Month: August 2024

Arm Stock: Buy Its Customers, Not The Stock

Posted on by io-fund

This article was originally published on Forbes on Aug 15, 2024, 05:09pm EDTForbes on Aug 15, 2024, 05:09pm EDT

Arm Holdings is the third-best performer of 2024 in AI-related semiconductor stocks with a 56% YTD return, behind only Nvidia and Taiwan Semiconductor. The stock is a market favorite as Arm’s heterogenous compute design has created a monopoly in mobile, primarily, yet Arm’s RISC architecture is also found in PCs, powers sensors and supercomputers. In total, over 280 billion Arm-based chips have been shipped dating back to the 1980s.

The latest Arm v9 architecture offers significant improvements in performance and efficiency, particularly for artificial intelligence (AI) applications. This has led to increased adoption by premium smartphone partners, and also with hyperscalers that are developing their own custom silicon for data center use.

The market is excited about Arm’s v9 architecture because it commands double the royalty rate with Arm receiving a higher percentage of the chip’s selling price when a manufacturer uses v9 designs. The estimated royalty rates for v9 are around 4%, compared to Arm’s blended 1.7% royalty rates for the prior generations – however, this is simply not enough to consistently accelerate Arm’s top-line growth to justify its valuation as $70+ billion more AI chips are sold this year. So even though Arm is leveraging its established royalty and licensing model through its extensive ecosystem to drive predictable future growth and a rather defensible bottom line, apart from the cyclical doldrums of the semiconductor industry, its growth story pales in comparison to some of its key customers.

Q1 Earnings Strong, Yet Q2 and FY25 Failed to Impress

Given the string of strong beat and raises from GPU leader Nvidia over the past several quarters, the market has been setting the bar high for AI-related stocks, including Arm. Despite beating Q1 estimates, Arm failed to meet high expectations as it guided for Q2 results below consensus.

Arm reported 39% YoY growth to a record quarterly revenue of $939 million in Q1. Looking ahead to Q2, Arm projected revenue between $780 million and $830 million, for flat YoY growth at midpoint, decelerating from Q1’s 39% print. Analysts had expected Arm to guide to $813 million in revenue for Q2, for YoY growth of 1%. Given the small growth rate, a miss feels odd given the trajectory of other AI stocks.

In Q1, licensing revenue rising 72% YoY and 14% QoQ to $472 million, offsetting a more than (9%) QoQ decline in royalties. Arm said that licensing “hit a record level as the proliferation of AI everywhere is driving more companies to make broad and long-term commitments to use Arm’s power-efficient technology in their future products,” while royalty revenues are benefitting from Arm v9, which commands higher royalties per chip.

With that said, Arm expects next quarter “to be the low point of the year due to the timing of revenue recognition from licensing,” while also being one of the “highest bookings quarters of the year.” Royalty revenue is also expected to accelerate from 17% YoY to the low-20% YoY range in the quarter.

Arm’s adjusted EPS guide also came in below consensus estimates for the quarter, with Arm projecting $0.23 to $0.27 in EPS, short of the $0.28 estimate. While these may seem like thin margins for a miss, Arm’s premium valuation offers little room for error.

For FY25, Arm guided for revenue between $3.8 billion and $4.1 billion, or $3.95 billion at midpoint, falling short of the $4 billion consensus estimate. This forecast points to YoY growth of 18% to 27%. Adjusted EPS was guided between $1.45 to $1.65, which at the midpoint fell short of the consensus estimate for $1.57.

Arm also guided down for royalty revenue growth, projecting royalty revenue growth in the low 20% range, compared to the mid-20% range previously. Licensing revenue is expected to increase in the mid-20% range, with Q2 expected to be the weakest quarter and Q4 the strongest.

Our firm has been quite vocal that IPOs are not worth the risk, stating “there is no riskier proposition than an IPO that is richly valued.” The liquidity event that an IPO becomes after its lockup expiration creates high risk for tech investors as individual investors are often up against a deluge of insider selling. The fact that Arm is an overpriced IPO that is missing estimates this early is a concern. GAAP operating margin also has contracted from 18.5% to 5.4% on a TTM basis, primarily from IPO-related expenses.

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v9 Growth Decelerated Quickly, But Projected to Rebound

As a primary driver of royalty revenue growth, v9’s revenue is important to track as it commands double the royalty of v8, and features in “virtually all high-end data center chips” and a majority share in smartphones. For example, v9 underpins Nvidia’s Hopper series chips, Amazon’s Graviton chips, Microsoft’s Cobalt chips, and many more. Arm also sees v9’s increased adoption (and increase in royalty mix) and the ramp of CSS-based chips in the second half of the year as growth drivers.

In Q1, v9 accounted for 25% of net royalty revenue, up from 20% last quarter, and up from 15% two quarters ago. Smartphones contributed to 40% of royalty revenue in FY24 and was the first to adopt v9. Notably, the smartphone market is recovering right now — smartphone revenues grew 50% YoY despite a single digit increase in unit sales, demonstrating how increased adoption of v9 can quickly impact revenue growth.

However, on the backs of a QoQ decline in royalty revenue in Q1, v9 revenue growth has decelerated dramatically, despite increasing its mix share by 500 bp QoQ. Growth decelerated from 46% QoQ in Q4 to 14% QoQ in Q1, reaching $116.8 million.

Arm Quarterly Revenue

On the backs of a QoQ decline in royalty revenue in Q1, v9 revenue growth has decelerated dramatically, but is projected to rebound. Source: I/O Fund

v9 revenue growth is expected to reaccelerate to above 30% QoQ in Q2, and remain at that level in Q3 as royalty revenue returns to QoQ growth, with ~9% QoQ estimated for Q2 and ~12% QoQ for Q3. Management said it expects the 500 bp QoQ mix increase “to be the continued trajectory” moving forward, implying Q2’s mix at 30% and Q3’s at 35%. This V-shaped recovery in v9 revenues arises from this consistent increase in mix along with a return to QoQ growth around the 10% to low-teens range. As such, v9 royalties are projected to rise to ~$153 million next quarter, up 31% QoQ, a 17 percentage point acceleration.

Yet despite the reacceleration in v9 revenue growth, it still contributes only a fraction of the end-market value being added from chips built on the design. Meaning, while v9’s revenue is increasing by just $37 million QoQ, end market customers such as Nvidia are selling $2 billion more QoQ in GPUs built on v9. I’ve said this since 2021 – despite Arm’s designs powering 99% of the mobile market, or the most important AI GPUs available today, the revenue gains generated from its royalties are nowhere near the same ballpark as the growth and revenue generated by its customers.

x86 Will Make for Strong AI PC Competition

Arm dominates in the mobile market, with more than 99% market share, but in some of Arm’s smaller end markets, such as microprocessors, the company faces steeper competition from x86-based players AMD and Intel.

According to data from Mercury Research, in the microprocessor unit market, AMD gained 68 bp QoQ to 19.2% market share in Q2, while Intel gained 37 bp QoQ to reach 71.1% market share. Arm, on the other hand, saw a 105 bp QoQ decline in market share, dropping to 9.7% share.

At a closer look, Arm lost share against AMD and Intel in both notebooks and desktop microprocessors, yet gained share in servers.

  • In notebooks, Arm lost 144 bp QoQ, falling from 12.8% share in Q1 to 11.4% share in Q2. AMD’s notebook share rose 121 bp QoQ to 18.0%, while Intel gained 23 bp QoQ to 70.6% share.
  • In desktops, Arm lost 31 bp QoQ to 5.9% share, AMD also lost 83 bp QoQ to 21.6% share, while Intel’s share rose 113 bp QoQ to 72.5%.
  • Servers were the only segment where Arm’s share grew in Q2, rising 41 bp QoQ to 6.7%. AMD’s share rose 40 bp QoQ to 22.5%, while Intel lost 81 bp QoQ to 70.8% share.

Notably, it’s premature to say how Arm-based PCs will do as more AI features are integrated into laptops. MacBooks switched from Intel’s x86-64 processors to Apple’s system on a chip (SoC) based on Arm 64 architecture. Arm offers much lower power consumption and generates less heat due to being a Reduced Instruction Set. The M2 is built on Taiwan Semi’s 5nm process with 100GB/s memory bandwidth and 24 GB of unified memory. When the M2 was released in 2022, Apple claimed 1.9X CPU performance at the same power. At the same performance level, Apple claims the M2 uses ¼ the power as x86.

From there, the M3 MacBook Air was released this year with Apple stating it’s 13X faster than an x86 Intel powered MacBook. The Arm-based system on a chip (SoC) combines a CPU and a GPU with a 16-core Neural Engine for what Apple is calling the “World’s Best Consumer Laptop for AI.”

Traditionally, Arm’s architecture was viewed as the best choice for mobile and Intel’s x86-64 as the best choice for the data center and PCs. However, we are on the precipice of going through a major shift to where Arm architecture will compete more directly with x86 architecture for PCs. This kicked off with Qualcomm’s Snapdragon Elite X, and will be further tested when AMD and Nvidia release Arm-based PC systems in 2025.

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Arm’s Growth Pales in Comparison to Customers

Arm’s value to the semiconductor industry is arguably indispensable, yet the stock trades at a premium valuation. The company is currently at highest top-line multiple in the entire semiconductor industry, even as its revenue growth pales in comparison to key chip customers.

Forward PS Ratio Comparison Chart

Source: YChartsYCharts

Arm trades at more than 33x forward revenue, a 40% premium to Nvidia’s 24x forward revenue multiple. The industry’s other most expensive names, and those with the most AI exposure trade at lower top-line multiples, with Monolithic Power at 19.6x forward revenue, and AMD at just 8.9x forward revenue.

Revenue Growth Estimate for Current Fiscal Year

Source: YChartsYCharts

Arm’s expected revenue growth of 23% for fiscal 2025 is not the most impressive in the industry. Astera Labs leads with 200% estimated revenue growth, although it’s coming off an extremely small base of less than $100 million per quarter. Yet, Nvidia is expected to nearly double its revenue with 97% estimated growth, essentially adding $60 billion YoY driven by GPU sales, on a very large revenue base.

Arm does not and will not share a similar hypergrowth profile from AI like Nvidia, which has seen ‘hockey-stick’ growth over the past six quarters, rising from more than $4 billion at the start of fiscal 2024 to potentially more than $25 to $26 billion in Q2 fiscal 2025. Arm, on the other hand, did not even add $300 million in revenue in that time frame.

For the entirety of 2024, Nvidia, AMD, and more of Arm’s key customers are likely selling more than $70 billion in additional AI chips this year, whereas Arm is only adding $740 million in revenue, or barely more than 1% of its customers’ sales increase.

While Arm’s royalty and licensing model offers more predictable revenue growth in a cyclical industry, it does not share the same operating leverage or margin profile to quickly grow into its premium top-line and bottom line multiple. Nvidia has visibly demonstrated its ability to capture much higher ASPs with each generation and drive significant operating leverage, rising from a 30% operating margin to 65% in four quarters while driving >600% bottom line growth.

Given this tremendous strength on the bottom-line, Nvidia trades at 43x forward earnings, with growth of 110% expected this year. However, Arm trades at nearly double that multiple, at almost 81x forward earnings, with just 23% growth expected. AMD and TSM both trade at much lower multiples for EPS growth in the 26% to 27% range.

Forward PE Ratio

Arm trades at the highest forward PE multiple among leading AI chip peers, at almost 81x forward earnings, with just 23% EPS growth expected. Source: YChartsYCharts

Conclusion

We’ve seen excitement over Arm’s AI opportunities and boosts to licensing fees and royalties, but our contention is that, similar to mobile, it’s better to own the AI leaders who license Arm’s technology. Investors have quite a few choices for AI stocks with stronger growth rates and cheaper valuations, rather than own Arm. Frankly, the valuation on Arm remains absurdly expensive, double or more than double the most-expensive chip stocks, including Nvidia.

There have been a few data points that have emerged since our last update on Arm in March 2024, and Arm’s Q2 and FY25 revenue guide also disappointed by falling short of analysts' expectations, a stark contrast to the billion-dollar beats and raises from Nvidia.

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

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AppLovin Corporation: Emerging Ad Tech AI Leader

Posted on by io-fund

Intro

AppLovin is an ad-tech company that saw a strong acceleration in growth and margins this past year driven by AXON 2.0, an AI-powered advertising engine that efficiently acquires users for mobile game publishers.

At IPO in 2021, AppLovin made most of its revenue from its Apps segment, a portfolio of free-to-play mobile games. This was historically seen as a cost center as AppLovin could gain a valuable trove of first-party data to feed into improving its user acquisition algorithms. However, management has since made an important pivot to grow its Software Platform segment, composed of MAX, its supply side platform (SSP) and AppDiscovery, its demand side platform (DSP).

This was because as MAX grew, AppLovin had a better source of data and gradually restructured its Apps business to focus on maximizing profitability. This transition made sense given the drastically different margin profile of the two segments, with a 15% long-term adjusted EBITDA margin profile for Apps compared to the over 73% adjusted EBITDA margin of the Software Platform segment.

After Apple announced its App Tracking Transparency (ATT) policy in 2021 which limited advertisers’ ability to track users across apps, AppLovin’s data became even more valuable as advertisers sought out AppDiscovery’s user acquisition algorithms to acquire high value users cost-effectively.

Furthermore, AppLovin’s CEO has repeatedly made clear that its AI recommendation engine has applications far beyond mobile gaming. It acquired Wurl, a Connected TV (CTV) SSP, in 2022 as an initial foray into CTV.

With a mobile ad network significantly larger than others in the market, AppLovin’s end-to-end advertising stack gives it a unique data advantage which enables superior algorithms that deliver better ad conversion rates, leading to higher return on ad spend to advertisers and higher spending, which attracts more inventory, leading to even better algorithms and so on.

Provided we can get the stock at a reasonable valuation, due to a durable data advantage, we believe AppLovin will be well-positioned to outperform.

Business Overview

AppLovin’s business consists of two segments: a fast-growing, high margin Software Platform and a slower-growing, lower margin (but still profitable) Apps segment consisting of its portfolio free-to-play mobile games. Our focus is on the software segment as it continues to drive top-line growth, powered by its AXON 2.0 AI-engine which we will discuss below.

Software Platform Segment (66% of Revenue, 87% of Adjusted EBITDA in Q2’24)

AppLovin’s software platform enables mobile gaming publishers to monetize their ad inventory, acquire new users more cost-effectively, and optimize their ad spend through three solutions:

MAX is AppLovin’s mediation platform, a type of supply-side platform (SSP) which is used by publishers to maximize the value they’re able to sell advertising inventory for by running real-time auctions across a wide range of ad networks. The service is free to use for publishers, with MAX charging advertisers a fee of 5% of header bidding. AppLovin acquired MoPub from Twitter for $1.05 billion in cash in 2022, turning MAX into by far the largest mediation platform for mobile gaming today.

AppLovin’s largest competitor in this segment is Unity Software, which has its own “Grow” segment where it offers tools to monetize and acquire mobile gaming users. It completed a $4.4 billion merger with ironSource in 2022, which was intended to remedy Unity’s own troubled mediation software as ironSource had its own leading mediation platform and tools for creating and managing ad campaigns.

