Please reference our recent editorial “Microsoft –AI Will Help Drive $100 Billion in Revenue by 2027” for more information on Microsoft’s AI positioning. The below information discusses in more detail our buy plan and what to look for with this AI leader.
Financial and Valuation Impact
The Q3FY23 earnings was better than expected. Microsoft’s Q3 FY23 revenue grew 7% YoY and 10% in constant currency to $52.9 billion. EPS came at $2.45 and was up 10% YoY and 14% in constant currency. The company beat revenue estimates by 3.6% and EPS estimates by 9.6%. All three main businesses – Intelligent Cloud, Productivity and Personal Computing – performed better than expected with Azure standing out.
Microsoft Azure grew by 31% YoY in constant currency and came at the higher end of the management guidance of 30% to 31%.
The management guidance for Q4 FY23 is $54.85 billion to $55.85 billion, representing a YoY growth of 6.7% at the midpoint. It was better than the consensus analyst's YoY growth estimate of 5.9%.
In the call, Satya Nadella also highlighted Azure gaining market share and the opportunities in AI.
“Azure took share as customers continue to choose our ubiquitous computing fabric from cloud to edge, especially as every application becomes AI-powered. We have the most powerful AI infrastructure and it’s being used by our partner, OpenAI, as well as NVIDIA and leading AI start-ups like Adept and Inflection to train large models.”
Interestingly, looking at the recent reported growth rates amongst the Cloud Big 3, suggests AWS is losing share to Azure and Google.
Meanwhile, Microsoft’s reported group operating margins of 42.3% are superior to Alphabet’s 25% and Amazon’s 3.8%.
Amy Hood, the CFO of the company, also highlighted the strong growth in AI and outlook for Q423. She said in the earnings call, “In our largest quarter of the year, we expect customer demand for our differentiated solutions, including our AI platform and consistent execution across the Microsoft Cloud to drive another quarter of healthy revenue growth. Last year, we had our largest commercial bookings quarter ever with a material volume of large multiyear commitments.”
“On that comparable, we expect growth to be relatively flat. We expect consistent execution across our core annuity sales motions with strong renewals and continued commitment to our platform as we focus on meeting customers' changing contract needs, which include shorter term, quick time to value contracts in this dynamic environment. Our key focus remains on delivering customer value.”
Against these tough y/y comps at a group level, Microsoft’s Q4FY23 Azure revenue guidance is 26% to 27% in constant currency, which includes roughly 1% from AI services. This indicates that Azure has barely scratched the surface and has plenty of room to grow.
Comps are getting easier
In the Q3FY23 call, Amy Hood also added, “Mark, maybe the one thing I would add to those comments is, we've been through almost a year where that pivot that Satya talked about from we're starting tons of new workloads, and we'll call that the pandemic time, to this transition post, and we're coming to really the anniversary of that starting. And so to talk to your point, we're continuing to set optimization. But at some point, workloads just can't be optimized much further. And when you start to anniversary that, you do see that it gets a little bit easier in terms of the comps year-over-year. And so you even see that in a little bit of our guidance, some of that impact from a year-over-year basis.”
Looking at quarterly eps estimates (calendar year adjusted)
Typically, Microsoft provides qualitative guidance for the next fiscal year at the Q4 earnings call which is upcoming. The current FY24 consensus forecasts about 11% sales and 14% earnings growth, which don’t appear to be aggressive. Microsoft’s AI story will unfold over multiple quarters. If we’re right, we expect a consistent pattern of better than expected earnings reports to emerge driven by continued growth in Azure and Intelligent Cloud coupled with a stabilization in Personal Computing.
Valuation:
In the case of Microsoft, we have used a sum-of-the parts valuation model alongside traditional metrics to determine a price target. The SUTP helps to separate and value the three main businesses – Intelligent Cloud, Productivity and Personal Computing – as each have different growth profiles.
Factoring in the AI/ML drivers we’ve described, we revisited our sum-of-the parts analysis. These drivers will have the biggest impact on the Productivity and Intelligent Cloud Businesses. The Productivity Unit consists of Microsoft Office Commercial and Consumer, LinkedIn, and Dynamics Business Solutions. Intelligent Cloud consists of Azure, other Cloud and Enterprise services.
We believe the implied market multiple assigned to the Intelligent Cloud and Productivity businesses still undervalues the potential revenue opportunities. As Microsoft continues to further integrate AI/ML into its offerings, this will further strengthen its core offerings and be the catalyst for new ones. This will provide new revenue opportunities from its installed Fortune 500 client base which we believe warrants a higher multiple.
Under our base case scenario, these drivers increase the SUTP by $40 per share and under the bull case by $70 leading to a total SUTP of between $360 and $390 versus the current price of $330.
Conservatively assuming that Microsoft’s group operating margins remain at current levels, a $100 billion increase in revenue could potentially add an additional in $40B in operating profit.
Based on this scenario, MSFT AI could earn $4.67 (vs MSFT consensus of $9.65 FY 2023). Placing a 30x multiple on gets you about $140 per share. So MSFT + MSFT AI = $485.
To be conservative for now, we can say MSFT AI may generate between $4.00 to $5.00 per share in earnings.
We can also take the avg of the 2 SUTP (390 + 485) for a SUTP value of about $440 over the next few years under the 100B AI scenario.
Buy Plan:
Considering where we are in the business cycle, it’s best to understand Microsoft within the context of the broader market. Our general market outlook is that the market will likely experience a bout of volatility into the summer. As long as the S&P 500 holds the 3900 – 3805 region, we can continue to see another swing higher into later 2023 before the recession starts to get priced into equities. Until the FED starts a fresh liquidity cycle, and we get eyes on the extent of damage the 2022 rate cycle caused in the economy, we expect choppy price action with a downward bias.
That being said, there are two general paths we are tracking in MSFT
Blue – As bullish as price action in Microsoft has been, we only have a 3-wave move off of the January low in Microsoft. This leaves the door open to the uptrend in 2023 being the corrective bounce in much larger corrective pattern that began in early 2022. The catalyst would likely be macro, as it relates to the manifestation of a credit cycle downturn that is not currently being priced into equities right now. We would need to see price break below $260.50 in the coming summer volatility. If this happens, then we will be targeting a retest of the January lows.
Red – On the other hand, this 3-wave move off the January low, can turn into a 5 wave move. This would require the summer volatility to hold within the green target box below, and then turn back up to make a fresh high. If this happens, then THE low is likely in for MSFT.
Our buy plan is to accumulate based on both scenarios playing out. So, we will start adding to our position in the $300 – $265 region.
The I/O Fund Analyst Team contributed to this analysis
Please reference our recent editorial “Microsoft –AI Will Help Drive $100 Billion in Revenue by 2027” for more information on Microsoft’s AI positioning. The below information discusses in more detail our buy plan and what to look for with this AI leader.
Financial and Valuation Impact
The Q3FY23 earnings was better than expected. Microsoft’s Q3 FY23 revenue grew 7% YoY and 10% in constant currency to $52.9 billion. EPS came at $2.45 and was up 10% YoY and 14% in constant currency. The company beat revenue estimates by 3.6% and EPS estimates by 9.6%. All three main businesses – Intelligent Cloud, Productivity and Personal Computing – performed better than expected with Azure standing out.
Microsoft Azure grew by 31% YoY in constant currency and came at the higher end of the management guidance of 30% to 31%.
The management guidance for Q4 FY23 is $54.85 billion to $55.85 billion, representing a YoY growth of 6.7% at the midpoint. It was better than the consensus analyst's YoY growth estimate of 5.9%.
In the call, Satya Nadella also highlighted Azure gaining market share and the opportunities in AI.
“Azure took share as customers continue to choose our ubiquitous computing fabric from cloud to edge, especially as every application becomes AI-powered. We have the most powerful AI infrastructure and it’s being used by our partner, OpenAI, as well as NVIDIA and leading AI start-ups like Adept and Inflection to train large models.”
Interestingly, looking at the recent reported growth rates amongst the Cloud Big 3, suggests AWS is losing share to Azure and Google.
Meanwhile, Microsoft’s reported group operating margins of 42.3% are superior to Alphabet’s 25% and Amazon’s 3.8%.
Amy Hood, the CFO of the company, also highlighted the strong growth in AI and outlook for Q423. She said in the earnings call, “In our largest quarter of the year, we expect customer demand for our differentiated solutions, including our AI platform and consistent execution across the Microsoft Cloud to drive another quarter of healthy revenue growth. Last year, we had our largest commercial bookings quarter ever with a material volume of large multiyear commitments.”
“On that comparable, we expect growth to be relatively flat. We expect consistent execution across our core annuity sales motions with strong renewals and continued commitment to our platform as we focus on meeting customers' changing contract needs, which include shorter term, quick time to value contracts in this dynamic environment. Our key focus remains on delivering customer value.”
Against these tough y/y comps at a group level, Microsoft’s Q4FY23 Azure revenue guidance is 26% to 27% in constant currency, which includes roughly 1% from AI services. This indicates that Azure has barely scratched the surface and has plenty of room to grow.
Comps are getting easier
In the Q3FY23 call, Amy Hood also added, “Mark, maybe the one thing I would add to those comments is, we've been through almost a year where that pivot that Satya talked about from we're starting tons of new workloads, and we'll call that the pandemic time, to this transition post, and we're coming to really the anniversary of that starting. And so to talk to your point, we're continuing to set optimization. But at some point, workloads just can't be optimized much further. And when you start to anniversary that, you do see that it gets a little bit easier in terms of the comps year-over-year. And so you even see that in a little bit of our guidance, some of that impact from a year-over-year basis.”
Looking at quarterly eps estimates (calendar year adjusted)
Typically, Microsoft provides qualitative guidance for the next fiscal year at the Q4 earnings call which is upcoming. The current FY24 consensus forecasts about 11% sales and 14% earnings growth, which don’t appear to be aggressive. Microsoft’s AI story will unfold over multiple quarters. If we’re right, we expect a consistent pattern of better than expected earnings reports to emerge driven by continued growth in Azure and Intelligent Cloud coupled with a stabilization in Personal Computing.
Valuation:
In the case of Microsoft, we have used a sum-of-the parts valuation model alongside traditional metrics to determine a price target. The SUTP helps to separate and value the three main businesses – Intelligent Cloud, Productivity and Personal Computing – as each have different growth profiles.
Factoring in the AI/ML drivers we’ve described, we revisited our sum-of-the parts analysis. These drivers will have the biggest impact on the Productivity and Intelligent Cloud Businesses. The Productivity Unit consists of Microsoft Office Commercial and Consumer, LinkedIn, and Dynamics Business Solutions. Intelligent Cloud consists of Azure, other Cloud and Enterprise services.
We believe the implied market multiple assigned to the Intelligent Cloud and Productivity businesses still undervalues the potential revenue opportunities. As Microsoft continues to further integrate AI/ML into its offerings, this will further strengthen its core offerings and be the catalyst for new ones. This will provide new revenue opportunities from its installed Fortune 500 client base which we believe warrants a higher multiple.
Under our base case scenario, these drivers increase the SUTP by $40 per share and under the bull case by $70 leading to a total SUTP of between $360 and $390 versus the current price of $330.
Conservatively assuming that Microsoft’s group operating margins remain at current levels, a $100 billion increase in revenue could potentially add an additional in $40B in operating profit.
Based on this scenario, MSFT AI could earn $4.67 (vs MSFT consensus of $9.65 FY 2023). Placing a 30x multiple on gets you about $140 per share. So MSFT + MSFT AI = $485.
To be conservative for now, we can say MSFT AI may generate between $4.00 to $5.00 per share in earnings.
We can also take the avg of the 2 SUTP (390 + 485) for a SUTP value of about $440 over the next few years under the 100B AI scenario.
Buy Plan:
Considering where we are in the business cycle, it’s best to understand Microsoft within the context of the broader market. Our general market outlook is that the market will likely experience a bout of volatility into the summer. As long as the S&P 500 holds the 3900 – 3805 region, we can continue to see another swing higher into later 2023 before the recession starts to get priced into equities. Until the FED starts a fresh liquidity cycle, and we get eyes on the extent of damage the 2022 rate cycle caused in the economy, we expect choppy price action with a downward bias.
That being said, there are two general paths we are tracking in MSFT
Blue – As bullish as price action in Microsoft has been, we only have a 3-wave move off of the January low in Microsoft. This leaves the door open to the uptrend in 2023 being the corrective bounce in much larger corrective pattern that began in early 2022. The catalyst would likely be macro, as it relates to the manifestation of a credit cycle downturn that is not currently being priced into equities right now. We would need to see price break below $260.50 in the coming summer volatility. If this happens, then we will be targeting a retest of the January lows.
Red – On the other hand, this 3-wave move off the January low, can turn into a 5 wave move. This would require the summer volatility to hold within the green target box below, and then turn back up to make a fresh high. If this happens, then THE low is likely in for MSFT.
Our buy plan is to accumulate based on both scenarios playing out. So, we will start adding to our position in the $300 – $265 region.
The I/O Fund Analyst Team contributed to this analysis
Amdocs is due to report their Q223 earnings on Wednesday, May 10 after the market close. Please check the forum for an updates to the earnings report.
We recently did a deep dive here and discussed how its 12-month backlog, large recurring revenue stream and multi-year engagements with large telecom clients made for a compelling investment case. We expect the quarter to be at least in line with market expectations and demonstrate a steady progression toward meeting its FY2023 targets.
These are the key points we will be looking for.
1. Has the macro environment impacted their business?
2. Growth in backlog? Contract wins?
3. Profitability improvements?
4. Free cash flow generation targets?
5. Price action since April 20th?
6. Earnings expectations?
Importantly, we will look for signs that they may reach or exceed the upper end of their 2023 guidance, which hasn’t yet been priced into earnings expectations. Since our report, the stock has presented an attractive entry point if Q2 proves to be “business as usual”.
1. Any impact from the macro?
Amdocs Q1 beat expectations and during the call management described the macro.
“As we mentioned, yes, we are not immune. I mean, we like ourselves that we are a very strong company, but we are not immune to everything that's going on around us. But I think that overall, we see a lot of demand for our services. The area of growth for Amdocs, today are highly strategic for our customers.
Everyone wants to be successful in — when they deploy 5G use cases, fixed wireless, network automation. Everyone wants to move to the cloud. So while there is some uncertainty, I can tell that we see that we continue the project with our customers. These are highly important for them and we see a very rich pipeline ahead of us.”
While addressing the uncertain macro vs solid company fundamentals, Amdocs revised their full year 2023 sales target range upward during the earnings call. A few snippets are worth pointing out.
“Strong reputation for successfully delivering mission-critical systems transformation.”
Amdocs is providing critical software to telecom companies as they upgrade their networks to 5G, migrate their legacy systems to the cloud and monetize their subscriber base. This is not opex that the telecom companies can afford to reduce, which is why there is a strong backlog.
“Highly recurring revenue streams”
Amdocs estimates that 75% of their revenue is recurring due to its managed services business. This provides earnings and cash flow stability during difficult macro environments.
“Multi-year engagements”
The majority of Amdocs clients are large telecom companies in their respective regions. In the US, ATT, T-Mobile and Verizon make up about 50% of total revenue. These multi-year arrangements provide visibility into future revenue and managing the cost base.
