQ.
Adjusted EPS of $0.42 vs $0.52 last year (8.2% beat) is down 19% YoY and was down 13% QoQ. The company guided for adjusted EPS in the range of $0.43 to $0.48 vs $0.49 last year.
HPE’s FY24 revenue guidance represents 1.5% YoY growth at the midpoint, a slight rise from Q1’24 where they guided for 1% YoY growth at the midpoint in constant currency. Adjusted EPS guidance for FY’24 was in the range of $1.85 and $1.95, higher than the guidance given during Q1 results of $1.82 and $1.92.
Key Segments:
The revenue beat was driven by strong performance in AI-related revenues. AI system sales more than doubled sequentially to over $900M for 12.5% of revenue, and the number of enterprise AI customers tripled YoY. AI systems accounted for all of the QoQ growth given the QoQ declines in Hybrid Cloud and Intelligent Edge.
Server Revenue of $3.9 billion dollars in Q2 represents a 16% increase sequentially and up 18% year-over-year, driven by AI servers and HPE Greenlake revenue.
HPE continues to expect sequential growth in both their traditional and AI server business. Operating margins were 11% in this segment, down 340 bps YoY due to pricing headwinds on AI systems, but it is in-line with their long-term operating margin guidance range of 11% to 13%.
HPE has reduced lead times for delivering Nvidia H100 solutions to six to 12 weeks, from over 20 weeks in Q1’24, which it expects will further boost revenues in H2’24, along with more large enterprise orders.
The backlog remained stable at $3.1B, down from $3.4B last quarter but up from $1.4B in the prior year quarter. This acceleration in AI systems revenue comes alongside a recovery in traditional and cloud infrastructure markets, creating a strong set-up for further acceleration into H2. This was also discussed in the Q&A with excerpts below.
Management also pointed to a growing enterprise customer base as evidence of its products’ value proposition.
“Our differentiation – with liquid cooling, software, HPE GreenLake, and increasingly services – is resonating in the market. We have seen a threefold increase in our enterprise AI customer base in the past year.” We have seen a threefold increase in our enterprise AI customer base in the past year.”
Hybrid Cloud revenue was $1.3 billion, down 8% from the prior-year period in actual dollars and 9% in constant currency, with 0.8% operating profit margin, compared to 1.9% from the prior year period.
This decline is being driven by two ongoing transitions. First is from hardware storage to HPE’s cloud-native Alletra storage solution, which reduces current revenues but leads to more predictable recurring revenues with storage ARR up 50% YoY.
Second is the transition from block storage to file storage driven by AI and is seeing strong progress with the pipeline of file storage deals tripling sequentially. Operating margins were down 110 bps YoY to 0.8% due to the decline in revenue as well as a larger mix of lower margin third-party products and traditional storage.
Management provided helpful insights around operational transitions the Company is working through:
“The business is managing two long-term transitions at once. We’ve talked about our migration to the more software intensive Alletra platform. This is reducing current period revenue growth though locking in future recurring revenue. Storage ARR growth of over 50 percent year-over-year offers early confidence in the migration. The second transition is from block storage to file storage driven by AI. While early, this is also on the right trajectory. Our new file offerings plus the sales force investment Antonio mentioned tripled our pipeline of file storage deals sequentially in Q2.”
The GreenLake as a service offering is expected to grow ARR at a 35-45% CAGR through FY’26.
HPE GreenLake, a leader in hybrid cloud infrastructure, is also attracting new customers to HPE’s portfolio with the number of customer organizations using GreenLake increasing 9% QoQ to 34,000 and ARR growing 39% YoY to over $1.5B. This increase is being driven by growth in AI systems and they expect high growth to continue to persist with a target 35-45% ARR CAGR from FY’22 to FY’26.
“We have strong momentum in HPE GreenLake. The number of customers that have adopted HPE GreenLake rose 9 percent sequentially. ARR grew 39 percent year-over-year to above $1.5 billion dollars in Q2. Storage and networking are typically the fastest growth elements of ARR and both retain robust growth rates. This quarter, AI was the fastest growth component of ARR. Our software and services mix rose approximately 200 basis points year-over-year to 67 percent. ARR is the best indicator of our model transformation to our as-a-service offerings. This growth validates what our customers are telling us – HPE GreenLake is a key differentiator. We expect HPE GreenLake’s value proposition to key customer, including enterprises and sovereigns, to sharpen with the advent of AI.”This quarter, AI was the fastest growth component of ARR. Our software and services mix rose approximately 200 basis points year-over-year to 67 percent. ARR is the best indicator of our model transformation to our as-a-service offerings. This growth validates what our customers are telling us – HPE GreenLake is a key differentiator. We expect HPE GreenLake’s value proposition to key customer, including enterprises and sovereigns, to sharpen with the advent of AI.”
Intelligent Edge revenue was $1.1 billion, down 19% from the prior-year period with 21.8% operating profit margin, compared to 24.7% in the prior-year period.
This was driven by difficult comps in both periods as HPE went through its backlog and also by soft macro conditions. However, HPE believes that the segment will return to modest sequential growth moving forward. The segment reported a 21.8% operating margin which was down 290 bps YoY due to lower revenues and the high margin switching business forming a lower percentage of revenue. Moving forward, HPE has already lowered its opex for the segment and they expect operating margins to return to the mid-20s by Q4’24.
Financial Services revenue was $867 million, up 1% from the prior-year period with 9.3% operating profit margin, compared to 8.9% from the prior-year period. Net portfolio assets of $13.2 billion, down 1.1% from the prior-year period.
Margins:
Margins contracted across the board with gross margin in Q2’24 the lowest since 2022. Gross margins were 33%, compared to 36% last quarter and in the prior year quarter. A shift from networking revenue to AI systems revenue is a headwind as AI servers are lower in margin (compared to the higher margin offerings i.e., Intelligent Edge). Management did revise forward guidance on adjusted gross margins downward based on the mix shift and expect to be below full year expectations of 35%.
GAAP gross margin of 33.0%, down 300 basis points year-over-year.
Q2 non-GAAP gross margin was 33.1%, down 310 basis points year-over-year.
GAAP operating margin of 5.9%, down 160 basis year-over-year and down 190 basis points sequentially. This is driven by gross margin compression as operating expenses decreased YoY.
Net Margin of 4.4%, down 160 basis year over year and down 130 basis points sequentially. The decreased net income margin is driven by gross margin compression and slightly offset by improvements in total operating expense year over year.
Cash:
HPE reported operating cash flow of $1.1 billion for an OCF Margin of 15.2%, up $204 million YoY.
Free cash flow of $610 million represents an 8.5% margin and an increase from a FCF margin of 4.1% last year due to prepayments for AI systems and the timing of working capital payments. HPE maintained guidance for at least $1.9B in FCF for FY’24, representing 6.4% FCF margins and noting that FCF is seasonally higher in the second half.
Management continues to target returning 65% to 75% of FCF to shareholders through repurchases and dividends. They repurchased $45M worth of shares in Q2’24 and noted that they expect a similar pace of repurchases going forward with an outstanding buyback authorization of ~$0.9B. The dividend yield as of July 10th, 2024 is 2.44%. The dividend yield has come down from >3% in 2019 as the amount of dividends paid has remained consistent at ~$619M since then despite an increase in stock price.
The cash conversion cycle was negative 4 days, which is a reduction of 28 days from Q2 2023. Inventory increased to $7.3 billion vs $4.6 billion in prior quarter. Management noted that “our days of inventory and days payable were both higher to support our expected growth in AI system revenue in the second half”.
Balance Sheet Discussion
HPE has a strong balance sheet despite having a seemingly high net debt balance of $8.6B as of Q2’24 relative to its current market cap of $27.8B as of July 10, 2024. This is because the Financial Services division is managed separately with Net Portfolio Assets of $13.2B which is the total amount of Financing Receivables and Operating Lease Assets, net of reserves against those assets. This is balanced against Gross Debt of $11.5B and Cash of $0.3B for the Financing Division. The actual Operating Company (i.e., HPE excluding Financial Services) has $2.5B of cash with no debt.
Overall, the debt balance has remained manageable with $11.3B of total debt as of Q2’24, down from $13.4B in Q2’23 and a peak of $19.5B in Q3’20. $7.5B of total debt is long-term, with the remainder being comprised of $3B of debt being current, $646M of commercial paper, and $121M of notes payable and lines of credit.
Earnings Q&A:
HPE’s IP Portfolio and Liquid Cooling:
On the call, an analyst asked how HPE separates itself given the large IP portfolio the company has with over 300 patents related to liquid cooling. Given we are Dell and Super Micro investors, this question was of importance to us. If we look at the sales we see today, these three companies are neck-and-neck in terms of total AI server $ revenue. However, HPE took the time to discuss how the company is differentiated, although we have yet to see that differentiation (or competitive edge) show up in revenue.
Question
Aaron Rakers – Wells Fargo:
Yes. Thanks for taking my question. I guess sticking on the AI topic, if I could first ask, when you referenced the AI enterprise customers starting to show up, and I think the comment on the conference call was…it's now north of 15% of your AI orders. Can you give a little bit more context of that? What has that been over the last couple of quarters? I'm just trying to think about the trajectory of that.
And then Antonio, on the liquid cooling side, as we and investors think about Blackwell product cycle from NVIDIA. I'm curious of…can you be a little bit more specific of exactly where, from a technology perspective, you differentiate at liquid cooling? Is there something unique that HPE does within the 300 patents that you would want to highlight for us, as sustainably differentiated. Thank you.
Answer:
Antonio Neri – CEO
As for the differentiation, HPE has three different ways to cool systems. So, one is the traditional way, which is called the liquid-to-air cooler, think about that, basically running water supply in chilled locations where basically cools the air around the systems. Everybody has done that for a long time. The second is what most of the industry is doing today, which is what I call 70% direct liquid cooling or hybrid liquid cooling. Those companies still use fans to cool aspects of the systems. Some of our competitors talk about direct liquid cooling, but that's exactly what they're doing, and they are doing only a hybrid direct liquid cooling. And HPE has…and by the way, in that environment, we have 10 systems already in market today that we are shipping and configuring for customers.
And then we have what I call 100% direct liquid cooling. And this is a unique differentiation HPE has because we have been doing 100% direct liquid cooling for a long time. And today, there are six systems in deployment, and three of them are for generative AI. And as we go to the next generation of the silicon and you talk about Blackwell, when you go to the B200, that will require 100% direct liquid cooling.
–End Quote
Here was another moment the CEO discussed the top 4 ways HPE is differentiated for AI:
“So Amit, on the differentiation, I will summarize this on four key elements. One is our ability to deliver and run systems at scale, so AI system scale, that's a unique expertise and we have decades of experience. Number two is our infrastructure cooling intellectual property. We actually have all the IP necessary to cool systems in three different ways for them other. Our manufacturing footprint, which is very unique. We have one of the largest water-cooled manufacturing footprints in the world with two very important locations in the US and in Europe, which are close to customers.
And then last but not least is services. What I think people are coming to realize that running the system of scale requires unique services capabilities. And that's why with Marie, we started showing you what the services pull-through is, which is also over time, a lever to improve the gross margin in this business. And we cover all aspects from day zero which consulting, to day one, which is advisory and professional services design and then — and build, and then day 2, which is a running part with our — in our operational services side and deep expertise when it comes down to this system of scale, including direct liquid cooling.”
Guidance Looks to Be Conservative:
An analyst called out that the guidance looks conservative. HPE could be setting up for a beat/raise in the second half of the year, which would be key to market enthusiasm and stock performance. Primarily, the key metrics including backlog support higher growth than management’s current guide. FY’24 revenue guide seems to assume no additional growth in the backlog, to traditional servers, or to intelligent edge, despite management noting their expectation for all three to experience sequential growth through year-end.
Management toned down expectations by noting that it takes longer than 6-12 weeks to install and that a decent percentage of AI system deals are in generative AI which are all GreenLake and therefore the services portion is deferred over the life of the contract. While this latter point may mean that the current backlog will take longer than 2 quarters to realize, expectations are still low enough to set for further large beat and raises.
Toni Sacconaghi:
[…] You talked about enthusiasm for the second half, but you beat revenues this quarter relative to your expectations by $400 million and by guiding up an additional percent, you're actually only guiding up the full year by $300 million. So, I'm wondering, are you just being conservative, given the commentary around enthusiasm and forces at work in the second half or how do we reconcile that discrepancy? And then also just on AI servers for the second half, I think you talked about six-week to 12-week lead times. So if you have $3 billion in backlog and lead times for six weeks to 12 weeks, why can't you deliver $3 billion in AI systems like next quarter or certainly in the second half? Thank you.