AppLovin actually offered to acquire Unity at $58.85 per share in August 2022 before its planned merger with ironSource. Unity turned down the offer and continued with the merger, which has not proven successful. In January 2024, Unity cut 25% of the combined company’s employees and the ironSource founders left shortly afterwards. In its recent Q2’24 earnings report, Unity’s Grow solutions revenue was $296 million, down 9% YoY and up 1% QoQ after two quarters of QoQ declines. This was a far cry from AppLovin’s own Q2’24 result of 75% YoY and 4.9% QoQ growth for its software segment to $711 million.

AppDiscovery, the majority of the software platform’s revenue, is AppLovin’s demand side platform (DSP) that leverages machine learning to identify high value users that are mostly likely to download and engage with an app and help game publishers to earn the highest return on ad spend. Advertisers pay AppLovin, typically on a cost-per-install performance-basis, who passes on the spend to publishers on a cost per impression model.

Adjust is a SaaS solution that provides analytics to optimize ad performance. It generates revenue mainly through an annual software subscription fee.

Finally, Wurl, a company that AppLovin acquired in 2022, essentially does what APP does but for the connected TV industry. It helps video content creators distribute, monetize, and acquire new users. Wurl generates revenue primarily from content companies which typically pay Wurl on a usage-basis.

Apps Segment (34% of Revenue, 13% of Adjusted EBITDA in Q2’24)

AppLovin’s other main business segment is Apps. AppLovin owns or partners with ten studios worldwide which have published over 200 free-to-play mobile games – mostly in casual and card game genres which are more predictable and target a wider audience.

These apps are monetized through in-app purchases by users (68% of apps revenue in H1’24) as well as advertising (32% of apps revenue in H1’24), with in-app advertising growing slightly more at 8.8% YoY compared to in-app purchases growing at 5.1% YoY.

This segment has become a secondary focus for AppLovin, and they’ve stated their openness to divestitures though they are waiting for the market to improve. The number of studios they partner with has also dropped from 14 in Q2’21 to ten today.

AppLovin competes against other publishers like Activision, Tencent, and Zynga. Notably, many of these companies are also customers for the software segment, with the CEO noting on the Q2’24 call:

“At this point, our platform is so successful in mobile gaming, it's very, very hard for any publisher to look the other way. And so we've gotten a lot more adoption across even those publishers. There isn't really a customer that I know of in mobile gaming that does not find success — scalable success on our platform at this point today.”There isn't really a customer that I know of in mobile gaming that does not find success — scalable success on our platform at this point today.”

Acceleration from AI-Powered Platform

AppLovin’s revenue growth saw a dramatic acceleration over the last four quarters, improving from -3.36% YoY growth in Q2’23 to 44% YoY growth in Q2’24, driven by the Software Platform which rose from 54% of revenue to 64% over the same period.

Management accredited a large part of this acceleration to the launch of AXON 2.0 in early 2023, with growth from this pivot first showing up in the numbers in Q2’23. AXON leverages data from its MAX mediation software to train AXON, an AI-powered advertising engine that drives AppLovin’s AppDiscovery product.

MAX gives AppLovin data on what different ad networks are willing to bid for ad placements, allowing AXON to competitively bid for ad placements to maximize return-on-ad-spend.

Management effectively encapsulates why the combination of their algorithm and their data gives them a first mover advantage in the Q1’24 call:

“We built cutting-edge AI technologies. It's a multi-year effort for anyone to be able to look at that and go be able to replicate that. And I don't even think it's conceivable that it's something that can be replicated. So, by the time there's anyone that's actually going to be able to compete against our technology, we will be years advanced from where we are today because we're continuing to evolve the technology.multi-year effort for anyone to be able to look at that and go be able to replicate that. And I don't even think it's conceivable that it's something that can be replicated. So, by the time there's anyone that's actually going to be able to compete against our technology, we will be years advanced from where we are today because we're continuing to evolve the technology.

Second piece is, we can open-source our code tomorrow. We can hand-out the code to competition. It still won't matter because these technologies need data that they're achieving in the marketplace to be able to drive themselves. So, if you think about like AI models, like what makes an AI model impactful? Well, they're utilized and that data feedback that they get from human behavior retrains the model and allows the model to continue to improve itself.”We can hand-out the code to competition. It still won't matter because these technologies need data that they're achieving in the marketplace to be able to drive themselves. So, if you think about like AI models, like what makes an AI model impactful? Well, they're utilized and that data feedback that they get from human behavior retrains the model and allows the model to continue to improve itself.”

Given AppLovin’s reliance on user tracking to feed its algorithms and how its apps business was impacted by IDFA changes in the past, one of the largest risks are privacy initiatives by Apple and Alphabet to limit user tracking. The CEO responded to this by noting on the Q3’23 call:

“Look, we’ve dealt with privacy changes probably since 2014. Every time there’s a change on platform or with regulators, you’ve changed something in your stock, but we’re a nimble company, we’ve rewritten our core technology multiple times over the years, and we are always able to adapt and perform in the face of any of those kinds of changes.”

Management has also hinted at possible applications outside of gaming, with AppLovin launching its first web advertising campaigns for e-commerce in Q2’24 and noting its early success, with material contributions expected as soon as 2025.

“In the quarter, Q2, we launched pilot of our web advertising program…This allows an e-commerce shop that has a website to buy on our in-app inventory, the billion-plus daily active users we see in mobile gaming, a video advertisement routes that user to their shop and purchase that user in the same way that mobile game companies like purchasing users on our platform.

…Results are looking really promising, materially better than what we would have expected this early in our progression in trying to get into web advertising. So this product, we think is something that we're going to invest heavily behind, start scaling out and hopefully will show a material impact in '25 and beyond. And it is not limited to just e-commerce. It opens the door to advertising for any website of any type that wants to drive transactions that are measurable on a performance basis on our platform.”hopefully will show a material impact in '25 and beyond. And it is not limited to just e-commerce. It opens the door to advertising for any website of any type that wants to drive transactions that are measurable on a performance basis on our platform.”

In the Q2’24 call, management expanded on how improving the algorithm both as a function of more data and model improvements can lead to 20 to 30% long-term software segment growth, compared to industry growth in the low-single-digits, without accounting for expansion into new verticals.

“You've got a mobile gaming category. It's got a few percentage points of growth a year now. So let's call that low-single digits. You've got a business that as these models continue to improve from gathering more data, we think that's an extra 3%, 4% a quarter as well. So, that sort of gets you to the low end.as these models continue to improve from gathering more data, we think that's an extra 3%, 4% a quarter as well. So, that sort of gets you to the low end.

And then we've got a team that's constantly working on improving the models and any improvement that's actually develop or driven enhancement to the models that makes them more accurate, then steps you up into the higher-end of that range. And so we've got a lot of confidence in the growth goal we put out there just on a baseline basis the current business.”any improvement that's actually develop or driven enhancement to the models that makes them more accurate, then steps you up into the higher-end of that range. And so we've got a lot of confidence in the growth goal we put out there just on a baseline basis the current business.”

AppLovin Q2 Financials

AppLovin reported a decent Q2’24, with a bottom-line beat and top-line that was in-line with estimates. Guidance also came ahead of estimates on revenue and adjusted EBITDA.

The software segment again was the driver of growth, reporting 75.1% YoY growth, compared to the overall business at 44% YoY growth, but QoQ growth slowed noticeably from recent quarters.

The highlight of the report was the strong margin improvements, driven by both the continued mix shift towards higher margin software revenue as well as outperformance in apps segment margins due to a reduction in costs.

AppLovin’s Q3’24 guidance also continues to assume strong growth; if the apps segment grows at the same rate YoY as Q2, then the guidance implies a slight re-acceleration in the Software Platform segment from 44% YoY growth to 46.6% YoY growth.

Revenue and EPS

  • Q2 revenue grew by 44% YoY to $1.08 billion. It was in-line with expectations
  • AppLovin guided for Q3 revenue of $1.125 billion at the midpoint, representing YoY growth of 30.2%, beating $1.10 billion consensus by 2.2% at the midpoint.
  • Management remains confident that they can grow their software segment at a 20% to 30% CAGR for the long term after first mentioning the goal last quarter.

Margins

Margins remained strong with gross, operating, adjusted EBITDA, and net margins all expanding YoY and QoQ, driven by a mix shift towards higher Software Platform revenue and cost discipline. Management expects these margin improvements to continue, guiding for QoQ expansion in adjusted EBITDA margin.

  • Gross profit rose 62.2% YoY to $797.6 million. Gross margin was 73.8%, up from 65.5% last year and 72.2% last quarter.
  • Operating income rose 197.2% YoY to $391 million. Operating margin was 36.2%, up from 17.5% last year and from 32.1% last quarter.
  • Net income rose 285.7% YoY to $310 million. Net margin came in at 28.7%, up from 10.7% last year and 22.3% last quarter. GAAP EPS of $0.89 beat estimates by $0.16, representing YoY growth of 304.5%.
  • Quarterly EPS growth is expected to level off with GAAP EPS of $1.01 expected for Q3’24 and the same for Q2’25.
  • Adjusted EBITDA rose 80% YoY to $601 million, beating guidance by 7.3% at the midpoint. Adjusted EBITDA margin was 55.7%, beating guidance of 52.5% at the midpoint and up from 44% last year and 52% last quarter.
  • Management guided for further improvement in adjusted EBITDA margins next quarter, targeting $640 million at the midpoint, representing a 57% margin and beating consensus of $587 million by 9%.

Cash and Debt

Operating cash flow was $454.5 million, up 97.8% YoY. Operating cash flow margin was 42.1%, up from 30.6% last year and 37.1% last quarter.

Free cash flow was $445.5 million, up 101.9% YoY. Free cash flow margin was 41.2%, up from 29.4% last year and 36.6% last quarter. For comparison, analysts expect competitor Unity Software to only earn a 12.7% FCF margin in 2024, compared to 8.2% in 2023. Digital Turbine, another ad tech company that offers user acquisition and monetization services is expected to earn just 4.3% FCF margins for FY’25 (ending March 2025) compared to 0.8% in FY’24. Even The Trade Desk, the leading DSP, is expected to earn 27% FCF margins in 2024, compared to 28% in 2023.

For Q2 2024, the company has $3.52 billion in total debt, up slightly from the $3.50 billion in total debt reported in the previous quarter and $3.2 billion last year. AppLovin reported $460.45 million in cash and marketable securities, down from $876.2 million last year but up from $436.3 million last quarter.

AppLovin repurchased 4.2 million shares for $356 million in the quarter. They currently have $500 million remaining in its $1.25 billion repurchase authorization. AppLovin has taken advantage of the drawdown in its share price to repurchase shares, reducing its share count by 10.6% since the end of 2022.

Revenue Segments

AppLovin’s Software Platform revenue grew 75% YoY and 4.9% QoQ to $711 million, marking the sixth consecutive quarter of QoQ acceleration driven by AXON 2.0, though noticeably by a smaller percentage than previous quarters.

AppLovin’s Software Platform adjusted EBITDA grew by 90.7% YoY and 5.8% QoQ to $520.5 million. Software EBITDA margins were 73.2%, up from 72.6% last quarter and 67.2% last year.

AppLovin’s Apps segment revenue grew 7.2% YoY to $369.1 million, marking the second consecutive quarter of YoY growth.

AppLovin’s Apps segment adjusted EBITDA grew 33.1% YoY and 42.2% QoQ. Apps adjusted EBITDA margins were 21.9%, a significant improvement from 18% last year and 15% last quarter. This quarter was a standout due to a readjustment in user acquisition return goals, resulting in a 11% QoQ decrease in app segment costs. Management expects Apps EBITDA margin to normalize at 15% over the long-term.

Key Metrics

AppLovin logged 1.6 million Monthly Active Payers (MAP) for their Apps segment, a decrease from 1.8 million last quarter and 1.7 million last year. However, Average Revenue per MAP grew to $52, up from $48 last quarter and $46 last year.

Regarding the Software Platform, net revenue per installation increased 7% YoY in Q2’24 while the volume of installations increased 77% YoY, both strong indicators on the effectiveness of its AppDiscovery product.

Valuation

On the top line, AppLovin is trading at the highest it’s traded since the 2021 blowoff top at 6.5X Forward PS. We could see a re-rating of stocks to pre-2022 top line valuations, but this is incredibly speculative. Therefore, a 4X Forward PS is a better target, in our opinion. Unity is trading at a 3.7X Forward PS.

On the bottom line, AppLovin trades at a lower multiple relative to its growth rate at 11x NTM EV/EBITDA and 20.5x LTM EV/FCF. Its closest competitor, Unity, trades at 16x NTM EV/EBITDA and its revenue its projected to fall 16% YoY this year due to backlash from the controversial Unity Runtime Fee last year, poor execution on integrating ironSource, and management turnover, compared to AppLovin’s 33% projected growth.

The reason behind this discount seems to be driven by AppLovin’s shrinking Apps segment. Although it reported 7% YoY growth in Q2’24, it was down 20% from two years ago as AppLovin intentionally divests away from the segment to focus on software. However, this segment continues to be profitable, with adjusted EBITDA margins never falling below management’s 15% long-term target over the last two years.

Even if we assign zero value to the Apps segment, the business still trades at 15x LTM EV/EBITDA for the Software Platform segment alone, which grew revenue 80% YoY over the same period and continues to project 20% to 30% growth.

Another concern could be AppLovin’s period of no-growth in 2022, where revenues stagnated YoY. However, this came after blistering 92% YoY growth in 2021 and before the launch of AXON 2.0 which has driven accelerating Software Platform growth since Q2’23.

While the durability of revenue growth associated with AXON 2.0 remains difficult to predict by management’s own admission, the product is becoming stronger every quarter and that is directly translating to efficiency gains and higher growth.

Conclusion

Ad-tech is one of the industries with the most potential to be transformed by AI and AppLovin is emerging as one of the leaders with its AXON 2.0 engine. AppLovin’s core advantage comes from its superior access to data, leading to better targeting, which leads to more data and so on. We see continued strong growth for the Software Platform segment because of this, driving high growth and an improving margin profile for the company.

We continue to watch AppLovin with interest as it continues to take share within mobile gaming and expand its AI engine to additional industries. Although we are not considering a buy at this time, Knox has a trading plan, which he will share with Advanced Members in this upcoming Thursday webinar.

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!

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

Recommended Reading:

AppLovin Corporation: Emerging Ad Tech AI Leader

Posted on by io-fund

Intro

AppLovin is an ad-tech company that saw a strong acceleration in growth and margins this past year driven by AXON 2.0, an AI-powered advertising engine that efficiently acquires users for mobile game publishers.

At IPO in 2021, AppLovin made most of its revenue from its Apps segment, a portfolio of free-to-play mobile games. This was historically seen as a cost center as AppLovin could gain a valuable trove of first-party data to feed into improving its user acquisition algorithms. However, management has since made an important pivot to grow its Software Platform segment, composed of MAX, its supply side platform (SSP) and AppDiscovery, its demand side platform (DSP).

This was because as MAX grew, AppLovin had a better source of data and gradually restructured its Apps business to focus on maximizing profitability. This transition made sense given the drastically different margin profile of the two segments, with a 15% long-term adjusted EBITDA margin profile for Apps compared to the over 73% adjusted EBITDA margin of the Software Platform segment.