“We see a lot of demand for our services. The area of growth for Amdocs, today are highly strategic for our customers.”
The competition for mobile subscribers is intense. Companies like Amdocs that can help increase a telecom operator’s competitive advantage are highly valued. The multi-year engagements are a reflection of that.
2. Growth in backlog? New contract wins?
Amdocs ended q123 with a record high 12 months backlog of $4.09 billion. This increased 6% from a year ago and went up $120m sequentially, reflecting continued sales momentum. According to management, the 12-month backlog has traditionally served as a good leading indicator of their business and has consistently averaged around 80% of forward-looking 12 months revenue over the years. We will look for continued growth in the backlog.
Amdocs has long standings relationships with large incumbent providers globally such as AT&T, T-Mobile, Verizon, Comcast, Dish, and Claro Brazil in the Americas; Vodafone and Three Group in Europe, Globe in the Philippines. In the most recent quarter, they announced new contract wins with regional providers in Europe and Latam. We will listen for new business engagements within its core client base and new clients.
3. Profitability improvements?
Amdocs has shown steady and incremental improvement in its non-gaap operating margin and currently stands at 17.7%. Amdocs has guided between 17.5% to 18.1% for the year. We will look for comments as to whether they may reach or exceed the upper end of guidance.
4. On track to meet 2023 free cash flow target?
In the Q1 call, management affirmed their free cash flow target.
“We are reiterating our full year free cash flow outlook of roughly $700 million, with free cash flow in the first half of fiscal 2023, tracking in line with our expectations, taking into consideration the normal seasonal timing of annual bonus payments in the second quarter.”
At current stock levels, this implies an attractive free flow yield of almost 7%.
5. Price action since April 20th
In our April 4th Amdocs deep dive, Knox’s technical analysis indicated that he was targeting better entry levels after its strong performance post Q1 earnings. Since April 20, Amdocs has declined more than the market. With only a 0.6 beta to the market, there was no company specific news to explain the price action.
One possible explanation is that Amdocs’s decline began at the same time ATT began its 12% decline post its Q123 earnings release on April 20th. ATT is one of Amdocs’s largest clients. The market reacted negatively to ATT’s reported fcf of $1.1 bn vs $2.9b consensus. Prior to Q1, ATT had already indicated that Q123 FCF, much like Q122, would be about of 5% of their total 2023 $16b FCF target due to seasonality issues. So this should have not been a surprise to the market. Management stated:
“We remain confident in our full year outlook for free cash flow of $16 billion or better. This expectation is largely due to the timing of capital investments, device payments, incentive compensation, which all peaked in the first quarter.”
We do not believe that this should impact Amdocs. ATT recently renewed its managed services engagement until 2026. Given the mission critical services that Amdocs provides, it is not likely ATT will reduce them.
Additional comments from the ATT’s conference call reinforced this.
“The second (priority) is the repositioning of our business to focus on exclusively communication services, particularly 5G and fiber. As the last few years have demonstrated, the solutions we provide are more critical than ever before, and we only expect the demand for purpose-built, best-in-class Internet access to grow. The resiliency of the services we provide, coupled with our improved financial flexibility, provide us with the right tool set to navigate the economic environment.”
“We recognize that in order to do that, we had to increase our investments in the business to enhance our customer value proposition and make more memorable and lasting connections with our customers.”
“In mobility, our largest business unit, we're growing subscribers and taking share. We also continue to see very healthy ARPU. This translates to growth in wireless service revenues and EBITDA, while improving margins”
We will listen to the call to see if anything has changed. If it’s business as usual, the price decline has presented a good entry point.
6. Earnings expectations
Amdocs has a recent history of telling the market what they will do and then doing a little bit better when they report quarterly through a combination of better than expected revenue and incremental improvement in non-gaap operating margins. We like this type of consistency and believe the market will pay higher multiples for businesses like this if Amdocs continues to deliver and the macro continues to weaken.
During the Q123 call, Amdocs reiterated FY 2023 sales, provided Q2 sales and revised up 2023 FY earnings guidance.
“We are reiterating our guidance for full year revenue growth of between 6% to 10% on a constant currency basis in fiscal 2023, with all three operating regions contributing positively over the full year.”
“Our annual outlook includes second fiscal quarter revenue within a range of $1.2 billion to $1.24 billion. On a reported basis, we expect full year revenue growth within an improved range of 5% to 9% year-over-year as compared with 4% to 8% year-over-year previously. The new outlook anticipates an unfavorable foreign currency impact of approximately 1% and year-over-year compared with an unfavorable impact of 2% year-over-year previously.
Moving down the income statement, we anticipate quarterly non-GAAP operating margins to fluctuate around the midpoint of our annual target range of 17.5% to 18.1%. Below the operating line, we anticipate that foreign currency fluctuations and cost of hedge will continue to impact our non-GAAP net interest and other expense lines, in the range of a few million dollars on a quarterly basis. We expect that our non-GAAP effective tax rate will remain within an unchanged annual target range of 13% to 17%, for the full fiscal year 2023.
Bringing everything together, we are raising our outlook for non-GAAP diluted earnings per share growth to a new range of 9% to 13% for the full year fiscal 2023”
For Q223
Amdocs has guided sales of between $1.20 to 1.24b vs consensus of $1.22b (+6.45% y/y)
Consensus expects a normalize eps of $1.47 lower y/y (-4.59%) vs a tough Q222 comp
We will be looking to see if Amdocs meets or exceeds consensus eps forecasts and if it can meet the upper of end of its sales guidance of 10%. Currently, the market is pricing 6%.
In February, we wrote about Big Tech capex shifting it’s spend to AI-related infrastructure. We've been tracking Big Tech capex since 2021 as a proxy for our semiconductor positions. Although the Big 3 are expected to be flat-ish YoY on absolute spend, these companies (plus Meta), are expected to increase AI investments in 2023.
Below is a chart of the yearly Big Tech capex spending from 2016 to 2022.
During Covid, Big Tech capex was needed to support the surge in enterprises that migrated to public cloud and hybrid cloud architectures overnight. As offices closed, companies scrambled to provide work-from-home environments supported by the Big 3 cloud hyperscalers, plus these cloud environments directly funneled to security, operations, marketing and sales tech stacks offered by the hyperscalers.
In addition to this, hyperscalers offered instant scale and elasticity for consumer applications. Whether it was streaming content, online shopping and e-commerce sites or gaming, hyperscalers were ramping capex to support this surge in demand.
Fast forward, and today, the capex spending continues to support the AI/ML ambitions for Big Tech. For example, Microsoft had to use tens of thousands of Nvidia’s A100 graphic chips to power its AI.
This demand has had a domino effect and spurred capex in other sectors.
Big Tech meet Big Tele: Can You Hear Me Now?
For example, this consumer demand has been an important driver behind capex Big Telecom (“Big Tele”). Big Tele refers to the large established US telecom companies AT&T, T-Mobile and Verizon. Together they have over 90% of the US market. AT&T has the highest at about 45%.
Big Tele are in the process of upgrading their networks from 4G to 5G. This will enable faster download speeds and increased connectivity between different types of devices. Below are Statista’s estimates of 5G capex since 2019. This spending began in earnest in 2019 of which Big Tele has been the biggest spender. Similar to Big Tech, Big Tele capex has been multi-year at about 1/3 the size.
We evaluated stocks that could potentially benefit from Big Tele’s capex. One company we identified is Amdocs (DOX, $11B mkt cap). We have focused on software rather than hardware. In part, because after the hardware has been implemented, the software requirements tend to be recurring and the engagements multi-year. In the case of Amdocs, revenue reached an inflection point in 2021, two years after Big Tele 5G capex began.
Who are Amdoc’s customers and what are they looking for?
Amdocs is benefiting from Big Tele upgrading their networks to 5G because as they undergo these hardware upgrades, they need to upgrade their software needs. This includes moving their legacy systems/processes/billing to the cloud and utilizing methods to better monetize their subscribers through ancillary services and offerings.
The majority of Amdocs clients are Big Tele and International telecom providers. Amdocs receives about 50% of its revenues from ATT and T-Mobile. Currently, Big Tele is focused on growing new revenue streams, cost reduction, and driving more efficient operations because of the ongoing trends of digital transformation, migration to the cloud and next-generation networks. Efforts all aimed at enhancing and monetizing the digital experience for the consumer, much like Big Tech.
Big Tele is investing in 5G and fiber rollout to meet the demand for increased bandwidth and innovation for digital services. This network modernization includes migrating their operational and business systems to the cloud and offering innovative new services for both enterprise and individual consumers that they can monetize.
5G will enable Big Tele to expand within existing and non-traditional business models. For example, Big Tele is partnering with leading suppliers to offer their customers a rich portfolio of offerings including media; entertainment, enterprise enablement; Internet of Things, and digital lifestyle services, all of which are driving Big Tele’s demand for multi-modal customer engagement capabilities and data.
One of the implementation challenges Big Tele faces is trying to rapidly introduce new cloud based applications while still operating legacy systems. Hence, Big Tele needs software providers that can provide modular expansion capabilities as it grows, to reduce these implementation risks.
In a presentation, at the Morgan Stanly Technology conference this month, Amdocs called Big Tele’s 5G initiatives as part of a wider megatrend which includes Cloud and Network Automation.presentation, at the Morgan Stanly Technology conference this month, Amdocs called Big Tele’s 5G initiatives as part of a wider megatrend which includes Cloud and Network Automation.
How does Amdocs help?
As a result, Big Tele is looking for software vendors such as Amdocs that can offer the right software and also provide managed services and end-to-end systems integration. Amdoc’s technological capabilities include individual products for commerce, catalog management, monetization, subscription management, Internet of Things, AI, services and network automation and network development and optimization.
For example, Amdoc’s eSIM Cloud enables Big Tele to launch Internet of Things solutions and monetize experiences on devices from Apple, Samsung, Microsoft, Google and other devices manufacturers.
Amdoc’s cloud based CES21 software suite enables Big Tele to build, deliver and monetize advanced services, leveraging their investments as a 5G standalone network, muti-access edge computing (MEC), software-defined networks (SDN), artificial intelligence (AI) and machine learning (ML). This technology is a visual software development approach that requires little to no coding skill on the part of the user, allowing the rapid development of applications with minimal dependency on IT and code developers. The suite also includes carrier-grade AI/ML based user cases to optimize the customer experience.
This is how Amdocs described their role in the most recent q123 call.
Amdocs is helping service providers to modernize and build agility in the 5G era by enabling the rapid launch and monetization of new 5G products
We see a growing number of service providers embarking on multi-year cloud migration journeys that Amdocs is supporting with our end-to-end suite of cloud platforms and services
Financial Impact
The “trickledown” effect from Big Tele’s 5G capex and demand for Amdocs software offerings can be seen through two key data points – orderbook and sales. Recall, Amdocs gets about 50% of its revenue from AT&T and T-Mobile.
Order book
There’s been a steady increase in the order book in the past few quarters, which provides strong revenue visibility. As of Q123, the 12-month backlog stood at $4b.
A portion of this consists of ‘Managed Services’ which are typically multi-year and have almost 100% renewal rates.
For example, of the 1.2B in Q1FY23 sales, 60% came from managed services which tend to be recurring. Overall, Amdocs estimates 75% of the total revenue is recurring.
Sales
Big Tele’s capex can also be seen in the inflection in Amdoc’s sales growth in 2021. For FY 2023, Amdocs has guided for a range of 6 – 10% sales growth. In FY 2022, sales grew almost 10%. This inflection point in 2021 occurred about 2 years after Big Tele’s 5G capex began.
What stock attributes do we like?
There are several stocks attributes we find attractive. In addition to the order book visibility and recurring revenues, the following stand out.
FCF generation
Currently, Amdocs has consistently generated free cash flow. The current FCF yield is almost 4% and pays a dividend of 1.8%.
Profitability – Gross Margins and Operating Margins
The inflection point in sales can also be seen in profitability. Gross margins have been steadily increasing since 2021 and through 2022 which was a difficult environment for many tech companies.
The same trend can be seen in GAAP OPM. Non-GAAP OPM have a similar trajectory and currently stand at almost 18%.
One of the attractions of Amdocs is its high portion of recurring revenue streams. Although not subscription based, the recurring nature has a similar impact on operating margins in terms of providing stability in different market environments.
In 2022, Amdocs’s saw a steady improvement in margins at a time when other companies’ operating margins – such as cloud companies – were declining. We discussed the differences of a subscription vs consumption model (Insert 12/10/22 blog link?)(Insert 12/10/22 blog link?)
EPS and Sales visibility
Amdocs order book visibility and recurring revenue can be seen in Amdocs positive and defensive earnings growth in 2022 (light blue bar). At a time when many tech companies were revising down estimates, Amdocs either beat or reported in-line earnings. Consensus earnings and sales forecasts – from 2023 to 2026 – paint a similar steady earnings profile.
Amdocs recently reported their q1fy23 earnings where they beat and revised up forecasts. Amdocs stated “Overall, our financial year is off to a strong start, positioning Amdocs to deliver consistent and profitable growth in fiscal 2023 within a global macroeconomic backdrop that remains challenging and uncertain.”. Amdocs reiterated their sales growth target of up to 10%.
Consensus has conservatively modeled 6% y/y sales growth, which provides an opportunity for upside surprise. In 2022, Amdocs had 10% sales growth.
Investment Summary
Taking all these factors into consideration. These are the investment attributes that we find attractive.
Well capitalized customerbase – Big Tele is well funded and has embarked on strategic investments. Amdocs provides critical software to allow them to compete
High switching costs – Once Big Tele begins to work with Amdocs, it makes it harder for them to switch to another provider given the type of mission critical support that Amdocs has provided. Amdocs has close to 100% retention rate
Revenue visibility – Amdocs has 12 month revenue backlog of $4.1B long which provides strong visibility into future earnings and is a positive reflection of the current demand environment
Recurring revenue – Amdocs estimates that 75% of its revenue is recurring which means earnings will be more resilient in difficult macro environments
Steady and increasing profitability – given the strong visibility on top line growth, Amdocs has been able to focus on profitability. Operating margins have gradually increased through different market cycles. Amdocs has guided for 18% opm in 2023.
Financially strong – Amdocs generates healthy cash flow used to buy back shares and pay dividends. It targets 100% fcf conversion and has forecasted $700m in fcf which equates to a 6% fcf yield.
Consolidation beneficiary – When Big Tele acquires another competitor, Amdocs helps in the processes involved in migrating customer information, billing etc. For example, Amdocs should benefit from T-Mobil’s recently announced acquisition of Ryan Reynold’s Mint Mobile
How does valuation look?
Currently, DOX’s valuation is not demanding based on 2024 EPS and trades at discount to the SPX. It has traded as high as 20x earnings in the past. Given the defensive nature of DOX’s earnings, strong balance sheet and FCF generation, we believe the market will pay a higher multiple for this type of business model and earnings visibility in the current economic environment.
We see a valuation potential of between $120 to $130.
