Month: November 2024

Dell Q3: AI Server Pipeline up 50% QoQ, Yet PCs Soft

Posted on by io-fund

Dell reported a soft Q3, with revenue missing estimates and Client Solutions revenue declining YoY. AI optimized server orders were a bright spot in the quarter with orders rising nearly 13% QoQ to $3.6 billion; however, AI server shipments declined sequentially by 6.5% QoQ.

Despite the strength of AI orders and Dell’s AI pipeline, Dell guided Q4 revenue $1 billion below consensus at midpoint due to a delayed PC refresh cycle. The guide for next quarter was $24 billion to $25 billion, or $24.5 billion at the midpoint compared to analyst expectations of $25.6 billion. The soft PC market is not news to our firm, as it’s something we covered closely in our Q4 webinar.

It’s generally understood that Dell’s participation in building rack scale solutions for the Blackwell generation of GPUs is what makes the stock investable, as opposed to the Hopper generation, where Dell did not participate with hyperscaler customers quite like Super Micro did. There is evidence that Dell will become a leading AI server company next year with a 50% QoQ increase in the five-quarter pipeline, from $11B to $13B last quarter to somewhere between $16 billion and $18 billion. If we read between the lines, Dell’s current AI server backlog is $4.5B but they are guiding for a $6B increase in the pipeline from one quarter alone, which means the backlog is slated to accelerate from here.

Revenue

Dell reported $24.37 billion in revenue in the third quarter, rising 9.5% YoY. This was short of the consensus estimate of 11.1% growth for $24.72 billion. AI growth was most visible in the quarter, with COO Jeff Clarke saying: “Interest in our portfolio is at an all-time high, driving record AI server orders demand of $3.6 billion in Q3 and a pipeline that grew more than 50%, with growth across all customer types.”

This comment is a bit vague, but in the Q&A, an analyst pinpointed the 50% QoQ growth implies $16.5B at the midpoint for the five-quarter pipeline – although back of the napkin math places it potentially higher, up to $19.5 billion on the high end: “I think last quarter you said it was multiples of backlog, which would have put it at $11 billion to $13 billion. And you said it grew 50% sequentially. So are we looking at a backlog that's a pipeline, excuse me, that's like $16 billion or $17 billion.”

Revenue growth failed to return to the double digits as expected in the quarter, but the major shortfall was Q4, with management guiding for revenue between $24 billion and $25 billion. At midpoint of $24.5 billion, this was just over $1 billion below the consensus estimate for $25.54 billion, and represents growth nearly 5 points slower, at 9.8% YoY versus the 14.5% expected.

The PC refresh being pushed out to next year and the timing of AI servers is the reason for the softer guide – here was the full explanation: “I'd say we did bring Q4 revenue guidance down, as you mentioned, Toni, and it's basically those two elements. PCs, it's not a matter of if the repurchase is going to happen, it's when, and we're seeing that move more into next year and then the unpredictability of the AI shipments. And so putting those two things together, we feel strong about the overall performance in Q4, but there's some more timing differences than what we were anticipating when we gave the guide the last quarter.”

Key Operating Segments

Infrastructure Solutions Group

Dell’s ISG segment dipped slightly QoQ, as servers and networking revenue declined sequentially. AI server shipments also declined QoQ, falling from $3.1 billion in Q2 to $2.9 billion in Q3, despite orders rising nearly 13% QoQ to $3.6 billion and backlog rising more than 18% QoQ to $4.5 billion.

ISG revenue of $11.37 billion rose 34% YoY, at the upper end of management’s forecast for low-30% growth, but declined (2%) QoQ.

Growth continues to be driven by servers and networking, with revenue increasing 58% YoY to $7.36 billion. However, this represented a (4%) QoQ decline for the segment and a 2200 bp deceleration in growth rate from Q2’s 80% YoY.

As stated from the CFO, the timing of AI servers played a role in this sequential decline for the segment, as AI server shipments declined (6.5%) QoQ to $2.9 billion, down from $3.1 billion in Q2. This was nothing out of the ordinary, as Dell had said last quarter that AI servers would be down quarter-over-quarter. However, analysts were expecting some higher numbers for shipments, with Evercore expecting $3.1 billion in shipments in the quarter.

Management also noted that their “AI server pipeline grew over 50% sequentially with growth across both Tier 2 CSPs and Enterprise customers.” Outside of AI, traditional server demand also remained quite strong, with management seeing YoY growth for the fourth consecutive quarter.

Per the CFO: “In Traditional servers, demand improved double-digits in Q3, making four consecutive quarters of year-over-year growth, driven by growing units and ASPs with denser core counts, memory, and storage per server.”

ISG’s profitability also improved in Q3, with the segment’s adjusted operating income of $1.51 billion for a margin of 13.3%. This marked a 230 bp expansion from 11% in Q2. Management noted in Q3’s call that ISG’s profitability is expected to continue next quarter. Per the CFO: “OpEx is expected to decline [next quarter] mid-single-digits as we continue to drive efficiencies in the business. We expect the operating income rate to be up sequentially with continued improvement in ISG.”

Client Solutions Group

CSG was Dell’s weakness in the quarter, with revenue in the segment declining (1%) YoY, falling short of management’s guidance for flat to low single digit growth.

CSG revenue was $12.13 billion, down (1%) YoY and (2%) QoQ, falling short of the $12.42 billion estimated by analysts. Commercial revenue increased 3% YoY but declined (4%) QoQ to $10.14 billion, with Dell saying that Q3 was the third consecutive quarter with Commercial demand growth and the second consecutive quarter where they gained share in premium PCs. Consumer revenue was weaker, declining (18%) YoY but rebounded 5% QoQ to $1.99 billion.

Given the strength in AI, PCs are likely to be weak in Q4, and a primary driver of the soft revenue guide.

Margins

Margins improved across the board sequentially, with Dell beginning to show signs of improved profitability as cost-cutting impacts appear. There still is room for improvement, however, as gross margins remain lower YoY.

Analysts were pleased that ISG operating income was up QoQ to 13.3% of revenue, an improvement of 230 basis points since last quarter and up 530 basis points from the beginning of the year, driven by higher gross margin from servers and reduced opex.

  • GAAP gross margin in Q3 was 21.8%, up 60 bp QoQ but down 130 bp YoY. Adjusted gross margin was 22.3%, up 50 bp QoQ but down 140 bp YoY. This is a key differentiator compared to Super Micro with a gross margin of 11% last quarter.
  • GAAP operating margin was 6.8%, up 140 bp QoQ and 10 bp YoY. The YoY growth stems from cost-cutting efforts, with operating expenses declining 140 bp YoY to 15.0% of revenue. Adjusted operating margin was 9.0%, up 90 bp QoQ and 20 bp YoY.
  • GAAP net margin was 4.6%, up 120 bp QoQ and 10 bp YoY. Adjusted net margin was 6.3%, up 80 bp QoQ and 10 bp YoY.

EPS

Despite the top line miss, Dell beat estimates for GAAP and adjusted EPS due to the margin strength in the quarter.

  • Adjusted EPS of $2.15 beat estimates by 4.4%. Adjusted EPS growth accelerated to 14.4% YoY in the quarter, up from 8.6% last quarter. Growth is expected to accelerate further to nearly 50% YoY by fiscal Q1 before moderating to the high-teens.
  • GAAP EPS of $1.58 beat estimates by 13.7%.

Cash and Balance Sheet

Operating cash flow margin expanded once again sequentially, though cash flows remain much lower on a YoY basis.

  • Operating cash flow was $1.55 billion in Q3, declining nearly (28%) YoY but rebounding 16% QoQ. OCF margin was 6.4%, expanding 100 bp QoQ but contracting 330 bp YoY.
  • Adjusted free cash flow was $716 million, down (17%) YoY and (44%) QoQ. Adjusted FCF margin was 2.9%, down 220 bp QoQ and 100 bp YoY.
  • Inventories reached $6.65 billion in Q3, rising ~$600 million sequentially. Since the end of FY24, inventories have increased just over $3 billion, or nearly 84% growth in three quarters.
  • Cash, equivalents and investments totaled $5.23 billion.
  • Debt totaled $25.02 billion.

The company repurchased 3.7 million shares of stock for an average price of $107.53.

Earnings Call:

Dell’s Rack Scale Systems

In the call, the company discussed the IR7000 server, which will include up to 144 GPUs per rack, which is double the size of Nvidia’s NVL72. Dell also plans to release the PowerEdge XE9586L with u up to 96 Blackwell GPUs and AMD’s 5th Generation GPUs and up to 12 PCIe5 slots. The PowerEdge M7725 offers up to 27,000 CPU cores and is powered by AMD 5th Generation CPUs to deliver more compute in less space.

Most of these new rack scale solutions will ship in Q1 and Q2 of calendar year 2025.

Below is the full quote as this is key to understanding why Dell should have a strong year next year:

“We have accelerated the speed of innovation to respond to our customers' GenAI needs over the past year. A few highlights from the past two months. We launched our 21-inch ORv3 Integrated Rack 7000, in both a 44 and 50 OU rack design with integrated cooling, power and networking that is multi-generational and future-proofed up to 480 kilowatts per rack.

This rack falls in our Integrated Rack Scaleable Solutions, which are focused on at-scale deployment ensuring Dell's AI Factories can meet the demands of foundational training at the Data Center scale. We are shipping the industry's first enterprise ready GB200 NVL72 server racks with our new XE9712, with direct liquid cooling that holds up to 72 GPUs per rack.

We also announced at SuperCompute 24 a new AI server supporting NVL-4, also with liquid cooling, supporting up to 144 GPUs per rack, one of the industry's most dense designs. And we have the M7725, a dense compute design, which supports up to 27,000 CPU cores per rack to meet high-performance computing demands.

Our IR5000 can achieve up to 96 GPUs per rack with a more traditional 19-inch rack design. Within the IR5000, which includes the XE9680L, we introduced the XE7740 and XE7745, designed for Enterprise customers focused on inferencing.”

For storage, Dell offers a PowerScale platform for file and object storage, PowerEdge for data analytics, and most recently, has launched a data lake warehouse based on the idea that most data is on-premise and this will only intensify with AI.

Management was adamant that storage will become a growth driver for their company: “I mean, I think I've said publicly multiple times that the AI opportunity for storage is immense simply because GPUs devour data. I mean, you have to feed the beast, and they're not very effective without a lot of information” […] “And remember, 80% of the data is on-prem. So we think AI is driving new needs in the storage architecture, which really drive to a three tier architecture. So the ability to scale, the ability to drive efficient deployment of storage, the ability to be flexible and above all high performance are all things required to meet these high performance modern AI workloads and that's what our portfolio is. The Dell IP portfolio is a three tier architecture moving towards disaggregated that allows us to scale CPU and storage and networking independently to optimize for performance.”

PC Refresh Cycle Pushed Out to Next Year

Dell is contending with a weak PC market, which is weighing considerably on the report after hours. Per management: “More Enterprise customers are beginning to refresh, albeit modest and in a more price competitive environment. We are seeing an indication that customers are lining up their upgrade cycles with new AI PCs in the first half of next year.”

Later it was stated the miss for next quarter was a result of PCs and timing on AI servers:

“Yes. I'd say we did bring Q4 revenue guidance down, as you mentioned, Toni, and it's basically those two elements. PCs, it's not a matter of if the repurchase is going to happen, it's when, and we're seeing that move more into next year and then the unpredictability of the AI shipments. And so putting those two things together, we feel strong about the overall performance in Q4, but there's some more timing differences than what we were anticipating when we gave the guide the last quarter.”

Dell Surprises on Margins; An Area to Watch

This quarter, Dell surprised with better-than-expected margins. This is key, as before Super Micro became the target of short seller reports and accounting issues, we stepped aside due to margin issues and cash flow issues.

Tariffs could impact margins although the CFO stated they are not foreseeing margin issues at this time from tariffs: “So I can talk a bit about the Q4 guide and we have taken into account in that guide the mix within AI and expecting, but expecting those margins, which I know we don't talk about holistically, but expect them to stay relatively consistent. So the mix would be what's driving there. We've talked about AI revenue and our offerings being margin dollar accretive and margin rate dilutive.”

This was also a strong statement in terms of why margins may remain higher than competitors: “Per the CEO: “I think we've tried to reflect that in our previous comments, but to maybe try to be very specific here, the opportunity is beyond the node into full rack scale integration. And in full rack scale integration, it's the networking opportunity, the storage opportunity, mundane things like cooling and how you actually build very efficient cooling subsystems to take the energy density out, how do we do power distribution, power management, putting telemetry in, doing power management, all of those are opportunities for us to expand our margins and why we believe we have a differentiated solution and ultimately are at a premium to our competitors.

Conclusion:

The I/O Fund is starting to prepare our portfolio for the transformational change to how servers are built – which is breaking the upper limits of what was once thought possible at the server-level. AI-forward enterprises and Big Tech especially is moving from systems with 8 GPUs to systems with 72 GPUs with Dell offering rack scale designs of up to 144 GPUs and also dense compute options with up to 27,000 CPU cores. The way in which Dell will take business from Super Micro is not only in reputation but also in scale.

Dell made it clear they were the first to market with the NVL72 systems, providing a hint of what’s to come. The 5-quarter pipeline growth of 50% QoQ is being overshadowed, and this is the kind of data point our company looks for. Due to the complexity of Blackwell servers, it’s likely key Blackwell suppliers will exceed Nvidia’s stock returns next year. Dell is top of mind on the candidates for this list.

Recommended Reading:

Dell Q3 Earnings Preview: Riding the AI wave

Posted on by io-fund

Dell will release its Q3 FY25 results on Nov 26. Analysts expect revenue to accelerate from 9.1% in Q2 to 11.1% in Q3 and adjusted EPS to grow 9% to $2.05.

The recent strong Nvidia results are a positive read-through for Dell in the coming quarters. Nvidia’s management suggested strong Blackwell and AI demand. Blackwell production shipments are scheduled for Q4 and are expected to ramp up in 2025. Nvidia’s CFO, Colette Kress, said in the earnings call, “Blackwell demand is staggering and we are racing to scale supply to meet the incredible demand customers are placing on us. Customers are gearing up to deploy Blackwell at scale.”

According to the recent UBS survey, Dell’s storage demand has been up year over year and stronger than that of its competitors. Dell’s all-flash storage demand was rated as strong by 71% of respondents compared to 53% for NetApp, 32% for HPE, and 20% for Pure Storage.

Similarly, another survey conducted by Morgan Stanley suggests that Dell is the best-positioned hardware vendor to capture traditional enterprise spending in the next three years. Analysts highlight the company's AI infrastructure momentum, driven by projected AI server shipments of about $20.6 billion in FY2026, up 56% from the previous forecast. We need an earnings report to confirm the survey results and hear management's AI demand commentary.

Dell also surprised the market with stronger-than-expected margins last quarter. The stock is a quality play compared to Super Micro even before the accounting issues cropped up.

Revenue

The company’s revenue is accelerating due to strong demand for Artificial Intelligence solutions. Management is optimistic about the significant opportunities in Enterprise AI, Tier-2 Cloud Service Providers, and sovereign AI opportunities. Dell is well-positioned to capitalize on these emerging markets by leveraging its existing solid relationships.

FQ2 revenue grew by 9.1% YoY to $25.03 billion. Jeff Clarke, Dell’s COO said in the earnings call, “Our AI momentum accelerated in Q2 and our results and outlook demonstrate that we are uniquely positioned to help customers leverage the benefits of artificial intelligence.”

  • Analysts expect FQ3 revenue to accelerate to 11.1% YoY to $24.72 billion and to 14.5% growth to $25.54 billion in FQ4.
  • During FQ2 results, management raised its full-year revenue guidance to $95.5 billion and $98.5 billion, representing 10% YoY growth at the midpoint. This is a $1.5 billion increase at the midpoint from the previous guidance, driven by solid momentum in AI servers and networking.
  • Analysts expect FY 2026 revenue to grow 8.6% YoY to $105.88 billion and 5.9% YoY to $112.10 billion for FY2027.

Given that Blackwell is expected to ramp significantly this year, and combined with Super Micro likely losing business from its accounting issues, we are foreseeing these estimates being too low by the time we exit next year.

Key Operating Segments

Infrastructure Solutions Group

FQ2 revenue accelerated significantly in the quarter as the segment grew 38% YoY and 26% QoQ to $11.65 billion, accelerating 1600 bps sequentially from 22% YoY growth in Q1. Management guided ISG growth to be in the low 30% range for FQ3, pointing to a slight deceleration sequentially. According to Zacks consensus estimates the revenue is expected to grow 32.7% YoY to $11.28 billion in FQ3.

For the full-year, management has guided for growth to be approximately 30%. Nvidia’s CFO, Colette Kress’s commented during the recent Nvidia’s results that “Both Hopper and Blackwell systems have certain supply constraints, and the demand for Blackwell is expected to exceed supply for several quarters in fiscal 2026.” This explains the fact that the Blackwell revenue will impact Dell’s guidance in the coming quarters.

ISG’s growth in FQ2 was driven by servers and networking, with revenue accelerating to 80% YoY and 40% QoQ to $7.67 billion, a record for the segment. This was a 3700 bps sequential acceleration in the YoY growth rate from 43% in Q1. According to Zacks consensus estimates, the servers and networking revenue is expected to grow 58.7% YoY to $7.39 billion in FQ3.