After Apple announced its App Tracking Transparency (ATT) policy in 2021 which limited advertisers’ ability to track users across apps, AppLovin’s data became even more valuable as advertisers sought out AppDiscovery’s user acquisition algorithms to acquire high value users cost-effectively.

Furthermore, AppLovin’s CEO has repeatedly made clear that its AI recommendation engine has applications far beyond mobile gaming. It acquired Wurl, a Connected TV (CTV) SSP, in 2022 as an initial foray into CTV.

With a mobile ad network significantly larger than others in the market, AppLovin’s end-to-end advertising stack gives it a unique data advantage which enables superior algorithms that deliver better ad conversion rates, leading to higher return on ad spend to advertisers and higher spending, which attracts more inventory, leading to even better algorithms and so on.

Provided we can get the stock at a reasonable valuation, due to a durable data advantage, we believe AppLovin will be well-positioned to outperform.

Business Overview

AppLovin’s business consists of two segments: a fast-growing, high margin Software Platform and a slower-growing, lower margin (but still profitable) Apps segment consisting of its portfolio free-to-play mobile games. Our focus is on the software segment as it continues to drive top-line growth, powered by its AXON 2.0 AI-engine which we will discuss below.

Software Platform Segment (66% of Revenue, 87% of Adjusted EBITDA in Q2’24)

AppLovin’s software platform enables mobile gaming publishers to monetize their ad inventory, acquire new users more cost-effectively, and optimize their ad spend through three solutions:

MAX is AppLovin’s mediation platform, a type of supply-side platform (SSP) which is used by publishers to maximize the value they’re able to sell advertising inventory for by running real-time auctions across a wide range of ad networks. The service is free to use for publishers, with MAX charging advertisers a fee of 5% of header bidding. AppLovin acquired MoPub from Twitter for $1.05 billion in cash in 2022, turning MAX into by far the largest mediation platform for mobile gaming today.

AppLovin’s largest competitor in this segment is Unity Software, which has its own “Grow” segment where it offers tools to monetize and acquire mobile gaming users. It completed a $4.4 billion merger with ironSource in 2022, which was intended to remedy Unity’s own troubled mediation software as ironSource had its own leading mediation platform and tools for creating and managing ad campaigns.

AppLovin actually offered to acquire Unity at $58.85 per share in August 2022 before its planned merger with ironSource. Unity turned down the offer and continued with the merger, which has not proven successful. In January 2024, Unity cut 25% of the combined company’s employees and the ironSource founders left shortly afterwards. In its recent Q2’24 earnings report, Unity’s Grow solutions revenue was $296 million, down 9% YoY and up 1% QoQ after two quarters of QoQ declines. This was a far cry from AppLovin’s own Q2’24 result of 75% YoY and 4.9% QoQ growth for its software segment to $711 million.

AppDiscovery, the majority of the software platform’s revenue, is AppLovin’s demand side platform (DSP) that leverages machine learning to identify high value users that are mostly likely to download and engage with an app and help game publishers to earn the highest return on ad spend. Advertisers pay AppLovin, typically on a cost-per-install performance-basis, who passes on the spend to publishers on a cost per impression model.

Adjust is a SaaS solution that provides analytics to optimize ad performance. It generates revenue mainly through an annual software subscription fee.

Finally, Wurl, a company that AppLovin acquired in 2022, essentially does what APP does but for the connected TV industry. It helps video content creators distribute, monetize, and acquire new users. Wurl generates revenue primarily from content companies which typically pay Wurl on a usage-basis.

Apps Segment (34% of Revenue, 13% of Adjusted EBITDA in Q2’24)

AppLovin’s other main business segment is Apps. AppLovin owns or partners with ten studios worldwide which have published over 200 free-to-play mobile games – mostly in casual and card game genres which are more predictable and target a wider audience.

These apps are monetized through in-app purchases by users (68% of apps revenue in H1’24) as well as advertising (32% of apps revenue in H1’24), with in-app advertising growing slightly more at 8.8% YoY compared to in-app purchases growing at 5.1% YoY.

This segment has become a secondary focus for AppLovin, and they’ve stated their openness to divestitures though they are waiting for the market to improve. The number of studios they partner with has also dropped from 14 in Q2’21 to ten today.

AppLovin competes against other publishers like Activision, Tencent, and Zynga. Notably, many of these companies are also customers for the software segment, with the CEO noting on the Q2’24 call:

“At this point, our platform is so successful in mobile gaming, it's very, very hard for any publisher to look the other way. And so we've gotten a lot more adoption across even those publishers. There isn't really a customer that I know of in mobile gaming that does not find success — scalable success on our platform at this point today.”There isn't really a customer that I know of in mobile gaming that does not find success — scalable success on our platform at this point today.”

Acceleration from AI-Powered Platform

AppLovin’s revenue growth saw a dramatic acceleration over the last four quarters, improving from -3.36% YoY growth in Q2’23 to 44% YoY growth in Q2’24, driven by the Software Platform which rose from 54% of revenue to 64% over the same period.

Management accredited a large part of this acceleration to the launch of AXON 2.0 in early 2023, with growth from this pivot first showing up in the numbers in Q2’23. AXON leverages data from its MAX mediation software to train AXON, an AI-powered advertising engine that drives AppLovin’s AppDiscovery product.

MAX gives AppLovin data on what different ad networks are willing to bid for ad placements, allowing AXON to competitively bid for ad placements to maximize return-on-ad-spend.

Management effectively encapsulates why the combination of their algorithm and their data gives them a first mover advantage in the Q1’24 call:

“We built cutting-edge AI technologies. It's a multi-year effort for anyone to be able to look at that and go be able to replicate that. And I don't even think it's conceivable that it's something that can be replicated. So, by the time there's anyone that's actually going to be able to compete against our technology, we will be years advanced from where we are today because we're continuing to evolve the technology.multi-year effort for anyone to be able to look at that and go be able to replicate that. And I don't even think it's conceivable that it's something that can be replicated. So, by the time there's anyone that's actually going to be able to compete against our technology, we will be years advanced from where we are today because we're continuing to evolve the technology.

Second piece is, we can open-source our code tomorrow. We can hand-out the code to competition. It still won't matter because these technologies need data that they're achieving in the marketplace to be able to drive themselves. So, if you think about like AI models, like what makes an AI model impactful? Well, they're utilized and that data feedback that they get from human behavior retrains the model and allows the model to continue to improve itself.”We can hand-out the code to competition. It still won't matter because these technologies need data that they're achieving in the marketplace to be able to drive themselves. So, if you think about like AI models, like what makes an AI model impactful? Well, they're utilized and that data feedback that they get from human behavior retrains the model and allows the model to continue to improve itself.”

Given AppLovin’s reliance on user tracking to feed its algorithms and how its apps business was impacted by IDFA changes in the past, one of the largest risks are privacy initiatives by Apple and Alphabet to limit user tracking. The CEO responded to this by noting on the Q3’23 call:

“Look, we’ve dealt with privacy changes probably since 2014. Every time there’s a change on platform or with regulators, you’ve changed something in your stock, but we’re a nimble company, we’ve rewritten our core technology multiple times over the years, and we are always able to adapt and perform in the face of any of those kinds of changes.”

Management has also hinted at possible applications outside of gaming, with AppLovin launching its first web advertising campaigns for e-commerce in Q2’24 and noting its early success, with material contributions expected as soon as 2025.

“In the quarter, Q2, we launched pilot of our web advertising program…This allows an e-commerce shop that has a website to buy on our in-app inventory, the billion-plus daily active users we see in mobile gaming, a video advertisement routes that user to their shop and purchase that user in the same way that mobile game companies like purchasing users on our platform.

…Results are looking really promising, materially better than what we would have expected this early in our progression in trying to get into web advertising. So this product, we think is something that we're going to invest heavily behind, start scaling out and hopefully will show a material impact in '25 and beyond. And it is not limited to just e-commerce. It opens the door to advertising for any website of any type that wants to drive transactions that are measurable on a performance basis on our platform.”hopefully will show a material impact in '25 and beyond. And it is not limited to just e-commerce. It opens the door to advertising for any website of any type that wants to drive transactions that are measurable on a performance basis on our platform.”

In the Q2’24 call, management expanded on how improving the algorithm both as a function of more data and model improvements can lead to 20 to 30% long-term software segment growth, compared to industry growth in the low-single-digits, without accounting for expansion into new verticals.

“You've got a mobile gaming category. It's got a few percentage points of growth a year now. So let's call that low-single digits. You've got a business that as these models continue to improve from gathering more data, we think that's an extra 3%, 4% a quarter as well. So, that sort of gets you to the low end.as these models continue to improve from gathering more data, we think that's an extra 3%, 4% a quarter as well. So, that sort of gets you to the low end.

And then we've got a team that's constantly working on improving the models and any improvement that's actually develop or driven enhancement to the models that makes them more accurate, then steps you up into the higher-end of that range. And so we've got a lot of confidence in the growth goal we put out there just on a baseline basis the current business.”any improvement that's actually develop or driven enhancement to the models that makes them more accurate, then steps you up into the higher-end of that range. And so we've got a lot of confidence in the growth goal we put out there just on a baseline basis the current business.”

AppLovin Q2 Financials

AppLovin reported a decent Q2’24, with a bottom-line beat and top-line that was in-line with estimates. Guidance also came ahead of estimates on revenue and adjusted EBITDA.

The software segment again was the driver of growth, reporting 75.1% YoY growth, compared to the overall business at 44% YoY growth, but QoQ growth slowed noticeably from recent quarters.

The highlight of the report was the strong margin improvements, driven by both the continued mix shift towards higher margin software revenue as well as outperformance in apps segment margins due to a reduction in costs.

AppLovin’s Q3’24 guidance also continues to assume strong growth; if the apps segment grows at the same rate YoY as Q2, then the guidance implies a slight re-acceleration in the Software Platform segment from 44% YoY growth to 46.6% YoY growth.

Revenue and EPS

  • Q2 revenue grew by 44% YoY to $1.08 billion. It was in-line with expectations
  • AppLovin guided for Q3 revenue of $1.125 billion at the midpoint, representing YoY growth of 30.2%, beating $1.10 billion consensus by 2.2% at the midpoint.
  • Management remains confident that they can grow their software segment at a 20% to 30% CAGR for the long term after first mentioning the goal last quarter.

Margins

Margins remained strong with gross, operating, adjusted EBITDA, and net margins all expanding YoY and QoQ, driven by a mix shift towards higher Software Platform revenue and cost discipline. Management expects these margin improvements to continue, guiding for QoQ expansion in adjusted EBITDA margin.

  • Gross profit rose 62.2% YoY to $797.6 million. Gross margin was 73.8%, up from 65.5% last year and 72.2% last quarter.
  • Operating income rose 197.2% YoY to $391 million. Operating margin was 36.2%, up from 17.5% last year and from 32.1% last quarter.
  • Net income rose 285.7% YoY to $310 million. Net margin came in at 28.7%, up from 10.7% last year and 22.3% last quarter. GAAP EPS of $0.89 beat estimates by $0.16, representing YoY growth of 304.5%.
  • Quarterly EPS growth is expected to level off with GAAP EPS of $1.01 expected for Q3’24 and the same for Q2’25.
  • Adjusted EBITDA rose 80% YoY to $601 million, beating guidance by 7.3% at the midpoint. Adjusted EBITDA margin was 55.7%, beating guidance of 52.5% at the midpoint and up from 44% last year and 52% last quarter.
  • Management guided for further improvement in adjusted EBITDA margins next quarter, targeting $640 million at the midpoint, representing a 57% margin and beating consensus of $587 million by 9%.

Cash and Debt

Operating cash flow was $454.5 million, up 97.8% YoY. Operating cash flow margin was 42.1%, up from 30.6% last year and 37.1% last quarter.

Free cash flow was $445.5 million, up 101.9% YoY. Free cash flow margin was 41.2%, up from 29.4% last year and 36.6% last quarter. For comparison, analysts expect competitor Unity Software to only earn a 12.7% FCF margin in 2024, compared to 8.2% in 2023. Digital Turbine, another ad tech company that offers user acquisition and monetization services is expected to earn just 4.3% FCF margins for FY’25 (ending March 2025) compared to 0.8% in FY’24. Even The Trade Desk, the leading DSP, is expected to earn 27% FCF margins in 2024, compared to 28% in 2023.

For Q2 2024, the company has $3.52 billion in total debt, up slightly from the $3.50 billion in total debt reported in the previous quarter and $3.2 billion last year. AppLovin reported $460.45 million in cash and marketable securities, down from $876.2 million last year but up from $436.3 million last quarter.

AppLovin repurchased 4.2 million shares for $356 million in the quarter. They currently have $500 million remaining in its $1.25 billion repurchase authorization. AppLovin has taken advantage of the drawdown in its share price to repurchase shares, reducing its share count by 10.6% since the end of 2022.

Revenue Segments

AppLovin’s Software Platform revenue grew 75% YoY and 4.9% QoQ to $711 million, marking the sixth consecutive quarter of QoQ acceleration driven by AXON 2.0, though noticeably by a smaller percentage than previous quarters.

AppLovin’s Software Platform adjusted EBITDA grew by 90.7% YoY and 5.8% QoQ to $520.5 million. Software EBITDA margins were 73.2%, up from 72.6% last quarter and 67.2% last year.

AppLovin’s Apps segment revenue grew 7.2% YoY to $369.1 million, marking the second consecutive quarter of YoY growth.

AppLovin’s Apps segment adjusted EBITDA grew 33.1% YoY and 42.2% QoQ. Apps adjusted EBITDA margins were 21.9%, a significant improvement from 18% last year and 15% last quarter. This quarter was a standout due to a readjustment in user acquisition return goals, resulting in a 11% QoQ decrease in app segment costs. Management expects Apps EBITDA margin to normalize at 15% over the long-term.

Key Metrics

AppLovin logged 1.6 million Monthly Active Payers (MAP) for their Apps segment, a decrease from 1.8 million last quarter and 1.7 million last year. However, Average Revenue per MAP grew to $52, up from $48 last quarter and $46 last year.

Regarding the Software Platform, net revenue per installation increased 7% YoY in Q2’24 while the volume of installations increased 77% YoY, both strong indicators on the effectiveness of its AppDiscovery product.

Valuation

On the top line, AppLovin is trading at the highest it’s traded since the 2021 blowoff top at 6.5X Forward PS. We could see a re-rating of stocks to pre-2022 top line valuations, but this is incredibly speculative. Therefore, a 4X Forward PS is a better target, in our opinion. Unity is trading at a 3.7X Forward PS.

On the bottom line, AppLovin trades at a lower multiple relative to its growth rate at 11x NTM EV/EBITDA and 20.5x LTM EV/FCF. Its closest competitor, Unity, trades at 16x NTM EV/EBITDA and its revenue its projected to fall 16% YoY this year due to backlash from the controversial Unity Runtime Fee last year, poor execution on integrating ironSource, and management turnover, compared to AppLovin’s 33% projected growth.

The reason behind this discount seems to be driven by AppLovin’s shrinking Apps segment. Although it reported 7% YoY growth in Q2’24, it was down 20% from two years ago as AppLovin intentionally divests away from the segment to focus on software. However, this segment continues to be profitable, with adjusted EBITDA margins never falling below management’s 15% long-term target over the last two years.

