Edge AI will be an important trend with AI-powered PCs allowing more people to access the full benefit of AI-powered applications. This, in turn, will help AI developers build a bigger ecosystem. There is a bottleneck right now for AI applications to where client devices are not powerful enough or energy efficient enough to leverage AI capabilities. We’ve discussed this previously in our Memory and PC analysis with details on the upcoming Windows 12 upgrade, and also in the Memory and PC stocks write-up

Inference is also pushing forward the need for AI Edge devices and networks to be more powerful, but also more energy efficient. Inference takes batches of real-world data and quickly comes back with an answer or prediction. This is best done at the edge, which includes the edge network that a company like Cloudflare provides, and edge devices, such as smartphones and laptops. In the inference stage, the compute intensive neural networks are modified for speed and to improve latency. In order to do this, inference is optimized for runtime performance. This allows the computation tasks to be as close to the data source as possible. In many cases, data is produced at the edge, and it’s more efficient and faster to run inferencing at the edge. We’ve covered this in the past in our Cloudflare analysis.

Arm-based PCs are sparking competition, and this will be more evident this time next year (Q1 2025). The analysis below expands on the topic of Edge AI devices to discuss what 2024 will bring, and how we want to be positioned for 2025.

x86 versus Arm versus RISC-V

If Arm-based PCs stick this time, it will mark a massive shift in edge devices. X86 dominates PCs as it stands today, yet AI leaders have their roadmaps loaded with Arm-based releases over the next year. This will be Qualcomm in 2024, followed by Nvidia and AMD in 2025.

x86 and x64 Computer and Laptop Processors:

x86 is a set of design instructions and the architecture for nearly every desktop and laptop computer except MacBooks. The x86 architecture has been around for decades and is considered the standard in personal computers and servers due to its high clock speed and ability to execute multiple instructions per clock cycle. When it comes to performance, the x86 architecture is superior with additional features such as hyper-threading and turbo boost, which assists with tasks that require high computational power. In the early 2000s, x64 was built on top of x86 and is the dominant complex architecture. 

Arm-Based Architecture: 

A few years ago, MacBooks switched from Intel’s x86-64 processors to Apple’s system on a chip (SoC) based on Arm 64 architecture. Arm offers much lower power consumption and generates less heat due to being a Reduced Instruction Set. The M2 is built on Taiwan Semi’s 5nm process with 100GB/s memory bandwidth and 24 GB of unified memory. When the M2 was released in 2022, Apple claimed 1.9X CPU performance at the same power. At the same performance level, Apple claims the M2 uses ¼ the power as x86.

Source: Apple

The M3 MacBook Air is hitting stores this month with Apple stating it’s 13X faster than an x86 Intel powered MacBook. The Arm-based system on a chip (SoC) combines a CPU and a GPU with a 16-core Neural Engine for what Apple is calling the “World’s Best Consumer Laptop for AI.”

To understand why Apple chose to go with Arm-based architecture and why Microsoft Windows has to play catch up in 2024, it’s important to understand what Arm offers.

The name Arm stands for “Acorn RISC Machine” with RISC standing for reduced instruction set computer. Reduced instruction set leads to lower power consumption and less heat. Decades ago, in the early 1980s, founders Sophie Wilson and Steve Furber discovered that a CPU can run faster on a small set of instructions. This means the operating system breaks down tasks rather than add more instructions to the processor. While most CPU designs were adding more instructions to chips, Arm patented the technique of using fewer instructions that run more quickly and efficiently.

CPUs require instruction sets that tell the processor to move data between registers and memory or to perform calculations with a specific execution unit. Architecture is defined by providing the link between instructions and processor hardware designs. Here’s what Arm’s instruction set looks like.

However, a major difference is that Intel maintains its IP in-house and sells chips while Arm licenses its IP. Revenue is generated from licenses for Arm’s technology and royalties that come from the sale of a licensees’ chips that contain Arm’s technology.

Arm Dominates Mobile, and AI May be the Catalyst for Arm to Dominate PCs:

Around 2012, mobile phones began using the 64-bit architecture that PCs had been using for some time. Arm introduced the ARMv8 64-bit architecture for mobile in 2011. This architecture has two execution states to run 32-bit code and 64-bit code. To run on both Arm and Intel architectures, a developer might compile native code for both or run code emulation, although it is more common to choose one and stick with that choice. This is why we see near ubiquity with Arm on mobile whereas Intel and AMD have done quite well in the data center. Due to power constraints of the mobile device, which was introduced much later, Arm found a massive market where it dominates at 99% market share of smartphones.

Today, Arm offers the most popular CPU architecture in the world with 250 billion chips shipped since inception, of which 30.6 billion were shipped in FY2023. As stated, Arm is most dominant in mobile CPUs with 99% market share, and is at 40.8% in automotive. The overall share of Arm’s related markets is 48%. The company’s dominant market share is achieved through its developer ecosystem.

For mobile, Arm’s design known as “heterogenous compute” has helped facilitate lower power requirements as the architecture allows different CPU parts to work together for improved efficiency. This enables workloads to work across both high-performance and low-performance CPU cores to lower energy by balancing performance.

Arm’s architecture is the best choice for mobile and Intel’s x86-64 is the best choice for the data center and PCs. However, we are on the precipice of going through a major shift to where Arm architecture will compete with x86 architecture for PCs. This has been promised many times in the past, yet starting with Qualcomm’s Snapdragon Elite X, there is a chance that a viable Arm-based Windows PC finally happens. To improve the chances an Arm-based PC finally sticks, both AMD and Nvidia are preparing to release Arm-based PC systems in 2025.

Arm’s different licensing models are the following:

Arm Total Access Agreements: It is a type of licensing model wherein the company provides a package of CPU designs and related technologies for an annual fee. The agreement has a fixed term and Arm reserves the right to modify the package by adding or removing specific products. 

Arm Flexible Access Agreements: This model provides a selection of CPU designs and related technologies for an annual fee. However, the latest products are not included. In comparison, the total access agreement is a comprehensive package. Another key difference is that the customers need to pay a single-use license fee for specific products if they are included in the final chip design. Like total access agreements, the company reserves the right to modify the package.

Technology Licensing Agreements: It involves licensing a specific CPU design or technology to the customer for a fixed fee. The license can be used for a fixed term or the number of uses.

Architecture License Agreements: Under this agreement the customers design their own customized CPU designs using the Arm’s Instruction Set Architecture (ISA).

RISC-V

For the fiscal year ending March 2023, more than 260 companies have reported shipping Arm-based chips, including Amazon, Alphabet, AMD, Nvidia, Qualcomm, and Samsung.

Arm is based on lower power instruction sets and hardware, which is also known as a RISC architecture or Reduced Instruction Set Computing. As stated, this contributes to Arm’s approach to power efficiency by reducing the number of instruction sets required. Intel and AMD’s x86 CISC, or Complex Instruction Set Computing, offers more complex instructions that execute multiple operations. This leads to better performance but more power consumption due to the need to decode the complex instructions.

There is a third competitor to Arm and x86 which belongs in the RISC architecture category, called RISC-V. The instruction sets for RISC-V are similar to Arm’s yet RISC-V is open source and is also very new with an official launch in 2019. Compare this to Arm, which was founded forty years ago. RISC-V emphasizes register access over direct memory access, which may be more suitable for parallel processing.

It’s unlikely that RISC-V overtakes Arm in the near-term but it could become a serious contender in future years. Companies like SiFive and Imagination Technologies are designing RISC-V processors. Think Silicon released a RISC-V GPU in 2022. As of last year, AMD’s Radeon RX 6700 works with the RISC-V platform from SiFive.

According to Ars Technica, Qualcomm is also starting a joint venture with NXP, Nordic, Bosch and Infineon “aimed at advancing the adoption of RISC-V” with a focus on automotive use cases. With that said, there are not many games that support RISC-V and it has a long way to go to become a true competitor to Arm.

Arm Holdings Financials:

Arm Holdings is positioned to capitalize on the growing adoption of artificial intelligence (AI) technologies, leveraging its established licensing model and extensive ecosystem to drive future growth. Arm's established licensing model offers a recurring and relatively stable income source.

However, despite Arm dominating the smartphone market at 99%, the company has made very little on licensing compared to its partners. For example, mobile handsets created a $200+ billion segment for Apple, which relies on Arm technology for the iPhone, yet only resulted in (roughly) $3 billion for Arm. In this case, it was far better to own Apple.

The market is excited about the fact that AI will drive double the licensing fees for Arm. My contention is that, similar to mobile, it’s better to own the AI leaders who license Arm’s technology rather than Arm. Analyst estimates have Arm growing to $6.5 billion by 2028. For our purposes, this isn’t high enough growth to ensure insiders won’t take their exit following the IPO lock-up expiration – and frankly, the valuation on Arm is absurd at 41.9 Forward PS and 108 Forward PE Ratio. There is no riskier proposition than an IPO that is richly valued.

