Credo offers active electric cables (AECs), which drove the bulk of the company’s phenomenal beat and raise last quarter. Power consumption will be at the forefront of infrastructure builds as we move into 2025 and beyond. Blackwell alone represents a 300% increase in power consumption across one generation of GPUs. We’ve covered in the past that as GPUs become more powerful in order to support trillion-plus large language models, the result is that AI requires more power consumption with each future generation of AI acceleration.
Although it’s easy to be laser focused on the AI chips driving this revolution, it’s my stance that 2025 will push networking, switches, optical modules and other networking components into the limelight. Networking performance is vital to the investments Big Tech is making, and Blackwell is the first generation of GPUs that truly test (or perhaps break) the upper limit of networking capabilities in terms of necessitating lower power consumption.
Fiber optic networking is superior to copper networking in nearly every way, as it’s 70% market share in networking in the data center clearly demonstrates. Fiber will continue to dominate in the above 7-meter distances as it’s bandwidth, durability, low electromagnetic interference, and transmission distance of up to hundreds of kilometers is unmatched.
In distances below seven meters, fiber optics are being challenged by active copper cables (ACC) and active electric cables (AECs) due to copper offering lower power, reduced costs, and in some cases, are more reliable. For distances between two meters and seven meters (or about six to 24 feet), active electric cables (AECs) are seeing heightened demand as servers scale up to eight GPUs to now 36 GPU to 72 GPU per rack-scale AI system, and also as GPU clusters grow from 10,000-GPU clusters to 100,000-GPU clusters to soon million-GPU clusters.
As AI applications grow increasingly more complex, requiring more advancements in AI cluster architecture, reliable networking solutions is at the forefront as a key facilitator. Credo operates in the outsized-demand environment that is the data infrastructure market. Credo’s relationship with hyperscale and enterprise data center customers as well as service provider networks and original design manufacturers (ODMs) helps to establish the company’s importance.
Demand for new networking architectures is further evidenced by Credo’s knockout earnings report, where the company reported a top line beat of 8% and a neck-breaking beat of 35% on the bottom line. Due to management’s strong forward-looking guidance, analysts have posted 1-month revisions of 70% on the bottom line and 38% on the top line for the upcoming quarter.
Below, we look at whether Credo can sustain this momentum and other key elements to the company’s hypergrowth.
The company’s ability to provide reliable yet cost-effective connectivity solutions make it a market leader candidate in the AI networking facilitators space. Additionally, Credo’s proprietary serializer/deserialzer (Ser/Des) technology, which is the cornerstone of its IP portfolio, gives it a significant competitive advantage as it enables the power-efficient connectivity and reasonable pricing that the company is known for. More so, Credo licenses this IP to the broader market, though this is not as significant a contributor to overall sales as product sales are. Credo’s product offerings are discussed below.
Active Electric Cables (AECs)
Active electric cables solve a critical issue of data loss that occurs with passive cables at longer lengths, especially in 800 Gbps/port environments with lengths longer than two to three meters. By using two re-timers per cable, AECs prevent data loss by creating a cleaner signal.
Active copper cables (ACCs) do not use retimers, rather they use redrivers. However, as data center network architectures look toward replacing fiber optic in some cases for short haul networking, both AEC and ACC are being evaluated.
Here is what was said in the ACC analysis, which solves a similar issue as AEC:
“Originally, the Blackwell B200s were designed to be 120 kilowatts of power. In order to achieve a lower power wattage of 100 kilowatts of power, Nvidia changed the interconnects from optic to copper. According to the Next Platform, these systems will use up to 5,184 copper cables with up to 200GB per SerDes lane with NVLink switches. The article has a link to a picture of the copper cables, which helps to visualize what thousands of cables going into a NVL72 server looks like.
The new Blackwell systems are being designed with copper cables for the short haul of connecting up to 72 GPUs. Copper networking previously had a reach of 1.5 meters, yet this has evolved to where there is now a reach of 3 meters to assist in connecting these large systems.”
AECs with retimers are a more expensive option compared to ACCs due to offering a cleaner signal, yet they have the additional benefit of being vendor agnostic, which is key for data center operators who are looking to upgrade as they add more racks. AECs also use clock data recovery to reduce jitter for higher signal integrity and can effectively reach distances of up to 5-7 meters, making it a solid choice for networking distances beyond 2-3 meters.