Storage revenue declined by (-5%) YoY and up 6% QoQ to $4.0 billion. During the earnings call, management mentioned that for FQ3, “Servers will grow in the low-single digits and storage will be down in the low-single digits. So that's relatively normal sequentially.” According to Zacks estimates, storage revenue is expected to grow 1.1% YoY to $3.89 billion. In the opening paragraphs, we discussed that UBS survey results point to better storage demand for the company. We need an earnings report to confirm the survey results.

AI server orders were $3.2 billion in FQ2, up 23% QoQ from $2.6 billion in Q1 as Tier 2 cloud service providers and enterprise customers increased. AI server shipments rose more than 82% QoQ, from $1.7 billion in Q1 to $3.1 billion in Q2. Growth also extended beyond AI to traditional servers, as traditional server demand rose YoY for the third consecutive quarter and rose QoQ for the fifth consecutive quarter.

Management had said during the earnings call Q&A that the AI servers would be down quarter-over-quarter. Evercore analyst note sounded more optimistic and expects the company to ship over $3.1 billion AI servers in FQ3, ahead of the management expectations due to the intra-quarter Tesla pull-ins and the expansion of xAI’s Colossus cluster. They also expect the backlog to remain between $3 billion and $4 billion for FQ3.

ISG’s adjusted operating margin expanded 300 bps QoQ to 11% in Q2, easing some concerns about AI servers weighing on segment margins. Management maintained its full year view for 11% to 14% adjusted operating margins for ISG, suggesting more upside to margins in the back half of the year.

Client Solutions Group

Client Solutions Group Q2 revenue declined (-4%) YoY but rose 4% QoQ to $12.41 billion. Commercial revenue was flat YoY and up 4% QoQ at $10.55 billion, while Consumer revenue declined (22%) YoY and up 2% QoQ to $1.86 billion. According to Zacks consensus estimates, the Client Solutions Group is expected to grow 0.3% YoY to $12.32 billion, while Consumer revenue is expected to decline by (-15.1%) YoY to $2.07 billion and Commercial revenue to grow 4.2% YoY to $10.24 billion.

The company is expecting growth in CSG in the second half of the year, with growth more concentrated in Q4. Q3 is expected to see flat to low single-digit growth, with management believing the “coming PC refresh cycle and the longer-term impacts of AI will create tailwinds for the PC market.” For the full-year, CSG is expected to also be “flat to low single digits for the year.” Recent data from Canalys showed strong AI PC shipments totaled 13.3 million, up 49% QoQ and accounting for 20% of PC sales in the third quarter signals a positive read-through for the Client Solutions Group.

Margins

The company’s margins remained resilient despite gross margin contracting, as Dell faces some competitive pressure and headwinds from increased AI server mix. Margins are expected to improve with a higher proportion of storage revenue in the second half of the year, as well as cost-cutting initiatives like reducing workforce.

  • FQ2 gross margin was 21.2% compared to 23.5% in the same period last year. Adjusted gross margin was 21.8% compared to 24.1% in the same period last year. For the FY25 management has guided for adjusted gross margin to decline 180 bps YoY to 22.5% due to inflationary input costs, competitive environment, and higher mix of AI optimized servers.
  • Operating margin improved to 30 bps YoY to 5.4%. Adjusted operating margin declined by 50 bps YoY to 8.1%, helped by higher revenue and lower operating expenses, offset by lower gross margins. Management expects FQ3 operating expenses to be $3.6 billion, down (-9.3%) sequentially and adjusted operating expenses to be $3.3 billion, down (-3.8%) sequentially.
  • For the FY25 management expects operating margin to improve 60 bps YoY to 6.5% and adjusted operating margin to decline slightly by 10 bps to 8.6%.
  • Net margin was 3.4% compared to 2.0% in the same period last year and adjusted net margin was 5.5% compared to 5.6% in the same period last year.

EPS

EPS growth rate is expected to accelerate in the coming quarters.

  • Management has guided FQ3 GAAP EPS in the range of $1.43 to $1.63 and adjusted EPS in the range of $1.90 to $2.10. Analysts expect adjusted EPS to grow 9.0% YoY to $2.05 in FQ3.
  • Adjusted EPS is expected to accelerate to 20.8% growth and 49.8% growth in the subsequent two quarters.
  • Management raised the mid-point range of FY2025 adjusted EPS by $0.15 to $7.80.
  • Analysts expect FY25 adjusted EPS to grow 10.5%, followed by 19.8% and 14.6% in the subsequent years.

Cash Flow and Balance Sheet

Cash flows were lower in FQ2 due to higher working capital requirements.

  • Operating cash flow was $1.34 billion or 5.4% compared to 14% in the same period last year.
  • Adjusted free cash flow was $1.28 billion or 5.1% of revenue compared to 13.3% in the same period last year.
  • Cash and investments were $5.85 billion and debt of $24.52 billion compared to $7.12 billion and $25.48 billion at the end of FQ1. The core leverage ratio was down to 1.4x from 1.5x in FQ1.
  • The company repaid $1 billion in debt during FQ2. It also repurchased shares worth $712 million and paid $316 million in dividends.

Other Key Points

Positive Blackwell comments from Nvidia management

Nvidia’s CEO Jensen Huang said in the recent Q3 earnings call, “Blackwell production is in full steam. In fact, as Colette mentioned earlier, we will deliver this quarter more Blackwells than we had previously estimated. And so the supply chain team is doing an incredible job working with our supply partners to increase Blackwell, and we're going to continue to work hard to increase Blackwell through next year. It is the case that demand exceeds our supply and that's expected as we're in the beginnings of this generative AI revolution as we all know.

And so Blackwell demand is very strong. Our execution is on — is going well. And there's obviously a lot of engineering that we're doing across the world. You see now systems that are being stood up by Dell and CoreWeave, I think you saw systems from Oracle stood up.”

Jeff Clarke, Dell’s COO, had announced earlier this month that Dell had started shipments of servers based on Nvidia's Blackwell GPUs. The servers, which are aimed at enterprises, use liquid-cooled PowerEdge XE9712 racks.

Dell was mentioned before HPE and Super Micro is another positive read-through from Nvidia’s earnings call.

“And in terms of how much Blackwell total systems will ship this quarter, which is measured in billions, the ramp is incredible. And so almost every company in the world seems to be involved in our supply chain. And we've got great partners, everybody from, of course, TSMC and Amphenol, the connector company, incredible company, Vertiv and SK Hynix and Micron Spill, Amkor and KYEC and there's Foxconn and the many the factories that they've built and Quanta and Wiwynn and gosh, Dell and HP and Super Micro, Lenovo and the number of companies is just really quite incredible, Quanta. And I'm sure I've missed partners that are involved in the ramping up of Blackwell, which I really appreciate. And so anyways, I think we're in great shape with respect to the Blackwell ramp at this point.”

Super Micro Woes

Dell is also expected to benefit from the recent challenges faced by Super Micro. According to an article from Tomshardware Elon Musk’s xAI has reportedly shifted $6 billion of AI server orders to its rivals.

Valuation

Dell is trading at a P/E ratio of 26.26 and a forward P/E ratio of 18.31, higher than the average P/E ratio of 13.24. Similarly, it trades at a P/S ratio of 1.15 and a forward P/S ratio of 1.04, higher than the average P/S ratio of 0.47.

Conclusion

Dell is a beneficiary of the AI server opportunity. The recent Nvidia management comments allayed investor fears about Blackwell delays. The company is also expected to benefit from Super Micro issues, which is another catalyst for the stock. In FQ2 the company eased some concerns about AI servers weighing on ISG segment margins and we continue to monitor the margins in the coming quarters.

Due to timing of Blackwell, we added to our position as we may be a hair early but not by much, the risk to us is greater in missing out on Dell becoming the leader in AI servers at the very time that AI servers go through an important transition toward complex AI systems with up to 36 CPUs and 72 GPUs combined.

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

Recommended Reading:

Nvidia Stock Is A Buy On Dips Before Blackwell Arrives In 2025

Posted on by io-fund

This article was originally published on Forbes on Nov 20, 2024,04:48am ESTForbesForbes on Nov 20, 2024,04:48am EST

Nvidia’s stock broke to all-time highs recently, trading at $148 in early November and $147 yesterday. The stock has left many investors wondering “what comes next” after the unrelenting, historic surge that began seven quarters ago.

To help my readers determine where Nvidia’s stock will go next, I’ve been fastidious in my analysis about the company’s outsized AI potential since 2018, tracking Big Tech capex as a proxy for AI demand since 2022, discussing the anomalous earnings and revenue revisions throughout 2023 and 2024, and reporting on never-before published data on supply chain checks as recent as two months ago.

The thoroughness is needed, however, as rumors from the media and short sellers alike run amuck. Rest assured, as 2025 approaches, supply chain data is giving bullish signals that the new generation of GPUs shipping in full volume by mid-2025 (and beginning to ship in the January quarter) will far exceed the GPU sales we saw in 2023 and 2024 combined.

Regarding my firm’s confidence in tracking supply chain data, when The Information stated Nvidia was experiencing a material delay on the next generation of GPUs, going so far as to state that Taiwan Semiconductor had machines sitting idle, I quickly refuted the report based on supply chain data my firm had been tracking. Those data points continue to indicate Blackwell is ramping. Here is what I stated:

“As of now, there’s a disconnect between next fiscal year’s revenue estimates of $167 billion and the $210 billion in GB200s alone expected to ship next year. Perhaps analysts are waiting for signals the supply chain can produce these outsized orders. So far, so good with the signals we see from TSMC and SMCI’s most recent earnings reports. Foxconn commentary helps, as well.”

Fast forward two months, and next year’s fiscal estimates stand at $185 billion up from $167 billion; showing no material impact from the delay (quite the opposite). Our firm was also able to use that same supply chain data to buy Nvidia in July/August, for an average cost basis of $109. The I/O Fund’s first trade was at $3.15, but we actively track the stock and publish our real-time trade alerts for anyone who feels they missed out on the AI juggernaut.

$5B+ in Blackwell Revenue for Q4

The first item that will determine the strength of the upcoming earnings report from Nvidia has nothing to do with the Q3 results. Rather, what the market will want to know is how much Blackwell revenue is expected in the January quarter. Morgan Stanley has estimates placed at $5 to $6 billion, with this number hitting a ceiling due to supply constraints; however, Piper Sandler sees Blackwell revenue potentially higher, at $5 billion up to $8 billion.

Given the company is lapping tough comparables, the growth rate will slow considerably even if Blackwell does ramp from $6 billion per quarter to $60 billion per quarter by late-2026 (Hopper is in its seventh quarter and Blackwell will be in its seventh quarter by late 2026). This is because excellence begets excellence, and thus, Nvidia is competing with itself with each new generation of GPUs. For example, with Hopper, the company reported peak quarterly growth of 262% and 265% earlier this year, yet is expected to slow to the mid-40% for growth as we close out 2025.

Nvidia has multiple levers it can pull and outside forces at play that will help it maintain this 40%+ growth rate. This includes a 1-year product road map, Big Tech’s large appetite for AI spending, and long-term AI GPU market growth from Enterprises and the Consumer, plus a commanding market share position.

By coming to market with upgraded, more powerful GPUs on a now-annual cadence, with Blackwell Ultra, Rubin and Rubin Ultra soon to come, Nvidia will continue to be the largest beneficiary of Big Tech’s AI capex to an unprecedented degree as the company continually raises the bar on performance and TCO upgrades with each new generation.

Additionally, Nvidia has a software moat with CUDA and the cash to reserve chip capacity in bulk at the fab level to maintain an 80% to 85% share of what executives foresee as a $500 billion AI accelerator market by 2028. I first covered these points in my free newsletter when I published: “Here’s Why Nvidia Stock Will Reach $10 Trillion Market Cap by 2030.”

Of these points, one of the most visible is that Nvidia continues to pry away tens of billions in cash – and now hundreds of billions —- from the world’s leading tech companies.

Big Tech Capex to Surpass a Quarter Trillion

All roads lead to Nvidia, and it’s no secret that Big Tech and others are competing to purchase Nvidia’s supply constrained GPUs. Our firm began tracking Big Tech capex as a proxy for Nvidia demand in 2022, and tracking it on a quarterly basis starting in early 2023 – to help gauge AI demand, I continue to track Big Tech capex quarterly closely for our readers.

Our recent checks published in the analysis “AI Spending to Exceed a Quarter Trillion Next Year” reveal that AI spending continues to accelerate, with Alphabet, Amazon, Microsoft, and Meta on track to increase their spend by ~$90 billion YoY in 2024. This does not include xAI, CoreWeave, Oracle and dozens of others who are also spending multiple billions on Nvidia’s GPUs, as well.

To better understand the trajectory of AI spending, let’s take a step back to 2023, where the rapid ascent of ChatGPT at the beginning of the year set the stage for AI to step into the spotlight.

  • In the first half of 2023, Big Tech spent ~$74 billion on capex. Through Q3, that sum had moved up to ~$109 billion.
  • In the first half of 2024, Big Tech spent nearly $104 billion, a 47% YoY increase. Through Q3, that sum had surged to $170 billion, up 56% YoY.

Big Tech could spend another $70 billion in Q4, based on guidance and comments from executives, who overwhelmingly discussed the need for more AI infrastructure, putting full year capex at ~$240 billion, or nearly 15% higher than the level they were tracking at the start of the year.

Big Tech Quarterly Capex

Big Tech’s Q4 capex could hit $70B, driven by AI infrastructure demand—pushing 2024’s total to ~$240B, up 15% from early-year estimates! Source: I/O Fund

For 2025, Big Tech has already signaled a willingness to spend substantially more on AI. There is clear ROI for Amazon, Google and Microsoft as they rush to meet the elevated demand that continues to outpace AI capacity in their cloud infrastructures. More broadly, Big Tech and large enterprises are racing to further develop and broaden AI services and models. UBS projects Big Tech will spend ~10% more YoY, placing AI-driven capex at $267 billion; however, if 2024 is any sign, this estimate is too low. This all fits in with longer-term projections from Bank of America that sees a cumulative $700 billion spent on AI through 2026.

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Nvidia Has Over 2X Better Margins Compared to Most Mag 7 Stocks

As we go through a lull between the Hopper generation being in its seventh quarter, and Blackwell not yet shipping in volume, our firm will be buying the dips on Nvidia for many reasons – one of them being it’s the market leader on margins. By having a near monopoly on GPUs, Nvidia has incredibly strong pricing power.

The GPUs coming in 2025, called Blackwell, are set to intensify this pricing power with DGX B200 systems reportedly going for up to a 40%+ premium to the previous DGX H100 systems, at $500,000 per server versus the low $300,000s per server, respectively.

While GB200 prices are estimated at $60,000 to $70,000 for a single chip, the NVL36 and NVL72 configurations carry much higher price tags and thus, higher average prices per GB200. For example, the NVL36 is expected to cost ~$1.8 million, and for 18 GB200s (36 B200 GPUs), that comes out to $100,000 per GB200 and additional components. For the NVL72, it works out to ~$83,333 per GB200 and additional components.

While there were concerns about Nvidia’s margins given that management guided for a sequential contraction in gross margins in Q3, the sheer pricing power of Blackwell will ultimately be a non-issue next year.

Nvidia’s operating margin of 62% exceeds second place Microsoft by 17.5 points and third place Meta by 21.9 points; Nvidia is more than double the rest of the Mag 7 including Apple and Alphabet. This is because Hopper’s pricing power versus the Ampere generation: Nvidia’s Compute and Networking operating margin expanded from 28.5% in Q3 FY23 when Hopper reached full production to 71.3% in the most recent quarter even as revenue grew 7x during that seven-quarter period.

Big Tech Operating Margins

Nvidia leads the MAG 7 with a 62% operating margin, driven by Hopper’s pricing power—more than double Apple, Alphabet, and others in the group! Source: YCharts

Nvidia is expected to report roughly 50 bps to 100 bps margin contraction this quarter compared to last quarter, and will see roughly 200 bps to 300 bps margin contraction from its peak growth quarters earlier this year. As stated, the pricing power I foresee from Blackwell will keep the margins strong well into 2025, therefore, any concerns over margins this quarter will be a moot point by next year.

The strong margins combined with the expected growth in AI accelerators has caused some analysts to increase earnings per share substantially as of late. Bank of America increased its EPS estimates for next calendar year from $3.90 to $4.47 and for calendar year 2026 from $4.72 to $5.67.

In February, I wrote an analysis describing how Nvidia’s valuation was “eerily low despite 420% rally since 2023” to help our readers prepare for a higher return in the coming months, which detailed the importance of these revisions.

Ultimately, these revisions make the stock cheaper as it leads to more room in the bottom-line valuation. Despite being fairly straight forward, the velocity of the revisions is the single most important point that short sellers and Nvidia critics cannot seem to understand.

Q3 Earnings Details:

Of all the quarters since Nvidia’s Hopper release, this is the quarter most likely to be lackluster. This is because the impact of Hopper and the H200s are well-known and the Blackwell generation won’t be shipping in volume until Q1 and ramping further into Q2.

I am looking forward to the fiscal year guide in the February call, and am even more excited about the May earnings call when Blackwell’s impact will be better understood.