In the event the valuation comes down drastically (which it likely will, given IPOs tend to selloff sharply in the year following lockup expiration), we’ve done a thorough analysis on Arm as it’s a central player to Edge AI and is key to the next phase for AI.

Armv9 Architecture

The latest Armv9 architecture offers significant improvements in performance and efficiency, particularly for artificial intelligence (AI) applications. This has led to increased adoption by its partners, particularly in the premium smartphone segment.

Compared to the previous Armv8 architecture, Armv9 chips command double the royalty rate. This means Arm receives a higher percentage of the chip's selling price when a manufacturer uses Armv9 designs.

The rapid growth in Armv9 adoption and its higher royalty rates have already contributed to a significant increase in Arm's royalty revenue. Armv9 constituted 10% of royalty revenue in the September quarter and accelerated to 15% in the recent quarter. By doing the math, Armv9 revenue grew 69% QoQ to $70.5 million. As adoption continues to rise, the Armv9 architecture is expected to be a major driver of future royalty income growth for Arm.

Addressable Market

The company’s total addressable market was $203 billion in 2022 and is expected to grow at a compound annual growth rate (CAGR) of 6.8% to $247 billion in CY2025. The company has maintained a market share of over 99% in the mobile applications processor market. It expects this market to grow at a CAGR of 6.4%, from $29.9 billion in 2022 to about $36 billion in 2025. The company estimates that the aggregate value of chips that contain Arm technology was $98.9 billion (48.9% market share) for the CY ending December 2022, up from 38.7% in 2014. Notably, the 6.8% CAGR is a low CAGR for an AI trend with AI chips expected to grow at a 38.2% CAGR.

Arm also has strong market share of 40.8% in the automotive chip market. Management expects the automotive chip market to grow from $18.8 billion in 2022 to $29.1 billion in 2025, growing at a CAGR of 15.7%.

The cloud compute chip market is expected to grow at a CAGR of 16.6% from $17.9 billion in CY2022 to $28.4 billion in CY2025. Arm’s market share in the cloud computing chip market has increased from 7.2% in CY2020 to 10.1% in CY2022. Since Arm-based chips are increasingly used in data centers, its market share is expected to increase significantly in the future. Per the prospectus, “Arm-based chips have been gaining market share as CSPs, such as Amazon AWS and Alibaba, have started to deploy Arm products in their own in-house designed chips used in their data centers, and as other CSPs, such as Microsoft and Oracle, start to deploy chips designed by Arm licensees, such as Ampere. As a result, we expect our market share of cloud compute to grow significantly faster than the overall cloud compute market.”

Financials

Arm’s recent Q3 FY2024 revenue ending December grew by 13.8% YoY to $824 million, helped by the recovery in the smartphone market and demand for AI technology. This marks the second consecutive quarter of positive revenue growth, following declines of (2.5%) in the June quarter and (3.7%) in the March quarter, due to the cyclical downturn from smartphones.

License and other revenue grew 18% YoY to $354 million. The company has seen strong growth in license revenue as they are signing long-term and high value agreements with its customers due to demand for Arm’s advanced CPUs to run AI workloads. The trend was strongest in the Sept quarter as license revenue grew by 106%.

The company’s CEO, Rene Haas, said in the earnings call, “And that has seen growth in not only the smartphone sector but also in infrastructure and other markets, which drives growth. We are also seeing strong momentum and tailwinds from all things AI. From the most complex devices on the planet for training and inference, the NVIDIA Grace Hopper 200 to edge devices such as the Gemini Nano Pixel 6 from Google or the Samsung Galaxy S24, more and more AI is running on more end devices, and that's all running on Arm.”strong momentum and tailwinds from all things AI. From the most complex devices on the planet for training and inference, the NVIDIA Grace Hopper 200 to edge devices such as the Gemini Nano Pixel 6 from Google or the Samsung Galaxy S24, more and more AI is running on more end devices, and that's all running on Arm.”

They expect another record quarter for the licensing revenue. The company’s CFO, Jason Child said in the earnings call. “We are expecting another strong quarter for licensing with revenue up sequentially to near record levels. As with recent quarters, we expect to sign multiple new ATA deals in Q4, and demand for our latest technology remains high as customers need access to AI-capable CPUs and related technology such as our Compute Subsystems.”we expect to sign multiple new ATA deals in Q4, and demand for our latest technology remains high as customers need access to AI-capable CPUs and related technology such as our Compute Subsystems.”

The company also reported record royalty revenue due to its higher value Armv9 technology and also market share gains in cloud server and automotive markets. Royalty revenue rebounded to 11% YoY growth to $470 million from a decline of (5%) and (8%) in the previous two quarters. Management’s guide for the next quarter is to grow over 30% YoY and mid-single digits sequentially.

The company’s CFO, Jason Child said in the earnings call, “Within Q4 total revenue, we expect royalty revenues to grow mid-single digits sequentially and to be up over 30% year-over-year as we compare against the bottom of the industry wide inventory correction that occurred in prior year Q4. Royalty revenue sequential growth is mainly coming from increasing penetration of Armv9, where royalty rates are on average, at least double the rates on equivalent Armv8 products. Additionally, we are seeing an increasing amount of Arm technology in chips being deployed and as the amount of Arm technology in chips increases, so does the royalty rate.”increasing penetration of Armv9, where royalty rates are on average, at least double the rates on equivalent Armv8 products. Additionally, we are seeing an increasing amount of Arm technology in chips being deployed and as the amount of Arm technology in chips increases, so does the royalty rate.”

The management has increased its revenue guidance for the next quarter by $95 million to a range of $850 million to $900 million, representing YoY growth of 38.2% at the midpoint. The strong upward revision was due to the points discussed earlier, like the rebound in royalty revenue and the higher revenue opportunity from AI.

Analysts expect revenue to grow 37.4% YoY to $869.88 million in the next quarter and 27.9% in the June quarter.

FY2023 revenue ending March declined by (0.9%) YoY to $2.679 billion. Analysts expect FY2024 revenue to grow 18.7% YoY to $3.18 billion and 23.9% YoY to $3.94 billion for FY2025. 

Annualized Contract Value

Annualized Contract Value (ACV) grew by 15% YoY and by 5% QoQ to $1.16 billion. The sequential increase was due to an increase in high-value license agreements and also the increase of total access agreements.

RPO

Remaining performance obligations (RPO) grew by 38% YoY to $2.43 billion, helped primarily by high-value license agreements and renewal of long-term customer agreement. As per the shareholder letter, “We expect to recognize approximately 28% of RPO as revenue over the next 12 months, 26% over the subsequent 13-to-24-month period, and the remainder thereafter.”

Margins

Gross margin was 95.6% in the recent quarter compared to 96% in the same quarter last year. Adjusted gross margin improved 50 basis points YoY to 96.8%.

Operating margin was 16.3% compared to 33.7% in the same period last year. The operating margin was lower due to the increase of R&D expenses from an increase in engineering headcount and SG&A expenses from increase of non-engineering headcount.

In the Sept quarter, the operating margin was low at (19.4%) due to increased R&D expenses, stock-based compensation, and IPO-related expenses. Stock-based compensation was higher than it’s expected to be in future quarters as the IPO triggered a one-time expense for previously granted shares. As per the September quarter shareholder letter, “Total share-based compensation cost (equity-settled) was $509 million with $19 million in cost of sales, $343 million in R&D and $147 million in SG&A. Share-based compensation costs were higher in Q2 than is expected in future quarters as the IPO triggered a one-time expense for previously granted shares. The future run-rate of share based compensation cost will depend on a number of factors, including the share price, but is currently expected to be between $150 million to $200 million per quarter.” At the midpoint, this will be about 20% of revenue.

Adjusted operating margin was 43.8% compared to 39.9% in the same period last year and 47.6% in the Sept quarter.

Net margin was 10.6% compared to 25.1% in the same period last year and (13.7%) in the Sept quarter. The adjusted net margin was 39.3% compared to 31.1% in the same period last year and 46.9% in the Sept quarter.

Cash Flow and Balance Sheet

The operating cash flow margin was 37.6% compared to 56.8% in the same period last year and 28.2% in the Sept quarter. The free cash flow margin was 30.5% compared to 53.5% in the same period last year and 21% in the Sept quarter.

The company has cash and short-term investments of $2.4 billion compared to $2.2 billion in the Sept quarter, and no debt.

Key Metrics

The company reports the actual chips shipped in the subsequent quarter. For the quarter that ended September, Arm’s customers shipped 7.7 billion chips, down (3%) YoY and up 8% QoQ, showing a sequential improvement for the second consecutive quarter on account of smartphone market recovery and demand for AI chips.

Total Access Licenses

Total Access Licenses grew by 80% YoY to 27, with the company signing five new licenses in the quarter. Notably, this included three companies upgrading from Flexible Access Licenses, marking the first time such a transition had occurred. This also caught the attention of the analyst, who asked “Did that take you by surprise or were these customers that were getting to be particularly large for an AFA and so it was natural for them to upgrade?”