Being copper-based, AECs are cheaper than fiber optic even with the cost of the retimer, and AECs consume less power due to having a small diameter. By allowing more air flow, there are fewer issues with thermal management. This is the primary catalyst for AEC growth within the data center. Per management on the earnings call: “AI-driven demand for high-speed, power efficient and reliable connectivity is accelerating. AECs outperform laser-based optics, offering lower power, reduced cost and maybe most importantly, greater reliability.”
Until recently, fiber optic cables and transceivers have represented the bulk of data center and high-performance computing networking as fiber optics reduce packet loss and increase data transmission. However, with more emphasis being placed on power consumption, hyperscalers are looking for alternatives to the increased power consumption from optical signal transmission and conversion.
Due to liquid cooling, data centers are becoming increasingly dense to where servers are stacked closer than before with only air cooling. This allows for new back-end network solutions that were previously not possible due to distance.
Another factor is the Active Electric Cables (AECs) that Credo offers reduce complexity as data centers scale out and add more racks. In active optic cabling (AOCs), if a module fails, there is significant downtime to contend with. This was pointed out recently on the earnings call: “With increasing rack power densities and the shift to liquid cooling, shorter physical lengths for back-end connections are now possible. This enables AECs to displace optics in certain GPU to switch applications. Optical Link Flaps and AI clusters have become increasingly costly, causing significant downtime and loss of productivity for training clusters.”
800-Gig ZeroFlaps AECs:
About three months ago, Credo announced the 800G HiWire ZeroFlap AECs for AI backend networks with the goal of enabling large AI clusters sized into the hundreds of thousands of GPUs. The new AECs are designed to reach 7 meters with full host-to-switch connectivity, and especially designed for liquid cooled servers. According to an independent source, the 800G OSFPs AOCs are particularly troublesome due to physical constraints that cause the connectors to break. There is also link lapse with AOCs, which are “momentary disruptions in network links.” This is what Credo’s new AECs aim to solve.
Retimers:
The company also offers line card retimers, which means the company participates at a higher attach rate per deal by offering both the network cables and retimers. The company stated: “In Q2, our line card retimer business also added to our positive overall momentum. During the quarter, we generated record quarterly revenue driven by 400-gig and 800-gig applications.”
Optical DSPs and PAM4 SerDes Solutions:
Credo offers data transmission hardware, known as serializer/deserializers (SerDes) solutions that convert multiple streams of data into a single stream of data at rates starting at 100gig and up to 1.6 TBps. The cost- and power-effective SerDes solutions based on mature process nodes, are available in chiplets for integrations with systems-on-chips, multi-chip modules.
The founders of Credo come from Marvell, and currently serve as CTO and COO, so it is not surprising that Credo competes with Marvell directly on DSPs. Optical Digital Signal Processors are key component in optical transceivers used in AI clusters, service provider networks and data centers infrastructures. You can read more about DSP products in our Marvell coverage here and also here. Also similar to Marvell, Credo works with both Ethernet and PCIe networking, which is important as Gartner sees Ethernet adoption rising rapidly for AI networks due to being an open standard, whereas the PCIe-based Infiniband is forecast to stagnant despite being the dominant leader today.
On the optical side, Credo offers 50G, 100G and will soon offer 200G per lane active optic cables (AOCs) and transceivers. The company is focused on lowering power requirements for modules and management expects the 3nm 200-gig per lane designs to make an impact later this year. In the discussions, management highlights the upcoming DSPs at 10 watts and LROs “at half that power.” This keeps Credo competitive with Marvell’s DSPs also currently at 10 watts.
Regarding LROs, we’ve covered linear pluggable optics here, which help to reduce power consumption and costs, while half-retimed linear optics (LRO) help to stabilize signal transmission. Credo was first to release a 800G PAM4 DSP for half-retimed modules with the idea these modules can reduce power by 40% compared to full-DSP modules. These are both in the discovery phase as to what extent they will be used in data centers, but it’s looking likely LPO and LRO-related suppliers will report revenue from LPOs/LROs come H2 2025/H1 2026.
Hyperscaler Customers:
Credo’s major customers are Microsoft and Amazon, with the third being perhaps Oracle or xAI. Here is what was shared on the call: “Yes. So we've talked about really being focused on the U.S. hyperscalers. And we kind of classify companies within that category, including Oracle. And we've also talked about emerging hyperscalers, companies like xAI, companies like Omniva. And so, we've – what we've talked about is we've talked pretty openly about our relationship with Microsoft, our relationship with Amazon.