Nvidia’s Q3 FY2025 Revenue:

Nvidia is expected to report revenue of $32.9 billion for growth of 81.8% at the midpoint. Analyst expectations are higher than management guidance of $32.5 billion at the midpoint, for growth of 79.4%. This is a deceleration from last quarter’s 122.4% growth, and peak growth of 262% and 265% in the April and January 2024 quarters.

As pointed out on EPS, another area where Nvidia is unique is the sheer amount of analyst revisions on the stock. It not only speaks to Nvidia’s dominance in the AI data center to continually surprise the Street, but also to the challenge that analysts face in terms of predicting Nvidia’s persistent revenue surge.

For example, this year alone, analysts originally expected Nvidia to report 33.4% revenue growth and this quarter is now expected to be 81.8% growth, for revisions that total 48.4 points in about six months’ time (more than double the original growth expectations).

This quarter, there is a wide range of expectations with UBS believing Nvidia will beat by as much as $2 billion, for revenue of $34.5 billion to $35 billion for Q3. Piper Sandler foresees a beat of $1.3 billion for Q3, and a beat of $1.5 billion for Q4.

It’s been quite clear for the past two years that analysts do not know how to gauge the growth coming from this company. In 2025, Blackwell is likely to wildly exceed analyst estimates again.

EPS:

This quarter, analysts are expecting EPS of $0.74 compared to EPS of $0.67 last quarter. For nearly two years, the company has beaten EPS estimates by 10% or more, yet in the last quarter, the beat was more muted at 5.7%.

On the topic of Nvidia having 2X better margins than most of the Mag 7, here is a glimpse of how Nvidia compares on EPS with a 35%+ growth rate compared to the Mag 7 reporting half this growth rate through 2026:

Nvidia: 35.5% 2Y revenue CAGR, 35.1% EPS CAGR

Apple: 7.1% revenue CAGR, 14.4% EPS CAGR

Microsoft: 14.2% revenue CAGR; 14.9% EPS CAGR

Amazon: 10.7% revenue CAGR; 22.3% EPS CAGR

Meta: 13.5% revenue CAGR; 12.5% EPS CAGR

Supply Constraints:

This quarter, Nvidia’s CFO Colette Kress, will not offer a full year guide yet have to address the elephant in the room — supply constraints.

The fab that makes Nvidia’s chips, Taiwan Semiconductor (TSMC), is working overtime to boost capacity to meet demand. TSMC’s monthly CoWoS capacity was estimated at ~15,000/month at the end of 2023, and was originally expected to triple to ~45,000 to 50,000/month by the end of 2024 in order to meet such high demand from Nvidia, AMD and other advanced node clients. Now, capacity is expected to rise ~300% to 60,000/month.

TSMC remains committed to significantly boosting CoWoS capacity over the next few years in order to accommodate these accelerated AI GPU timelines from both Nvidia and AMD, with multiple different product lines expected to come to market over the next couple of years. By year-end 2025, CoWoS capacity is estimated to be 80,000 to 90,000/month, per Morgan Stanley, with Nvidia reportedly already reserving half of this capacity.

By the end of 2026, CoWoS capacity is estimated to expand to as much as 140,000 to 150,000/month, representing 10x growth in capacity from the end of 2023.

TEMC Twitter Post

Source: Beth_Kindig xAI

Foxconn and Quanta are also both signaling strong demand for Blackwell come 2025. Foxconn has said that they see “crazy” demand for Blackwell servers, and forecast AI servers to make up half of their overall server business in 2025. Foxconn has said that initial shipments are on time for Q4 before ramping much faster in Q1, with Quanta saying the same, that initial shipments are on schedule and will ramp in Q1.

Quanta sees triple-digit AI server growth through next year on the back of strong demand, with Deputy Spokesperson Carol Hsu saying that “recent capex guidance from top US hyperscalers also confirmed their aggressive spending on AI in 2025, all from a high base in 2024.”

Nvidia’s China Exposure is Low

Nvidia is the subject of some of the most severe export restrictions from the US due to its integral role in advancing AI computing. Subsequently, the company’s China exposure is among the lowest in the semiconductor sector, leaving it less exposed should we see heightened geopolitical tensions — especially tariffs.

Nvidia’s China revenue was 9.6% in Q1 and 12.2% in Q2, down from the low-20% range in the same quarters in fiscal 2024. For all of FY 2024, Nvidia’s China revenue was 16.9%, down from 21.5% the year prior. Other semi peers are much more heavily exposed to China: Broadcom’s China exposure was 32.2% in FY 2023, Intel’s exposure was above 27%, and Qualcomm and Marvell both had more than 40% of revenue stem from China in FY 2024.

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Semiconductor Peers are Quite Weak

Although Nvidia’s fundamentals are a perfect 10, the stock is contending with weak peers, as evidenced by major semiconductor ETFs, SOXX and SMH, not making new highs with the S&P 500.

Retail investors often find out the hard way, even the most perfect stock must contend with market forces beyond its control. This is the primary reason Nvidia’s stock may pullback as Nvidia is holding up the semiconductor market, which has grown unusually weak in the past few weeks. SOXX is 20% of its all-time highs and SMH is 14% of its all-time highs despite the S&P 500 making new highs. In a 1-hour webinar for I/O Fund Members last quarter, I discussed why this is an issue for AI investors and what I’d like to see before I resume buying Nvidia.

Conclusion:

My firm has become well-known for calling Nvidia an AI stock in 2018, and later stating Nvidia would Surpass Apple, and finally that Nvidia will reach a $10 trillion market cap by 2030. Yet, perhaps lesser-known is that I nailed the October 2022 bottom by stating Nvidia was Ready to Rumble on H100 GPUs along with a real-time trade alert for $10.80 on October 13th 2022 a mere 25 months ago.

Here is what I stated at the exact moment Nvidia’s stock bottomed in October after selling off 60% following the August earnings report:

“Today, Nvidia’s AI products serve nearly every enterprise company’s artificial intelligence and machine learning ambitions. The company has an impressive launch schedule starting in October for two flagship products – the RTX 40 Series and the H100 GPU. The timing of these releases is no coincidence as it’s a rapid two months following the crypto/gaming revenue miss. Suffice to say, Nvidia’s management team is prepared to rumble —- putting its very best release in gaming and its most powerful AI chip to-date up against the crypto mining selloff. If history is any indication, the turnaround will only be a matter of time.”

The upcoming earnings report has a few similarities to October of 2022, which is that we are toward the end of a product cycle and the CFO cannot offer fiscal year guidance. Despite the H100s ramping and Nvidia having visibility into that ramp, the CFO was tight-lipped two years ago stating: “Our Data Center yes, we do expect it to grow. It may grow about what we just saw between Q1 and Q2. We’ll continue to look at it.” Therefore, I am not expecting much from the CFO on Blackwell in this report, but that lack of detail will be a distant memory this time next year.

Make no mistake, Nvidia is the best stock of the decade and we are only four years in. The big picture is that Nvidia's trajectory will continue due to two words: pricing power.

Our firm has an aggressive buy plan at key levels should the stock pullback, and we have a backup plan should the stock overcome the peer pressure we are seeing from SMH and meaningfully breakout.The keyword is “buy” but the skillset is patience. My firm has blended cutting-edge analysis alongside careful, patient buys for returns of 3280% since our first tranche. Most importantly, the I/O Fund continues to offer buy zones for those who’d like to participate.

The I/O Fund first called out Nvidia’s AI opportunity in November 2018 with our first trade alert at $3.15 for returns of 3280%. We also provided 9 buy alerts from 2021 – 2022 to buy NVDA stock below $20. The I/O Fund has been closely analyzing lesser-known stocks in AI plus crypto with real-time trade alerts and webinars. For a limited time, get up to $250 off with one of our biggest sales of the year starting Nov 28th. Sign up for our newsletter for more information on the upcoming sale or Follow me on xAI/Twitter.more information on the upcoming sale or Follow me on xAI/Twitter.

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

Recommended Reading:

Nvidia Q3: Lackluster Quarter until Blackwell Arrives

Posted on by io-fund

Nvidia once again posted a $2 billion beat to revenue estimates, reporting YoY growth of nearly 94% to over $35 billion in revenue. Data center revenue more than doubled in the quarter to over $30 billion, speaking volumes as to the level of demand for its GPUs given that Blackwell had not begun to ship in Q3.

Blackwell matters – a lot. As stated in the webinar, the more the team looked at the details of the release, the clearer it has become that 2025 will be Nvidia’s year – again. Some of this was covered in the pre-earnings write-up published this morning.

On the positive side:

  • Hopper drove the beat that analysts were expecting, with UBS tagging the beat at $2 billion. This did, indeed, materialize in the earnings report. This beat is clearly not lackluster but given the performance of the stock, up about 850% since two years ago when Hopper began to ship, the product cycle is lackluster and not able to reinvigorate the stock.
  • My primary message going into tonight’s results was that the I/O Fund is tracking supply chain signals indicating the new generation of GPUs shipping in full volume by mid-2025 (and beginning to ship in the January quarter) will far exceed the GPU sales we saw in 2023 and 2024 combined. This was echoed tonight when Jensen Huang stated: “You see now that at the tail-end of the last generation of foundation models were at about 100,000 Hoppers. The next generation starts at 100,000 Blackwells.”
  • The importance of big tech capex was also echoed with the CEO stating we will see $1 trillion in data infrastructure rebuild before he expects to see digestion from the hyperscalers. As Damien on the team helped to point out last week, we are at a quarter-trillion right now. Per the CEO: “I believe that there will be no digestion until we modernize a trillion dollars with the data centers.” That would imply another 3X from here for the remaining three-quarter trillion – not in stock price, but in capex. Presumably, it would mean a higher trajectory for the stock price in terms of valuing that revenue.
  • Management debunked the supply chain rumors (which the inaccuracy is getting to be a tad annoying at this point). When asked about supply chain rumors, the CEO stated “Blackwell production is in full steam. In fact, as Colette mentioned earlier, we will deliver this quarter more Blackwells than we had previously estimated.” As expected, Colette Kress was tight lipped and no official number was provided. I have personally found Nvidia’s management style to be to our benefit as they were a closed book two years ago in the quarters that preceded the historic ramp.

What the Street Asked About:

  • Despite the rather large top-line beat, margins were relatively in line with guidance, and forecast to contract nearly 2 points sequentially.
  • Never underestimate Wall Street’s ability to miss the bigger picture. Analysts on the call cross-examined this 200 bps decline despite Nvidia having an operating margin of over 60% compared to most of the Mag 7 having operating margins at half that. The CFO was clear that following Blackwell, the gross margin will eventually return to its current percentage: “As Blackwell ramps, we expect gross margins to moderate to the low-70s. When fully ramped, we expect Blackwell margins to be in the mid-70s. GAAP and non-GAAP operating expenses are expected to be approximately $4.8 billion and $3.4 billion, respectively.”
  • Supply chain constraints: There has been some FUD published by The Information back in August and again this week. Management provided a strong comment to refute these claims, primarily that: “We completed a successful mask change for Blackwell, our next Data Center architecture, that improved production yields.” Yields is what matters here and this comment along with Q4 seeing more Blackwell revenue than previously estimated helps to eliminate these concerns.
  • Broadly speaking, there are supply constraints but this is nothing new as it’s been widely understood Blackwell is already sold out for next year.  
  • As we close out the year and move into 2025, investors should be prepared to hear about China and tariffs. Per the pre-earnings report, Nvidia has limited exposure at 12.5% yet it’s quite clear with weak SMH and SOXX ETF price action that the market is pricing in this impact. It’s unclear to me today how TSM will be viewed in terms of tariffs given the Arizona plant is up and running. You can view our webinar clip here regarding SMH.

Fiscal Q3 2025 Results:

As stated, Hopper drove the beat that analysts were expecting, with UBS tagging the beat at $2 billion. However, due to declining from peak revenue growth of 265% earlier this year, Hopper-driven growth of 94% is not what will drive the stock up for the next leg higher. Nvidia investors, such as myself, will need Blackwell’s pricing power and Blackwell’s clear demand signals to re-invigorate the stock.

As stated, the one weak link of the report was Q4’s margin guidance, with management pointing to potential contractions down the line as Blackwell ramps.

Revenue

Nvidia reported 93.6% YoY growth to $35.08 billion in revenue, well ahead of the consensus estimate for $33.13 billion (83% YoY). Nvidia is now lapping its peak growth quarters, Q3 FY24 to Q1 FY25, where revenue more than tripled each quarter as Hopper ramped tremendously fast. Management said in Q3 that the H200 “grew significantly in the quarter.”

Growth technically is decelerating nearly 30 points in Q3 and growth will further decelerate nearly 24 points next quarter, but to be reporting above 93% YoY and almost 70% YoY versus 200-260%+ growth comps is a strong report to say the least.

For Q4, management guided for revenue of $37.5 billion, +/- 2%, just slightly ahead of consensus estimates for $37.02 billion at the midpoint. Management noted that they have “completed a successful mask change for Blackwell…that improved production yields. Blackwell production shipments are scheduled to begin in the fourth quarter of fiscal 2025 and will continue to ramp into fiscal 2026.”

Both Hopper and Blackwell will be shipping in tandem, placing more emphasis on supply constraints moving forward, as management was clear in saying that both products have “certain supply constraints” with Blackwell’s demand “expected to exceed supply for several quarters in fiscal 2026.”

China revenue was 15.4% of revenue compared to 12.7% year-to-date. This is down from the low-20% range last year.

Key Segments

It should be of no surprise that data center revenue beat estimates in the quarter, but what’s interesting is that the segment posted the largest surprise relative to estimates since Hopper’s breakout quarter in FY24.

Data center revenue of $30.77 billion increased 112.0% YoY and 17.1% QoQ, beating estimates by $1.95 billion. Assuming a similar mix as the current quarter, Q4’s data center revenue would be implied to be nearly $32.5 billion.

In the segment, data center compute revenue was $27.64 billion, rising 132% YoY and 22% QoQ. Networking revenue increased 20% YoY but declined (15%) QoQ to $3.13 billion – this slowed sharply from 114 % YoY growth in Q2.

Management said networking growth was driven by Ethernet for AI; “NVIDIA Spectrum-X Ethernet for AI revenue increased over 3 times year-on-year and our pipeline continues to build with multiple CSPs and consumer Internet companies planning large cluster deployments.” It was also indicated that networking would resume sequential growth next quarter: “So this quarter is just a slight dip down and we're going to be right back up in terms of growing. They're getting ready for Blackwell and more and more systems that will be using not only our existing networking but also the networking that is going to be incorporated in a lot of these large systems that we are providing them to.”

  • Gaming revenue of $3.28 billion increased 15% YoY and 14% QoQ, driven by GeForce RTX series 40 GPUs and game console SoCs.
  • Pro Viz revenue of $486 million increased 17% YoY and 7% QoQ, driven by the ramp up of RTX GPU workstations.
  • Automotive revenue of $449 million increased 72% YoY and 30% QoQ, accelerating 35 bp QoQ from 37% YoY growth in Q2, driven by Nvidia’s self-driving platform.
  • OEM and other revenue of $97 million increased 33% YoY and 10% QoQ.

Margins

Despite the rather large top-line beat, margins were relatively in line with guidance, and forecast to contract nearly 2 points sequentially. This forecasted weakness as Blackwell ramps may be one of the factors behind the initial post-earnings sell-off, with GAAP operating margin seen coming back towards 60%.

  • GAAP gross margin was 74.6%, just ahead of guidance for 74.4%. Adjusted gross margin was 75%, in line with guidance. This reiterated our view from last quarter that Q1 was the peak for gross margins, as margins have contracted about 380 bp since then.
  • For Q4, management guided for GAAP gross margin of 73%, +/- 0.5%, and adjusted gross margin of 73.5%, +/- 0.5%, for a sequential contraction of ~150-160 bp.
  • GAAP operating margin was 62.3% in Q3, increasing slightly from 62.1% in the prior quarter but up from 53.1% in the year ago quarter. Adjusted operating margin of 66.3% dipped slightly from 66.4% in Q2, but increased from 64.8% in the year ago quarter.
  • For Q4, similar to gross margins, management guided for sequential contraction based on operating expense forecasts. GAAP operating margin is implied to be 60.2%, while adjusted operating margin is implied to be 64.4%, or about a 200 bp sequential contraction. 
  • GAAP net margin was 55.0%, down from 55.3% last quarter but up from 51.0% in the year ago quarter. Adjusted net margin was 57.0%, up from 56.4% last quarter and 55.3% in the year ago quarter.

    While it may seem like a small difference, putting it to the scale of revenue growth will show that net income has more than doubled YoY – GAAP net income was $19.31 billion in Q3, up from $9.24 billion last year despite only a 4-point margin expansion.

  • GAAP EPS of $0.78 beat estimates by $0.08, and represented YoY growth of 111%. Adjusted EPS of $0.81 beat estimates by $0.06 and represented YoY growth of 103%.

Cash and Balance Sheet

Cash flows remained strong in the quarter, with operating and free cash flow margins both expanding sequentially.

  • Operating cash flow was $17.63 billion, rising 141% YoY and 22% QoQ. OCF margin was  50.3%, expanding from 48.2% last quarter and 40.5% last year; to note, this remains below the 58.9% margin from Q1.
  • Free cash flow was $16.79 billion, rising 138% YoY and 25% QoQ. FCF margin was 47.9%, up from 44.9% last quarter and 38.9% in the year ago quarter.
  • Inventories totaled $7.65 billion, increasing nearly 60% YoY and more than 14% QoQ. Purchase commitments and obligations for inventory and capacity also rose 4% QoQ to $28.9 billion. Capacity and supply pre-payments were $5.2 billion, reaffirming that Nvidia is well prepared to launch Blackwell in full-force.
  • Cash and equivalents totaled $38.49 billion, while debt totaled $8.46 billion.

