Vertiv reported exceptionally strong Q4 2024 results, but the midpoint guidance for Q1 2025 missed consensus estimates triggering a sell-off. The robust 25.8% YoY revenue growth and 77% YoY adjusted EPS growth in Q4 accented the drop-off into Q1 2025 revenue growth of 17.4% and adjusted EPS growth of 39.5%. Management stated that rather than a weak Q1, they had an “particularly strong” Q4.

Management now estimates 2025 sales at $9.2 billion at the midpoint—$75 million above November's guidance—even with a $125 million FX headwind. However, a $200 million Q4 revenue beat increased the revenue base, lowering full-year organic growth to 16% from 17%. Essentially, while absolute sales were higher, the beat diluted the year-over-year growth percentage compared to last year's forecast.

Perhaps a tad frustrating, management is contradicting itself by guiding for organic growth of 19% at the midpoint for Q1 but 16% growth for the fiscal year (i.e., slower growth later in the year) while also stating the following:

“Mark Delaney   Goldman Sachs Group, Inc.

You spoke a bit already on the 1Q revenue outlook as a percent of the full year guide, but I'm hoping you can provide some more details on your expectations for the shape of the year from a top line perspective, and specifically if Blackwell supply chain readiness or other supply chain factors are gaining the revenue growth in the first half. And then on that topic, in particular with supply chain readiness, have you seen any changes in delivery schedules as a result of that?

David Fallon   CFO

Yes. I can address the first part, Mark. If you look at the shape of the year from a top line perspective and really from a profitability perspective, just like prior years, we expect sequentially increases each quarter as we progress through the year.

From a percentage of the whole, similar to the first quarter, which is comparable, maybe a little bit higher than what we saw last year. We would see the cadence as a percentage of total sales each quarter in '25 to be similar to what we saw in 2024, and that's also the case as it relates to adjusted operating profit.”

How can that be – that on one hand, we have sequential increases each quarter as it progresses throughout the year yet we see Vertiv guiding lower as the year progresses? My hypothesis is that any effects from the Blackwell delay will peak in Q2 and that is what is not being revealed, as it’s not required to be at this moment (only Q1 is required). This aligns to the H2 and mid-summer discussions from other suppliers. I covered this yesterday here in the analysis “AI Hardware Suppliers Forecast Muted H1, Strong H2 – and What it Might Mean for Nvidia.”

Given we had Vertiv and Super Micro report recently, I expand more on this analysis below.

More Info on What Vertiv Results Could Mean for Nvidia (and SMCI)

As you know by now, our spidey senses are up due to suppliers not coming in with convincing QoQ growth, leading me to be believe the larger GB200 systems are delayed. Although there were rumors prior to a Q1 delay, I believe the actual issue delaying the systems is newer in nature as suppliers were on track over the past few months and it’s something more recent causing the new commentary.

Vertiv is especially sensitive to this outcome as these larger systems necessitate the power and thermal management technologies that VRT offers. Meaning, as I’ve collected the various commentary from suppliers, I was especially keen to hear Vertiv’s report as the company would have to reveal if the larger systems were shipping or not as a key supplier. Where I think the issue resides goes beyond the headline numbers and is found in the QoQ/YoY growth percentages.

Last year, Vertiv was down (12.1%) due to seasonal sequential growth from Q4-Q1. This year, Vertiv is down (16.9%) from Q4-Q1. That’s not convincing in terms of a major ramp being on time that necessitates Vertiv’s direct liquid cooling technologies. What’s even more interesting in terms of validating this theory is that Vertiv’s full year guidance slightly missed:

“2025 sales are projected to be approximately $9.2 billion at the midpoint, approximately $75 million higher than the implied sales guidance in November. And this increase is despite an estimated incremental $125 million foreign exchange headwind. So on an absolute dollar basis, organic sales are up approximately $200 million from our November outlook. Of course, our full year organic growth is lower on a percentage basis from what we presented a few months ago, 16% at the midpoint versus 17%. But this is primarily due to the significant $200 million top line beat in the fourth quarter.”

If these assumptions are correct, remember that Nvidia’s revenue will not come to a screeching halt. The B100s, B200s and leftover Hopper GPUs will continue to drive sales. Yet, it’s the GB200s that define the Blackwell generation, and if these systems are truly delayed (still need confirmation from the horse’s mouth), the risk remains to the downside for the stock.