Marie Myers
[…] What I did point to though, Toni, is I pointed to the higher end of the range, so that's really what's giving us confidence based on the increase that we made on revenue. So you're seeing that higher top-line and then also the confidence I got around just the cost discipline […] So overall, Toni, keeping the guide at $1.85 to $1.95, but really pointing to the higher end of the guide in terms of just the confidence that you articulated. So I'll turn it over to Antonio to cover the second question.
Antonio Neri
Yes. Toni, I think there is an opportunity to potentially exceed that. I think the limiting factor is not the supply, to be honest with you, is the availability of data center space. I made this comment in Q1, if you recall, data center space and power and cooling. And so some — we are working with the customers to time everything correctly, 6 to 12 weeks, think about it, maybe less than a quarter, but then you have to go and install it.
And there is a nice percentage of our deals in generative AI, which are all actually GreenLake. And so while we can recognize the revenue upfront, we are deferring all the services piece of it. So it really is going to come down to the timing of the data center and the power and cooling. And if that all aligns correctly, then we may have an opportunity to do better. But we felt prudent at this point in time to keep it the way it is and raising by 1%.
–End Quote
With an AI backlog of $3.1B and lead times being reduced to 6-12 weeks, HPE can conservatively recognize their backlog over the next 1-2 quarters, resulting in at least $1.55B of AI systems revenue per quarter. This alone would meet consensus estimates for H2’24, and with management expecting sequential growth in traditional servers and intelligent edge as well as a backlog that is growing almost as fast as revenues, HPE is well-positioned to deliver a surprise or two over the next few quarters.
Valuation:
Despite top-line growth being positioned to accelerate from the low-single-digits over the last three years to the mid-single-digits and potentially higher going forward, HPE still trades in-line with its historical range on a NTM EV/EBITDA basis. With a NTM EV/EBITDA of just 6.6x, it trades below peers like DELL at 10.8x despite comparable growth (Dell is projected to grow in the high-single-digits going forward).
However, as previously mentioned, HPE’s enterprise value is overstated since it accounts for all of the liabilities of the Finance division and none of its assets. Backing out the book value of the finance division yields an EV of $23.3B as of July 11th, 2024, compared to EBIT of $297M in the division in the TTM. Backing out Financial Services EBIT yields non-GAAP operating profit of $2.6B for an EV/EBIT of 9x.
Comp Table
Assuming HPE meets consensus revenue expectations of $31.8B of revenue in FY’26 (3.5% CAGR) and maintains adjusted EBIT margins of 11%, it would generate $3.5B of EBIT. Assuming Financial Services forms the same percentage of EBIT as it does today and backing that out from total EBIT yields Operating Company EBIT of $3.1B. Assuming a similar pace of buybacks, HPE can reduce its share count by 0.8% annually, along with a 2.3% dividend yield. Assuming no multiple expansion, this would yield a high-single-digit IRR.
If we assume that HPE re-rates to 13.3x EV/EBIT by 2026, a valuation in-line with CSCO which is projected to see flat growth through 2026 and is the second cheapest in the group, then HPE would generate a low-20s IRR. This scenario could become more likely as AI systems revenue continues to accelerate and the market starts to recognize HPE as a direct liquid cooled server company. This scenario is still conservative as it doesn’t take into account the likely possibility that HPE will beat consensus estimates.
Conclusion:
HPE will test mental flexibility as it’s a sleeper stock; viewed as an outdated tech company from the dot-com era. Yet, 1990s hardware players are auspiciously positioned to capture AI server revenue, and to also offer software platforms for hybrid AI architectures.
There will be many investors too set in their ways to consider the possibility that we are in a new era. Those who see HPE or Dell doing well will cry “dot-com bust.” AI servers will drive the revenue for these companies in the near-term, yet keep an eye on the AI software segments (GreenLake, etc.) for dot-com-defying longevity.
Our portfolio’s motto is the best AI hardware players will make the best AI software players, which gives a strong nod to how we plan to secure future gains as opposed to resting on our laurels with the current hardware-driven AI cycle. HPE is certainly a candidate that fits this motto, yet it’s too early to tell if HPE has what it takes to compete in what is shaping up to be a highly competitive space.
This analysis is a preview of what you can expect in our upcoming Discovery tier, which will provide additional analysis on new idea generation stocks that are not currently in the I/O Fund portfolio. We look forward to launching this tier late August/early September. There will be no changes to our current service tiers, rather I/O Fund Discovery is a service for those who want more new stock ideas beyond what our service currently provides. Stay tuned for more information!upcoming Discovery tier, which will provide additional analysis on new idea generation stocks that are not currently in the I/O Fund portfolio. We look forward to launching this tier late August/early September. There will be no changes to our current service tiers, rather I/O Fund Discovery is a service for those who want more new stock ideas beyond what our service currently provides. Stay tuned for more information!
Richard Chu, Equity Analyst for the I/O Fund, contributed to this analysis.
Every quarter, we objectively review our portfolio for our earnings kickoff webinar to determine the strongest and weakest stocks. AMD topped our fundamental checks going into this earnings season due to its expected YoY and QoQ acceleration. The company is expected to post annual revenue growth of 13% for FY2024, accelerating to 28% growth in FY2025.
On a quarterly basis, the upcoming quarter is expected to be the bottom, with growth of 6.8% for June, growth of 14% in the September quarter, with further acceleration into the December quarter at 23% and the March quarter at 33%.
The future looks bright as the Client segment is expected to stabilize and the data center segment is expected to do its thing. Where there’s a will, there’s a way, and AMD is slowly making cracks in Nvidia’s Empire. The single most important announcement this quarter across our portfolio companies was the announcement of AMD’s acquisition of Silo AI. AMD plans to hit Nvidia where it hurts, which can be summarized in two words: open source.open source.
I fully expect AMD’s data center potential to take time to materialize, for the market to go through periods of doubting the stock, and for that to create immense opportunity for our portfolio. Those who have been with us for a while know that we are an incredibly patient analyst team; in fact, we first called AMD an AI stock about 4.5 years ago and the company is only now reporting actual AI revenue for the first time 2024. Per our analysis AMD: 2020 Premium Research:
“Nvidia remains my top AI choice as there is a better moat with the developer platform CUDA (in my opinion). AMD is my second choice in artificial intelligence and I find it fortunate the selloff has given me a second opportunity to build a position at a reasonable valuation.”
I can’t tell you exactly when the stock performance will match it’s AI potential, but I am uniquely skilled at finding semiconductor bottoms. We are at a fundamental bottom for AMD, and I doubt we return to this low of growth for the company for a very long time.
Financials:
These numbers will be updated Tuesday night with a report hitting your inboxes after hours. For now, here’s a preview of what to expect:
Revenue:
Management guided for revenue of $5.7 billion +/- $300 million, for growth of 6.4% at the midpoint. Analyst consensus is for revenue of $5.72 billion for growth of 6.8%.
September quarter is expected to report 14.1% for revenue of $6.6 billion.
December quarter is expected to report 23.2% for revenue of $7.6 billion
March quarter is expected to report 33% for revenue of $7.28 billion (December quarter is higher due to PC sales).
The rebound is also seen on a fiscal year basis where FY2023 reported growth of (3.9%) for revenue of $22.7 billion.
FY2024 ending in December is expected to report growth of 12.6% for revenue of $25.5 billion
FY2025 is expected to report growth of 27.6% for revenue of $32.6 billion
FY2026 is expected to report growth of 18.4% for revenue of $38.6 billion
Key Segments:
Last quarter, AMD reported data center revenue of $2.34 billion, up 80% YoY and up 2.4% QoQ. The guide for GPUs was originally $2B coming into this year, and the company is now guiding for $4 billion. Per management: “Expect data center segment revenue to increase by double-digit percentage, primarily driven by the data center GPU ramp.”
Another key point is that AMD’s Client segment is expected to increase sequentially. Last quarter, Client reported $1.37 billion, which was up 85% YoY yet down 6% QoQ. This segment has seen nothing but bloodshed for many quarters. Consider that in 2022, AMD peaked at $2.8 billion in quarterly revenue for the Client segment. Management’s guidance communicates that last quarter was the bottom: “Client segment revenue to increase sequentially.” Client segment revenue to increase sequentially.” This is key for AMD’s price action as Client is too big of a hit to offset GPUs ramping.
Gaming continues to weigh on results, reporting $922 million last quarter. Per management: “Based on current demand signals, gaming revenue expected to decline by significant double-digit percentage sequentially.”
Embedded revenue of $846 million was down (46%) YoY and (20%) QoQ. This segment is tied to automotive weakness. Per management: "Given the current embedded market conditions, we're now expecting second quarter embedded segment revenue to be flat sequentially with a gradual recovery in the second half of the year."
Zooming out, this is what management stated to expect for FY2024: “Sequentially, we expect data center segment revenue to increase by double-digit percentage, primarily driven by the data center GPU ramp. Client segment revenue to increase. Embedded segment revenue to be flat. And in the Gaming segment, based on current demand signals, revenue to decline by significant double-digit percentage.”
EPS:
Last quarter, AMD reported adjusted EPS of $0.62 with consensus seeing adjusted EPS turning up from here; meaningfully so in late 2024 and early 2025. This quarter is expected to report $0.68 in adjusted EPS for growth of 17.4% YoY. Over the next two to three quarters, we will see nearly a doubling in adjusted EPS.
September quarter is expected to report adjusted EPS of $0.94 for growth of 34.7% YoY.
December quarter is expected to report adjusted EPS of $1.24 for growth of 60.4% YoY.
March quarter is expected to report adjusted EPS of $1.15 for growth of 85.3% YoY.
Margins:
AMD’s gross margin last quarter was 47% versus Nvidia’s 78%. In 2022, before the AI boom, AMD’s gross margin was 45% versus Nvidia’s 65%. This is one of the reasons Nvidia has historically had a premium valuation. AMD undercuts Intel on price, and this is the strategy with Nvidia going forward, as well.
AMD reported a gross margin of 47% last quarter.
Management guided for adjusted gross margin of 53%, and if reported, will be a 100 bps improvement from last quarter. This will also mark the highest adjusted gross margin in two years. This will represent adjusted gross profits of $3.021 billion.
Last quarter, AMD reported a GAAP operating margin of 1% for operating profits of $36 million. This is very low as AMD had a GAAP OM of 22% in FY2021.
The adjusted operating margin guide is for 21%, which if reported, will be flat QoQ.
Net margin last quarter was 2% for GAAP net profits of $123 million. We’ve seen up to a 26% GAAP net margin in FY2020.
Adjusted net margin was 19% for adjusted net income of $1.01 billion.
Cash:
Last quarter, AMD reported $521 million in operating cash flow for a OCF margin of 10%. This was a nice 400 bps uptick from the previous quarter, which reported a 6% OCF margin. We’ve seen up to a 25% OCF margin for AMD in Q2 2021.
Last quarter, AMD reported free cash flow of $379 million for a FCF margin of 7%. The company has cash and short-term investments of $6.03 billion and debt of $2.46 billion.
Stock based compensation is 7% of revenue.
Silo AI Acquisition
We had stated on our most recent webinar that we want to give AMD the space to fill the very big shoes an Nvidia contender has to fill. A good example of AMD playing the long-game is the acquisition of Silo AI for $665 million. This is Europe’s largest AI-related acquisition, sizably larger than the acquisition of DeepMind by Google for $400 million in 2014.
The company is known for its pool of AI talent, with experience in training large language models on AMD Instinct GPUs. These custom, open source LLMs called Poro and Viking are multilingual and can be customized and applied to many end-markets. Poro is a 34 billion parameter model that is cross-lingual for Europe’s 24 official languages and offers AI sovereignty by allowing companies or countries to create proprietary models. Viking is a 7 billion parameter model and highlights Silo AI’s unique approach in developing smaller LLMs for Nordic languages. These low-resource languages lack large training data sets. There are also 13B and 33B parameter Viking models, but the point is to not have to use hundreds of billions of parameters or even trillion+ parameter models being developed by OpenAI and Deep Mind/Google’s Gemini. Instead, Silo AI rivals LLMs such as Mistral and Meta’s Llama in English, yet processes multiple Nordic languages and programming code.
The official announcement for the 7B Viking LLM provides a clear message on why Silo AI was acquired by AMD: “With a purpose-built software layer to train models on AMD, Silo AI and TurkuNLP possess unmatched experience with training on AMD at scale, having shown that their theoretical predictions for throughput scaling materialize in weak and strong scaling experiments. As one of the seminal initiatives on AMD GPUs, this shows how it’s possible to achieve good throughput on the AMD-based LUMI, training the models with their open source training framework and utilizing up to 4096 MI-250X GPUs simultaneously.”
Our original thesis on Nvidia centered around the CUDA moat. This moat is fully in tact today, and has helped Nvidia enjoy unrivaled pricing power. Silo AI greatly speeds up AMD’s open-source software effort, which is the critical piece to AMD’s strategy as CUDA is closed-source and proprietary.
