Month: November 2024

Palantir Stock: How High Is Too High?

Posted on by io-fund

This article was originally published on Forbes on Nov 7, 2024,09:08pm ESTForbesForbes on Nov 7, 2024,09:08pm EST

Two weeks ago, I highlighted that Palantir is “one of the rare few that sees AI drive both real returns for its business and real value for its customers,” while it continues to crush its software peers in AI-related growth. AI offerings have driven a clear acceleration in customers and overall revenue, while many SaaS peers, such as MongoDB and Salesforce, struggle to say the same.

This week, Palantir proved again in Q3 that it’s undeniably one of the stronger AI software stocks in the market outside of the cloud hyperscalers. The company reported visible AI-driven growth and persisting business momentum for AIP, strong revenue acceleration to 30% YoY, combined with strong profitability – a rare combination for growth stocks.

Despite proving again that it’s one of the only software names with real revenue in the market, Q3’s report pushed the valuation even higher. Due to an outlandish valuation, price momentum may soon be approaching a peak.

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Blistering AI Momentum Continues

Palantir’s third quarter was characterized once again by strong underlying AI momentum. Palantir beat Q3 revenue expectations by more than $21 million, reporting revenue of $725.5 million in the quarter. The FY24 revenue guide was boosted to just above $2.80 billion, up from $2.75 billion last quarter.

Revenue growth continued to accelerate, with Palantir reporting revenue growth of 30.0% in Q3, ahead of its guidance for 25.2% growth and up from 27.2% in Q2.

Palantir Quarterly Revenue Growth, YoY chart

Palantir’s Q3 highlights: Strong AI momentum with $725.5 million revenue, exceeding expectations by $21 million. FY24 revenue guidance increased to over $2.80 billion. Q3 revenue growth at 30.0%, surpassing guidance and Q2’s 27.2% growth rate. – I/O Fund

Q3’s results have marked quite the turnaround in just over a year for Palantir, with revenue growth accelerating more than 17 percentage points from Q2 2023 (AIP’s release) to Q3 2024. This was also the highest revenue growth rate recorded since Q1 2022.

AIP has been the primary driving force of this revenue reacceleration, with strong adoption in the US commercial segment. AIP’s scalability, interoperability and versatility allow it to quickly be integrated by enterprises. Commercial customers can lever Palantir’s AI and machine learning tools to harness the power of the latest large language models (LLMs) within Foundry and Gotham for near-instant analytics & insights, and productivity & efficiency gains.

For a closer look at AIP and how it separates Palantir from the rest of the SaaS universe, read This Stock Is Crushing Salesforce, MongoDB And Snowflake In AI Revenue.This Stock Is Crushing Salesforce, MongoDB And Snowflake In AI Revenue.

AIP Aids US Commercial Growth

What’s interesting to note in Q3 is that government revenue growth outpaced commercial growth, at 33% YoY versus 27% YoY, a contrast to recent quarters where commercial had been the primary driver. Government’s outperformance was driven by 15% QoQ growth in US government revenue, its fastest growth rate in 15 quarters, while commercial was impacted by a 7% QoQ decline in international commercial revenue due to European headwinds and “a step down in revenue from a government sponsored enterprise in the Middle East.”

However, US commercial growth remained strong in the quarter, with a growth rate nearly in line with Q2’s. Management said that AIP drove “new customer conversions and existing customer expansions in the US,” as AI models continue to be deployed into production. Here’s what the growth in US commercial revenue looks like:

Palantir US Commercial Revenue chart

Palantir’s US commercial revenue rose 54% YoY and 13% QoQ to $179 million, slightly decelerating from 55% YoY growth in Q2. FY24 US commercial revenue is expected to exceed $687 million, indicating at least $199 million in Q4 revenue, with ~52% YoY growth. – I/O Fund

US commercial revenue increased 54% YoY and 13% QoQ to $179 million, slightly decelerating from 55% YoY growth in Q2. Palantir guided for US commercial revenue to exceed $687 million, or 50% YoY growth, for FY24, implying Q4 revenue of at least $199 million, or ~52% YoY growth, representing a 2 point deceleration should it meet that target.

US commercial customer growth remained strong, with customers rising 77% YoY to 321 in Q3. This decelerated from 83% YoY in Q2. Here’s what the US commercial customer growth looks like:

US Commercial Customer Count chart

US commercial customer growth remained strong, rising 77% YoY to 321 in Q3, slightly down from 83% YoY growth in Q2. Here’s what the US commercial customer growth looks like. – I/O Fund

US commercial customer count has essentially doubled since AIP’s release, but Q3 was the second quarter to show slightly slower customer growth, indicating that Palantir may be relying on existing customers to drive revenue, whereas customer acquisition should be monitored moving forward. Most importantly, NRR has risen to a two-year high, while RPO is surging, suggesting customer spend could remain elevated for the next few quarters.

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Net Retention, RPO Strong, but Watch US Net New Adds

In Q3, net dollar retention expanded to 118%, up from 114% in Q2, 111% in Q1, and 107% a year ago. Management said that this “increase was driven both by expansions at existing customers and new customers acquired in Q3 of last year, as we see the effect of the AI revolution in both industry and government.” Net dollar retention has reached the highest level in two years, but still has room to expand, given that rates were >120% in 2021 and 2022.

Net Dollar Retention chart

In Q3, Palantir’s net dollar retention rate increased to 118%, up from 114% in Q2 and 107% a year ago. This growth was driven by expansions at existing customers and new acquisitions, reflecting the impact of the AI revolution in both industry and government. Net dollar retention reached its highest level in two years, with further growth potential, previously exceeding 120% in 2021 and 2022. – I/O Fund

Palantir has an advantage over other software peers due to its differentiated AI offerings, while adding significant new customers this year and expanding deal sizes with new customers (with FY24’s additions not appearing until FY25) — this provides a path forward for NRR to continue expanding. Initial AIP customers are beginning to appear in NRR, and a few more quarters will provide a clearer picture of how far NRR could expand and at what level it will plateau.

RPO is also sharply rising, implying that customer spend is likely to remain strong over the next few quarters. RPO growth has accelerated over the past four quarters, from 27.8% in Q4, breaking a string of declines in the rest of 2023, to 58.6% YoY by Q3. This is the highest RPO and growth rate since the I/O Fund began tracking Palantir in late 2023, and another data point underlying its AI-driven momentum.

RPO ($B) chart

Palantir’s RPO (Remaining Performance Obligation) is sharply rising, indicating strong customer spending over the next few quarters. RPO growth accelerated over the past four quarters, from 27.8% in Q4 to 58.6% YoY in Q3. This is the highest RPO and growth rate since the I/O Fund began tracking Palantir in late 2023, highlighting its AI-driven momentum. – I/O Fund

However, net additions in the commercial segment are slowing, both in the US and overall. In Q3, Palantir added 31 net new customers in its commercial segment, down from 40 net new customers in Q2 and 52 net new customers in Q1.

This has been predominantly driven by the US, as international commercial has yet to scale. In the US, net new commercial customers have dropped over the past two quarters, falling from 41 net new adds in Q1 to 26 net new adds in Q3. There is a clear deceleration from peak customer acquisition following AIP’s ramp, where net new adds surged from 6 in Q2 2023 to 41 by Q1, before slowing again. Palantir has acknowledged hiccups and issues in its sales cycle, saying in Q1 that they are “at the way early days of figuring out how to actually get customers to buy [AIP]” and “we're not flawlessly executing on our sales motion.” The friction is appearing within lumpy net new adds.

US Commercial Net Customer Additions chart

US commercial has been a driving factor for Palantir, as the primary segment adopting AIP and concentrating AI momentum. Palantir guided for a larger QoQ revenue deceleration for Q4 than in Q3, implying ~26.4% YoY growth, a 3.6-point deceleration from 30% YoY. Last quarter, Palantir’s guidance implied a 2-point deceleration from 27.2% YoY in Q2 to 25.2% in Q3, but a significant beat pushed growth to 30%. – I/O Fund

US commercial has been a driving factor for Palantir as the primary segment adopting AIP and where this AI momentum is concentrated. Palantir guided for a larger QoQ revenue deceleration for Q4 than it had in Q3 – guidance implies revenue growth of ~26.4% YoY, a 3.6-point deceleration from 30% YoY. Last quarter, Palantir’s guide implied only a 2-point deceleration, from 27.2% YoY in Q2 to 25.2% in Q3 – the large beat pushed growth to 30% in the quarter.

Analyst estimates do support this, with Q4 revenue estimated at $777 million, nearly 1% above Palantir’s guide as the market expects a beat once more; yet given the size of the recent beat, estimates may be lagging the underlying business momentum. The estimates correlate to 27.8% YoY growth, a 2.2 point deceleration, while Q1 is expected to decelerate further to 24% YoY before continuing to decelerate in each quarter of FY25.

Cash Flow and Margins are Bonkers

Palantir is in uncharted territory, as it is separating itself as a rare breed in SaaS to see both strong and profitable AI-driven growth. The company’s revenue growth plus GAAP operating and net margins have been in the double-digit range for four consecutive quarters. Additionally, Palantir’s Rule of 40 (revenue growth + adjusted operating margin) reached 68%, up from 46% last year.

To be consistently expanding on the Rule of 40, from the ~40% range at the end of 2022 to nearly 70%, is important as it shows that Palantir is efficiently investing in AI to drive revenue growth higher while increasing its profitability.

Cash flow margins were bonkers in Q3 — operating cash flow was nearly $420 million, or a 58% margin, while adjusted free cash flow was $435 million, a 60% margin. This was a large step up from cash flow margins in the low-20% range in the first half of 2024.

For FY24, Palantir is targeting adjusted free cash flow in excess of $1 billion, implying a margin of ~36%. Fundamentally, to have revenue growth around 30%, free cash flow margin of 30%, and adjusted operating margin nearing 40% is impressive, to say the least.

Valuation is Stretched

Palantir is at Mount Everest valuations, trading at topline multiples more than double the next three most expensive enterprise and AI-exposed SaaS stock in the market – Cloudflare, ServiceNow, and CrowdStrike. At $55, Palantir is valued at 50x TTM revenue, and 45x forward revenue – its highest ever multiples, exceeding even 2021’s peak – versus 18x to 20x forward revenue for those three peers. Even down the line, Palantir is trading at double its peers, at 146x forward earnings, versus 88x for CrowdStrike and 71x for ServiceNow.

Palantir, Cloudflare, ServiceNow, Crowdstrike Forward PS Ratio chart

Palantir is trading at Mount Everest valuations, with topline multiples more than double those of Cloudflare, ServiceNow, and CrowdStrike. At $55, Palantir is valued at 50x TTM revenue and 45x forward revenue, the highest ever, surpassing 2021’s peak. In comparison, its peers trade at 18x to 20x forward revenue. Palantir’s forward earnings multiple is also double, at 146x, compared to 88x for CrowdStrike and 71x for ServiceNow. – YChartsYCharts

Growth investors should not forget when we saw this happen before; which was Snowflake, a Wall Street darling trading 2X more than any other cloud stock at 45X Forward PS with retail investors cheering Warren Buffet’s participation in the IPO. It currently trades at an 11.7 forward PS.

The primary question here is not whether Palantir is a strong AI stock, but will buyers continue to step-in?

Conclusion

Palantir’s Q3 report was met with quite the enthusiasm from the market, but the fundamentals must be immaculate at this valuation. RPO growth has surged over the past four quarters, while Palantir’s Rule of 40 continues to rise as adjusted operating margins expand and revenue growth accelerates. Net retention has risen to two-year highs, reaching 118% in Q3, as deal expansion continues.