To compare, Super Micro is less sensitive as they offer a mix of air cooled and liquid cooled systems. As you know, SMCI has been growing rapidly from the Hopper generation, and thus, is not as dependent on Blackwell’s GB200s ramping. However, there are clues that SMCI is aligned with these assumptions as the company stated the following:

“Moving on to our technology progress, we are excited to announce that our NVIDIA Blackwell products are shipping now. We have begun volume shipments of both air-cooled 10U and liquid-cooled 4U NVIDIA B200 HGX systems. Meanwhile our NVIDIA GB200 NVL72 racks are fully ready as well.” – Super Micro CEO, Charles Liang

There was additional information that implies timing is off than previously expected on the GB200s, in the most recent quarter: “And especially talking about liquid cooling, we believe DLC or overall liquid cooling, market share, will grow all the way to 30% or even more in the next 12 months.” This is a change in tone as it was previously stated DLC would be 30% of market share in 12 months in the August call (six months ago): “we are targeting 25% to 30% of the new global data center deployments to use DLC solutions in the next 12 months.” – the original statement was implying H1 of 2025 but would now be implying H2 2025. This is important because, same as above with Vertiv, DLC is closely tied to the bigger GB200 systems.

These are subtleties that quant systems won’t be able to pick up on, but as someone who follows the AI market very closely from an investor’s POV, there is a marked change of tone in terms of the time on when the systems will be delivered. These management teams are being subtle to not get in the crosshairs with Nvidia while complying to SEC regulations around their guidance.

What if I’m wrong? I’m open to that. However, I don’t have one management team giving the green light on the GB200 systems, and these earnings reports and management commentary is only increasing in number.

I provide more information on Vertiv specifically in the Q&A below.

Vertiv Revenue Growth Driven by Hyperscale and Colocation Data Center Market

As stated, the weak price action is from a weaker Q1 and the nominal fiscal year guide miss, yet it’s understandable the market has jitters over a confirmed Blackwell supplier not being able to meet estimates. Equally understandable about the weak price action is the roughly 18% guide on fiscal year revenue compared to the 17.5% guide for Q1, implying little room for upside as we continue into the year. As stated, organic growth also illustrates a similar problem – Q1 at 19% midpoint compared to FY at 16% midpoint implies a weaker Q2 perhaps.

• Q4 revenue grew by 25.8% YoY and 6.4% QoQ to $2.346 billion, compared to Q3 revenue growth of 19% YoY and 6.18% QoQ to $2.074 billion.
• Q4 revenue of $2.346 billion beat consensus estimates for $2.16 billion by 8.61%, compared to Q3 revenue of $2.074 billion, beating consensus estimates for $1.92 billion by 4.79%.
• Organic sales grew 27.1% YoY compared to 19.2% YoY in Q3. Revenue strength was driven by the hyperscale and colocation data center market. The pipeline increased sequentially, reflecting strength in data center project activity.
• Vertiv had a significant number of new product launches in Q4, but customers wanted products ASAP resulting in overdelivering the top line by $200 million higher than midpoint guidance contributing to the particularly strong Q4.
• Management’s Q1 2025 revenue guide is $1.900 billion to $1.950 billion, with a midpoint at $1.925 billion representing YoY growth of 17.44%, beating estimates by 0.26%.

Regional Segment Revenue Growth will Slow for EMEA

Vertiv collects its revenues from three geographical regions.

• The Americas generates the bulk of the orders, followed by APAC (primarily India) and EMEA. Americas generated 23.2% sales and 25% YoY organic sales growth driven by strong demand in colocation and hyperscale market with strong contribution from switchgear, busway, liquid cooling and services.
• APAC generated 26.4% sales and 27% YoY organic sales growth driven by continued recovery in China and strong market growth in India.
• EMEA generated 31.6% sales and 33% YOY organic sales driven by demand from colocation and hyperscale markets across switchgear, chillers, modular solutions and services. The Americas trailing twelve-month order growth has surpassed 50%. Vertiv noted that Q1 growth forecasts for Americas is low 20s, APAC in mid-20s and EMEA trimmed to high single-digits, down from low high-teens, due to the timing of projects being pushed forward in 2025, and more challenging comparables.

