Category: Stock Analysis PDFs

Plug Power: Hypergrowth in the Renewables Sector

Posted on by io-fund

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“Hypergrowth” and “renewables” are two words that rarely go together. The infrastructure that is required tends to prevent the rapid growth that we see in cloud or advertising stocks. Most renewables either show the signs of a cyclical industry or they show signs of “growth at any cost.” Plug Power is a growth at any cost company. This has worked many times in tech – to do whatever it takes keep growing – so we won’t want to discount the company based on this tactic. What Plug Power and other renewables require is a different mindset than cloud, ad-tech, consumer tech or crypto investing.

We’ve discussed before that the cost for clean energy is finally competitive with the cost for fossil fuels. This has helped drive the investments in building more infrastructure. However, this isn’t the case for clean hydrogen which complicates Plug’s story. We discuss this more below and why we are interested in Plug despite hydrogen being far behind solar and wind in terms of cost reduction.

Please note: at this time, the I/O Fund has chosen Stem and Plug Power as our two choices for exposure to renewables. This was discussed in the July 2021 Renewables Overview.July 2021 Renewables Overview.

Overview of Hydrogen:

The Paris Agreement of 2016 is widely considered to be the point when global initiatives in renewable energy were kickstarted. The proclamation was signed by 196 countries that promised to limit global warming to “below 2-degree Celsius above pre-industrial levels.” This translates to a goal of cutting carbon emissions by 25% by 2030 and to be net zero by 2070.

When we’ve covered renewables in the past, the main takeaway is that the cost to produce energy is dropping to where it’s competitive with fossil fuels. This lower cost to produce solar PV and wind has resulted in more interest in electrolytic hydrogen. The ultimate goal is to use clean energy to produce hydrogen rather than natural gas or coal. This will be accomplished by building electrolyzers near solar fields and wind farms to supply the hydrogen and then transport it where it’s needed. Hydrogen is transported either by pipeline or by liquid form on ships. From there, it’s used to fuel a wide variety of vehicles and buildings. 

Source: IEA

Most importantly, hydrogen is designed for energy storage whereas wind and solar are designed for energy generation, therefore, a hybrid of the two is ideal. Hydrogen allows energy to be stored for weeks — and even up to months — after solar or wind has generated energy. This is important because wind and solar fields are often located too far away from cities to be effective without a storage option

Of all the technologies in existence today, hydrogen has the greatest potential for seasonal energy storage, according to the National Renewable Energy Laboratory (NREL). The major components to hydrogen power is fuel cells, refueling equipment and electrolyzers. Fuel cells use the fuel from hydrogen with the oxidizing effects of oxygen to create electricity. They are made up of an anode, electrolyte of ions and cathode.

Source: Fuel Economy

Today, the grid is mainly used to produce hydrogen. Currently, natural gas is the primary source of hydrogen production and accounts for 75% of the hydrogen production in the world today, or about 70 million tons. This equates to 6% of the global natural gas use. After natural gas, the second most popular supply source for hydrogen is coal. Grid-based hydrogen is used in oil refining, ammonia production, methanol production and steel production. This is distinct from clean hydrogen.

Here are the various ways to produce hydrogen:

  • Renewables: using solar and wind, hydrogen can be produced with water (electrolysis) – considered clean hydrogen (or green hydrogen)
  • Nuclear: same as renewables, nuclear energy can be used for electrolysis
  • Steam methane with CCS: proven method with carbon capture, utilization and storage with natural gas, needs to scale – considered blue hydrogen
  • Steam methane: uses natural gas without carbon capture, utilization and storage, thereby producing carbon emissions. This is the current way hydrogen is produced and produces many emissions as it’s not clean hydrogen production rather it’s gas and coal powered hydrogen – considered gray or brown hydrogen

Fuel costs account for 45% to 75% of production costs. This makes hydrogen fuel cells sensitive to gas prices (for the natural gas production) and this is why it costs more to produce hydrogen in regions like Japan, China and Korea, where natural gas is an import.

To put in perspective how far behind hydrogen development is (and, consequently profitability), consider that in terms of megawatts, hydrogen in 2017 was comparable to solar in 1996 and wind in 1992.