However, Q4’s revenue guidance implies a larger sequential deceleration than what was expected for Q3, while US commercial net new adds continue to decline sequentially. This may sound like splitting hairs, but the company is priced far above what any peer is trading, and that typically doesn’t resolve well for tech investors.

Given the outsized valuation, the I/O Fund is looking for a lower entry in Palantir before adding the stock to our portfolio. Join the I/O Fund’s next webinar on Thursday, November 14th where Knox Ridley, Technical Analyst, will discuss the firm’s buy zones and targets for AI leaders. 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:

Chainlink: A Front Runner Among Blockchain Technologies

Posted on by io-fund

Chainlink is one of our favorite long-term plays for a ten-year holding period or more. The number of stocks our firm has held without interruption since the day we launched our site in July of 2019 is very few, not even Microsoft makes that list. But, Chainlink does.

The company is a reliable source for off-chain data across all blockchain networks and blockchain apps. Chainlink’s interoperability causes its oracle networks to be leveraged and trusted across competing blockchains. Customers that require the highest level of security, such as bank transfers, rely on Chainlink’s oracle price feeds and the other off-chain data that Chainlink supplies.

To understand the problem that Chainlink solves, it’s important to discuss the overarching issues the blockchain faces. There are three necessary tenets to a fully developed blockchain protocol: security, decentralization and scalability. This trifecta is often called the “trilemma” as blockchain technologies can typically solve for two of these problems, yet struggle to solve all three. Instead, current blockchain technologies excel at two of the three, and then must experiment to solve the third with sidechains, sharding and other nascent attempts at solving the third requirement.

The analysis below discusses how Chainlink solves some of the toughest pain points in blockchain development by enabling the third, missing pillar – whether that be security, decentralization or scalability. Because Chainlink is both middleware and a Layer 2 technology, its oracle networks are utilized across nearly all leading blockchain networks plus hundreds of applications. By offering must-have solutions early-on, Chainlink is proving it can become a frontrunner for the day when blockchain reaches critical mass.

I realize the information below can be technical, and thus I’d like to provide a 10,000 foot overview of what is being described in the deep dive.

Summary:Summary: Chainlink has the key ingredients to become a front runner in blockchain technologies because:

  • it can serve nearly all Layer 1s and Layer 2s for the ultimate addressable market
  • Chainlink’s suite of technologies solve some of the hardest problems that blockchain technologies faces today 
  • An oracle network for offchain data can form a moat — as the quality of its security and decentralization increases– it will be harder to disrupt as time goes on. Blockchain technologies will not want to take a chance on a new entrant ten years from now. I foresee a duopoly of sorts for oracle networks.
  • The finance sector has essentially adopted two blockchain technologies: Bitcoin as a store of value, and Chainlink for its ability to facilitate transfers with offchain data. Given there have been thousands of blockchain technologies, it’s clear to see front runners are being adopted by the savvy $6.4 trillion banking sector.

Section 1: How Chainlink Solves Blockchain’s Trilemma

Bitcoin’s network has prioritized security and decentralization, while sacrificing scalability. The network sends 7 transactions per second and can take up to 10 minutes to confirm a transaction. The upside is the network’s security is bullet-proof with a hash rate of 460 Exahash per second. It’s impossible today for a super computer to crack the Proof-of-Work encryption.

When you add the fact there are thousands of nodes globally, a Proof of Work system is truly decentralized whereas a Proof of Stake (PoS) system could still concentrate itself through “whales,” those who own a disproportionate amount of a single token. This results in the wealthiest crypto holders having a higher concentration in what is essentially a lottery system of validators. If a person has a thousand lottery tickets compared to a person with only ten, the person with 1,000 tickets (or nodes in this case) is more likely to be chosen to validate the ledger. This could lead to corruption and ultimately does not fit crypto’s ethos that those with a higher concentration of wealth are allowed to be more trusted and have more authority.

It’s been generally understood for some time that Ethereum has prioritized security and decentralization over scalability. Despite scalability being the primary problem Ethereum has left to solve, there are solid debates that Ethereum is not as secure or decentralized as it once was following the merge to Proof of Stake (PoS). To understand these concerns, consider that Ethereum has seen up to 70% of its supply held by whales in 2021, although the latest report is that 43% of ETH supply is held by whales. The concentration is staggering as six of the top crypto wallets have 98% of their wallets allocated to the Ethereum blockchain, according to TechCrunch.

When looking more closely at Proof of Stake (PoS) validators for Ethereum, Lido is the largest Ethereum validator at 33% stake and Coinbase is at 15%. To help illustrate how unusual this concentration is, consider that the Nakamoto Coefficient for Ethereum is 2, which means it takes only two nodes to control the blockchain. Truly, it’s beyond belief the coefficient is this low for the world’s top blockchain Layer 1. Bitcoin’s is estimated to be as high as 9601. The highest Coefficient beyond Bitcoin is 236 for a network called Humanode, and its goal is to increase the coefficient over time. The last time Solana’s was reported in 2023, it stood at a coefficient of 31.

Also consider that PoS requires 32 ETH, or about $96,000 per node, whereas Proof of Work requires a mining setup of less than $10,000. This means Ethereum is far less democratized. There was also a report in May of 2024 that one whale staked about $500 million to the network. There is also some centralization by the very fact Lido has such a large pool of validators at 33%.

Solana receives less criticism as it offers Proof of History (PoH) which offers a high throughput of 65,000 transactions per second on GPUs although other blockchain networks have a higher time to finality. Solana accomplishes this without second layers or side chains by using the Proof of History (PoH) consensus mechanism. PoH creates a historical record that proves an event has occurred at a specific moment in time. Rather than validators agreeing on a time, Solana validators maintain their own clock by encoding the time with a cryptographic hash function (SHA-256). This circumvents the need to wait for confirmation, thereby resulting in a higher throughput.

The purpose of this discussion is to say that many Layer 1s need Layer 2s or middleware to solve for the third tenet of the blockchain. For Ethereum, this is scalability (yet some critics also point toward a lack of decentralization compared to what other Layer 1s offer). What is unique about Layer 2s is the addressable market may be higher than a Layer 1, as the space is heavily fragmented with many Layer 1s competing. The very best middleware and Layer 2s can solve a critical pillar for these competing Layer 1s with little to no fragmentation.

Quick Primer on Smart Contracts

Decentralized systems require contracts if a system is to be created where all data, all messages, all token transfers, and all users are validated. Machines need contracts to offer ultimate security and decentralization as contracts ultimately allow for a revocation if a request is found to be fraudulent. In this case, the machine can shut the request down or otherwise deny the user/token transfer/data/message to move forward. The bilateral nature of contracts allows for a validation process to where nodes can determine if the action is trustworthy.

To put it simply, without contracts, trusted systems cannot truly exist as otherwise there is no penalty. This is why Web2, which is not based on smart contracts, is rife with bad actors. One centralized system can create thousands of bots, or a centralized tech company can push its agenda to the top of a newsfeed. There is no contract, and therefore, there is no revocation for unethical behavior.

Chainlink solves the critical issue of supplying trusted contractual data for smart contracts. Oracles are trusted third-parties that retrieve off-chain information and push that information to the blockchain at predetermined times. Technically, oracles introduce a potential point of failure, and this is why Chainlink’s ultimate goal is to maintain a good reputation. With a good reputation, the network effect will take care of itself since blockchain developers will be attracted to whichever oracle network is the most reliable.

Solving for Decentralization with Oracles:

Decentralization for the blockchain is achieved by having backend code on a decentralized network instead of a centralized server. Developers use a blockchain like Ethereum for data storage and use smart contracts for the app logic. The Ethereum blockchain is run off of thousands of nodes. These nodes are constantly computing the transactions within the blockchain from around the world, making it nearly impossible to hack as well as regulate.

Decentralized applications (Dapps) rely on smart contracts. Dapps deployed on the Ethereum network are controlled by logic written into the smart contract and cannot be altered by the developer. Smart contracts function like APIs (this was also discussed in the Chainlink webinar). This allows applications to build on one another similar to the way applications use APIs today; except blockchain applications build on smart contracts.

Chainlink was primarily built for off chain data for non-currency smart contracts. The principal is the same where there is a set of rules which self-execute – the more common analogy is that it operates like a vending machine to where there is no middleman. When you use a vending machine, you’re inputting a payment and terms (like pushing the buttons #D5) and the output is a bottle of water; the exchange did not require a gas station clerk. Smart contracts are similar in that terms are defined, and when those terms are met, there is an output.

The front-end application can be written in any language with calls made to the backend. The main qualities are that the applications are decentralized, can perform any action given the required resources (whereas Bitcoin is not Turing complete – more on this below) and are executed in a virtual environment such as the Ethereum Virtual Machine. The virtual machine acts as a buffer to where if the application is faulty, it does not affect the blockchain network.

Sounds great, but There’s One Problem …

The concept of decentralization sounds great in theory, yet the problem remains that even if a network is decentralized and secure, the data the applications use may not be decentralized or secure. If banks use the blockchain to drive down costs associated with money transfers, where will the banks get secure foreign exchange data that can’t be tampered with?

Where the Bitcoin protocol differs from networks like Ethereum, Solana, Cardano, Polkadot, Avalanche and others, is that the Bitcoin protocol has only one purpose – which is to transfer and store Bitcoin. Bitcoin is not intended to function like an operating system, and developers cannot develop dencentralized apps (Dapps) for the Bitcoin protocol. Due to having a single purpose, the Bitcoin protocol does not introduce or rely on off-chain data.

As we stated in our 2019 writeup, it’s the world’s most secure network, and in fact, is more secure than 10,000 banks combined. This inherent quality is a primary thesis to the investability and moat of Bitcoin:

“Bitcoin is based on the most secure network in the world, and this solves a very real need for the financial system – which cannot be automated without a decentralized blockchain solution. Technically speaking, bitcoin is also the world’s most secure financial network. The transfers eliminate 3% in processing fees and hedges against inflation. This can, and should be, worth as much as a search engine, enterprise software, a social media network, warehouse fulfillment (AMZN) or iPhone hardware.

Apple, Google, Microsoft and Amazon reached market caps of $1 trillion because their products scale to global populations and are required on a daily basis. Bitcoin not only scales to the global population but it also protects their livelihood – a necessity rather than a convenience. In fact, we see populations who are not necessarily tech savvy most enthusiastic about bitcoin, and this is a strong signal that it will scale beyond the reach of $1 trillion market cap.”

Bitcoin is very different from other blockchain networks because it’s not Turing complete, which means the Bitcoin protocol is not intended to perform computations or to solve complex problems. By limiting its functionality, Bitcoin’s protocol is highly secure. Bitcoin Script verifies transactions but is not programmable for general-purpose computations. Rather than offer scripting capabilities, Bitcoin Script offers a restricted set of operations that apply only to transactions.

The Turing incomplete design offers the ultimate security rather than seeking the functionality of a general-purpose platform. There are about 50,000 distributed Bitcoin nodes, as well, that help to verify and record transactions with a decentralized architecture.

Bitcoin’s goal is very different from Web3 technologies, and this distinction is important. Ethereum’s Solidity programming language is designed to facilitate smart contracts on the Ethereum blockchain. It’s considered “Turing Complete” as it has key features such as reading and writing to memory, branching to move the machine forward and looping to restart execution.

Yet, decentralized applications will require some data, so how can a network claim to be decentralized if the data itself is not originating from a decentralized network?Yet, decentralized applications will require some data, so how can a network claim to be decentralized if the data itself is not originating from a decentralized network?