Amdocs Technicals
By Knox Ridley
Since the COVID low, DOX has been tracing a very large termination wedge pattern. The question remains – has it topped, or does it have one more larger swing before we complete the pattern? As long as any weakness holds the $82-$80 region, we could see a possible buying opportunity for the push into the $103-$110 region. If we break below the $82-$80 region, the odds favor the top being in. Like many stocks, DOX is marching towards a bigger top. We believe for the long-term investors, patience and lower prices will pay off handsomely for quality stocks.
This article was originally published on Forbes on Mar 23, 2023,09:56pm EDTForbes Forbes on Mar 23, 2023,09:56pm EDT
Following last quarter’s earnings, we published an analysis on cloud that showed hyperscalers were slowing (5%) sequentially and best-of-breed was slowing (12%) sequentially, based on Q4 guides.
What was most important for tech investors to realize, is that this is out of character for cloud, as Q4 is typically the strongest quarter. We concluded that this foreshadows a weaker-than-expected Q1 and also a weaker FY2023 than was currently baked into estimates.
Following the most recent earnings reports, our prediction is playing out that the slowdown we had predicted would worsen after the current quarter results.
This is important because the cloud category has treated investors quite well with recurring revenue, resiliency during Covid, and some of the strongest examples of product-market fit available on the public markets. However, not even this can overcome the effects of lower budgets and cloud spend, which is the top driver in terms of year-over-year comparisons.
Below, we discuss the fundamental weakness apparent in the most recent earnings reports. For our Premium Research Members, we are extending the analysis next week to include a few outliers that seem more resilient than others in the category, and those that are definitively the weakest.
Often times, identifying one or two strong companies in a category and patiently waiting can pay off, as the cloud category will put downward pressure on the stock price, including the outliers. Our goal is to buy the outlier(s) after they’ve been unduly penalized.
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Big Tech: Bellwethers for Cloud Spend
Big Tech competes with best-of-breed cloud companies in nearly every capacity. For example, although most think of Azure when looking at Microsoft’s earnings reports, the company has a formidable presence in cybersecurity worth over $20 billion in revenue. Google’s BigQuery is one of Snowflake’s largest competitors, as is Amazon’s RedShift. I covered the differences between the three for Forbes here.
“The Big 3 are the best proxy because their reports represent the layer in the tech stack that tends to be the most resilient in terms of churn. The switching costs are quite high for cloud IaaS services. The Big 3 also afford a more concentrated view by owning 66% of market share across three companies whereas SaaS is spread across thousands of companies.”
The slowdown over the past four quarters is quite visible:
The Cloud slowdown over the past four quarters is quite visible – I/O FUND
The Cloud slowdown over the past four quarters – COMPANY RESULTS
Key Highlights from the Cloud Hyperscalers:
AWS:
AWS sales grew by 20% YoY to $21.4 billion in Q4, down from 27% YoY growth reported in Q3 and down from 33% YoY reported in Q2
Q4 2022 growth rate of 20% was halved as AWS sales grew by 40% YoY in Q4 2021
AWS revenue also missed the management guidance of 25% growth
Guidance for Q1 was not provided, however, it was stated the YoY growth rates in January were “in the mid-teens”
Azure:
Microsoft Azure revenue grew by 31% YoY and was down from 35% in Q3. In constant currency, it grew 38% and beat the management guidance by 1%.
Microsoft Azure revenue grew by 46% YoY and also in CC basis in Q4 2021.
The management provided guidance of 30% to 31% growth rate for the March quarter, down from 38% this quarter and down from 49% on a CC basis in the year ago March quarter.
You may recall the 5-point deceleration announced in the October report caused concern in the market. This is technically a steeper deceleration.
GCP:
Google Cloud revenue grew by 32% YoY to $7.3 billion and was down from 38% growth in Q3. Revenue missed the analyst consensus estimates by 1.5%.
The growth rate was also significantly lower than last year’s growth (down about 1/3rd) when Google Cloud revenue grew by 45% YoY in Q4 2021.
What Big 3 Management Teams are Saying
When there’s evidence of a deceleration, analysts will typically ask the management teams to elaborate on the call with the idea of identifying how much more deceleration may be reported in the future and for how long.
Here’s a question regarding AWS’s slowdown:
Mark Mahaney
[…] Brian, just any color on why mid-teens is kind of a holdable growth rate for AWS over the next couple of quarters, given what looks like pretty clearly, continuing deterioration in enterprise demand?
Brian Olsavsky (CFO)
So on the AWS growth rate, I'm not sure I can forecast for you with any level of certainty what is going to happen beyond this quarter. You kind of — this is a bit uncharted territories economically. And as we mentioned, there's some unique things going on with the customer base that I think many in this industry are all seeing the same thing.
[..] And whether there's short term, perhaps short-term belt tightening in the infrastructure expense by a lot of companies, I think the long-term trends are still there. And I think the quickest way to save money is to get to the cloud, quite frankly.”
Amazon’s management also volunteered the following in their opening remarks:
“Starting back in the middle of the third quarter of 2022, we saw our year-over-year growth rates slow as enterprises of all sizes evaluated ways to optimize their cloud spending in response to the tough macroeconomic conditions. As expected, these optimization efforts continued into the fourth quarter.”
They expect the optimization efforts to continue at least for the next couple of quarters and, in the absence of proper guidance for Q1, said that the YoY growth rates in January were in the mid-teens.”
Per management: “As we look ahead, we expect these optimization efforts will continue to be a headwind to AWS growth in at least the next couple of quarters. So far in the first month of the year, AWS year-over-year revenue growth is in the mid-teens.”
Here’s what Microsoft’s CEO, Satya Nadella, said in the first part of his opening comments:
“As I meet with customers and partners, a few things are increasingly clear. Just as we saw customers accelerate their digital spend during the pandemic, we are now seeing them optimize that spend. Also, organizations are exercising caution given the macroeconomic uncertainty.”
Later in the call the CFO mentions, “As noted earlier, growth continued to moderate, particularly in December, and we exited the quarter with Azure constant currency growth in the mid-30s.”
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My Translation:
Cloud will see belt tightening in 2023 and investors will have to gamble on the timing for when this turns around. It could be in the next few quarters or it could take years. Most of this will depend on the economy, as the common denominator for cloud stocks is budgets.
To be clear, the category has the potential to be quite resilient, which we covered in 2019 when we said, “My prediction is this may be one of the last cycles when tech is considered less safe than value stocks. As the market will find out (the hard way), cloud software is actually very safe. It is insulated from trade wars and overseas manufacturing issues. It reduces costs for enterprises, which is ideal for a recession. Lastly, cloud software is at the beginning of a rapid growth cycle compared to its counterparts in tech — such as mobile, e-commerce and advertising — which are reaching saturation, are finding themselves in the cross hairs of anti-trust and are susceptible to consumer spending changes.”
There are a lot of cloud software bulls and for good reason, this category has treated investors well with predictable revenue growth. Cloud software is resilient because it drives down costs and increases productivity. We know this scenario well as we wrote about it many times in the past few years to defend cloud. Often, cloud selloffs were welcomed to position for a 6-month bounce back after the category sold off (40%) or more. I pointed this out in the past on the free side and here on MarketWatch (behind paywall) in 2019 (i.e., when we weren’t facing a brick wall on growth).
The issue with this assumption is that Cloud growth is actually slowing downCloud growth is actually slowing down —- that is the reality of things —- and this wasn’t true in 2019 and hasn’t been true in the last decade. Couple this with weak bottom lines that require cash injections, and what get is a sector that is largely out of favor.
What Analysts are Saying about the Big 3
Institutional analysts are able to do channel checks. It doesn’t hurt to see if there is more information available directly from large cloud customers.
Here are some recent analyst notes:
BMO Capital analyst Keith Bachman said until Azure growth stabilizes, the shares are likely to be range bound. The firm believes there is too much remaining uncertainty on Azure, which represents about 31% of BMO's revenue estimates.
Piper Sandler analyst Thomas Champion said that the Alphabet’s Q4 revenue and EBITDA missed across the board with advertising trends slightly weaker than expected, driven especially by Network. Search growth also slowed and Cloud growth decelerated 550 basis points. He further said Alphabet is transitioning the cost base for slower growth.
Piper Sandler analyst said that the Amazon’s Q4 results were mostly positive with revenues topping the high end of the guidance range. However, Amazon's guidance was slightly weak as Consumers sound cautious and the Cloud deceleration cadence appears to be landing in the mid-teens for Q1. The analyst believes management comments suggest the company is still navigating a difficult stretch.
Interesting enough, Dan Ives lowered his price target on Microsoft following earnings, yet has raised the price target again recently stating:
[…] [Wedbush is] "seeing steady cloud enterprise spending for Microsoft that has stabilized from the softness we saw in the month of December." Wedbush added that Microsoft, along with cloud competitors such as Amazon (AMZN), Google (GOOG), Oracle (ORCL), and IBM (IBM), are "seeing a surge of Beltway cloud deal activity in 2023 with a major shift to cloud underway from the Pentagon to civil agencies in the 202 area code."
More on Best-of-Breed
To help illustrate how the deceleration is quite steep for some best-of-breed names, we took a sample of the top-ranking cloud stocks on revenue growth, free cash flow, adjusted operating margin and/or valuations.
Among the best-of-breed cloud stocks, only ServiceNow’s guide shows sequential growth. The company’s QoQ growth was 7% last year and is expected to be 8% this year. The largest deceleration was in GitLab, with revenue that grew 12% QoQ last year, is expected to decline (4%) sequentially this year.
Overall, the category is slowing down sequentially (a rather drastic) 83% for Q1 guides compared to the previous year — from an average of 12% QoQ last year to 2% QoQ growth this year.
As stated in our previous analysis, it’s assumed that H1 2022 was strong so YoY is less important than QoQ/YoY. This is because the cloud slowdown happened later in the market cycle with first management comments appearing in Q3.
For example, best-of-breed cloud reported a 71% slowdown in QoQ/YoY growth for Q4 guides and is now guiding for a 83% slowdown in QoQ/YoY growth for Q1 guides.
Best-of-breed cloud reported a 71% slowdown in QoQ/YoY growth for Q4 guides and is now guiding for a 83% slowdown in QoQ/YoY growth for Q1 guides. – YCHARTS
Here is how this compares to last quarter when we were seeing a 2/3 slowdown from 17% to 5% when I stated:
“Yet, the Q4 guidance is out of character as we see a 2/3 decline in average sequential growth rate from 17% to 5%. This is the more severe drop off because Q4 2021 was much better than Q2 2022 in terms of the economy. However, my contention is that Q4 could be reflecting what is to come in 2023 rather a reflection of budgets from 2022 as the slowdown is more pronounced in Q4 than it has been in previous quarters from 2022.”
Source: YCHARTS
Conclusion
Below is cloud’s price action since we last covered the weakness in this sector. This is despite a surprisingly strong January and February for tech.
Above is cloud’s price action since we last covered the weakness in this sector. This is despite a surprisingly strong January and February for tech. – YCHARTS
Both Bill.com and GitLab saw weak price action compared to the others, and coincidentally, both saw sequential growth turn negative. Prior to the current earnings reports, I spoke about Bill.com and GitLab specifically with Samuel Burke of Real Vision when I forecast there would be further weakness in this category.
Many cloud stocks are on thin ice in this regard, and I imagine that if/when more cloud stocks turn negative on a QoQ/YoY basis compared to last year, weak price action will follow.
Every investor must determine their personal risk tolerance. The I/O Fund noticed unusually weak fundamentals in cloud in Q3 and re-allocated our positions to other sectors within tech at that time. However, we are hard at work in determining the one or two cloud positions we’d like to buy when this category reaches a bottom. We share our stock picks plus entries and exits with our premium members. You can learn more here.
Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.
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.
We’d like to set our sights on a few ad-tech names that may benefit from the Google antitrust lawsuit. It may feel like the words “Google” and “lawsuit” are commonplace, but the trial in September carries enormous weight and is unlike the lawsuits of the past. Not only do we want to identify what ad-tech names could benefit should Google’s monopoly be broken up and the juggernaut come out weaker, but we also want to be prepared if the tech giant is able to hold off regulators.
Considering that Google is sitting on the world’s very best consumer data, which is not an exaggeration in the least bit, its ability to lead on artificial intelligence and large language models should not be underestimated. For our purposes, the company is far from sitting on its laurels and there’s a predictable path where the company competes in a duopoly with Microsoft.
Therein lies the issue. Google undisputedly has the world’s best consumer data, but did this grow to become part and parcel with operating a monopoly? The Department of Justice has asserted anti-trust violations against Google with the trial beginning in September 2023. The trial is expected to last ten to 12 weeks, although a lawyer for the DOJ told CNBC it could be as brief as five weeks.
Why it matters:
With Google and other ad-tech companies trading this low, one of two outcomes will happen. The antitrust outcome will be mild, and Google will be empowered to continue to dominate. Or, the outcome will require the ad properties to be broken up, leading to a weaker stance for Google. This could benefit smaller ad-tech players.
The Goal — Looking back:
A few years back, I analyzed the potential outcome of a government decision when the Pentagon was evaluating cloud providers. Clearly, this decision is far outside of anyone’s control and requires some speculation. At the time, I speculated Azure would be a winner. For a year or so, Microsoft did secure the Pentagon contract over the more-favored Amazon. This decision was ultimately reversed, and the contract was split between four tech companies.
The exact outcome of the Pentagon contract was not particularly important because the analysis led to my conclusion that Microsoft’s hybrid computing was a material advantage and this would be the path Nadella would most likely use to take market share from AWS’s heavily-slanted public cloud strategy.
I’m hoping for something similar, which is to acknowledge something very important is going on with ad-tech, which is Google’s antitrust case. This is not a headline to simply dismiss. It’s the first time the DOJ has brought a case of this kind against a technology company since Microsoft. If there are even minor cracks in Google’s monopoly, there could stand to be a stock or two that starts a new trajectory.
On similar note, Cambridge Analytica is what sparked my coverage on Facebook. Similar to Google’s antitrust case, it became apparent to me that Facebook was peaking in terms of its ability to monetize through third party data. I covered this extensively, for example here and here.
Brief Overview of Antitrust Case:
According to Lanier Law Firm, which is the litigation team for the State of Texas in the state coalition case, a primary argument against Google is that the company went above and beyond to become the default search engine on iOS devices by paying Apple $12 billion per year.
The lawsuit includes other deals that Google struck with Apple’s Safari browser, the Mozilla browser and Android device manufacturers where Google either paid up or imposed restrictions on Android device makers to strongarm having their suite of apps pre-installed on the home screen.
The company has already lost an antitrust case in Europe in 2018 with a $4.4 billion Euro fine for forcing Android manufacturers to pre-install Google’s bundle of apps on the device, including Chrome, Maps and the Play Store.
Google’s market share of Search is at 91% and the argument is being made this was accomplished through anti-competitive practices, especially since Google owns Android and had leverage over the many device makers that used this operating system.
In addition to being pre-installed and the default browser/search engine, Google also attempts to keep people on its search engine by using a website’s data on its page. For example, if you look up “Best Dog Breed” Google scrapes Wikipedia and puts the results onto the search page instead of sending you to Wikipedia. This is seen as anti-competitive as it takes a website’s data to profit from it, rather than directing the traffic to the rightful copyright owner, which is the function of a search engine.