The company’s CEO, Rene Haas replied, “Yeah. Thank you for the question. We didn’t bring it up in our comments. We had a lot of good stuff to talk about this quarter, and I was trying to keep it as concise. But the AFA transition to ATA, thank you for calling that out. That’s a great trend for us. When we designed the program a number of years ago, that was absolutely the intent is that customers that launched into an AFA would ultimately go on to a total access license.When we designed the program a number of years ago, that was absolutely the intent is that customers that launched into an AFA would ultimately go on to a total access license.

What largely drives that, quite frankly, is the company that AFA start to get commercial traction in their business. Some of the AFA customers are early-stage companies. They may have an early exit or get acquired. But as they get larger and mature, we expect them to embrace Arm technology in a broader way. So I wouldn’t call it a surprise. I would actually call it an expected outcome that we have, and we’re really happy to see it. It’s great.”

Flexible Access Licenses

The Flexible Access Licenses grew by 6% YoY to 218. These agreements are renewed annually and over 50 were renewed in the quarter and 14 new agreements were signed with 6 net additions in the quarter.

Risks

The company also highlighted the risk in its prospectus that some of its customers support open-source RISC-V. This may not be a potential immediate risk to the business. However, it might be difficult for Arm to raise prices.

Arm China accounted for about 24% of revenue for the FY ending March 2023. The company said in its prospectus, “Neither we nor SoftBank Group control the operations of Arm China, which operates independently of us.” So, this is a potential political risk to consider if the US-China tensions escalate.

The company’s IPO lock-up period expired on March 12th, so volatility is likely in the coming months. The risk that Arm cannot hold the exuberant valuation it currently trades at post-lockup is very high. 

Arm was previously listed from 1998 to 2016 when it was taken private by SoftBank Group, and it holds about 90% of the outstanding shares. The high ownership of SoftBank is a significant risk to consider since SoftBank could slowly start to book profits on Arm Holdings once the IPO lock-up expiry is now over. Arm’s current valuation of $135 billion (90% is $122 billion) is significantly higher than SoftBank’s current market valuation of $85 billion.

Arm’s shares have doubled since its IPO in September 2023. Arm is currently trading at a forward P/S ratio of 41.9. As seen in the chart below, this is trading far higher than the other AI semiconductor companies. The 1-year forward for fiscal year ending in March 2025 is a PS ratio of  33.8, which still exceeds other AI-related semi companies – including Nvidia.

Qualcomm

As we look into Arm-based PCs, it’s worth noting that Qualcomm will be the first to release an Arm-based PC this summer with ETA of June. Qualcomm is a tough stock to own because it’s subject to licensing and IP lawsuits that the company most recently won, and anti-trust lawsuits that the company has lost. China adds complexity, as similar to Samsung and Apple, the OEMs use Qualcomm but ultimately seek to compete with Qualcomm where possible. This leads to IP battles and creates risk not present in other stocks. Interesting enough, Qualcomm is being sued by Arm following the acquisition of Nuvia as Arm alleges the IP deal it had with Nuvia should have been terminated at acquisition. What goes around, comes around.

For the most part, Qualcomm’s customers are frenemies. This is true for all of tech but especially Qualcomm. The tug-o-war between partners/competitors was noted in the most recent earnings call when an analyst asked the following:

“Tal Liani:

Thanks. I have two follow-ups on answers or questions you had before. The first one is Samsung. On one hand, there is a new contract. On the other hand, Samsung is going to use their own more in '24 versus '23. So net-net, are you expecting revenues of Samsung to go up or down in '24 versus '23? What are your expectations of share losses within — can you frame it for us?”

Management didn’t directly answer the question so I’m not going to quote their answer here other than to note the material concern to Qualcomm’s business model. Even as the company innovates on chips, chipsets and SoCs, the older products typically get replaced (where possible).

Qualcomm is not of interest for our portfolio right now as we would want to see more top line growth. Handsets have been in a decline, IoT is in a deep trough, yet automotive is surprisingly strong – which is all detailed below. However, Qualcomm is an important company to cover for AI edge devices and can be instrumental in helping us time our other investments.

From the most recent earnings call, the major takeaways for our purposes are timing for the Windows upgrade, Android’s roll-out for AI features, and China’s ramp in mobile that favors domestic OEMs like Huawei instead of Apple. Most importantly, as stated, the company is working with Microsoft on an Arm-based PC due out mid-2024. Details around this help to inform our thesis on AI-powered PCs, which was detailed here and here.

Brief Overview of the Financials:

In 2023, Qualcomm entered a trough similar to many other semiconductor companies. This was driven by mobile handsets and internet of things (IoT). Qualcomm’s IoT segment includes consumer virtual headsets and edge networking such as WiFi 7 broadband devices. In the most recent quarter, Qualcomm returned to positive growth of 5% after four quarters of negative growth, some as steep as (-24%) and (-23%).

The rebound will be strongest in the second half of CY2024 when Qualcomm returns to growth with an estimated 12.5% in the September quarter. Notably this estimate has come down since the last earnings report, when it was estimated to be 14.3%. The December quarter estimate is for 5.90%.

According to the earnings call, the September quarter will be seasonally stronger due to the anticipated Windows upgrade that is due to be released around the school season.

Here is what was said on the earnings call:

“We're tracking to the launch of products with this chipset tied with the next version of Microsoft Windows that has a lot of the Windows AI capabilities. We're still maintaining the same date, which is driven by Windows, which is mid-2024, getting ready for back-to-school, what we're excited about it is since we announced that Tech Summit showing the performance of the product and the AI capabilities, design traction continues to increase.”

On the bottom line, Qualcomm reported $2.75 non-GAAP EPS, beating estimates for $2.37. The company is returning to growth on the bottom line with the September quarter being the peak at 22% growth for EPS of $2.46. Last quarter, Qualcomm “returned $1.7 billion to stockholders during the quarter, including $784 million in stock repurchases and $895 million in dividends.”

Margins:

• Gross margin of 56.6% is in line with previous quarters
• Operating margin of 29.5% is higher than previous quarters. Discussion from Q&A is noted below.
• Net margin of 28% is higher than previous quarters.

More on Mid-2024 Timing

As mentioned above, the Windows upgrade is expected to hit mid-2024. There were some additional notes on timing:

Tom O'Malley:

Thanks for taking the question. Just passing on my congratulations to Akash as well. I just wanted to ask on the ASP side for Android. You're obviously kind of characterizing the market that's flattish into March, kind of the bottom in June and then improving from there. But you benefited from some good mix in the beginning of the fiscal year here. Could you talk about what you would expect from a mix perspective as you go to the back half? Would you see the same kind of strength on the ASP side that you've kind of seen over the past year? That would be really helpful to understand. Thank you.

Akash Palkhiwala:

Yeah. So if you think about premium flagship launches for our OEMs, a lot of the launches happen in the holiday time frame just before the holidays going into Chinese New Year as well. And so you've seen a lot of those happen. We do have some significant launches through the middle of the year, but obviously, the next big launch goes into the holiday season, starting with Apple and then going into the Android launches. So that's a typical cadence.”

China is a Problem for Apple

We outlined how BYD was becoming a problem for Tesla. According to commentary on Apple’s earnings call and Qualcomm’s earnings call this quarter, China’s preference for domestic OEMs is becoming a problem for the iPhone. In particular, Huawei is making a comeback. Below is mention that Huawei is performing well in the premium tier.

“Samik Chatterjee

[…] So just wondering if you can give us an update in terms of what you’re seeing from those customers? And if at all, Huawei and their reemerges in the market is starting to have an impact in terms of volume or market share for these customers as well in the context of your flat guide for them for quarter-over-quarter? Thank you.

Akash Palkhiwala

In terms of your comment on Huawei, really what we’ve seen since Huawei 5G launch is that the premium tier TAM in China has expanded. And so we’re continuing to see strong demand from our customers post that launch.”

There’s additional evidence that a Chinese OEM is gaining market share as a new customer emerged at 14% of revenue for Qualcomm compared to an estimated 20% from Apple.

“Ross Seymore

Great. And I guess for my follow-up, I noticed in the 10-Q, you had a new 10% customer, I think it was a 14% customer. I don't expect you to name who that is. But is that a reflection of the strong China demand that you talked about in the continuation of good future growth opportunities or was there any onetime aspect of that customer, whoever it may be popping up in the quarter?

Akash Palkhiwala

I think the you framed it in your first theory is a reasonable way of thinking about it.”

Per our write-up on Big Tech earnings, “Apple is facing competition from other smartphone companies in China due to foldable designs and advanced AI features. The company’s total revenue from China in the recent quarter was $20.8 billion, which missed estimates of $23.8 billion.”

Some of Qualcomm’s commentary is useful for if/when we build a position in Apple in anticipation of AI mobile devices. As of now, Apple faces a serious headwind with Huawei and Chinese OEMs. We saw the technicals flashing a few months back in a free analysis here and again here.