Swift is a system used by banks and institutions for money and security transfers. Currently, 11,000 banks use SWIFT across 200 countries, and it’s the largest and most streamlined payment system for international transfers. SWIFT facilities secure and efficient communication between institutions with 45 million messages sent in 2022. The reason Swift is looking to innovate with blockchain technologies is to avoid becoming disrupted. The company charges between $15 to $50 on average for a transfer and it can take hours or days for the transfer to be completed. The security and decentralization of a blockchain network is attractive to Swift, yet there will be issues if the pricing data used by the blockchain for settlement is not accurate.

In this example, Chainlink provides a pricing oracle for Swift’s smart contracts and for many other financial applications that need accurate pricing information for settlements. The pricing information needed for foreign exchanges, cryptocurrency swaps, stock prices and other assets is sourced from decentralized data.

Oracles assist in helping blockchains use off-chain data.

Chainlink has built a decentralized oracle network (DON) that aggregates independent node operators, reliable data sources and also oracle networks for accurate, decentralized data. For example, Chainlink will determine crypto pricing by combining many sources from price data aggregators (like Coinbase and dozens of others like Coinbase), with node operators (there are hundreds), and with oracle networks like Ethereum or Solana. By aggregating many data sources and many types of data sources, the pricing feed eliminates a single source of failure.

Solving for Scale: Chainlink Securely Enables Rollups

Blockchain seeks to disrupt nearly every industry, and yet, it’s unfathomable for some investors to envision this outcome when it’s costly and slow to transfer tokens and data. Ethereum’s primary issue is scale as the Layer 1 has seen exorbitant gas fees. There was an outlandish case where someone bought a NFT for 1 ETH, or about $2600, and was charged $70,000 due to high gas fees. Yuga Labs has seen gas fees of up to $176 million for $285 million in sales prior to the merge to Proof of Stake. Gas fees are a result of Ethereum having low transactions per second (TPS) in the 20-40 transactions range. Once the limit is reached, the remaining transactions compete, resulting in higher fees.

Proof of Stake (PoS) relies on a few key technologies to drive down energy consumption, such as staking with validators for decentralization purposes, shards that break tasks into a subset, a dispersed network of nodes to increase efficient processing using the Beacon chain, and Rollups where hundreds of transfers can be rolled into a single transaction. With Rollups, the smart contract verifies all of the transfers in the Rollups. The goal is to reduce computing and storage resources by reducing the amount of data held in a transaction.

Ethereum offers ZK Rollups, or Zero-Knowledge, which we’ve covered here. However, rollups are a dedicated instance, and therefore can be customized and are interchangeable with other networks. A company called Cosmos released Rollkit and other developer tools that increase time to market for developers while seeking to lower the cost of zero-knowledge proofs.

Therefore, the development and functionality are separate from the Layer 1. This is especially attractive to enterprises that do not need a specific Layer 1 (like Ethereum) to reach scale since they already have a customer base. We touched on Coinbase using Rollups for the Base Layer 2 stating it offers “1 cent, 1 second transactions.” SAP has recently minted USDC on a Layer 2 solution with a statement it’s “getting close to that one cent cost basis.”

The Optimistic Collective developed a network and stack that Coinbase’s Base uses for its Rollups. This means that CB’s Base settles on Ethereum’s network for security purposes, yet uses the OP stack to execute Rollups outside of Ethereum. This is ideal as Coinbase can switch blockchain Layer 1s at any time. The amount of development that has occurred on Layer 2s since Rollups and the merge to PoS on Ethereum is staggering. For example, according to Chainlink, there are “approximately 48X the amount of on-chain calls from dApps to Chainlink Data Feeds over the past 12 months compared to Ethereum’s baselayer.”

Offchain Labs created a Layer 2 called Arbitrum that directly competes with CB’s Base and is currently ahead of Base on a few key metrics, although Base’s growth has been more rapid and will likely surpass Arbitrum. According to the writeup and data from Token Terminal, Arbitrum’s fees are much lower than Base, which is a distinct advantage in utility, yet Base is leading on gross profits at $30 million estimated compared to Arbitrum’s $9.5 million.

With Rollups, Chainlink’s purpose has expanded to where Chainlink nodes are used to do computations and verifications before posting a bundled transaction. This means an app built on a Layer 2 like Arbitrum or Base only has to use the main chain when necessary.

Layer 2 chains and rollups have a separate ledger, and there’s a chance a malicious actor forks a Layer 2 to create a parallel chain to mint new assets or burn assets on the Layer 1. Decentralized oracle networks like Chainlink prevent this from happening by offering Oracle Network Governance, or a trusted source, for routing upgrades to L2/Rollup chains, importing the ledger state, resolving disputes, and helps facilitate L2s that are forked.

Rollups provide an easier path to development as enterprises can avoid having to build a complex Layer 1 chain, while also providing much faster and cheaper transactions. This is ultimately a catalyst for Chainlink to become the oracle network for enterprise dApps. For example, Sony Group’s venture arm recently announced the company is using Chainlink to launch a developer platform that delivers consumer blockchain applications. Similar to Base, Sony will also use Optimism for its scaling layer, while using Chainlink for Data Feeds.

There are 200 protocols that operate on Base (and growing). Chainlink Automation allows developers to offload tasks that require high computational power to the Chainlink Network for a reduction in fees by 90%. Chainlink’s Cross-chain interoperability allows for currency and data transfers between blockchain networks, which can help with Base’s goal of having low cost, yet fast transfers.

Section 2: How Chainlink is Becoming a Blockchain Frontrunner

Here are some of the technologies that Chainlink is using today to quietly become a frontrunner in the crowded and complex Blockchain space:

Chainlink is an abstraction layer, which means it’s agnostic and works across all major chains, such as Polkadot, Avalanche, Binance Smart Chain, Polygon, Optimism, Arbitrum, and more, which eliminates vendor lock-in. This is incredibly important given how nascent the Blockchain ecosystem is, and how the rate of failure is already high and will remain high as blockchain technologies continue to mature.

Chainlink is also future-proofed, which refers to being compatible and scaling even as the blockchain is continually developed. Amazon Web Services (AWS) offers a Quickstart for Chainlink to where DevOps teams can quickly launch a Chainlink oracle node on AWS to sell real-world data. The framework is future-proofed because Chainlink continually updates the integration for data providers to sign their data and broadcast it to the blockchain. For example, NOAA hosts weather data on Google Cloud, which can then be accessed on Ethereum’s blockchain, which in turn powers crop insurance agreements.

Trust-Minimized Oracle Computation: As enterprise apps grow in complexity, Chainlink not only offers trusted off-chain data through decentralized oracle networks (DONs) but the company also offers developers a path in performing off-chain computations. These off-chain computations are gasless and as fast as native hardware. For example, if a developer wants to make a conclusion based on historical weather data, there would be multiple steps in taking the API data and performing a computation. These computations can be done on behalf of smart contracts in a trust-minimized manner. Chainlink Functions is a serverless developer platform that offers compute runtime to test, simulate and run offchain logic for Web3 apps, similar to how AWS Lambda offers serverless solutions.

Chainlink Automation: Automation uses oracle computation to run predefined conditions and to trigger smart contracts, for example, when stock or token limit orders are hit on a decentralized exchange. The decentralized network of nodes performs the off-chain computation of the contract’s logic that is then verified on-chain.

According to Chainlink, there are three key benefits to using the company’s smart contract automation. The first is that the company removes any centralized point of failure through decentralized oracle networks (DONs). Secondly, DevOps time is reduced by leveraging LINK’s Automation-compatible contract infrastructure. Third, developers enhance the security of their protocols by removing the need for centralized servers.

Secondly, rather than investing time and resources in creating scripts for on-chain monitoring and triggering smart contract execution, developers can plug into Chainlink Automation’s optimized infrastructure by simply creating an Automation-compatible contract and registering it. This saves time, reduces the DevOps workload, and allows developers to focus on writing more great code. 

Lastly, by using Chainlink Automation, developers can enhance the security of their protocol. Developers no longer have to risk exposing their own private key when initiating transactions from centralized servers—the nodes on the Chainlink Automation Network will sign on-chain transactions.

Cross-Chain Interoperability Protocol (CCIP): Blockchains are fragmented and there is too much friction in payment transfers and information exchanged between applications. Web3 must function seamlessly like Web2 to where the infrastructure (AWS, Azure, GCP), the protocols (TCP/IP, SMTP) the operating systems (Windows, Linux, MacOS, Android, iOS), the applications and the software are seamlessly working together without friction. In the majority of these cases, the user is unaware of the systems that support the user experience.

Chainlink’s CCIP sets out to solve this by providing a bridge between blockchains and DeFi applications. The protocol was launched in July of 2023 to solve the pain point of seamlessly transferring data and currencies across various blockchain networks. At launch, it was integrated with Ethereum, Avalanche, Polygon and Optimism. This allows users to use any decentralized application (dApp) on these blockchains for liquidity purposes and connectivity.

Chainlink is uniquely positioned to solve the problem of bridging blockchains and popular applications because it has built a secure oracle network. CCIP extends the idea of an oracle network, which was originally designed to on-load off-chain data, to also offer decentralized oracle computation for performance histories and to monitor for malicious activity. Off-Chain Reporting (OCR) is used to aggregate a report from many validators, which reduces congestion.

Please note: The deep dive 2023 Chainlink Update: Interoperability for Blockchains, Bullish SWIFT Partnership goes into more detail around the importance of CCIP.2023 Chainlink Update: Interoperability for Blockchains, Bullish SWIFT Partnership goes into more detail around the importance of CCIP.

Price Feeds: Chainlink Price Feeds provide smart contracts with access to financial market data. Decentralized Finance (DeFi) is a $100 billion+ market and whichever oracle network is deemed most reliable will carve a deep moat for itself. Price Feeds are used for on-chain currency transfers where a reliable token or currency amount is needed. Chainlink’s data feeds and price feeds currently secure tens of billions in value across DeFi.

Chainlink SCALE: Chainlink’s SCALE program was launched to help newer blockchains to cover the cost of decentralized oracle networks initially before decentralized apps (dApps) can cover these costs. This helps to reduce the operating costs of oracles while allowing Layer 2s to access higher volumes of data and more advanced applications. This helps to incubate apps where startup costs would otherwise be prohibitively high.

Chainlink Verifiable Random Function (VRF): Blockchain engineers use random number generation for cryptographic keys to prevent tampering. Private and public cryptographic keys are used today to encrypt and decrypt data, and are used across domain name systems (DNS), application security and zero-knowledge trust. There is a similar need for private and public cryptographic keys for blockchain applications. Chainlink VRF is the most widely adopted random number generator (RNG) in Web3, and has generated over 21 million request transactions for thousands of smart contracts.

Chainlink’s Ecosystem:

Chainlink launched on the Ethereum mainnet on May 30th, 2019. We covered the altcoin for the first time in August of 2019. Prior to launch, Chainlink signed 30 partnerships. By 2020, when we covered Chainlink a second time, total value secured (TVS) had grown from $254 million to $6.3 billion, or 23,000% growth in TVS. At crypto’s peak in Nov of 2021, Chainlink had $75 billion in total value secured across up to 1500 protocols and hundreds of DeFi applications. This has declined to $25.5 billion today and $31 billion in the past 30 days, yet the TVS from 2021 is important as it shows Chainlink is capable of securing $75 billion without a hack. As the CEO stated at SmartCon:

“Right now, the Chainlink Network has provided the most cryptographic truth in history.”

According to CoinDesk, the transaction value of data points that Chainlink has delivered on-chain stands at $15 trillion, up from $9 trillion at the start of the year. As stated, there’s been no hacks or otherwise any tokens lost through Chainlink’s secure network.

The predominant use of Chainlink is for market data for DeFi apps. DeFi apps have grown in total value locked (TVL) from $700 million in December of 2019 to more than $90 billion today. With the launch of CCIP, Chainlink can use its strong track record in securing DeFi blockchain smart contracts to expand to cross-chain smart contracts.