Seasonally Weak Q1 Margin is Up 170 bps YoY

Adjusted operating margin rose 383 bps YoY to 21.5%, marking the fourth consecutive quarter of margin improvement. Adjusted operating profit was $504.3 million, firmly beating management’s earlier guide of $427 million to $447 million. Margin improvement was driven by improved variable contribution margin and lower fixed costs as a percentage of sales. Management is guiding Q1 2025 adjusted operating income of $315 million to $335 million with a midpoint of $325 million, which equates to a 16.9% adjusted operating margin.

Adjusted EPS Guidance Missed Consensus Estimates as Growth Slips

Q4 adjusted EPS rose 76.79% YoY to $0.99, beating consensus estimates for $0.82 by 20.73%. Adjusted operating profit is primarily driven by volume, commercial execution and productivity, partially offset by higher OPEX investment in growth capacity and ERD.

However, management guided Q1 2025 adjusted EPS range of $0.57 to $0.63, midpoint of $0.60, falling short of the consensus estimates of $0.64. This implies a 39.53% YoY growth rate at the midpoint versus consensus analyst estimates for 48.1%.

Steady Cash Flow as Debt Remains Flat But Net Leverage Improves to 1X

Q4 operating cash flow reached its highest levels in five quarters at $425.2 million. The operating cash flow percentage has remained steady between 19.4% to 18.1% for the past three quarters. Adjusted free cash flow rose to its highest level in six quarters to $361.8 million. Debt remained flat throughout 2024 closing the year at $2.93 billion, down from $2,934 billion in Q1, however net leverage has improved from 2.2X to 1X in the same period.

Vertiv generated over $1.1 billion in adjusted free cash flow in 2024, translating into a conversion of 103% after converting 114% last year. Adjusted free cash flow for Q1 2025 is expected to be higher YoY than Q1 2024.

Backlog Peaked in Q3 as Book-to-Bill Has Been Falling Since Q1 2024

The backlog grew steadily for the past five quarters until Q4 when it dropped to 30% YoY and (2.7%) QoQ. However, the book-to-bill ratio peaked at 1.5X in Q1, dropping to 1.4X in Q2, 1.1X in Q3 and 1X in Q4. This may be due to seasonal normalization. Management stated that orders are historically “always lumpy”. The backlog to sales ratio is 78%, up from 69% in the prior year relative to 2024 actual sales.

While quarterly book-to-bill ratio has declined from 1.5X to 1X in2024, Vertiv’s trailing twelve-month organic orders are still up 30% YoY in Q4. Backlog growth trailed off in Q4 to 30% YoY down (2.4%) sequentially but still stand at $7.2 billion.

Valuation

Vertiv trades at a P/E of 76.59,  forward P/E of 32.16.
The price/sales (P/S) ratio is 5.88, forward P/S is 4.66 vs five-year avg P/S of 6.5.
The price-to-free cash flow ratio is 41.05
Debt-to-equity is 1.61.

Earnings Call:

Weak Q1 Questioned by Analysts:

Management defended Q1 by saying: “Now of course, Q4 was particularly strong. So we should not look at Q1 as a quarter-to-quarter, really look at the first quarter sales as the acceleration that has taken place. With a 19% organic growth in the first quarter, I feel very, very good about what that tells us about our overall trajectory” and also “it's actually higher than what we actually saw in 2024. So I would say there's actually a step-up in '25 versus the first quarter of last year, so certainly reflective in the 19% sales growth versus the 16% full year sales growth and then also a 31% increase in adjusted operating profit.”

However, I agree with the analyst sentiment that it doesn’t check out exactly. Per I/O Fund numbers, management is contradicting itself by guiding for organic growth of 19% at the midpoint for Q1 but 16% growth for the fiscal year (i.e., slower growth later in the year). Additionally, the QoQ/YoY has to be looked at which is lower than what typical seasonality would account for, as our numbers indicate Vertiv was down (12.1%) due to seasonal sequential growth from Q4-Q1. This year, Vertiv is down (16.9%) from Q4-Q1.

Here was one Q&A exchange that voiced these concerns.

Steve Tusa

Okay. And then just one follow-up for me. Obviously, there's a lot of focus on orders, I think, for good reason. Everybody's trying to discern the trend relative to these CapEx numbers, the pipelines that are obviously pretty eye-popping. You're now two quarters step down relative to what we see at your customers and the way they're spending in these pipelines. What is that disconnect?

Is there some sort of disconnect between you guys and everybody else talking about doubling their data center businesses? I admit, obviously, that's a lower base for some of these guys. But what is that disconnect between you and your customer spending that seems to have opened up here over the last two quarters?