We haven't been too clear about exactly which is the hyperscaler that represents customer number three, out of the five U.S. hyperscalers. We did mention during our press release during the OCP conference that we've been doing a lot of good work with xAI specifically in the ZeroFlap category. And so, I can say that we're doing well really, with several customers that will be ramping production.”
Management referred to Microsoft being just above 10% which most closely matches Customer B, which would leave Amazon as Customer A below. Management has emphasized the ramps are not linear.
Financials
Revenue
The company reported record revenue across the three main product lines i.e. active electric cables (AECs), Optical DSPs and line card retimers. Credo witnessed an uptick in shipments, which marked the beginning of the revenue inflection point due to strong AI demand.
- Q2 was a record-breaking quarter for Credo as revenue grew by 63.6% YoY and 20.6% QoQ to $72.03 million.
- Management expects Q3 revenue to be in the range of $115 million to $125 million, growing 126.2% YoY and 67% QoQ at the midpoint.
- Analysts expect Q4 revenue to grow 125.2% YoY to $136.89 million and 133.5% YoY to $139.44 million in FQ1.
- Looking further out, management guided FY25 (Apr) topline growth of 100%+ and double-digit sequential growth from Q3 to Q4.
Credo Segments:
Products
The product segment is comprised of various Credo’s high-speed and power-efficient connectivity hardware solutions tailored to the data infrastructure market, offerings that are growing in prevalence as the rapid deployment of AI applications require more bandwidth. In Q2, Product sales grew 88% YoY and 21% QoQ to $64.4 million or 89.4% of total sales, driven by record sales from its AEC and optical DSP product lines. Management highlighted it saw strong demand from its top two customers and an emerging hyperscale customer for AEC products, and that it remains highly optimistic about the future of this business as Credo is well-positioned as a market leader when the adoption of this product line becomes more widespread.
Management highlighted in the earnings call that the second half revenue growth will be driven by AEC products and revenue growth will continue beyond FY2025 as the adoption expands the broader data center market.
The company sees long-term growth opportunities for the 50-gig and 100-gig per lane DSP solutions, driven by strong demand and close relationships with its customers. Looking ahead, management is optimistic on the 200-gig per lane solutions and have recently completed the tape-out of the 3-nanometer 200-gig per lane designs, showcasing power efficiency.
The company witnessed record revenue in the line card retimers revenue driven by 400-gig and 800-gig applications.
Products Engineering Services
Accompanying its robust products business is Credo’s engineering services business, which provides services related to its IP licensing agreements and product engineering services as part of its agreement with certain customers to integrate Credo’s technology solutions into customers’ products. In Q2, engineering services sales grew 90% YoY to $4.6 million as Credo saw a 156% increase in time spent on product engineering service arrangements due to increased shipments.
IP Licensing
Credo’s IP business consists mostly of its propriety SerDes and DSPs technologies licensing, which allows for comparable performance as its peers in data transmission but at a much lower cost. The business posted a revenue decline of (-60% YoY) to $3.0 million in Q2 due to fewer contract wins. Notably, management said during its earnings call that “that IP licensing will become a smaller percentage over time. We will continue to treat the business strategically.”
Margins: Management Guides for Strong QoQ Improvement in Operating Margin
Margins have been improving steadily, yet most importantly, the operating margin is expected to swing to GAAP positive and expand from (-20.2%) two quarters ago, and (-11.7%) one quarter ago, with guidance for an operating margin of 11.9% in the upcoming quarter. Due to commentary that adjusted operating expenses will grow “at less than half the rate of revenue from FY2024 to FY2025,” we expect that Credo will continue to see strong operating leverage. Adjusted operating margin is also expanding nicely from (-1.7%) a year ago to 11.5% in the most recent quarter.
The product adjusted gross margin improved by 70 bps sequentially and 940 bps YoY to 62.2% in Q2, driven primarily by increasing scale.
- Q2 adjusted gross margin was 63.6% compared to 59.9% in the same period last year. Management is targeting a long-term adjusted gross margin in the range of 63% to 65%.
- Q2 operating margin was (-11.7%) compared to (-20.2%) in the same period last year.
- Management has guided a strong improvement in the operating margin for the next quarter to 11.9%, primarily driven by operating leverage.