Update on SWIFT Partnership:

Perhaps where Chainlink is most promising in the near-term is the SWIFT Partnership as Swift facilitates $50 billion in transactions every year.

SWIFT stands for the Society for Worldwide Interbank Financial Telecommunications (SWIFT) and is the system used by banks and institutions for money and security transfers. Currently, 11,000 banks use SWIFT across 200 countries, and it’s the largest and most streamlined payment system for international transfers. SWIFT facilities secure and efficient communication between institutions with 45 million messages sent per day in 2022.

When we last covered the SWIFT partnership, a test had been completed using Chainlink’s CCIP to facilitate transactions with tokenized assets on public and private blockchains using back-end systems. This will allow financial institutions to integrate blockchain technology into the existing infrastructure. You can read more about this on Swift’s website here.

This month, it was announced the testing phase has been complete and the Swift partnership is now in the pre-production phase.

Tokenomics:

One area where critics find fault with Chainlink is the tokenomics. The monthly growth in Chainlink’s circulating supply is at 1.4% per month on average. Over the course of a year, this can dilute token holders 10 to 15%, on average.

Chainlink’s fully diluted market cap tracks 2.1X higher than its current market cap. There is a circulating supply of 568M tokens yet a max supply of 1 billion tokens.

Of the 1 billion tokens, at the initial coin offering, a little more than one-third was to go to node operators, a little more than one-third was sold in the public sale, and a little less than one-third went to the company to be held in reserves. The 350 million held at the company can be released anytime, which dilutes token holders.

When more of Chainlink’s supply is in circulation, there is likely to be stronger price action. About 63% is in circulation now, and so look for Chainlink’s price to be less volatile in 2 years if we assume the 1.4% per month rate in circulating supply continues.

Conclusion:

The blockchain is needed to decentralize information to where the global population is not dependent on Big Tech companies for data and inputs. I’ve boldly stated that if people are not concerned by this today, they are not paying attention. The internet is broken as tech companies, media companies and other corporations are full of self-interest and have proven they can’t be trusted. The internet has gatekeepers, and there is ample reason to remove these structures.

Looking beyond information from search and social media, of which there is a great dependency, there is also a dire need for the decentralization of loans, interest-bearing accounts and credit. Imagine if you could make the 20% APR that Chase makes off loaning for credit cards, yet to do so by using the blockchain for ensuring the borrower has a high credit score (or collateral) and through a smart contract to where the collateral is retrieved if the borrower does not pay you. Instead, we are offered 4% interest rates on money market accounts and CDs, and this is rare — for the past decade, it’s been as low as 0%. Finance is broken today, as it’s highly centralized and skewed in favor of a few.

There is also the upcoming need over the next decade to improve automation as machine-to-machine communication is not truly possible unless it encompasses the three tenets of the blockchain (security, decentralization, scalability). As the AI era evolves, this will become a driving force for blockchain use cases.

A Note on Crypto …

Last year, I was on a Real Vision interview where they asked me what my investment framework for crypto is and I said: “Technicals, technicals, technicals.” If you want to buy Apple or Microsoft without using technicals, and hold over a long period, that will probably work out just fine. But to participate in these extraordinary companies at an early stage, it’s of ample importance to carefully consider technicals.

We lead with technicals on crypto given it’s early-stage tech. This is different than stocks, where fundamentals lead. The good news is that crypto is sentiment driven, and so it respects price and technicals quite well when managing these positions. With that said, crypto is high risk, high reward and requires an active stance – it is not for those who are new to investing or coming to grips with the ups and downs of the market. We believe there will be extraordinary returns on Chainlink, yet there will also be extraordinary drawdowns.

Our history with Chainlink is quite good – we bought at $1.50 and trimmed in the $25 to $50 range, and then began buying again much lower in the $7 to $11 range. We plan to actively manage Chainlink moving forward. Please join Knox’s weekly webinars on Thursdays at 4:30 p.m. Eastern to hear more on how we plan to manage Chainlink, with a special emphasis this week on crypto.

Recommended Reading:

Cloudflare Q3 24: Soft Q4 Guide as Company Transitions on Billing Terms

Posted on by io-fund

Cloudflare beat on the top and bottom lines in Q3, although net retention rate softened again. The company missed on revenue expectations for Q4 with management guiding for a midpoint of $451.5 million, for growth of 24.6% compared to analyst expectations of $455.08 for growth of 25.8%. Management spoke at length about being at an inflection point for a sales organization shift, yet this felt like a speculative discussion as evidence of an inflection was not visible in the Q4 guide.

Key metrics were mixed and revenue growth is getting further away from the coveted 30% mark with a 4-point deceleration in Q4. Yet RPO and customer growth remains persistently strong.

Revenue

Cloudflare reported revenue of $430.1 million in Q3, increasing 28.2% YoY, slowing from the 30.0% YoY increase reported in Q2. Revenue growth had been expected to be steady at ~26% YoY for the next few quarters, which is quite strong for best-of-breed cloud as many >40% revenue growth cloud companies have dipped <20%.

However, Cloudflare guided to just 24.6% YoY growth in Q4, seeing revenue between $451 million and $452 million, shy of the estimate for $455.8 million. This implies a sequential deceleration of ~3.6 points.

For FY24, management slightly raised its guidance, though it seems as if the raise stemmed solely from Q3’s outperformance relative to its initial guide. Cloudflare now sees FY24 revenue of $1.661 to $1.662 billion, a raise of just $3.5 million at the midpoint from its prior view for $1.657 to $1.659 billion. Q3’s $430.1 million sum beat management’s internal guidance by ~$6.5 million, implying that it is the primary factor behind the raised guide given Q4 was a miss.

Margins

Cloudflare reported strong adjusted operating margin of 14.8%, which led to raising its adjusted operating margin guide for FY24 to 13.3%, up from last quarter’s FY24 guide of 11.9%. GAAP operating and net margins continue to make slow progress towards positive territory due to high stock-based compensation of 20.5%.

  • GAAP gross margin was 77.7%, down slightly from 77.8% in Q2 but up 1 point from 76.7% in the year ago quarter. Adjusted gross margin was 78.8%, down from 79.0% in Q2 but up slightly from 78.7% in the year ago quarter.
  • GAAP operating margin was (7.2%), improving from (8.7%) in Q2 and (11.7%) in the year ago quarter. Adjusted operating margin was 14.8% in Q3, well above the 11.9% guided and improving from 14.2% in Q2 and 12.7% in the year ago quarter.
  • For Q4, management guided adjusted operating margin of 11.9%.
  • For FY24, management guided for adjusted operating margin of 13.3%, a strong increase from 9.8% at the beginning of FY24 and its previous guide for 11.9% given in Q2. The increased guide is driven by Q2 and Q3’s outperformance, with both quarters seeing adjusted operating margin >14%.
  • GAAP net margin was (3.6%), improving slightly from (3.8%) in Q2 and (7%) in the year ago quarter. Adjusted net margin was 16.9%, falling from 17.3% in Q2 but up slightly from 16.5% in the year ago quarter.

EPS

For fiscal year 2024, Cloudflare is expected to report EPS growth of 51% YoY to $0.74. Cloudflare beat slightly on EPS in Q3, while guiding for flat QoQ growth for adjusted EPS for Q4.

Cloudflare is close to GAAP profitability yet it’s not clear given stock-based compensation when the company will tip over the edge. The stated in the investor’s presentation the long-term goal is a 20% adjusted operating margin, which implies GAAP profitability would be narrow, yet achievable. Notably, there is no firm date being provided.

  • GAAP EPS was ($0.04), flat QoQ and up from ($0.07) last year.
  • Adjusted EPS was $0.20, beating estimates and Cloudflare’s guide for $0.18. This was also flat QoQ and up 25% YoY.
  • For Q4, management guided for adjusted EPS of $0.18. For FY24, based on the slight beat in Q3, management raised its adjusted EPS guide to $0.74, up from its previous view for $0.70 to $0.71. This represents YoY growth of 51%.

Cash and Balance Sheet

Cash flow generation remained steady in the quarter as cash flow margins expanded sequentially.

  • Operating cash flow was $104.7 million in Q3, for a 20% margin. This improved from a 19% margin in both Q1 and Q2.
  • Free cash flow was $43.7 million, for an 11% margin, an improvement from 10% in Q2 and 9% in Q1. The company stated its goal is a 25% FCF margin.
  • Cash and available-for-sale securities totaled $1.824 billion while convertible notes totaled $1.286 billion.

Cloudflare’s free cash flow is especially impressive given the company has to build a bigger network and invest in GPUs for edge AI.

“Network CapEx represented 10% of revenue in the third quarter. During the quarter, we saw a notable shift in customer conversations and buying behavior from AI training to AI inference, including our first multimillion dollar workers AI contract. 

This gives us confidence to continue to increase our investment in higher-end GPUs as well as the breadth of our GPU rollout as we provision greater capacity to support demand in 2025. As. A result, we continue to expect network CapEx to increase again in the fourth quarter to reach 10% to 12% of revenue for the full year 2024.”

Key Metrics:

RPO

RPO came in at $1.53 billion for growth of 39% year-over-year and up 6% sequentially. This is higher than the year ago quarter when RPO was at 30% YoY and up 5% sequentially.

Compared to last quarter, RPO reported growth of 37% year-over-year and 6% QoQ, for 69% of total RPO, which means this was technically a stronger quarter on this key metric.

DBNRR

Cloudflare’s DBNRR dropped again in Q3, falling to 110%, compared to 112% in Q2 and 115% in Q1. Throughout 2023, DBNRR hovered around 115% and higher, so the decline over the past two quarters is important to watch. This quarter, management reiterated the decline is being driven by slower net expansion in the larger customer cohorts as they move to “pool of funds” contracts, which shifts billings from annual contracts to pool of funds accounts that are on a monthly basis for three or more years (for larger customers).

Per management again this quarter:

“Our dollar-based net retention was 110%, down 2 percentage points quarter-over-quarter. While customer churn remains consistently low, our shift to more pool of funds deals with our largest customers, which represented nearly 10% of new ACV booked in the quarter, up from 1% a year ago has put downward pressure on dollar-based net retention and change the shape of revenue recognition in the short term. 

Over the long term, however, we believe pool of fund deals are very positive for the business as they represent our largest customers making a broad commitment to Cloudflare's overall platform.”

Customers

Paying customers increased 22% YoY to 221,540, accelerating from 21% in Q2 and 17% in Q1. Management stated on the call they count 35% of the Fortune 500 as customers.

For customers with >$100K ARR, growth decelerated 2 points sequentially to 28% YoY to 3,265 customers. This cohort accounted for 67% of revenue in Q3, flat with Q2 but up from 65% last year. Management pointed out that the 28% resulted in a record addition 219 large customers, referring to the growth remaining high even on a larger base of customers.

Billings

Despite other metrics such as >$100K ARR customers and DBNRR decelerating, Billings accelerated sequentially in Q3. Billings increased 24% YoY to $447.3 million, a 1-point acceleration from 23% growth last quarter.

Earnings Call:

Net Retention Rate; New Sales Org

The tone on the earnings call was more of a “wait and see” tone about the new sales organization reaching an inflection point. On one hand, we are seeing strong total customer growth and billings inflect. Yet, on the other hand, Cloudflare is asking investors to place their trust in the company on the “pool of funds” deals that are causing a rapidly decelerating net retention rate.

What investors should keep in mind is that management is foreshadowing the mixed key metrics could last for a few quarters as current customers shift to the new billing terms: “As we mentioned last quarter, we expect new customers to contribute a higher percentage of our overall year-over-year revenue growth for the next several quarters.”