Giordano Albertazzi

I don't think there is a disconnect, quite honestly. If you look at our orders trajectory last year, if you think about a 60% year-on-year growth in the first half of the last year, that's a lot of growth. When our customers talk about their CapEx, of course, they also talk about a lot of the silicon part of their CapEx, not all the data centers. So, I feel pretty good about our visibility of the market and what we win in the market. So, I don't think there is a disconnect.

Additional Q&A Points: Robust Colocation and Hyperscale Markets

Chairman David Cote noted that Vertiv’s stock price has been very volatile on the news, as shares surged higher on Stargate news and fell excessively on Deep Seek news, which was actually good news for them.

“I'd have to say, over the last two or three months, we've been actually quite surprised to see the overreactions to any kind of news in our stock, whether it was the Stargate up the Deep Seek, big crush downward, which made no sense, given that the news implying lower cost to compute, meaning More data, meaning more data centers, meaning more verdict was actually good, not negative.”

Furthermore, Cote also took a jab at the analysts for being overly critical in reaction to the orders data in the Q4 earnings release.

 “Again, orders are quite strong for us, but if you take a look at orders historically, they're always lumpy. They're just the way it is. It's just the lumpy quarter to quarter, and it seems to be masking the really good news we had in the fourth quarter regarding America's orders, especially as you look at hyper and colo, which is a focus for everyone extraordinarily strong.”

Vertiv had a significant number of new product launches in Q4, but customers wanted products ASAP resulting in overdelivering the top line by $200 million higher than midpoint guidance. Broad economic uncertainty entering 2025 in China, cautiously optimistic. Markets remain robust and have good visibility into the future. CEO Albertazzi is more confident in its five-year outlook than ever before. He stated:

“We believe our strong backlog and new product pipeline sets up very well for many years, as Dave noted in his remark, we have heard consistently also from the largest hyperscalers, that likely compute and LLM efficiency should drive more AI adoption. Most of these hyperscalers have confirmed significant increases in their capex span to support AI. This means large investments in data center builds that need our equipment and services.”

“In 2024 we expanded and strengthened our supply base and manufacturing footprint in the United States as part of our overall capacity strategy with the customer demand we see in the US. Vertical operating system is truly becoming part of the culture that is translating into tangible productivity gains, it is also liberating capacity needed to support the strong demand trajectory in combination with our ongoing footprint expansion.”

Management was adamant in making the point that they are a leader in power management. The system matters more than ever with the increasing densification of enabling AI data centers. Vertiv sees more opportunities to further integrate power conversion, distribution and thermal management in ways to simplify critical mechanical and electric infrastructure.

“Power Management represents approximately 1/3 of our total business, and we have been in this market for decades, at global scale, when we engage with our customers on their system designs, our full view of the power system enables us to help them properly scope the solution and right side each element of the infrastructure, we offer an holistic view of the total infrastructure and have access To and engagement with customers regarding their full facility design and challenges. Our visibility into the future of the IT load and our leading R and D allow us to partner with our customers to make their infrastructure, very importantly, future proof.”

Vertiv makes technology-based acquisitions early in the maturity curve that reinforce organic process and scale globally. For example, the BSC acquisition announced in December has high efficiency and capacity centrifugal chiller and heat reuse technology, which is increasingly being used to support high density compute application.

Conclusion:

The word “disconnect” used by the JPM analyst is a great word, as there is certainly a disconnect between what we’ve seen from Big Tech capex being raised to unprecedented levels nearing $300 billion, yet many suppliers including Vertiv are forecasting a muted Q1. Equally as questionable right now is Q2 as the suppliers we track closely seem to be in unison between the H2, mid-summer commentary. Vertiv did not say this directly, yet their guide implies something hidden in the middle of Q1 and FY. I’m guessing it’s Q2 and will keep you in the loop as we go along.

Should this happen, you can expect the news and pundits to stir up custom silicon eating into Nvidia’s GPU market share narratives, commoditization of hardware narratives as Nvidia isn’t that great after all, etcetera. The DeepSeek reaction is a warm-up to how fast sentiment can turn on a stock. Yet, any delays from Nvidia’s Blackwell systems aren’t going to matter in the long run – we know this capex is pointed straight at Nvidia and a handful of suppliers. It won’t even matter this time next year. Our plan is to load up at lower prices. If we trim, it will be nominal (you know we like to trim and get stocks lower, it’s our style). This was generally outlined for you here. You can expect more actionable information in the webinar tomorrow as well as through trade alerts.