Earnings Call:

To elaborate on the margin concerns, here was an exchange in the Q&A:

Timothy Arcuri:

“[…] And then Colette, you kind of talked about Blackwell bringing down gross margin to the low-70s as it ramps. So I guess if April is the crossover, is that the worst of the pressure on gross margin? So you're going to be kind of in the low-70s as soon as April. I'm just wondering if you can sort of shape that for us. Thanks.”

Colette Kress

Sure. Let me first start with your question, Tim. Thank you regarding our gross margins, and we discussed our gross margins as we are ramping Blackwell in the very beginning and the many different configurations, the many different chips that we are bringing to market, we are going to focus on making sure we have the best experience for our customers as they stand that up. We will start growing into our gross margins, but we do believe those will be in the low 70s in that first part of the ramp. So you're correct, as you look at the quarters following after that, we will start increasing our gross margins and we hope to get to the mid-70s quite quickly as part of that ramp.”

–End Quote

For More Reading:

Please reference our pre-earnings write-up which summarizes my current thoughts on the stock.

Conclusion:

I said on Fox Business News on Tuesday that I would love to get Nvidia lower, and I truly would. The nitpicking around the margins, the weaker semiconductor peers, the low volume as the stock trades near its all-time highs, the tariff concerns … one or all of these may present us that opportunity.

Nvidia’s fundamentals are a perfect 10. The pre-earnings report had stated: “Make no mistake, Nvidia is the best stock of the decade and we are only four years in. The big picture is that Nvidia's trajectory will continue due to two words: pricing power.”

We are already tracking a 30% minimum difference between GB200NVL72 orders and what Wall Street has estimated for next year. When you add that the DGX B200 systems will be priced 40% higher, and if we assume pricing power affects more SKUs the way it’s going to affect the DGX B200 systems, then we could see about 70% upside next year for Nvidia. Now, the I/O Fund likes to be aggressive, it’s why you’re here. If we can get the stock lower, that potential upside increases.

Wish us luck – and keep an eye on those trade alerts!

Recommended Reading:

Nvidia Q3: Lackluster Quarter until Blackwell Arrives

Posted on by io-fund

Nvidia once again posted a $2 billion beat to revenue estimates, reporting YoY growth of nearly 94% to over $35 billion in revenue. Data center revenue more than doubled in the quarter to over $30 billion, speaking volumes as to the level of demand for its GPUs given that Blackwell had not begun to ship in Q3.

Blackwell matters – a lot. As stated in the webinar, the more the team looked at the details of the release, the clearer it has become that 2025 will be Nvidia’s year – again. Some of this was covered in the pre-earnings write-up published this morning.

On the positive side:

  • Hopper drove the beat that analysts were expecting, with UBS tagging the beat at $2 billion. This did, indeed, materialize in the earnings report. This beat is clearly not lackluster but given the performance of the stock, up about 850% since two years ago when Hopper began to ship, the product cycle is lackluster and not able to reinvigorate the stock.
  • My primary message going into tonight’s results was that the I/O Fund is tracking supply chain signals indicating the new generation of GPUs shipping in full volume by mid-2025 (and beginning to ship in the January quarter) will far exceed the GPU sales we saw in 2023 and 2024 combined. This was echoed tonight when Jensen Huang stated: “You see now that at the tail-end of the last generation of foundation models were at about 100,000 Hoppers. The next generation starts at 100,000 Blackwells.”
  • The importance of big tech capex was also echoed with the CEO stating we will see $1 trillion in data infrastructure rebuild before he expects to see digestion from the hyperscalers. As Damien on the team helped to point out last week, we are at a quarter-trillion right now. Per the CEO: “I believe that there will be no digestion until we modernize a trillion dollars with the data centers.” That would imply another 3X from here for the remaining three-quarter trillion – not in stock price, but in capex. Presumably, it would mean a higher trajectory for the stock price in terms of valuing that revenue.
  • Management debunked the supply chain rumors (which the inaccuracy is getting to be a tad annoying at this point). When asked about supply chain rumors, the CEO stated “Blackwell production is in full steam. In fact, as Colette mentioned earlier, we will deliver this quarter more Blackwells than we had previously estimated.” As expected, Colette Kress was tight lipped and no official number was provided. I have personally found Nvidia’s management style to be to our benefit as they were a closed book two years ago in the quarters that preceded the historic ramp.

What the Street Asked About:

  • Despite the rather large top-line beat, margins were relatively in line with guidance, and forecast to contract nearly 2 points sequentially.
  • Never underestimate Wall Street’s ability to miss the bigger picture. Analysts on the call cross-examined this 200 bps decline despite Nvidia having an operating margin of over 60% compared to most of the Mag 7 having operating margins at half that. The CFO was clear that following Blackwell, the gross margin will eventually return to its current percentage: “As Blackwell ramps, we expect gross margins to moderate to the low-70s. When fully ramped, we expect Blackwell margins to be in the mid-70s. GAAP and non-GAAP operating expenses are expected to be approximately $4.8 billion and $3.4 billion, respectively.”
  • Supply chain constraints: There has been some FUD published by The Information back in August and again this week. Management provided a strong comment to refute these claims, primarily that: “We completed a successful mask change for Blackwell, our next Data Center architecture, that improved production yields.” Yields is what matters here and this comment along with Q4 seeing more Blackwell revenue than previously estimated helps to eliminate these concerns.
  • Broadly speaking, there are supply constraints but this is nothing new as it’s been widely understood Blackwell is already sold out for next year.  
  • As we close out the year and move into 2025, investors should be prepared to hear about China and tariffs. Per the pre-earnings report, Nvidia has limited exposure at 12.5% yet it’s quite clear with weak SMH and SOXX ETF price action that the market is pricing in this impact. It’s unclear to me today how TSM will be viewed in terms of tariffs given the Arizona plant is up and running. You can view our webinar clip here regarding SMH.

Fiscal Q3 2025 Results:

As stated, Hopper drove the beat that analysts were expecting, with UBS tagging the beat at $2 billion. However, due to declining from peak revenue growth of 265% earlier this year, Hopper-driven growth of 94% is not what will drive the stock up for the next leg higher. Nvidia investors, such as myself, will need Blackwell’s pricing power and Blackwell’s clear demand signals to re-invigorate the stock.

As stated, the one weak link of the report was Q4’s margin guidance, with management pointing to potential contractions down the line as Blackwell ramps.

Revenue

Nvidia reported 93.6% YoY growth to $35.08 billion in revenue, well ahead of the consensus estimate for $33.13 billion (83% YoY). Nvidia is now lapping its peak growth quarters, Q3 FY24 to Q1 FY25, where revenue more than tripled each quarter as Hopper ramped tremendously fast. Management said in Q3 that the H200 “grew significantly in the quarter.”

Growth technically is decelerating nearly 30 points in Q3 and growth will further decelerate nearly 24 points next quarter, but to be reporting above 93% YoY and almost 70% YoY versus 200-260%+ growth comps is a strong report to say the least.

For Q4, management guided for revenue of $37.5 billion, +/- 2%, just slightly ahead of consensus estimates for $37.02 billion at the midpoint. Management noted that they have “completed a successful mask change for Blackwell…that improved production yields. Blackwell production shipments are scheduled to begin in the fourth quarter of fiscal 2025 and will continue to ramp into fiscal 2026.”

Both Hopper and Blackwell will be shipping in tandem, placing more emphasis on supply constraints moving forward, as management was clear in saying that both products have “certain supply constraints” with Blackwell’s demand “expected to exceed supply for several quarters in fiscal 2026.”

China revenue was 15.4% of revenue compared to 12.7% year-to-date. This is down from the low-20% range last year.

Key Segments

It should be of no surprise that data center revenue beat estimates in the quarter, but what’s interesting is that the segment posted the largest surprise relative to estimates since Hopper’s breakout quarter in FY24.

Data center revenue of $30.77 billion increased 112.0% YoY and 17.1% QoQ, beating estimates by $1.95 billion. Assuming a similar mix as the current quarter, Q4’s data center revenue would be implied to be nearly $32.5 billion.

In the segment, data center compute revenue was $27.64 billion, rising 132% YoY and 22% QoQ. Networking revenue increased 20% YoY but declined (15%) QoQ to $3.13 billion – this slowed sharply from 114 % YoY growth in Q2.

Management said networking growth was driven by Ethernet for AI; “NVIDIA Spectrum-X Ethernet for AI revenue increased over 3 times year-on-year and our pipeline continues to build with multiple CSPs and consumer Internet companies planning large cluster deployments.” It was also indicated that networking would resume sequential growth next quarter: “So this quarter is just a slight dip down and we're going to be right back up in terms of growing. They're getting ready for Blackwell and more and more systems that will be using not only our existing networking but also the networking that is going to be incorporated in a lot of these large systems that we are providing them to.”

  • Gaming revenue of $3.28 billion increased 15% YoY and 14% QoQ, driven by GeForce RTX series 40 GPUs and game console SoCs.
  • Pro Viz revenue of $486 million increased 17% YoY and 7% QoQ, driven by the ramp up of RTX GPU workstations.
  • Automotive revenue of $449 million increased 72% YoY and 30% QoQ, accelerating 35 bp QoQ from 37% YoY growth in Q2, driven by Nvidia’s self-driving platform.
  • OEM and other revenue of $97 million increased 33% YoY and 10% QoQ.

Margins

Despite the rather large top-line beat, margins were relatively in line with guidance, and forecast to contract nearly 2 points sequentially. This forecasted weakness as Blackwell ramps may be one of the factors behind the initial post-earnings sell-off, with GAAP operating margin seen coming back towards 60%.

  • GAAP gross margin was 74.6%, just ahead of guidance for 74.4%. Adjusted gross margin was 75%, in line with guidance. This reiterated our view from last quarter that Q1 was the peak for gross margins, as margins have contracted about 380 bp since then.
  • For Q4, management guided for GAAP gross margin of 73%, +/- 0.5%, and adjusted gross margin of 73.5%, +/- 0.5%, for a sequential contraction of ~150-160 bp.
  • GAAP operating margin was 62.3% in Q3, increasing slightly from 62.1% in the prior quarter but up from 53.1% in the year ago quarter. Adjusted operating margin of 66.3% dipped slightly from 66.4% in Q2, but increased from 64.8% in the year ago quarter.
  • For Q4, similar to gross margins, management guided for sequential contraction based on operating expense forecasts. GAAP operating margin is implied to be 60.2%, while adjusted operating margin is implied to be 64.4%, or about a 200 bp sequential contraction. 
  • GAAP net margin was 55.0%, down from 55.3% last quarter but up from 51.0% in the year ago quarter. Adjusted net margin was 57.0%, up from 56.4% last quarter and 55.3% in the year ago quarter.

    While it may seem like a small difference, putting it to the scale of revenue growth will show that net income has more than doubled YoY – GAAP net income was $19.31 billion in Q3, up from $9.24 billion last year despite only a 4-point margin expansion.

  • GAAP EPS of $0.78 beat estimates by $0.08, and represented YoY growth of 111%. Adjusted EPS of $0.81 beat estimates by $0.06 and represented YoY growth of 103%.

Cash and Balance Sheet

Cash flows remained strong in the quarter, with operating and free cash flow margins both expanding sequentially.

  • Operating cash flow was $17.63 billion, rising 141% YoY and 22% QoQ. OCF margin was  50.3%, expanding from 48.2% last quarter and 40.5% last year; to note, this remains below the 58.9% margin from Q1.
  • Free cash flow was $16.79 billion, rising 138% YoY and 25% QoQ. FCF margin was 47.9%, up from 44.9% last quarter and 38.9% in the year ago quarter.
  • Inventories totaled $7.65 billion, increasing nearly 60% YoY and more than 14% QoQ. Purchase commitments and obligations for inventory and capacity also rose 4% QoQ to $28.9 billion. Capacity and supply pre-payments were $5.2 billion, reaffirming that Nvidia is well prepared to launch Blackwell in full-force.
  • Cash and equivalents totaled $38.49 billion, while debt totaled $8.46 billion.

Earnings Call:

To elaborate on the margin concerns, here was an exchange in the Q&A:

Timothy Arcuri:

“[…] And then Colette, you kind of talked about Blackwell bringing down gross margin to the low-70s as it ramps. So I guess if April is the crossover, is that the worst of the pressure on gross margin? So you're going to be kind of in the low-70s as soon as April. I'm just wondering if you can sort of shape that for us. Thanks.”

Colette Kress

Sure. Let me first start with your question, Tim. Thank you regarding our gross margins, and we discussed our gross margins as we are ramping Blackwell in the very beginning and the many different configurations, the many different chips that we are bringing to market, we are going to focus on making sure we have the best experience for our customers as they stand that up. We will start growing into our gross margins, but we do believe those will be in the low 70s in that first part of the ramp. So you're correct, as you look at the quarters following after that, we will start increasing our gross margins and we hope to get to the mid-70s quite quickly as part of that ramp.”

–End Quote

For More Reading:

Please reference our pre-earnings write-up which summarizes my current thoughts on the stock.

Conclusion:

I said on Fox Business News on Tuesday that I would love to get Nvidia lower, and I truly would. The nitpicking around the margins, the weaker semiconductor peers, the low volume as the stock trades near its all-time highs, the tariff concerns … one or all of these may present us that opportunity.

Nvidia’s fundamentals are a perfect 10. The pre-earnings report had stated: “Make no mistake, Nvidia is the best stock of the decade and we are only four years in. The big picture is that Nvidia's trajectory will continue due to two words: pricing power.”

We are already tracking a 30% minimum difference between GB200NVL72 orders and what Wall Street has estimated for next year. When you add that the DGX B200 systems will be priced 40% higher, and if we assume pricing power affects more SKUs the way it’s going to affect the DGX B200 systems, then we could see about 70% upside next year for Nvidia. Now, the I/O Fund likes to be aggressive, it’s why you’re here. If we can get the stock lower, that potential upside increases.

Wish us luck – and keep an eye on those trade alerts!

Recommended Reading:

AI Spending To Exceed A Quarter Trillion Next Year

Posted on by io-fund

This article was originally published on Forbes on ForbesForbes on Nov 14, 2024, 05:29pm EST

Big Tech’s AI spending continues to accelerate at a blistering pace, with the four giants well on track to spend upwards of a quarter trillion dollars predominantly towards AI infrastructure next year.

Though there have recently been concerns about the durability of this AI spending from Big Tech and others downstream, these fears have been assuaged, with management teams stepping out to highlight AI revenue streams approaching and surpassing $10 billion with demand still outpacing capacity.

Below, I take a look at the growth in AI spending from Big Tech this year and yet, as it quickly approaches the quarter-trillion mark, and next week, I’ll discuss exactly what this means for the market’s biggest beneficiary.

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AI Capex Accelerating

Big Tech’s AI-fueled capital expenditures serve as a barometer for the broader AI industry, as Microsoft, Meta, Alphabet and Amazon are among the first to recognize multi-billion dollar revenue streams from AI and generative AI offerings. The four are also leading the charge by pouring billions each quarter towards AI infrastructure, signaling that they are still attempting to catch up to AI demand and invest more aggressively in AI come 2025.

To better understand the trajectory of AI spending, let’s take a step back to 2023, where the rapid ascent of ChatGPT at the beginning of the year set the stage for AI to quickly step into the spotlight.

In the first half of 2023, Big Tech spent ~$74 billion on capex. Through Q3, that sum had moved up to ~$109 billion.

In the first half of 2024, Big Tech spent nearly $104 billion, a 47% YoY increase. Through Q3, that sum had surged to $170 billion, up 56% YoY.

So far in 2024, Big Tech has spent nearly $171 billion on capex, predominantly for AI infrastructure, up 56% from 2023.

Big Tech Capex

Source: I/O Fund

To understand why these four are accelerating spending this year and laying the groundwork for even higher spend in 2025, consider this: why is Big Tech spending billions on AI infrastructure globally? Why is Big Tech procuring GPUs en masse or building out custom silicon to deliver AI services in the cloud to millions of enterprise customers?

The answer is three-fold:

1) AI is expected to have a multi-trillion dollar economic impact globally, with a recent estimate from IDC placing AI’s cumulative potential impact through 2030 at $20 trillion. The mobile economy, which sprouted a handful of the trillion-dollar tech behemoths of today, added approximately $5.7 trillion to the economy in 2023. Big Tech’s leaders are well aware of how critical it is to capture and capitalize on an opportunity of this magnitude, and will not miss it.

2) Developing larger models and doubling model sizes requires massive computing power that only Big Tech can afford to develop, meaning a majority of genAI progress is likely to be made primarily in the hyperscalers’ clouds.

3) Big Tech is already realizing AI-related gains, with three of the four saying AI revenue is at least in the mutli-billion dollar range. With millions to billions of users for products to either enhance with AI integrations or target with AI features in subscriptions, the long-term revenue opportunity could dwarf some of their leading revenue streams of today.

I had said in May this year 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.”