As the Forbes article points out, Hugging Face has partnered with AMD to run AI models on Instinct GPUs. Meta and OpenAI have ordered AMD’s new GPUs. From there, these companies can also open source their frameworks and models to help speed up time to market for smaller teams.
These large R&D departments are sophisticated enough to circumvent CUDA and program custom silicon or program competing GPUs if the total cost of ownership (TCO) presents a compelling reason. AMD’s MI300s go for $15,000 and as low as $10,000 when sold in bulk. Meanwhile, Nvidia’s GPUs go for an average of $35,000.
I first covered this in March of 2020 when our analysis pointed out: “It’s estimated that for every $1.00 in Rome chip sales, Intel loses $2.25 on average in Intel Xeon SP sales. The savings are then deployed to buy more Rome chips, which can further depress Intel’s revenue.”$1.00 in Rome chip sales, Intel loses $2.25 on average in Intel Xeon SP sales. The savings are then deployed to buy more Rome chips, which can further depress Intel’s revenue.”
“From there, AMD undercuts Intel on price, which becomes a virtuous cycle as driving down costs means more chips will be bought from AMD. […] In the past, AMD advertised up to 20% Capex savings compared to Intel based on Epyc processors delivering more performance from a single chip compared to Intel’s dual-processor powered by two CPUs. Big Tech has capex budgets into the tens of billions. Although it’s not specifically disclosed exactly how much goes toward AI acceleration, we know that Big Tech is driving forward Nvidia’s GPU sales at $8 billion per quarter or $35 billion to $40 billion per year.$8 billion per quarter or $35 billion to $40 billion per year.
Here is the thesis in a nutshell: If a competitor can deliver 20% savings on this kind of budget with similar performance, then it will turn heads. We can geek out all day long on the computing performance of Nvidia’s H100 GPU, however, if the MI300s drive down total cost of ownership through low unit pricing, better power efficiency and reducing the number of GPUs required, then hyperscalers will line up to support this.
What Google, Amazon, Microsoft, Meta and large enterprises want most of all is to build incredible AI systems but at a manageable cost. This goes back to the virtuous cycle. The more they save, the more they can build.”
As Big Tech becomes pressured over their capex spend, it will only be natural that AMD is evaluated as an option to help alleviate this massive AI infrastructure spend.
Conclusion:
The future is bright for AMD. This company has what it takes to make cracks in the Nvidia GPU data center Empire. For our purposes, we think AMD could take up to 20% market share of the GPU data center, although it would take up to a decade for this to materialize. We are basing this estimate on what AMD has achieved in gaming GPUs, and the market share dynamic 80/20 on data center CPUs with Intel.
Equally important, AMD is a frontrunner on the Client side for AI. The company spans both x86 and Arm architectures for AI devices, and has the Xilinx acquisition waiting in the wings once automotive heats up again.
In our webinar, we had stated that a great tech story should have financials to match. AMD ticks this box, as well, with a rebound into the second half of this year and early next year. You will get an update from us post-earnings that looks at the gritty details of the report. But let me emphasize well ahead of time that we are in no rush for AMD’s AI story to materialize, as our sights our firmly on the horizon.
Watch Portfolio Manager Knox Ridley as he covers the broad market, Nvidia, Broadcom, and Bitcoin.
Broad Market
Nvidia, Broadcom, and Bitcoin
Pro premium members receive deep-dive research on all the stocks in the portfolio and participate in the quarterly earnings kickoff webinar. In addition, the Advanced Market Signals Members receive regular technical and broad market analysis, weekly webinars from our Portfolio Manager, Knox Ridley, hedge signal, and trade alerts. We booked a total 275% gain on Super Micro in early May across all entries and exits. Also, we booked sizable gains in two cybersecurity stocks in April. Learn more here.We booked a total 275% gain on Super Micro in early May across all entries and exits. Also, we booked sizable gains in two cybersecurity stocks in April. Learn more here.
Lam Research reports its fiscal Q4 (June quarter) earnings next week on July 31, following a dismal market reaction to peer ASML’s report last week. Estimates are rather muted heading in to Lam’s report, though sentiment seems to have drifted sharply lower as semiconductor stocks declined 9% through the end of the week of July 19th.
Management has guided to $3.8 billion in revenue in Q4, approximately flat QoQ but up 18.5% YoY against weak comps from the rapid downturn in the memory market in 2023. Lam is expected to close the year with revenue and EPS both declining in the mid-teens YoY, with Q4’s strong YoY growth offsetting first half softness.
Revenue and EPS
Lam is expected to break its five-quarter streak of declining revenue on a YoY basis in Q4, with revenue growth accelerating more than 20 percentage points to ~18.5% YoY. EPS growth is expected to follow suit, with management guiding for operating margin to expand sequentially.
Analysts project Lam to report 19.4% revenue growth in the quarter to $3.83 billion, at the very high end of management’s guided range. This would represent a revenue acceleration of 2140 bp QoQ. Raymond James last month said that it expects “sector fundamentals to remain strong into 2025 due to secular growth from Gen AI, aggressive government subsidies around the world, multiple technology transitions, and intensifying competition among foundry suppliers.” Revenue is expected to increase sequentially by more than $200 million in each quarter in fiscal 2025.
For Q4, management guided revenue at $3.8 billion, +/- $300 million, for a YoY increase of 18.5% and approximately flat QoQ growth.
Management guided for GAAP EPS of $7.20, +/- $0.75 and adjusted EPS of $7.50, +/- $0.75, for adjusted EPS growth of 25.4% YoY. Analysts expect Lam to report $7.58 in adjusted EPS in Q4.
For FY24, revenue is expected to be $14.87 billion, for a YoY decline of (14.7%).
For FY24, adjusted EPS is expected to $29.75, down (12.8%) YoY.
Current estimates for FY25 point to revenue of $17.66 billion, up 18.8% YoY, and adjusted EPS of $36.56, up 22.9% YoY.
As we had noted in April, Lam’s rebound through 2025 is primarily dependent on NAND recovering. Discussions around the incoming NAND rebound will be important, as well as discussions on DRAM given the surge in HBM we’ve seen to accompany rising GPU shipments.
Margins
Though management guided for gross margin to decline sequentially in Q4, there is some strength down the line, with operating margin expected to expand. China mix is also impacting margin positively, with Lam seeing gross margin as high as 48% compared to normalized levels of 46% when China’s revenue share is high.
For Q4, management guided GAAP operating margin (above) at 46.7%, +/- 1%, implying a slight 80 bp QoQ contraction but a YoY expansion of 120 bp. Adjusted gross margin was guided at 47.5%, +/- 1%, a 120 bp QoQ contraction.
GAAP operating margin was guided at 28.3%, +/- 1%, a 40 bp QoQ and 170 bp YoY expansion. Adjusted operating margin was guided at 29.5%, +/- 1%.
Lam’s net margin has remained strong, with GAAP net margin at 25.4% to 25.5% in each quarter of FY24 so far.
Management shed some light on margins in the longer term as it begins to ramp up output in Malaysia, which is expected to be margin accretive due to cost advantages:
CEO Timothy Archer: “I think that we've built now a global footprint for our manufacturing and supply chain that makes us significantly more resilient. It allows us to scale much faster to the demand that we see coming in the future. And also improve our gross margin looking forward. And I think that as we move through these next cycles of industry upturn, companies and our output hitting new highs, the real power of that new manufacturing and supply chain infrastructure will really start to come to bear in our profitability.”And also improve our gross margin looking forward.And I think that as we move through these next cycles of industry upturn, companies and our output hitting new highs, the real power of that new manufacturing and supply chain infrastructure will really start to come to bear in our profitability.”
Cash and Debt
Cash flows have been strong for Lam despite the tough macro backdrop in the first half of the fiscal year.
Operating cash flow was $1.38 billion in Q3, a 36.5% margin. YTD operating cash flow is $3.79 billion, down (6.6%) YoY, and for a margin of 34.3%. Operating cash flow for FY24 is projected to be $5.04 billion, implying $1.25 billion in OCF in Q4, a 11.3% YoY increase and representing a 32.9% margin.
Free cash flow was $1.28 billion in Q3, a 33.7% margin. YTD free cash flow is $3.49 billion, down (3.9%) YoY, and for a margin of 31.6%.
Cash and equivalents totaled $5.67 billion.
Debt totaled $4.98 billion.
Key Metrics
For Lam’s upcoming Q4 report, memory sales mix will be closely watched, as non-volatile memory (NVM) recovers, a sign of the upcoming recovery in NAND.
Memory accounted for 44% of systems revenue in Q3, down from 48% in Q2, but up from 32% in the year ago quarter. DRAM accounted for 23%, with NVM accounting for 21%. NVM has recovered from 15% in Q2, but it remains far below its peak at the 40% range, seen during the prior cyclical peak in 2022.
In terms of geographic concentration, similar to its WFE peers, Lam has high exposure to China currently, with the nation accounting for more than 40% of revenue each quarter this year. While this has provided some margin tailwinds, it also presents a real headwind as export restriction tensions escalate.
It was discussed in-depth in Q3’s earnings call that China revenue is first-half weighted and revenue is expected to decline as the year progresses. Also, in the Q&A, it was brought up that management is possibly expecting more weakness as the year progresses due to customers being blacklisted – this was not confirmed directly but also was not denied.
Second to China in terms of revenue contribution is Korea, at 24%, followed by Japan and Taiwan at 9% each and the US at 6%. Korea is a key geographic market to track, given its significant global share in both DRAM and NAND. Over the past two quarters, Korea has increased its revenue share, rising to that 24% level from 19% in Q2 and 16% in Q1, hinting at NAND spending resuming and utilization ticking higher.
Noteworthy Points to Watch
As just mentioned, NAND’s recovery looks as if it is beginning to unfold with the first signs in NVM revenue share ticking higher. Management offered some perspective last quarter on what 2025 could look like for NAND, stating the following:
“I mean, clearly, we all know that the NAND spending has been incredibly weak for the last 12 to 18 months. And so we're in the very early stages of starting to see that recover. And I think if you look at what most of our — we rely on our customer commentary that they make publicly for a lot of this, but they talk about the fact that maybe 90% of the bits they're shipping are at the leading edge.
But when we look at the installed base of our systems, that was my comment. I believe that there is still going to be a large portion of the installed base that will move forward to the next technology nodes. It's the most efficient way for our customers to to do that is to upgrade what they already have. And I think you'll see that move forward and therefore, NAND WFE move up in '25. But because it comes through a large — to a large degree, through upgrades, Lam's capture rate of every dollar of WFE spend will be much higher than in a greenfield capacity added. So when I think about Lam's opportunity to outperform in 2025, in NAND, I think it is obviously with high confidence because of the type of spending we would expect to be seen in 2025. And in the other market segments, it's also pretty high because of the — as I mentioned, the technology inflections that are occurring […] And so I just feel like there are a number of growth drivers for the company besides the one that is the most obvious, which is a NAND recovery in 2025.”I believe that there is still going to be a large portion of the installed base that will move forward to the next technology nodes. It's the most efficient way for our customers to to do that is to upgrade what they already have. And I think you'll see that move forward and therefore, NAND WFE move up in '25. But because it comes through a large — to a large degree, through upgrades, Lam's capture rate of every dollar of WFE spend will be much higher than in a greenfield capacity added. So when I think about Lam's opportunity to outperform in 2025, in NAND, I think it is obviously with high confidence because of the type of spending we would expect to be seen in 2025. And in the other market segments, it's also pretty high because of the — as I mentioned, the technology inflections that are occurring […] And so I just feel like there are a number of growth drivers for the company besides the one that is the most obvious, which is a NAND recovery in 2025.”
In the upcoming report, management’s commentary on the NAND recovery will be closely watched, as will NVM’s revenue share, given the emphasis placed on NAND as one of the primary growth drivers in 2025.
While this may seem a bit obvious, ultimately, Lam’s revenue guide for fiscal Q1 2025 will be a crucial data point for both Lam and the WFE manufacturers. ASML’s results, which sparked that sharp selloff across semis last week, saw strong net bookings but a Q3 revenue guide short of consensus, with the EUV maker expecting €6.7B to €7.3B in revenue versus the €7.5B consensus estimate. Analysts are expecting a strong report for Lam, with the consensus estimate at the high end of management’s guidance, and Q1’s estimate for $4.03 billion pointing to a 5.2%, or $200 million, sequential increase.
Valuation
Lam is trading above its median top line and bottom-line valuations, even with its steep sell-off after ASML’s earnings.
On the top-line, Lam trades at 8.9x trailing sales, and 7.1x forward sales with the rebound in sight. Looking back to 2021, Lam peaked at a trailing 7x sales multiple, so it’s currently trading above its peak multiples withheld historically as well as more than 40% higher than its 5-year average multiple of 5.2x for both trailing and forward sales.