I/O Fund Equity Analyst, Jea Yu, contributed to this analysis

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:

• Vertiv: AI Data Center and Direct Liquid Cooling Stock; Nvidia Supplier
• AI Hardware Suppliers Forecast Muted H1, Strong H2 — and What it Might Mean for Nvidia
• Astera Labs Q4 Earnings: Strong Commentary for H2 Ramp; What It Could Mean
• Coherent FQ2: Networking Segment up 56% YoY, Keep an Eye on Co-Optics for H2
• AMD Q4 Earnings: Q1 Decline in Data Center, Mgmt Drops AI Guidance

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.

Recommended Reading:

• Q1 2025 Webinar with Beth Kindig
• TSMC Q4 2024 Earnings: Record Profit Led by Robust AI Demand
• Coherent: Key Nvidia Supplier for Optical Networking Components
• Semtech: Fiber Optics and Copper (ACC) AI Networking Components
• Vertiv: AI Data Center and Direct Liquid Cooling Stock; Nvidia Supplier

Vertiv offers power management and thermal management to data centers and telecom companies, such as Alibaba, AT&T, China Mobile, Tencent and Verizon. The company was formed in 2016 after spinning off from Emerson, and reported $6.8 billion in revenue last year. Vertiv is considered one of the larger players in data center technologies in terms of power management and thermal management, with 24,000 employees and 30 manufacturing facilities.

Vertiv offers many thermal management solutions. Among them is the Liebert XDU, which is a compact unit that sits in the row near the rack or on the perimeter. The liquid-to-liquid cooling distribution unit (CDU) functions as a heat exchanger between the data center and IT equipment, and is used in all forms of liquid cooling: direct-to-chip, rear door heat exchange and immersion. The Liebert XDU offers a secondary fluid cooling loop so that alternative cooling fluids can be used alongside water.

In 2023, Vertiv acquired a company called CoolTera, after partnering with the company for three years, to add advanced cooling technologies to its thermal management portfolio. One of the main areas of need for data centers and colocation sites is to convert air-cooled equipment to liquid cooled equipment. Retrofitting existing air-cooled infrastructure is an area where Vertiv specializes, as opposed to only providing thermal solutions for new servers and racks.

The benefits of retrofitting was touched on in the most recent earnings call: “A great example of enabling the industry to be future-ready is our truly unique Vertiv CoolPhase CDU, which makes it simple to deploy high density liquid cooling where needed without having to reengineer the entire data center environment, even in the absence of a chilled water loop.”

In 2024, Vertiv joined the Nvidia Partner Network with a statement that Vertiv is “collaborating to build state-of-the-art liquid cooling solutions for next-gen NVIDIA accelerated data centers powered by GB200 NVL72 systems.” Now that we are close to the roll-out for Blackwell, Vertiv has officially announced a co-developed GB200 NVL72 system with up to 40% less power management space and up to 20% lower cooling costs. Vertiv is also partnered with Intel to supply air-cooled and liquid-cooled servers for the Gaudi3 AI accelerators.

Notably, Vertiv is a vendor that supplies original design manufacturers (ODMs) such as Dell with thermal management. Here is how the mutually beneficial relationship was described (as opposed to being direct competitors):

“ODMs play certainly an important role in the go-to-market for the likes of us. ODMs in a play that for liquid cooling sometimes is a white space play. They have a role with their servers, with their racks, with their integration. So it’s natural that they integrate liquid cooling technology in what they do. […] When we think about those ODMs, we think of them as a go-to-market for us. And those ODMs very often also rely on our ability not only to deliver and provide technology, but also to provide the service and the liquid cooling know-how at rack, row and system level that they might need kind of being complemented with. So we do not look at that part of the market as competition. We look at a part of the market that we have opportunity to synergize with.”  

The data center accounts for 80% of Vertiv’s business, up from 75% when we initially covered Vertiv back in June. The communications networks and commercial/industrial facilities is at 20% of revenue.

A few quarters back, the management team stated that AI-related projects were doubling in a two-month time frame:

“The ramp-up of production of liquid cooling globally continues as planned, and I'm happy to report we have production underway already at two of the three plants we shared with you we were planning to activate in 2024. We are on track with the capacity ramp-up as shared in February. We continue to see strong momentum with AI-related orders. While we are not disclosing specific detail on our liquid cooling orders, or more broadly AI-related orders, we did see the pipeline for AI projects more than double in the last two months.”