Source: Green Tech Media

Bull Case for Hydrogen:

The bull case is that hydrogen can be useful in many industries where is has little to no presence, such as transport, manufacturing, buildings and for power generation. This will be catalyzed by the need for energy storage as it will be impossible to power the world’s energy needs with renewable energy sources on their own. Essentially, the argument here is that world cannot meet its renewable energy goals without energy storage and hydrogen is the best candidate for this.

The decarbonization goals set forth by the Paris Agreement and the decarbonization that commercial industries are seeking on their own (Amazon, Wal-mart, etc) will require a versatile energy carrier. Therefore, a primary bull case is that the decarbonization goals will require hydrogen for energy storage as they simply can’t be met with renewable energy sources alone. The expectation is that governments will be forced to drive down the cost of hydrogen to meet these goals. The driving down of costs for solar and wind with subsidies is cited as an example of how this has been successfully accomplished. For instance, New York has committed $13 million in state tax credits to Plug Power for building its Gigafactory in the Rochester area.

On a similar note, costs to produce hydrogen have halved in the last five years and are at 3% of their 2005 level currently. Another point for the bull case is that hydrogen can use the existing natural gas pipelines and network. Transporting hydrogen through existing pipelines is a lower cost option for delivering larger volumes.

The hybrid method of using hydrogen as an energy converter alongside renewables energy production can save hundreds of billions in Euros, according to a study done on the European Union. In the EU, the goal is to have 32% of the energy demand and 50% of the electricity demand come from renewables by 2070.

Bear Case for Hydrogen:

The bear case is that hydrogen production is cost prohibitive as there is an efficiency loss of up to 70% when converting energy to another form, such as from electricity to hydrogen that is then shipped, stored, and then converted back to a fuel cell. In this scenario, the 70% efficiency loss means hydrogen is more expensive than the electricity or gas used to produce it.

According to the Wall Street Journal and BloombergNEF, hydrogen supplies less than 5% of the world’s energy and could reach nearly a quarter of global energy consumption by 2050 for a total of $2.5 trillion in direct revenue annually.

Admittedly, 2050 seems a ways off with current CAGR at 4.32% through 2027. The global generation market was at $117 billion in 2019 and is estimated to reach $165 billion by 2027. Another source puts the near-term projection at 5.7% CAGR from 2021 to 2028. Steam methane will continue to have the largest share through the forecast period.

This low CAGR and far-off projections add to the bear case around the efficiency loss for hydrogen, which is why we placed the CAGR growth under the cons. Typically, this low CAGR would mean the market is not investable (at least not for growth investors like ourselves).

However, as the bulls point out, this can change quickly if there is enough pressure from legislation and corporate interest.

Plug Power:

Plug Power manufactures fuel cell systems for the industrial sector and manufacturing sector. The company’s line of products include GenKey, GenDrive, GenFuel, GenCare and ProGen. GenKey helps material handling vehicles reduce dependency on lead-acid or lithium-ion batteries. GenDrive offers a proton exchange membrane fuel cell to power material handling vehicles, such as forklifts and hand operated trucks. GenFuel provides a hydrogen fueling system for GenDrive vehicles. ReliOn provides backup power for telecommunications and the utility sector. ProGen offers fuel cell engines for the electric vehicle market to replace batteries. Here’s a good article about ProGen and the partnership with Renault.

By the end of 2022, Plug Power will have two of three plants operational in Georgia, Pennsylvania and New York. The plants will be green hydrogen plants using electrolyzers for hydrogen produced by wind, solar and hydropower. These plants will help Plug achieve the company’s goals of producing 500 tons per day of green hydrogen by 2025 and 1,000 tons by 2028.

  • New York’s Gigafactory will be where the largest green hydrogen product facility plant will be built in North America. The initial production will be 45 metric tons of green liquid hydrogen to service the NE regions with 120 megawatts of eletrolyzers producing hydrogen.
  • In Southern Central Pennyslvania, Plug will be leveraging Brookfield Renewables hydroelectric facility to potentially produce 15 tons per day.
  • Last month, Plug announced plans to build a plant in Georgia with plans to produce 15 tons per day. This plant will be near Home Depot and Southern Company’s headquarters.