Part of Microsoft’s antitrust case was based on Microsoft using its dominance on Windows to force a Microsoft Explorer to be the default browser. At the time, the decision was that default settings are anticompetitive.
The secondary argument filed by a 10-state group led by Texas, is that Google leverages its properties to be the buyer and the seller via its ad exchange. Per Lanier Law Firm, the Texas case states Google and Facebook “unreasonably restrained trade and harmed competition through an unlawful agreement to allocate auction wins and to fix prices in violation of Section 1 of the Sherman Act, 15 U.S.C. § 1”
This is where it gets very messy, and so I’ve dedicated a specific section below to break down these details. The purpose of understanding the minutiae is not to only determine if we should buy Google and when, but also what companies could stand to benefit if Google’s products are shutdown or broken up.
My long-ago analysis on Facebook pointed toward a conflict of interest in the company owning a third-party ad network called Audience Network while also being publisher. At the very least, the conflict of interest created a risk since Facebook was essentially siphoning oil from real estate the company didn’t own (iOS users). This was a serious, material risk for investors that played out over time (note: it certainly wasn’t immediate, it took four years from the first time I covered the topic).
If you’re a Meta investor, you’ll want to watch the CPMs on the company and make sure the erosion below is not permanent. Despite Apple only impacting third-party data, it’s unclear how much of that third-party data was informing its first party data. The unusually high CPMs that Meta charged points towards enhanced targeting – that in my opinion – was likely due to mixing both first-party data with third-party data. This means there will be an eventual erosion, over time, of the CPMs Facebook can charge even on its own applications.
Pictured above: Although subtle, there is an erosion to Facebook’s otherwise high CPMs. You can see that Nov 2022 made a lower high over Black Friday compared to the two previous years. Many factors could be at play, such as lower ad budgets, but it’s something investors should keep a close eye on.
Google currently does the same thing that Facebook used to do, which is to run an ad exchange that is undeniably a conflict of interest. The difference is that rather than renting real estate, like Facebook did with iOS, Google is a real estate tycoon. There isn’t a tech company that can kick Google off their turf because Google owns all of the turf – primarily Chrome, Android, Google Search, and YouTube.cBy conflict of interest, I’m referring to AdX, DoubleClick and DV360, collectively known as the Google Network.
Below, you can see Google Network is a $32 billion annual revenue stream. Not exactly peanuts.
To further the lawsuit, a 30-state coalition has issued a third claim that Google uses its monopoly to rip off smaller companies, such as Yelp, DoorDash, and Kayak. You can see evidence of this when Google Search returns flight searches powered by Google at the top, with a large embedded format, rather than producing a fair search result that includes competitors. Yelp has been in a battle with Google over this for over a decade. After Google Reviews were launched, Google pushed Yelp down the page in terms of search results.
The two search engine allegations are fairly straight forward. Most of us who use Google Search can reasonably understand those arguments.
The Messy, Blackbox that is AdExchange (AdX):
DoubleClick was acquired in 2007 for $3.1 billion. As author Tony Yiu points out on Toward Data Science, this was twice the amount paid for YouTube a year earlier. Google Network is a by-product of many acquisitions including AdMob for $750 million and AdMeld for $400 million, among others, yet DoubleClick truly set the supply side dominance in motion as the company owned 60% of the desktop publisher market at the time of acquisition.
DoubleClick allows Google to set a cookie on a website so that online publishers can better target visitors with ads. The DoubleClick cookie provides the time and date a user saw an advertisement, as well as a unique ID that identifies a user by their browser. Publishers are then able to auction inventory to advertisers.
DoubleClick was a major move by Google to expand beyond search advertising. This was the first time Google entered the market on display ads. As stated, DoubleClick owned 60% of the publisher market when it was acquired, which means Google would eventually profit from monetizing millions of websites.
This led to a concentration of power for Google, because with this advantage, it was able to grow quickly as a predominant ad server for publishers. Naturally, Google wanted to maximize this advantage, and so the company made the appropriate acquisitions to operate on the demand side (advertiser side) in addition to the publisher side.
Through a series of acquisitions, Google built DV360, which allows advertisers to use their own data to target customers across publisher inventory. Google always has strong ties to data, in this case powering DV360 with Google Analytics 360. In addition to this, Google’s AdX allows advertisers to create campaigns across Google-owned properties in addition to millions of websites from third-party publishers on the DoubleClick publisher side, as mentioned above.
An easy analogy here would be to compare it to a real estate transaction, since ads are transactional between a buyer and seller. In this case, Google was representing both the buyer and the seller, and in some cases brokered its own real estate to the buyers. You can imagine due to Google’s scale of doing millions of transactions a day, things might get unethical real quick.
Here’s how a Google executive put it:
“[I]s there a deeper issue with us owning the platform, the exchange, and a huge network?” the executive allegedly asked. “The analogy would be if Goldman or Citibank owned the NYSE.”
With that in mind, let’s continue because the depth of Google’s black box is quite deep.
The product AdSense further pools the data provided by publishers. When millions of websites join AdSense to pool data, Google can record more information on a person’s browsing history. It provides a complete view of the consumer for more enhanced targeting. Another area that Google allegedly monopolizes the market is that the company mixes its first party data with this third party data, but only in instances where Google will benefit.
The AdMob acquisition in 2009 provided a similar strategy as DoubleClick but on mobile. It deepened Google’s reach on the supply side for the mobile market. This, of course, was especially advantageous considering Google bought Android in 2005.
You can imagine, that the depth of Google’s data on desktop users and mobile users is deep (and likely quite dark). Meaning, Google knows more about you than you know about yourself. Now, take that depth of data and add the serious conflict of interest that can occur when Google bids against competitors.
Where Google (Allegedly) Went Wrong with AdX
Despite the allegations below that Google was unethical, I want to point out that antitrust could be harder to prove for AdX. This is because many corporations combine first-party publisher data with a third-party ad exchange, such as Amazon, Facebook, Disney and Comcast. Microsoft is building its ad exchange, as well right now, after acquiring Xandr from AT&T. However, Xandr/Microsoft’s strategy is to support the “free and open web” by adopting the Unified ID.
Point being, if the product AdX is found to be anticompetitive, it could have far-reaching implications for other companies. This wasn’t the case with Microsoft, as the company was rather isolated on its throne in the late 90s. With that said, Google is the worst offender in terms of the sheer advantages it has compared to other corporations with large media properties.
Here are some of the more unethical things Google is being accused of:
According to the lawsuit, there was a 65% drop in revenue if publishers chose to not use Google on the demand side. Advertisers are also stating this was a conflict of interest as Google restricted inventory in this case. This would be like a real estate agent refusing to show a house if they did not have both the buyer and the seller to double-end the transaction.
Google also allegedly circumvented waterfall auctions to prioritize their own bids on AdX. Waterfalls were prevalent throughout the ecosystem because they allow exchanges to be ranked by bids. Based on historical bids, if the ad exchange in the number one position doesn’t buy the inventory, it goes to the next ad exchange in the waterfall (the number two position).
Where Google may have manipulated the bidding is by allowing their exchange to meet only floor prices to win the bid, even when another exchange would have bidded higher in a waterfall-like auction. This would be like a real estate agent only presenting their Buyer’s offer to a Seller even if they knew they could get higher offers from another agent.
Due to DoubleClick and AdX waterfalls having the issues described above, programmatic header bidding was introduced to offer true, real-time bidding to increase publisher yield. It essentially increased competition by holding an open auction rather than a closed, blackbox auction that pushes inventory back and forth in an attempt to sell the inventory.
Per Digiday written in 2015: “One notable side effect of header bidding adoption is that it puts pressure on Google’s DoubleClick for Publishers ad server, which, through its dynamic allocation feature, lets AdX — but no other exchange — see and bid on every impression.”
That sentence and general understandingand general understanding of what AdX did to manipulate the waterfall process nicely sums up where Google could face trouble in a courtroom. According to the lawsuit, publishers saw 30% to 40% more revenue through header bidding by simply removing Google’s ability to manipulate the waterfall auction. I bolded “general understanding” because Google is so powerful that the ad ecosystem knew full and well that it was using its monopoly in anticompetitive ways but there was nothing any publisher or advertiser could do about it.
Google has tens of thousands of engineers and is a very advanced company, which is why the allegations are quite complex. The lawsuit points out that Google then later manipulated header bidding by allowing AdX to bid last. As long as AdX beat the previous bids, then it would win the bid. Going back to the real estate agent scenario, this would be like having multiple offers on a house, and the listing agent going to their exclusive buyers to reveal what the prices are to help the buyers win the bidding war.
Google is also accused of using more acquisitions for ad technology that would later be leveraged to subsidize bids. This means Google paid the difference on an advertiser’s bid in order to be the winning bid. In this case, Google simply increased its margin or cut in order to make up for the amount that was subsidized.
Google’s DSP called DV360 was also allegedly engineered to decrease bids from competing ad exchanges, including those who were using header bidding for a more fair auction process. This was done by setting the highest competing bid at the floor price while AdX was able to bid higher.
Google is accused of suppressing header bidding through covert mechanisms by reducing header bids by up to 90%. Meanwhile, Google’s own DV360 bid was not decreased. This was done even when Publishers attempted to set a lower floor for competing ad exchanges, meaning, Publishers were without recourse even if they agreed to a lower bid.
Possible Outcomes
The outcome that many competing supply-side platforms (SSPs) and demand-side platforms (DSPs) are hoping for is the adoption of the Unified Ad ID 2.0 (UID2). There are many investors in The Trade Desk on our site, so this term is likely very familiar to our IOF Members.
The Unified Ad ID is essentially a replacement for cookies that uses email-based identifiers. There are a few hurdles here, such as users would have to opt-in and it brings up privacy issues to have ad exchanges passing a more persistent signal, such as anonymized IDs based on emails. What UID does solve for is any anticompetitive practices as there are many companies in the ecosystem that have signed on to support the open web initiative.
There are more companies than just The Trade Desk that would benefit if this happens – companies like Magnite, PubMatic, Microsoft/Xandr, to name a few.
To be clear, I’m not sure UID2 is realistic because of the privacy hurdles. The ad ecosystem may be “all-in”, but consumers are not likely to opt-in to having a persistent signal.
Another possible outcome is that Google Network is not broken up because what the company did was perhaps unethical but not anticompetitive since many corporations do something similar – which is mix first-party data with third-party data, and otherwise wield their large, corporate publisher dominance.
Instead, there could be regulations that force more transparency in the pricing structure. Or, perhaps Google has to choose a side in the transaction (publisher or advertiser) but cannot serve both.
It’s also possible that Google is not allowed to compete as a Search Engine across other verticals, such as flights, reviews, or dining reservations and must direct the traffic to web pages.
Companies that Challenge the Walled Garden
The ad ecosystem is quite large, although there are only a handful of public companies for us to discuss. Below is a view of the 2023 ecosystem per Publisher Management company Playwire. Most of these companies stand to benefit in some manner should Google be broken up or otherwise made weaker.
As stated, Google Network generated $32.8 billion in 2022. The DOJ is asking for divestiture ‘at minimum’ to divest the Google Ad Manager, including its publisher ad server (DFP) and the ad exchange (AdX).
In addition, the search engine is in the crosshairs for anti-competitive behavior, such as requiring mobile OEMs to make Google the default search engine. When Microsoft did this by requiring Microsoft Explorer to be the default browser across PCs, the behavior was found to be anti-competitive.
We believe the following companies stand to benefit:
Perion Network is partnered with Microsoft Bing. For this reason, the company is considered a beneficiary of Chat-GPT. If Google Search is forced to play fair, it’s likely Bing would see an incremental increase in its market share. In addition to this, Perion does not rely on cookies. As cookies are phased out, ETA around Jan 2024 (assuming no further delays), Perion will stand out in this regard, as well. Perion uses search intent insights to create audiences or “SmartGroups” for targeting purposes. Perion can help any search function, so imagine the search you might perform on Pinterest or Expedia. This is unique because search intent is often a superior signal compared to other forms of behavioral targeting.
The Trade Desk sits on the demand side and is in direct competition with Google’s DSP. If Google has been strongarming publishers into using its exchange for ads, per the allegations noted above, then breaking this up would be an immediate tailwind to The Trade Desk. Essentially, Google is penalizing publishers in various ways if they use another DSP.
If it becomes a more equitable ecosystem, to where publishers are rewarded equally no matter which DSP they use, then The Trade Desk will be able to fairly compete with Google on their publisher inventory. This assumes that Google will be able to keep the supply side ad machine it acquired from DoubleClick for Publishers. Clearly, The Trade Desk has done well in a walled garden environment despite all odds. It’s reasonable to assume The Trade Desk will do better if those walled gardens become weaker.
Notably, as stated above, The Trade Desk has two hurdles – the second one being the elimination of cookies and IDs. This is a separate issue entirely and does not relate to the antitrust case, it just happens to be timed to where the antitrust case is in 2023 and cookies will be phased out in 2024.
The goal is for Unified ID to be accepted as part of the open web, but there are privacy hurdles here that don’t relate to anticompetitive practices. In 2021, 96% of iOS users opted-out of tracking. The same can happen to UID 2.0. In other words, Google could be broken up but this may not do much for allowing the demand-side to access third-party IDs for attribution and measurement.
Magnite and PubMatic compete with Google on the supply side. Publishers have an outsized advantage when they use Google on the publisher side as the company mixes its first party data with third party data to drive the industry’s best targeting. Similar to Meta’s Audience Network covered here, it’s nearly impossible to compete as a SSP when a publisher of Google’s magnitude combines its data and brokers for a pool of publishers.
If this is broken up, then those who specialize on the publisher side — while also not directly competing with publishers — stand to benefit. Because Google is the largest publisher in the world while also competing with smaller publishers for ad inventory, it seems a likely outcome will be the breakup of the SSP side, at the very least.
The hurdle the SSP side must clear is that many corporations do this – with that said, Google is by far the largest offender due to its commanding properties of Android, Chrome, Search and YouTube. It’s also not clear if the other corporations (Comcast, Disney, etc.) have leveraged their position to penalize publishers who use other SSPs.
Ad-Tech Fundamentals
Below, we go into brief overviews of each company’s financials. The goal of combing over these companies during a lull in earnings is to accomplish a few things. First, to acknowledge that this antitrust lawsuit should not be overlooked. The ramifications could be quite advantageous to a few small cap companies. Secondly, to cautiously watch the charts ahead of the trial. We don’t want to front run but we also don’t want to be complacent. Third, is to understand Google a bit more. In the avalanche of Chat-GPT coverage, we want to be realistic about a potential position in Google, and look at the brass tacks of this important lawsuit.
Ultimately, I believe the outcome of the antitrust lawsuit is more important than the hype of the chatbots in the near term – that goes for both Google Search and Bing. AI chatbots are great for early adopters but search engines serve the masses. In addition to this, considering Google Network is worth $32 billion, and we have some small caps that could stand to benefit, we want to be prepared if there is a favorable outcome for the smaller players.
Perion Network
Perion Network is a digital advertising company headquartered in Holon, Israel. The company offers digital solutions in three primary channels of digital advertising: ad search, social media, and display/video/CTV advertising.