More recently, in Q3, management highlighted its belief that liquid cooling will grow rapidly over the next three years. Per the earnings call: “We believe from a market value standpoint that air and heat rejection combined will be 70% of the market and liquid 30% over the next few years. Air and heat rejection will grow at a 10% CAGR and liquid at a 30% CAGR, all growing very nicely."

At the recent Investor’s Event, Vertiv raised its long-term projections with an updated horizon from 2028 to 2029:

Source: Vertiv’s Investor Event PresentationVertiv’s Investor Event Presentation

Q3 Financials and 2024 Investor Event Financial Forecast Updates:

Q3 revenue grew by 19% YoY to $2.1 billion, beating estimates by 4.8%. Adjusted EPS rose by 46.2% YoY to $0.76, beating consensus estimates by 10.2%. Management also revised financial metrics during the recent 2024 Investor Event, which is discussed below.

Revenue

The company is witnessing an inflection in revenue due to strong AI data center growth (data center accounts for 80% of revenue). During the 2024 Investor Event held on Nov 18, the company's financial objectives were rolled forward one year through 2029 and guided for higher organic revenue growth for the forecasted period. The long-term organic revenue growth guidance has been raised from 8% to 11% (2023-2028F CAGR) to 12% to 14% (2024-2029F CAGR).

• Q3 revenue grew by 19% YoY to $2.1 billion. Organic sales (adjusted to exclude foreign currency exchange rate impact) growth was 19.2%, which was helped by double-digit growth in all three regions.
• The company’s CEO, Giordano Albertazzi said in the Q3 earnings call, “Pipelines continue to grow. We saw pipeline increase sequentially from Q3 – from Q2 to Q3 across all regions. We also are seeing more convincing signals that AI is indeed accelerating in EMEA.”
• Organic sales in the Americas region grew by 20.5% YoY to $1.2 billion. Demand in the colocation and hyperscale markets drove organic sales growth in the Americas, with strong contributions from switchgear, busway, and liquid cooling and services.
• The APAC region showed a 470-basis sequential improvement to 10.4% YoY growth to $432.4 million, helped by strong growth in China and the Rest of Asia.
• The EMEA region witnessed the fastest growth, with 25.2% YoY to $442.5 million, driven by robust demand from colocation and hyperscale markets.
• Management has guided Q4 revenue between $2.115 billion to $2.165 billion, representing YoY growth of 14.8% at the midpoint. The organic sales growth guide for Q4 is 11% to 15%.
• Analysts expect Q4 revenue to grow 15.5%, followed by 17.5% and 16.8% in the subsequent two quarters.

• Management has guided FY2024 revenue in the range of $7.78 billion to $7.83 billion, representing YoY growth of 13.7% at the midpoint. The organic sales growth guide for FY2024 is 14% at the midpoint. Analyst consensus for FY2025 indicates an acceleration to growth of 18.4% on revenue.
• During the Q3 earnings call, the CEO said, “The orders trends and our robust backlog indicate that growth in 2025 will accelerate relative to 2024’s 14%.” During the recent Investor Event, management provided organic sales growth guidance of 16% to 18% for FY2025, representing a solid 3-point acceleration at the midpoint.

Expanding Margins Helps Vertiv Stand Apart

Vertiv’s margins are improving helped by strong operating leverage. During the 2024 Investor Event, management provided adjusted operating margin guidance of 25% for FY2029, representing an expansion of 600 bps from the 19% guide for FY2024 over a five-year period. This helps illustrate Vertiv’s ability to stand apart as a hardware company with already-strong margins that are expected to only expand further over time.

The company plans to achieve about 4% improvement through operating leverage by deepening Vertiv Operating System (VOS) adoption, functional optimization, and digitalization, including AI utilization. About 1% will come from productivity gains and another 1% from commercial execution by delivering positive price-cost through customer value creation.

During the 2023 Investor Event, management had guided the adjusted operating margin to be above 20% during the 2026-2028 timeframe. The company is expecting to reach the previous goal two years earlier, as management has provided an adjusted operating margin guide of 21% at the midpoint for FY2025.