Snapdragon AI Platform Roll-Out:

Qualcomm’s Snapdragon 8 Gen 3 mobile platform is helping to bring generative AI to the edge with an AI engine that can run LLMs up to 20 tokens per second. It offers on-device AI such as live translate, interpreter and chat assist. Per management: “This marks the beginning of how gen AI will evolve the overall smartphone experience and highlights the significant opportunity for Snapdragon platforms.” 

The Samsung Galaxy S24 Ultra, GalaxS24 and S24 Plus is using the Snapdragon 8 Gen 3 mobile platform. Per management: “The Snapdragon 8 Gen 3 mobile platform is setting a new standard for on-device gen AI experiences for premium smartphones and powers all through flagship Android devices launched and launching this fiscal year.”

In addition, the Snapdragon X Elite will offer on-device gen AI and copilot for the upcoming Windows upgrade. There was a second mention of “mid-2024” for this release.

The Snapdragon X35 will also serve 5G-enabled industrial IoT devices equipped with generative AI, such as enterprise workflow, inventory management and warehouse applications (there are dozens or use cases). According to Qualcomm: “We continue to believe that industrial edge devices with connectivity, high-performance computing and on device AI will become one of our largest addressable opportunities fueled by the secular trends of digital transformation.”

Custom Oryon CPU Cores:

Qualcomm’s Snapdragon AI platform is powered by a new Arm-based CPU called Oryon. This effort began with the acquisition of Nuvia, a company that specializes in custom Arm silicon. This was important for Qualcomm to compete with Apple’s M1 chip, released in 2020 with more iterations since, such as M1 Pro, M1 Max, M2 and M3.

Prior to Nuvia, Qualcomm used Arm designs off-the-shelf with Cortex cores designed by Arm. The Oryon CPU will be the first 64-bit that Qualcomm has designed itself using an architectural license. Legally, only ARM themselves or companies Arm has sold a license to are allowed to design Arm CPUs. When Qualcomm bought Nuvia for its CPU design, Arm is asserting the license is no longer valid and is not transferrable since the company with the license no longer exits.

The importance of this is that Arm architecture on PCs is expected to help Windows PCs compete on performance and power efficiency with MacBooks. It could also spell trouble for Intel. Here are current benchmarks (benchmarks tend to be skewed in favor of one performance measurement rather than overall performance). This is also benchmarked against the M2 whereas the M3 on 3nm technology came out last Fall. According to Apple, the M3 is 15% faster than the M2 with efficiency cores that are 30% faster than what was benchmarked against the upcoming Qualcomm release.

With that said, Oryon is rumored to have power efficiency issues due to Qualcomm using cell phone PMICs. The power management integrated circuits (PMICs) are what manage and regulate the power in electronic components. By using cell phone PMICs, the CPU cores won’t run in the optimal efficiency range. In order to handle the needs of a laptop, Qualcomm is bundling together PMICs. In the very near-term, this means selling more Qualcomm PMICs, but in the medium-term, it means a competitor like AMD or Intel (or Nvidia) could crush Qualcomm on price and performance. The full write-up from SemiAccurate is worth a read. Here is what the independent analyst stated:

“Laptops have a large multiple of the board area of a cell phone, think more than 10x rather than a percentage. So a very expensive cell phone spec board just blew out costs for Oryon laptops. Whoops. Some OEMs SemiAccurate talked to were a tad peeved by this because it is entirely unnecessary, it is mandated solely by the force bundled PMICs. Allowing a suitable PMIC would also allow for a much cheaper PCB too but as you might guess, Qualcomm took a different path.”

Although we will have to wait until 2025 for AMD and Nvidia’s Arm-based laptops, the stage is being set for Qualcomm to stumble and this is something we track for portfolio purposes. To translate, Qualcomm could do well in 2024 given it will be the first to launch Arm-based Windows PCs for AI purposes but whatever lead Qualcomm gains in roughly 6 months time will be harder to maintain in 2025 and beyond as Qualcomm’s exclusive deal expires and more competition arrives.

Qualcomm will release its first smartphone processor with the Oryon CPU in late 2024. The Snapdragon 8 Gen 4 will feature custom CPU cores for the first time since 2016.

Note on Automotive:

The handset segment reported +16% growth and IoT reported (-32%) growth whereas the Automotive segment reported +31% growth.

It’s the smallest segment by revenue size at $598 million compared to handsets at $6.7 billion and IoT at $1.1 billion. However, what’s important to note is that Qualcomm’s automotive segment is growing when other pockets of Automotive are weak on an industry-wide basis. 

According to the Auto Investor Day, Qualcomm expects to have “greater than $4 billion in revenue in fiscal '26 and greater than $9 billion in revenue in fiscal '31.”

Here is what was stated on the call:

“And we already have some revenue from ADAS processing. You see a lot of cars for example, in China with both ADAS and autonomy with our processor, you see some of our customers in the United States of our processor. And I think that continues to grow as we get towards our 2026 revenue target, you’re probably going to see very healthy components of all of those elements.” 

Regarding the disconnect between Qualcomm’s growth in automotive versus the industry declining, the following was stated:

“Switching over to your second question on automotive. You should really think — the way to think about our automotive business is we're tied to the launch of new cars. Clearly, the industry is going through a transformation, digitization of cars, and we are right at the intersection of that transformation. We are we're benefiting our cars put in more infotainment content for experience within the car. More ADAS content comes into the car as well.

And really, we get to benefit from all those intersection points in the car, and we're increasing the content as new cars launch. So that's the maybe a disconnect between some of our peers what they're seeing and what we're seeing. Stepping back, I mean, clearly, this is an industry that's going through some shorter-term dynamics, so we'll be closely monitoring it. But when you step back, our technology, our position, our products look really good, and we're excited about where we're going.”

Nvidia and AMD could strong ARM Qualcomm

The efficiency shown by the M1 and M2 chips from Apple has resulted in a long battery life and high performance per watt. Apple’s laptops like the M2 Max Macbook Pro can compete with discrete graphics and is better suited for AI processing than laptops with x86 processors. This has led to Apple doubling its market share since the M1, and has caught the attention of Nvidia and AMD. Qualcomm has an exclusive through 2024, which leaves 2025 as the year the world’s top design companies can release an Arm-based PC. According to Reuters, this is exactly what they plan to do.

In addition to Qualcomm’s controversial use of mobile PMICs, which could alter the benefits of an Arm-based PC in terms of power requirements, Nvidia and AMD are more equipped to build advanced AI features into CPUs and devote on-chip resources for AI-enhanced software (need I go further into how Nvidia and AMD will potentially beat Qualcomm on advanced AI features? This one is a tad obvious)

Where the rubber meets the road is that x86 applications have a mature ecosystem and is ubiquitous whereas code for Arm-based Windows is far less supported. If Nvidia and AMD are getting involved, then they must be envisioning the power requirements for AI will be enough of a motivating factor to push forward efforts for Windows Arm-based code.

Conclusion:

We are not interested in Qualcomm or Arm as a portfolio position at this time, rather we are tracking these companies more closely as they will help to bring AI to the edge with Arm-based PCs. This will be timed to an AI-focused release for Windows in mid-2024. There is also quite a bit of excitement around Arm at the moment. For the most part, our firm does not participate in IPOs as the vast majority trade below their opening price after the lockup expires. Arm’s valuation is particularly shocking as it exceeds even Nvidia. We find it advantageous to take our time and buy post-lockup, especially given Arm CPUs dominate 99% of mobile and it’s procured very little revenue compared to mobile heavy hitters in hardware and software. What’s also of interest to our portfolio is that Qualcomm may stumble given the mobile PMICs being used, and in that case, our favorites AMD and Nvidia could have an opening to dominate come 2025.

The overarching theme is that Edge AI is approaching and we want our positions to be aligned as closely as possible given client revenue has been weak for semis across the board. It will be the perfect recipe when client revenue segments return to growth, combined with ongoing data center strength. We want to be positioned when this happens for otherwise strong semiconductor companies that are currently a “tale of two cities” – weak PC and mobile segments detracting from strong data center/AI segments.

Resources:

• In 2021, the IOF covered Arm in a Forbes analysis.
• Broadcom: $10B in AI Revenue This Year Plus Software is Rapidly Accelerating
• Marvell Q4: Data Center Strong but AI Slow to Materialize
• Super Micro Q2 2024 Earnings: The AI Bullet Train

Marvell’s report was primarily in line with a marginal miss for the Q4 guide. The market was expecting $1.46B on the guide and Marvell provided $1.42B at the midpoint. For Q4, the adjusted EPS of $0.46 guided by management also missed estimates of $0.49. However, the cash was strong at $503M in operating cash flow and $448.3M in free cash flow.