Even if we assign zero value to the Apps segment, the business still trades at 15x LTM EV/EBITDA for the Software Platform segment alone, which grew revenue 80% YoY over the same period and continues to project 20% to 30% growth.

Another concern could be AppLovin’s period of no-growth in 2022, where revenues stagnated YoY. However, this came after blistering 92% YoY growth in 2021 and before the launch of AXON 2.0 which has driven accelerating Software Platform growth since Q2’23.

While the durability of revenue growth associated with AXON 2.0 remains difficult to predict by management’s own admission, the product is becoming stronger every quarter and that is directly translating to efficiency gains and higher growth.

Conclusion

Ad-tech is one of the industries with the most potential to be transformed by AI and AppLovin is emerging as one of the leaders with its AXON 2.0 engine. AppLovin’s core advantage comes from its superior access to data, leading to better targeting, which leads to more data and so on. We see continued strong growth for the Software Platform segment because of this, driving high growth and an improving margin profile for the company.

We continue to watch AppLovin with interest as it continues to take share within mobile gaming and expand its AI engine to additional industries. Although we are not considering a buy at this time, Knox has a trading plan, which he will share with Advanced Members in this upcoming Thursday webinar.

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!

Recommended Reading:

Big Tech Battles On AI, Here’s The Winner

Posted on by io-fund

This article was originally published on Forbes on Updated Aug 8, 2024, 09:24pm EDTForbes on Updated Aug 8, 2024, 09:24pm EDT

The major theme over the past month in Big Tech and AI semiconductors has been the durability of demand: essentially, what is Big Tech’s return on more than $150 billion in capex over the last twelve months (primarily for AI infrastructure), and if the companies can generate a substantial enough return from AI products to continue catalyzing GPU demand and revenue for Nvidia.

Though Big Tech’s June quarter earnings were met mostly with rather gloomy reactions, management teams reiterated positivity on the long-term potential of generative AI products and services, and the need for continual investment in AI infrastructure.

Microsoft stands out as the clear leader with multiple different monetization pathways from generative AI, whether through Azure or GitHub Copilot, while AWS has seen growth reaccelerate as AI’s revenue contribution reaches a multi-billion-dollar run rate.

Alphabet has touted billions in AI related revenue, while Meta is seeing an in-house effect with AI playing an increasingly large role in engagement and ad delivery across Meta’s family of apps.

The Quest for ROI

Sequoia Capital recently raised an alarm on Big Tech’s massive AI investments, and whether companies will be able to realize large enough returns to justify these expenditures, calling it “AI’s $600B Question,” in a follow up to their September 2023 analysis and the $200B question. Sequoia’s analysis suggests that based on Nvidia’s annualized $150B data center run rate by Q4, the revenue required for payback on capex would be $600B, based on a 50% software margin for CSPs and 50% operating cost from GPUs.

This sparked fears as Big Tech is not yet able to convince investors or analysts that these investments will pay off. This has led to analysts pressing management over monetization and potential overinvestment in capacity in earnings calls.

Lead Tech Analyst Beth Kindig recently discussed this with Bloomberg Asia following Alphabet’s earnings, saying that investors are looking for an ROI from Big Tech in terms of quarter-over-quarter revenue accelerations from AI in the cloud, and if these accelerations are enough to justify the amount of capex spent.

Sign up for I/O Fund's free newsletter with gains of up to 2600% because of Nvidia's epic run – Click here.Click here.

Capex Growth Continues

We recapped Big Tech’s capex and commentary following Q1’s earnings in mid-May for our newsletter readers, saying at the time that Big Tech “will likely commit upwards of $200 billion, maybe even $210 billion, combined in capex this year, predominantly for AI infrastructure – from data center construction and expansion, to GPU procurement and custom silicon efforts and more.

It’s no wonder the four are boosting capex by more than 35% YoY, given positive outlooks on AI’s potential to drive revenue growth in the billions and how demand continues to outstrip GPU supply.”

Following the recent Q2 reports, Big Tech did, indeed, commit $210 billion to capex.

In the first half of 2024, Alphabet, Amazon, Meta and Microsoft spent nearly $104 billion in capex, up 47% YoY, with more than half of that total coming in Q2. Microsoft and Alphabet saw the largest YoY increases among the four, driving capex 78% and 91% higher for the first half of the year, respectively.

Big Tech Capex Growth

Big Tech spent nearly $104 billion in capex in the first half of 2024, up 47% YoY, with more than half of that total coming in Q2.

Source: I/O Fund

Microsoft: Capex this quarter was $19 billion, an increase of nearly 78% YoY from $7.8 billion in the year ago quarter, and a QoQ increase of almost 36% from $14 billion last quarter. Microsoft’s fiscal 2024 (ending June) capex was $55.7 billion, up nearly 75% YoY, and management is guiding for a YoY increase in capex in FY’25.

Meta: Capex was almost $8.5 billion in Q2, up more than 33% YoY and 26% QoQ. Meta’s first half capex totaled $15.2 billion, with management raising the lower-bound of their 2024 capex guidance range by $2 billion, from a prior view for $35 to $40 billion to $37 to $40 billion. This would imply ~37% YoY growth at midpoint for the full year, and indicate a significant acceleration in the back half, with more than $23 billion in capex projected at midpoint. Meta also expects “significant” capex growth in 2025 to support AI initiatives.

Alphabet: Capex totaled $13.2 billion in Q2, up 91% YoY and approximately 10% QoQ. Management said the surge in Q2 was “driven overwhelmingly by investment in our technical infrastructure with the largest component for servers followed by data centers.” For the year, management expects quarterly capex to be flat or above Q1’s $12 billion figure, implying capex of $50 billion or more.

Amazon: Capex was $16.5 billion in Q2, with Amazon the second-largest spender in the quarter after Microsoft. Amazon projected capex in the back half to be higher, suggesting 2024’s capex will come in well above $60 billion, with management saying the majority will go to support AWS infrastructure to meet high demand for both generative AI and non-generative AI services.

Big Tech’s capex is a barometer for the AI semiconductor industry, one that we closely track as we have a heavy allocation of stocks in this booming industry. Learn more about the I/O Fund’s holdings and consistent deep dive research on AI stocks, crypto and more here.here.

Analysts Pressing Big Tech Over ROI

Given this significant spending through 2023 and 2024, analysts are questioning whether monetization is going to match the level of investment, and grilled management teams over ROI timelines and AI capacity.

The management teams offered similar responses – which is that the predominant risk in AI is for those arrive late. Note, that it’s quite rare to have management teams from this many different companies agree (on anything really); and they are not only saying it in words, rather are showing us the seriousness of what is being stated in their budgets. Due to the sheer amount of capex, plus the unanimous agreement we are seeing across companies with $1T+ market cap on the importance of this capex, we are quoting the management teams directly.

Amazon:

Eric Sheridan (Analyst): “There's been a theme during the last couple of weeks of earnings of the potential to over-invest as opposed to under-invest in AI as a broad theme. I'm curious, Andy, if you have a perspective on that in terms of thinking about elements of capitalizing on the theme longer term against the potential for pace or cadence of investment on AWS as a segment.”

Amazon CEO Andy Jassy: “We also are getting a lot of signals from customers on what they need. I think that it's — the reality right now is that while we're investing a significant amount in the AI space and in infrastructure, we would like to have more capacity than we already have today. I mean we have a lot of demand right now. And I think it's going to be a very, very large business for us.”

Jassy also discussed the challenges in managing a business of AWS’ scale, and delivering too little or too much capacity, saying AWS understands the balance and how to manage capacity “reasonably well” to ensure AWS deploys the “right amount of capacity."

Alphabet:

Ross Sandler (Analyst): “Just two questions on the AI CapEx. So it looks like from the outside at least, the hyperscaler industry is going from kind of an under bill situation this time last year to better meeting the demand with capacity right now to potentially being overbuilt next year if these CapEx growth rates keep up. So do you think that's a fair characterization? And how are we thinking about the return on invested capital with this AI CapEx cycle.”

Alphabet CEO Sundar Pichai: “I think the one way I think about it is when we go through a curve like this, the risk of under-investing is dramatically greater than the risk of over-investing for us here, even in scenarios where if it turns out that we are over investing. … But I think not investing to be at the frontier, I think definitely has much more significant downsidethe risk of under-investing is dramatically greater than the risk of over-investing for us here, even in scenarios where if it turns out that we are over investing. … But I think not investing to be at the frontier, I think definitely has much more significant downside.”

Meta:

Brian Nowak (Analyst): “You have a lot of CapEx priorities from building new infrastructure for next-generation models, compute capacity. Just walk us through again on the CapEx philosophy and any guardrails you have around ensuring you generate a healthy return on invested capital for investors from all the CapEx.”

Meta CFO Susan Li: “On the ROI part of your question, I’d broadly characterize our AI investments into two buckets; core AI and Gen AI. And the two are really at different stages, as it relates to driving revenue for our businesses and our ability to measure returns. On our core AI work, we continue to take a very ROI based approach to our investment here. We are still seeing strong returns as improvements to both engagement and ad performance have translated into revenue gains and it makes sense for us to continue investing here.And the two are really at different stages, as it relates to driving revenue for our businesses and our ability to measure returns. On our core AI work, we continue to take a very ROI based approach to our investment here. We are still seeing strong returns as improvements to both engagement and ad performance have translated into revenue gains and it makes sense for us to continue investing here.

Gen AI is where we are much earlier. … We don't expect our Gen AI products to be a meaningful driver of revenue in 2024. But we do expect that they are going to open up new revenue opportunities over time that will enable us to generate a solid return off of our investment while we are also open sourcing subsequent generations of Llama. And we've talked about the four primary areas that we are focused here on the Gen AI opportunities to enhance the core ads business, to help us grow in business messaging, the opportunities around Meta AI, and the opportunities to grow core engagement over time.Gen AI is where we are much earlier. … We don't expect our Gen AI products to be a meaningful driver of revenue in 2024. But we do expect that they are going to open up new revenue opportunities over time that will enable us to generate a solid return off of our investment while we are also open sourcing subsequent generations of Llama. And we've talked about the four primary areas that we are focused here on the Gen AI opportunities to enhance the core ads business, to help us grow in business messaging, the opportunities around Meta AI, and the opportunities to grow core engagement over time.

… So while we do expect that we are going to grow CapEx significantly in 2025, we feel like we have a good framework in place in terms of thinking about where the opportunities are and making sure that we have the flexibility to deploy it, as makes the most sense.”So while we do expect that we are going to grow CapEx significantly in 2025, we feel like we have a good framework in place in terms of thinking about where the opportunities are and making sure that we have the flexibility to deploy it, as makes the most sense.”

CEO Mark Zuckerberg said he would “rather risk building capacity before it is needed rather than too late,” rather risk building capacity before it is needed rather than too late,” as the “people who bet on those early indicators tend to do pretty well,” in a reference to Meta AI’s early success and it being “on track to achieve our goal of being the most used AI assistant by the end of this year”.

Microsoft:

Keith Weiss(Analyst): “Right now, there's an industry debate raging around the CapEx requirements around Generative AI and whether the monetization is actually going to match with that. Is CapEx still an appropriate leading indicator for cloud growth? Or does the shift in gross margin profile change that equation? Or said another way, maybe can you give us a little bit more help in understanding the timing between the CapEx investments and the yield on those investments?”

Microsoft CEO Satya Nadella: “So I would say – and obviously, the Azure AI growth, that's the first place we look at. That then drives bulk of the CapEx spend, basically, that's the demand signal ,,, we will only be scaling training as we see the demand accrue in any given period in time. So I would say it's more important to manage to capture the opportunity with the right product portfolio that's driving value.”the Azure AI growth, that's the first place we look at. That then drives bulk of the CapEx spend, basically, that's the demand signal ,,, we will only be scaling training as we see the demand accrue in any given period in time. So I would say it's more important to manage to capture the opportunity with the right product portfolio that's driving value.”

“The asset, as Amy said, is a long-term asset, which is land and the data center, which, by the way, we don't even construct things fully, we can even have things which are semi-constructed, we call [cold] (PH) shelves and so on. So we know how to manage our CapEx spend to build out a long-term asset and a lot of the hydration of the kit happens when we have the demand signal.”we don't even construct things fully, we can even have things which are semi-constructed, we call [cold] (PH) shelves and so on. So we know how to manage our CapEx spend to build out a long-term asset and a lot of the hydration of the kit happens when we have the demand signal.”

CFO Amy Hood:

“[…] when we did this last transition, the first transition to the Cloud, which seems a long time ago sometimes, it rolled out quite differently. We rolled out more geo by geo and this one because we have demand on a global basis, we are doing it on a global basis, which is important. We have large customers in every geo. And so hopefully, with that sort of shape of our capital expense, it helps people see how much of that is sort of near-term monetization driver as well as a much longer duration.”because we have demand on a global basis, we are doing it on a global basis, which is important. We have large customers in every geo. And so hopefully, with that sort of shape of our capital expense, it helps people see how much of that is sort of near-term monetization driver as well as a much longer duration.”

Microsoft reiterated that capacity was and will continue to be the primary constraint for AI and Azure’s growth. They noted the need to invest ahead of demand with respect to land and data centers on a global basis, which necessitates an elevated level of capex to maintain growth over the long-term. However, they noted that they are waiting to fully outfit data centers to align with demand and thus the first clue to when capex might slow down likely will be seen in a QoQ stagnation in AI-driven Azure revenues from Microsoft.

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Microsoft Leads in AI Monetization, Amazon Close Behind

When it comes to Big Tech’s ability to monetize AI features and services, Microsoft leads the pack, with multiple different AI revenue streams and multiple billions in revenue. Amazon follows closely behind with AWS, while Meta and Google are both improving revenue generation and profitability via AI integrations in core products.

For Microsoft’s Azure, AI services contributed 8 percentage points of growth in the quarter, up from 7% in the prior quarter. Azure AI Services revenue run rate is estimated to be ~$5 billion, up 900% YoY, with 60% YoY growth in customers to more than 60,000. Though management guided for slightly softer Azure growth next quarter (fiscal Q1’25), demand continues to outstrip capacity, and management expects an acceleration in the second half of fiscal 2025 as AI capacity increases.

Microsoft is also seeing strong AI growth via Copilot offerings in GitHub and Office. GitHub’s ARR has reached $2B, with GitHub Copilot accounting for over 40% of GitHub’s revenue growth this year. GitHub Copilot has been adopted by over 77,000 companies, up 180% YoY. Copilot for Microsoft 365 continues to gain traction in just its second quarter of availability, with the number of people using Copilot daily at work nearly doubling QoQ. Copilot customers increased 60% QoQ and the number of customers with over 10,000 seats more than doubled QoQ. Copilot Studio, a low-code tool for creating and maintaining copilots, saw a 70% QoQ increase in organizations using it to 50,000.

Amazon has not provided a clear-cut breakdown of what percentage of AWS’ growth is being driven by AI, but management pointed out that Amazon has “a multibillion-dollar revenue run rate already in AI, and it's so early.” Management also noted that AWS “has launched more than twice as many machine learning and generative AI features into general availability than all the other major cloud providers combined.”