This quarter, the company discussed expanding its product line from material handling to expanding more into mobility. This includes various vehicles, such as commercial fleets, airport ground equipment and tuggers for factories. General Motors (GM) was named as the “fourth pedestal” customer for its auto manufacturing facilities. This includes factory tuggers and forklifts. These factory vehicles are loading and unloading heavy equipment everyday which typically requires battery power. The other three pedestal customers for Plug are Amazon, Walmart and Home Depot. We touch more on this below.

The company also released a new product last year called GenSure HP that provides backup power for data centers and energy storage systems with potential deployment in 2021. The backup power solutions compete with generators and backup battery power.

Plug Power acquired United Hydrogen Group and Giner ELX, a leading provider of hydrogen engines and fueling solutions. This acquisition lends itself to Plug Power producing more green hydrogen. At the time of acquisition, United Hydrogen Group was producing 6.4 tons of hydrogen with expertise in hydrogen generation, liquefaction and distribution.

Giner ELX specializes in PEM electrolysis including grid-level storage solutions and also fuel cell vehicle refueling stations. The company uses electrolyzers to turn surplus power into hydrogen. The result is injecting hydrogen into the natural gas network or fueling turbines for peak-time electricity generation. The long-term goal is to have hydrogen fueling stations that look like gas stations.

Partnerships:

Most stock analysts will point towards the partnerships that Plug Power has as either a major benefit or as a customer concentration risk. Both are probably true.

Amazon is Plug’s biggest customer for both fuel cells and electrolyzers. The partnership formed in 2017 when Amazon agreed to a $600 million deal to equip forklifts in Amazon’s warehouses. The incentive to use fuel cells over batteries is partly driven by reducing labor and freeing up physical space. In exchange, Amazon had the right to buy up to 23% of the company through warrants. The warrants vested last year and Amazon took control of 55 million shares at a price of $6. The warrants caused Plug Power to report negative revenue last year with the loss from the warrants being greater than the company’s sales.  The more headline-worthy development as of late is that Amazon sold its shares and this can appear like a lack of confidence from one of Plug’s partners. On the other hand, Amazon may have wanted to cash in on the gains as Plug has been trading around $25.

In 2010, Wal-Mart partnered with Plug for the first time, and in 2017, the partnership was expanded with a three-year contract and an opportunity for Wal-Mart to buy 17% of Plug Power. At the time, Wal-Mart made up 34 percent of Plug’s revenue. Plug supplies Wal-Mart with GenDrive fuel cell-powered vehicles in 37 distribution centers. In August of 2020, Plug Power expanded again with Wal-mart to supply their eCommerce network.

Similar to Wal-Mart and Amazon, Home Depot is a partner with Plug Power on reducing electricity and battery use by using fuel cell-powered material handling fleets. Most recently, the two companies partnered on a Dallas, Texas facility that is 1.5 million square feet with Plug powering the material handling fleets.

In the Q1 2021 recap, Plug Power also discussed its partnership with General Motors, what the company calls its “fourth pedestal customer” with GM deploying GenKey solutions at multiple plants.

With the Renault partnership, Plug Power will be putting its fuel cells into light commercial trucks in Europe. Road tests will start by early 2022 with a goal of 20,000 trucks on the road by 2025. The two companies have a goal of reaching 1/3 of the market in 2030, when an anticipated 500,000 vehicles will be hydrogen powered. That would represent 7X growth between 2025 and 2030.

Financials:

As the title of this analysis states, Plug Power is a hypergrowth company in renewables. This hypergrowth is priced at a premium with Plug trading at up to a 75 forward P/S. When you adjust Plug Power for a 1-year forward to account for its forward growth compared to renewables peers, it becomes more reasonable. Pictured below, Plug narrows the gap with Enphase from a difference of 14 to a difference of 7 on the 1-year forward.

 For the first quarter of 2021, Plug Power reported $72 million in revenue, up 76% year-over-year from $40.8 million. Gross billings were up 71% year-over-year at $73.7 million, compared to $43.0 million in the year-ago quarter. The revenue was a beat as analysts were expecting $69 million in sales but the EPS missed.

The gross product margin was at 38% although the company reported gross losses of ($12 million). Operating losses were at ($48.2 million) with net losses of ($60.8 million). This works out to EPS of ($0.12) with analysts expecting ($0.08).  These gross margins are an improvement on a percentage basis from the ($9.7 million) lost in the year-ago quarter on ($40.9 million) in revenue.