Although the data center beat expectations, Marvell is expected to face near-term weakness in its Carrier Infrastructure (5G) and Enterprise Networking end markets, which partially contributed to the miss in guidance vs. consensus for both revenue and Non-GAAP EPS. The 5G market is weak because the initial wave of 5G rollout is finishing and also demand is continuing to weaken as carriers are holding back on CapEx spend in tough macroeconomic conditions. For Enterprise Networking, weakness is due to both inventory management form OEM customers and weak demand. Furthermore, there isn’t that much visibility for the Enterprise Networking business.

Regarding the data center, last quarter, Marvell was forthright in saying they had a $200 million quarterly revenue run rate, or $800 million annualized. Per the Q2 transcript: “Based on our latest demand outlook for our electro-optics products, we now expect revenue from AI to exit this year at over a $200 million quarterly revenue run rate or $800 million annualized.” It naturally follows that investors want an update to this number the following quarter.

Despite there being 20% growth this quarter in the data center and an impressive 35% expected next quarter for the data center, the CEO declined to raise the exit rate for AI other than to say: “well north of $200 million.” When pressed further, management declined to update the exit rate. This may seem like semantics, but it’s important because this is Marvell’s bull case. The rest of the segments weigh considerably on the company due to cyclicality.

Looking further into Q1, management seemed to imply the other segments could drag on the company’s outlook. They didn’t guide Q1, of course, but the response to a question in terms of whether the other segments will drag too much on revenue growth was answered with what appeared to be low confidence.

Financials

Marvell reported revenue of $1.419B, down 8% YoY and up 6% QoQ, slightly above consensus. Revenue next quarter is expected to be $1.420B, which is below consensus of $1.46B.

Non-GAAP EPS was $0.41, slightly above consensus of $0.40. GAAP EPS of ($0.19) missed guidance of ($0.07) EPS. Of this $269.8M is for the amortization of acquired intangible assets from the Inphi and Innovium acquisitions. There is another $158.5M paid in stock-based compensation.

Adjusted EPS for next quarter is expected to be $0.46 which is below consensus of $0.49.

The gross margin has been improving quite a bit. The adjusted gross margin was 60.6% and the guide for next quarter is 63.5% to 64.5%. The GAAP gross margin was considerably lower at 38.9% this quarter.

The adjusted operating margin was in line at 29.8% and the adjusted net margin was 25% for profits of $354 million.

Cash and cash equivalents was $726M, increasing by $202M from the Jul quarter. Operating Cash Flow was $503M up from last year of $411M. The gross debt-to-EBITDA ratio was 2.21 times and net debt-to-EBITDA ratio was 1.83 times. In other words, debt of $4.19 billion didn’t improve this quarter.

Revenue Segments:

Data Center:

Data Center Revenue of $555.8M (down 11% YoY, up 21% QoQ)

The strength in Data Center revenue was driven by stronger than expected AI revenue. A positive within the Data Center end market was cloud revenue returning to YoY growth. Cloud revenue grew >30% with contributions from AI and cloud infrastructure with AI revenue growing substantially faster than cloud infrastructure revenue. Marvell’s product portfolio of PAM4 optical products, Teralynx, Ethernet switches, and Data Center Interconnect products contributed to the QoQ growth for Data Center revenue. You can read our previous write-up on Marvell here.

However, the strength in cloud revenue was offset by enterprise on-premise data center revenue declining QoQ, which was expected by management. Similar to Q2, data center revenue for the storage market remains weak.

Enterprise Networking:

Enterprise Networking revenue of $271.1M (down 28% YoY, down 17% QoQ). Enterprise Networking revenue weakness was due to weak demand in this end market, which is in-line with management expectations.

Carrier Infrastructure:

Carrier Infrastructure (5G) revenue of $316.5M (up 17% YoY, up 15% QoQ. 5G revenue strength was driven by the wireless part of its 5G end market

Consumer:

Consumer revenue of $168.7M (down 5%, up 1% QoQ)

Automotive:

Automotive/Industrial revenue of $106.5M (up 26% YoY, down 3% QoQ)

Earnings Call:

AI Revenue:

The comments on AI revenue were positive in the opening remarks yet the CEO sounded less confident during the Q&A. Personally, I found it to be confusing and analysts did, as well.

To start, the opening remarks were encouraging but it later changed, for example: “In our data center end market, revenue for the third quarter was $556 million, well above our guidance, driven by stronger than forecasted AI revenue,” and also, “In cloud, revenue from both AI and standard cloud infrastructure grew sequentially with AI growing significantly faster.” 

At this point, given this commentary, the expectation was for a higher exit rate than the $200M provided last quarter.  Yet, when pressed in the Q&A, management had a different tone.

Q:: I'm kind of hearing mixed signals on the custom silicon opportunity. And I just wanted you guys to clarify on that. I guess, first of all, are you guys above or below $200 million expectation you guys had for the year? […] You guys talked about that $200 million for this year -Christopher Rollins 

A: Yeah, exactly. So yeah, so we're tracking, I'd say, close to the $200 million, okay, for this year. And then what we had said at the Investor Day and kind of the long-term was this $800 million, and that was between, sometime between FY 2025 and 2026, that was what the — if you looked at the slide from a couple of years back.

And what we had said, I think I think two quarters back or it was a quarter back that, that number would be bigger overtime now because of the AI piece of it, even though some of the stuff had shifted around that wasn't an AI. And I think that's still largely on track in that timeframe. We never gave an exact kind of — it's going to happen in XYZ quarter.

But in that FY 2024, 2025 to FY 2025, 2026 timeframe it should be able to get towards above that number we gave before which is the $800 million.

So I don't think there's any mixed signals. I don't think there's any update, which I think we're – I think there's some enthusiasm around, but nothing's changed from a quarter ago. In fact, I think the thing that's positive is that the chips are looking really good to go to production for next year, and that was always a risk.” -CEO, Matthew Murphy

My translation: To be frank, I do think the CEO gave mixed signals as the opening remarks stated “significantly above our forecast,” yet later, the CEO stated: “nothing's changed from a quarter ago.” It seems management is mixing words by saying “above our forecast” to reference a forecast from many quarters or even years ago instead of the forecast in Q2.

It's quite obvious this year the market is keen on AI revenue, and mixing words when describing the AI revenue was odd, at best, and careless, at worst.

Fiscal Q1:

The rebound we outlined in our pre-earnings report is crucial for a win-win scenario to where the rebound ideally aligns with AI driving more data center revenue. Therefore, although being two quarters out, Q1 is important because it’s the quarter the rebound is expected to be most evident with 13.2% revenue growth and 60% EPS growth expected.

The question on the call about fiscal Q1 did not exude confidence:

“And then also for fiscal Q1, do you still think that revenue can grow? I know you said that networking is down and carriers down. But data center would be up. Do you think that total revenue can be up? Thanks.” -Tim Acuri, UBS

“On Q1, while we don't guide specifically, I understand what you're looking for. I think the way to think about it is that, and I guess I gave the information. Carrier is down after a really great run in that's going to stay weak. The telco environment and CapEx spending is very constrained out there and the end customers seem to be having some trouble. We talked about enterprise being down.

And then on consumer, which actually did a little bit better than we thought it would have this year. The last time buy program that we had has been largely going to conclude now in the fourth quarter, and so we see a stepping down there. So if you kind of add all that up, that's about half our revenue that's going to come down in Q1.

And then the real question is the data center strength and how does that continue? And it's too early to call, but just the way to think about it is it's a lot to offset at this juncture when you have that much of your of your revenue coming down.” -CEO, Matt Murphy

Later, it was asked if carrier would bottom in Q4 but the CEO indicated it could be Q1 or further out. Carrier is the second largest segment and so this may be where the lack of confidence in Q1 is coming from.

Q: “Thank you for that Matt. One last one on carrier. Is Q4 going to be the bottom? Or do you think there could be some more yet to drop? And then I think you have some additional content coming at one of your customers at the end of the year. Is that going to be a meaningful lift for the segment? Thanks.” -Christopher Rolland

A: “Yes. So there's – as I think I said in my remarks, there's going to be continued softness into Q1 in carrier, okay? It's going to take, who knows how many quarters. And it really depends, I think, there'll be some inventory and then you've got to also look at kind of where the CapEx ends up during next year and where carriers are actually going to spend globally on their deployments.” -Matt Murphy

Conclusion:

Marvell has a strong AI story that is obfuscated by its other segments. The lack of confidence for fiscal Q1 due to the other segments, plus management declining to update the AI exit rate is why the price action reversed. I agree with the market; I think the report needed to be stronger in terms of management communicating more clearly on the AI story since this is the bull case. The tone is that this is a waiting game, and it’s not possible for management to help investors time when the many pieces will come together. Lastly, the opening remarks were confusing — although it doesn’t change Marvell’s potential, it did create some disappointment that there was not “significantly more revenue” from AI – rather, come to find out, the guide was unchanged. Or, if there is significantly more revenue, than Marvell is not willing to be as forthright as management was last quarter, and is leaving investors guessing.

There were some positives such as the cash flow and margin improvement. However, without more AI revenue to report in terms of an exit rate, these improvements won’t be enough to end the year as a 2023 outlier.