• Q3 gross margin was 36.5% compared to 36% in the same period last year.
• This compares to 28.4% for FY2022 and 35% for FY2023.
• Q3 operating margin improved 350 bps YoY to 17.9%. Adjusted operating margin improved 310 bps YoY to 20.1%. Management’s adjusted operating margin guide for Q4 2024 is 20.4%.
• Q3 net income was $176.6 million or 8.5% of revenue compared to $94.1 million or 5.4% of revenue in the same period last year. Adjusted net income was $290.5 million or 14% of revenue compared to $201.2 million or 11.5% of revenue in the same period last year.

EPS

The company’s Q3 adjusted EPS grew by 46.2% YoY to $0.76. It beat analyst estimates by 10.2%, which was helped by strong operating leverage. Analysts expect strong EPS growth in the coming quarters.

• Management Q4 adjusted EPS guide is $0.80 to $0.84, representing YoY growth of 46.4% at the midpoint.
• Analysts expect adjusted EPS to grow 51.2% and 32.8% in Q1 and Q2, respectively.
• Analysts expect adjusted EPS to grow 32.3% YoY to $3.56 for FY2025 and 25.8% in FY2026.

Cash Flow and Balance Sheet: $1B in FCF This Year

Vertiv announced the annual dividend increase from $0.10 to $0.15, to be paid quarterly. Management expects the 2029 dividend to be about 2x the 2025 annual dividend. In addition to achieving a net leverage ratio of 1.4x, Vertiv has repurchased $600 million worth of shares in 2024 and still has $2.4 billion authorized to repurchase by 2027.

• Q3 operating cash flow was $375.1 million or 18.1% of revenue compared to 14.3% in the same period last year. It is also a significant improvement from the 13.1% for the FY2023.
• Q3 adjusted free cash flow was $335.9 million or 16.2% of revenue compared to 12.7% in the same period last year.
• Management raised the full-year adjusted free cash flow guide to $1.0 billion, up $125 million from the prior guidance. Management expects strong free cash flow generation to continue in 2025.
• Cash was $908.7 million and debt of $2.931 billion compared to $579.7 million and $2.935 billion in Q2. Net leverage ratio has come down to 1.4x from 2.4x in the same period last year.

Key Metrics

Backlog

The backlog at the end of Q3 was $7.4 billion, up 47% year over year and 5% quarter over quarter. Expansion in all three regions helped drive the strong growth in backlog. As seen below, the 47% rate for the backlog is particularly high and is more than double the rate of revenue growth.

TTM Orders Grow 37% YoY

Management introduced a trailing twelve-month metric last quarter. The CEO said in the Q2 earnings call, “This quarter, we have introduced a trailing 12-month orders metric. As we have previously highlighted, there can be a natural variation to the timing of large orders in any quarter. Trailing 12-month is a good metric to assess order activity, smoothing some of the quarter-to-quarter push and pulls.”

The trailing twelve-month orders grew by 37% YoY and were consistent with 37% TTM growth at the end of the second quarter. Q3 orders grew by 17% and were lower than 57% growth in Q2. Management has tried to temper expectations of such high order growth as previously seen this year: “We've enjoyed extremely strong orders in the first half of 2024 and we would agree that continued approximately 60% order increases are unlikely as we tried to say last quarter.” This also helps illustrate why the company is moving to TTM reporting metric.

Earnings Call:

Backlog Elongation:

Given the backlog is growing at more than double the rate of revenue, there were quite a few questions about the backlog and pipeline on the earnings call. Most of them were too forward-looking for management to answer to, however, one question in particular was insightful in terms of Vertiv continuing to have pricing power. It’s also insightful as the analyst is implying the strong backlog may be coming from deals that are elongating from 9-15 months to 12-18 months; this makes sense if we generally apply what we know about Blackwell coming in H1 2025 and these systems being more complex, perhaps requiring a longer sales cycle.

“Noah Kaye

All right. Thank you. And just to piggyback on this, Gio, for the last few quarters you talked about the elongation in order to revenue conversion cycle times for cloud and colo. And that's supporting some of the strength and visibility you have going into 2025. But just what drives your confidence in remaining price cost positive in 2025 given that longer conversion cycle?