However, that figure is already likely too small, given the pace of acceleration seen in Q3 and commentary for Q4 and full-year spending. Combined, Big Tech spent $64.9 billion in Q3, up 11% QoQ. This increase was driven primarily by Amazon, which boosted capex by ~$5 billion sequentially.

Big Tech Quarterly Capex

Big Tech spent $64.9 billion on capex in Q3, up 11% QoQ and accelerating to 68% YoY. Source: I/O Fund

Microsoft and Amazon combined for $42.6 billion in capex in the third quarter, with Alphabet maintaining its ~$13 billion/quarter rate and Meta beginning to accelerate its spending.

Amazon signaled in Q3 that it was expecting to spend $75 billion on capex this year, with Meta tightening and raising its capex guide to $38 billion to $40 billion – alone, the two are expecting to spend nearly $115 billion in 2024. To meet that target, combined capex from the duo will need to be nearly $35 billion.

Alphabet is expecting Q4’s capex to be relatively in-line with Q3’s as it maintains its pace for ~$50 billion in full year spend, while Microsoft did not lay out a concrete picture for capex this year. Assuming spend is flat sequentially for Microsoft, the two would be spending ~$33 billion in Q4.

Putting this all together, Big Tech could spend another $70 billion in Q4, overwhelmingly for AI infrastructure, putting full year capex at ~$240 billion, or nearly 15% higher than the level they were tracking for at the start of the year.

The I/O Fund will spell out what this means for the biggest beneficiary of this trend in next week’s newsletter – make sure you don’t miss it.

Come 2025, this AI-driven capex surge is set to stay, with executives foreseeing lasting AI demand and a need to still invest to capture growth and meet demand.

Executives Signal AI Demand is Lasting, Requiring More Spend

I want to reiterate this quote from May’s newsletter, Big Tech Q1 Earnings: AI Capex Increases As AI-Related Gains Continue, as it continues to remain relevant for investors: it is no surprise that Big Tech is boosting spending by more than 50% versus 2023 “given positive outlooks on AI’s potential to drive revenue growth in the billions and how demand continues to outstrip GPU supply.”

This theme was evident across Big Tech’s Q3 earnings calls. Listen to what executives had to say:

Microsoft: Microsoft spent close to ~$10 billion this most recent quarter on GPU and CPU servers, primarily to meet cloud demand, with management signaling that “demand continues to be higher than our available capacity.”

CFO Amy Hood explained that Microsoft expects capex “to increase on a sequential basis, given our cloud and AI demand signal,” as they aim to stay aligned with demand signals. Microsoft also “announced new cloud and AI infrastructure investments in Brazil, Italy, Mexico, and Sweden as we expand our capacity in line with our long-term demand signals.”

Hood further clarified that Microsoft has confidence that as they “get a good influx of supply across the second half of the year, particularly on the AI side that we'll be better able to do some supply-demand matching and hence, while we're talking about acceleration [in Azure] in the back half.”

Amazon: Amazon CEO Andy Jassy said that AWS has “more demand that we could fulfill if we had even more capacity today,” and that “pretty much everyone today has less capacity than they have demand for, and it's really primarily chips that are the area where companies could use more supply.” He explained that AWS is growing rapidly in AI, but he believes “the rate of growth there has a chance to improve over time as we have bigger and bigger capacity.”

What Jassy is saying is that AWS and Microsoft are not the only supply-constrained firms, with Alphabet, Oracle, and others all struggling to meet demand because they cannot purchase enough GPUs or deploy enough custom accelerators alongside GPUs to meet demand.

Jassy also dropped a big clue on long-term demand and AWS’ need for rapidly increasing AI investments. He said that he thinks AI is at an “earlier stage [and] more fluid and dynamic than our non-AI part of AWS,” and customers not “showing up for 30,000 chips in a day. They're planning in advance. So we have very significant demand signals giving us an idea about how much we need.”

It’s interesting that this comment comes as Amazon has significantly ramped capex over the past two quarters, from $14.6 billion in Q1 to $22.6 billion in Q3. Jassy’s comment implies that AWS is seeing much larger demand than what they were expecting at the beginning of the year, hence the need to spend much more on AI infrastructure, from data centers to servers to GPUs to custom silicon.

Alphabet: The Search giant was a bit more obscure on AI demand in the cloud, but executives signaled spending to increase in 2025. CFO Anat Ashkenazi said that realizing growth opportunities and innovating in AI “requires global reach, which we have through our products and platforms, as well as continued meaningful capital investment.” Ashkenazi explained that Alphabet thinks that “into 2025, we do see an increase coming in 2025, and we will provide more color on that on the Q4 call, likely not the same percent step-up that we saw between '23 and '24, but additional increase.”

Meta: Though Meta is positioned primarily in advertising as opposed to the cloud, executives still signaled long term opportunities and a need to continually invest in AI. CEO Mark Zuckerberg said that it is “clear that there are a lot of new opportunities to use new AI advances to accelerate our core business that should have strong ROI over the next few years,” while Meta’s “AI investments continue to require serious infrastructure, and I expect to continue investing significantly there too.”

CFO Susan Li added that Meta is “growing our infrastructure investments significantly this year, and we expect significant growth again in 2025.” For Q4, she clarified that Meta foresees the large QoQ jump in part from “increases in server spend and to a lesser extent data center capex” due to delivery and cash recognition dynamics.

Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.Learn more hereLearn more here.

AI Revenue Streams Emerging

AI revenue streams are emerging as Big Tech continues to spend prolifically on AI, with Microsoft among the leaders as it sees AI revenue soon to be double digits.

Microsoft: CEO Satya Nadella pointed out that “monetization from these [AI] investments continues to grow, and we're excited that only 2.5 years in, our AI business is on track to surpass $10 billion of annual revenue run rate in Q2. This will be the fastest business in our history to reach this milestone.”

At a closer look, AI contributed 12 points to Azure’s growth in the recent quarter, implying that Azure’s AI run rate has already surpassed $6 billion, with other gains coming from Microsoft’s product suite, with Power Platform seeing 4x YoY growth to 600,000+ users utilizing AI capabilities and 70% of the Fortune 500 using Microsoft 365 Copilot.

Azure AI Quarterly Run Rate

Azure’s AI run rate is estimated to have already surpassed $6 billion. Source: I/O Fund

To read more about how AI could drive the $100 billion in revenue for Microsoft by 2027, read more here: Microsoft – AI Will Help Drive $100 Billion In Revenue By 2027.Microsoft – AI Will Help Drive $100 Billion In Revenue By 2027.

Amazon: Amazon did not provide an exact number for AI revenue, but said that “AWS's AI business is a multibillion-dollar revenue run rate business that continues to grow at a triple-digit year-over-year percentage ,and is growing more than 3 times faster at this stage of its evolution as AWS itself grew.”

For comparison, it took AWS ~2 years to scale from ~$500 million in revenue in 2010 to over $2 billion in revenue in 2012, and then another 3 years to grow to nearly $8 billion. To have AI growing at triple this rate in the multi-billion dollar level already speaks volumes about the magnitude of the AI opportunity ahead and the demand that exists that still can’t be met in the market today.

Alphabet: Alphabet did not provide a new update for AI revenue, with the latest update from Q2 noting that “AI infrastructure and generative AI solutions for Cloud customers have already generated billions in revenues and are being used by more than 2 million developers.”

Management provided a few additional points about the swift uptake of AI across its products, saying that “Gemini API calls have grown nearly 40x in a 6-month period,” while AI Overview in Search “will now reach more than 1 billion users on a monthly basis.”

Meta: Unlike the other three, Meta’s path to monetizing AI in the billion-dollar scale is less clear, as AI’s primary role in operations is driving better ROI and conversions for advertisers, thus driving advertising revenue higher.

Management said that “Meta AI now has more than 500 million monthly active improvements to our AI driven feed and video recommendations have led to an 8% increase in time spent on Facebook and a 6% increase on Instagram this year alone. More than a million advertisers used our Gen AI tools to create more than 15 million ads in the last month and we estimate that businesses using image generation are seeing a 7% increase in conversions and we believe that there's a lot more upside here.” What’s not as clear is the direct impact to revenue growth stemming from these AI-fueled increases, but management has faith in the longer-term of driving strong ROI from AI investments.

Conclusion

Big Tech’s AI spending is only set to surge through the end of 2024 and into 2025, with management teams reiterating the need to invest more to meet demand and build out AI infrastructure. Microsoft leads the pack with AI on the cusp of surpassing a $10 billion run rate, while Amazon and Alphabet see AI revenue in the billions.

In next week’s free newsletter, the I/O Fund will discuss what this surge in spending to more than a quarter trillion will mean for one of AI’s largest beneficiaries. The I/O Fund is also closely tracking the next sectors to benefit from AI, regularly sharing our research on the biggest growth opportunities. We also share our buy and sell plans with real-time alerts for our premium members. Learn more here.

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

Recommended Reading:

Astera Labs: Hypergrowth AI Networking Stock

Posted on by io-fund

Astera Labs is a stock that simply cannot be ignored despite having a fraction of the market cap compared to much larger AI hardware players.

The company offers a few key products that are enabling larger and faster AI clusters. For data center AI accelerators, the company was first to offer PCIe 5 switches and retimers. Growth will likely continue due to next-generation PCIe 6 products with higher average sales prices that will be released in 2025 and ramp in 2026.

There are additional growth opportunities, including a software architecture that allows hyperscalers to monitor their data center infrastructure and increase utilization rates; the software helps to incentivize hyperscalers to use Astera Labs hardware products. The company also offers ethernet smart cable modules and is introducing a new CXL product for CXL-enabled CPUs next year.

We are interested in Astera Labs for the increased average sales prices that are expected to persist at least through 2025-2026 due to the Aries products and upcoming Scorpio products. Astera Labs is a highly technical company, yet this quote clearly communicates why the growth trajectory can sustain:

“One is generally speaking with each new generation of a protocol like PCIe going from Gen 5 to Gen 6. There is an ASP uplift. That's number one. Number two, of course, we were hinting at the Scorpio product line, which because of the value it delivers to customers is at a higher ASP, as you can imagine. So overall, if you look at the design wins we have today, the dollar content per GPU goes up, that's one way to look at it based on what we've shared before […] So overall, if you look at sort of the increasing speed, additional product line as well as the fact that the internally developed platforms, AI accelerated database platforms, they are starting to gain more and more traction. So when you look at all of them, on an average, our content is on the up.”

Investment Thesis:

  • Current Growth Driver: Increased average sales prices are being driven by CPUs, GPUs and ASICs all moving to the new PCIe 5.0 standards. Arista Labs’ Aries Retimers and PCIe 5.0 components is driving the current growth, and the company is unchallenged in this new generation of PCIe, which came to market for AI accelerators only recently with Nvidia’s H200s.
  • Catalyst: Scorpio is a new product that is expected to expand the TAM to more than $12B by 2028: Astera Labs is releasing a PCIe Gen 6 fabric switch custom designed for AI data flows with high performance per watt compared to incumbents. Rather than building a large switch, the company built a smaller device that is more efficient for high-speed signals. With Scorpio, Astera Labs is defending its dominance in PCIe5 by doubling the bandwidth at lower power requirements than the 5th generation of PCIe.
  • The market demand for Astera Labs is healthy, as a major supplier to Nvidia’s PCIe-enabled GPUs (note: most of Nvidia’s GPUs use their in-house NVLink). Yet, Arista also supplies other AI accelerator platforms for Big Tech, and Arista is the only provider for PCIe5. In addition to hardware, ALAB offers Big Tech data centers software-defined architecture called COSMOS that allows for performance monitoring. There is some favorable vendor lock-in dynamics with COSMOS as the many different product lines can be optimized and monitored with the software.
  • Financials on Astera Labs are impressive as the company is hypergrowth at 206% growth last quarter and 153% guided next quarter. The free cash flow margin is at 41%. The company is not GAAP profitable due to being a recent IPO with outsized stock-based compensation. However, there is a path to GAAP profitability, which is detailed in the financials section below.

Overview of Astera’s Products:

Broadly speaking, Astera’s products are seeing increased relevance as AI clusters grow to support hundred-billion and trillion parameter models. The company’s hardware and software increase AI server performance and productivity for the current generations and future generations of AI accelerators.

Transition to PCIe5 and PCIe5 Retimers are Driving Astera’s Growth:

The Aries products offer PCIe5 interfaces that GPUs and AI accelerators (like custom silicon) use to connect components including ethernet networking. Compared to the previous generation, PCIe5 is twice as fast with data transfer rates that reach up to 128 GBs/s on multi-directional bandwidth in each lane. By increasing the data transfer for each lane, it allows more lanes to become available to help leverage the power of the GPU or AI accelerator.

PCIe5 Retimers are chips that boost signals across high-speed components and are seeing increased demand, starting with Nvidia’s H200s, and also for application-specific chips. Specifically, Aries Retimers and smart cable modules allow hyperscalers to connect multiple racks together with up to 7 meters of copper cables. Aries can also go up to 50 meters with optical fiber. According to a presentation at Nvidia’s GTC event, this is 3X the standard reach defined in PCIe specs.

Despite PCIe5 being out since 2019, it was Nvidia’s H200s released in 2024 that were the first data center GPUs to use PCIe5. What’s interesting is that Astera is said to have captured 95% of the XPU market, which refers to application-specific chips that are specific on a product level. Per an analyst on the earnings call: “Majority of the XPU shipments are still going to be I think Gen 5 based where your market share is still somewhere in the range of, I think, like 95%.”

Management also stated: “The upside to the guidance was driven largely from Aries' revenue, both for the third-party GPUs, but also as well with the strong ramps on new platforms on the internally developed AI accelerators. And we're seeing that across multiple hyperscaler customers, so it's not just one. So the upside was largely driven by that Aries revenue.”

Notably, Aries devices are used to interconnect AI accelerators with CPUs and networking, yet are also used for backend networking between GPUs for larger clusters. Astera supplies the HGX H100 systems with PCIe-based GPUs with up to 25 retimer chips per HGX system.

Scorpio PCIe6 Custom-Built for AI is a Catalyst:

Scorpio is where the excitement is building for continued growth next year with management stating it will “exceed 10% of revenues in 2025” with “good momentum going into 2026.” This is due to the PCI Express switches being custom built for AI purposes, whereas in the past, PCIe was built for storage and then retrofitted for AI purposes.

PCIe 6 doubles the bandwidth from the 5th generation, with up to 256 GB/s of bandwidth per lane, which will require faster supporting components, such as the retimers that Astera Labs offers. The demo from GTC showed the Scorpio fabric switches (name released in October) delivering twice the bandwidth with less power at 11W instead of the 13W from the PCIe 5 interfaces.

There are two Scorpio fabric switches. The Scorpio P-Series is a small chip that connects the CPU, GPU, NIC and NVMe storage. Rather than building a large switch, the company built a smaller device that is more efficient for high-speed signals to help feed GPUs with data. The fewer ports and smaller switch decrease complexity in a bid to compete against Broadcom with twice the lane count.

The X-Series is for back-end networking in GPU-to-GPU configurations, and will offer a higher port count. Astera is essentially building something similar to Nvidia’s NVSwitch with the X-Series, but for PCIe-enabled GPUs: “And this one, like Mike noted, it's a greenfield use case, meaning if you keep Nvidia and NV Switch aside, everyone else is starting to build configurations that are obviously going to need some kind of a switching functionality, which is what we are addressing with our X Series device.” The X-Series improves efficiency for ever-increasing AI cluster sizes. The majority of AI clusters are in the tens of thousands GPUs, but are expected to go to the hundreds of thousands (already has with X and some other Big Tech companies), and will see AI clusters with millions of GPUs over the next couple of years.

Here is another quote from the management team as to why the X-Series Scorpio switch fabric is a big opportunity for their company:

“X series will have a bigger TAM. The TAM today is nearly zero. It's not very commonly used outside of the Nvidia ecosystem. We do expect many hyperscalers to start deploying this, starting with the X family and the designs for which that we have. And we are able to do that because of the architecture that we have. Because of our software-defined architecture, we can customize many parts of the X-Series to cater to the specific requirements of the hyperscalers both on the side of performance, the exact configuration that they require in count and so on and also the diagnostics framework that they require to monitor their infrastructure. So over time, we do expect X-Series to become larger [than the P-Series].”

COSMOS Software:

In order of importance, COSMOS Software ranks higher than some of Astera’s hardware as it offers performance monitoring for data center infrastructure. This is especially important for Big Tech companies concerned with utilization rates for expensive GPU systems.

The adoption of the software stack to monitor for performance is expected to increase with the Scorpio X-Series:

“Where the Scorpio family sits, we have access to a lot more diagnostic information. And we can couple that with the information that we are collecting from our other families deployed such as Aries and even Taurus to provide a holistic view of the AI infrastructure to the data center operators. So both from the hardware side, the kind of the purpose-built nature of these devices as well as the software stack that comes with it is a big differentiator for us.”

Taurus Ethernet Smart Cable Modules:

Astera Lab offers Ethernet smart cable modules which help to alleviate bandwidth issues with 100-gig per lane connectivity over copper cables including AEC. The company recently released 400-gig Ethernet SCMs, which help to stabilize the network. When thinking of ALAB’s investment thesis, Ethernet is not top-of-mind given the sheer size and lead we see from Broadcom, Nvidia’s Spectrum, and Arista Networks.