Recommended Reading:

• Marvell Q3: AI-Driven Rebound on the Books, Bottom Line in Focus
• CrowdStrike Q3 Earnings: Net New ARR Accelerates, Billings Decelerate
• Nvidia Fiscal Q3 Earnings: The China Impact
• 2024 Trend: Memory and PC Rebound
• Big Tech companies continue to invest in AI
• Supermicro Fiscal Q1: “Conservative” Guide

The price action was more muted, yet the earnings report was quite spectacular. Primarily, the guide for Q3 implies data center growth of 226%, an acceleration from the 171% year-over-year reported in Q1. We had been posting on the forum that channel checks published by The Financial Times and The Information, plus China were pointing toward analysts/sources expecting between $30B to $40B in data center revenue growth. We are going to now easily clear the $40B number. If we assume an incremental $3B in Q4 (which is a reasonable assumption), then we will be at $42.6B.

The $42.6B is now probably too low if we factor in that Nvidia just beat 28% on data center in this quarter and 30% for overall revenue in Q3.

• $8B in data center expected versus $10.3B reported = 28% beat
• Q3 revenue expected of $12.35B versus $16B reported = 29.5% beat 

Should the trend continue, it will lead to a $20B revenue quarter for Q4 and overall data center revenue for FY2024 of $48 billion, up from $15 billion last year for growth of 220%. These are hypothetical, but in line with what Nvidia has been reporting. 

What I’m trying to describe here is that myself and the analysts covering this stock cannot keep up with the large beats and raises — even when you think you’ve provided a reasonable estimate, Nvidia blows right past it.

Financials Scorecard:

Revenue and EPS:

• Revenue of $13.5B beat estimates of $11.1B for growth of 101.5%
• Q3 Revenue of $12.35B beat estimates of $16B for growth of 169% estimated
• Look for FY2024 estimates to go up, although hopefully they aren’t too aggressive to help secure a beat next quarter. A beat is very important for Nvidia next quarter given the spotlight on this company.
• Adjusted EPS of $2.09 was expected versus $2.70 reported
• The company announced a $25 billion buyback with $4 billion remaining

Margins:

Similar to revenue, this was a blowout quarter on the margins. Although pricing power may not sustain, as software revenue grows, it will continue to help the margins. The strong margin is likely due to a mix from software and also higher average sales prices.

• 70% gross margin is also bonkers. This is the best gross margin in Nvidia’s history (typically in the mid-50%) and this marks the turning point of Nvidia becoming a software company.and this marks the turning point of Nvidia becoming a software company. 
• Adjusted gross margin of 71.2% beat guidance of 70%
• Operating margin of 50% beat guidance of 44%. On a year-over-year basis, operating income was up an incredible 1,263% from $499 million last year Q2 to $6.8B this year and was up 218% QoQ.
• Adjusted operating margin of 57.6% beat guidance of 52.7%
• Net margin of 45.9% compares to net margin of 28% last quarter
• Net profits were $6.2B compared to $656 million in the year ago quarter – yes, 8-9X higher!

 

Earnings Call:

The CFO said the following in her opening comments about supply:

“We expect supply to increase each quarter through next year” and she also said “Demand for our Data Center platform where AI is tremendous and broad-based across industries on customers. Our demand visibility extends into next year. Our supply over the next several quarters will continue to ramp as we lower cycle times and work with our supply partners to add capacity.”

This is an indirect way of implying sales will increase each quarter through next year as Nvidia has plenty of demand.

The call was not as exciting this quarter. Per our notes last quarter, management said the following, which led to the stock action moving from 15% AH to 25% AH.

“Let me see if I can add a little bit more color. We believe that the supply that we will have for the second half of the year will be substantially larger than H1 […] Yes, we do plan a substantial increase in the second half compared to the first half.” -CFO Collette Kress, Q1 call

Considering the analyst was able to get this important color on the last call, the same analyst, Vivek Arya, thought he’d give it a go again by asking about supply. This time, the CFO declined to comment, and the price action AH softened from 9% to 6.5%.

Vivek Arya

Thank you. Just had a quick clarification and a question. Colette, if you could please clarify how much incremental supply do you expect to come online in the next year? You think it's up 20%, 30%, 40%, 50%? So just any sense of how much supply because you said it's growing every quarter […] 

Colette Kress

So thanks for that question regarding our supply. Yes, we do expect to continue increasing ramping our supply over the next quarters as well as into next fiscal year. In terms of percent, it's not something that we have here […]

Speaking of demand, the CFO confirmed that cloud service providers (CSPs) are “a little bit more than 50% of revenue” in the data center followed by consumer internet companies.

Regarding software revenue, which is what leads to higher margins, the CFO said the following:

“Colette Kress

And let's see if I can answer your question regarding our software revenue. In part of our opening remarks that we made as well, remember, software is a part of almost all of our products, whether they're our Data Center products, GPU systems or any of our products within gaming and our future automotive products. You're correct, we're also selling it in a standalone business. And that stand-alone software continues to grow where we are providing both the software services, upgrades across there as well.

Now we're seeing, at this point, probably hundreds of millions of dollars annually for our software business, and we are looking at NVIDIA AI enterprise to be included with many of the products that we're selling, such as our DGX, such as our PCIe versions of our H100.”

Conclusion

I took the opportunity to make a plug for technical analysis after SMCI dropped as it was a strong report that received a harsh reaction. I want to make another plug for technical analysis because our last entry at $410 was bold given the stock was up 200% this year. We used technical analysis for this, not fundamentals. Our hope is that we can take gains in the mid-$500s to low $600s per this July Positions Report. When we do, you will be alerted via real-time trade alerts. Keep an eye out for the webinar invite for tomorrow, as well, where Knox will be discussing the I/O Fund’s Nvidia position.

Risk:

It may seem like Nvidia stock will keep climbing forever, but the words “China ban” can and will rock this stock. There is 20% to 25% exposure to China in the data center. We assume this risk by owning the stock and will use technicals to risk manage when appropriate.

Additional Reading:

• Nvidia: A Leader in AI Hardware and AI Software – this lays out why the software opportunity is important
• Nvidia Stock: How We Plan to Position for Q2 Earnings – this was our pre-earnings writeup, also posted on the forum here.
• Nvidia Q1 Earnings: Est 100% Growth for Data Center in Q2 is Bonkers – this was the write-up from the last earnings report
• Nvidia is Ready to Rumble with RTX 40 Series and H100 GPUs – this was written near the October low on why investors could expect Nvidia to bottom, I also wrote this about the Gaming bottom. 
• Here’s Why Nvidia Will Surpass Apple’s Valuation in 5 Years – an editorial from 2021 that laid out the bull case on AI

We recently published a deep dive on the potential of AMD’s MI300s here. In the medium-term, starting later in 2023 and into 2024, we laid out reasons why we are very positive about the competitive and financial opportunity it presents for AMD.

In the short-term, AMD faces a delicate balancing act of confronting weakness in PCs while providing assurances of a 2nd half rebound and acceleration into 2024. In that regards, AMD Q2 earnings report will be closely watched for evidence of this. For the past 3 months, analysts have steadily reduced their quarterly earnings estimates to reflect weakness from the consumer-facing PC segment. However, the multiple has expanded in part due to the optimism surrounding AMD’s AI opportunity. It’s also helpful that AMD continues to take market share from Intel on CPUs, which we’ve covered extensively.

Here are the Q2 estimates going into earnings announcement on 8/1 (amc).

All numbers for current quarter and YoY unless otherwise stated

EPS & Revenue:

• EPS: Consensus estimates $0.57 vs $0.60 last quarter
• EPS: Next quarter consensus estimates $0.74
• Revenue: Mgmt midpoint guidance of $5.3B (-19% y/y) vs Consensus of $5.32B
• Next quarter revenue consensus of $5.32B
• Full year revenue consensus of $23B (-2.5% y/y)

Group sales by division (a reference guide of what was reported the last two quarters)

• Data centers – $1.3B Q123 vs $1.7B Q422  
• Client segment – $739m Q123 vs. $903m Q422
• Gaming – $1.8B Q123 vs $1.6B Q422

Gross Margins based on midpoint

• Mgmt adj guidance of 51% vs last quarter of 50% actual
• Mgmt adj $ guidance of $2.65B vs last quarter of $2.68B actual 

Operating Margins based on midpoint

• Mgmt adj op margin guidance of 19.8% vs last quarter of 21% actual
• Mgmt adj operating margin $ guidance of $1.6B vs last quarter of $1.1B actual

Cash flow + Cash

• Last quarter operating and free cash flow was $486B and $328B for a margin of 9% and 6%, respectively
• Last quarter cash stood at $2.8B and $333m in debt

Here are the things we’ll be looking for:

Will Q223 mark the bottom?

The market will be looking to see if this is the bottom in yearly revenue growth

And improvement on a sequential quarterly basis.