Amazon continues to roll out AI services and features across its businesses, recently unveiling its AI-powered shopping assistant Rufus, to assist customers with e-commerce purchases. Amazon believes Amazon Q is the “most capable generative AI powered assistant for software development,” while it is also deploying AI and computer vision in fulfillment centers to optimize deliveries and uncover product defects.

Alphabet similarly has two core businesses where it can integrate and monetize AI at a large scale, in cloud and advertising, with management seeing AI generating “billions in revenue.” Alphabet said it sees “tremendous ongoing momentum in Search and great progress in Cloud with our AI initiatives driving new growth,” with Cloud driving billions in AI revenue year-to-date.

In addition, Alphabet’s developer tools and Gemini are witnessing strong adoption, with more than 2 million developers using its AI tools, and more than 1.5 million developers utilizing Gemini. Alphabet added that a “majority of [its] top 100 customers” are adopting its generative AI solutions. For Search, AI features are improving profit optimization for advertisers – when “paired with Search or PMax,” Alphabet’s new AI-powered DemandGen ad campaigns deliver “an average of 14% more conversions,” more efficient cost-per-click rates, and profit uplifts.

Unlike Microsoft and Amazon, Meta’s AI monetization is not as visible, with AI aiding in engagement and advertising. CEO Mark Zuckerberg noted that AI is already enabling increased engagement and better targeting across the business, as its unified AI systems have “already increased engagement on Facebook Reels more than our initial move from CPUs to GPUs did.” For advertising, Meta says that it has “seen promising early results since introducing our first Generative AI ad features, image expansion, background generation, and text generation with more than 1 million advertisers using at least one of these solutions in the past month.”

However, Meta said that it does not “expect [its] Gen AI products to be a meaningful driver of revenue in 2024” with Mark Zuckerberg referencing his philosophy of maximizing engagement first before focusing on monetization “I think you all know this from following our business for a while, but we have a relatively long business cycle of starting a new product, scaling it to something that reaches 1 billion people or more and only then really focusing on monetizing at scale…before we are really talking about monetization of any of those things [Meta AI or AI Studio] by themselves, I mean I don't think that anyone should be surprised that I would expect that — that will be years”, implying that the timeline for fully recognizing real revenue tailwinds will take more than just a few quarters.

Conclusion

We’ve seen concerns rise recently that Big Tech may be overspending on AI capacity, with not enough revenue to justify this level of expenditure. However, comments from the largest four management teams highlighted one crucial similarity – demand remains above capacity, and they would rather risk overbuilding than underbuilding when it comes to AI capacity.

The weight of four Big Tech CEOs speaking in unison on this topic is either a staggering coincidence —- or they have important insights that are leading to the same conclusion, which is that AI’s primary risk is for those companies that are not early enough to capture it. It’s interesting Big Tech CEOs feel that way, as the I/O Fund’s stance is similar for investors, which is that the primary risk to a portfolio over the next 3-5 years is not being early enough to capture the powerful trend of AI.

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

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Broad Market and Positions Update

Posted on by io-fund

Watch Portfolio Manager Knox Ridley as he covers the broad market, Nvidia, Broadcom, and Bitcoin. We also have a special guest, Vincent Duchaine of Wealth Umbrella, with whom we partnered to create our hedge signal available to our advanced tier members.

Timestamps:

00:00 Introduction

20:11 Bitcoin

37:08 Knox Ridley (Broad Market)

50:08 Nvidia

52:18 Broadcom

52:57 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.

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Alpha & Omega Q4: Revenue in Line, All Segments Rebound Sequentially

Posted on by io-fund

Alpha and Omega reported Q4 revenue in line with guidance, while margins rebounded at the high end of management’s guided range. Each of Alpha and Omega’s four key segments recorded sequential growth in the quarter, with management saying this “broad-based” rebound “confirmed the inventory correction is largely complete.”

However, management noted that PCs are “taking longer to recover than originally expected,” though sequential growth is still expected in the September quarter due to seasonal strength. Intel’s report last week showed that the challenged chipmaker is going all-in on AI PCs, making the decision to “more quickly ramp” its Core Ultra AI PC chips at the expense of margins and profitability.

Intel also said that its “Core Ultra volume more than doubled sequentially in Q2,” with shipments surpassing 15 million and remaining on track for more than 40 million by year end, and over 100 million cumulatively by the end of 2025. With Intel aggressively pursuing AI PCs, it’ll likely spark fierce competition in the space against Qualcomm and AMD, a positive for Alpha and Omega given its tie-ins and content on Intel and AMD’s AI CPUs.

Quite a few questions on the earnings call were about a graphics card customer that is using AOSL for accelerator cards, which increases the number of MOSFETs from 9 to 16 per driver up to 50 MOSFETs per driver. Given the customer has used AOSL for graphics cards in the past, and will now use AOSL for the upcoming GPU architecture, it’s likely the customer is Nvidia. There was also this announcement in June indicating Nvidia.

Notably, the company’s “midterm target model” is $1 billion in revenue with adjusted gross margin of 30%.

Revenue

Alpha and Omega’s Q4 revenue was largely in line with both management’s guide and analyst estimates. Notably, every key segment grew QoQ.

Q1’s forecast was above estimates and points to YoY revenue growth returning as early as next quarter. Management said that in Q4, they “saw relative strength coming from gaming, tablets, e-mobility, A.I., and home appliances, while the PC segment is taking longer to recover.”

  • Q4 revenue was $161.3 million, down (0.1%) YoY but up 7.5% QoQ as all four key segments rebounded sequentially. Management had guided to ~$160 million in revenue for the quarter, with analysts expecting the same.
  • FY 2024 revenue was $657.3 million, a decrease of (4.9%) YoY.
  • Q1 revenue was guided to $180 million, +/- $10 million, for flat YoY growth and QoQ growth of 11.6%. This came in above the consensus estimate for $174.4 million.

Alpha and Omega is now expected to potentially return to top-line growth in Q1, and accelerate through Q3 FY2025 to the low double digit range. Exiting the prolonged inventory correction, which dented growth significantly in FY 2023, clears up one major hurdle to revenue growth, though the extended PC recovery timeline is something to pay closer attention to through the September quarter.

Margins

Margins came in at the high end of management’s guided range, with CFO Lifan Yiang saying the QoQ expansion in adjusted gross margins, which flowed down the line, “was mainly driven by the improved factory utilization.”

  • GAAP gross margin in Q4 was 25.7%, up 200 bp QoQ from 23.7%, but down 190 bp YoY from 28.2%. Adjusted gross margin was 26.4%, up 120 bp QoQ but down 210 bp YoY.
  • For Q1, management guided GAAP gross margin at 25.0%, and adjusted gross margin at 26.4%, signaling that margins are likely to have found a bottom in Q3.
  • FY24’s GAAP gross margin was 26.2%, down 270 bp YoY. Adjusted gross margin was 27.2%, down 300 bp YoY. Management has remained positive about reaching a long-term target of >30% for gross margins.
  • GAAP operating margin was (0.9%) in Q4, well ahead of the implied (5.2%) margin based on management’s expenses guide, and increasing from (7.0%) last quarter. Adjusted operating margin was 2.0%, up from (0.7%) last quarter but down from 4.3% in the year ago quarter.
  • For Q1, GAAP operating margin is implied to be (1.1%), due to the guide for a slight QoQ decline in GAAP gross margin. Adjusted operating margin is implied to be 4.2%, a solid QoQ increase of 220 bp.
  • GAAP net margin was (1.7%), improving from (7.5%) last quarter. Adjusted net margin was 1.6%, improving from (0.8%) last quarter. GAAP EPS in Q4 was ($0.09), ahead of estimates for ($0.31), while adjusted EPS of $0.09 was ahead of estimates for $0.04.

Cash and Debt

Cash flow on this company (and most small caps) needs to be watched closely. FY2023 ended with cash flow margin of (-13%).

  • Operating cash flow was $7.1 million in Q4, for a 4.4% margin. This included $4.5 million in repayments of customer deposits. Management expects to refund ~$8.4 million in customer deposits in Q1.
  • For FY24, operating cash flow was $25.7 million, increasing 25.6% YoY.
  • Q4 free cash outflow was (-$0.21 million) with Capex at $7.2 million
  • Cash and equivalents totaled $175.1 million.
  • Debt totaled $38.4 million.

Key Segments

Computing

Computing revenue decelerated to 37.6% growth in Q4. The segment rebounded 4.4% QoQ to approximately $71.6 million in revenue. Management said that this was “slightly below our original expectation for mid-to-upper single digit growth,” primarily impacted by PCs.

Management said they saw “relative strength from tablets, A.I, and graphics cards in the quarter, offset by a slower PC market recovery. Notably, tablet revenue was a record high, and the contribution from A.I. and datacenter related applications continued to grow.”

Looking ahead, Alpha and Omega expects Q1 to see mid-single digits QoQ growth on a seasonal PC pickup, combined with strength from tablets, graphics, and AI accelerators. CEO Stephen Change shed more light on some of the opportunities ahead: “We are working on multiple opportunities leveraging our existing relationship with a key graphics card maker, as well as our product portfolio including new multiphase Vcore controllers and power stage solutions for advanced computing. We are also seeing some ramp in September from a leading power supply maker that is a key supplier to the same A.I./graphics customermultiple opportunities leveraging our existing relationship with a key graphics card maker, as well as our product portfolio including new multiphase Vcore controllers and power stage solutions for advanced computing. We are also seeing some ramp in September from a leading power supply maker that is a key supplier to the same A.I./graphics customer.”

Consumer

Consumer revenue declined (35.5%) YoY but rebounded 19.7% QoQ, as the segment looks to have marked a bottom in Q2, with revenue accelerating from ~$23 million quarterly to more than $28 million quarterly. Management said that it “is now clear that the inventory correction in gaming is behind us and a seasonal build is underway.”

Looking ahead to Q1, management expects “low double-digits sequential growth in the consumer segment driven by strong seasonal pick-up from wearables and continued strength in gaming, offset by slower home appliances.”

Communications

Communications revenue rose 59% YoY and 2.1% QoQ, driven by the “seasonal pick-up from a Tier 1 U.S. smartphone customer, offset by sequential declines from Korea and China OEMs.” This was ahead of expectations for flat QoQ growth.

For Q1, management is expecting QoQ growth to accelerate to the double-digits on “seasonal strength ahead of new smartphone launches in the US and increasing demand from China smartphone OEMs.” Management added that they see two tailwinds for growth, one from rising mix of premium phones, and the other from increasing BOM content in smartphones, stemming from increased battery charging currents.

Power Supply and Industrial

Power supply and industrial revenue declined (33.7%) YoY but increased 11.3% QoQ. Management said this was ahead of expectations for mid- to high-single digit QoQ growth due to “strength in the e-mobility segment for e-bikes and e-scooters and DC fans for applications in areas such as datacenters.”

For Q1, QoQ growth is expected to accelerate to 15% to 20%, driven by quick chargers and “strength from AC-DC power supplies tied to the seasonal build in PCs.”

Earnings Call:

AI Accelerator Cards

Per an announcement in June, AOSL is expected to become a new GB200 supplier for Nvidia and to start shipments by the end of this year. Although AOSL does not call out Nvidia specifically on the call, the announcement helps us infer that it’s likely Nvidia being spoken about on the calls. The only other option is that it’s AMD.

AOSL sells MOSFETs that go into bus converters for DC to DC power conversion. AOSL works with a leading power supply company that, in turn, supplies the unnamed AI/graphic customer plus the company supplies the unnamed AI/graphic company directly. AOSL supplies the MOSFETs powering each GPU, and for the upcoming platform of this customer, AOSL will additionally sell the total solution controller and the multiphase controller. The number of MOSFETs is expected to triple from 9 to 16 up to 50 MOSFETs per GPU.

Here was some discussion on the call about this opportunity:

“David Williams

With that, I guess, Stephen, I wanted to ask — yes, I wanted to ask a little bit just on the graphics card and some of the datacenter accelerator and GPUs. We've talked about this before and starting to see those revenues, but I'm trying to understand what is it the magnitude of maybe that could be over time? And maybe is there a way to size, understanding there's different flavors or varieties of those products, but is there a good way to think about what your content can be and maybe where you're at within that maybe qualification process? Any color around that would be, I think, incredibly helpful. Thank you.

Stephen Chang

Sure. Yes. So an entry into artificial intelligence programs, a lot of it actually is built upon where we have already been with our graphics cards. And accelerator cards actually aren't that different from a graphics card in the sense that you are basically powering a high-performance GPU in both cases. And — but with datacenter, that performance requirements are being driven even higher.

[…] . So to quantify some of that, so for example, in graphics card, you can have anywhere from 9 to 16, something in that range of number of driver [MOSFETs] per GPU. But when you move to an A.I. accelerator card, that number actually jumps up to even up to 50 power stages to power that GPU.

And those are the solutions that we are shipping today in our graphics card/AI customer in their existing platforms. And we are working with them on being — on transitioning over to the new platform that they will be launching soon.”

-End Quote

There was also discussion on the call that AOSL’s opportunity is expanding with the new platform as the company will be integrated from the ground-up. The CEO stated they are engaged at the manufacturing process and engaged with the power supplier for the OEM.

Conclusion:

It was interesting the PC opportunity was not discussed in the call today, rather the call was almost entirely about the unnamed AI/graphics company. Perhaps this is because the June announcement helps to expand AOSL’s immediate opportunity considering the new platform for this unnamed customer is expected to ramp in H2 and into next year.

There is a contract expiring in early 2025 that we plan to go back and dig up information on this 24-month contract to make sure it’s not presenting an outsized risk. The contract, signed in February 2023, licensed AOSL's SiC tech and provided engineering and development services for 24 months, with a total fee of $45 million. $18 million was paid upfront by the customer, with AOSL also receiving $6.8 million in March and July 2023, with the remaining balance to be paid upon achieving certain milestones. Given that AOSL has already collected a majority of the contract's revenue, it does not look to present outsized risk here.

On the topic of risks, there is high customer concentration with AOSL as there is with most small cap semiconductor companies. For example, last quarter, the top two customers accounted for 71% of revenue.

AOSL is a stock where we are using technical analysis to its fullest. Our goal is to participate in opportunities where small cap suppliers expand their serviceable addressable market (SAM) as AI systems increase in complexity. However, the only reasonable way to do so is to adhere to our stops. You can expect updates from Knox as we go along.

Damien Robbins and Beth Kindig, Equity Analysts for the I/O Fund, contributed to this analysis

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Super Micro FQ4: Strong DLC Commentary, what it Means for Nvidia’s Blackwell

Posted on by io-fund

Super Micro beat Q4 revenue only marginally by $10 million, yet the Q1 and full year fiscal 2025 revenue outlook came in far ahead of estimates. Fiscal Q1 guide beat consensus by more than $1 billion with management guiding between $6 billion and $7 billion for next quarter, compared to consensus of $5.45 billion. This will represent record revenue growth of 207% at the midpoint. The previous highest growth rate was 200.7% two quarters back. We’ve called Supermicro the AI bullet train, and it’s quite clear that train is still in motion.

Management also guided on the call for fiscal year 2025 revenue between $26 billion and $30 billion, which is 30% higher than consensus. Going into this call, FY2025 revenue growth was expected to be 57.2% and will now be 87.4%, at the midpoint.