The company has raised cash by selling stock for $1.6 billion and also for $1.8 billion. This resulted in $4.4 billion in cash for the company with $330 million in debt despite diluting shareholders. The company has a term loan with a 9% interest rate.

These losses are incurred due to the costs associated with fuel cell systems and related infrastructure, plus the cost to deliver fuel to customers. Growth investors need to understand there is an inherent cost to the renewables sector and get comfortable with losses before a company reaches scale. As discussed in the Hydrogen Overview above, Plug Power is exposed to commodities such as natural gas prices and also natural gas supply.

In regards to this quarter, Plug Power highlighted a few events that negatively impacted their operating margins. Fuel gross margins were negatively impacted due to the escalation of rates from one of their natural gas suppliers and from force-majeure events that caused the price of hydrogen to spike. One of those was the Texas freeze. The company is also exposed to freight costs, which caused a $2 million expense. The company stated in the Investors Letter that they plan to diversify their supply chain to mitigate this moving forward.

The company reaffirmed its targets for 2021 and also for 2024. The company’s goal for 2024 is $1.1 billion in revenue from 50% green hydrogen. The company stated the following regarding 2021 guidance: “Investors should expect $115 million to $120 million of gross billings for the quarter. This is approximately 40% of our target revenue of $475 million for the year. Usually, at this point in the second quarter, we are about 33% of our annual revenue will have been achieved. We are at a run-rate that is higher from both a revenue and growth rate level than we have experienced in the past. We also foresee a very strong third quarter.”

If Plug Power hits the revenue target for 2021 at $480 million and then the gross billings target of $1.2 billion and the revenue target of $1.1 billion in 2024, then that would be 150% growth. This is substantial for a renewables company that faces cost efficiency issues inherent to its industry.

Accounting Issues:

On March 15th, Plug Power announced the company would need to restate three years’ worth of financial statements. At the time, the company stated the restatement would not affect the company’s cash position, business operation or the return from commercial agreements.

The changes were: 2020 net revenue was $7.2 million compared to the previously stated net loss of $100 million and the net revenue of $230 million was an adjusted revenue loss of $300,000. This came after a large EPS miss in the fourth quarter of ($1.12) compared to ($0.11) expected. As previously discussed, the revenue was also negative because of Amazon exercising its warrants which led to a revenue miss in the fourth quarter of $32 million in losses compared to roughly $50 million expected.

The restatements pertained to the accounting for service contracts and classification of certain costs, such as R&D. The overall impact was minimal with a total decrease in EPS of ($0.13) or about a 6% increase in the company’s total loss. The change in reported sales amounted to a 2% decline. There was no change in cash.

Risks:

We’ve reviewed the risks in this analysis. Mainly the concentration of customers and also the cost efficiency of hydrogen as it costs more than the gas to produce it. Competitors are another risk as they range from smaller in size, such as Ballard and FuelCell Energy, to gas companies, like Shell and BP Amoco.

Conclusion:

We understand the challenges around hydrogen yet are willing to take the risk as any progress will be aptly rewarded. Perhaps it will be to our benefit the company’s stock was beaten down over a minor accounting error. We like Plug’s Power ability to post hypergrowth despite the challenges with hydrogen and especially clean hydrogen. We think incremental improvements – whether that’s subsidies, new global partnerships, or a stronger move into mobility – could cause the company to become a renewables leader.

AR/VR H2 2021 Update and Vuzix Deep Dive

Posted on by io-fund

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Previous Coverage:

· AR/VR is a trend we first covered eight months ago with the release of the Unity PDF.

· We also provided an overview of the microtrend with a concentration on Snap and Apple in December.

· In February, we covered Snap’s virtual Investor Day in this update here.

· We also published an update on Unity’s Q4 earnings here.

· We also let you know our intent to enter Vuzix here.

Below, we update the leaders in this space with a concentration on a small cap that is breaking grounds in areas where big tech is struggling – primarily the intersection of enterprise use cases and smart glasses, which are lighter weight and more ergonomical compared to headsets.