When an anticipated bottom is approaching, a beat can be aptly rewarded. Also, the opposite, a miss can be severely penalized. The reason the pressure is on when a bottom is expected is because a beat often translates to a quicker recovery where a miss at this junction translates to a slower or delayed recovery. Our goal is to see AMD come in as expected (at least) and offer strong commentary on H2.

In providing their Q223 guidance, this is how AMD described the factors driving y/y decline and improvement (less negative) sequentially.

“Now turning to our second quarter 2023 outlook. We expect revenue to be approximately $5.3 billion, plus or minus $300 million, a decrease of approximately 19% year-over-year and approximately flat sequentially. Year-over-year, we expect the Client, Gaming and the Data Center segment to decline, partially offset by Embedded segment growth. Sequentially, we expect Client and Data Center segment growth to be offset by modest Gaming and Embedded segment decline.”

Data Centers:

AMD has indicated the decline in Data Center revenue was primarily due to lower enterprise server processor sales plus some inventory correction: “Data Center segment revenue of $1.3 billion was flat year-over-year with higher cloud sales offset by lower enterprise sales. In cloud, the quarter played out largely as we expected. EPYC CPU sales grew by a strong double-digit percentage year-over-year but declined sequentially as elevated inventory levels with some MDC customers resulted in a lower sell-in TAM for the quarter.”

However, due to the visibility AMD has, H2 is expected to be quite strong – note, that doesn’t necessarily help us AMD investors with Q2 but it’s good to know management is expecting a shift on the horizon in terms of growth. You may recall that we pulled out the conversation below because we felt it was important to portray management’s confidence level for H2 growth rates. You can view more important quotes from the last call on our post-earnings write-up here.

Question

“So you said double-digit Data Center. Was that a full year statement? Or was that a second half year-over-year statement? Or was that a half-over-half statement for Data Center?”

Lisa Su

“Yes. Let me be clear. That was a year-over-year statement. So double-digit Data Center growth for the full year of 2023 versus 2022.”

Question

“Got it. Which just given what you did in Q1 and sort of are implying for Q2 needs something like 50% year-over-year growth in the second half to get there. So you're endorsing those — you're endorsing that now?”

Lisa Su

I am…

Jean Hu

Yes, your math is right.

Client and Gaming Segment

The decline in these 2 segments will be less compared to Data Centers. Per AMD’s CFO Jean Hu:

“Client and Gaming segments would be seasonal. So you would expect that the Data Center would be more than seasonal. So maybe to help you size that, think about the Data Center sequential drop as double digit, whereas the Client and the Gaming segments are more like single digit, if that helps.”

PCs will be an important factor for both the Client and Gaming segment. AMD’s plan to navigate PC weakness was to under ship for a quicker rebound, which was Nvidia’s strategy for gaming. This makes it more painful in the short term but sets up a better recovery in the long term. According to management, this is the bottom for PCs and they expect a rebound in H2.

In Intel's Q223 earnings call, they gave positive indications that the pc environment was improving.

“We have worked closely with our customers to manage client CPU inventory down to healthy levels. As we continue to execute against our strategic initiatives, we see a sustained recovery in the second half of the year as inventory has normalized.” 

Profitability

Despite the decline in sales, AMD has been able to maintain steady gross margins. For Q2FY23, AMD has guided for an adj gross margin guidance of 51% vs Q123 of 50% actual vs Q422 of 51% actual.

If Q2 is in fact the bottom, we will look for comment on what levels of profitability can be achieved when these segments return to growth.

MI300 release – We’ll listen for any updates on MI300 which is due to be released in Q4 and is expected to contribute to revenue by early 2024. You can read more about these highly anticipated GPUs in our most recent analysis here.

Here’s what analysts are saying

07/31 Susquehanna analyst Christopher Rolland lowered the firm's price target on AMD to $135 from $145 and keeps a Positive rating on the shares. The firm previewed AMD's Q2 results and said they face a number of near-term headwinds including softer Genoa, console, GPU, Xilinx and an elevated DC expectation, putting Street estimates at risk. However, longer term Susquehanna loves the server gain and MI300 opportunities.

07/26 Citi sees "bad news" for Intel (INTC) and AMD (AMD) in the earnings reports from three of the largest cloud service providers – Alphabet (GOOG, GOOGL), Meta (META), and Microsoft (MSFT). Meta lowered 2023 capex 10% and Alphabet's Q2 capex was lower than anticipated, the analyst tells investors in a research note. Microsoft's fiscal Q4 capex of $8.9B beat the consensus of $8.1B, but the company didn't provide a full year capex guide for fiscal 2024, adds the firm. It believes the Street was expecting a raise in capex given the strength at Nvidia was expected to broaden out to other artificial intelligence chip suppliers. Citi is below consensus on AMD as it expects the company to lower Q3 guidance given weakness in the data center market. It has a "negative catalyst watch" on AMD and remains Neutral rated on both AMD and Intel.

07/26 Jefferies analyst Mark Lipacis said that Microsoft's (MSFT) and Alphabet's (GOOGL) comments regarding capex and AI spending on their earnings calls lead the firm to believe that its "above-consensus" Nvidia (NVDA) estimates "may prove conservative." The firm, which notes that "AI" was mentioned 170 times on the calls, which is twice the rate in the companies' Q4 reports, views Microsoft's and Alphabet's commentary as positive for Nvidia as well as AMD, Intel, Marvell and Broadcom.

Note: Read our takeaway that is similar to Jefferies’ Mark Lipacis that capex comments were positive on Google’s call here and Microsoft’s call here. 

07/11 KeyBanc analyst John Vinh raised the firm's price target on AMD to $160 from $150 and keeps an Overweight rating on the shares. While near-term challenges associated with delays of its MI300 AI server and stability issues with its PC NB Ryzen Phoenix could result in near-term risk to estimates, AI server wins give KeyBanc high conviction that AMD could see well over $2B in AI revenues in 2024.

07/12 TD Cowen analyst Matthew Ramsay raised the firm's price target on AMD to $135 from $115 and keeps an Outperform rating on the shares. The firm believes investors are prepared for a mixed Q2/Q3 on revenue and margins as the macro remains challenging. The firm adjusted 2H estimates to be more 4Q-weighted. and they believe investor focus post earnings will again turn longer-term to AMD's strong Datacenter prospects, including a crystallizing AI strategy supported by stronger HW/SW roadmaps. 

(06/14) Goldman Sachs raised the firm's price target on AMD (AMD) to $137 from $97 and keeps a Buy rating on the shares after the company's Data Center & AI Technology Premiere event. The analyst states that the firm was encouraged by AMD customers' endorsements and continues to model share gains for AMD in server CPUs primarily at the expense of Intel (INTC), adding that AMD should grow into a credible second supplier over the medium- to long-run.

How we plan to handle our position will be posted in real-time on I/O Fund Advanced Market Signals

The I/O Fund Analyst Team contributed to this analysis

 Recommended Readings:

• AMD is Ready to Rival on AI Acceleration
• July Positions Report
• AEHR: Strong Top Line & Strong Bottom Line – Fiscal Q4 2023 Earnings
• ON Semiconductor: Powering the EV Highway
• Super Micro: Sandwiched In The AI Trend

Objectively, AMD had a mixed report. There are no serious red flags, per se, and the report was a bit better than Microsoft as management gave investors something to look forward to. Management sounded confident (or even adamant) there would be a H2 rebound in the data center and a Q2 rebound on PCs. 

Certainly, the report wasn’t a disaster like Intel, and that comparative performance is likely helping AMD with flat price action despite there being some puts and takes. 

Where the report was mixed is the weaker-than-expected data center sequential growth and lower gross margin. Investors will need to trust management has enough visibility into H2 to deliver. It’s helpful TSM echoed the same, which is a H2 rebound. However, the current information provided for next quarter is double digit deceleration sequentially in the data center due to high inventory levels. 

We remain positive on AMD but want to be a good messenger on the nuances of the earnings report. 

Financials: 

AMD reported inline with expectations for Q4. There was a slight beat on revenue at $5.52 billion expected compared to $5.6 billion actual. This represented growth of 16% compared to growth of 14.3% expected. 

The March quarter guide missed, and this is where analysts on the earnings call were primarily focused. Guidance of $5.3 billion missed by expectations of $5.52 billion, which equals growth of (10%) compared to (6.3%) expected. Please read the Earnings Call Notes below, as it required further discussion to put the pieces together. Prior to Xilinx, GAAP tracked about 1 point within the Non-GAAP margins.  

The inline Q4 resulted in the FY2022 also being in line for growth of 44% and revenue of $23.6B. 

GAAP Margins are not the best to focus on right now as they include the amortization of Xilinx assets and intangibles. Rather, for YoY comparison, the adjusted margins are a better indication of AMD’s business operations.   