Looking beyond the impressive acceleration in revenue growth for Q1 and the welcomed raise for next year, Supermicro on a company-specific level has weak margins and a cash flow problem. The margins also got hit hard due to the cost of direct liquid cooling components.

We’ve been quite clear the cash flow is this company’s Achilles heel, and this was the key reason we closed the position in the past. However, the valuation is low enough (and the growth is high enough) that odds favor the stock bottoming soon.

Bullish Liquid Cooling Growth

Here’s a quick refresh on liquid cooling from the recent analysis we published on Liquid Cooling Leaders:

“Liquid cooling technology has been around for decades, yet this technology is becoming mission critical due to the increasing levels of compute power from AI accelerators, starting with the GB200 systems and B200 GPUs […] Although the GB200 will ship end of this year, and the B200 will fully ship in early 2025, vendors are scaling their liquid cooling capacity now […]

The Blackwell architecture is a catalyst for liquid cooling as it nears 1000W, specifically the GB200 systems and the B200. This represents a 40% increase from the previous generation.”

At the time, we discussed Blackwell being a clear catalyst for direct liquid cooling. Therefore, it is odd to say the least that Supermicro would report that DLC is surging when there are rumors that Blackwell is delayed. Here are snippets as to what the CEO discussed on Supermicro’s call in terms of how quickly DLC is ramping:

“Answer
Charles Liang (Executives):

Yes. Thank you. I mean as you know, liquid cooling has been in the market for 30 years and market share compared with overall data center size always small, less than 1% or close to 1%, I would have to say. But just June and July 2 months alone, we shipped more than 1,000 racks to the market. And if you calculate 1,000 racks, AI rack right, is about more than 15% on a global data center new deployment”

To another question, the CEO responded:

“It's a very good question. I mean, last month, we have about 1,000 racks per month liquid cooling capacity. And today, we already grow another 50%. So now we have a 1,500 rack per month capacity. By this year-end, we will grow that to 3,000 rack per month.” Takeaway: that’s 50% growth in one month and 200% growth in 6 months on liquid cooling.

Regarding Blackwell, the CEO stated:

“So for Q3, for sure, we do not expect any Blackwell volume. For Q4, I mean December quarter, I guess, it will be very small. Engineering sample small volume. So the real volume, I believe, had to be March quarter next year. And that's why we only $26 billion to $30 billion.”

The CFO also added: “I would say, we prepared the market for a downturn in margins or a softening of margins in our guidance last quarter. But even we were surprised by the acceleration that we saw in the liquid-cooled rack market. And so we had to ramp up our supply chain. We paid a lot of expedite costs and higher supply chain costs. So I think as the supply chain improves, we expect those efficiencies to now come back out, but that impacted us more than we had expected.”

Putting the Pieces Together:

Supermicro has to walk a fine line and cannot speak for Nvidia. However, per Tom’s Hardware and other sources, direct liquid cooling truly starts with Blackwell: “Even Nvidia's high-end H100 and H200 graphics cards work well enough under air cooling, so the impetus to switch to liquid hasn't been that great. However, as Nvidia's upcoming Blackwell GPUs are said by Dell to consume up to 1,000 watts, liquid cooling may be required.”

Supermicro’s report is communicating that servers that require direct liquid cooling are soaring (suddenly) as of June and July from 1% of all new servers shipped to 15% at 1,000 racks. Management is also communicating that it’s expected to continue to soar to 3,000 racks by the end of this year. Per our understanding and industry analysts (like Tom’s Hardware) there’s an incredibly high probability this is Blackwell driving a sudden surge in DLC sales. But if Blackwell is delayed, how can this be?

We will need Nvidia’s report to be certain, but one possibility is the GB200 NVL36 and NVL72 systems are taking up TSMC’s CoWoS-L capacity. That implies there would still be Blackwell sales through the GB200NVL systems, while pushing the B200 release out further. Essentially, one possible theory I’ve come up with is that the larger systems with 36 GPUs or 72 GPUs are so popular, the single B200 GPUs are being delayed.

This theory is supported by preliminary data that the GB200 systems were reportedly seeing outsized demand, which we’ve shared on social media here, here and here. Theoretically, if the GB200 systems were seeing outsized demand (per the preliminary data), it would bump the B200s to a later date.

Here's a breakdown on how pricey the GB200 systems are:

  • Nvidia’s GB200, featuring one Grace CPU and 2 B200 GPUs, is estimated to sell for ~$60,000 to $70,000.
  • In the NVL36 configuration, featuring 18 GB200s (18 Grace CPUs and 36 B200s), each GB200 would be selling for $100,000 at the current estimated ASP of $1.8 million.
  • In the NVL72 configuration, featuring 36 GB200s (36 Grace CPUs and 72 B200s), each GB200 would be selling for ~$83,333 at the current estimated ASP of $3 million.

In this case, Nvidia would theoretically prioritize the GB200 NVL36 and NVL72 as the price points are quite high. Per Semi Analysis: “Combine these two issues and it’s clear that TSMC will not be able to supply enough Blackwell chips as Nvidia would like. Consequently, Nvidia is focusing what capacity they have almost entirely on GB200 NVL 36×2 and NVL72 rack scale systems. HGX form-factors with the B100 and B200 are effectively now being cancelled outside of some initial lower volumes.”Nvidia is focusing what capacity they have almost entirely on GB200 NVL 36×2 and NVL72 rack scale systems. HGX form-factors with the B100 and B200 are effectively now being cancelled outside of some initial lower volumes.”

The two NVL36 and NVL72 rack configurations carry a ~27% to ~54% higher selling price per GB200, making it understandable why Nvidia would focus on the racks given production constraints from CoWoS capacity.

This is one theory as to how Supermicro could forecast a surge in DLC server shipments, and meanwhile, the B200 GPUs be delayed.

Another explanation is that the rising costs of power consumption is causing customers to order DLC servers instead of air cooled for the H100 and H200. Yet, it’s the sudden surge in sales (in two months) that has me leaning toward the first possibility where SMCI’s 1,000 racks is from the GB200 NVL systems that can be produced and are still shipping, with GPU clusters are being prioritized over GPUs.

Going into the report, we had stated: “What we hopewe hope to hear from management is that the exact date for the B100s and B200s arrival is immaterial given the demand environment. Meaning, there are enough buyers lined up for Nvidia’s Hopper GPUs, along with enough CoWoS-L capacity from TSMC to meet demand for the GB200’s, that combined this can meet or exceed fiscal year estimates. There are also additional variations of Blackwell being designed for the CoWoS-S packaging from TSMC.”

Supermicro confirmed today the company is able to meet and exceed current estimates regardless of the current Blackwell delay.

Why the Stock Sold Off

Despite the incredibly bullish commentary on direct liquid cooling, the stock reversed from being up double-digits to being down double-digits. While the headline numbers point toward it being the margins, my hunch is it’s the cash situation.

Here are two questions from the call that echoes our concerns a few months back:

Question
Dong Wang (Analysts)

Okay. Can you address on the working capital, if you can give any color on that?

Answer
David Weigand (Executives)

Yes. So we announced a $500 million credit line with a group led by the Bank of America. And so we expect we are really working on our balance sheet and leveraging our balance sheet. And we expect to — some announcements to be coming in terms of additional loan possibilities in the future.

Question
Mehdi Hosseini (Analysts)

And then a question I have for Charles. Obviously, you've done a good job of doubling revenue in fiscal year '24. But you also had a negative free cash flow of $2.6 billion. And if I were to look at the high end of your revenue guide for fiscal year '25, you're on track to double revenues again. Does that mean that you're going to need to burn another $2.5 billion to $2.6 billion of free cash flow to hit those revenue targets?

Answer
Charles Liang (Executives)

Not necessarily. I mean, if we try to be very aggressively growing market share, maybe — for example, we forecast $30-something billion, right, so in that case, we may need more. But if we try to focus on below $30 billion, then not necessary.

Answer
David Weigand (Executives)

And Mehdi, 1 thing I would add to that is we believe that we have NIG profile, and as such, like I mentioned earlier, we're starting to leverage our balance sheet more with targeting toward unsecured debt. And so that will help us on an inter-quarter basis.”

My takeaway: Cash remains Supermicro’s Achilles heel and per our last analysis: “What lies beneath this phenomenal growth rate is the need to raise cash to fund operations, which for Super Micro means buying excess inventory to prepare for future growth, especially as it relates to liquid cooling.”

However, when I wrote that in April, the company was trading at a 3.3X Forward PS with a Forward PE ratio of 36X. With the new fiscal year guide, we are in the 1.3X forward PS range and 15 forward PE range. There is a lot of negativity priced into Supermicro right now, and when you account for the cash situation, I think we are close to a bottom of sorts. The economy is out of an investor’s control, yet identifying quality companies at a discount is one way to combat the volatility.

Revenue and EPS:

As discussed, Q4 marked a third consecutive quarter of triple-digit top line growth, and Q1’s guide points to a more than 60 percentage point acceleration to >200% revenue growth. Next quarter will also mark the highest quarter growth in Supermicro’s history. This quarter growth was driven by: “strong demand for next-generation air-cooled and direct liquid cooled rack scale AI GPU platforms, representing over 70% of revenues across enterprise and cloud service provider markets where demand remains strong.”

  • Q4 revenue was $5.31 billion, an increase of 144% YoY and 38% QoQ. This compares to consensus for $5.30 billion in the quarter.
  • Management guided for a strong Q1, projecting revenue between $6.0 billion and $7.0 billion, for a YoY increase of nearly 207% at midpoint and well ahead of the consensus estimate for $5.45 billion.
  • FY24 revenue was $14.94 billion, an increase of 110% YoY.
  • For the full year, Super Micro guided for revenue between $26 billion and $30 billion, for YoY growth of 87%. This was nearly $5 billion ahead of the consensus estimate of $23.4 billion at midpoint, suggesting that Q1’s revenue level is expected to be the floor for the year.

Earnings:

  • GAAP EPS was $5.51 in Q4, an increase of nearly 61% YoY but a QoQ decline of (16%) as gross margins shrunk sequentially. Per management: “Some key new component shortage delayed about $800 million of revenue shipped into July, which lowered our EPS for June and will be recognized in our September quarter.”
  • Adjusted EPS of $6.25 missed estimates for $8.14, primarily due to margin weakness in the quarter. Adjusted EPS increased more than 78% YoY but declined (6%) QoQ.
  • Q1’s GAAP EPS was guided at $5.97 to $7.66, or ~$6.82 at midpoint for YoY growth of 148%. Adjusted EPS was guided at $6.69 to $8.27, or ~$7.48 at midpoint for YoY growth of 118%; this was slightly below estimates for $7.68 in the quarter.
  • GAAP EPS was $20.09, an increase of nearly 76% YoY. Adjusted EPS was $22.09, an increase of 87% YoY.

Margins:

This is where Q4’s report struggled, with gross margin contracting to a low 11% level, driving the bottom line miss. Regardless, of the uptick expected next quarter to 12%, this is a concern as DLC components drag on the margins. Operating margins also contracted significantly in Q4.

  • GAAP gross margin was 11.2% in Q4, reaching the lowest level ever, and contracting from 15.5% last quarter and 17% in the year ago quarter. According to management, gross margins is expected: “to be above 12% in the first quarter.”
  • Adjusted gross margin was 11.3%, down from 15.6% last quarter and 17.1% in the year ago quarter. This adjusted gross margin level was in line with the prior two quarters adjusted operating margin, highlighting the weakness in gross margins this quarter.
  • GAAP operating margin was 6.5%, down from 9.8% last quarter and 10.4% in the year ago quarter.
  • Adjusted operating margin was 7.8%, down from 11.3% last quarter and 11% in the year ago quarter. Per the CFO: “which is lower than what we expected due to the higher mix of hyperscale data center business and expedited cost of our DLC liquid cooling components in June and September quarter.”
  • GAAP net margin was 6.7%, down from 10.5% last quarter and 8.9% in the year ago quarter.
  • Adjusted net margin was 7.6%, down from 10.7% last quarter and 9.2% in the year ago quarter.

For the full year, margins shrank rather significantly:

  • FY24’s GAAP gross margin was 14.0%, down from 18.1% in FY23. Adjusted gross margin was 14.1%, down from 18.2% in FY23.
  • GAAP operating margin was 8.5%, down from 10.7% in FY23. Adjusted operating margin was 10.0%, down from 11.4% in FY23.
  • GAAP net margin was 8.1%, down from 9.0% in FY23. Adjusted net margin was 9.0%, down from 9.5% last year.

Cash and Debt:

Super Micro recorded another quarter with significant cash outflow, and for the full year, operating cash flow was roughly ($2.5 billion), driven by increasing inventories, which rose by $3 billion YoY to $4.4 billion by the end of Q4.

  • Operating cash flow was ($635 million), for a margin of (12%); this was a notable improvement from Q3’s outflow of more than ($1.5 billion), but still marked a third straight quarter with significant cash outflows.
  • For FY24, operating cash flow was ($2.48 billion), a substantial change to OCF of $664 million in FY23. This represented an annual OCF margin of (16.6%).
  • Free cash flow was ($662 million), with capex of just $27 million, far below management’s expectations for $55 to $60 million in capex in the quarter.
  • FY24 free cash flow was approximately ($2.61 billion), for a margin of (17.5%).
  • Cash and equivalents totaled $1.67 billion at the end of Q4, despite Super Micro padding the balance sheet to $2.12 billion in cash at the end of Q3. Burning through this much cash this rapidly raises the risk of another capital raise.
  • Inventories were $4.4 billion, up from $1.4 billion at the end of FY23 and
  • Debt and convertible securities totaled $2.17 billion.

Conclusion:

If you track Supermicro’s commentary closely, the direct liquid cooling market has accelerated from previous expectations only two months ago. At Computex 2024 in early June, CEO Liang stated he “expects 15 percent of racks it sells this year to use DLC, and 30 percent to employ it next year.” Fast-forward only two months and the company is now stating: “And if you calculate 1,000 racks, AI rack, it's about more than 15% on a global data center new deployment” [shipping now] and “we are targeting 25% to 30% of the new global data center deployments to use DLC solutions in the next 12 months.”

It's a mystery as to how Supermicro could achieve this if Blackwell is truly delayed the way the media portrays it (the media is ultimately portraying that the delay means a loss of revenue). We’ve provided one theory, which is that the high priced GB200 systems’ popularity has crowded out the other SKUs. We won’t know for sure until Nvidia reports if the GB200 NVL systems are shipping as planned, but we do know for sure that Supermicro is accelerating in revenue next quarter and raised guidance by 30 points for next fiscal year. It is the mark of a multi-generational opportunity that you could have any sort of delay, and yet demand is so great, there is still an acceleration in growth from the server maker.

As previously stated, there is a lot of negativity priced into Supermicro right now, and even when you account for the company needing to raise cash to support growth, I think we are close to a bottom of sorts for this stock. The economy is out of an investor’s control, yet identifying quality companies at a discount is one way to combat the volatility.

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

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Alpha & Omega Semiconductor Earnings Preview: Signs of recovery ahead?

Posted on by io-fund

Alpha & Omega Semiconductor will announce its Q4 FY2024 results on August 07th. The midpoint of the management revenue guide for FQ4 is $160 million, representing a YoY decline of (-0.9%). Analysts expect revenue growth to resume from the December quarter.