There was also a note that larger deals were pushed back, yet the miss in Q4 doesn’t inspire confidence they were pushed back only by a quarter: “However, some larger deals slipped out of the quarter in the U.S. in particular, during what was a transitional period under new sales leadership in that region. These deals are still active in our pipeline with many having already closed this quarter.”

The company discussed being at an inflection point, yet as an investor, I prefer more evidence of this with revenue growth inflecting, as well (which did not happen): “All the changes in our sales force may have impacted the short-term cadence of some larger deal cycles. What stood out to me is that the third quarter felt like we hit the inflection point in the rebuild of our go-to-market team.”

However, when pressed, management remained confident it was truly an inflection point. My best guess is the inflection will catch up to revenue perhaps by Q2 given the note it’s a few quarters out.

Timothy Horan   Oppenheimer & Co. Inc.

There's a lot of moving parts, obviously, with the sales productivity and limited capacity there in the pooling. Can you maybe talk about the timing of when revenue growth can accelerate again. Do you think the fourth quarter around 25% guide, is that the bottom? Or do you think it's still a few more quarters out? And related to this, can you update us on what you think the timing of for the $5 billion revenue target that you have? And I had a quick product follow-up.

Thomas Seifert   CFO

Yes. Thank you for the question. As we said before, for us, in our subscription business model, revenue is very much a lagging metric. Sales capacities is a product of the amount of headcount we have and the productivity progress they are making, this translates into pipeline and sales prospects, turns into ACV and then ACV is recognized ratably over the lifetime of the contract as revenue. So it's very much a lagging indicator. And as we said before, models like this, there are slow on their way down, but they're also slowing their way up. 

But the important part is, as you heard in Matthew's prepared remarks that we think we have reached this key inflection point with net sales capacity now, which is the leading growth indicator have been patent. So from there on, we expect sales activity translating the ACV moving forward and going up. And you see this already in those parts of the world where this conversion and transition has happened successfully. Revenue was up 38% already in APAC, and it was up 1% in Europe, which is our highest productivity region has been over the last several quarters. So we think we have bottomed out from a net sales capacity perspective, and move forward from there.”

Capex Spending and Edge AI

Cloudflare has offered visibility in capex spending plans as it builds out GPU-powered edge servers for AI inferencing purposes. This involves large orders of GPUs, to which Cloudflare made it quite clear they are able to work with any hardware on the market and at a high utilization rate.

Given Cloudflare may one day become a leading AI stock, discussions around the AI market are provided for future reference as we along, especially given there is no official AI revenue number being reported by Cloudflare today.

Per the company, there has been progress: “During the quarter, we saw a notable shift in customer conversations and buying behavior from AI training to AI inference, including our first multimillion dollar workers AI contract.”

Notably, there was not an update to the Workers key metric of 2.4 million developers this quarter.

The discussions around one of Cloudflare’s key value propositions was the following:

“And in order to support that, we have made the investments to increase not only just the number, but also the power of the GPUs that we're deploying around the world. What I think is unique about Cloudflare is 2 things. One, we are actually able to deliver inference incredibly close to where anyone is on earth because we've deployed the inference capabilities across at this point, nearly all of our network. 

But in addition to that, we've actually done the work to get higher utilization out of those same GPU resources where what we see when we survey customers that are trying to manage this themselves, through hyperscale public cloud is that they're getting utilization rates that are sort of in the 5% to 10% range of the resources that they're buying.

We're able to deliver much higher utilization. And in the process of that, that means that we can actually pass on the effective savings to our customers. So they not only save in not having to maintain their own team to manage these virtual machines and containers, but they also save because we can just do more with the same GPU resources that are being deployed.”

Conclusion:

Cloudflare is among the highest in terms of valuations for best-of-breed stocks at a 19.7 forward PS. Although this was a decent report with no major red flags, this valuation is not where I’d be buying the stock given the report was not a knockout. The question being considered is if we should close the position since odds are quite high we will get the stock lower.

Recommended Reading:

Cloudflare Q3 Earnings Preview: All eyes on the guide

Posted on by io-fund

Cloudflare will release its Q3 results on November 07th. Analysts expect revenue to grow 26.4% YoY to $424.12 million and adjusted EPS to grow 14.2% YoY to $0.18.

During Q2 results, management increased the FY revenue guide to $1.658 billion at the mid-point from $1.65 billion, representing YoY growth of 27.9%. The FY2024 adjusted operating margin guide was raised to 11.9% from 9.8%, up from 9.4% in 2023.

There was a survey published by Wells Fargo that stated Cloudflare is taking more market share from cybersecurity vendors. The downside is the report also stated Q3 was the weakest environment they’ve seen in three years. We need an earnings report to confirm the results of the survey, yet it’s encouraging to see NET is stronger than its peers in a spending environment that is largely outside of the company’s control.

Regarding AI, Cloudflare is uniquely positioned to capture inference at the edge. The company has grown developers on the Workers platform from 2 million to 2.4 million, for 20% QoQ growth. Companies with decent sized developer moats (Nvidia, Apple, etc) have a developer following in the 3 to 4 million range. Given the majority of the AI market is focused on training large language models at the moment, inference needs time, but there are early signs of which companies will succeed as AI matures.

Revenue

The company’s revenue is expected to grow steadily at around 26% in the next few quarters. The growth is quite strong for best-of-breed cloud as many >40% revenue growth cloud companies have dipped <20% in recent years in what has been a seismic shift in cloud. Our firm was early to report on this shift for our members. Yet, Cloudflare is one of the very few that have sustained strong growth levels.

  • Q2 revenue grew by 30% YoY to $401 million. Management guide for Q3 is $423 million to $424 million, representing a 26.2% year-over-year growth at the midpoint.
  • Analysts expect Q3 revenue to grow 26.4% YoY to $424.12 million and 25.8% YoY to $455.80 million in Q4.
  • Last quarter, management increased FY2024 revenue guide to $1.658 billion at the midpoint from $1.65 billion, representing 27.9% YoY growth.
  • Analysts expect revenue to remain steady over the next three years at 28% growth, 27.1% growth and 27.8% growth YoY through 2027.

Margins

Cloudflare showed strong improvement in operating margin and net margin in Q2. It also significantly increased the full-year adjusted operating margin guide from 9.8% to 11.9%.

  • Q2 gross margin was 77.8% compared to 75.6% in the same period last year. Adjusted gross margin was 79% compared to 77.7% in the same period last year.
  • Operating margin was (-8.7%) compared to (-18.2%) in the same period last year. Adjusted operating margin also significantly improved to 14.2% from 6.6% in the same period last year. The operating expenses were reduced due to focus on higher productivity and better efficiency in the operations.
  • Management’s adjusted operating income guide for next quarter is $50.5 million at the midpoint or 11.9% of revenue compared to $42.5 million or 12.7% of revenue in the same period last year.
  • The difference between the GAAP and non-GAAP operating margin is due to stock-based compensation which was $86 million in Q2 or 21.4% of revenue. The high level of stock-based compensation reflects what the competitive cloud industry must do to retain talent.
  • During Q2 results, management had increased the FY 2024 adjusted operating income guide from the range $160 million-$164 million or 9.8% of revenue at the mid-point to $196 million-$198 million or 11.9% of revenue at the midpoint. By doing the math, the Q4 adjusted operating income guide comes to $47.1 million or 10.4% of revenue.
  • Q2 adjusted net income was $69.5 million or 17.3% of revenue compared to $33.7 million or 10.9% of revenue in the same period last year.

EPS

Analysts have increased adjusted EPS estimates after the company raised the FY 2024 guidance to $0.70 to $0.71 from the earlier guide of $0.60 to $0.61. Management Q3 adjusted EPS guide is $0.18.

  • Analysts expect Q3 adjusted EPS to grow 14.2% YoY to $0.18 and 15.4% YoY to $0.17 for Q4.
  • Analysts expect strong growth with 2024 adjusted EPS to grow 46.1% YoY, followed by 20.5% in 2025, and 28% in 2026.

Cash Flow and Balance Sheet

The company’s cash flows are improving. Management has reiterated they expect full year free cash flow in the range of $160 million to $164 million. This is a significant improvement from the $119.5 million free cash flow in 2023 and also suggests an acceleration in the second half with estimated free cash flow of $88.1 million.

  • Q2 operating cash flow was $74.8 million or 19% of revenue compared to $64.45 million or 21% of revenue in the same period last year.
  • Q2 free cash flow was $38.3 million or 10% of revenue compared to $19.97 million or 6% of revenue in the same period last year.
  • Network capex was 6% of revenue in Q2. Management expects network capex to reach 10% to 12% of FY 2024 revenue in the 2H of the year as the company is rolling out GPUs in every location. We see setting these expectations while ultimately increasing cash flows as a positive.
  • The company had cash and available-for-sale securities of $1.757 billion and debt of $1.285 billion compared to $1.716 billion and $1.284 billion in Q1.

Key Metrics

Remaining Performance Obligations (RPO) Accel’d QoQ

RPO increased 6% sequentially and 37% YoY to $1.42 billion although it was a deceleration from 40% growth in Q1. The current RPO was 69% of total RPO.

Billings

The company primarily focuses on RPO as a more comprehensive measure of its business. We track billings since they are reported for other cybersecurity stocks. Billings grew by 23% YoY and 9% QoQ to $421.7 million, a slight deceleration from 24% growth in Q1.

DBNRR

DBNRR was 112% in Q2, a 3-percentage point deceleration from 115% in Q1. The CEO stated the decline was driven by slower net expansion in the larger customer cohorts and an increase in “pool of funds” contracts. The pool of funds contracts is a transition in billing from annual contracts to pool of funds accounts that are on a monthly basis for three or more years. The pool of funds accounts are unique to the largest customers (for example, 4 of the top 10 customers are this account type) that use many products across the entire Cloudflare platform. These are considered larger platform deals that are paid on a monthly basis in a multi-year contract rather than an annual contract on one product. This is shifting how DBNRR and RPO are reported since revenue is recognized as the customer consumes the service.

Customers and Workers AI platform

Paying customers grew by 21% YoY to 210,166 and accelerated from 17% in Q1. For customers with an ARR of >$100K, Cloudflare reported 30% YoY growth to 3,046. This customer cohort contributed 67% of revenue, flat with Q1 yet up from 64% in the year ago quarter.

Cloudflare Worker Applications grew from 2M developers to 2.4M developers in four months, per the CEO’s opening remarks. The Workers AI Platform developer accounts grew 67% QoQ and inference requests grew 700% QoQ.

Other key point to watch

Customer Wins

Wells Fargo noted that the Q3 security reseller survey was the weakest in the last three years. However, Cloudflare’s survey results showed a strong uptick. “Cloudflare's (NET) results significantly up ticked to +31% net (-9% last qtr), as resellers noted strong overall demand trends for the full suite, including SASE, CDN, and cloud security.” This data point is not meant to make an earnings call, rather we will look for management to confirm the results of Q3.

Management mentioned in the last earnings call that the go-to-market initiatives are reaping rewards. The company also delivered another quarter of double-digit year-over-year increase in sales productivity during the second quarter, and saw an uptick in close rates, and an improved sales cycle.

The management also announced several large customer wins, and the notable one was the land & expand customer, who was a free customer: “A leading Australian technology company expanded their relationship with Cloudflare, signing a two-year $17.5 million contract, $7.2 million of which is expansion. They started with Cloudflare back in 2016 as a free customer and today use nearly all our products spanning use cases as diverse as remote application access, worker serverless development and bot management.”

Another prominent U.S. university signed a five-year $5.7 million contract. With Cloudflare, they were “able to replace multiple legacy vendors with a unified platform and cloud-first architecture.”