Perion helps brands and publishers to identify and reach customers through the company’s proprietary Intelligent HUB (iHub), which processes billions of signals, and powers the cookieless solution SORT. By mixing contextual data with user insights, Perion is able to forego cookies by using this data with AI-based clustering techniques. SORT stands for Smart Optimization of Responsive Traits, which translates to categorizing customers into 1 of 30 Smart Groups through shared traits.
The primary sources of data are contextual – so what a customer is reading at the moment, why they’re reading it, how long they’re reading it and/or what search words brought them to the content. This is combined with signals such as time of day, weather, browser, device, etc. Ultimately, what Perion’s technology does is calculates the similarities between groups, and then to target the group that performs the highest in terms of converting. The model is deemed effective when one group has a significantly higher click-through-rate (CTR).
Second, SORT then optimizes the bids so that it’s a cost-effective solution. SORT analyzes the bid of each publisher and selects the price that is likely to win. If the price is too high, SORT finds another publisher with a similar audience as the SmartGroup. The entire process happens in real-time.
Doron Gerstel, CEO of the company, said in the Q2 2022 earnings call, “iHub sits in the center of the supply and the demand side of the market. This is an innovative model that no one else in the industry has, aggregate data signals from all channels and from both sides of the open web to create the model that eliminates waste and rewards clients. The data goes into Perion’s privacy first cookieless solution known as SORT.”
This is important because cookies are expected to be phased out from Chrome in 2024. Cookies have already been phased out by Mozilla Firefox and Apple Safari.
In addition to this, Perion has partnered with Microsoft Bing. CodeFuel is the Perion product that powers intent-based monetization. When you go to search for something on a search engine, Perion’s CodeFuel can power the search results in an optimal way for conversion. This has led to a strategic partnership between Microsoft and Perion that was renewed in 2020 for four years.
Per the recent earnings call, “If the new Bing search with ChatGPT sparks even modest share gains, Microsoft can do very well in the business. As their CFO, Amy Hood said yesterday, every percentage point of share it gains in search equals roughly $2 billion in additional advertising revenue, and as a strategic partner of Microsoft Bing, I’m sure we will be benefiting from this increase.”I’m sure we will be benefiting from this increase.”
Notably, there is a risk that Microsoft does not renew its partnership next year. However, this risk is muted a bit since Perion was named “Global Supply Partner of the Year” by Microsoft in 2022.
What’s interesting about Perion is that the company is fundamentally one of the strongest ad-tech companies on the public markets due to a strong bottom line and a top line that was more resilient than its peers. Any windfall here could very interesting for a company that already proven operational efficiency with a 20% operating margin while maintaining 30%+ growth in the tough year of 2022. Notably, the top line is decelerating but a catalyst that could lead to a reversal here could be quite interesting
The company’s revenue in the recent quarter grew by 33% YoY to $209.7 million. Display advertising revenue grew 24% YoY to $123.8 million and search advertising revenue grew 49% YoY to $85.9 million. The company had an operating margin of 20% compared to 13% in the same period last year.
The company is GAAP profitable, and margins are improving. The net profit margin improved to 18% from 11% in the same period last year. The adjusted EBITDA margin was 23% compared to 18% in the same period last year.
Source: Company IR
The company has free cash flow of $37.90 million representing a free cash flow margin of 18%. Perion had cash and bank deposits of $429.6 million and no debt at the end of December 2022.
Revenue growth is expected to slow, as seen below. The company’s revenue grew above 30% in all four quarters in 2022, and it grew 34% YoY to $640.3 million for the full year of 2022. This is expected to level off quite a bit, presumably due to industry-wide headwinds.
Source: Seeking Alpha
Magnite
Magnite is another ad-tech company that is a potential beneficiary. Magnite is a sell-side platform (SSP) that offers exposure to a higher mix of CTV ads from an independent SSP than what is currently on the market.
We previously discussed Magnite is both an ad server and a Supply Side Platform. Strategically, this allows Magnite to compete with FreeWheel and Google and helps them maintain their position “as the largest independent programmatic CTV marketplace.” The SSP allows for programmatic and private market place bidding while the ad server stores the creatives and serves the ads. The SSP facilitates the selling/bidding (auction) while the ad server actually manages, stores and serves the ads. SpringServe is ad server that Magnite acquired for $31 million. The acquisition came from SpotX’s option to buy.
In their recent earnings call, the management highlighted that Disney has renewed their agreement to use Magnite as Disney’s global programmatic SSP partner. “As you may recall, our relationship with them started with Hulu. We have since grown the relationship to include the full portfolio of Disney properties.”
The company’s Q4 2022 revenue ex-TAC grew by 10% YoY to $156.6 million. The operating margin was (16%) compared to +2% in the same period last year.
Net losses are increasing to ($36.4) million with a net margin of (21%). This compares to $453,000 in net profit for a flat net margin in the year-ago quarter.
The company reported GAAP EPS of ($0.27) compared to GAAP EPS estimates of $0.02. The adjusted EPS also missed at $0.24 versus $0.32 expected.
Our recent analysis discussed that the company missed on the bottom line due to the new CTV ad platform that was launched in February. The newly launched Magnite Streaming is a single supply-side platform that merges the technology from Magnite CTV and SpotX platform. Magnite Streaming led to a $35 million accelerated amortization.
Cash flow was the strongest line item in Magnite’s report. Free cash flow margin was 28% compared to 34% in the year-ago quarter. The company has $326.3 million in cash on the balance sheet with $726.4 million in debt for net debt of $400.1 million.
Below are the analyst’s ex-TAC revenue estimates. Magnite’s revenue is also decelerating.
Source: Seeking Alpha
PubMatic
PubMatic is another sell-side platform that is a potential beneficiary. The company works with over 1,600 publishers. In the recent earnings call, the management highlighted new partnerships with Roku, TiVo, and Kroger.
Rajeev Goel, CEO and co-founder, pointed out that the company has increased its market share from 2-3% at time of IPO in Dec 2020, “We ended 2022 with an estimated market share of 4% to 4.5%, significantly up from when we went public just over two years ago. We are well on our way to our stated goal from the time of our IPO of 20% market share, and we intend to use the downturn to further accelerate our gains.”
The CEO pointed out that Google’s antitrust case could help them achieve the (lofty) 20% goal: “Advertisers and publishers continue to seek alternatives to the walled gardens. This tailwind, along with structural changes, including ongoing antitrust activities, will only expand our total addressable market as an independent technology provider.”
The company’s revenue in the recent quarter declined by (1.7)% YoY to $74.3 million. The operating margin was 22% compared to 37% in the same period last year. The drop in revenue led to lower margins when we compare it to the year-ago quarter. However, the Q4 operating margin was the highest for the year 2022. Net margin was 17% compared to 37% in the same period last year.
The free cash flow in the recent quarter was $7.02 million, with a free cash flow margin of 9% compared to a free cash flow of $18.72 with a free cash flow margin of 25% in the year-ago quarter. The company has cash and marketable securities of $174.4 million with no debt. The analysts expect revenue to decline in the next two quarters. In the earnings call, management was cautious about the macro environment.
Source: Seeking Alpha
The Trade Desk
The Trade Desk is an independent demand side ad platform. We discussed the Universal ID in August 2019. “Strong drivers for The Trade Desk include omnichannel capabilities, which is the ability to buy ads across many channels, such as mobile, video, audio, display, social and native. The universal ad ID is another important differentiation as it offers an anonymized ID that helps track users, target audiences and provide attribution.”
The Trade Desk has benefitted from its omnichannel approach that also focuses on CTV. Jeff Green, CEO and founder of the company, said in the recent earnings call. “CTV continued to be our strongest growth driver as more content owners from around the world are moving beyond ad-free subscription models and offering ad-supported options for viewers.”
Jeff Green mentioned in fourth quarter last year, about 15% of the Trade Desk’s third-party data had UID2 associated with it and expects it to be in the 75% range in the first half of this year. “In fact, I would say again that it becomes about 10x more valuable than with cookies, simply because UID2 solves the needle in the haystack problem that came with cookies, because advertisers can now match their customer data with accuracy across the open Internet more effectively than ever before.”
Jeff Green also sounded confident in the earnings call that the outcome of the DoJ will benefit the company. “I know there is some at Google who tried to suggest that we have been through this three or four times before. I do believe that this is fundamentally different. And part of that is just because of how detailed I think the case is outlined.”
The Trade Desk has illustrated a strong bottom line despite a tough 2022. The company’s Q4 revenue grew by 24% YoY to $491 million. The operating margin was 20% compared to (6%) in the same period last year. The net margin was 15% compared to 2% in the same period last year. The adjusted EBITDA margin was 50% compared to 48% in the same period last year.
The company has free cash flow of $123 million with a free cash flow margin of 25% compared to $151 million compared to a free cash flow margin of 38% in the year-ago quarter. The company had cash and short-term investments of $1.4 billion with no debt.
Below are analyst revenue estimates for the next few quarters. Analysts expect the revenue of the company to grow faster when compared to the other ad-tech companies we covered, and the company also has a premium valuation.
Source: Seeking Alpha
The Trade Desk has a forward P/S ratio of 15.14 compared to 2.53 for PubMatic, 2.47 for Magnite, and 2.22 for Perion Network.
Given the sheer impact a weaker Google could have on the ad-tech ecosystem, we wanted to do a deep dive and get in front of this. Most of the names listed are familiar to our Members, yet these names may be seeing the biggest catalyst in their respective company’s history. This will depend on outcome of the antitrust lawsuit and the severity of the DOJ’s actions.
Perhaps the opposite will happen. Perhaps Google’s deep pocketbooks will provide top tier lawyers who can defend the case accordingly. As investors, it’s not our job to take sides but to find where ad dollars may be flowing next.
Ultimately, I believe this is the number one catalyst across ad-tech this year and we want our readers to benefit no matter the outcome. As the market can often do, there may be some price movements ahead of the trial, and if so, we will be watching for entries closely.
The world today was engineered to be ephemeral and noisy. This is a terrible combination for an investor.
On Twitter alone, there are 456,000 messages sent every minute. On Facebook, there are 510,000 comments posted every minute and 293,000 status updates. Outside of social media, there are 16 million text messages sent every minute and 156 million emails.
For an investor, the antidote to noise is quality stock analysis. Due diligence requires dozens of hours per equity, and it takes hundreds of hours every year to produce a free newsletter with quality analysis. I/O Fund strives to offer some of the team’s best analysis for free, and we believe the consistency and depth of what we provide for free is hard to replicate.
We offer this in the most challenging sector for investors, which is hands-down the tech sector. The tech sector is unusually challenging because it involves many different verticals – consumer, media, cloud, artificial intelligence, electric vehicles, and more. It’s also the highest risk and highest reward sector in the market. Due to sudden price movements in both directions, the stakes are high. Perhaps we are biased, but quality analysis particularly in the tech sector can be hard to come by.
Below are highlights from our free newsletter during the grueling year that was 2022. Due to the broad market being in the driver’s seat, our first few highlights review the free broad market analysis we published followed by a few strong fundamental calls.
For more information on our premium services, please click here.
Top Broad Market Highlights from I/O Fund’s Free Newsletter
The August to September Pullback:
Portfolio Manager, Knox Ridley, warned our free readers in August in the article, “Levels to Monitor in the Coming Pullback,” that the broad market failed to make a new low despite bad news and that a pullback was on the horizon. He also detailed why weakness in the bond market was coinciding with the pullback he was forecasting.
The analysis stated, “In last week’s broad market webinar, we warned our readers that a pullback was imminent. We also laid out what levels need to hold in order to confirm a new uptrend is forming. We also showed that the bond market is simply not buying what the equity market is, and that the USD pushing to new highs along with equities. These markets are simply not aligned with the current uptrend in equities, and until they are, we will remain cautious.”we warned our readers that a pullback was imminent. We also laid out what levels need to hold in order to confirm a new uptrend is forming. We also showed that the bond market is simply not buying what the equity market is, and that the USD pushing to new highs along with equities. These markets are simply not aligned with the current uptrend in equities, and until they are, we will remain cautious.”
Despite a level of exuberance in the markets following a bear market rally that formed in July, our analysis clearly stated now was not the time to buy – rather it was better to wait for the coming pullback: “These markets are warning investors that are paying attention to not get too excited, yet. No matter what scenario plays out, we do believe there will be a better opportunity to get aggressive on the long side.”
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Perhaps most importantly, to help with risk management, the analysis provided a long-term prediction for investors. The analysis stated: “No matter what scenario plays out, we expect around a ~10% pullback in the coming weeks, which should be followed by one more large push above SPX 4400 before the next leg lower begins.”
Carefully Timing the October Bottom:
Knox followed up with another article, “The Pullback is in Effect – Broad Market Levels – 08/26/2022”, to reiterate to our free newsletter readers that the pullback we have been warning about is in effect. The analysis provided two long term bullish scenarios. In the bullish scenario, we advised investors to buy on the second wave retrace, sometime in October.sometime in October.
Knox provided a macro update in September and discussed the key economic data points in the article “Broad Market Update: The FED versus Inflation.” The analysis points out how the FED team of experts completely missed the warning signs of data from The NAHB Index, The Case-Shiller Home Price Index, The Bloomberg Commodity Index, Crude Oil, and M2 Money Supply, pointing that inflation was a concern in 2021.
The analysis stated, “Despite the numerous market indicators pointing towards growing inflation pressures in September of 2021, the FOMC ignored the signs, and instead continue to press their loose monetary policies. They ultimately waited a year after inflation showed up to begin addressing it, putting them much farther behind the curve than investors are used to.” The aggressive increase in interest rates led to the worst stock market on record in nearly 50 years.
The analysis pointed out the similarities seen during 2021 and we hedged most of September last year to protect the portfolio from the downside risk with real-time alerts sent to members. Knox also provides regular macro updates to our premium members.
He stated: “I do believe many stocks and some markets have bottomed, and those are the ones that tend to lead going into the next uptrend […] In conclusion, we are seeing the types of extreme sentiment readings as well as divergences that mark a reversal. We are also seeing the market shrug off horrible inflation data. Since the PPI and CPI numbers came in hotter than expected, the market is up 6.5%. The last time we saw these patterns was in mid-June, just before the market moved up 18% in less than 2 months.”
Since then, we have seen a 3-month plus bounce where some stocks in our portfolio are up over 100% since we bought them around those lows. The I/O Fund portfolio manager put cash to work based on the analysis he provided at the free level. He also used more advanced analysis that he provides to our premium subscribers to help guide entries.
For example, after raising cash in mid-late August, on October 13th, we went on a buying spree within the first hour of the market open, while removing half of our hedge. We followed this up with various buys between October 14th, 18th, 21st, November 4th, 7th and 9th.
Every trade the I/O Fund makes is done through real-time trade alerts. Learn More.Every trade the I/O Fund makes is done through real-time trade alerts. Learn More.Learn More.
In detailing the October low, the I/O Fund free newsletter stressed the importance of tracking divergences.
The analysis pointed out, “We are seeing [divergences] now across bellwether stocks, varying sectors, and global markets. Many risk assets as well as global markets did not follow the S&P 500 (SPY) to new lows last week. Instead, they are signaling that a new push higher is likely to follow.”