Management has been quite transparent throughout the inventory corrections in the PC space in 2022 and the growth opportunities it sees in the computing segment, not just in PCs but also extending to graphics and AI accelerators. Management is seeing signs of a gradual rebound in the coming quarters and is approaching a recovery phase of the next cycle. Until we see actual improvement in the fundamentals, we would treat the company as a momentum play.

Revenue

Analysts expect FQ4 revenue to decline by (-0.9%) YoY to $160.03 million. Revenue will further decelerate to (-3.5%) YoY to $174.37 million and then return to growth, accelerating to 4.2% and 11.9% in the subsequent quarters.

FQ3 revenue grew by 13.2% YoY to $150.1 million, in line with analyst estimates. Management expanded on seasonality, saying that while the “March quarter is historically our seasonally lowest revenue quarter due to the technicality of consumer spending, the year-over-year growth indicated the strength of our recovery from the inventory corrections.”

Margins

  • Gross margin improved 50 bps YoY but was down 290 bps sequentially to 23.7%. Adjusted gross margin improved 10 bps YoY but was down 280 bps sequentially to 25.2%. Management attributed the sequential decline to lower utilization and ASP, partially offset by a better mix.
  • Management guide for the next quarter is 26.3% at the midpoint. Over the longer term, management remains optimistic about a return to 30% adjusted gross margin as it works towards hitting its $1 billion revenue goal:

Q, Analyst Craig Ellis: “What are some of the bigger gives and takes that we should be aware of for gross margin and really the pace of expansion and what do you need to see to be confident that gross margins can move back to that 30% level and then at some point higher? Thank you.

A, CFO Yifan Lang: At this point and I mean we still think on our mid-term target model and when we reach the $1 billion in revenue, we expect to get to 30% gross margin on the non-GAAP basis level.”

  • Operating margin improved 390 bps YoY and declined sequentially by 630 bps to (-7.0%). Management guide for the next quarter is (-5.2%). Adjusted operating margin improved 150 bps YoY and declined by 580 bps sequentially to (-0.7%). Management guide for the next quarter is 1.6%. Higher payroll taxes at the start of the year also negatively impacted the operating margins.
  • Net loss came at (-$11.2 million) or (-7.5%) of revenue compared to (-$18.9 million) or (-14.3%) of revenue in the same period last year. Adjusted net loss came at (-$1.2 million) or (-0.8%) of revenue compared to (-$5.9 million) or (-4.4%) of revenue last year. GAAP loss per share came at (-$0.39) and beat estimates by 18.2% and adjusted loss per share came at (-$0.04) and beat estimates by 71.4%.
  • The analysts expect adjusted EPS to decline (-77.2%) YoY to $0.04 in FQ4.

Cash Flow and Balance Sheet

  • Operating cash flow was $28.2 million or 18.8% of revenue compared to $11.6 million or 8.8% of revenue in the same period last year. The operating cash flow included $9.9 million in repayments of customer deposits. Management expects to refund about $4.5 million of customer deposits in the June quarter.
  • Free cash flow was $20.5 million or 13.7% of revenue compared to (-$11 million) or (-8.3%) of revenue last year. Capex was $7.4 million compared to $22.7 million in the same period last year. Capex was higher last year due to the Oregon fab expansion. Management guide for FQ4 capex is in the range of $6 million to $8 million.
  • The company repurchased 287,000 shares of employee restricted stock units vested for $6.7 million.
  • The company had cash of $174.4 million and debt of $41.2 million compared to $162.3 million and $44.1 million in the previous quarter.

Key Segments

Computing

Computing segment revenue grew by 80.4% YoY and declined by (-4.3%) sequentially to $68.7 million. It was the largest segment and represented 45.8% of the total revenue. The growth was led by graphics cards, tablets, and AI accelerators and partially offset by seasonal decline in notebooks. Management expects the computing segment to grow in the mid to higher single digits with continued strength in graphic cards, AI accelerators and tablets.

Consumer

The consumer segment declined by (-47.1%) YoY and up 0.3% sequentially to $23.6 million. The inventory correction in gaming continued in the March quarter. However, the rate of decline slowed, and management expects double-digit sequential growth in the segment, which will be helped by the end of the inventory correction in gaming.

Communication

The communication segment grew by 39.2% YoY and declined (-7.4%) sequentially to $26.8 million. Strong sales from the Korea and China-based OEMs were offset by a seasonal decline in shipments to the Tier 1 U.S. smartphone customers and a slowdown in networking. Management expects a strong sequential rebound in shipments to Tier 1 U.S. smartphone customers as they prepare for the fall launch, while they expect a sequential decline from Korea and China OEMs.

Management said “even with a sequential decline, our China OEM business remains strong and up significantly year-over-year. Overall, we estimate the Communication segment will be flat sequentially in the June quarter, which is notably higher year-over-year, because of our BOM content and market share increases.”

Power Supply and Industrial

The Power Supply and Industrial segment revenue declined by (-6.5%) YoY and (-29%) sequentially QoQ to $24.8 million on continued inventory corrections in quick chargers in addition to sequential declines in AC-DC power supplies, power tools and solar. Looking ahead to the June quarter, management expects sequential growth in the mid-to high-single digits as the quick charger inventory correction ends alongside strength in e-mobility.

Other Key Points to Watch

AI PCs and AI Mobile

In our recent deep dive here, we discussed that we will be closely monitoring the Computing segment that is expected to benefit from the strong demand for AI PCs.

We had noted, “Moving through the rest of 2024 and into 2025, Computing segment’s growth is likely to be driven by two primary factors – AI PC growth aided by Intel’s Meteor Lake platforms and AMD’s FP8 and FP11 next-gen chips, as well as a rather robust server and AI accelerator point-of-load (POL) roadmap.

For example, AOSL’s power delivery content is increasing significantly on Intel’s Meteor Lake chips, compared to the Arrow Lake predecessor, which should translate into a healthy BOM increase. Intel is targeting a significant 8x increase in Core Ultra AI PC chip shipments (across its Arrow Lake, Meteor Lake and Lunar Lake platforms) — from 5 million since December 2023 to at least 40 million by year-end 2024. This is estimated to grow 50% in 2025 to 60 million Core Ultra chip shipments.”

Intel CEO Patrick Gelsinger said in the recent Q2 earnings call that they shipped 15 million AI PCs since the Meteor Lake launch in December. “We have now shipped more than 15 million Windows AI PCs since our December launch, multiples more than all of our competitors combined, and we remain on track to ship more than 40 million AI PCs by year end, and over 100 million accumulative by the end of 2025.” They also mentioned Lunar Lake, the next generation AI PC, achieved production release ahead of schedule in July. Arrow Lake will follow it. Next, Panther Lake is expected in the second half of 2025.

“The AI PC will grow from less than 10% of the market today to greater than 50% in 2026. We know today's investments will accelerate and extend our leadership and drive significant benefits in the years to come. Our efforts will culminate with the introduction of Panther Lake in the second half of 2025.”

Lisa Su, CEO of AMD, provided positive insights into the Client segment in the recent earnings call “Our view of this is the AI PC is an important add to the overall PC category. 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 us call it above-typical seasonality, given the strength of our product launches and when we are 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.”

Outlook

Management mentioned that they saw signs of a gradual rebound in the coming quarters and are approaching a recovery phase of the next cycle. We would closely watch management comments on the recovery of the PC and smartphone market. The CEO mentioned in the last earnings call, “Looking beyond, we anticipate the second half of this year will be stronger than the first half as customers gear up for new product launches in smartphones as well as PCs.

Looking beyond 2024 to the growth phase of the next cycle, AOS is transitioning from a component supplier to become a comprehensive solution provider, enabling us to go deeper with increasing BOM content and penetrating new products and verticals.”

GB200 Supplier

According to the analyst Ming-Chi Kuo, Alpha and Omega Semiconductor, a current supplier of MOSFETs and power ICs for HGX/DGX H100, is expected to become the new GB200 supplier. If the news is confirmed, it could be another positive catalyst for the stock.

Valuation

The P/S ratio peaked in March 2022 when the quarterly revenue was close to $200 million, GAAP profitable, and before the PC inventory correction. The company is currently trading at a P/S ratio of 1.5 and a forward P/S ratio of 1.4 and higher than the average P/S ratio of 1.2.

Conclusion

AI PCs may emerge as one of the stronger growth trends in consumer AI devices over the next few years. AOSL’s tie-ins to Intel’s Meteor Lake CPU and its position in the development stages for AMD’s FP11 platform position it for strong growth in this space. The company is also seeing signs of recovery in its segments. However, until we see actual improvement in the fundamentals, we would treat the company as a momentum play.

Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.

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Super Micro FQ4 Preview: High Anticipation for Blackwell & DLC Commentary

Posted on by io-fund

Super Micro’s report carries enormous weight given the news that Nvidia’s Blackwell will be delayed up to three months. From what we know today, the GB200 systems will be given the CoWoS-L capacity and the B100s and B200s will have to wait until more capacity comes on line from TSMC’s side. Clearly, the market is nervous about this news, and coupled with the economic data from last week, Nvidia and SMCI have seen especially weak price action with NVDA down (-10%) in a week and SMCI down (-13%) in a week.

Blackwell and direct liquid cooling (DLC) are intricately linked, which we’ve covered here. Although SMCI cannot speak for Nvidia, the report today has enough readthrough that it will set the tone for both stocks. What we hopewe hope to hear from management is that the exact date for the B100s and B200s arrival is immaterial given the demand environment. Meaning, there are enough buyers lined up for Nvidia’s Hopper GPUs, along with enough CoWoS-L capacity from TSMC to meet demand for the GB200’s, that combined this can meet or exceed fiscal year estimates. There are also additional variations of Blackwell being designed for the CoWoS-S packaging from TSMC.

Per Semi Analysis: “Combine these two issues and it’s clear that TSMC will not be able to supply enough Blackwell chips as Nvidia would like. Consequently, Nvidia is focusing what capacity they have almost entirely on GB200 NVL 36×2 and NVL72 rack scale systems. HGX form-factors with the B100 and B200 are effectively now being cancelled outside of some initial lower volumes.”Nvidia is focusing what capacity they have almost entirely on GB200 NVL 36×2 and NVL72 rack scale systems. HGX form-factors with the B100 and B200 are effectively now being cancelled outside of some initial lower volumes.”

What we don’t know from the journalists and analysts is how many GB200 systems Nvidia can produce with TSMC’s available CoWoS-L capacity along with the amount of GPUs Nvidia will sell on using CoWoS-S advanced packaging technology. We’ve discussed on social media that the GB200s are oversubscribed. Read more here on Blackwell and its GPU series, including differences between the B100, B200 and GB200s and CoWoS advanced packaging.more here on Blackwell and its GPU series, including differences between the B100, B200 and GB200s and CoWoS advanced packaging.

In terms of importance, Supermicro’s report far outweighs what a journalist publishes or an analyst’s note on this topic — we will update you in the after-hours with granular detail on what is reported after hours and what we think it implies for Nvidia and AI semis.

With that backdrop, Super Micro will release its Q4 FY2024 results on August 06th. Management revenue guide for Q4 is in the range of $5.1 billion to $5.5 billion, representing a YoY growth of 142.6% at the midpoint. The FY 2024 guide was raised to $14.7 billion to $15.1 billion, representing YoY growth of 109.3% at the midpoint, up from the previous range of $14.3 billion to $14.7 billion.

Last quarter, adjusted EPS grew by 308% YoY to $6.65 and beat estimates by 19.4%. Consensus for adjusted EPS is growth of 134.2% YoY to $8.22 in FQ4 and 117.7% YoY to $7.58 in FQ1.

Supermicro started shipping DLC liquid cooling racks in volume to top AI customers in May. For direct liquid cooling (DLC) adoption, management expects to reach 15% in the next 12 months and 30% over the next two years, a rapid shift from the current 1% of the market. Any updates on DLC will be viewed as a readthrough to Blackwell.

Revenue

The analysts expect FQ4 revenue to grow 142.3% YoY to $5.29 billion. Revenue growth is expected to accelerate to 155.3% in FQ1 and then slow to 62% and 54.3% in the next two quarters.

Q3 revenue grew by 200% YoY to $3.85 billion; however, it missed the analyst’s consensus estimates by 1.2%. Management attributed the revenue miss to the shortage of new key components, and they expect the situation to gradually improve in the coming quarters.  

Charles Liang, President and CEO of Supermicro, said, “Strong demand for AI rack scale PnP solutions, along with our team’s ability to develop innovative DLC designs, enabled us to expand our market leadership in AI infrastructure. As new solutions ramp, including fully production ready DLC, we expect to continue gaining market share. As such, we are raising our fiscal year 2024 revenue outlook from $14.3 to $14.7 billion to a new range of $14.7 to $15.1 billion.”

Margins

The company has been focusing on market share gains, which has led to gross margins decelerating. Management guided a sequential decline in adjusted gross margin for the next quarter. An analyst on the call implied it would be 13.5% to 14% next quarter. To the question on the long-term adjusted gross margin target of 14% to 17%, the management reiterated that the target is still 14% to 17%, as they are expected to benefit from the economies of scale, particularly when the new Malaysian facility to be in production later in the calendar year.

  • Gross margin declined by 210 bps YoY and up 10 bps sequentially to 15.5% and adjusted gross margin came at 15.6%.
  • Operating margin improved by 210 bps YoY and declined by 30 bps sequentially to 9.8%. Adjusted operating margin improved 260 bps YoY and flat sequentially to 11.3%. The improvement in operating margin was due to the benefits of economies of scale and improved operating leverage.
  • Net income came at $402.46 million or 10.5% of revenue compared to $85.85 million or 6.7% of revenue in the same period last year. Adjusted net income came at $411.54 million or 10.7% of revenue compared to $93.53 million or 7.3% of revenue in the same period last year. GAAP EPS grew by 329% YoY to $6.56 and beat estimates by 27.1%. Adjusted EPS grew by 308% YoY to $6.65 and beat estimates by 19.4%.
  • Management Q4 GAAP EPS guide is $7.20 to $8.05 and adjusted EPS guide is $7.62 to $8.42. Analysts expect adjusted EPS to grow 134.2% YoY to $8.22 in FQ4 and 117.7% YoY to $7.47 in FQ1.

Cash Flow and Balance Sheet

  • FQ3 operating cash outflow was (-$1.52 billion) or (-39.5%) of revenue compared to operating cash flow of $198.2 million or 15.5% of revenue in the same period last year and cash outflow of (-$595 million) in the previous quarter. The cash flows from higher profitability were offset by higher inventory and increasing accounts receivable.
  • FQ3 free cash outflow was (-$1.61 billion) or (-41.9%) of revenue compared to $190.26 million or 14.8% of revenue in the same period last year and free cash outflow of (-$610 million) in the previous quarter. Capex was $93 million. Management guide for the next quarter is $55 million to $65 million.
  • The company had cash of $2.12 billion and debt of $1.86 billion compared to $726 million and $376 million in the previous quarter. Net cash declined to $252 million compared to $350 million in the previous quarter.
  • The company raised $1.55 billion during the quarter from a 0% coupon 5-year convertible notes due in 2029. The company also raised $1.73 billion in equity offering to support operations, including purchases of inventory and other working capital needs, manufacturing capacity expansion and increased R&D investments.