Lam’s bottom line strength offers a bit more breathing more in the valuation, though it does remain stretched with a thin margin for error. Lam is trading at 35.3x trailing PE and 26.3x forward PE, again with EPS expected to rebound 23% YoY to $36.56. Again, while these multiples are elevated compared to Lam’s 5-year average in the 20x to 21x range, on a forward basis, Lam is trading at the same valuation as it entered 2024, around 26x, despite a nearly 30% YTD rally.
Conclusion
Lam’s fiscal Q4 report next week will hopefully show more growth and progress in the unfolding NAND rebound, which we had said we were a tad early to in April this year. We still see DRAM and HBM as a major growth opportunity in the AI semiconductor space, with Nvidia and AMD showing no signs of slowing in GPU development or revenue growth; however, NAND is expected to be a core growth driver for Lam moving through 2025.
Revenue growth is expected to be flat sequentially in Q4, before rising sequentially in each quarter of fiscal 2025, with earnings growth to follow. Cash flows also have remained quite strong despite the weak first half of the year. We’ll be keeping track of how this recovery will unfold next week, even if this report may not be enough to justify Lam’s elevated valuations in the near-term.
Damien Robbins, Equity Analyst at the I/O Fund, contributed to this article.
The market is currently pricing in up to three rate cuts this year, which is putting pressure on Magnificent 7 stocks, defined as Apple, Alphabet, Amazon, Meta, Microsoft, Nvidia and Tesla. Due to their global exposure, heavy cash positions and positioning within the growing AI trend, they have been perfectly situated to benefit from a bifurcated and complex macro environment. Because of this, the Mag 7 has significantly outperformed the broad market, and also led it higher for nearly 2 years.
To put this into perspective, the first six months in 2023 was the biggest 6-month rally in Nasdaq history – and since then, over a year ago now, the NASDAQ has plowed through key levels to reach a staggering 72% return in a little over 21 months. It’s not only the returns we’ve seen in 2023 and 2024 that are unusual, but the fact it happened back-to-back. Tech investors can thank the Mag 7 for this spectacular outperformance.
However, we are now getting evidence that a change is happening. As excitement over reduced rates has investors rotating into beaten down small caps and consumer facing stocks that have sat out tech’s historic rally.
By not participating, small caps and other pockets in tech that are more traditionally cash-strapped are now undervalued. Optimism around the Fed could spark a continuation of the relief rally in the Russell 2000 and further rotation out of the Mag 7. Below, we look at the pros and cons of a Mag 7 rotation and how we plan to personally handle this shifting landscape.
Why The Mag 7 Worked
The complexity of this business cycle can’t be overstated. On one hand we are seeing one of the longest and steepest yield curve inversions in market history. This signal has a near perfect track record of predicting recession, which is being backed up by a weakening consumer, and a deep and prolonged manufacturing recession that is now filtering into the services sector. On the other hand, corporate profits are healthy, the job market remains relatively tight, and AI is creating a new economy that is driving historic top line and bottom line growth for the AI leader (we think there will be many moremany more beneficiaries beyond Nvidia).
This bifurcation within the economy can be seen in equity markets. For example, markets that are dependent on a strong consumer, thrive with lower interest rates, or in need of cheap money to expand – like high beta tech, small caps, real estate, consumer discretionary – are still well below their 2021-2022 highs.
At the same time, we are seeing markets that have global exposure, flush with cash and are not dependent on the consumer, all well above their 2021-2022 highs. This is most obvious with the Mag 7, who were leading this market higher in early 2023, and continuing into today.
For this reason, we need to take a closer look at select charts within the Mag 7 to get an idea on where the market is going over the short-term, as well as the medium to long-term.
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Certain Stocks Within the Mag 7 Continue to Provide Clues
Our broad market analysis in 2024 has been focused on the relative performance of the Mag 7. Without question, these 7 stocks are the most important stocks in the current bull market. Historically, as long as the cycle leaders continue to move higher with the market, all is well. However, as stated in our March Report…
“When the cycle leaders start to underperform, it tends to mark the start of a trend change. The Magnificent 7 have been the undoubted leaders of this bull run, and we are now seeing them start to trend lower against the indexes. More times than not, the leaders on the way up, tend to be the leaders on the way down.”
This was the pattern that warned us about the April selloff, and again in July.
What followed our March report was a 6.3% drop in the broad market. However, high fliers like NVDA and META dropped 22%, TSLA dropped an additional 32% while the rest of the Mag 7 dropped between 15% – 10%.
Since then, the market has recovered and resumed the bull market higher; however, we have seen new leadership emerge from the Mag 7. Since the April 19th low, the S&P 500 is up +12%, while Apple is up 32%, Nvidia is up 64% and Tesla is up 77%. Lead Tech Analyst, Beth Kindig, pointed out on Bloomberg Asia that Tesla was simply trading too low at the time, and to look for a bounce.
What is interesting is that the same pattern that we saw from the Mag 7 in early March, was also warning investors leading into the July 16th high.
Nvidia first started making lower highs on June 10th, followed by Tesla on July 10th, and then finally Apple on July 15th. So, while the broad market continued to make higher highs, it was doing so without its leaders, signaling that trouble is likely ahead.
What The Majority of the Mag 7 is Saying Now
The divergence above within the Mag 7 stocks warned us of the coming volatility. We can use further analysis of these important stocks to help tell us what the market may do next.
Of the Mag 7 charts, Apple, Microsoft, Nvidia, Amazon and Google are the clearest. They all suggest that what we are seeing is a correction within a larger uptrend, and that it is likely that we see higher levels in the coming weeks. While Meta and Tesla can be interpreted in the same way, they are not as clear as the ones we will discuss below. For reference, the 5 stocks below account for ~28% of the S&P 500, and should have a very strong correlation on the direction of the broad market over the coming weeks to months.
Nvidia
Nvidia is the most important stock in the current bull market. Within the most recent bull market, it has gone from a top 25 stock in the S&P 500 to now the 2nd most valuable company in the U.S. due to its positioning within the new AI trend. Our firm was the first to lay out NVDA’s path to becoming the most valuable company in the world. Now that it has surpassed Apple, we further presented how it has a clear path to becoming a $10 Trillion Company by 2030.
Since the 2022 low, NVDA has been tracing out a very large 5 wave pattern higher. Note the vertical move higher in early 2024. This was met with max volume and max momentum to the upside. This is the marker that you are in the most powerful moment of a trend, which is the 3rd wave. This is also around the halfway point of the entire 5 wave pattern.
The pattern appears to be incomplete. Even though NVDA topped early, the drop is a clean 3 wave pattern within an incomplete uptrend. We still need a 5th wave to new highs in order to complete the larger 5 wave move.
Nvidia may have one more drop into the $113 region before bottoming, but appears to be developing a bottom right now. Look at the momentum indicator below. It is bottoming in the exact same region the April low tagged, and it is doing so while price is much higher. These are the type of bottoming signals we look for when degerming a low is close within a developing uptrend. As long as any further drop holds $103, we expect NVDA to push higher.
Apple
With Apple’s push into bringing AI to the consumer, coupled with the likelihood that the Fed will lower rates soon, Apple has stopped becoming a laggard and is instead one of the leading Mag 7.
It appears to be a bit further along in its uptrend pattern off the 2022 low. While NVDA needs a large degree 5th wave, Apple is missing a smaller degree 5th wave. Like NVDA, the pattern is incomplete while giving us clear bottoming signals.
Note how the momentum indicator is making a lower low from the June low into today’s low. This is happening while price is making a higher low. This is the type of pattern we see in on-going uptrends, and supports that we should see another swing higher into late summer/early fall. As long as Apple hold over $206, we expect to see this move higher manifest.
Microsoft
Our firm recently closed MSFT for a sizable profit due to valuation concerns. While the chart does suggest it has one more swing higher, we see other stocks within tech having more upside in both valuations and technical targets. For this reason, we have rotated these gains into Nvidia, as well as other AI stocks that we have been targeting for months.
However, like Apple and Nvidia, Microsoft is a bellwether for the broader market and an important stock to cover. It is very rare to see MSFT move against the market, and when it does, it is a sign of a brewing trend change.
The below chart shows a very mature uptrend off the 2022 low. We have a very large 5 wave pattern that is suggesting it has one more swing left. This would be wave 5 of a larger 5th wave, and is estimated to be anywhere between 8 – 15%.
We are seeing similar bottoming patterns in MSFT as we saw in AAPL. Microsoft appears to be completing what looks like a 4th wave drop. As long as any further weakness holds $406, I expect a final 5th wave push in the coming weeks.
Amazon
Amazon looks a lot like MSFT and AAPL. It is tracing out a 5 wave pattern and needs the final 5th wave higher to complete the uptrend. The current drop also appears to be a 4th wave and showing bottoming signals like the above charts. As long as AMZN can hold $174.50, we expect a 5th wave bounce in the coming weeks.
Google
Google is making a lower high while it is at extreme oversold conditions. Like the above charts, it looks like it needs one more high to complete the larger 5 wave pattern. As long as any additional weakness can hold $169, it looks like it needs a 5th wave bounce to complete the bigger uptrend.
Broad Market
The broad market in the S&P 500 is signaling the same push higher that we are seeing in the above key stocks. While it appears that we have another move higher to look forward to, according to the larger pattern in play, the next move will likely be the final move we see before having to contend with, at best, a multi-month and deep correction.
The pattern that the S&P 500 is tracing off the 2022 low is what is called an ending diagonal pattern. It is the only pattern that can account for the messy, overlapping moves that we have seen in both directions. The only question is what degree of a 5 wave pattern is in play, which is what my two counts represent.
Green – This count has the 2022 bear market as a large degree 4th wave in the secular bull market that started in March of 2009. That would put us in the final 5th wave, which is developing as a large ending diagonal pattern.
These patterns are 5 wave patterns that overlap. More times than not, the 4th wave will go be so deep, as to move into 1st wave territory. The next swing higher would be the final move in the 3rd wave, which would be targeting 5850 – 6340. Once this 3rd wave ends, the 4th wave would likely be a multi-month drop and on the larger side of a bull market correction. This would set up a tremendous buying opportunity, once completed.
Red – This count has us in a smaller degree ending diagonal pattern. It has an extended 5th wave that is playing out. The targets would be the same as above, 5850 – 6340 SPX. However, unlike the green count, we would not see a 5th wave to new highs, but instead a lower high in a much larger downtrend.
As long as any further weakness holds over 5375 – 5200, we should continue to see the bull market continue for another move higher. Below this level decrease the odds of this happening. The final support for any pattern that can take us higher would be 5,200. Below this level and the larger period of volatility will have likely begun.
Small Caps
The June CPI numbers came in softer than expected. This coupled with weakening economic data, triggered the market into a rotation based on the expectation that the FED will have to cut rates sooner rather than later. As a result, the Russell 2000 is up about 9% from that moment, while the Mag 7 are down an average of 13%. Furthermore, we are seeing an expansion of breadth into more consumer based value stocks as well as some high beta names.
As stated, it appears that the majority of the Mag 7 and the S&P 500 are supporting another push higher. This is also supported by small caps. The benchmark for small caps, the Russell 2000, for example, appears to be in a 4th wave correction, which is around the halfway point of the move higher. As long as any further weakness holds $211 (IWM), like the rest of the markets and stocks we covered, it should continue higher before putting in a more meaningful top.
The broads Small Cap Index is also suggesting that a low is being put in and we should see another swing higher. The upside pattern is incomplete and likely around the halfway point of the move higher. However, we do still believe this is a stock pickers market, so we have positioned some of our portfolio into select small cap positions that have exposure to AI. While the rotation into small caps may continue, it looks like the bulk of this rotation is complete, as the broad market is setting up the next leg higher.
Realized Volatility
Realized volatility (RV) is a measurement of price swings on a day-to-day basis. The lower RV is, the smaller swings in either direction are to be expected. Ideally, you want to see RV trending lower as price moves higher. This tends to mark a healthy uptrend.
The best way to think about Realized Volatility is as a measurement of liquidity entering or exiting the markets. The more liquidity there is, the smaller the moves we tend to see, as the market continues to grind higher. The higher Realized Volatility goes, the less liquidity is in the market – i.e., big money is raising cash, which can cause larger swings in the market.
What matters to me is how Realized Volatility is trending with the market. This is what we are seeing today. Look at the 10-day, 20-day and 30-day measurement of Realized Volatility is trending up with price. The last time RV hit these levels that we last around the April low. This is significant, as it is indicating that liquidity is leaving the markets while price is much higher.
As long as Realized Volatility continues to trend higher with price, it is a warning that liquidity is exiting. However, this also means that less liquidity can propel the markets higher up to several months.