This was partly determined by the fact transportation stocks, high beta, and small caps have been leading the markets since 2021, and when the S&P 500 made a new low, these markets made a new high. This was unique analysis that informed a critical turning point in the tough market of 2022.
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There’s more — the above article was followed up with more evidence in the article – “The Bear Market Rally has Much Further to Go.” when Knox stressed that the market was ignoring the fact that small caps, financials, and industrials are in notable uptrends. Even within tech, there was new leadership developing and these new leaders tend to be stocks that outperform in new uptrends.
Knox talks about patterns of major indices like the Canadian S&P/TSX Composite Index, the Japanese Nikkei 225 Index, and the Australian S&P/ASX 200 Index. The Canadian Index has a history of leading the S&P 500 Index. He stated that if all the major global markets are moving in the same direction, you are in a very powerful trend. Knox also points to some of the key levels that he monitored to confirm an uptrend for the S&P 500 Index. He said three markets, namely the Canadian Index, the Japanese Index, and the Australian Index need one more move to go higher. This pattern is very bullish for equities.
Below is a chart that shows the I/O Fund’s accurate broad market calls, particularly the prediction of a market drop in August and the bottoming in October. These calls were used alongside an automated hedge signal developed by Vincent Duchaine of The Wealth Umbrella, who is an A.I. and Machine Learning engineer.
Bitcoin:
We announced that we were buyers of Bitcoin around $16,000 and gave in-depth analysis on why a major low was likely from these levels in the article, “Bitcoin is Going to Rally Again – Here’s What You Need to Know.”
Per the article, “We are seeing more and more institutional investors, economies and businesses adopting Bitcoin. Though we are in the 4th bear cycle in Bitcoins history, the prior 3 cycles suggest where we are is a rare buying opportunity. There is ample evidence to support the $15,500 level is either a major either a major lovelow or very close to a major low. Both the technical and on-chain analysis support this.”
Bitcoin is up 36% since the article was published in December, and is just shy of the initial price target discussed in the article of $25,600. Here is what was stated: “our multifaceted analysis into Bitcoin is supporting the likelihood of a larger trend reversal. This is not confirmed from our end until we see price make that last high in the coming weeks towards the $25,600 region.”
As of now, it appears to be setting up for one more push before we see a deeper pullback. Knox updates our premium members in real-time on Bitcoin and all other portfolio positions the I/O Fund owns.
Source: YCharts
Top Fundamentals Highlights from I/O Fund’s Free Newsletter
Nvidia Stock:
The I/O Fund has an unusually strong track record on Nvidia. In fact, Beth Kindig began covering Nvidia’s product strength on artificial intelligence nearly five years agonearly five years ago. Considering it’s the best performing mega cap stock in the tech sector since the team initiated coverage – beating all FAANGs on returns — we think this is an important accomplishment.
In 2022, Beth Kindig encouraged her followers to stay long on Nvidia in August during an interview with Charles Payne on Fox Business News. Nvidia had pre-announced a Q2 2022 revenue miss of $2.5 billion due to gaming and crypto mining related weakness and the stock was tanking. The revenue miss caused the stock to sell off (8%) in one day on already weak price action of (40%) YTD.
Many pundits were questioning if Nvidia could overcome the gaming segment weakness, given Ethereum’s Merge to Proof of Stake would permanently reduce demand for gaming GPUs.
Charles Payne asked Beth Kindig if she still plans to hold the stock given the crypto mining surprise. Her answer was fairly simple: “It’s a tough day for Nvidia investors but in the long run it’s not going to matter. We hold the stock for its lead in artificial intelligence. Anything outside of that thesis is not important to us. To be contrarian, data center is going to be up 61%, so for AI investors such as myself, we are right on track.” AI investors such as myself, we are right on track.”
At the time of writing, the stock is up 39% since the interview compared to the negative (6%) for the Nasdaq-100 Index. However, most importantly, this conviction coupled with Knox Ridley’s broad market analysis caused the I/O Fund to enter Nvidia on the very day the stock bottomed for a price of $108 with a real-time alert sent to Premium customers. Below is the I/O Fund trading history on Nvidia which shows why it’s important to have conviction in tech stocks.
The Gaming Bottom:
Many thought it would take Nvidia a long time to recover from gaming, however, our analysis in September stated the company was “Ready to Rumble” and would stage a quick comeback. The free analysis stated: “Nvidia’s GeForce RTX 40 Series is perfectly timed” Nvidia’s GeForce RTX 40 Series is perfectly timed” and that the “timing of these releases is no coincidence as it’s a rapid two months following the crypto/gaming revenue miss. Suffice to say, Nvidia’s management team is prepared to rumble —- putting its very best release in gaming and its most powerful AI chip to-date up against the crypto mining selloff.”
This was important because it helped the team time the Nvidia entry at bottom, and it was this exact analysis the team depended to feel confident that the crypto mining sell-off would not take as long to absorb as many critics had forecast. Fast forward, and the most recent earnings report in February of 2023 confirmed that gaming had bottomed and was up 16% sequentially, which is what Beth’s analysis had called for a few months prior.
Notably, all of this analysis was provided for free in the I/O Fund newsletter.
Netflix:
Netflix is another hidden gem that Beth wrote about for her free newsletter readers in June. She highlighted that the market was focusing on the loss of subscribers for the stock selloff, which was a mistake, and that it was more important to look at Netflix’s plan to monetize the 100 million viewers who are sharing passwords.
Beth said, “I would argue the day that Netflix’s stock price dropped 35% was consequently one of the most important days in the company’s history in terms of its chances for a boost in revenue and a renewed uptrend. Patience, though, will be required, as Netflix has work to do (minimum one to two years for full global roll-out). Yet the path to adding more subscribers is finally clear for Netflix and will pay off long-term especially during times of inflation or muted consumer confidence as it drives down household costs across fragmented subscriptions.”
The company’s decision to start an ad-supported tier was a key highlight in the article that would drive the share price higher. “We think Netflix could set a new record on ad-supported ARPU due to its premium content and captive audience.”
The stock was down YTD 71% at the time the article was written in June for free newsletter subscribers. The stock is currently up 70% since the article was published.
Source: YCharts
While reviewing the financials of the company, Beth also noted to her readers to keep an eye on improving free cash flow as management was expecting $1 billion free cash flow in 2022 and
“substantial” free cash flow in 2023.
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In a premium note to I/O Fund subscribers, the team stated said the free cash flow for 2023 would likely be in the $2 to $3 billion range. Months later, the company beat its guidance by reporting a $1.6 billion free cash flow in 2022 and also provided a strong guide of a $3 billion free cash flow in 2023. This also contributed to Netflix’s strong price action of the 2022 low.
Cloud:
During the podcast Barron’s Live, Beth highlighted to her readers that cloud valuations were still trading higher than they did prior to Covid. She also pointed out that the Enterprise sector could be the next shoe to drop after the consumer sector due to budget constraints.
About two months later, this exact scenario was echoed in cloud earnings. In December, our free analysis highlighted that cloud growth rates were slowing very quickly. On average, analysts expected the top cloud companies to only grow 5% sequentially QoQ compared to 17% QoQ last year. The analysis was quite clear this was a red flag because Q4 is typically quite strong for cloud, and that this deceleration likely foreshadowed more slowing growth for 2023 once annual budgets were set in January.
Below is a chart that the I/O Fund published to premium members, however, there was coverage on the free side that pointed toward the same conclusion.
Using this analysis, the I/O Fund prudently decided to reduce the firm’s exposure to cloud. The Q1 guides would later report one of the slowest growth rates in the Cloud segment in the past decade.
Conclusion:
Last year marked the biggest destruction of wealth on record, and the tech sector was not immune to this. However, by dedicating to due diligence, the I/O Fund team was able to mitigate some of those losses with a few strong calls – not only in tech stocks – but also strong calls on where the broad market might go next.
Certainly, there were many lessons learned last year and this write-up is not intended to forego the puts and takes that all investors experienced in 2022. Rather, it’s a spotlight on how the I/O Fund strives to provide quality analysis to the community for free.
In addition, this write-up helps illustrate how the team operates behind the paywall. The team is proficient at not only product and fundamentals, but most importantly during a bear market, the team is capable of making accurate calls on what the broad market might do next. To raise the bar, the team partnered with The Wealth Umbrella on an automated hedge signal for their Premium Members. The hedge combined with buying a few high-allocation stocks near or at the lows last year is how the I/O Fund was able to mitigate losses in 2022.
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The I/O Fund is a publishing company. The analysis, strategies, reports, activity and all other features of our service is provided for informational and educational purposes only, and should not be construed as personalized investment advice. Hedging is an advanced method of trading stocks, sudden losses can occur, and hedging should only be pursued under the supervision of your personal financial advisor.
Last week, we published the Top 5 Stocks of 2022 on Forbes. Below, we expand on that list to include an additional 5 Stocks for our Essentials Members. We believe this is one of the most important pieces we can write – not because we are looking to buy these exact stock tickers in 2023 – but because it’s sending an important message about what stocks performed well in the new macro conditions of 2022.
The number one mistake that tech investors are making is to white knuckle the idea that growth will lead. We know this mistake well as we made this mistake ourselves before pivoting hard in April/May of last year to overhaul our tech portfolio for bottom line strength. This will change again but we think it’s premature to assume it will happen in H1 2023.
What you’ll note below are a few things:
The market greatly rewards expanding margins and increasing profitability:
o Gross Margin should be flat to expanding
o Operating Margin should be flat to expanding
o Net profits should be flat to expanding, this is expressed by earnings per share growth (EPS)
As we move into Q1 earnings, the above three-line items can make or break an earnings report. Our plan is to build key positions that demonstrate strength in these line items throughout this upcoming earnings season. This is playing it safe and assuming top line growth is not in the driver’s seat yet. It also means we believe there could be more deceleration to come on the top line across many otherwise-solid tech companies. It’s hard to guess which ones will decelerate and we prefer to make companies prove themselves and earn a spot in the portfolio.
The market rewards accelerating revenue. You can argue this is a no-brainer but with so few tech companies being able to accelerate revenue right now, this requires a sharp eye as tech investors are hung up holding on to favorites/darlings that reported decelerating revenue in 2022. We allow some variance here but it’s better to step aside if the revenue is decelerating too much and return to a stock when it can prove it’s found a revenue bottom in its fundamentals.
This means, we’ve made a choice to put risk above reward. We could be wrong and growth could go on a big winning streak. We feel we are agile enough to recognize if the leadership changes, and if so, we will change our strategy at that time. For now, every signal we follow proves that earnings are in the driver’s seat. We’ve published on this throughout many of our broad market and earnings coverage articles, for example:
Knox has stated the Dow is the leading broad market index to watch. He has also discussed that the FAANGs are not the leaders, which also marks an important change. Overall, this means growth stocks are not truly in the drivers seat right now over value.
I covered the slowing growth in cloud for Essentials here. I fully believe some cloud stocks will provide positive and negative bottom line surprises this year – I don’t know which ones those will be given the weak bottom line cloud characteristically has. We prefer to wait and see, and then build those that can meet the bullet points outlined above.
We’ve covered the bottom line strength in other sectors here — for example, building semi positions despite negative new headlines.
The first half of the article below as published in Forbes. We’ve copied the article in full. The second half is for Essentials Members only. Please note, although we disclose the positions we own to adhere to disclosure guidelines, these positions may change at any time. For example, at time of writing we owned Enphase and we have recently cut back on Enphase. The disclosure below is not to be relied on as “Stock Picks” for Essentials Members. We provide a stock pick once per month and if that stock pick changes, we will cover our new positioning and new fundamentals outlook. For example, we will cover AMD and Netflix earnings reports and let you know if we are changing those positions.
Top 10 Stocks for 2022
By Royston Roche and I/O Fund Team
Original copy from Forbes starts here:
In this analysis, rather than prognosticate on the top stocks of 2023, we think it’s more productive to go back and review the stocks that performed well under new macro conditions in 2022. This exercise helps to inform tech portfolios for the upcoming year as investors can reasonably assume 2023 will look more similar to 2022 than the preceding years.
2022 was a very volatile year for the stock market with rising rates, inflation, and geopolitical tensions leading to sudden sell-offs. All three main U.S. indices ended the year with negative returns, with Dow Jones Industrial Average down 6.86%, S&P 500 index down 18.11%, and Nasdaq down 32.54%. Despite the indexes being in the red, some stocks greatly outperformed the broad market.
We think it’s important to pause and draw some parallels around the stocks that performed well in 2022 to form an opinion on what might perform well in 2023. This is assuming macro will be more similar to 2022 than the preceding years, which is a reasonable assumption to make at this time. Below, we review the [top ten] stocks of 2022. These stocks were chosen based on their price action and strong fundamentals. Choosing a [top 10] means many great stocks were left off this list, yet this sample helps to form conclusions around how 2022 was a different trading environment from years past.
Source: YCharts
Super Micro Computer (SMCI)
Super Micro Computer stock had 2022 returns of 86.8% and is the best-performing stock in our tech universe. Below is a chart that shows the quarterly year-over-year revenue acceleration Super Micro posted in 2022, which helped support its 2022 winning streak.
Pictured above is SMCI’s Qly revenue YoY growth. Source: YCharts
The company provides server and storage solutions to data centers, cloud computing, 5G, AI, and edge computing markets. The company was recently added to the S&P MidCap 400 Index and enjoys tailwinds from leading semiconductor companies such as AMD, Nvidia, and Intel.
In the recent earnings call, the founder and CEO of the company, Charles Liang said, “For Intel, we are engaged with many large opportunities with Intel’s upcoming Gen 4 scalable Xeon CPU codenamed Sapphire Rapids. We now have hundreds of early seeding engagements including several dozen early shipments. Similar programs have been executing with AMD, and we have seen very strong demand for our upcoming Genoa CPU based platforms.”
“With respect to NVIDIA, not only do we have the most complete portfolio of systems supporting H100 GPUs, but we have also developed many brand new architectures for the leading Metaverse and Omniverse partners.”
The company’s revenue in the recent quarter, Q1 FY23, grew by 79% YoY to $1.85 billion. The gross margin improved to 18.8% in Q1 FY23 up from 13.4% in the same period last year. The company’s profits have grown steadily with net income of $184 million compared to $25 million in the same period last year. The stock is currently trading at a P/E ratio of 10.3 and a fwd P/E ratio of 8.1.
Source: YCharts
Microsoft (MSFT)
Microsoft was one of the best performing tech mega cap stocks last year ending the year down (28%), compared to Meta and Tesla, which ended the year down (64%) and (65%), respectively. Notably, Microsoft narrowly beat the Nasdaq in 2022.
The company is positioned for outsized growth due to its exposure to secular tailwinds such as Artificial Intelligence (AI), Machine Learning (ML), and the build out of the 5G edge network. Microsoft could take a substantial share of these markets at the infrastructure level due to its relationships with the Fortune 500 and Global Fortune 2000.
In addition to top-down enterprise penetration across the Fortune 500, Microsoft is also focused on developers to help complete Microsoft’s customer cloud strategy. Microsoft addressed its previously poor reputation in open-source communities by acquiring GitHub for $7.5 billion in 2018. Developers help determine the cloud IaaS service an enterprise or SMB customer will choose, so in-roads into this community could help Microsoft hedge the developer favorite, Amazon Web Services.