Key Metrics

Server and Storage Systems & Subsystems

  • Server and storage systems were $3.7 billion in revenue for growth of 218% YoY and was 96% of FQ3 revenue.
  • Subsystems and Accessories were $152 million, up 27% YoY and was 4% of FQ3 revenue.

Vertical Markets

OEM Appliance & Large Data Center revenues grew by 222% YoY and declined by (-10%) sequentially to $1.94 billion. It represented 50% of revenue compared to 59% in the previous quarter.

Enterprise and Channel revenue grew by 190% YoY and 26% sequentially to $1.88 billion. It represented 49% of revenue compared to 40% in the previous quarter.

Emerging 5G/Telco/Edge/IoT revenues were $37 million or 1% of Q3 revenues compared to $35 million in the previous quarter.

According to the CFO, “One existing CSP large data center customer represented 21% of Q3 revenues and one existing enterprise channel customer represented 17% of revenues.” This compares to FQ2 "Two existing CSP/large data center customers represented 26% and 11% of total revenues for Q2."

Other key points to watch

AI GPU

The company’s 200% FQ3 revenue growth was primarily helped by the AI GPU business from enterprise and cloud service provider customers. The AI business contributed over 50% of revenue in the last four quarters. Per the last report, supply chain improvement and new air-cooled and liquid-cooled customer design wins they expect strong growth in the coming quarters. We will hope management confirms the information again this quarter.

According to TrendForce, AI server shipments in Q2 will increase by 20% sequentially as cloud service providers focus on procuring AI servers. They also observe that advanced AI servers are expected to be strong through 2025, particularly as Blackwell is going to replace the Hopper platform.

According to Economic Daily, SMCI is expected to ship more than 10,000 cabinets of AI servers next year equipped with GB200, accounting for 25% of Nvidia’s total GB200 cabinets.

Direct Liquid Cooling

Liquid Cooling is essential in reducing the heat that AI systems generate. We first covered Liquid Cooling in our analysis here and also recently here. Although liquid cooling technology has been around for decades, yet this technology is becoming mission-critical due to the increasing levels of compute power from AI accelerators, starting with the GB200 systems and B200 GPUs.

Although the GB200 will ship at the end of this year and the B200 will fully ship in early 2025, vendors are scaling their liquid cooling capacity now. The capacity investments are being made right now, and we can see evidence of this in Super Micro’s earnings report with an increase in inventory. We also find hints of this in Dell’s earnings report, with the company also reporting an increase in inventory as these leading AI server companies wait for Nvidia’s Blackwell to ship.

Super Micro expects liquid cooling to be rapidly adopted over the next year and a half. The company is deploying three of the “world’s largest DLC liquid-cooled” systems in the current quarter, ending in June. The Nvidia HGX AI supercomputers with liquid cooling are expected to “potentially” save customers up to 40% of energy costs compared to air-cooled systems.

Charles Liang said in the earnings call, “At this moment, we are focusing on delivering more than 1,000 racks of NVIDIA HGX AI supercomputers, each rack supports 64 piece H100, H200 or B200 GPUs, with the latest DLC liquid cooling technology to three industry-leading customers, from April to June of this quarter. These three deployments will be among the world's largest DLC liquid-cooled AI clouds, potentially saving our customers up to 40% of energy costs compared to standard air-cooled deployments by our competition.”

SVP and CFO, David Weigand, explained at BofA’s conference, “So, we have started to ship liquid cooling at really at scale, at larger volumes in this core….. As much as the fact that all the GPUs and CPUs are running at higher wattage as they go over 1000, it's going to start to become painfully obvious.”

SMCI’s management has stated that liquid cooling will cost more as it takes longer to assemble and test, and the company plans to charge for this. It’s also expected that SMCI will be the first to ship liquid cooled AI systems before its competitors.

Capital raises likely

The company expects strong growth in the coming quarters due to robust AI demand and market share gains. Management mentioned that “sequential growth will become normal.” The company raised $3.28 billion in convertible senior notes and equity offering in the FQ3. During the Q&A, management replied to an analyst’s question that they might need to raise more capital in the future due to the strong expected growth. They also mentioned earlier in the call that they want to support growth with minimal equity dilution.

Inventory

The company’s FQ3 closing inventory was $4.1 billion, which increased by 67% quarter-over-quarter from $2.5 billion in Q2 due to the “purchase of key components.” Management attributed the increase in inventory due to the expected strong growth in the June quarter and the liquid cooling opportunity. The rise in inventory also negatively impacted the cash flows particularly as the company received about $700 million in inventory in the last week of the quarter.

Valuation

Supermicro has an old school semiconductor top line valuation that reflects its roots as a server maker. Currently it has a P/S ratio of 3.0 and a forward P/S ratio of 1.5. The P/S ratio peaked in March 2024 and is presently trading above the average P/S ratio of 1.17 as the market is rewarding the stock due to the company’s transition from a traditional server player to an AI server player.      

Conclusion

AI GPU demand has no signs of slowing down as Big Tech Capex continues to spend billions on AI Infrastructure. This has led to an exponential increase in power consumption. Data Centers are expected to adopt liquid cooling technologies to reduce the heat and Super Micro benefits from these emerging tech trends. The stock, which was included in the S&P 500 Index earlier this year, was also included in the Nasdaq-100 Index on July 22nd. At the same time, the capital raise and the cash flow issues are to be monitored in the coming quarters.

Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.

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Cloudflare Q2: Significant Margin Expansion, Customer Acceleration

Posted on by io-fund

Cloudflare’s adjusted operating margin reported significant expansion and the company is nearing GAAP profitability. In addition, its free cash flow grew 92% YoY and there was noticeable customer acceleration in the key metrics.

Cloudflare is going through a transition in customer contracts, transitioning from annual recurring contracts to offering more platform deals that are on monthly, pay-as-you-go terms with 3+ year duration. This is causing DBNRR and RPO to look lumpy, yet the company’s beat/raise is helping to shrug off any concerns from this transition.

Ultimately, Cloudflare is well positioned for AI inference at the edge and it’s operating leverage is a near-term bonus. We look at this and more below!

Revenue and EPS:

Q2 revenue topped estimates by nearly 2%, with Cloudflare’s revenue growth rate decelerating 50 bp to 30% in the quarter. Management increased full year revenue guide. Most importantly, Cloudflare reported significant progress toward becoming GAAP profitable.

  • Revenue of $401 million beat estimates by $6.5 million, representing YoY growth of 30.0%.
  • For Q3, management guided revenue between $423 million and $424 million, slightly ahead of the analyst consensus for $423.34 million. This represents YoY growth of 26.2%, a 380 bp deceleration.
  • GAAP EPS of ($0.04) beat by $0.06, marking significant improvement from ($0.28) in the year ago quarter.
  • Adjusted EPS of $0.20 beat estimates by $0.06, for YoY growth of 100% from $0.10 adjusted EPS last year and QoQ growth of 25% from $0.16 EPS last quarter.
  • Management guided adjusted EPS of $0.18, ahead of estimates for $0.15. 

For FY24, Cloudflare now sees revenue between $1.657 billion and $1.659 billion, for YoY growth of 27.8%. This also represented an $8 million increase from the guidance given in Q1. Management also boosted the adjusted EPS outlook to $0.70-$0.71, up from the prior view for $0.60-$0.61.

Margins:

Cloudflare showed strong improvement in operating margin and net margin, and significantly boosted its full-year operating margin outlook.

Based on management’s guidance for adjusted operating income of $50-$51 million in Q3, adjusted operating margin is expected to be 12%. For the full year, management boosted its adjusted operating income guide to $196-198 million, a nearly 22% increase from the prior view for $160-164 million. This pulls full-year adjusted operating margin up to 11.9%, a 210 bp increase from Q1’s view for a 9.8% margin and is suggesting that Cloudflare expects to witness strong operating leverage in the back half of the year.

  • GAAP gross margin was 77.8%, up from 75.6% last year and 30 bp QoQ expansion. Adjusted gross margin was 79.0%, up from 77.7% last year but a 50 bp QoQ contraction.
  • GAAP operating margin was (8.7%), a significant improvement from (-18.2%) last year and up from (-14.4%) last quarter.
  • Adjusted operating margin was 14.2%, a significant improvement from 6.6% last year and up from 11.2% last quarter, reaching its highest quarterly level.
  • GAAP net margin was (3.8%), a significant improvement from (9.4%) last quarter. Adjusted net margin was 17.3%, up from 10.9% last year, and up 190 bp QoQ.

Cash and Debt:

Cash flow continued to expand as well, certainly a plus in this environment for a cloud stock. Free cash flow expanded significantly by 92% YoY.

  • Operating cash flow was $74.8 million, for a margin of 19%, flat QoQ but up 6 percentage points YoY. OCF increased 16% YoY.
  • Free cash flow was $38.3 million, for a 10% margin, up from 9% in Q1 and 6% last year. Free cash flow increased nearly 92% YoY.
  • Cash and available-for-sale securities totaled $1.76 billion.
  • Debt (convertible senior notes) totaled $1.28 billion.

Network capex was 6% of revenue compared to 8% in the previous quarter. Management reiterated to expect network capex in the range of 10% to 12% in the second half of the year.

Key Metrics:

DBNRR was 112% in Q2, a 3 percentage point deceleration from 115% in Q1. Per the CFO’s opening remarks: “The decline in [DBNRR] was driven by slower net expansion in our larger customer cohorts, increased platform deals in the form of pool of funds contracts, which reduced friction to adoption across our product portfolio but can impact the shape of revenue recognition as well as deferred revenue and current RPO, especially for existing customers that transition into this structure and anniversarying the price increase to our Pro and business pay-as-you-go plans last year. For the next several quarters, we expect new customers to contribute a higher percentage of our overall year-over-year revenue growth. similar to the second quarter.”

There were questions about the pool of funds contracts in the Q&A, detailed below.

Billings increased 23% YoY and 9% QoQ to $421.7 million. This represents a 9% QoQ growth from $387.6 million last quarter. With that said, Billings growth has been decelerating for a few quarters and is down 9 points from 32% growth YoY in the year ago quarter. 

Deferred revenue totaled $394.5 million, a 5.5% QoQ increase.

RPO of $1.421 billion represented an increase of 6% QoQ and 37% YoY. This is lower growth than last quarter, when RPO grew 8% QoQ and 40% YoY. See below discussions around Pool of Funds accounts.

Paying Customers & Workers Platform Accelerated

Cloudflare Worker Applications grew from 2M developers to 2.4M developers in four months, per the CEO’s opening remarks. The Workers AI Platform developer accounts grew 67% QoQ and inference requests grew 700% QoQ. Of course, this is large growth on small numbers, but take notice that Cloudflare is one of the only best-of-breed software companies able to quantify their AI impact right now.

Paying customers totaled 210,166 in Q2, a 21% YoY increase. This represented a 400 bp acceleration from 17% YoY growth reported in each of the last three quarters. On a QoQ basis, Cloudflare added more than 13,000 customers, compared to sequential additions of less than 10,000 in each quarter in the last two years.

For customers with ARR of >$100K, Cloudflare reported 30% YoY growth to 3,046. This customer cohort contributed 67% of revenue, flat with Q1 yet up from 64% in the year ago quarter.

Earnings Call:

Pool of Funds Accounts

The CFO explained that Cloudflare is seeing a transition in their billing from annual contracts to pool of funds accounts that are on a monthly basis for three or more years. The pool of funds accounts are unique to the largest customers (for example, 4 of the top 10 customers are this account type) that use many products across the entire Cloudflare platform. These are considered larger platform deals that are paid on a monthly basis in a multi-year contract  rather than an annual contract on one product. This is shifting how DBNRR and RPO are reported since revenue is recognized as the customer consumes the service.

This is how the CFO explained it: “So as it relates to revenue, the revenue is now recognized as the customer consumes the service, and as a result, the record revenue recognition might be nonlinear and might ramp over time with respect to deferred revenue because those deals have monthly billing terms, we do not report upfront deferred revenue, and this can result then in lower deferred revenue growth. And then current RPO is also impacted because the contract duration is longer. So you recognize upfront less in current RPO. So while there the deals are very beneficial and healthy to the business. They generate some noise in this transition in our DNR and in the other metrics.”

There was a question about this from an analyst where the CFO pointed toward this creating lumpy, yet “significantly higher total contract values.”

Question
Fatima Boolani (Analysts)

Matthew and Thomas, this is for you both. I had a bare picture question around the pricing strategy across the portfolio. So at a tactical level, you had some meaningful price increases that you're first ones ever. Thomas wondering if you could just opine on how far deep those have pervaded the installed base. And if you can kind of talk to where we are in terms of the innings in terms of how that inferred in the base? 

And then Matthew, the bigger picture question for you is, if I piece together a lot of what you shared in the prepared remarks as it relates pool of fund deals, more pay as you go, more consumption, payment modalities especially as the Workers' portfolio scales, how should we generally think about the business impact and sort of revenue elasticity, if you will.

Answer
Thomas Seifert (Executives)

There's not much to add to what Matthew just said. Some of the impacts of this transition, you have seen, we talked about how pool of funds deal impact the lumpiness or make our numbers a little bit more lumpy. We will also have an increasingly higher share of variable revenue in our numbers, while this number is still small today, and it will grow meaningful over time. 

But this is less driven by price increases, as Matthew said, but it's more driven by the structural changes that this transition implies. And with all the overall benefits of more stickiness, longer-duration deals, platform fills with better expansion capability and significantly higher total contract values.

Cloudflare’s View on the Inference Market

We’ve discussed in the past how Cloudflare is uniquely positioned to capture inference at the edge. Per the opening remarks, Cloudflare signed a $500,000 contract for Workers AI for inference tasks across their edge network. The key metrics around 2.4M developers on the Workers platform and 67% QoQ growth on Workers AI are also important to pay attention to as we go along.

The CEO explained that his view on inference is that half of it will be run on devices and the other half will be run on networks like Cloudflare: “That also has the benefit of making it as performant as possible. And it also means that you can have the AI that's responding have regional differences more easily so that if you're responding in the U.K., the — an AI can spell color with a U, whereas if it's in the U.S., it can spell it with no U. I think all of those things then drive a lot of the other 50% of inference tasks to be running at a network like Cloudflare.

And so we are trying to build that network out ahead, make sure that we can answer any inference tasks that can't get determined on your own device as close as possible to that device and then make it very easy to get that inference task from us are from the device to us in a standard-based API-driven way, so that it's seamless to that end user […] But I really think that inference is going to be between the end devices themselves and a network that is like Cloudflare that spans the globe and is incredibly close and in every jurisdiction where end users might be.”

Conclusion:

The operating leverage is helping Cloudflare’s stock price today while its AI inference positioning is more of a medium-term story. We are encouraged by the initial ramp of the Workers platform and believe key AI winners are being decided today, evidenced by this early traction. Cloudflare is physically positioned at the edge to where there is no way around Cloudflare when it comes to inference (literally) as hyperscalers are positioned too far away from devices for the low latency that AI inference will require. Management being able to improve margins and cash flow help make it an easy choice to keep Cloudflare in the portfolio as we wait for the medium-term story to solidify.

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

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