- Adjusted operating margin was 11.5% in Q2 compared to (-1.7%) in the same period last year.
- Management is targeting long-term adjusted operating margin of 30% to 35%.
- Management expects adjusted operating expenses to grow at less than half the rate of revenue from FY 2024 to FY 2025, suggesting strong operating leverage for this fiscal year.
- Net loss in Q2 was (-$4.2 million) or (-5.9%) of revenue compared to (-$6.6 million) or (-15%) of revenue in the same period last year. Adjusted net income was $12.3 million or 17.0% of revenue compared to $1.2 million or 2.6% in the same period last year.
- The difference between the GAAP and non-GAAP net income is due to high stock-based compensation. Stock-based compensation was $16.7 million or 23.1% of revenue.
EPS Grows 600% YoY with more Triple Digit Growth Expected
Q2 adjusted EPS grew by 600% YoY to $0.07, driven by substantial operating leverage. Analysts expect EPS to continue to improve, primarily driven by operating leverage as sales growth stands to outpace expense.
- Analysts expect Q3 adjusted EPS to grow 358.6% YoY to $0.18 and 219% YoY to $0.22 for Q4.
- Looking ahead, analysts expect the adjusted EPS to grow 467.6% YoY to $0.51 for FY2025 and 96.6% YoY to $1.00 for FY2026.
Cash Flow and Balance Sheet
Credo’s cash flows have been lumpy in the last few quarters, with the company investing in growth due to strong AI demand. The cash flows should improve in the coming quarters as profits increase.
- Q2 operating cash flow was $10.3 million, or 14.3% of revenue, compared 11.4% in the same period last fiscal year. This is considerably higher than FY 2023’s (-13.4%) margins but lower than FY 2024’s 17.0% margin.
- Q2 free cash flow was (-$11.7 million), or (-16.2%) of revenue, compared to 6.7% of revenue in the same period last year. This was also considerably higher than FY 2023’s (-25.2%) margin but still lower than FY 2024’s 8.9% margin. CapEx was higher at $21.9 million in Q2 that led to lower free cash flows, was driven largely by production of 5-nanometer tape-outs.
- The company has a cash and short-term investments of $383 million and no debt as of the end of Q2 FY 2025. During the Q2 earnings call, management highlighted its belief the company remains well-capitalized to continue investing in growth opportunities while maintaining a “substantial” cash buffer.
Valuation:
Credo’s stock continues to build momentum, climbing over 130% in six months (over 300% uptick in one year) benefitting from the global acceleration of AI adoption. On a sales valuation, Credo is trading at 35x Forward P/S compared to Nvidia at 28x Forward P/S and Astera Lab at 32 Forward P/S. These are the highest priced AI-related stocks on the hardware side.
The PE Ratio is high at 158X forward but this is irrelevant as the company will become newly GAAP profitable next quarter and is only recently profitable on an adjusted basis.
Conclusion:
The over-arching investment thesis for a portfolio concentration in AI networking component companies is that AI models are driving an exponential increase in compute requirements, while the scaling of workloads is limited by the existing network. Although GPUs and AI accelerators capture the headlines, as we move into 2025, hyperscalers will become equally as focused (if not more so) on networking capabilities as GPUs and ASICs are reaching the upper limit of what current networking architectures are capable of.
Ushering in the golden age of AI applications requires a cost-effective and technologically advanced connectivity solutions, and Credo is well-positioned to benefit from as a market leader. Though the company’s stock has already experienced exponential growth and current valuation might give some investors pause, there is room for more upside as management believes Q3 marks the beginning of the topline inflection point that Credo has long anticipated to come. As AI clusters advancements necessitate innovations in computing power and cooling technology, network reliability and the need to reduce costs/power has become ever more important.
We are looking at a handful of companies in the area of AI networking, advanced packaging metrology, and direct liquid cooling plus others that collectively fall into the category of AI hardware. Due to being a firm that specializes in Nvidia and AI, you can look forward to a more strategic approach to how we plan to build our portfolio come 2025. Learn more in our Q1 webinar.in our Q1 webinar.
This is a sample of what you can expect in our upcoming Discovery tier, where we will cover a new stock idea every week. We are excited to bring you more coverage from the I/O Fund team that is geared toward new idea generation only. Our ETA for launching this new tier is February 2025.
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
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