The company’s Q1 FY23 revenue grew by 11% YoY and down 3.4% QoQ to $50.1 billion.
Operating income increased by 6% YoY to $21.5 billion. Net income was $17.6 billion compared to an adjusted net income of $17.2 billion in the same period last year (adjusted net income in the previous year as the company received income tax benefit last year).
The net profit margin was 35% in the recent quarter.
Microsoft has proven it has many levers it can pull during a tougher macro compared to its mega cap tech peers – primarily seen in the consistency of its profit margin.
Source: YCharts
ASML Holding (ASML)
ASML Holding is benefitting from strong semiconductor equipment demand from the leading foundry companies. As new fabs are built, these companies will need equipment in the coming years. The company’s fiscal year 2022 revenue analysts estimate rose 12% in the last 2 months. The company raised the 2025 revenue guidance to be between €30 billion and €40 billion, up from the previous guidance of €24 billion to €30 billion. The company in its press release acknowledged, “While the current macro environment creates near-term uncertainties, we expect longer-term demand and capacity showing healthy growth.”
The company’s Q3 revenue was €5.8 billion compared to €5.2 billion in the same period last year. The management expects Q4 revenue to be between €6.1 billion to €6.6 billion. The gross margin was 51.8% compared to 51.7% in the same period last year. Net income was €1.7 billion (net profit margin of 29.4%) compared to a net income of €1.7 billion (net profit margin of 33.2%) in the same period last year.
The company has a strong backlog of over €38 billion. The company’s CEO Peter Wennick said in the earnings call, “And as a matter of fact, our 2023 shipment demand is still significantly above our build and shipment capacity for next year. And this is supported by the record bookings this quarter, of €8.9 billion and our largest backlog ever of over €38 billion. Almost 85% of this backlog is for EUV and immersion, which is used for advanced nodes and related wafer capacity expansions.”
Palo Alto Networks (PANW)
Leading cybersecurity company Palo Alto Networks has a strong free cash flow margin, which is rare in the cloud and cybersecurity category. The company has been GAAP profitable in the last two quarters. The company’s revenue in the Q1 FY23 grew by 25% YoY to $1.6 billion, which was above the management guidance of $1.535 billion to $1.555 billion.
The company’s margins are improving. The company reported a GAAP net income of $20 million compared to a GAAP net loss of ($103.6) million in the same period last year. The adjusted net income was $266.4 million compared to $170.3 million in the same period last year. Consistent GAAP profitability is key in this macro environment.
The company reported free cash flow of $1.2 billion (76.6% of revenue) compared to $554 million in the same period last year (44.4% of revenue). Dipak Golechha, CFO of the company, said in the earnings call, “This cash flow performance was largely driven by strong collections in the quarter, that we expected based on the strength of our business in Q4.” The management has guided an adjusted free cash flow margin in the range of 34.5% to 35.5% for the FY23.
Dipak Golechha said, "We exceeded our top-line guidance while generating $1.2 billion in free cash flow and expanding our operating margins," He further added, "We will continue to balance growth with profitability and cash generation to further strengthen our position in the market."
Source: YCharts
First Solar (FSLR)
Solar stocks were the leading sector in tech last year. First Solar ended the year on fire with a return of 72% compared to the (33%) return of the Nasdaq. The sector got a boost from the Inflation Reduction Act of 2022, which we covered last year in our free newsletter when we said:
“The solar industry will benefit since Inflation Reduction Act includes the extension of Production Tax Credits (PTCs) and Investment Tax Credits (ITCs) for the construction of wind and solar projects beginning before January 1, 2025. It means a three-year extension for PTCs and a one-year extension for ITCs.
It also extends the 30% federal tax credits for installing solar panels on rooftops by another 10 years, from 2022 to 2032. Solar installations are eligible for 26% tax credit for installations in 2020 and 2021. It now extends till 2032 for 30% tax credits, and in 2033 the tax credit will be reduced to 26% and 22% in 2034. There will be no tax credit after this period unless Congress renews it. Home battery systems that store energy generated by solar systems for later use will also be eligible for a 30% tax credit.”
First Solar is a leading provider of photovoltaic (PV) energy solutions. It is one of the major beneficiaries of the IRA in the form of solar manufacturing tax credits. The company was also recently added to the S&P 500 index.
The company announced last year its plan to invest $1.2 billion to expand its solar module manufacturing in the U.S. It includes a $1 billion investment for a new manufacturing facility in the Southeast U.S. and $185 million for the upgradation of the existing Ohio facility.
Mark Widmar, CEO of the company, said in the Q3 earnings call, “In our view, by passing and enacting the Inflation Reduction Act of 2022, Congress and the Biden-Harris administration has entrusted our industry with responsibility of enabling and securing America's clean energy future, and we recognize the need to meet the moment in a manner that is both timely and sustainable.”
The company’s Q3 2022 revenue was up 7.8% YoY to $628.9 million. It reported a net loss of ($49.2 million) compared to a net income of $55.8 million in Q2 2022 and $45.2 million in the same period last year. The company benefitted from the gain from the sale of the Japan project development platform in the Q2 2022 and also experienced higher logistics charges in the recent quarter.
Mark Widmar, CEO of First Solar said, “Our focus continues to be on setting the stage for long-term growth, and from this point of view, 2022 has so far proven to be foundational,” He further added, “This year we have developed the potential for our CdTe semiconductor technology by progressing our next-generation Series 7 and bifacial platforms, set in motion plans to scale our global manufacturing capacity to over 20 GWDC by 2025, and secured record year-to-date bookings of 43.7 GWDC with deliveries extending into 2027.”
Taiwan Semiconductor Manufacturing (TSM)
Taiwan Semiconductor Manufacturing was in the news in November after Warren Buffet’s Berkshire Hathaway invested $4.1 billion in the company.
The company has developed market leadership in the foundry industry particularly with advanced nodes, which are nodes defined as 7nm and below. The advanced nodes have strong demand by top design companies, such as Apple and Nvidia, particularly in high-performance computing and smartphones. The company has started the production of 3nm process technology and currently this is the most advanced chip production technology. Samsung is a competitor that has begun production using 3nm technology. However, in the past TSMC has been able to win the business from Samsung due to better yields and economies of scale. Apple constituted 26% of the total revenue of 2021.
TSM’s Q3 2022 revenue grew by 36% YoY and 11% QoQ to $20.23 billion. Wendell Huang, CFO of the company, said, “Our third quarter business was supported by strong demand for our industry-leading 5nm technologies.” This means TSM is maintained strong growth throughout 2022 with 37% in Q2 2022 and 36% in Q1 2022.
The margins are also expanding – TSM’s gross profit was $12.2 billion, with a gross margin of 60.4%, up from 51.3% in the same period last year. This was higher than management guidance of 57.5% to 59.5% as the company benefited from favorable foreign exchange and cost improvements.
The net profit was $9.3 billion compared to $5.6 billion in the same period last year. The net profit margin was 45.8% compared to 37.7% in Q3 2021. Many companies have struggled with rising costs, while TSM has successfully navigated these challenges with cost controls and negotiating better prices with its customers.
In addition to expanding margins, the company generated a total of $18 billion in free cash flow in the last four quarters.
Pictured above: TSM’s expanding net margin. Source: YCharts
Enphase Energy (ENPH)
Enphase has an exceptional product, which is the IQ8 Microinverters, and a strong management team. Enphase was one of the top performing stocks in the Nasdaq last year and for good reason – the company reported accelerating revenue in 2022 across two quarters and has expanding margins. It ended the year with a return of 45% compared to the (33%) return of the Nasdaq. The company is also a beneficiary of the Inflation Reduction Act of 2022. Enphase is seeking new ways to manufacture domestically to take advantage of the Inflation Reduction Act. The company plans to open 4-6 manufacturing lines in the USA by the second half of 2023. The IRA provides a credit of approximately $43 per microinverter manufactured in the United States directly to Enphase.
The company reported Q3 revenue of $634.7 million, up 80.6% YoY. Management guided Q4 revenue of $680 million to $720 million, representing an expected YoY growth of 70% at the mid-point.
The company’s margins are also expanding along with strong revenue growth. The gross margin was 42.2% in Q3 2022 compared to 39.9% in Q3 2021. The operating margin was 21.4% compared to 10.6% in Q3 2021. Similarly, the adjusted operating margin improved from 24.5% in Q3 2021 to 30.6% in the recent quarter.
The GAAP net margin of 18.1% is nearly three times higher than Q3 2021 net profit margin of 6.2%. Analysts on the call were excited to hear about the prospect of Enphase improving its already-good bottom line with IRA credits. The company’s CEO Badri Kothandaraman mentioned in the earnings call, “Once the IRA with details have been finalized and the implementation is clear, the U.S. manufacturing could provide substantial benefits in terms of the production based tax credit.”
Texas Instruments (TXN)
Texas Instruments has a strong net profit margin. The company’s Q3 2022 revenue grew by 13% YoY to $5.24 billion. Operating profit increased by 16% YoY to $2.68 billion. Operating profit margin improved to 51.1% from 49.6% in the same period last year. Net income grew by 18% YoY to $2.3, billion with a net profit margin of 43.8% compared to 41.9% in Q3 2021.
Source: YCharts
In addition to strong margins the company has been generating consistent cash flows. The company’s CEO and President, Rich Templeton, said, “Our cash flow from operations of $9.0 billion for the trailing 12 months again underscored the strength of our business model. Free cash flow for the same period was $5.9 billion and 29% of revenue. This reflects the quality of our product portfolio, as well as the efficiency of our manufacturing strategy, including the benefit of 300-mm production.”
The company also accrued investment tax credit in Q3 from the CHIPS Act. Rafael Lizardi, CFO of the company, said in the earnings call, “Let me now make a few comments on the CHIPS Act that was recently signing to law. The combination of the investment tax credit, the grant as well as funding for research and development will help make the U.S. semiconductor industry more competitive. We accrued about $50 million on the balance sheet in third quarter due to the 25% investment tax credit for investments in our U.S. factories. This will eventually flow some statement as lower depreciation and we will receive the associated cash benefit in the future.”
Box Inc (BOX)
Box was the best-performing cloud stock of 2022 and gave a return of 19%. The company beat analyst estimates on 3 out of 4 occasions last year in both top-line and bottom-line estimates. The company’s margins are improving, which is another reason for the stock’s outperformance.
The company’s revenue in the Q3 FY23 grew by 12% YoY to $250 million. The adjusted gross profit margin was 76.5% compared to 74.7% in the same period last year. Adjusted operating margin improved to 24% from 20.7% in Q3 FY22.
Dylan Smith, co-founder and CFO of the company, said in the earnings call, “Box will be better positioned to continue delivering profitable growth as we scale, exiting next year with an even stronger operating margin model after completing this important transition to the public cloud.”
GAAP net income was $4.98 million compared to a net loss of ($18.2) million in the same period last year. The adjusted net income was $46.6 million compared to $35.4 million in Q3 FY22. Free cash flow was $55 million (22% of revenue) compared to $31.2 million (14% of revenue) in the same period last year.
For those who closely follow cloud, it may be surprising that Box was the top performing stock in the category yet this is sending a strong signal to cloud investors as to what is being rewarded in the current macro conditions – as stated, it’s firmly a strong bottom line is being rewarded. It’s also a strong signal as to the change in paradigm as Box has been a lagging cloud stock for many years when growth was in the driver’s seat.
Indie Semiconductor (INDI)
Indie Semiconductor is benefitting from the growth trend in advanced-driver assistance systems and electric vehicles. The company has a Serviceable Addressable Market (SAM) of $48 billion by 2027. The company supplies chips and software to the automobile sector. Its chips power sensor capabilities like LiDAR and Radar, and vehicle electrification.
The consensus analyst revenue estimate for FY 2022 is $110.73 million, representing a YoY growth of 129% and for FY 2023 it is $222.64 million, representing YoY growth of 101%.
The company’s revenue in Q3 2022 grew by 147% YoY to $30 million. The company’s margins have been expanding. The adjusted gross margin was 50.4% compared to 43% in Q3 2021.
Tom Schiller, CFO of the company, said in the earnings call, “To put this performance in better context, when we announced our plans to IPO in Q4 2020, indie was at just $6.7 million in quarterly revenue with a 35.4% gross margin. Since then, and despite global supply chain constraints, we successfully scaled our business nearly five-fold and increased our gross margin by 1,500 basis points in less than 24 months”. Net loss was ($37.6) million compared to ($79.6) million in the same period last year.
Co-founder and CEO Donald McClymont discussed a strong backlog when he said“We’re excited to announce that our strategic backlog has grown to $4.3 billion, more than doubling from the level we initially outlined during our IPO launch less than twenty-four months ago.”
Beth Kindig and the I/O Fund own TSM, Microsoft, and Enphase from the list of top ten stocks at the time of writing. I/O Fund has losses on Enphase, minimal gains on TSM and has owned Microsoft off/on for a few years. The stock disclosure is not intended to recommend a stock pick to Essentials, rather these disclosures are required to avoid any conflict of interest. These stocks are included in this list because they were notable performers last year. The I/O Fund trades stocks frequently and offers position updates on our official stock picks for Essentials Members only.
This article was originally published on Forbes on Dec 29, 2022,09:41pm ESTForbes on Dec 29, 2022,09:41pm EST
CrowdStrike has one of the better fundamental profiles out of the cloud category. This is due to its 50%+ revenue growth rate, GAAP operating margin of (7%) and free cash flow margin of 31%. The company also has one of the best Rule of 40 numbers in the cloud category at 89%. The companies that have higher growth rates or higher Rule of 40 numbers tend to be IPOs, which are designed to be strong out the gate and then fade over time. Meanwhile, CrowdStrike has consistently offered best-of-breed performance for over three years.
Therefore, it’s important to look into what caused CrowdStrike’s weak price action following its earnings report particularly because the stock is widely recognized as one of the strongest cloud stocks on the market. CrowdStrike’s steep selloff of (27%) over the past 30 days isn’t fully satisfied by the $10 million miss on forward revenue and ARR in the last earnings report. Forward Q4 revenue was expected to be $634M and the company guided $619M to $628M for a miss of about $10 million, if we take a midpoint of $624 million (about 1.5% miss). ARR was $2.34 billion compared to analyst expectations of $2.35 billion, for a $10 million miss (less than 1% miss).
Although this likely contributed, I believe the analyst we quoted in our Pre-ER write-up for premium members may be providing a missing link. An analyst from Barclays was modeling for net new ARR of $224M to $230M-plus for this key metric compared to actual results of $198 million.
At the midpoint, this would be more of a miss of 14.6%.
Here is what was said in the Pre-ER write-up for our premium members:
“An analyst note from Barclays’ Saket Kalia is modeling ARR net addition of $224 million “but thinks upside could be $230M-plus given strong pipeline commentary.” At $230M, it would represent 5% sequential growth and 35% YoY growth. This would be down from 15% sequential growth in the previous quarter and 45% YoY.”
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The reason we flagged this prior to earnings is because the net new ARR at a high point of $230M would still mark a strong deceleration to 5% sequential growth down from 15% sequential growth last quarter. This means the company would have to meet the number the Barclays analyst modeled or we would be nearing flat to negative sequential growth on net new ARR. Therefore, we emphasized the importance of this number prior to the earnings report as it was truly a “line in the sand” moment for CrowdStrike’s earnings performance.