Valuation

Cloudflare is trading at a P/S ratio of 20.04 and a fwd P/S ratio of 18.06 and is trading below its five-year average P/S ratio of 32.67. Cloud has seen a re-rating, so the multi-year averages are not reliable in the current macro backdrop.

Conclusion

Given CrowdStrike has stumbled recently, Cloudflare has emerged as the leading best-of-breed cybersecurity stock. Although not GAAP profitable yet, the company saw a slim (3.8%) net margin in the last quarter, which puts GAAP profitability on the horizon. In the meantime, the company is improving its margins and cash flows, putting investor concerns to rest about capex, and is quietly sitting on one of the biggest developer ecosystems in the market with a fairly frictionless path to onboard the Workers AI platform once the inference market takes off.

We continue to watch Cloudflare’s report with anticipation as the company is firing on many cylinders. We are participating in the event Cloudflare beats, and we also have a trading plan in mind should we be able to get shares lower.

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

Recommended Reading:

AOSL Q1 2025: Foreshadowing Consumer Weakness

Posted on by io-fund

This quarter, Alpha and Omega reported a beat in Q1, yet gross margins are contracting due to eroding average sales prices (ASPs). AOSL guided Q2 below consensus with further margin pressures for both gross and operating margin. The commentary implies a weak Q4, one that is weaker this year than it was last year, despite 2024 largely being an expected rebound year.

Regarding AOSL’s partners, it seems that AMD’s beat on desktop is flowing through to AOSL, with management stating desktop helped offset laptop weakness. Although there is bound to be progress in the graphic cards and AI accelerator cards eventually, the emerging AI use case is less clear in this quarter as these both took “a pause before the next platform transition.”

Our firm is weighing sitting a quarter or two out on AOSL, but it’s worth noting management reiterated the bullish comment about bill-of-materials expected to increase from $5 to $6 for MOSFETS to up to $20 for the MOSFETs powering GPUs.

This and more is detailed below.

Revenue

Due to consumer weakness, AOSL missed revenue guidance for the December quarter. The company was expected to report 6.3% growth for revenue of $175.7 million, and is instead guiding for 2.8% growth for revenue of $170 million. This was more than $5 million below the analyst estimates.

This quarter ending in September, AOSL reported $181.9 million in revenue in fiscal Q1, up 0.7% YoY and ahead of expectations by $1.3 million. AOSL reported YoY growth in the quarter despite expectations for a marginal YoY decline.

The miss for next quarter is primarily due to an erosion in average sales prices, as the CFO stated: “During the quarter, we did see increased pricing pressure. I mean, I guess this is a reflection of softer overall market recovery. Competitors impacted by inventory correction and demand slowdown, especially in automotive and industrial. They're shifting more toward consumer-related markets to fill their fabs.

So we see increased competition from all players, large or small. Right now, I mean, the ASP erosion for this year is more trending toward high single-digits annual erosion versus typical mid to high single-digits. Here, what we want to do is to accelerate our new product rollout to counter the ASP erosion. So that has been what we have been doing all along the years.”

Looking forward, AOSL seemed to imply that it would be more of a calendar Q2 turnaround with comments that they lack visibility into 2025 (which is not exactly encouraging): “At this point, our visibility into 2025 is limited and the calendar first quarter of 2025 is typically seasonally soft as well.”

Margins

Q1’s report missed on the guided gross margin and guided adjusted gross margin, at the midpoint. Management is also guiding for further contraction on gross margin next quarter and also a contraction on the operating margin next quarter. As stated above, the weaker gross margin is due to lower average sales prices.

  • GAAP gross margin was 24.5%, slightly below guidance for 25% at midpoint and contracting 120 bp QoQ and 370 bp YoY. Adjusted gross margin was 25.5%, below guidance for 26.4%, and contracting 90 bp QoQ and 330 bp YoY. Management said the contraction in adjusted gross margin was “mainly impacted by ASP erosion and mix changes.”
  • GAAP operating margin was (0.1%), improving from (0.9%) last quarter and ahead of guidance for (1.1%); however, this was a 530 bp YoY contraction from 5.2% in Q1 FY2024. Adjusted operating margin was 4.4%, improving from 2.0% last quarter but contracting from 6.2% in the year ago quarter.
  • GAAP net margin was (1.4%), improving from (1.7%) last quarter but down from 3.2% in the year ago quarter. Adjusted net margin was 3.5%, improving from 1.6% last quarter but down from 5.5% in the year ago quarter.

Looking ahead, management forecast pressure on margins across the board in Q2:

  • GAAP gross margin was guided at 24.0%, +/- 1%, for a 50 bp QoQ and 260 bp YoY contraction. Adjusted gross margin was guided at 25.0%, +/- 1%, for a 50 bp QoQ and 300 bp YoY contraction.
  • Based on operating expenses guidance, GAAP operating margin is expected to be (2.5%), down 240 bp QoQ and 180 bp YoY. Adjusted operating margin is expected to be 2.2%, down 220 bp QoQ and 290 bp YoY.

EPS

Given the margin weakness, AOSL slightly missed EPS expectations.

  • Adjusted EPS of $0.21 missed expectations by $0.01.
  • For Q2, analyst estimates were at $0.21 heading in to Q1’s report, but given the below-consensus revenue guide and forecast for margin contractions at the gross and operating level, it’s likely that Q2 adjusted EPS estimates will be revised downward in the coming days.
  • GAAP EPS of ($0.09) missed estimates of ($0.02).

Cash and Balance Sheet

Operating cash flow remained strong despite weaker margins, while cash on hand was relatively unchanged QoQ.

  • Operating cash flow was $11.0 million, down (20%) YoY but up 55% QoQ. OCF margin was 6.0%, down from 7.7% in Q1 FY2024 but up from 4.4% last quarter.
  • Free cash flow was ~$4.3 million, for a FCF margin of 2.4%, versus 0.7% in the year ago quarter and (0.1%) last quarter.
  • Cash and equivalents totaled $176.0 million.
  • Debt totaled $35.5 million.
  • Net inventory decreased by $10.8 million QoQ to ~$184.7 million.

Key Segments

Computing

Computing revenue increased 8.6% YoY and 6.6% QoQ to ~$76.3 million. This marked a dramatic deceleration from 37.6% growth Q4, despite coming against a rather weak comp of (21.2%) YoY in Q1 FY2024.

Management said the company “saw relative strength from PC desktops, notebooks, and servers, which was offset by softer graphics and A.I.- accelerator cards due to a pause before the next platform transition.” Reading between the lines suggests that this is another reference to Nvidia’s Blackwell platform, ahead of its launch; however, it is a bit odd to see some softness given the channel checks we have imply very strong demand for Blackwell.

Management further added that their “backlog for both graphics cards and A.I. accelerator cards is now growing due to the new platform transition,” and they expect BOM (bill-of-material) content “to increase as more power stage ICs, paired with our controller, are being used to power the GPU.”

For the December quarter, AOSL guided to slight sequential growth due to “share gains in desktops, as well as strength in graphics cards and servers,” while seasonal slowdowns were expected in PCs, notebooks, and tablets.

Management also hinted at some larger announcements next quarter, saying “we are collaborating with customers on larger data center opportunities slated for 2025. We anticipate having more to talk about with these developments during our next earnings report.”

Consumer

Consumer revenue increased 2.0% YoY and 12.4% QoQ to ~$31.7 million. While this marked a return to growth in the segment, it may be short lived, with management forecasting a near (30%) sequential decline in Q2.

For Q1, management said that the results “were in-line with our forecast for low double digit sequential growth and were primarily driven by gaming, wearables, and TVs, offset by a decline in home appliances.” Given the strength in gaming, management believes that the inventory correction has passed, but demand and “meaningful growth” may not arise until the next platform transition. Management also said wearables “were a notable standout” in Q1.

Looking ahead to the December quarter, as previously mentioned, management forecast a nearly (30%) QoQ decline due to seasonal gaming and TV declines, alongside softness in home appliances.

Communications

Communications revenue rose 14.2% YoY and 29.4% QoQ to ~$35.5 million, ahead of expectations for double-digit QoQ growth as its Tier-1 US smartphone customer geared up for a new product launch, alongside “strong sequential growth from China OEMs.”

For Q2, management expects “a low double-digit sequential decline in the December quarter due to seasonality and overall limited visibility on smartphone sell through heading into next year.”

Power Supply and Industrial

Power Supply and Industrial revenue declined (23.7%) YoY but rose 15.6% QoQ to ~$31.8 million, driven by “seasonal strength in AC-DC power supplies and quick chargers.”

Looking ahead, management expects the segment “to grow low single digits sequentially primarily driven by e-mobility and continued growth from quick chargers,” with more opportunities ahead in 2025 for quick chargers “due to increased BOM content driven by higher charging currents.”

Earnings Call:

AI Accelerator Card Opportunity

Given we may step aside from the position until roughly Q2 time frame, it’s important to reiterate the bigger picture for AOSL. When an analyst asked about the dollar content across its socket opportunities, the CEO answered the following:

“[…] In general, I think you've heard us talking more about selling total solutions and this is one evidence of that happening in the market now and we can sell both the controller as well as the power stages. And in this case, in terms of BOM content, it's going to grow from what used to be maybe around $5 to $6. It can — and then going to the next platform, it can range anywhere from $7 to $15 to maybe even over $20 a content, depending upon the number the power or the level of the GPU being paired with.”

Guiding Below Seasonality for Consumer:

Although management referred to the QoQ decline as seasonal in the Consumer segment, there was a question on the call that pointed toward it being steeper than seasonal. Last year, the September quarter matched this quarter at about $31 million in revenue, yet the QoQ decline into December is steeper for 2024 than it was for 2023. This year’s QoQ decline is expected to be (30%) compared to last year’s at (24.4%). This especially matters considering 2024 was largely expected to improve for Consumer facing semiconductors.

Here was the question on the call – since the puts and takes here are critical to the stock, I’m including the full excerpt:

David Williams

Great. Just wanted to ask too on the seasonality. It looks like you're guiding down just a bit more than seasonality. Is it fair to assume that, maybe we're back to a place that we can expect kind of seasonal trends here, or is there still enough volatility out there that you think is too early to call?

Stephen Chang

I think for the standout markets that we've been in Computing and Consumer, that seasonal pattern has returned. But at the same time, the full recovery, especially for PCs hasn't come yet. We're still waiting for PC shipments to grow, I guess, for the replenishment cycles to come back again. Therefore, at least for the last few years, after the inventory correction of the previous year, right now, we're just waiting for the PC shipments to be able to grow more.

That said, we are not standing still and even in those in the PC markets, we're seeking to gain more BOM content as we sell more of a total solution going into that application. We do think that seasonally, yes, it's going to go through that cycle, where the September quarter is typically the peak because of back-to-school and the holiday seasons.

And then going into the March quarter is probably more of a trough when it comes to the PC shipments, but that should come back up again and going into the following year. We're hoping that, to be able to layer that in especially with our advances in the graphics card and AI-accelerator card side that can help to fill in the gap and layer in on top of what we see as our base business.

Conclusion:

There was an anticipated Consumer rebound this year, that according to management teams, is not materializing. AOSL is one of quite a few in the Consumer-facing supply chain saying we can’t meet analyst expectations. Apple also missed its Q4 guide at the midpoint, guiding for “low to mid-single digits” which implies lower than the 7% YoY growth analysts expected.

As you know, the I/O Fund leans cautious for the moment with cash as our largest position, which is not to say we aren’t bullish in the medium-term — but rather, the risk/reward for an all-tech portfolio is not where it was a year ago. Apparently, having a large cash position is popular at the moment.