Giordano Albertazzi

When we were talking, first of all, thanks for the question, Noah. When we think in terms of the elongation, we were talking about the elongation happening de facto and specifically for the cola and large cola and hyperscale. And that elongation was at 12, was, let's say from the 9, 15 months to the 12, 18 months. So it's not a dramatic elongation. We're talking about a three-month elongation. So we have good visibility on our pipelines. We have of course, very good visibility on our backlog. We have visibility on the price elements of that backlog and pipeline. We have good visibility on the cost side of the equation. And the cost side of the equation, of course, is very, very important. So combine the two, enhance our continued reiterated statement that we believe price cost to continue to be favorable.”

“Resounding Yes” to Higher Q4 Pipeline:

Although pipeline is not an official key metric offered, an analyst dug around for information on how Q4 is shaping up to which the CEO was quite emphatic is better than Q3. The analyst also asked more about lead elongation but the CEO is clearly referring to Blackwell’s arrival being the impetus.

“Michael Elias

Great. Thanks for taking the question. Two quick ones, if I may. First, I want to be absolutely clear. Are you saying that your demand pipeline entering 4Q is higher than the levels you saw entering 3Q? That's my first question.

And then second, I just want to revisit a prior question related to like elongating lead times. One of the things that we're seeing in the data center market is that as the preleasing window elongates and we go further out, the lower pricing that, that data center capacity is commanding. So as I think through the equipment side, does it stand to reason that as the customer lead time elongates, Vertiv actually has less pricing power in the conversation? Any color there would be helpful. Thank you.

Giordano Albertazzi

Well, thank you, Mike. The answer to the first question is if – the answer is yes. I was just trying to think about the formulation. But yes, that pipeline entering Q4 is higher than the pipeline entering Q3, no doubt. So that is a resounding, yes.

When it comes to the elongated lead times, we do not necessarily see a correlation between lead time elongation. And again, I want to remind everyone it's not a lead time elongation because of Vertiv's need to elongate lead time. So we can, most of the time deliver on shorter lead time on their request. But simply because of lead time gets elongated because that is consistent with our customers, project plans and schedules.”

Production Capacity:

It’s important to make a quick note here that capacity is something Vertiv remains confident on, which is where rival Super Micro may become weak due to cash constraints. According to the Investor Event: “But sometimes, if we go back to some of the earnings call, we talked about, yes, do you have capacity? How much capacity are you making available? Oh, I said, "Hey, we always have this 20%, 25%, 30% wiggle room. That's the way we think about capacity being made available […] And a year from now, we will have a similar probably bigger and more impressive list of all improvements of all the capacity that has been — that will be created. But it is about new factories. New factories in India, new factories in the U.S. opened this year. It's about operating and starting production. Example, for liquid cooling, virtually — actually, not virtually in every continent in which we operate.”

Conclusion:

AI power demand is forecast to rise at a rapid rate. GPU demand is showing no signs of slowing as Big Tech continues to spend billions on AI infrastructure, and each new GPU generation is seeing higher peak power consumption. The industry is quickly taking steps to address this, and power consumption, or more specifically, power efficiency per chip, looks to be emerging as the third realm of competition.

As we’ve made abundantly clear, the arrival of Nvidia’s Blackwell is the moment when things like thermal management and power distribution become mission critical. It will not only be Nvidia’s Blackwell systems, for example, we recently published on Amazon’s Trn2 systems that will have hundreds of thousands of custom chips (i.e., not GPUs). Yet, Blackwell signals the arrival of a moment when key suppliers will have their turn in the spotlight. Vertiv remains on our list as a top contender and supplier of choice in what will become a marathon for key AI beneficiaries at the hardware level.

Recommended Reading:

• Dell Q3: AI Server Pipeline up 50% QoQ, Yet PCs Soft
• Astera Labs: Hypergrowth AI Networking Stock
• Cloudflare Q3 Earnings Preview: All eyes on the guide
• Micron Q4: Data Center Drives Beat, Profitability Soars

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

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

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

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

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

Investment Thesis:

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

Overview of Astera’s Products:

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

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

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

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

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

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

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

Scorpio PCIe6 Custom-Built for AI is a Catalyst:

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

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

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

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

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

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

COSMOS Software:

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

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

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

Taurus Ethernet Smart Cable Modules:

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

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

Leo Compute Express Link (CXL):

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

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

Financials: Strong Revenue Growth, Expanding Margins

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

Revenue:

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

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

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

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

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

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

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

Source: Company website

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

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

Margins:

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

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

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

EPS:

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

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

Cash Flow and Balance Sheet:

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

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

Valuation and IPO Risk:

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

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

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

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

Conclusion:

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

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

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

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