Note the two most recent periods this happened – 2020 and 2022. Once we saw RV start trending higher with price in 2022, we only saw a 5% move higher over a 1.5 month period. However, in 2020, this trend lasted for +3 months and led to a 10% swing higher in the markets.
Conclusion
In conclusion, the stage is set for a meaningful move higher, if we can see SPX break above 5670. While less liquidity tends to mark the early warning of trend reversals, it also means that any bullish catalyst can propel the markets higher in larger than normal daily swings. This lines up with what the majority of the Mag 7 is suggesting – a 5th wave rally to new highs is needed to complete the larger uptrend.
As long as the supports listed hold, this is what we are expecting. While the next move higher could last anywhere from a few weeks to several months, it’s important for investors who are buying the dip to realize the risks involved within the larger picture. While being nimble can pay off handsomely in moments like this, not having a risk management plan can do the opposite once the market rolls over.
If you are sitting on outsized gains from the current bull market, looking to protect those positions, or interested in owning AI leaders at reasonable prices, join us each Thursday, at 4:30 EST for our premium members webinar. This week we will discuss our risk management plan, buy and trim targets for various AI positions as well as crypto. Learn more about I/O Fund’s premium services herepremium services here.
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
Marvell is one of the earliest semiconductor stocks we’ve covered on our site, dating back to November of 2019 when we first covered application-specific integrated circuits (ASICs), commonly known as custom slicing. Despite having a clear AI story, Marvell has lagged other AI stocks over the past year:
Our last position in Marvell was bought at $56.90 in June of 2023 and closed at $77.19 in March of 2024. Not bad, but not great. At the time of closing the stock, it was becoming clear that Broadcom was the stronger near-term story when my last analysis stated: “As I left the Marvell call and moved along to join the Broadcom earnings call, there is no doubt which company is stronger right-here, right-now. It’s Broadcom. Marvell has a strong product story but it’s in a sea of AI whales that are ramping quickly.”
Despite closing Marvell, the stock remains on the list of our top 10 ideas. There is abundant AI potential buried by other segments that are in a steep, cyclical trough. As we look on the horizon, CY2025 has the makings of a solid comeback for this often-overlooked AI stock.
Marvell’s Fiscal Q1 2025 Financials:
For fiscal Q1 ending in April, Marvell reported revenue growth of (-12.2%) for revenue of $1.16 billion. This marginally missed estimates by (-0.1%). The revenue growth is the lowest since we’ve tracked the stock, dating back to 2021. According to analyst consensus, this should mark the bottom with sequential growth of 8% next quarter.
For fiscal Q2 ending in July, management guided revenue of $1.25 billion, at the midpoint, representing a decline of (-6.8%). According to consensus, this will be the first quarter to report sequential growth of 7.8%, and the sequential growth is expected to continue.
Here is some more information on the rebound that is materializing:
Fiscal Q3 ending in October is expected to report (-0.9%) YoY for $1.41 billion, which will represent QoQ growth of 12.8%.
Fiscal Q4 ending in January is expected to report 11.3% YoY for $1.59 billion, which will represent QoQ growth of 12.7%
Fiscal Q1 ending in April is expected to report 39.76% YoY for $1.62 billion, which will represent QoQ growth of 1.9%.
When looking on a fiscal year basis, it’s easy to see that Marvell’s stock is struggling due to cyclical segments. This is not unique to Marvell as the recovery in consumer electronics, automotive, and telecom has taken longer than anticipated. As a reminder, these segments surged during the pandemic and during a long period of quantitative easing. Now, semiconductor companies are collectively weathering a deep trough that began in CY2022.
For FY2025 ending in January, analyst consensus is for (-1.88%) on revenue of $5.4 billion – yet, twelve months ago, FY2025 estimates were for growth of 17.8% for revenue of $8.40 billion. What’s interesting is that AI is doing better than expected, and it’s the other segments that created the twelve-month disparity.
For FY2026, the estimates have gone up but not due to higher revenue, rather due to lower comps. The growth rate of 32.6% for FY2026 is expected on revenue of $7.17 billion. This is a bit lower than the $7.52 billion expected for this fiscal year twelve months ago.
What this situation represents is a lack of confidence in both management’s tone and analysts’ financial modeling in predicting when consumer-driven segments will see a sustained recovery.
Marvell is not GAAP profitable due to recent acquisitions and the related costs, and also stock-based compensation sits at 11% of revenue.
In the most recent quarter, the company reported GAAP EPS of ($-0.22) which missed estimates of (-$0.25). Adjusted EPS of $0.24 was in line. According to analyst estimates, this is expected to be the bottom with sequential growth beginning in the July quarter.
For the upcoming quarter ending in July, the company is expected to report adjusted EPS of $0.30, representing a YoY decline of (-9.78%).
Here is what the rebound looks like on the bottom line. We can reasonably assume Marvell will be GAAP profitable again sometime during FY2026. Notably, this depends on the other segments as growth in AI accelerators (custom silicon) weighs on margins.
On a fiscal year basis, Marvell is expected to see the following:
FY2025E adjusted GAAP EPS of $1.40 for a decline of (-7.5%)
FY2026E adjusted GAAP EPS of $2.46 for growth of 76%
FY2027E adjusted GAAP EPS of $3.33 for growth of 35%
Key Segments:
For the past two quarters, the data center has been growing rapidly, and has reached a historical high. This is notable given Marvell completed a large data center-focused acquisition a few years back (Inphi) which provided immediate, accretive data center revenue.
Data center revenue in the current quarter was $816.4 million, up 87% YoY and up 7% QoQ. This is on the heels of another historic data center quarter of $765.3 million, up 54% YoY and up 38% QoQ. The data center outperformance comes from electro-optics and interconnect products, whereas custom silicon saw “initial shipments” in the quarter. Looking to next quarter, management expects data center to grow in the mid-single digits “as our custom AI silicon continues ramping.” It was mentioned on the call that optical interconnects are up against a tough comp, and thus, will be flat QoQ but will still perform well YoY.
“I'd say in the short-term, the way to think about the optical business into July is we're modeling it right now and our guide is flattish to slightly up. And the reason for that is we outperformed pretty big both in Q4 and Q1. […] So as we look into July, we're modeling it to be flat to slightly up, it may do better, let’s see order trend come in. But year-over-year will be very strong because also in the second half to your point, those traditional standard cloud infrastructure build-outs and upgrades are going to happen.”
Of this, the company is expected to exit the year with a minimum of $1.5 billion in AI revenue in FY2025. About a year ago, we had published that Marvell was on track to report 14.4% in AI revenue when the company doubled its AI expectations to $800 million, up from $400 million.
With the current update of $1.5 billion provided in April at the AI Investor Day, the company is now on track to report 27.8% in AI revenue. Per management comments, the $1.5 billion is a “floor” and there was discussions in the Q&A on the likelihood the FY2025 exit rate will be higher in the next few months.
Brace yourself, however, as the other segments are deep in the red:
Carrier infrastructure was down (75%) YoY and down (58%) QoQ for $72 million. Carrier infrastructure is expected to be flat sequentially next quarter. According to commentary, the recovery in this segment is harder to predict than the others. The company is shipping a new 5nm DPU product next year that is expected to help expand 5G market share.
Enterprise networking was down (58%) YoY and down (42%) QoQ for $153 million. Enterprise networking is also expected to be flat sequentially. The recovery is expected to begin in the second half of this fiscal year.
Consumer was down (70%) YoY and down (71%) QoQ for $42 million. This segment has been weighed down from a soft gaming market, yet Marvell’s primary customer is expected to rebound and the segment is expected to double on a sequential basis.
Automotive was down (13%) and down (6%) QoQ for $78 million. This segment is expected to be flat sequentially yet will resume growth in the second half of the fiscal year.
Margins:
Gross margin in the current quarter of 45.5% is low and there were questions on the call about this (see below). Ultimately, the AI story weighs on Marvell’s gross margins but does not affect the operating margin. The guide for next quarter is gross margin of 46.2%. This will represent gross profits of $577.5 million.
Adjusted gross margin of 62.4% in the most recent quarter with a guide of 62% next quarter is low compared to the historic adjusted gross margin in the 65% range. Next quarter, adjusted gross profits are expected to be $775 million.
GAAP operating margin last quarter was (13.1%) and this is certainly a blemish in the report. Next quarter, GAAP operating margin is expected to be (8.8%) for a GAAP operating loss of $110.5 million.
Adjusted operating margin of 23.3% last quarter is lower than the historic adjusted OPM in the mid-30% range. Adjusted operating margin in the upcoming quarter is expected to be 25.6% for adjusted operating profit of $320 million.
Net margin last quarter was (18.6%) and adjusted net margin was 17.8% for adjusted net profits of $206.7 million.
Cash Flow:
Cash flow for Marvell is decent yet the debt-to-equity ratio is high.
In the most recent quarter, the operating cash flow was $324.5 million for a margin of 28%. The free cash flow was $232.5 million, for a margin of 20%. This is lower than usual due to annual employee cash bonuses. Inventory was $826 million, decreasing $38 million from the prior quarter. On a year-over-year basis, inventory has been reduced by $200 million or 20%. Days sales outstanding decreased 8 days to 69 days.
The company has $847.7 million in cash on the balance sheet and has $4.15 billion in debt. The company’s net debt to EBITDA ratio is 1.8X and the gross debt to EBITDA ratio is 2.27X.
In the recent quarter, the company returned $52 million to shareholders through cash dividends. The company also repurchased $150 million of our stock during the first quarter, an increase of $50 million from the prior quarter with expectations to increase repurchases in Q2.
Quick refresher on Marvell’s Products:
Marvell offers 200-gig, 400-gig and 800-gig PAM-based electro-optics. The 800-gig is the primary interconnect for AI deployments. The company is qualifying a 1.6T solution with 200-gig per lane for the next leg up in AI acceleration. For the 1.6T solution, Nvidia will be a lead partner. Here’s a video on Marvell and Nvidia’s partnership on optical interconnects.
Electro-optics help to increase data rates and has replaced NRZ data transmission due to doubling the bit rate. Hyperscalers require high bandwidth and port density. PAM4 connects networking ASICs and machines, like servers and AI machines. Digital-based PAM4 uses analog-to-digital converters to clean up the signal in the digital domain before converting it back to analog to transmit.
Artificial intelligence and machine learning drive demand for the 800-gig PAM to increase the speed of input-output and to process the data flows. This doubles the throughput (bandwidth) due to an 8x100Gpbs optical transceiver for inside and between AI clusters.
In the most recent earnings call, Marvell discussed their plans to compete in the PCIe Gen 6 retimer interconnect market. PCIe 6.0 will be the first to use PAM4 signaling technology. Marvell is sampling eight and 16 lane PCIe 6.0 retimers with customers, which will help data center compute fabrics scale. Per management: “AI applications are driving data flows and connections inside server systems at significantly higher bandwidth, driving the need for PCIe retimers to meet the required connection distances at the faster speeds.”
Marvell also offers data center interconnect (DCI) products, which connects data centers over various distances to transfer data, content and critical assets. COLORZ silicon photonics increase the speed of data movement while keeping power and cost low. The 400 gig ZR and 800 gig DCI products with coherent DSP (digital signal processor) extends the reach to 1,000 kilometers.
Teralynx are ethernet switches with the 800 Gb/sec Teralynx 10 built for cloud data center and AI fabrics. The company also provides Ethernet controllers and PHY transceivers, and is a competitor to Broadcom on switch ASICs in that regard. Teralynx and Broadcom’s Tomahawk will be in lock-step for the release of 1.6Tb switch ASICs.
Custom silicon refers to ASICs or application-specific integrated circuits that are customized to be “application-specific” with the benefit of becoming cheaper with volume production. ASICs are expensive at the onset, yet become cheaper with volume production. Custom silicon is attractive to Big Tech as cash is not an issue with these companies for ASICs very high startup costs (well into the millions). Big Tech also immensely popular applications to justify the non-recurring engineer (NRE) costs in developing chips for a specific purpose.
Across ASICs, the most well-known is Google’s tensor processing unit (TPU). Yet, there is a vast array of custom silicon that has hit the market since TPUs were first introduced in 2016 for the TensorFlow framework. Amazon was second to diversify with custom silicon for AI workloads with Graviton and Inferentia in 2018, and the more recent Trainium announced in 2020. Last year, Microsoft announced the 5nm Maia 100 AI chip to reduce dependency on data center GPUs, and a Cobalt 100 Arm-based CPU to increase the performance on Azure-based virtual machines for scaling web applications, microservices and open-source databases. We covered in our 2019 Marvell analysis that Microsoft was pursuing FPGAs (Xilinx), but FPGAs have now been replaced with ASICs, which is what Marvell and Broadcom offer.