Right now, the maximum bandwidth supported by PCIe 5.0 is 400Gbps per port. By using 106Gbps PAM4 SerDes, ASICs can be tuned to support 100, 200 and 400 Gbps port speeds. To work around this, and to achieve 800Gbps, larger chip makers are building NICs directly into the accelerator. According to The Register, the 800Gbps ports built into accelerators may reduce bottlenecks before PCIe 6.0 arrives on the market. The larger Ethernet players are moving quickly on this, and we will need to keep an eye on Astera Labs to determine if the company’s Taurus product can remain competitive.

Leo Compute Express Link (CXL):

Leo is slated to impact revenue in 2025 when data center platforms plan to utilize CXL technology for memory bandwidth and capacity bottlenecks. Next year, CXL-capable CPUs will become broadly available. We’ve covered in the past how CXL is a new server architecture that “dynamically assigns memory resources between servers.” The result is boosted memory bandwidth and also at a lower cost than adding more CPUs. Partially-disaggregated racks are expected to deploy in 2024-2025 with separate compute, memory and I/O racks with the interconnect being CXL.

Per Astera’s management team: “In the past, this was done by adding additional CPUs into the server box to provide for more memory channels. But what we have demonstrated is that by using Leo you're not only able to get the higher performance by the added memory. But from an overall TCO standpoint, it's significantly less than adding additional CPUs. “

Financials: Strong Revenue Growth, Expanding Margins

Astera Labs reported solid top-line and bottom-line beats in the recent Q3 results. The company reported record revenue of $113.1 million, up 47% QoQ and 206% YoY, beating estimates by 16.1%. The adjusted operating margin expanded to 32.4% from 2% in the same period last year, which was helped by strong operating leverage. The adjusted EPS of $0.23 beat estimates by 35%.

Revenue:

The company is one of the fastest-growing tech companies and is emerging as a rising star in the AI data center networking space. The company’s Q3 revenue grew by 206.2% YoY and 47% QoQ to $113.1 million.

Jitendra Mohan, CEO and co-founder of the company, said in the Q3 2024 earnings call, “Our business has entered a new growth phase with multiple product families ramping across AI platforms, featuring both third-party GPUs and internally developed AI accelerators, which drove the Q3 sales upside verus our guidance.”

  • Management also provided a strong Q4 revenue guide of $126 million to $130 million, representing YoY growth of 153.4% at the mid-point. This also represents QoQ growth of 13% at the midpoint.

    According to management, the QoQ growth is being driven by “our Aries product family across a diverse set of AI platforms, some of which are just starting to ramp and also from our Taurus SCM for 400-gig applications, and additional preproduction shipments of our Scorpio P-Series switches.”

  • Analysts estimate revenue to grow 103.5% to $132.78 million in Q1 2025 and 85.2% YoY to $142.34 million in Q2 2025. While the growth rates are strong, growth is expected to slow down due to tougher comps.

Jitendra Mohan said, “Looking into Q4, we expect our revenue momentum to continue, largely driven by the Aries PCIe and Taurus Ethernet product lines. The Scorpio Fabric Switches are continuing to ship in preproduction volumes.”

The newly introduced Scorpio Fabric Switches are expected to increase the total market opportunity to more than $12 billion by 2028 for the company. Scorpio Switches are also expected to constitute more than 10% of revenue in 2025.

Source: Company website

Analysts expect 2024 revenue growth of 230.9% YoY to $383.14 million, followed by 55.5% and 40.4% in the subsequent years. Meanwhile, management comments seem to imply the growth recently reported will sustain, implying the growth phase has only begun: “Our business has entered a new growth phase with multiple product families ramping across AI platforms, featuring both third-party GPUs and internally developed AI accelerators, which drove the Q3 sales upside versus our guidance.”

Management also later stated: “Yes, right now, our visibility is very strong, both as always with our backlog position, but also the breadth of designs we have — right now, we're really kind of entering a new phase of growth here where our revenue streams are clearly diversifying […].”

Margins:

The company’s margins are improving, helped by strong operating leverage. However, the product mix might weigh on the margins going forward. Management mentioned in the recent earnings call that they have a long-term gross margin target of 70%.

  • Q3 gross profits grew by 212.7% YoY to $87.88 million or 77.7% of revenue compared to 76.1% in the same period last year.
  • This compares to 73.5% for FY2022 and 68.9% for FY2023.
  • Adjusted gross margin was 77.8% compared to 76.1% in the same period last year.
  • Management gross margin and adjusted gross margin guide for the next quarter are 75%. This is down sequentially due to higher product mix towards hardware solutions during the quarter.
  • Operating margin was (-7.9%) compared to (-5.3%) in the same period last year. The adjusted operating margin expanded to 32.4% from 2% in the same period last year, helped by strong operating leverage.
  • Management operating margin guide for the next quarter is (-4.3%) and adjusted operating margin guide is 32.4%.
  • It’s important to consider that stock-based compensation is quite high due to the recent IPO at 40.3% this quarter, and was at 56% last quarter. Once SBC naturally levels out, this company has strong enough margins to become GAAP profitable.
  • Net loss was (-$7.6 million) or (-6.7%) of revenue compared to (-8.5%) in the same period last year.
  • Adjusted net income improved significantly to $40.28 million or 35.6% of revenue compared to (-$0.41 million) or (-1.1%) of revenue in the same period last year.

The difference between the GAAP and non-GAAP net income is due to high stock-based compensation. Stock-based compensation was $45.5 million or 40.3% of revenue in the recent quarter. Stock-based compensation has been lumpy as the company’s IPO was in March 2024.

EPS:

The company beat EPS estimates helped by solid operating leverage. Q3 GAAP loss per share was ($0.05) compared to ($0.08) in the same period last year, beating estimates by 28.1%. Adjusted EPS was $0.23 and beat estimates by 35%.

  • Management has guided the Q4 GAAP EPS in the range of $0.04 to $0.06.
  • Notably, the company will not be GAAP operating income positive next quarter as the guide suggests an operating loss of (-$5.5 million) and interest income of about $10 million in the next quarter will make it GAAP profitable. However, it’s very close to being GAAP profitable across all margins, and we think it’s only a matter of time before this happens.
  • Adjusted EPS guide is $0.25 to $0.26.
  • Analysts expect adjusted EPS to be $0.25 in Q1 2025 and $0.27 in Q2 2025.
  • Analysts expect strong EPS growth. They expect 2025 adjusted EPS to grow 58.9% YoY to $1.14 and 48.6% YoY to $1.70 in 2026.

Cash Flow and Balance Sheet:

The company’s cash flows margins are high and are also improving due to increased profits.

  • Q3 operating cash flow was $63.5 million or 56.2% of revenue compared to (-0.9%) in the same period last year. It is also a significant improvement from (-17%) for the full year 2022 and (-6.5%) for 2023.
  • Free cash flow was $46.81 million or 41.4% of revenue compared to (-$1.07 million) or (-2.9%) in the same period last year.
  • Inventory was $24.4 million compared to $28.6 million in Q2.
  • The company had cash and marketable securities of $886.8 million with no debt.
  • Net proceeds from the IPO were $672.2 million. The shares began trading on the NASDAQ on March 20, 2024.

Valuation and IPO Risk:

On a sales valuation, Astera Labs is trading higher than Nvidia at 36X Fwd P/S compared to Nvidia’s at 29 Fwd P/S. On the bottom line, whether it’s PE Ratio, EV/EBITDA or Price to FCF, Astera is trading nearly double Nvidia’s valuation.

The company went public on March 20th, 2024 with shares opening for public trading around $62. The company raised $672.2 million with a lockup that expired September 11th, 2024. Insiders saw shares priced at $36 per share at time of IPO and the highest the stock has traded is $95 following the last earnings report.

The valuation is testing the upper limits of AI semi-related stocks. Therefore, we foresee participating now as a momentum play and participating longer-term with a new entry sometime late 2024-early 2025.

This stock requires an active stance, to where if we enter, we will exit for a quick trade, and try again at a lower valuation for a longer-term position. We offer real-time trade alerts on our Advanced tier.

Conclusion:

Management commentary is at odds with analysts’ estimates, as the commentary suggests there is a new growth phase occurring while estimates suggest a drop off in growth over the next 1-2 years. The products are enabling faster data speeds with PCIe5 and also increased back-end networking with PCIe6 for large AI clusters, and thus management’s commentary that this is a new growth phase holds weight. We certainly know the future for AI clusters is going to exponentially increase from 10s of thousands for AI clusters to eventually millions of AI accelerators per cluster. This is not only a GPU opportunity but also a custom silicon opportunity, as Astera Labs exclusively offered PCIe5 switches and retimers, and will now compete against Broadcom on PCIe6.

Astera Labs is technically in the lead and Broadcom is the follower in this case; but where it gets even more interesting is with the new product Scorpio. It is expected to increase the TAM by $5.0 billion with a total TAM of over $12B over the next 3 years. If we assume Astera captures 50% of the total TAM, then what we have is a stock that will remain in hypergrowth territory. If you do the math, that’s a potential 12X increase in revenue by 2028 from the $500M run rate Astera has today.

Certainly, technical analysis is critical given we are dealing with a very stretched valuation, a recent IPO, and ultimately, a stock that will be volatile in the years to come – yet perhaps, with the right timing, the stock will be as equally rewarding. We typically do not participate in IPOs, and Astera Labs illustrates why given its trading 2X higher than the AI juggernaut with impeccable financials (Nvidia). We do not plan to participate long-term in Astera Labs for this reason, yet may participate briefly, and then keep the stock on our watchlist from there.

Recommended Reading:

Astera Labs: Hypergrowth AI Networking Stock

Posted on by io-fund

Astera Labs is a stock that simply cannot be ignored despite having a fraction of the market cap compared to much larger AI hardware players.

The company offers a few key products that are enabling larger and faster AI clusters. For data center AI accelerators, the company was first to offer PCIe 5 switches and retimers. Growth will likely continue due to next-generation PCIe 6 products with higher average sales prices that will be released in 2025 and ramp in 2026.

There are additional growth opportunities, including a software architecture that allows hyperscalers to monitor their data center infrastructure and increase utilization rates; the software helps to incentivize hyperscalers to use Astera Labs hardware products. The company also offers ethernet smart cable modules and is introducing a new CXL product for CXL-enabled CPUs next year.

We are interested in Astera Labs for the increased average sales prices that are expected to persist at least through 2025-2026 due to the Aries products and upcoming Scorpio products. Astera Labs is a highly technical company, yet this quote clearly communicates why the growth trajectory can sustain:

“One is generally speaking with each new generation of a protocol like PCIe going from Gen 5 to Gen 6. There is an ASP uplift. That's number one. Number two, of course, we were hinting at the Scorpio product line, which because of the value it delivers to customers is at a higher ASP, as you can imagine. So overall, if you look at the design wins we have today, the dollar content per GPU goes up, that's one way to look at it based on what we've shared before […] So overall, if you look at sort of the increasing speed, additional product line as well as the fact that the internally developed platforms, AI accelerated database platforms, they are starting to gain more and more traction. So when you look at all of them, on an average, our content is on the up.”

Investment Thesis:

  • Current Growth Driver: Increased average sales prices are being driven by CPUs, GPUs and ASICs all moving to the new PCIe 5.0 standards. Arista Labs’ Aries Retimers and PCIe 5.0 components is driving the current growth, and the company is unchallenged in this new generation of PCIe, which came to market for AI accelerators only recently with Nvidia’s H200s.
  • Catalyst: Scorpio is a new product that is expected to expand the TAM to more than $12B by 2028: Astera Labs is releasing a PCIe Gen 6 fabric switch custom designed for AI data flows with high performance per watt compared to incumbents. Rather than building a large switch, the company built a smaller device that is more efficient for high-speed signals. With Scorpio, Astera Labs is defending its dominance in PCIe5 by doubling the bandwidth at lower power requirements than the 5th generation of PCIe.
  • The market demand for Astera Labs is healthy, as a major supplier to Nvidia’s PCIe-enabled GPUs (note: most of Nvidia’s GPUs use their in-house NVLink). Yet, Arista also supplies other AI accelerator platforms for Big Tech, and Arista is the only provider for PCIe5. In addition to hardware, ALAB offers Big Tech data centers software-defined architecture called COSMOS that allows for performance monitoring. There is some favorable vendor lock-in dynamics with COSMOS as the many different product lines can be optimized and monitored with the software.
  • Financials on Astera Labs are impressive as the company is hypergrowth at 206% growth last quarter and 153% guided next quarter. The free cash flow margin is at 41%. The company is not GAAP profitable due to being a recent IPO with outsized stock-based compensation. However, there is a path to GAAP profitability, which is detailed in the financials section below.

Overview of Astera’s Products:

Broadly speaking, Astera’s products are seeing increased relevance as AI clusters grow to support hundred-billion and trillion parameter models. The company’s hardware and software increase AI server performance and productivity for the current generations and future generations of AI accelerators.

Transition to PCIe5 and PCIe5 Retimers are Driving Astera’s Growth:

The Aries products offer PCIe5 interfaces that GPUs and AI accelerators (like custom silicon) use to connect components including ethernet networking. Compared to the previous generation, PCIe5 is twice as fast with data transfer rates that reach up to 128 GBs/s on multi-directional bandwidth in each lane. By increasing the data transfer for each lane, it allows more lanes to become available to help leverage the power of the GPU or AI accelerator.

PCIe5 Retimers are chips that boost signals across high-speed components and are seeing increased demand, starting with Nvidia’s H200s, and also for application-specific chips. Specifically, Aries Retimers and smart cable modules allow hyperscalers to connect multiple racks together with up to 7 meters of copper cables. Aries can also go up to 50 meters with optical fiber. According to a presentation at Nvidia’s GTC event, this is 3X the standard reach defined in PCIe specs.

Despite PCIe5 being out since 2019, it was Nvidia’s H200s released in 2024 that were the first data center GPUs to use PCIe5. What’s interesting is that Astera is said to have captured 95% of the XPU market, which refers to application-specific chips that are specific on a product level. Per an analyst on the earnings call: “Majority of the XPU shipments are still going to be I think Gen 5 based where your market share is still somewhere in the range of, I think, like 95%.”

Management also stated: “The upside to the guidance was driven largely from Aries' revenue, both for the third-party GPUs, but also as well with the strong ramps on new platforms on the internally developed AI accelerators. And we're seeing that across multiple hyperscaler customers, so it's not just one. So the upside was largely driven by that Aries revenue.”

Notably, Aries devices are used to interconnect AI accelerators with CPUs and networking, yet are also used for backend networking between GPUs for larger clusters. Astera supplies the HGX H100 systems with PCIe-based GPUs with up to 25 retimer chips per HGX system.

Scorpio PCIe6 Custom-Built for AI is a Catalyst:

Scorpio is where the excitement is building for continued growth next year with management stating it will “exceed 10% of revenues in 2025” with “good momentum going into 2026.” This is due to the PCI Express switches being custom built for AI purposes, whereas in the past, PCIe was built for storage and then retrofitted for AI purposes.

PCIe 6 doubles the bandwidth from the 5th generation, with up to 256 GB/s of bandwidth per lane, which will require faster supporting components, such as the retimers that Astera Labs offers. The demo from GTC showed the Scorpio fabric switches (name released in October) delivering twice the bandwidth with less power at 11W instead of the 13W from the PCIe 5 interfaces.

There are two Scorpio fabric switches. The Scorpio P-Series is a small chip that connects the CPU, GPU, NIC and NVMe storage. Rather than building a large switch, the company built a smaller device that is more efficient for high-speed signals to help feed GPUs with data. The fewer ports and smaller switch decrease complexity in a bid to compete against Broadcom with twice the lane count.

The X-Series is for back-end networking in GPU-to-GPU configurations, and will offer a higher port count. Astera is essentially building something similar to Nvidia’s NVSwitch with the X-Series, but for PCIe-enabled GPUs: “And this one, like Mike noted, it's a greenfield use case, meaning if you keep Nvidia and NV Switch aside, everyone else is starting to build configurations that are obviously going to need some kind of a switching functionality, which is what we are addressing with our X Series device.” The X-Series improves efficiency for ever-increasing AI cluster sizes. The majority of AI clusters are in the tens of thousands GPUs, but are expected to go to the hundreds of thousands (already has with X and some other Big Tech companies), and will see AI clusters with millions of GPUs over the next couple of years.

Here is another quote from the management team as to why the X-Series Scorpio switch fabric is a big opportunity for their company:

“X series will have a bigger TAM. The TAM today is nearly zero. It's not very commonly used outside of the Nvidia ecosystem. We do expect many hyperscalers to start deploying this, starting with the X family and the designs for which that we have. And we are able to do that because of the architecture that we have. Because of our software-defined architecture, we can customize many parts of the X-Series to cater to the specific requirements of the hyperscalers both on the side of performance, the exact configuration that they require in count and so on and also the diagnostics framework that they require to monitor their infrastructure. So over time, we do expect X-Series to become larger [than the P-Series].”

COSMOS Software:

In order of importance, COSMOS Software ranks higher than some of Astera’s hardware as it offers performance monitoring for data center infrastructure. This is especially important for Big Tech companies concerned with utilization rates for expensive GPU systems.