With the actual of $198 million reported, this dropped the net new ARR to negative sequential decline of (9%) down from $218 million last quarter. This marks a change compared to the comp of +13% sequential growth from Q2 2022 to Q3 2022.
In August/September time frame, during the Q2 reports, we also emphasized that the market is nervous that cloud will become the other shoe to drop by stating: “I also want to be a messenger and say that another reason we are seeing strong price activity [with cloud stocks] is that analysts are concerned that enterprise spend will be the next shoe to drop. This concern was expressed across quite a few cloud companies’ [Q2] earnings calls. The thinking is that enterprise spend will follow consumer spend, (eventually), yet is slower because budgets are cut more slowly and added back more slowly.”
Because enterprise and cloud budgets are slower to be cut than ad or marketing budgets, there is outsized pressure being placed on sequential growth. The market does not care about YoY because it’s assuming enterprise spending wasn’t affected yet this time last year. We cautioned in a previous analysis two weeks ago “Slowing Growth in Cloud Stocks: When Will We Hit a Bottom” to be careful of YoY guidance as QoQ growth in cloud saw a remarkable slowdown.
CrowdStrike Q3 Financials:
CrowdStrike beat both top line and bottom line for Q3. In fact, an area where CrowdStrike continues to stand out from its peers is the health of the bottom line and both Q3 actual and Q4 guide was no exception in this regard.
For example, the free cash flow margin of 30% is exceptional for the cloud category. The company reported revenue of $581 million for growth of 53% compared to revenue of $574 million expected for growth of 51%. This is a slight deceleration from 58% last quarter.
For Q4, the company guided for revenue of $619 million to $628 million compared to expectations of $634 million. At the midpoint of $623.5million, this is a $10.5 million miss. This represents growth of 44.7%.
Adjusted EPS for Q3 came in at $0.40 compared to $0.32 expected. Adjusted EPS guide for Q4 also beat at $0.42 to $0.45 compared to $0.34 EPS expected.
GAAP operating margin of (9.70%) compares to (9%) last quarter and (10.5%) in the year ago quarter. This resulted in GAAP operating loss of ($56.4) million which is a tad higher than the $48 million losses last quarter and the $40 million losses in the year ago quarter.
The adjusted operating margin was a beat in Q3 and Q4. This was a bright spot in the report with adjusted OM of 15.4% compared to 13% estimated. This compares to 16% Adj OM last quarter and Adj OM of 13% last year. This was essentially flat and it’s important it did not contract. The guide on adjusted operating income of $87.2M to $93.7M implies an adjusted operating margin of 14.5%.
CrowdStrike is very strong on cash flow and is one of the top-ranking cloud stocks in this regard. This quarter the company reported a free cash flow margin of 30% for FCF of $174 million. The company is guiding for a FCF margin of 28% to 30% next quarter. The operating cash flow was $242.9 million for a margin of 41.8%.
There is $2.47 billion in cash on the balance sheet. The company paid $140 million in stock-based compensation for a margin of 23.7%.
The I/O Fund has launched a new$99/year Premium Newsletter called "Essentials" — this newsletter delivers premium samples for our readers who want more actionable analysis for their tech portfolios. This month, we released a stock pick that we believe will be a leader in 2023 plus a video with the buy plan.$99/year Premium Newsletter $99/year Premium Newsletter called "Essentials" — this newsletter delivers premium samples for our readers who want more actionable analysis for their tech portfolios. This month, we released a stock pick that we believe will be a leader in 2023 plus a video with the buy planbuy plan.
Key Metrics:
To recap, CrowdStrike reported a quarter with 52% growth and forward growth in Q1 of 44.7%. The company leads popular cloud stocks on free cash flow with a 30% margin and has a healthy adjusted operating margin of 15%. Although stock based compensation weighs on GAAP operating margin, it still ranks high compared to peers with a GAAP operating margin of (9.7%) —- so why did the stock selloff after hours and is down (27%) over the last 30 days?
The answer is found in the key metrics.
RPO was up 44% year-over-year for $2.797 billion and was up 11.6% sequentially. However, management reminded analysts that ARR is the leading key metric for their business.
Ending ARR grew 54% year-over-year to $2.34 billion and grew 9.3% sequentially. Therefore, because ending ARR was strong, the net new ARR could be easily underestimated in terms of impact. The net new ARR at $198 million in fiscal Q3 compared to $218 million net new ARR in fiscal Q2 indicates a 9% sequential decline.
The market has the jitters right now so the sequential decline is important to pay attention to especially because management said to expect further weakness in the upcoming Q4 quarter. Here is what the CFO said:
“Even though we entered Q3 with a record pipeline, we are expecting the elongated sales cycles due to macro concerns to continue, and we are not expecting to see the typical Q4 budget flush given the increased scrutiny on budgets. While we do not provide net new ARR guidance given the current macro uncertainty, we believe it is prudent to assume that Q4 net new ARR will be below Q3 by up to 10%.”While we do not provide net new ARR guidance given the current macro uncertainty, we believe it is prudent to assume that Q4 net new ARR will be below Q3 by up to 10%.”
This implies a net new ARR of $178.3 million for Q4 (10% lower than the current quarter at $198.1M) compared to net new ARR of $216 million in the year ago quarter. This is important because it’ll mark not only a sequential decline but a year-over-year decline in net new ARR. The market had already sold off for what I presume was a sequential decline in CrowdStrike’s leading key metric, and management then stated the decline would be steeper for Q4 on the call. Once the comment above was made, we were certainly not going to see a reversal in the stock price from the earnings call.
Customer count was strong at 44% growth. The mix of domestic versus international was slightly lower than usual for North America at 69% with EMEA being slightly higher at 15%. Deferred revenue grew 56.4% year-over-year and backlog grew 19%.
Additional Commentary:
CrowdStrike was transparent about the importance of ARR even in the face of net new ARR being lower than expected.
Here is what was said by the CFO:
“And then finally, just to comment on ARR. You pointed out that's how we run our business. ARR, though, is really an X-ray into the contracts themselves. And as we view that as the most important — or most transparent metric into the outlook for our business, that's the one where we're focused on. So, hopefully, that gives some more clarity on how we think about cRPO and ARR.
Later on, an analyst did zero-in on the (9%) decline.
“Andrew Nowinski
Great. Thank you for taking the question this afternoon. So total ARR of $2.3 billion, growing 54% is still absolutely amazing, I was – and it's at scale. But I was wondering, were you surprised that the net new logos that you added were down 9% this quarter?
Burt Podbere
Thanks, Andy. So when we think of the net new logos, it really corresponds to what we talked about in terms of what we saw in that SMB space. The SMB space is the one that drives the velocity of our net new logos. And as we talked about, we saw an 11% increase in our sales cycle in the SMB space. And that actually equated into $15 million in terms of deals in that space that could push out. And so when you think about 15 million in that space and what it means in terms of logos, where you can do the math, it's a pretty big number.
So that's how we think about net new logos corresponding to what we saw in net new ARR from the SMB space. So from that perspective, we weren't surprised at the end of the day when we saw that what happened with respect to the increased sales cycles and the amount of money that got pushed out in the SMB space.
“Push out” refers to a delayed sales cycle for an impact of $15 million. The CFO did reiterate the 10% further sequential decline in net new ARR between Q3 and Q4 when he said:
“When we do talk about net new ARR, I did talk about in the prepared remarks about how we think about up to 10% headwinds going into Q4 from Q3, and that's just to coincide with some of the headwind activity that we saw accelerated at the end of this quarter. So that's how we think about that.”
Conclusion:
The market is cooling off from previously popular cloud stocks. The reason is that QoQ likely hints at what is to come for enterprise budgets that are typically determined in January of the new year. There will certainly be some cloud stocks that are stronger than others, comparatively. Attempting to guess which ones these will be carries outsized risk if the QoQ trends we saw in Q4 continue into Q1.
The quarter from CrowdStrike sounded very familiar, in my opinion.
Here is a brief overview from our Microsoft’s post-earnings report:
“Microsoft is guiding down for next quarter with analyst expectations for the December quarter at $56.04 billion compared to management guidance on the call for revenue of $52.75 billion, at the midpoint. This represents 2% growth. […] That’s a 11% deceleration over the next few months. Some of this is coming from Azure as the company is expected Azure to decline 5% next quarter for its current growth rate. This will be 37% growth on a constant currency basis, down from 42% this quarter.”
While some investors believe this is a stock picker’s market – we disagree with this thinking. In May, we pivoted to hedging up to 100% of the I/O Fund portfolio as macro will eventually affect even the strongest companies. We are seeing that now with Tesla – a strong consumer company that is following its consumer peers into a material slowdown that is entirely macro based. Our macro coverage, such as Divergences Point Toward the Market Moving Higher, which called the October low, is published bi-monthly for our free readers and published daily for our premium readers along with real-time trade alerts. The hedging strategy has proven successful since we pivoted 8 months ago, primarily it has removed the pressure of the market’s intense selloff while allowing us to build key positions at valuations that are extremely low.
Ultimately, we started to move toward a neutral stance with cloud after Q2 reports after we saw initial signs of weakness and continued to trim/cut following some Q3 reports. We continue to hold one cloud name at a high allocation and we hold three more at medium sized allocations. We call this a neutral stance to where we are participating but not overweight. If we get additional signs that cloud is too weak to withstand macro pressure, we have a short candidate in mind. If we get signs that cloud will be resilient in 2023, we will buy into those with underlying strength.
Notably, the I/O Fund portfolio manager sees a relief rally of sorts coming in the early part of this year. That will be the time that we determine what to do with our remaining cloud positions — whether we sell into strength or buy into weakness.
Note: This analysis was originally published on November 30th 2022 and accompanies our previous free analysis: Slowing Growth on Cloud Stocks: When Will We Hit a Bottom.Note: This analysis was originally published on November 30th 2022 and accompanies our previous free analysis: Slowing Growth on Cloud Stocks: When Will We Hit a Bottom.Slowing Growth on Cloud Stocks: When Will We Hit a Bottom.
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.
This article was originally published on Forbes on Dec 15, 2022, 10:27pm ESTForbes on Dec 15, 2022, 10:27pm EST
Nearly all cloud companies are reporting a notable, sequential slowdown between Q3 to Q4. Amazon and Microsoft’s cloud infrastructure services slowed from mid-30 percent growth in prior years to 24 percent growth and 30% growth. Only a quarter ago – in Q2 – the growth was at 29 percent and 35%. This quarter marks a 5 percent decline sequentially, which is considered a rapid decline for these two companies.
For many more highly valued cloud software companies, the sequential decline is much steeper and is closer to a 15% sequential decline. On a YoY basis, the Q3 to Q4 growth is 70% lower than it was tracking last year. For example. Snowflake grew 15% QoQ last year and is expected to grow 3% QoQ this year, marking a 12 point decline in its growth rate. This is true for most best-of-breed cloud stocks.
We covered this point on popular cloud software stocks in granular detail in a premium note for our research Members when we said:
“In some ways, the Q4 guides – assuming most come in at or near those guides – marks a historic slowdown for cloud as it’s always been a resilient category.”
The question is, at this rate of rapid decline, when will we hit a bottom on slowing growth?
Gartner, a reputable and accurate third-party analyst firm, is indirectly calling for a bottom in cloud in 2022, per its recent two surveys. However, judging by the most recent earnings results provided by the Big 3 and cloud’s top performing stocks, I believe this could be premature and it’s more likely we bottom sometime in 2023.
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Gartner 2023 Surveys
In a recent report, Gartner predicted that in 2023, IT spending will recover from a notable low in 2022 in all areas except Data Center Systems. Devices will still remain negative to flat, yet show a remarkable recovery from (8.4%) to (0.6%), per the CFO 2023 survey. Software will accelerate from 8% to 11.3% while IT services will double in growth from 4.2% to 7.9%.
Across all categories of IT spending, Gartner is calling for combined growth of 5.1% in IT budgets compared to 0.8% growth in 2022. This will be down from 10.2% in 2021.
Gartner is also forecasting that 2022 is the bottom for a few public cloud end-user verticals with a year-over-year increase in software-as-a-service (SaaS), cloud management and security, and infrastructure-as-a-service (IaaS).
Of these, Cloud IaaS is expected to see the most growth from 27% in 2022 to 30% in 2023. This is on a large revenue base of $115 billion, expected to grow to $150 billion in 2023. Software-as-a-service is the largest category in cloud with revenue of $167 billion, expected to grow to $195 billion at a rate of 17%.
Notably, some areas are expected to decline, such as BPaaS and DaaS.
Shown below, the overall cloud market is expected to grow 21%, up from 19% in 2022. This will outpace overall IT spending with growth of 5.1% by over 5X.
The 5.1% growth lags the current inflation rate of 6.5%.
Cloud IaaS Growth Saw 3% Headwind in 2022, More to Come?
Gartner released the 2023 survey results in October, and later that month, Q3 earnings results from Big Tech reported a decline in Cloud IaaS. Perhaps the survey is predicting a rebound from H2 2022 to H1 2023, but this would be hard to determine until budgets are set in the earlier part of next year.
In most cases, we are seeing a 10% deceleration from the early part of the year to the second half of the year. For now, actual results from the Big 3 Cloud IaaS providers disagree with Gartner’s survey predictions that a rebound is coming. This is despite Cloud IaaS predicted to be the more resilient line item in public cloud end-user spending.
The biggest names in tech are reporting their earnings right now, and our premium members are getting updates almost daily. Learn more about about our premium membership here.The biggest names in tech are reporting their earnings right now, and our premium members are getting updates almost daily. Learn more about about our premium membership here.Learn more about about our premium membership here.
Mixed Reports Following Q3 Results
Gartner’s prediction that cloud budgets will expand contrasts with other surveys that suggest the opposite. For example, according to a survey by Wanclouds, 81% of companies were directed by the C-suite to reduce cloud spending or to occur no additional costs.
The venture capital firm Accel published a report that showed private funding for cloud companies dropped as much as 42% across Europe, Israel and the United States in Q3. This often translates to lower valuations and/or lacking a clear path to a strong exit on the public markets or through an acquisition.
This doesn’t mean the migration to the cloud is slowing down, by any means. According to Accel, spending on automation and digital transformation is expected to rise from $1.8 trillion to $2.8 trillion by 2025. The drawback to these kinds of forecasts is that it may slow considerably in 2023 before a rebound occurs.
Conclusion:
Cloud spending may turn out to be softer than industry surveys indicate, especially until inflation cools off. This is because surveys capture a perception while earnings results are the culmination of a 7.1% inflation rate, plus a softer Chinese market and a softer European market.
The Big 3 are the best proxy because their reports represent the layer in the tech stack that tends to be the most resilient in terms of churn. The switching costs are quite high for cloud IaaS services. The Big 3 also afford a more concentrated view by owning 66% of market share across three companies whereas SaaS is spread across thousands of companies.
For our premium members, we dig deeper into mid-cap cloud companies to determine which ones are decelerating more quickly than their peers and also which leading cloud stocks we plan to buy when we sense there is a rebound. You can learn more here.
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