We’ve had a stop in place for AOSL at $31.50 and the stock is trading a penny below that price in the after-hours. If the stock remains below this level, expect us to trim or exit depending on the price action. In terms of timing on our re-entry, we foresee this matching when we resume buying Nvidia, AMD, Broadcom, TSM and some of the other AI bellwethers.

Recommended Reading:

AOSL Q1 FY2025 Pre-Earnings: Looking for Growth in December from Key Customers

Posted on by io-fund

Alpha & Omega Semiconductor will release its Q1 FY2025 results today. AOSL is expected to become a new GB200 supplier for Nvidia and to start shipments by the end of this year. Although AOSL does not call out Nvidia specifically on the earnings call, the announcement in June helps us infer that it’s likely Nvidia being spoken about on the call. The other catalyst is AOSL tie-ins to Intel’s Meteor Lake CPU and possible launch on its upcoming Panther Lake platform, as well as its position in development stages for AMD’s FP11 platform, positioning it for strong growth in this space.

Analysts expect FQ1 revenue to decline (-0.3%) YoY to $180.07 million, before it accelerates to 6.3% YoY growth in the December quarter, and further accelerates to 14.7% in the March quarter. Alpha and Omega’s four key segments recorded sequential growth in FQ4, with management saying this “broad-based” rebound “confirmed the inventory correction is largely complete.” They noted that PCs are “taking longer to recover than originally expected,” though sequential growth is still expected in the September quarter due to seasonal strength. Management has guided sequential growth in the four key segments for FQ1.

Revenue

Positive revenue growth is likely from the December quarter as inventory corrections are largely resolved.

  • FQ4 revenue declined by (-0.1%) YoY to $161.3 million. However, it was up 7.5% sequentially, with key segments growing sequentially. Management said that in Q4, they “saw relative strength coming from gaming, tablets, e-mobility, A.I., and home appliances, while the PC segment is taking longer to recover.”
  • Analysts expect FQ1 revenue to decline (-0.3%) YoY to $180.07 million and accelerate to 6.3% YoY growth to $175.67 million in FQ2 and 14.7% to $172.13 million in FQ3.

Stephen Chang, CEO, said in the earnings call, “Looking into the September quarter, we expect PCs and servers to grow sequentially while tablets sustain the strong current run rate within Computing. The Consumer segment will likely see continued strength in gaming and a strong seasonal pick up from wearables, offset by slower home appliances. Smartphones will drive sequential growth in Communication, while AC-DC power supplies and quick chargers are relatively stronger in Industrial.”

  • Analysts expect FY2025 revenue to grow 8% YoY to $709.53 million.
  • For FY2026, analysts expect revenue to grow 10.1% YoY to $781.33 million.

Margins

As FY2025 progresses, management expects margin improvement with higher revenue, better product mix, and higher factory utilization. Margins are contracting, and this is one reason we consider AOSL a momentum stock for now.

  • FQ4 gross margin was 25.7% compared to 27.6% in the same period last year and 23.7% in FQ3. Management guide for next quarter is 25%.
  • Adjusted gross margin was 26.4% compared to 28.5% in the same period last year and 25.2% in FQ3, the sequential improvement was primarily due to improved factory utilization. Management’s adjusted gross margin guide for next quarter is 26.4% compared to 28.8% in the same period last year.
  • FQ4’s operating margin was (-0.9%) compared to 1.6% in the same period last year. Management guide for the next quarter is (-1.1%).
  • Adjusted operating margin was 2% compared to 4.3% in the same period last year. Management guide for next quarter is 4.2% compared to 6.2% in the same period last year.

Yifan Liang, CFO said in the earnings call Q&A, “As you know, our September quarter's margin guidance, we guided a flattish than quarter-over-quarter. This is mainly because we expect similar quarter-over-quarter factory utilization and we plan to consume some inventories and reduce inventory balance in the September quarter. So other factors impacting the margin, like product mix and ASP erosion that we expect they're similar to the June quarter. So overall, we expect a flattish margin quarter-over-quarter for the September quarter.

So going forward, yes, I mean, I would expect and as we grow our revenue and then our product mix will continue to improve and then factory utilization will be higher. So those factors will be contributing to our margin improvement.”

  • Net loss was (-$2.7 million) or (-1.7%) of revenue compared to (-$1.1 million) or (-0.7%) of revenue in the same period last year. Adjusted net income was $2.6 million or 1.6% of revenue compared to $5.7 million or 3.5% of revenue in the same period last year.

EPS

The adjusted EPS estimates have been revised up from the estimates at the beginning of August, except for FY2026 adjusted EPS, which has been revised down from $1.51 to $1.28.

  • FQ4 adjusted EPS was $0.09 compared to $0.19 in the same period last year.
  • Analysts expect FQ1 adjusted EPS to be down (-33.3%) YoY to $0.22 and down (-13.9%) YoY to $0.21 in FQ2. However, these are higher than the estimates of $0.19 for FQ1 and $0.18 for FQ2 as of August 01st.
  • Analysts expect FY2025 ending June adjusted EPS to grow 24.7% YoY to $0.77.
  • For FY2026, they expect to grow 65.1% YoY to $1.28.

Cash Flow and Balance Sheet

The cash flow of this company (and most small caps) needs to be watched closely.

  • FQ4 operating cash flow was $7.1 million or 4.4% of revenue compared to (-17.5%) of revenue in the same period last year. Repayment of customer deposits was $4.5 million in FQ4, and management expects to refund about $8.4 million in FQ1.
  • Free cash outflow was (-$0.21 million) or (-0.1%) of revenue compared to (-29.3%) in the same period last year. Capex was $7.2 million in FQ4, and the management has guided $6 million to $8 million for FQ1.
  • Inventories were $195.8 million compared to $198.1 million in FQ3.
  • Cash was $175.1 million and debt of $38.36 million compared to $174.4 million and $41.2 million in FQ3. The company repaid $3.1 million of debt in FQ4.

Key Segments

Computing

Computing segment grew by 37.6% YoY and 4.4% QoQ to $71.6 million. Management said they saw “relative strength from tablets, A.I, and graphics cards in the quarter, offset by a slower PC market recovery. Notably, tablet revenue was a record high, and the contribution from A.I. and datacenter related applications continued to grow.” However, management said that the revenue was “slightly below our original expectation for mid-to-upper single digit growth,” primarily impacted by PCs.

Alpha and Omega expect FQ1 to see mid-single digit QoQ growth on a seasonal PC pickup, combined with strength from tablets, graphics cards, and AI accelerators. CEO Stephen Chang shed more light on some of the opportunities ahead: “We are working on multiple opportunities leveraging our existing relationship with a key graphics card maker, as well as our product portfolio including new multiphase Vcore controllers and power stage solutions for advanced computing. We are also seeing some ramp in September from a leading power supply maker that is a key supplier to the same A.I./graphics customer.”

Consumer

Consumer revenue declined (-35.5%) YoY but rebounded 19.7% QoQ to $28.2 million, as the segment looks to have marked a bottom in Q2. Management said it “is now clear that the inventory correction in gaming is behind us and a seasonal build is underway.”

Management guide: “For the September quarter, we forecast low double-digit sequential growth in the Consumer segment driven by strong seasonal pickup from wearables and continued strength in gaming, offset by slower home appliances.”

Communications

Communications segment revenue grew by 59% YoY and 2.1% QoQ to $27.4 million, driven by the “seasonal pick-up from a Tier 1 U.S. smartphone customer, offset by sequential declines from Korea and China OEMs.”

Management expects double-digit sequential growth in FQ1. “Looking ahead, we anticipate double-digit sequential growth in the September quarter on seasonal strength ahead of new smartphone launches in the U.S and increasing demand from China smartphone OEMs. We are benefitting from a mix shift to more premium phones and we anticipate rising growth in BOM content as phone makers increase battery charging currents.”

Power Supply and Industrial

Power Supply and Industrial revenue was down (-33.7%); however, it was up 11.3% sequentially to $27.6 million. The sequential growth was “driven by strength in the e-mobility segment for e-bikes and e-scooters and DC fans for applications in areas such as datacenters. The inventory correction in quick chargers appears complete as we also saw the beginnings of recovery in the June quarter.”

For FQ1, management expects the segment to grow sequentially 15-20% “primarily driven by a solid uptick from quick chargers, as well as strength from AC-DC power supplies tied to the seasonal build in PCs.”

Other Key Points to Watch

GB200 Supplier:

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

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

Margins

We want to see margins improve in the coming quarters. During the FQ4 earnings call Q&A, management reiterated its mid-term target of above 30% non-GAAP gross margin with a target revenue goal of $1 billion. The adjusted gross margin was 30.2% for the FY2023 ending June and dropped to 27.2% for the FY2024 due to the continued inventory correction. Management confirmed during the FQ4 results that the “inventory correction is largely complete.”

David Williams (Analyst)

“Okay. Yes, that's really a great color. If I could just ask one last thing, kind of just thinking about how margins are going to change as your business kind of picks up into this new realm, are we going to see normalization back to kind of like historic peaks at around 30-ish, or is this sort of the new normal now with 25 to 28 kind of extending forward?

Stephen Chang (Executive)

Yes, I mean, our overall midterm target model is still above 30% non-GAAP gross margin with a target revenue goal of $1 billion. So that model will still stay. So we believe in the — when we continue to grow, then incremental business, we expect we can bring in the better product mix. So that would help us improve the gross margin gradually. Also, those incremental business would help us increase our utilization at factories.”

Valuation

The company is trading at a forward P/E ratio of 42.8. The P/S ratio peaked in March 2022 when the quarterly revenue was close to $200 million, GAAP profitable, and before the PC inventory correction. The current P/S ratio is 1.45, and the forward P/S ratio is 1.35. It is trading above the five-year average P/S ratio of 1.2.

Conclusion

AOSL is a momentum stock in which we are using technical analysis to the fullest, and we plan to follow our stops. Our goal is to participate in opportunities where small-cap suppliers expand their serviceable addressable market (SAM) as AI systems increase in complexity. However, given the weakness we’ve seen in SMH, it could be a tall order for AOSL to overcome the selloff we’ve seen in the larger semis. But we also want to give AOSL an opportunity to report any progress from key customers. Therefore, anything is possible following the earnings call – we could close the position or add to it.

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

Recommended Reading:

Bitcoin Bull Market Intact as Risk Increases

Posted on by io-fund

In December of 2022, when Bitcoin was trading around $17,000, we boldly stated that “Bitcoin is a buy.” At the time, we were beginning to position for a new Bitcoin bull cycle.  We even posted a chart in this report entitled “Bitcoin’s Upcoming Rally – What You Need to Know,” showing our targets for the coming bull market of $75,000 – $132,000, shown below.

A chart illustrating Bitcoin’s potential bull market price targets of $75,000 to $132,000, referencing a December 2022 statement that “Bitcoin is a buy” when it was trading around $17,000.

This was an unpopular report at the time, as Bitcoin was down nearly 80% from the 2021 highs, and was coming off the heels of a crypto panic following the FTX scandal. Over 1 year later in March of 2024, Bitcoin did indeed hit $73,757 — just shy of our lower target.

With tech stocks, we offer fundamental analysis to identify what to buy, and then we use technical analysis as a supplement for gauging sentiment and risk. However, with Bitcoin, there is no management team, earnings calls, and minimal news events. For this reason, we lean heavily into technical analysis and on-chain analysis to guide our position management.

These techniques are what we used to call the 2022 low as well as the accurate upper targets a year in advance. These same techniques were used when we increased our upper targets to $106,000 – $190,000 in our April of 2024 report.

We believe these targets are attainable, which is supported by the updated technical analysis as well as the on-chain analysis below. However, the correction that started in March of this year was simply too long in time, and has led to us adjusting our targets. We are also adjusting our game plan for the sake of risk management and will look to reduce our crypto exposure by ~50% on the next push to all-time highs (ATHs), locking in well-deserved gains. We will then revisit buying back once we get more information on the following consolidation.