The adoption of the software stack to monitor for performance is expected to increase with the Scorpio X-Series:

“Where the Scorpio family sits, we have access to a lot more diagnostic information. And we can couple that with the information that we are collecting from our other families deployed such as Aries and even Taurus to provide a holistic view of the AI infrastructure to the data center operators. So both from the hardware side, the kind of the purpose-built nature of these devices as well as the software stack that comes with it is a big differentiator for us.”

Taurus Ethernet Smart Cable Modules:

Astera Lab offers Ethernet smart cable modules which help to alleviate bandwidth issues with 100-gig per lane connectivity over copper cables including AEC. The company recently released 400-gig Ethernet SCMs, which help to stabilize the network. When thinking of ALAB’s investment thesis, Ethernet is not top-of-mind given the sheer size and lead we see from Broadcom, Nvidia’s Spectrum, and Arista Networks.

Right now, the maximum bandwidth supported by PCIe 5.0 is 400Gbps per port. By using 106Gbps PAM4 SerDes, ASICs can be tuned to support 100, 200 and 400 Gbps port speeds. To work around this, and to achieve 800Gbps, larger chip makers are building NICs directly into the accelerator. According to The Register, the 800Gbps ports built into accelerators may reduce bottlenecks before PCIe 6.0 arrives on the market. The larger Ethernet players are moving quickly on this, and we will need to keep an eye on Astera Labs to determine if the company’s Taurus product can remain competitive.

Leo Compute Express Link (CXL):

Leo is slated to impact revenue in 2025 when data center platforms plan to utilize CXL technology for memory bandwidth and capacity bottlenecks. Next year, CXL-capable CPUs will become broadly available. We’ve covered in the past how CXL is a new server architecture that “dynamically assigns memory resources between servers.” The result is boosted memory bandwidth and also at a lower cost than adding more CPUs. Partially-disaggregated racks are expected to deploy in 2024-2025 with separate compute, memory and I/O racks with the interconnect being CXL.

Per Astera’s management team: “In the past, this was done by adding additional CPUs into the server box to provide for more memory channels. But what we have demonstrated is that by using Leo you're not only able to get the higher performance by the added memory. But from an overall TCO standpoint, it's significantly less than adding additional CPUs. “

Financials: Strong Revenue Growth, Expanding Margins

Astera Labs reported solid top-line and bottom-line beats in the recent Q3 results. The company reported record revenue of $113.1 million, up 47% QoQ and 206% YoY, beating estimates by 16.1%. The adjusted operating margin expanded to 32.4% from 2% in the same period last year, which was helped by strong operating leverage. The adjusted EPS of $0.23 beat estimates by 35%.

Revenue:

The company is one of the fastest-growing tech companies and is emerging as a rising star in the AI data center networking space. The company’s Q3 revenue grew by 206.2% YoY and 47% QoQ to $113.1 million.

Jitendra Mohan, CEO and co-founder of the company, said in the Q3 2024 earnings call, “Our business has entered a new growth phase with multiple product families ramping across AI platforms, featuring both third-party GPUs and internally developed AI accelerators, which drove the Q3 sales upside verus our guidance.”

  • Management also provided a strong Q4 revenue guide of $126 million to $130 million, representing YoY growth of 153.4% at the mid-point. This also represents QoQ growth of 13% at the midpoint.

    According to management, the QoQ growth is being driven by “our Aries product family across a diverse set of AI platforms, some of which are just starting to ramp and also from our Taurus SCM for 400-gig applications, and additional preproduction shipments of our Scorpio P-Series switches.”

  • Analysts estimate revenue to grow 103.5% to $132.78 million in Q1 2025 and 85.2% YoY to $142.34 million in Q2 2025. While the growth rates are strong, growth is expected to slow down due to tougher comps.

Jitendra Mohan said, “Looking into Q4, we expect our revenue momentum to continue, largely driven by the Aries PCIe and Taurus Ethernet product lines. The Scorpio Fabric Switches are continuing to ship in preproduction volumes.”

The newly introduced Scorpio Fabric Switches are expected to increase the total market opportunity to more than $12 billion by 2028 for the company. Scorpio Switches are also expected to constitute more than 10% of revenue in 2025.

Source: Company website

Analysts expect 2024 revenue growth of 230.9% YoY to $383.14 million, followed by 55.5% and 40.4% in the subsequent years. Meanwhile, management comments seem to imply the growth recently reported will sustain, implying the growth phase has only begun: “Our business has entered a new growth phase with multiple product families ramping across AI platforms, featuring both third-party GPUs and internally developed AI accelerators, which drove the Q3 sales upside versus our guidance.”

Management also later stated: “Yes, right now, our visibility is very strong, both as always with our backlog position, but also the breadth of designs we have — right now, we're really kind of entering a new phase of growth here where our revenue streams are clearly diversifying […].”

Margins:

The company’s margins are improving, helped by strong operating leverage. However, the product mix might weigh on the margins going forward. Management mentioned in the recent earnings call that they have a long-term gross margin target of 70%.

  • Q3 gross profits grew by 212.7% YoY to $87.88 million or 77.7% of revenue compared to 76.1% in the same period last year.
  • This compares to 73.5% for FY2022 and 68.9% for FY2023.
  • Adjusted gross margin was 77.8% compared to 76.1% in the same period last year.
  • Management gross margin and adjusted gross margin guide for the next quarter are 75%. This is down sequentially due to higher product mix towards hardware solutions during the quarter.
  • Operating margin was (-7.9%) compared to (-5.3%) in the same period last year. The adjusted operating margin expanded to 32.4% from 2% in the same period last year, helped by strong operating leverage.
  • Management operating margin guide for the next quarter is (-4.3%) and adjusted operating margin guide is 32.4%.
  • It’s important to consider that stock-based compensation is quite high due to the recent IPO at 40.3% this quarter, and was at 56% last quarter. Once SBC naturally levels out, this company has strong enough margins to become GAAP profitable.
  • Net loss was (-$7.6 million) or (-6.7%) of revenue compared to (-8.5%) in the same period last year.
  • Adjusted net income improved significantly to $40.28 million or 35.6% of revenue compared to (-$0.41 million) or (-1.1%) of revenue in the same period last year.

The difference between the GAAP and non-GAAP net income is due to high stock-based compensation. Stock-based compensation was $45.5 million or 40.3% of revenue in the recent quarter. Stock-based compensation has been lumpy as the company’s IPO was in March 2024.

EPS:

The company beat EPS estimates helped by solid operating leverage. Q3 GAAP loss per share was ($0.05) compared to ($0.08) in the same period last year, beating estimates by 28.1%. Adjusted EPS was $0.23 and beat estimates by 35%.

  • Management has guided the Q4 GAAP EPS in the range of $0.04 to $0.06.
  • Notably, the company will not be GAAP operating income positive next quarter as the guide suggests an operating loss of (-$5.5 million) and interest income of about $10 million in the next quarter will make it GAAP profitable. However, it’s very close to being GAAP profitable across all margins, and we think it’s only a matter of time before this happens.
  • Adjusted EPS guide is $0.25 to $0.26.
  • Analysts expect adjusted EPS to be $0.25 in Q1 2025 and $0.27 in Q2 2025.
  • Analysts expect strong EPS growth. They expect 2025 adjusted EPS to grow 58.9% YoY to $1.14 and 48.6% YoY to $1.70 in 2026.

Cash Flow and Balance Sheet:

The company’s cash flows margins are high and are also improving due to increased profits.

  • Q3 operating cash flow was $63.5 million or 56.2% of revenue compared to (-0.9%) in the same period last year. It is also a significant improvement from (-17%) for the full year 2022 and (-6.5%) for 2023.
  • Free cash flow was $46.81 million or 41.4% of revenue compared to (-$1.07 million) or (-2.9%) in the same period last year.
  • Inventory was $24.4 million compared to $28.6 million in Q2.
  • The company had cash and marketable securities of $886.8 million with no debt.
  • Net proceeds from the IPO were $672.2 million. The shares began trading on the NASDAQ on March 20, 2024.

Valuation and IPO Risk:

On a sales valuation, Astera Labs is trading higher than Nvidia at 36X Fwd P/S compared to Nvidia’s at 29 Fwd P/S. On the bottom line, whether it’s PE Ratio, EV/EBITDA or Price to FCF, Astera is trading nearly double Nvidia’s valuation.

The company went public on March 20th, 2024 with shares opening for public trading around $62. The company raised $672.2 million with a lockup that expired September 11th, 2024. Insiders saw shares priced at $36 per share at time of IPO and the highest the stock has traded is $95 following the last earnings report.

The valuation is testing the upper limits of AI semi-related stocks. Therefore, we foresee participating now as a momentum play and participating longer-term with a new entry sometime late 2024-early 2025.

This stock requires an active stance, to where if we enter, we will exit for a quick trade, and try again at a lower valuation for a longer-term position. We offer real-time trade alerts on our Advanced tier.

Conclusion:

Management commentary is at odds with analysts’ estimates, as the commentary suggests there is a new growth phase occurring while estimates suggest a drop off in growth over the next 1-2 years. The products are enabling faster data speeds with PCIe5 and also increased back-end networking with PCIe6 for large AI clusters, and thus management’s commentary that this is a new growth phase holds weight. We certainly know the future for AI clusters is going to exponentially increase from 10s of thousands for AI clusters to eventually millions of AI accelerators per cluster. This is not only a GPU opportunity but also a custom silicon opportunity, as Astera Labs exclusively offered PCIe5 switches and retimers, and will now compete against Broadcom on PCIe6.

Astera Labs is technically in the lead and Broadcom is the follower in this case; but where it gets even more interesting is with the new product Scorpio. It is expected to increase the TAM by $5.0 billion with a total TAM of over $12B over the next 3 years. If we assume Astera captures 50% of the total TAM, then what we have is a stock that will remain in hypergrowth territory. If you do the math, that’s a potential 12X increase in revenue by 2028 from the $500M run rate Astera has today.

Certainly, technical analysis is critical given we are dealing with a very stretched valuation, a recent IPO, and ultimately, a stock that will be volatile in the years to come – yet perhaps, with the right timing, the stock will be as equally rewarding. We typically do not participate in IPOs, and Astera Labs illustrates why given its trading 2X higher than the AI juggernaut with impeccable financials (Nvidia). We do not plan to participate long-term in Astera Labs for this reason, yet may participate briefly, and then keep the stock on our watchlist from there.

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 Q3: Market Leader in AI-Driven Ad-Tech

Posted on by io-fund

AppLovin has done the unthinkable, which is to awaken a low-growth mobile gaming ads industry with an AI engine that is showing demonstrable results. The market is loving this stock as it has doubled its margins, more than doubled its cash flow and has a surging AI segment due to its AXON 2.0 AI advertising engine.

Our near-term plan is to trade this stock, while our medium-term plan is to build a longer-term position. Both require an active stance rather than guessing on the buys. However, we think App is setting up for a longer-term trajectory and our firm plans to participate.

Update on Investment Thesis:

There are a few key points to the investment thesis that I’d like to bookmark here for future reference.

APP has User Data from 1.4 Billion Mobile Users

The first point to the longer-term investment thesis is that AppLovin has data from 1.4 billion mobile gamers. We’ve seen the razor-razor blade model with hardware, to where a company will own the hardware market to get recurring software revenue. AppLovin has a different variation of this, which is they own mobile gaming apps and a supply-side platform to mix both first-party data and third-party data, which in turn, fuels their AI engine to help them capitalize on the broader mobile gaming market.

The word moat is overused in tech stocks, yet AppLovin has an enviable advantage in the era of AI. Off the top of my head, I cannot think of another company with this level of user data for advertising purposes that is not a Big Tech company and in the Mag 7.

Catalyst: E-commerce and more Web-based Advertising Categories in 2025

AppLovin’s success has been entirely based on gaming companies advertising to mobile gamers.

The company is planning to introduce new advertising segments to the 1.4 billion users they serve in 2025, which is likely to help the company grow into the foreseeable future. The catalyst for 2025 is expected to broaden to also include a self-service platform for all types of web-based advertising. According to management, the pilot for introducing e-commerce demand is going quite well: “E-commerce, on the other hand, is looking so strong that it's something that we think will be impactful to the business financially '25 and then for the long term.”

Product Differentiation:

The ad engine AXON 2.0 offers a monumental advantage to AppLovin as the company is ahead in the race for AI-driven advertising. Part of this is the user data from 1.4 billion users, which cannot be overemphasized, and it’s also due to the company owning both a supply-side platform MAX and demand-side platform, App Discovery. 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. 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.

AppLovin is also an arbitrage advertising platform, which means they can quantify the impact of their reach for advertisers by returning back to the advertiser what was spent or more within 30 days. If an advertiser spends $10,000 (or multiples of this), AppLovin is able to return that or more to the advertiser. The company is also unique in that it offers performance marketing for brands and direct-to-consumer. The Trade Desk primarily works with agencies, whereas AppLovin is attracting smaller and medium sized businesses that rely on performance.

Most importantly, AXON 2.0 is an AI-powered advertising engine that is continuously improving. Every quarter and every year, AXON becomes more effective by ingesting more data that improves the model through self-learning. The management has been quite clear they believe these step-ups in model efficiency can help to maintain a 20% to 30% growth rate in gaming alone, and not accounting for the new web-based advertising catalysts expected in 2025.

“Last quarter, I shared our confidence in achieving 20% to 30% year-over-year growth for the foreseeable future. We continue to expect 4% to 5% quarterly growth through self-learning and market growth, with occasional step changes resulting from enhancements to our AXON algorithm.”

Strong Bottom Line and Cash Flows:

On top of the growth potential, APP has a strong bottom line and cash flows, which we review in more detail below. The adjusted EBITDA margin is at 60% and the GAAP operating margin has doubled YoY from 21.6% to 44.6%. The free cash flow margin of 45.5% has also doubled from 22.4%. Notably, the company carries $3.5 billion in debt, yet at this cash flow margin is not a concern.

You can read more about AppLovin here.about AppLovin here.

Q3 Earnings: Software/Advertising Segment up 16% QoQ

In addition to reporting growth on the bottom line, AppLovin’s primary AI segment inflected 17% QoQ to $835 million, up from $711 million last quarter. The software/advertising platform has a high adjusted EBITDA of 78%, easily making this one of the more profitable hypergrowth companies the market has ever seen. This is not exactly a secret, as AppLovin is up over 600% YTD but what is important to look at it, is whether AppLovin can continue this winning streak.

Given commentary on the most recent earnings call, we think analyst estimates are too low for next year. There’s also a valuation case being made by institutional analysts following the last earnings report that APP should be valued by EV/EBITDA, which creates room in the valuation that traditional top line and bottom-line metrics are not showing.

Revenue

APP reported $1.2 billion in revenue in Q3, beating estimates by nearly 6% after missing slightly in Q2. Revenue growth continued to decelerate from its peak of 47.9% YoY in Q1, with Q3 revenue growth of 38.6% YoY.

For Q4, APP guided for revenue between $1.24 to $1.26 billion, or 31.1% YoY growth at the midpoint, pointing to growth decelerating once more as comps get tougher. Moving through the first half of 2025, growth is expected to hover in the low-20% range, up from the mid-teens before the report.

The reason the market is ignoring the deceleration is that the key AI segment is growing QoQ and re-accelerated in the most recent quarter. This hints at a re-acceleration potentially in the top line in the coming quarters.

For FY24, APP is expected to see revenue rise 39.9% YoY to $4.59 billion, before slowing to 18.9% YoY growth to $5.46 billion in FY25.

Our firm is tracking the 2025 catalysts of e-commerce and other web-based advertising segments as offering strong potential that analyst estimates are too low, especially when coupled with management comments that gaming alone will drive 20% to 30% revenue growth into the foreseeable future.

Margins:

APP’s margin strengths have been an underlying driver of the surge in the stock price, with increased operating leverage driving a strong expansion on the bottom line.

  • Gross margin in Q3 was 77.5%, improving from 73.8% in Q2 and 69.3% a year ago.
  • Operating margin in Q3 was 44.6%, a significant improvement from 36.2% in Q2 and more than double the 21.6% operating margin in the year ago quarter. This degree of operating leverage is ridiculous! Especially while seeing revenue growth rates above 30% — essentially, APP has been able to drive this revenue growth with barely any change to its operating expenses, even as it continues to improves its AXON AI engine. Wow.
  • Net margin in Q3 was 36.3%, improving from 28.7% in Q2 and nearly triple the 12.6% margin in the year ago quarter, due to that substantial operating leverage. Again, wow.
  • Adjusted EBITDA margin was 60% in Q3, up from 56% in Q2 and 49% in the year ago quarter. For Q4, APP guided adjusted EBITDA margin to remain flat QoQ at 60%.

EPS

Given the dramatic improvement in operating and net margins, APP’s net income and EPS has followed suit, rising over 300% YoY in Q3.

Q3’s GAAP EPS of $1.25 increased 317% YoY, and easily beat estimates for $0.93. This accelerated slightly from Q2’s 304% YoY growth. Looking ahead, GAAP EPS is expected to remain flat QoQ in Q4 at $1.25, before advancing slightly in the first half of 2025 to the mid-$1.30 range.

Through Q3, APP’s GAAP EPS has risen 462% YoY to $2.81. Using Q4’s guide, FY24’s EPS would be estimated at $4.06, or YoY growth of 314%.

For FY25 and FY26, EPS growth is expected to remain robust even after this surge, with growth projected currently at >30% in both years: analysts estimate 37% YoY growth to $5.57 in FY25, and 31% YoY growth to $7.26 in FY26.