Discussions on AI Revenue:
Naturally, there were questions on the guidance for $1.5 billion in AI revenue exiting the fiscal year. Regarding the current quarter, one analyst is modeling for $500 million per quarter in AI revenue.
When pressed, management hinted this is the minimum number to work with: “And then, the whole thing in flex meaningfully in the second half and I'd say from a full year perspective, the way to think about it, maybe some additional color would be, we talked about a floor of $1.5 billion for AI revenue for Marvell for this fiscal year with about two-third in electro-optics and a third in custom. . And we see now both of those exceeding that number.”
Where the market could get excited is if Marvell’s custom silicon surprises to the upside. As of now, it’s expected to contribute one-third of the $1.5 billion quoted above next year. Marvell’s custom AI silicon business is beginning to ramp and investors will see more evidence of this in the second half of this year. Per the opening remarks: “Our custom compute AI programs are beginning to shift in the first half of this fiscal year and we are expecting a very substantial ramp in the second half of this year, followed by a full year of high volume production in fiscal 2026.”
The market for custom silicon is expected to grow from $7 billion in CY2023 to $40 billion in CY2028 at a 45% CAGR. My comment is that this is probably too low; as the market is too nascent to accurately predict a higher number.
Outside of custom silicon, Marvell’s management expects the aggregated data center opportunity to grow at a CAGR of 29% from $21 billion to $75billion. There was a comment that management predicts they will double their market share from 10% to 20%: “We see a massive opportunity ahead with the data center TAM expected to grow from $21 billion last year to $75 billion in calendar 2028 at a 29% CAGR, we have numerous opportunities across compute, interconnect, switching and storage, as a result, we expect to double our market share over the next several years from our approximately 10% share last fiscal year.”
That’s quite a statement as it implies Marvell’s data center segment will grow from $3.2 billion today to $15 billion in the next several years. Given they tied the statement to the 2028 projection, then this implies a 368% growth rate on the data center segment over the next 4 years.
Notably, the statement was repeated in the Q&A: “So we articulated the AI day, a very robust custom silicon TAM in excess of $40 billion going out into 2028 time frame and that TAM growing very significantly. And yes, we — I think your numbers are about right in terms of the share. We're going to end up with near-term and then Raghib articulated our goal to drive that in the custom silicon area to 20%. So you got to draw a line kind of from here to there in terms of the opportunity.”
Looking forward, management stated the floor for next fiscal year on AI revenue is $2.5 billion, up from the $1.5 billion, as custom silicon is expected to see its first full year of volume.
On the topic of custom silicon expanding next year, this will weigh on the gross margin, yet it will help to drive a strong operating margin, primarily due to non-recurring engineering costs.
Conclusion:
We have another attempt at Marvell in the works, and we are looking closely at timing. On one hand, we may be too early and have to deal with a couple of earnings reports that are duds until we get to the rebound in 2025. On the other hand, Marvell may start to move quicker than current consensus is forecasting as it’s participating in a few explosive trends.
How the market perceives the non-AI segments until we get a material recovery in these segments is anyone’s guess. In a risk-on environment, these segments will be dismissed and the number of times a management team mentions the words “AI” on an earnings call is all that matters. In a risk-off environment, Marvell’s unfortunate exposure to telecom and gaming will mute the upside.
To put it simply, we are cautiously optimistic on Marvell. Over the next few months, we plan to revisit if we see a break above $79.
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This article was originally published on Forbes on Jul 18, 2024,05:46pm EDTForbes Forbes on Jul 18, 2024,05:46pm EDT
We are no strangers to Palantir’s story, saying as far back as September 2020 prior to Palantir’s public offering that the “commercial sector is the growth story” for the company as it expands beyond government clientele. Heading into 2024, Palantir was exhibiting “multiple signs of acceleration” stemming from strong growth in its US commercial segment, driven by AIP, Palantir’s Artificial Intelligence Platform that lets customers lever Palantir’s AI and ML tools and harness the power of the latest large language models (LLMs) within Foundry and Gotham.
AIP and US commercial growth are still the main storyline for Palantir investors to watch moving through 2024, given the two are the pr imary growth drivers this year. A closer look in Q1 reveals that momentum is not slowing down for AIP, and US commercial revenue growth remains intact. Government revenue also bucked its trend of decelerating growth throughout 2023, rebounding from under 11% YoY growth in Q4 to 16% YoY growth in Q1.
However, Palantir’s management shed light on some potential hiccups in AIP’s sales cycle, which we outline below. Meanwhile, the market is pricing in a perfect story this year, which puts pressure on the stock to execute.
US Commercial Business Remains Strong
Palantir’s US commercial segment remained strong in Q1, with AIP driving strong customer growth as revenue growth accelerated on a sequential basis. Management continued to drill home AIP’s momentum in the quarter by saying: “US commercial business continues to see unprecedented demand driven by momentum from AIP.”
Palantir reported $150 million in US commercial revenue in Q1, an increase of 40% YoY.
Source: I/O Fund
US commercial revenue rose 40% YoY and 14% QoQ to $150 million in Q1, accelerating 100 bp on a QoQ basis. While this was technically a deceleration from 70% YoY growth last quarter, that came against an extremely weak comp, with the QoQ growth acceleration more reflective of Q1’s strength.
Management explained that the segment is “where we're seeing the greatest transformation. While Q1 is seasonally our slowest quarter, AIP adoption by new and existing customers helped drive notable growth in customer acquisition and revenue in our US commercial business.”
Palantir added 41 net new US commercial customers in Q1, an increase of 69% YoY and 19% QoQ.
Source: I/O Fund
Palantir added 41 net new customers in the segment, an increase of 69% YoY and 19% QoQ. This accelerated from 55% YoY growth in Q4. We also saw customer additions broaden beyond the US this quarter – the commercial segment (including international) reported total net new adds of 52. As a whole, commercial customer count rose 53% YoY and 14% QoQ to 427 customers.
This means that the commercial segment, driven by US commercial, once again dominated net new adds in the quarter. US commercial contributed 41 (and commercial 52) of Palantir’s 57 net new additions, or ~72%, compared to more than 90% of net new adds last quarter; the entire segment still contributed more than 90% of net new adds with international growth.
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AIP Interest Remains High
As has been the case since its launch just over a year ago, Palantir is continuing to witness elevated interest and high demand for AIP, and is offering developers a free trial to explore and build on AIP, but it is limited in user size and Ontology quantity.
Management said that “continued interest in AIP is loud and clear,” and shared an update on AIP bootcamp progress, saying that they have sustained the “high volume of bootcamps with over 915 organizations participating to date to meet inbound demand.” Palantir had completed 560 bootcamps across 465 organizations by February, tacking on an additional 450 organizations in just the past five months. Palantir did not share an updated bootcamp total.
Palantir also said that AIP was aiding in customer conversion and expansion, aligning with trends observed earlier in the year, where management said AIP bootcamps were “quickly converting to paying customers” or expanding existing customers’ contracts. US commercial deals rose 94% YoY to 136, and total contract value (TCV) increased 131% YoY in Q1 to $286 million. Overall, commercial TCV bookings increased 187% YoY to $505 million, with the US driving more than half of that.
In addition, Palantir said that it is “seeing substantial deal cycle compression. As one example, a leading utility company signed a seven-figure deal just five days after completing a bootcamp. Another customer immediately signed a paid engagement after just one day of their multi-day bootcamp and then converted to a seven-figure deal three weeks later.” We have seen Palantir’s quarterly deals accelerate following AIP’s launch, but we have also seen a larger proportion of deals on the smaller end, between $1 million and $5 million.
Palantir signed 87 deals in Q1, of which 27 were >$5 million and 15 of which were >$10 million.
Source: I/O Fund
Questions In Converting Customer Interest to Contracts
Despite the optimism and reiteration on elevated interest in AIP, CEO Alex Karp shared one key shortfall that the company has – which is difficulties in selling AIP.
Karp explained that Palantir is “at the way early days of figuring out how to actually get customers to buy our product. We are good at educating customers on what is the art of the possible, and then some portion of those customers buy it. So, I expect as we get better and better at that, our numbers will increase. But it is really early days. It's not — we're not flawlessly executing on our sales motion.”
While this could be viewed as a positive given the high interest in AIP, implying that Palantir is not closing as many deals as it potentially could, the market is pricing in perfection this year, and essentially looking for a beat and raise in every quarter this year. Having a sales model where management is still figuring out how to market and sell AIP to interested customers while the market wants acceleration sets the stage for a potential shortfall if Palantir cannot meet these elevated expectations.
International Headwinds Persist
Palantir is also facing some headwinds internationally, primarily in its European business.
International commercial revenue grew 16% YoY, but declined (3%) QoQ to $149 million, “as a result of continued headwinds in Europe and the revenue catch-up in Q4 that we noted last quarter.”
Management further clarified that they “do have headwinds in Europe, 16% of our business in Europe. Europe is gliding towards zero percent GDP growth over the next couple of years. That is a problem for us. There is no easy remedy for that.” Shifting into a low or no GDP growth environment may continue to pressure customer deal expansion and present headwinds to larger deal sizes if budget scrutiny persists.
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Market Pricing Palantir’s Stock for Perfection
With Q1’s beat in store and US commercial still strong, the market is looking ahead for a strong year – essentially pricing in beat and raises each quarter this year, though Palantir’s extended valuation for barely 20% YoY growth enhances downside risk to shares given the international headwinds and the noted friction in its sales process.
Palantir reported $634 million in revenue in Q1, and guided fiscal Q2 revenue between $649 million to $653 million, an increase of 22.1% YoY at midpoint. For FY24, management guided revenue of $2.677 billion to $2.689 billion, up 20.6% YoY, with US commercial revenue of $665 million, for at least 45% YoY growth.
This translates to $1.285 billion in revenue in 1H, and $1.398 billion in revenue in 2H. However, analysts are expecting Palantir to generate $1.414 billion in 2H, with FY24 revenue estimates ranging from $2.68 billion on the low end to $2.80 billion on the high end. That’s about 4.4% higher than Palantir’s guide, suggesting analysts are expecting business momentum to accelerate each quarter with a beat and raise, and increased FY24 guidance.
Palantir’s valuation leaves little to no room for error here, trading at elevated levels compared to AI-exposed large-cap enterprise software stocks with similar top-line growth and bottom-line margins. For example, Palantir’s stock trades at more than 24x forward sales, versus less than 14x forward sales for ServiceNow, which has been reporting revenue growth of >24% the last three quarters, versus 17% to 21% for Palantir.
Other ‘best-of-breed’ software stocks trade at lower multiples, despite having stronger top-line growth rates than Palantir – CrowdStrike has pulled back to below 21x sales after hovering at 24x. Snowflake and Cloudflare trade at 12.9x and 16.3x forward sales, respectively. Since the start of 2023, best-of-breed software has repeatedly struggled to achieve or maintain a valuation above 24x sales, with most rerating back to the 16x level.
While investors can argue that Palantir deserves an ‘AI premium’ from its product suite, investors will still have to value it as a mature company rather than a hypergrowth SaaS, as it’s no longer in that basket. This is the most expensive Palantir has been on a top-line valuation since November 2021, with revenue growth nearly 30 percentage points slower.
Palantir trades at more than 24x forward sales, a premium to best-of-breed software peers.
Down the line, Palantir trades at nearly 89x forward earnings (non-GAAP), again at its most expensive level in more than a year, with adjusted EPS expected to grow 32% YoY to $0.33. ServiceNow trades below 55x forward earnings for 25% EPS growth, while CrowdStrike trades similarly to Palantir at 85x forward earnings. Snowflake and Cloudflare, both not profitable on a GAAP basis, trade far above 100x forward adjusted earnings.
If Palantir’s adjusted EPS growth does slow to <20% as currently estimated by analysts, its premium multiple risks rerating lower.
Palantir trades at nearly 89x forward adjusted earnings, again at its most expensive level in more than a year.
In terms of cash flow, Palantir trades at more than 100x operating and free cash flow multiples, with an operating cash flow margin of 20% and an adjusted FCF margin of 23% in Q1. ServiceNow trades at less than half of Palantir’s multiples, despite having a superior margin profile, at a 52% OCF margin and 47% FCF margin. CrowdStrike trades at 67x OCF with a 42% margin, while Snowflake trades below 49x OCF with a 43% margin.
Across the board, Palantir trades at elevated valuation multiples, whether it be on the top-line, bottom-line, or on cash flows, not only relative to peers, but also relative to itself, trading at its highest levels or near its highest levels of the past twelve months.
Conclusion
Palantir continues to exhibit strong momentum in its US commercial segment, with Q1 results reflective of this with sequential growth accelerating alongside customer count. While AIP demand remains elevated and a core driver of Palantir’s growth, management highlighted a pitfall in that there is friction in selling the product, a key risk to watch moving forward as the market is looking for nothing short of perfection through the end of fiscal 2024.