Technical Analysis

Since 2019, we have repeatedly presented to our Premium Members that we are in a large degree uptrend that started in late 2018. This uptrend is taking the shape of a standard 5-wave pattern, which is one of the reasons we were calling for a low in 2022.

In our December 2022 report, we stated…

“As of now, since the 2018 low, we only have 4 waves in place, which implies that we have one more 5th wave push before the larger bull cycle is over.”

As bad as it felt, this made the recent bear market a correction within a larger uptrend. We simply did not have a full 5 waves in place, and until we saw a 5th wave push to new highs, the pattern remained incomplete.  We are currently in that final 5th wave of this nearly 7-year uptrend. That being said, we still see the potential for another +50% – 90% move higher in the coming months.

A chart depicting Bitcoin’s market trend, showing a correction within a larger uptrend and highlighting the current final 5th wave of a nearly 7-year uptrend.

Source: I/O Fund

The below is our price analysis on this final 5th wave that started in November of 2022. It is also unfolding as a standard 5-wave pattern, and is incomplete until we push to new all-time highs. We stated this in our April 2024 report, which we used to buy this dip.

“We are in a large 5 wave pattern, which is targeting well above $100,000. It is an incomplete pattern, and needs 2 more large swings higher to complete the full 5 waves. Like with all 5 wave patterns, we have bought on each dip, and continue to buy as long as we stay above critical support.”

As stated earlier, the correction this year was simply too long in time to not adjust our prior price targets. While we still believe Bitcoin can go well into the $100,000 region, we will take a more active stance going forward to protect our gains.

Updated Bitcoin Targets

Our updated target for this next push higher is between $82,000 – $106,000. There are now two scenarios that we are tracking, which will determine our risk management:

  • Red – We push into the $82,000 – $106,000 region, completing the minimum number of waves required within this bull cycle. This will end the large degree bull market that started in 2018.
  • Green – After pushing into the $82,000 – $106,000 region, instead of topping in the 5th wave, we are topping in the 3rd wave. We then see another multi-week to multi-month correction that holds over $41,156 – $47,750, which eventually leads to the final 5th wave taking us well into the $132,000 – $190,000 region.
A chart analyzing Bitcoin’s final 5th wave, starting in November 2022, showing an incomplete 5-wave pattern targeting above $100,000 and emphasizing dip buying while maintaining critical support.

Source: I/O Fund

We do believe the next breakout will likely be limited, and that another correction will soon follow. To support this, note when price went vertical in February, which was met with max volume and max momentum. This is what 3rd waves look like. It is the part of the trend where everyone realizes, at once, the direction of the market. This leads to shorts covering, and longs buying more, putting everyone on the same side of the market.

The common characteristic of a 5th wave, which is the final swing in a trend, is that price makes one more high, but on less volume and lower momentum. From a sentiment perspective, the start of a 4th wave consolidation is when smart money exits. The 5th wave tends to happen when investors that are late, want to get exposure to what is believed to be a continuation of the trend. This explains why price goes higher with reduced buyers and weaker momentum.

Note these patterns in play in the chart above. We are clearly in a 5th wave, which will give way to more volatility when it completes.

Confirmation of 5th Wave Targets

To further support our new targets, the pattern of this new swing is also pointing to the same region. If we zoom in on the current bounce we are in, it is taking the shape of an ending diagonal pattern. This pattern only shows up at the end of a move, which fits with us being in some type of a 5th wave.

An ending diagonal consists of 5 waves with large overlaps. The 3rd wave is targeting $74,000 – $82,000, and the final 5th wave is targeting the $82,000 – $106,000 region. As long as any volatility stays above $60,800 – $58,800, I expect us to push into these targets.

A chart of Bitcoin showing a potential breakout and correction, highlighting the final 5th wave’s lower volume and momentum, with an ending diagonal pattern targeting $74,000 - $106,000 if volatility stays above $60,800 - $58,800.

Source: I/O Fund

As of now, we have provided 13 buy alerts to our premium members at the $17,000, $26,000, $33,000, $40,000, $55,000 and $62,000 regions. These unrealized gains range from +300% to 15%, based on our buy alerts. Our game plan is to reduce risk, take well deserved gains on this next push higher. Once we approach these upper targets, we will enter distribution mode.  We will then analyze the next pullback to determine if the more bullish scenario in green is likely to play out. If so, we will add back at levels that are lower risk.

On-Chain Analysis

For those that are not familiar with on-chain data, it offers a unique type of fundamental analysis within crypto and is a relatively new field of study. We partnered with WealthUmbrella, a team of machine learning engineers and professors, to provide this level of analysis within the crypto space. The below was provided to us by Vincent Duchaine, the CEO of WeathUmbrella, and interestingly, they are arriving at the same general conclusions as our technical analysis.

The current imbalance between supply and demand is favorable for a sustained uptrend. This was one of the thematic catalysts that we believed would propel Bitcoin over $100,000, and it is still playing out today. If you look at the ETF flows over the last several weeks, we are seeing buyers move back into the ETFs, creating positive flows.

An analysis of on-chain data showing a favorable supply-demand imbalance for Bitcoin, supported by Vincent Duchaine of WealthUmbrella, with positive ETF flows indicating a potential uptrend above $100,000.

Source: The Block

This is further backed up by the amount of newly created addresses on the blockchain with a non-zero starting balance. This metric has also been consistently on the rise over the last 2 months. It is suggesting that new investors are becoming interested in Bitcoin, which increases also demand.

A metric showing an increase in newly created blockchain addresses with non-zero balances, indicating rising interest from new Bitcoin investors and increased demand.

Source: WealthUmbrella

The above data supports a renewed interest in Bitcoin, as demand from new investors is back on the rise. What we like to see along with this pattern is the behavior of the long-term Bitcoin investors (hodlers). We can measure behavior by analyzing the percentage of Bitcoins that have not moved in over a year, which we call our 1-Year HODL percentage indicator.

A 1-Year HODL percentage indicator showing the proportion of Bitcoin that hasn’t moved in over a year, reflecting renewed interest from long-term investors.

Source: WealthUmbrella

As demand increases at a greater rate than the supply of Bitcoin, we expect price to continue to rise. The above trends should also continue as price increases, which is typically what we see at the onset of a fresh Bitcoin rally.

Regarding where we see this rally going, we first need to see a price candle close above the current all-time highs. The history of Bitcoin tells us that once we accomplish this, we typically see Bitcoin in price discovery mode for at least a few weeks before going into a consolidation or a pullback.

The March high was an exception. Even though we closed above all-time highs in March, this was accompanied with very rare overbought signals that tends to precede a correction. Today, all our metrics have been reset due to the length of the recent correction, which further supports a rally.

For example, one of our primary metrics for gauging cyclical tops/bottoms in Bitcoin, our Metcalfe's Law discount/premium model, was at 3.3 standard deviations around the ATH in March 2024.  This is a reading only seen at prior cyclical tops, and warranted caution. Today, this same model is at only 0.2 today, which is consistent with meaningful lows within on-going uptrends.

A chart comparing Bitcoin’s Metcalfe’s Law discount/premium model, highlighting a previous reading of 3.3 standard deviations at the March 2024 all-time high and the current reading of 0.2, suggesting a potential low in an uptrend.

Source: WealthUmbrella

For reference, the last time this indicator was at such a value was in October 2023 when Bitcoin was at $28K. This allowed Bitcoin to reach $45K, a 60% move, before consolidating.

As Bitcoin's market cap increases, investors should not expect the same % moves when it was much smaller. However, if we were to move higher in only the absolute value from the last time we saw this metric at a similar support, we would see a ~$16,000 increase in price, which would bring Bitcoin to around $80,000.

This doesn't mean that Bitcoin will stop at this conservative target, as the move to $45,000 last year was then followed by a move to $73,000 after some consolidation. If Bitcoin were to move by the same percentage, this would bring price to around $115,000, a price we believe Bitcoin will someday reach, but not necessarily as soon as the current rally.

This lines up with the technical analysis presented – a high probability rally that will likely fall below the $100,000 mark. If our on-chain analysis had to lean in one direction with what we are seeing now, it would support the green scenario outlined above. In other words, we should see another period of consolidation before pushing well into the $100,000 region.

According to our Cyclical Top Indicator, we are still quite early this next leg higher. One of the projects we spent an enormous amount of time on was creating cyclical top and bottom indicators that will give a normalized reading across each cycle. Our bottom indicator has already proven to be quite accurate in calling the November 2022 bottom.

An overview of the Cyclical Top Indicator for Bitcoin, indicating that the market is still early in the next upward leg, with a note on the accuracy of the bottom indicator in identifying the November 2022 low.

Source: WealthUmbrella

We expect the same with our Cyclical Top Indicator, which is shown below. At this moment, even though we are pushing toward new all-time highs, all our top indicators remain depressed. So, even with a push into the $80,000 – $100,000 range in the coming rally, this indicator will still leave ample room for a prolonged uptrend to continue.

A chart of the Cyclical Top Indicator for Bitcoin, showing that despite nearing new all-time highs, the indicator remains depressed, suggesting ample room for a prolonged uptrend even with a potential rally into the $80,000 - $100,000 range.

Source: WealthUmbrella

We anticipate that we will need at least one pullback or consolidation after the current push, followed by another push, before seeing them at a level that will start to enter the zone that could be consistent with a major top.

One final point worth mentioning is the considerable rise in the absolute floor for Bitcoin’s price. Bitcoin tends to not trade too far within this floor, which we can derive from Bitcoin's realized value (the average value at which every BTC last traded) and Bitcoin’s Thermocap history.

An analysis of Bitcoin indicating a needed pullback after the current push and highlighting a rising price floor based on realized value and Thermocap history.

Source: WealthUmbrella

While the realized value and price floor from Thermocap were around $24,000 in March 2024, these values are now $33,000 for the realized value and $28,300 for our price floor from Thermocap. These are very strong levels that tend to act as a floor at the height of a cyclical decline.

Although we don’t think we are going there, seeing them considerably increase while Bitcoin's price did nothing is, for us, a massive improvement that should pay off later. While this still represents considerable downside, what is important is knowing that at a cyclical top Bitcoin usually trades at 4-5X these values. The current downside appears limited and expectations for Bitcoin's price at a cyclical top become very interesting ($120K-$150K, which aligns with some targets we got in December 2023 by playing with some of our top indicators).

In conclusion, while we still believe the original price targets of $106,000 – $190,000 are attainable, we do believe risk has increased. As a result, we will likely reduce some risk on the next rally to all-time highs. Both the technical and on-chain analysis support a move the likely falls short of $100,000, followed by another correction. We will prudently take some gains in the hope of adding back when the technical picture and on-chain data support the outlined green scenario, which would take us well into the $100,000 region.

It is difficult to predict these targets, which we hold loosely as general guides for our risk management. However, there are two things we know for certain: 1) the uptrend pattern is incomplete, and will remain so until the breakout to new all-time highs; 2) several on-chain metrics have cooled off considerably over the past few months and now indicate a promising uptrend that could easily approach the $100,000.

If you own crypto or are interested in how to invest in crypto, we encourage you to attend our weekly webinar that we hold for premium members, held every Thursday at 4:30 EST. This week, we will outline our game plan for Bitcoin in real-time, as well as how we plan to manage the gains in three other altcoins that we currently own. If you would like a more automated risk-on/risk-off signal to help navigate your crypto positions, we encourage you to look at WealthUmrella’s hedge signal.

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 BTC at the time of writing and may own stocks pictured in the charts.

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