Q4 Margins: 

• Adjusted Gross Margin of 51% compares to Adjusted GM of 50% in the year ago quarter and 50% in Q3
• Adjusted operating margin of 23% compares to 27% a year ago, analysts were concerned about this
• Adjusted net margin of 19.6% compares to 23% a year ago, analysts were concerned about this 

FY 2022 Margins: 

Same as above, the GAAP margins aren’t reflective of the business operations due to the Xilinx acquisition.  

• Adjusted Gross Margin of 52% for gross profit of $12.273B
• Adjusted operating margin of 27% for operating profit of $6.345B
• Adjusted net margin of 23.3% for profit of $5.5 billion 

Cash Flow: 

AMD reported lower than usual cash flow in Q4: 

• Operating cash flow of $567 million, for a margin of 10% compared to a margin of 17% a year ago and 17% last quarter
• Free cash flow of $443 million, for a margin of 7.90% compared to FCF of 15% a year ago and FCF of 15% last quarter 

For Fiscal Year 2022, cash flow:

• Operating cash flow of $3.6 billion for a margin of 15.2%
• Free cash flow of $3.1 billion for a margin of 13% 

The company repurchased $250M shares this quarter. There is $2.3 billion in cash on the balance sheet and $330 million in debt. 

Revenue Segments: 

The data center was up 42% YoY for $1.7B in revenue. This is $1 billion higher than the previous quarter for 6% QoQ growth. As stated above, the issue is the miss on Q1. It was vague in the quarterly report yet was indicated on the call that data center would be down “double digits” sequentially due to high inventory levels. However, management had positive things to say about H2 and the data center.  

Client revenue of $903 million was down (51%) YoY and down (9.7%) sequentially. It was indicated on the call that client revenue would be down single digits in Q1 and this would mark the bottom, according to management. There was a reported operating income loss of ($152) million.  

Gaming revenue of $1.6 billion was down (7%) YoY and flat sequentially.  

Embedded revenue of $1.4 billion was up 1,868% YoY due to the Xilinx acquisition and was up 7.6% QoQ. 

Earnings Call: 

The first hint of some data center weakness in Q1 was in this information provided by the new CFO, Jean Hu: 

“Year-over-year Data Center and Embedded segment revenue are expected to grow, offset by lower Client and Gaming segment revenue. Sequentially, Embedded segment revenue is expected to increase. Client and Gaming segment revenue are expected to decline largely consistent with seasonality. Data Center segment revenue is expected to decline due to elevated levels of inventory with some cloud customers.” 

Despite not guiding for full year 2023, the CFO added: 

“Directionally, we expect Embedded and Data Center annual revenue to grow from 2022 based on the strength of our product portfolio and expected share gains. In addition, we expect Client and the Gaming segment revenue to decline based on the current demand environment.” 

This was followed by a question later on by Ross Seymore: 

“So just trying to get the magnitude of just how much Data Center has to drop to make that outcome on the mix side be true.” 

Lisa Su: 

“Sure, Ross. So let's see. We said the Client and Gaming segments would be seasonal. So you would expect that the Data Center would be more than seasonal. So maybe to help you size that, think about the Data Center sequential drop as double digit, whereas the Client and the Gaming segments are more like single digit, if that helps.” 

The bulk of the call was dedicated to dissecting the data center segment with some additional questions on gross margin and the Client segment/PCs.  

Right out the gate, an analyst asked what is on everyone’s mind: 

“But I've gotten about a zillion versions of the same question tonight, which was do you think the company can grow for the year 2023 overall? And if you could just kind of walk us through the drivers of the business as we work through the year? Thanks.” 

The CEO answered with the following, indicating that data center would be a growth driver with emebedded: 

“As we mentioned in the prepared remarks, coming off of a very strong 2022, there is some inventory at some of the cloud customers. And so, we are expecting a softer first half and then a stronger second half, but we feel very good about our market share position and opportunity to grow with Data Center.  

Also on the embedded side, I would say we have a very strong portfolio there. The Xilinx business has done very well in 2022. It's a diversified set of markets. We see strength in a number of the end markets. And so, we think that's also a grower for AMD.  

On the other side, our Client and Gaming businesses, we believe, will decline. We have made good progress. When we look at the PC markets in the second half of the year of 2022, we were really trying to rebalance inventory.” 

That was the first of many times management clarified that the data center would grow in H2. Here were a few other times:

“Our expectation is that sort of the first half softness for cloud and then second half strength as that's worked through. But like I said, it's different for each customer. And then in terms of overall growth, as I said, we're very bullish on the overall growth of our Data Center business and the opportunity to gain share as we go through the year.” 

Discussion on Q1 Being the Bottom for PCs: 

Vivek Arya: 

“But when we look at the shipments, right, from you and your competitor, they could be down as much as 40% or 50%, right, year-on-year in Q1. So do you think there's a possibility that the TAM assumption of just down 10% could be an optimistic one?”  

Lisa Su: 

“I think second quarter – first quarter should be the bottom for us in PCs. We – and then grow from there into the second quarter and then into the second half. And I should note also, Vivek, I mean, we just launched our Ryzen 7000 Series with sort of our AI capabilities, both from a notebook and desktop standpoint.”  

There was more reiteration later by Lisa Su but she was hesitant to say if the H2 strength will result in YoY growth. 

“I think our Data Center grow – growth in the second half versus first half, we expect that to be significantly stronger. As it relates to clients, we would also expect it to be stronger. Again, depending a bit on macro and sort of how the TAM actually evolves. 

I think for the Embedded businesses, I would say that we expect to grow over the full year 2023 versus 2022. What we see right now is a fairly strong backlog and good visibility into the first half of the year. I'm not ready to say that Embedded will grow in the second half versus the first half, though, because we're coming off very strong growth already. And so I think those are the puts and takes.” 

It was interesting to hear that AMD took market share on PCs as the narrative has been that Intel did due to aggressive pricing 

Lisa Su: 

“I would say that in general, the PC market share numbers are probably a bit noisy right now, just given all of the sell-in, sell-through and the inventory dynamics that are being worked through. Actually, in the fourth quarter, we believe we gained a little bit of share in the PC market.” 

There was (yet) another question on PCs: 

Mark Lapacis: 

“And Lisa, correct me if I am wrong, I thought I heard you say in an answer to an earlier question that you expect the PC client, but just to grow into second quarter. So is that suggest that 1Q, you think is the bottom on the PC? And then I had a follow-up? Thank you.” 

Lisa Su: 

“We do believe the first quarter is the bottom for our PC market – for our PC business, and we'll see some growth in the second quarter and then a seasonally higher second half.”

Discussion on Adjusted Gross Margin Guide: 

Management provided guidance of 50% on the adjusted gross margin which is 3% lower than the year ago quarter. Due to data center being down sequentially, the Q1 margin is expected to be lower than usual. 

Matt Ramsay: 

“But I kind of wanted to focus on the drivers of the longer-term margin that's down, I guess, three or four points from where you were a few quarters ago despite more mix of the revenue coming from Embedded and Data Center?” 

Lisa Su: 

“In terms of the sequential question that you had from Q4 to Q1, that's just a product of the mix. So with Data Center being lower sequentially that – that's that. We are also working through our client inventory clearing [..] And so as Jean said in the prepared remarks, we would expect margin expansion as we go into the second half with the growth in Data Center, Embedded and some normalization of the client business as well.” 

Stacy Rasgon: 

“Can you give us any idea like first half to second half? Or I mean just for the full year, do you think gross margins grow year-over-year from the 52% that you printed in 2022?” 

Jean Hu: 

“The major headwind we are facing is really Client side, which if you think about the gross margin in the first half of 2022 versus the first half of 2023, the major impact is from the client revenue, inventory correction, which impact the gross margin in the Client segment […] But overall, we feel pretty good. Once we normalize the Client segment, our gross margin will continue to expand.” 

Conclusion: 

We plan to see it through with AMD. I had just written in the Tesla write-up that we won’t get a perfect ER from any company this quarter, so investors will need to subjectively determine what they are willing to hold through and what will cause them to move to the sidelines. 

We don’t have to wait too long as the Q2 guide on PCs should potentially clear some of the cloudy skies. From there, we will know from not only AMD but also from TSM, NVDA and others if the much-anticipated H2 rebound will be on time. It makes sense because the comps were low in Q3 from the initial PC miss and same for NVDA’s crypto miss.  

If a picture is worth a thousand words, then this is why we plan to see it through with AMD. Notably, other semi industry analysts believe AMD’s true market share is in the mid-20s. We covered this here.

 Source: Reuters 

Notably, I had stated on the forum in the pre-ER report for AMD that I’m not expecting much from the company for Q1. We are looking at Q2 and beyond. 

Look for Meta’s comments tomorrow on capex to potentially hurt AMD and NVDA stock if the rumors are true about a $2B pullback on capex spending. We covered this on the forum here. We aren’t too concerned as there’s only one path to build out the AI economy – which is data centers and eventually edge microdata centers. If not Meta, then other Big Tech players will step up. Meta is simply trying to keep up as there are many hyperscaler customers to consider.