Cash and Balance Sheet:

Operating cash flow and free cash flow growth has also been remarkably strong, with margins quickly approaching 50%.

  • Operating cash flow was $550.7 million in Q3, increasing 177% YoY. OCF margin was 46%, improving from 42.1% in Q2 and doubling from 23% in the year ago quarter.
  • Free cash flow was $545.1 million in Q3, rising 182% YoY. FCF margin was 45.5%, improving from 41.2% last quarter and 22.4% in the year ago quarter.
  • Cash and equivalents totaled $567.6 million.
  • Debt totaled $3.51 billion.

What’s of note here is that APP carries a high debt load, with the first $1.5 billion tranche of senior secured term loans due in 2028, with the remaining $2.1 billion senior secured loan due in 2030.

Key Segments and Metrics

APP’s Software segment (soon to be reclassified as Advertising) and its AXON AI engine has been the primary growth driver over the course of the past six quarters, with Software Platform revenue rising from 50% of total revenue at the beginning of 2023 to 70% in Q3 2024.

Software’s growth remained strong in Q3, with revenue rising 66% YoY to $835 million. This marked the fifth straight quarter of YoY growth >60% for the segment, with growth also reaccelerating sequentially, with QoQ of 17.4% in Q3 versus 4.8% in Q2.

Software’s adjusted EBITDA increased 79% YoY to $653 million, outpacing revenue growth as a result of increased operating leverage. Adjusted EBITDA margin in the segment was 78%, expanding from 73% last quarter and 72% in the year ago quarter.

On the other hand, App revenue was relatively unchanged, rising just 1% YoY to $363 million, and decelerating from 7% growth in the prior quarter. App’s revenue has not yet rebounded after a trough in early 2023.

App’s adjusted EBITDA rose nearly 24% YoY to $68 million, or a 19% margin. This contracted slightly from 22% in Q2 but had improved from 15% in the year ago quarter; however, segment performance remains slightly challenged as APP continues to optimize the segment’s cost structure.

Monthly Active Payers, Average Revenue:

APP’s monthly active payers were 1.6 million, flat sequentially but down from 1.8 million last year. On the other hand, average revenue per monthly active payer (ARPMAP) was $52, flat sequentially but improving from $46 last year.

Earnings Call Discussion:

Bull Case: 20% to 30%+ Growth into Next Year

As stated, the comments that gaming alone can drive 20% to 30% growth, in addition to the important catalyst of expanding into e-commerce and web-based advertising is why AppLovin can continue on a strong growth trajectory. Analysts currently have FY2025 estimates at 19.6%:

Here is the tone from the earnings call:

“While we remain confident in 20% to 30% growth for mobile gaming advertisers alone, we're also exploring new areas, as shown by our recent e-commerce pilot. Early data has exceeded our expectations, with the advertisers in the pilot seeing substantial returns, often surpassing those from other media channels, and in many cases, experiencing nearly a 100% incrementality from our traffic.”

The Scale + AI Engine is Why AppLovin is Just Getting Started

AppLovin’s 1.4 billion users is key to why this company’s trajectory may just be getting started. The company has stated even if they release the code and algorithm for AXON 2.0, competitors cannot mimic what they’ve built due to the data they own.

Here is what was stated on the call:

“[Our customers] care about optimization and automated advertising to a revenue goal. And that's really like what our system is predicated on is that. We take all the risk on the media side. We have to deliver really compelling performance on the technology side. And I guess, like what's most exciting for me on what we've built and where we are in terms of, like you said, market cap and scale as a business today is we're on top of 1.4 billion daily actives. So it's really easy to forget the scale of the audience reach that we have on our platform. We've got the largest mediation solution in the sector, and our teams built maybe the most innovative advertising technology that the world has yet seen.”

Valuation:

EV/EBITDA Valuation Shows Room

No doubt, AppLovin is richly valued on the top line and bottom line. The top line is trading at 21X Fwd PS compared to ad-tech peer The Trade Desk at 26X Fwd PS. On the bottom line, AppLovin is trading at 52 Fwd PE Ratio compared to a Fwd PE Ratio of 79 for TTD.

However, where there is more room is seen in the EV/EBITDA valuation, which institutional analysts are making the case should be the correct valuation. Per current data, there is nearly 100% upside to APP on this valuation.

Here is what analysts are saying: “(11/07) Macquarie raised the firm's price target on AppLovin to $270 from $150 and keeps an Outperform rating on the shares after the company's beat and raise Q3 report. The firm, which raised its 2024 adjusted EBITDA estimate to $2.6B from $2.4B and its 2025 estimate to $3.2B from $2.9B, notes that it shifted its valuation method to "straight EV/EBITDA, given the predominance of the Software Platform now."

Source: YCharts

Conclusion:

Our firm is preparing to participate in AppLovin in two ways — first, a quicker momentum play to see if we can capture any remaining upside presented in the EV/EBITDA valuation that institutional analysts are favoring for this stock. Knox’s technical analysis is showing a potential move, and this is supported by fundamentals. However, for our longer-term position, we will look to close the momentum trade and participate again come 2025. Stay tuned!

Recommended Reading:

AppLovin Q3: Market Leader in AI-Driven Ad-Tech

Posted on by io-fund

AppLovin has done the unthinkable, which is to awaken a low-growth mobile gaming ads industry with an AI engine that is showing demonstrable results. The market is loving this stock as it has doubled its margins, more than doubled its cash flow and has a surging AI segment due to its AXON 2.0 AI advertising engine.

Our near-term plan is to trade this stock, while our medium-term plan is to build a longer-term position. Both require an active stance rather than guessing on the buys. However, we think App is setting up for a longer-term trajectory and our firm plans to participate.

Update on Investment Thesis:

There are a few key points to the investment thesis that I’d like to bookmark here for future reference.

APP has User Data from 1.4 Billion Mobile Users

The first point to the longer-term investment thesis is that AppLovin has data from 1.4 billion mobile gamers. We’ve seen the razor-razor blade model with hardware, to where a company will own the hardware market to get recurring software revenue. AppLovin has a different variation of this, which is they own mobile gaming apps and a supply-side platform to mix both first-party data and third-party data, which in turn, fuels their AI engine to help them capitalize on the broader mobile gaming market.

The word moat is overused in tech stocks, yet AppLovin has an enviable advantage in the era of AI. Off the top of my head, I cannot think of another company with this level of user data for advertising purposes that is not a Big Tech company and in the Mag 7.

Catalyst: E-commerce and more Web-based Advertising Categories in 2025

AppLovin’s success has been entirely based on gaming companies advertising to mobile gamers.

The company is planning to introduce new advertising segments to the 1.4 billion users they serve in 2025, which is likely to help the company grow into the foreseeable future. The catalyst for 2025 is expected to broaden to also include a self-service platform for all types of web-based advertising. According to management, the pilot for introducing e-commerce demand is going quite well: “E-commerce, on the other hand, is looking so strong that it's something that we think will be impactful to the business financially '25 and then for the long term.”

Product Differentiation:

The ad engine AXON 2.0 offers a monumental advantage to AppLovin as the company is ahead in the race for AI-driven advertising. Part of this is the user data from 1.4 billion users, which cannot be overemphasized, and it’s also due to the company owning both a supply-side platform MAX and demand-side platform, App Discovery. 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. 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.

AppLovin is also an arbitrage advertising platform, which means they can quantify the impact of their reach for advertisers by returning back to the advertiser what was spent or more within 30 days. If an advertiser spends $10,000 (or multiples of this), AppLovin is able to return that or more to the advertiser. The company is also unique in that it offers performance marketing for brands and direct-to-consumer. The Trade Desk primarily works with agencies, whereas AppLovin is attracting smaller and medium sized businesses that rely on performance.

Most importantly, AXON 2.0 is an AI-powered advertising engine that is continuously improving. Every quarter and every year, AXON becomes more effective by ingesting more data that improves the model through self-learning. The management has been quite clear they believe these step-ups in model efficiency can help to maintain a 20% to 30% growth rate in gaming alone, and not accounting for the new web-based advertising catalysts expected in 2025.

“Last quarter, I shared our confidence in achieving 20% to 30% year-over-year growth for the foreseeable future. We continue to expect 4% to 5% quarterly growth through self-learning and market growth, with occasional step changes resulting from enhancements to our AXON algorithm.”

Strong Bottom Line and Cash Flows:

On top of the growth potential, APP has a strong bottom line and cash flows, which we review in more detail below. The adjusted EBITDA margin is at 60% and the GAAP operating margin has doubled YoY from 21.6% to 44.6%. The free cash flow margin of 45.5% has also doubled from 22.4%. Notably, the company carries $3.5 billion in debt, yet at this cash flow margin is not a concern.

You can read more about AppLovin here.about AppLovin here.

Q3 Earnings: Software/Advertising Segment up 16% QoQ

In addition to reporting growth on the bottom line, AppLovin’s primary AI segment inflected 17% QoQ to $835 million, up from $711 million last quarter. The software/advertising platform has a high adjusted EBITDA of 78%, easily making this one of the more profitable hypergrowth companies the market has ever seen. This is not exactly a secret, as AppLovin is up over 600% YTD but what is important to look at it, is whether AppLovin can continue this winning streak.

Given commentary on the most recent earnings call, we think analyst estimates are too low for next year. There’s also a valuation case being made by institutional analysts following the last earnings report that APP should be valued by EV/EBITDA, which creates room in the valuation that traditional top line and bottom-line metrics are not showing.

Revenue

APP reported $1.2 billion in revenue in Q3, beating estimates by nearly 6% after missing slightly in Q2. Revenue growth continued to decelerate from its peak of 47.9% YoY in Q1, with Q3 revenue growth of 38.6% YoY.

For Q4, APP guided for revenue between $1.24 to $1.26 billion, or 31.1% YoY growth at the midpoint, pointing to growth decelerating once more as comps get tougher. Moving through the first half of 2025, growth is expected to hover in the low-20% range, up from the mid-teens before the report.

The reason the market is ignoring the deceleration is that the key AI segment is growing QoQ and re-accelerated in the most recent quarter. This hints at a re-acceleration potentially in the top line in the coming quarters.

For FY24, APP is expected to see revenue rise 39.9% YoY to $4.59 billion, before slowing to 18.9% YoY growth to $5.46 billion in FY25.

Our firm is tracking the 2025 catalysts of e-commerce and other web-based advertising segments as offering strong potential that analyst estimates are too low, especially when coupled with management comments that gaming alone will drive 20% to 30% revenue growth into the foreseeable future.

Margins:

APP’s margin strengths have been an underlying driver of the surge in the stock price, with increased operating leverage driving a strong expansion on the bottom line.

  • Gross margin in Q3 was 77.5%, improving from 73.8% in Q2 and 69.3% a year ago.
  • Operating margin in Q3 was 44.6%, a significant improvement from 36.2% in Q2 and more than double the 21.6% operating margin in the year ago quarter. This degree of operating leverage is ridiculous! Especially while seeing revenue growth rates above 30% — essentially, APP has been able to drive this revenue growth with barely any change to its operating expenses, even as it continues to improves its AXON AI engine. Wow.
  • Net margin in Q3 was 36.3%, improving from 28.7% in Q2 and nearly triple the 12.6% margin in the year ago quarter, due to that substantial operating leverage. Again, wow.
  • Adjusted EBITDA margin was 60% in Q3, up from 56% in Q2 and 49% in the year ago quarter. For Q4, APP guided adjusted EBITDA margin to remain flat QoQ at 60%.

EPS

Given the dramatic improvement in operating and net margins, APP’s net income and EPS has followed suit, rising over 300% YoY in Q3.

Q3’s GAAP EPS of $1.25 increased 317% YoY, and easily beat estimates for $0.93. This accelerated slightly from Q2’s 304% YoY growth. Looking ahead, GAAP EPS is expected to remain flat QoQ in Q4 at $1.25, before advancing slightly in the first half of 2025 to the mid-$1.30 range.

Through Q3, APP’s GAAP EPS has risen 462% YoY to $2.81. Using Q4’s guide, FY24’s EPS would be estimated at $4.06, or YoY growth of 314%.

For FY25 and FY26, EPS growth is expected to remain robust even after this surge, with growth projected currently at >30% in both years: analysts estimate 37% YoY growth to $5.57 in FY25, and 31% YoY growth to $7.26 in FY26.

Cash and Balance Sheet:

Operating cash flow and free cash flow growth has also been remarkably strong, with margins quickly approaching 50%.

  • Operating cash flow was $550.7 million in Q3, increasing 177% YoY. OCF margin was 46%, improving from 42.1% in Q2 and doubling from 23% in the year ago quarter.
  • Free cash flow was $545.1 million in Q3, rising 182% YoY. FCF margin was 45.5%, improving from 41.2% last quarter and 22.4% in the year ago quarter.
  • Cash and equivalents totaled $567.6 million.
  • Debt totaled $3.51 billion.

What’s of note here is that APP carries a high debt load, with the first $1.5 billion tranche of senior secured term loans due in 2028, with the remaining $2.1 billion senior secured loan due in 2030.

Key Segments and Metrics

APP’s Software segment (soon to be reclassified as Advertising) and its AXON AI engine has been the primary growth driver over the course of the past six quarters, with Software Platform revenue rising from 50% of total revenue at the beginning of 2023 to 70% in Q3 2024.

Software’s growth remained strong in Q3, with revenue rising 66% YoY to $835 million. This marked the fifth straight quarter of YoY growth >60% for the segment, with growth also reaccelerating sequentially, with QoQ of 17.4% in Q3 versus 4.8% in Q2.

Software’s adjusted EBITDA increased 79% YoY to $653 million, outpacing revenue growth as a result of increased operating leverage. Adjusted EBITDA margin in the segment was 78%, expanding from 73% last quarter and 72% in the year ago quarter.

On the other hand, App revenue was relatively unchanged, rising just 1% YoY to $363 million, and decelerating from 7% growth in the prior quarter. App’s revenue has not yet rebounded after a trough in early 2023.

App’s adjusted EBITDA rose nearly 24% YoY to $68 million, or a 19% margin. This contracted slightly from 22% in Q2 but had improved from 15% in the year ago quarter; however, segment performance remains slightly challenged as APP continues to optimize the segment’s cost structure.

Monthly Active Payers, Average Revenue:

APP’s monthly active payers were 1.6 million, flat sequentially but down from 1.8 million last year. On the other hand, average revenue per monthly active payer (ARPMAP) was $52, flat sequentially but improving from $46 last year.

Earnings Call Discussion:

Bull Case: 20% to 30%+ Growth into Next Year

As stated, the comments that gaming alone can drive 20% to 30% growth, in addition to the important catalyst of expanding into e-commerce and web-based advertising is why AppLovin can continue on a strong growth trajectory. Analysts currently have FY2025 estimates at 19.6%:

Here is the tone from the earnings call:

“While we remain confident in 20% to 30% growth for mobile gaming advertisers alone, we're also exploring new areas, as shown by our recent e-commerce pilot. Early data has exceeded our expectations, with the advertisers in the pilot seeing substantial returns, often surpassing those from other media channels, and in many cases, experiencing nearly a 100% incrementality from our traffic.”

The Scale + AI Engine is Why AppLovin is Just Getting Started

AppLovin’s 1.4 billion users is key to why this company’s trajectory may just be getting started. The company has stated even if they release the code and algorithm for AXON 2.0, competitors cannot mimic what they’ve built due to the data they own.

Here is what was stated on the call:

“[Our customers] care about optimization and automated advertising to a revenue goal. And that's really like what our system is predicated on is that. We take all the risk on the media side. We have to deliver really compelling performance on the technology side. And I guess, like what's most exciting for me on what we've built and where we are in terms of, like you said, market cap and scale as a business today is we're on top of 1.4 billion daily actives. So it's really easy to forget the scale of the audience reach that we have on our platform. We've got the largest mediation solution in the sector, and our teams built maybe the most innovative advertising technology that the world has yet seen.”

Valuation:

EV/EBITDA Valuation Shows Room

No doubt, AppLovin is richly valued on the top line and bottom line. The top line is trading at 21X Fwd PS compared to ad-tech peer The Trade Desk at 26X Fwd PS. On the bottom line, AppLovin is trading at 52 Fwd PE Ratio compared to a Fwd PE Ratio of 79 for TTD.

However, where there is more room is seen in the EV/EBITDA valuation, which institutional analysts are making the case should be the correct valuation. Per current data, there is nearly 100% upside to APP on this valuation.

Here is what analysts are saying: “(11/07) Macquarie raised the firm's price target on AppLovin to $270 from $150 and keeps an Outperform rating on the shares after the company's beat and raise Q3 report. The firm, which raised its 2024 adjusted EBITDA estimate to $2.6B from $2.4B and its 2025 estimate to $3.2B from $2.9B, notes that it shifted its valuation method to "straight EV/EBITDA, given the predominance of the Software Platform now."

Source: YCharts

Conclusion:

Our firm is preparing to participate in AppLovin in two ways — first, a quicker momentum play to see if we can capture any remaining upside presented in the EV/EBITDA valuation that institutional analysts are favoring for this stock. Knox’s technical analysis is showing a potential move, and this is supported by fundamentals. However, for our longer-term position, we will look to close the momentum trade and participate again come 2025. Stay tuned!

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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