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.
Last week, Aehr’s stock surged after providing a preliminary look at fiscal 2025’s revenue and net profit before tax, guiding to $70 million in revenue, for a YoY gain of ~5.7%, as well as net profit before tax of at least10%. However, $10 million in revenue would be coming from Incal, meaning organic revenue would be $60 million, or a YoY decline of just over (9.3%).
Today, the stock surged again due to an AI-related acquisition announced yesterday in the official earnings report. We’ve had close eyes on this stock as it was a former I/O Fund holding in the tough market of 2022, and was our highest performing stock that year, before it turned sharply downward in 2023. We ultimately closed the position around the time the EV market softened and bellwether Tesla sold off. As a reminder, AEHR supplies wafer burn-in testing systems for silicon carbide to ON Semi, who in turn, supplies silicon carbide inverters to Tesla and other EV OEMs. However, AEHR has discussed for some time that their end markets are diversifying. This report points toward progress in these new end markets.
The positive price action this week is not based on fundamental strength. Under the hood, AEHR is quite weak. The $70M guidance includes $10M per year from the acquisition. Therefore, organic revenue for FY2025 of $60M would represent a decline of (-9.3%) from the $66.2 million AEHR reported this past fiscal year (FY2024). Keep in mind, that a few months ago, AEHR was forecasting revenue of $100M for FY2024 ending in May. Despite the positive price action, this company will not return to growth in the next four quarters and the $100M is more than two years out, per current consensus.
With that said, AEHR is trading at a low valuation, and even after the 66% power move off the low, there’s still quite a bit of room in the valuation due to the ongoing, steep selloff over the past year. Of the stocks we monitor, this one has substantial room. Valuation alone may be enough to justify this price action.
AEHR Q4 Earnings Report:
Aehr Test Systems reported preliminary Q4 revenue and net income figures last week, with both figures exceeding management’s guided range. Management noted that while Aehr “saw customer push outs of our products for silicon carbide devices due to slowing electric vehicle (EV) demand in the second half of our fiscal year, we still achieved another record year for annual revenue.”
Management also provided a quick look into the trends driving fiscal 2025: while SiC is expected to remain a core part of Aehr’s revenue, management sees bookings and revenue from new markets and customers, including silicon photonic ICs, flash memory and SSDs, AI processors, and GaN power chips for data centers and solar.
Aehr also announced that it received $12.7 million in FOX WaferPak orders from an SiC customer, with WaferPaks expected to be delivered over the course of the next three months. This likely will provide a large boost to fiscal Q1’s results. The company also expects to receive orders “from a significant number” of SiC customers by the end of this fiscal year.
There was mention of a hard disk drive customer that is forecast to ramp in the current fiscal year, “most likely the second half.” This customer will be up to 10% of revenue. Management also discussed a silicon photonics customer that will ship in the third fiscal quarter of this year. GaN is expected to penetrate power conversion in EVs, solar and the data center. AEHR received “a significant number of WaferPak orders through the year” for GaN.
Revenue and EPS
Aehr reported Q4 revenue of $16.6 million, for a YoY decline of (25.5%), and a QoQ increase of 120%.
Aehr reported Q4 GAAP net income of $23.9 million, which includes a $20.8 million tax benefit from the release of Aehr’s full income tax valuation allowance. Excluding this impact, net income would normalize to $3.1 million.
GAAP EPS was $0.81, including the $0.61 impact from the tax allowance. Adjusted EPS was $0.84.
For fiscal 2024, revenue was $66.2 million, up 1.4% YoY and above prior guidance for $65 million.
For fiscal 2024, GAAP net income is $33.2 million, including Q4’s tax benefit; excluding that, GAAP net income is $12.4 million.
GAAP EPS was $1.12 for FY24; non-GAAP EPS was $1.21.
Margins
Aehr’s preliminary results offered no insights as to how margins would look, after taking a hit in fiscal Q3 as revenue declined substantially on a QoQ basis. Margins recovered sequentially in Q4, but operating margin remained substantially lower on a YoY basis.
Q4’s gross margin was 50.9%, up 820 bp from 41.7% in Q3, but down 60 bp from 51.5% in the year ago quarter.
FY24’s gross margin was 49.1%, down 130 bp from 50.4% in FY23.
Q4’s operating margin was 15.3%, up from (27.1%) in Q3, but down from 25.3% in the year ago quarter. As discussed in the call, management believes they will reach an operating margin of 20% when they return to an annual run rate of $80M+.
FY24’s operating margin was 15.2%, down 540 bp from 20.6% in FY23.
Excluding the income tax valuation benefit, Q4’s net margin would be ~18.8%, versus 30.4% in Q4 2023.
For the full year, net margin was 50.1% including Q4’s tax benefit; excluding that, net margin would be ~18.8%.
Cash and Debt
Cash flows have struggled this year, with Q3 seeing significant net outflows at nearly 40% of revenue.
Q4 operating cash flow is $1.23 million, or a margin of 7.4%. This is down from an OCF margin of 26.4% in the year ago quarter.
FY24 OCF was $1.76 million, down nearly (82%) YoY, for a margin of 2.7%.
Cash and equivalents totaled $49.2 million in Q4, and debt remained zero.
Key Metrics
Inventory was $37.5 million in Q4, down from $38.1 million in Q3, but up from $23.9 million in the year ago quarter.
Bookings were $4 million in Q4, down from $24.5 million in Q3.
Backlog was $7.3 million in Q4, down from $20 million in Q3. Effective backlog was $20.8 million.
To note, Aehr’s largest customer accounted for 59.6% of revenue in Q3 2024, and its second largest customer accounted for 19.3% of revenue.
Acquisition of Incal and Wafer Burn-in for AI Accelerators
Aehr also announced that it was acquiring Incal to expand its presence in the burn-in market for AI accelerators, which it believes is a $100 million annual market with the potential to capture “meaningful share” in fiscal 2025. Aehr purchased Incal for $21 million, or ~1.75x TTM revenue of $12 million (or ~2.1x forward revenue of $10 million). The purchase price is split between $14 million in cash and more than 552K shares, convertible at $12.673 per share.
The goal is to combine Incal’s high-power test solutions with AEHR’s wafer-level testing to sell FOX-XP systems to AI chip companies for wafer testing up to 3,500 watts. According to management, the opportunity size is $100 million “and with this combined product portfolio, we have the opportunity to capture a meaningful share of this market within this fiscal year.” This naturally led to questions in the Q&A as to why the guide is weak for next year. I’ve included the response in the section below.
On the note of wafer burn-in for AI accelerators, this comment was key in the opening remarks – I’m quoting it in full so our Members understand the full effect of the comment that has led to today’s price action as the comment implies AI revenue will come to fruition this year:
“Now let me talk about the AI processor market. Last month, we announced we're working with an AI accelerator company to move their AI processor test and burn-in to wafer level and have secured a commitment from them to evaluate our FOX Solution for production level test and burn-in of their high power processors. This company recognizes the potential of the significant benefits of production test and burn-in of their accelerators while still in wafer form before they're integrated into the end application product, which would prove to be more cost effective and significantly more scalable than doing the screening later in their manufacturing process.
We think this is an amazing opportunity to displace the current package and system level tests for AI processes for large language model development and we believe we can meet this enormous challenge with the current capabilities of our new high power FOX-XP system with up to 3,500 watts per wafer testing. We're working on this benchmark as I speak here in the lab right now and expect to complete the evaluation in the next couple of months. Upon successful demonstration of wafer level test results and throughput, we expect they will utilize our new high-power FOX-XP systems for production of their next generation AI processors, starting this fiscal year.”
It was later clarified the customer is “not Nvidia.” It’s also important to emphasize the qualification is not complete yet: “I've got my fingers crossed that we can work through all this stuff. And we think we are pretty confident that we can make this work. And the customer is hoping and cheering us on to make it work.”
Lack of Revenue Growth in FY2025:
The obvious issue is management’s opening comments do not match the revenue guide. There is a stark contrast between the bullish earnings call/commentary and the weak guide. The issue is the weak EV market, as despite AEHR seeing promising signs of new end markets, the fact remains that SiC is AEHR’s primary market as it stands today. The new markets are not able to offset the softness in EVs (yet).
Here was a question to that effect:
Jon Gruber
Yeah, yeah, I mean good presentation, a lot of prospects, but what I don't understand is with the acquisition, all these prospects, you get flash member 30% in new things, the disk drive, why is there no revenue growth excluding the acquisition?
Gayn Erickson
[…] It's really about the push-outs that we saw with respect to the silicon carbide ramps, things we were expecting people to be coming in pretty strong. And we're just looking at soft forecasts right now.
[…] But I think if you look at the top four silicon carbide customers, they all guided down this year. And so, there have been people that are — we're wondering how bad it was going be for us, and can we even continue to maintain our growth while they're having a soft year followed by a strong year. So I think we're — it's the right thing to do right now is to communicate this. If we see strength in the second half come in harder than we are currently conservatively forecasting, then we'll guide up at that time.
Valuation:
Aehr’s valuation is low if we look at its historic trend. Granted, the stock had stronger fundamentals at the time, it’s important to note this small cap remained GAAP profitable even after a 36% reduction in its expected annual revenue. The company also held onto a thin cash flow margin, yet to Aehr’s credit, remained FCF positive for FY2024.
Conclusion:
Small caps are being hyped in the market; this makes sense because many are on sale. We began to sniff this out with entries into AOSL but we certainly wouldn’t mind more exposure if this rotation is confirmed.
Due to a lack of fundamental strength, we will only consider AEHR a quality stock once the company has returned to growth. Aehr will one day report real AI revenue, but for now, the price action is exuberant in nature. We want to be clear as day quality fundamentals are not in the driver’s seat at this time, rather, pure speculation is driving the price action. In the meantime, it’s under consideration for a momentum play only. If we re-enter, the position will come with a tight stop.
Damien Robbins, Equity Analyst at I/O Fund, contributed to this analysis
GPU sales are surging at the moment, primarily from Big Tech’s $200 billion in capex for AI infrastructure services. Critical data center components, including networking, are required for GPU systems. There is a well-quoted discussion from Dell executives earlier this year, that by the end of the systems lifecycle, $2 to $3 will be spent on networking and storage for every $1 spent on GPUs. Granted, the effects of this 2-X market demand will be spread across many more players compared to GPUs. Yet, there is ample evidence that networking is sparking a remarkable growth trajectory of its own. For example, Nvidia’s InfiniBand has seen triple digit growth, Cisco has provided strong AI commentary, and Arista Networks’ view is that networking is mission-critical to improve GPU utilization.
Arista Networking is positioning itself as a pure-play in AI-driven networking, and management sees tailwinds to growth not only via Ethernet establishing itself as the go-to choice in networking, especially for AI training, but also stemming from the broader market opportunity arising from the massive shipment volumes of Nvidia’s GPUs.
Why Data Center Spend Is Accelerating
The current AI landscape is spearheaded by Big Tech. Microsoft and Amazon are touting multi-billion-dollar cloud revenue run rates from AI, Google sees a clear path to monetizing AI features, and Meta is aggressively investing in AI with some initial evidence it’s boosting average revenue per user (ARPU). What’s unfolding is an AI ‘arms race’, in that Big Tech, and a handful of startups including OpenAI, Mistral, Anthropic, and others, are competing to develop, deploy and commercialize the next cutting-edge AI model. This race also spreads over to who can develop the best AI assistants/Copilots, increase adoption of GenAI tools, and accelerate revenue growth in the cloud.
Nvidia CEO Jensen Huang explained exactly why this race is rapidly unfolding, and why Big Tech’s AI expenditures are increasing not only this year, but likely for the next few years: “time is really, really valuable to them. Let me give you an example of time being really valuable, why this idea of standing up a data center instantaneously is so valuable and getting this thing called time to train is so valuable. The reason for that is because the next company who reaches the next major plateau gets to announce a groundbreaking AI. And the second one after that gets to announce something that's 0.3% better. And so the question is, do you want to be repeatedly the company delivering groundbreaking AI or the company delivering 0.3% better? And that's the reason why this race, as in all technology races, the race is so important. And you're seeing this race across multiple companies because this is so vital to have technology leadership, for companies to trust the leadership and want to build on your platform and know that the platform that they're building on is going to get better and better.”
The conclusion is that Big Tech firms are snapping up Nvidia’s GPUs as fast as they reach the market, and this demand spills over into AI servers and networking components, as both are crucial for AI systems.
Networking Becoming Indispensable
Big Tech is deploying thousands to (soon) millions of GPUs and in-house AI accelerators, and networking is a mission-critical piece. Switches are crucial for communication inside the GPU clusters, allowing quick, efficient communication and transfer of data between each node, which is essential for parallel processing, and thus overall job completion time when it comes to training large-scale AI models and completing larger workloads.
A cohesive networking layer with high-quality switching technology can lower power consumption needs significantly and improve performance job completion times. As a result, the industry is going all-in on Ethernet, Nvidia included, in part due to its compatibility, cost and performance advantages, and security.
According to Arista, Ethernet has advantages over Nvidia’s InfiniBand: “AI workloads are placing greater demand on Ethernet, as they are both data and compute-intensive across thousands of processes today. Basically, AI at scale needs Ethernet at scale. AI workloads cannot tolerate the delays in the network, because the job can only be completed after all flows are successfully delivered to the GPU clusters. All it takes is one culprit of worst-case link to throttle an entire AI workload.”
Broadcom’s management seconded this, explaining that as companies scale GPU clusters, they are “going to have to use the best networking technology. And we believe that the best networking technology is Ethernet.” Broadcom’s Ram Velaga added that whether GPUs are “connected inside a data center or across data centers, you cannot get around the fact that you have to connect multiple GPUs. Once you accept the fact that it is a distributed computing problem and you need a network, then I would make a very strong case for you that the best network in the world, over multiple generations, over and again, has been Ethernet.”
Velaga used Meta as an example as to why networking (and Ethernet) is so important: when Meta is running “large workloads, anywhere between 18% to 57% of the time, the traffic is just sitting in the network. That means during this period of time, the GPUs are actually sitting idle. Now think about it. If on an average somebody is charging somebody between $20,000 to $30,000 per GPU and you've got 100,000 GPUs, you're talking about a $2 billion to $3 billion infrastructure. And if $2 billion to $3 billion infrastructure is sitting idle for 18% to 57% of the time, that's a lot of money, right?”
By creating more efficient lines of communication between GPUs, Ethernet can help accelerate job completion times, and in turn, allow more jobs to be completed on the clusters. Velaga touched upon the performance advantages of Ethernet versus Nvidia’s InfiniBand, noting that Meta tested both on a 24,000 GPU cluster and found that Ethernet provides up to 10% better performance at half the cost, which, when translated over to overall infrastructure costs, could equal hundreds of millions to billions saved.
Nvidia is also prioritizing Ethernet with its new Spectrum-X solution, despite seeing strong triple-digit networking revenue growth (accelerating from 94% YoY to 242% YoY in 4 quarters to over $3 billion in quarterly revenue) driven by InfiniBand. CEO Jensen Huang said Nvidia is “all-in on Ethernet” with an “exciting road map coming.” He added that “Spectrum-X is ramping in volume with multiple customers, including a massive 100,000 GPU cluster. Spectrum-X opens a brand-new market to NVIDIA networking and enables Ethernet only data centers to accommodate large-scale AI. We expect Spectrum-X to jump to a multibillion-dollar product line within a year.”
For more information on how Ethernet compares to InfiniBand, reference our analysis: “Broadcom: Networking/ASICs Giant and The Second Largest by AI Revenue” where we go through a side-by-side comparison including why Big Tech is pushing for Ethernet over Nvidia’s in-house InfiniBand.Broadcom: Networking/ASICs Giant and The Second Largest by AI Revenue” where we go through a side-by-side comparison including why Big Tech is pushing for Ethernet over Nvidia’s in-house InfiniBand.
Arista Confident in Ethernet Opportunity
Arista echoed much of Broadcom’s comments on Ethernet’s performance advantages versus InfiniBand, reiterating that Ethernet is “proving to offer at least 10% improvement of job completion performance across all packet sizes versus InfiniBand.”
Arista added that they are “witnessing an inflection of AI networking and expect this to continue throughout the year and decade” as Ethernet emerges as “a critical infrastructure across both front-end and back-end AI data centers.”
Per Arista’s Q1 call, we are “progressing well in four major AI Ethernet clusters that we won versus InfiniBand recently,” and in the four clusters, they are “migrating from trials to pilots, connecting thousands of GPUs this year, and we expect production in the range of 10K to 100K GPUs in 2025.”
Arista’s management reiterated the company will reach an AI target of $750 million in 2025. Barclays believes Arista “can top its guidance of $750M in AI-related back-end revenue for 2025,” commanding 18% market share in data center switching (versus 27% share for Nvidia and 22% for Cisco).
Arista also has a few core risks, particularly in that revenue is heavily concentrated in two major customers, Microsoft and Meta, accounting for 38% of company-wide revenue ($2.2 billion of Arista’s $5.8 billion in revenue in 2023). While we are seeing both companies spending quite aggressively in AI this year and next, revisions to capex plans intra-year (much like how we saw Meta increase its full year capex guide last quarter) can move Arista’s stock price.
Microsoft and Meta accounted for 39% of Arista’s revenue in 2023, down slightly from 42% in 2022 but up significantly from less than 25% in 2021. In dollar terms, the two are both billion-dollar customers, with revenue from Microsoft increasing more than 50% in 2023 and nearly 59% in 2022.
Both Microsoft and Meta increased 2024’s capex plans, with Microsoft’s Q1 capex rising 80% YoY to $14 billion, and full fiscal year capex up 50% YoY to $50 billion. Microsoft is reportedly seeking to triple its GPU supply this year to 1.8 million GPUs to support AI demand on Azure, and demand for networking components should rise hand in hand.
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 – hinting that Meta’s contributions to Arista’s revenue growth may not be felt in full force until the back half of 2024.
While the capex growth is positive, competition in the networking space is high, from Broadcom to Nvidia to Cisco to others. Cisco noted that it has been seeing strong momentum in Ethernet AI fabric deployment at three of the top four hyperscalers, possibly alongside Arista’s solutions, while Nvidia has recently released its Spectrum-X Ethernet solution which it expects to become a multibillion-dollar product line with a year. According to Nvidia, Spectrum-X delivers 1.6X better networking performance than traditional Ethernet.
Our previous Broadcom analysis points toward the Ethernet networking giant being second in AI revenue, primarily from AI networking revenue. Forward-looking, Broadcom is expected to end the year with $2.75 billion per quarter in AI revenue for $11B per year. Compare this to Nvidia’s networking revenue at $3.2 billion.
InfiniBand increases dependency on Nvidia, requires a new networking stack, and lags Ethernet on raw bandwidth. Improvements in Ethernet systems are expected to offer better load balancing and congestion control to help close the gap with InfiniBand’s low latency. Broadcom’s Jericho3-AI switch platform is the company’s AI fabric that competes with InfiniBand on AI training completion times, and it allows for more than 32,000 GPUS to be linked for a massive AI training system.
Regarding Arista, the company has partnered to offer a holistic solution, where a remote Arista-based AI agent will help customers optimize and manage their AI clusters with a single control point; however, investors should expect competition in the market to remain fierce as hyperscalers continue to build out data center infrastructure.
Turning to fiscal Q1’s earnings — Arista delivered a solid report, with revenue ahead of expectations as margins remained strong. However, headline revenue growth has decelerated rather quickly as Arista faced difficult comps in Q1. Despite the deceleration, the bottom line remains strong and in fact is strengthening.
In terms of AI revenue, management did not provide a figure for 2024, but its $750 million target for 2025 would represent close to 10% of total revenue, with consensus for FY2025 at $7.82 billion.
Revenue and EPS:
Arista reported revenue of $1.57 billion in Q1, representing YoY growth of 16.3% and beating expectations by nearly $24 million. This is down from 54% growth in the year-ago quarter. Growth is expected to decelerate more than 4 percentage points on a sequential basis in Q2.
GAAP EPS of $1.99 represented YoY growth of 44.2%, beating estimates by $0.40.
For Q2, Arista guided revenue between $1.62 billion and $1.65 billion, representing YoY growth of 12.1% at midpoint, a fifth consecutive quarter of decelerating revenue growth. However, Q2 is expected to mark the bottom, with analysts expecting growth to reaccelerate to the 14%+ range by Q4.
Margins:
Gross margin was 63.7% in Q1, down 120 bp QoQ from a six-year high in Q4 at 64.9%. Gross margin has been relatively stable in the 63% to 64% range aside from a dip to the 60% range in the first half of 2023.
Operating margin reached a record high at 42.0% in Q1, and represented a 50 bp QoQ and 610 bp YoY expansion. Operating margin has expanded steadily since 2021, increasing nearly 10 percentage points from the low 30% level.
Net margin was 40.6%, up 80 bp QoQ and 830 bp YoY. Arista’s bottom line strength should not be overlooked, especially as leverage improves down the line even with decelerating revenue growth. In the market’s top AI stocks at the moment, Arista has one of the strongest bottom lines outside of Nvidia.
Cash and Debt:
Arista reported cash and equivalents of $5.45 billion, and has zero debt.
Cash flow margins are strong — operating cash flow increased over 37% YoY to $514 million, for a 32.7% margin. Free cash flow also increased 37% YoY to $504 million, for a 32% margin.
How Arista Networks Ranks on AI Revenue:
Here’s a quick glance on the rankings for AI networking revenue, with Arista near the bottom of the list. Nvidia and Broadcom lead the sector, with Nvidia recently surpassing a $13 billion annual run rate in networking.
Nvidia is in first with $3.2 billion in networking revenue in fiscal Q1, after recently surpassing a $13 billion annual run rate in Q4. Nvidia is expecting its new Spectrum-X product to reach a multi-billion dollar run rate “within a year.”
Broadcom is in second place with AI revenue of $3.1 billion in fiscal Q2, projecting an annual run rate of more than $11 billion, or more than $2.75 billion per quarter. Based on management’s commentary, networking likely contributed upwards of $1 billion in the quarter, and could exit the year in the mid-$4 billion range.
Marvell reported approximately $500 million in AI revenue in the most recent quarter, with management eyeing a “a floor of $1.5 billion for AI revenue” for this fiscal year, with two-thirds coming from electro-optics and one-third from ASICs.
Juniper Networks reported $321.2 million in the AI enterprise segment, or 23.5% of revenue. Recently, it was announced that Juniper is being acquired by HPE.
Arista has not broken out AI revenue on a quarterly basis yet, but is targeting $750 million in AI revenue in 2025, which is equivalent to ~10% of revenue for that year.
Valuation:
Arista’s top line valuation has surpassed historical peaks. Bottom line strength and improved operating leverage are driving increased earnings power exiting 2024 with a bottom line valuation in line historically.
Arista currently trades at 19.4x sales and 17.3x forward sales, both above historical highs – in late 2021, Arista peaked at just under 17x sales, the same level where it pulled back from in early May following its post-earnings rally. Buying in the 8x sales range offers a higher probability for upside, although notably, AI stocks have not offered low entries over the past year.
On the bottom line, Arista trades slightly below 52x earnings and nearly 47x forward earnings, which on the surface is expensive, and above its 5-year average of 34x. Arista peaked at 60x earnings at its 17x sales peak multiple in late 2021, providing a tiny bit of breathing room for the bottom-line valuation on improved earnings power later this year and through next; however, downside risk is more prevalent as both the top and bottom-line valuations become stretched.
There are currently two counts that I see playing out in this final push higher. Both counts have us in the final swing higher of the larger 3rd wave, they only differ on how high this swing can go before we see a larger pullback:
Technical Analysis
By Knox Ridley
There are currently two counts that I see playing out in this final push higher. Both counts have us in the final swing higher of the larger 3rd wave, they only differ on how high this swing can go before we see a larger pullback:
Green – If we can breakout over $390 and hold this level, then the odds favor this path higher. This would target the $440 – $480 region directly. The final target should be between $490 – $520 before we see the larger 4th wave pullback.
Red – If we fail to breakout over $390, and instead see a breakdown below $335. This would signal that we are in the 4th wave drop, which I generally have targets between $260 – $200. If this plays out, as long as we hold $195, this would be a decent buying opportunity for the final 5th wave swing higher.
Conclusion
InfiniBand has been reporting up to 500% growth and more recently 300% growth, yet for the first time since the AI surge, Nvidia reported that networking declined sequentially this past quarter.
Despite Nvidia’s GPU moat being fully intact, its networking lead is in question. Gartner recently reported that by 2028, 80% of hyperscalers will “opportunistically” prefer Ethernet over proprietary technologies. According to Broadcom, this shift is happening quickly with management predicting that as soon as next year “all mega-scale GPU deployments will be on Ethernet.”
Arista Networks is a stock to watch in this space, primarily for its defensibility on the bottom line. The company sees $750 million in back-end AI revenue in 2025 stemming from growth among hyperscalers. Heavy revenue concentration in Meta and Microsoft is a core risk to watch, yet capex spend is accelerating for the time being, providing growth tailwinds for the networking industry as a whole. Next week, we will revisit another Ethernet networking play with more revenue and a stronger growth story for 2025, despite being weaker on the bottom line.
Damien Robbins, Equity Analyst at the I/O Fund, contributed to this article.