AR/VR Macro Overview

According to new statistics published this week, AR/VR is set to grow at a CAGR of 46% between 2021 and 2025 worth $162.71 billion of incremental growth. The growth in 2021 will be 25.13% implying the larger growth will come from the second half of the five-year period.

According to IDC’s Commercial AR/VR Survey, we see the most popular device for AR is mobile phones and tablets:

For virtual reality, Emergen Research points to gaming arcades, theme parks and medical training as key markets for headsets. For example, Snap has partnered with Disney to deliver VR to their theme parks and Vuzix is making key entries into medical training.

Head-Mounted Displays account for the second largest share as it provides an immersive environment for training purposes. The virtual reality market by itself is expected to grow at 27.5% to reach $43 billion by 2028.

The third driver for VR is robotic surgery, surgery simulation, and skills training. Vuzix overlaps in two markets – medical training (#1 driver) and surgery (#3 driver).

The report from Emergen also highlights APAC leading growth over North America. This is due to favorable government initiatives and the rapid rollout of 5G. We cover 5G in a separate section below as these two trends are intricately connected.

When we break the market down further for Vuzix’s sake, the estimate for smart glasses is at $33 billion by 2027. Statista also confirms healthy revenue growth for consumer and enterprise smart glasses in the near term, going from a nearly $0 market in 2019 to $13 billion in 2024.

Source: Statista

Those leading AR/VR will have defensible positions based on being first movers. Artificial Intelligence, on the other hand, will like see a period of mergers and acquisitions as the bigger companies cherry pick innovation from the private markets (to compare the two).

The takeaway, is that we could see an influx of institutional interest in AR/VR this year if we see key companies break ground. It feels early because you and I are not using AR/VR in our everyday lives. This is why we need to be very careful to not use confirmation bias when choosing our investments. We also need to be prudent in knowing exactly what markets our AR/VR stocks are cornering as this market is tough to crack. The “what” is not as important in this case as the “how.”

Below, we revisit the larger companies in the space and we end with a deep dive on Vuzix. We expect to build our largest positions in Snap and Vuzix for now, and Unity later in the year or early next year, when we see signs software is reaching enough hardware.

AR/VR: Tough Nut to Crack

The caveat to AR/VR being a 0 to 100 market as we stated in the Unity PDF, is that the trend is very tough to crack. The most notorious failure is Google Glass yet Oculus hasn’t exactly crushed it since the $2 billion acquisition either. Facebook is losing money on the Oculus Quest 2 with some believing this is because they will make up for the losses with software. My personal opinion is that it’s tough to get consumers to adopt AR/VR and the price is being lowered to reflect this. Regardless of the reasons, these are two very capital efficient companies with thousands of engineers and large R&D budgets who have not done well in this trend.

Apple seems to be sleepy here, too, in terms of hardware with a headset rumored for 2022/2023 and smart glasses sometime after the headset. We see Apple foreshadowing the importance of AR/VR for the company in the ongoing augmented reality iOS updates, especially in iOS 14 along with the iPhone 12’s LiDAR that we covered in-depth here. We cover iOS 15 updates below.

Here is the “reality” to virtual reality:

1. Distribution is tough; people simply don’t want to put on a headset for entertainment.

2. If you’ve ever used a headset, you know the lack of 5G creates the obstacle of latency.

3. The demographic needs to be right; this technology requires early adopters who are keen on new experiences.

4. Consumers will be second to the enterprise to adopt AR/VR; meanwhile, the tech giants are broadly positioned across many demographics and are primarily consumer companies. In contrast, Microsoft’s HoloLens is likely seeing early success due to Microsoft having more exposure to defense and aerospace than its competitors.

5. Investors shouldn’t ignore the trust issues around FB and GOOGL. In fact, both Apple in ad campaigns and Snap in the earnings calls are capitalizing on these issues by emphasizing privacy with their software. We will see if this translates to consumers preferring smaller brands for AR/VR or those that place privacy first.

In reference to the list above, we want to circumvent the need for consumer buy-in by focusing on:

1. Lightweight hardware bc headsets are a tough sell

2. Early adopter industries

3. The availability of 5G

4. The right demographic

“Snap, Inc is a Camera Company”

The first slide of the Investor Presentation from Snap says it all: “Snap, Inc is a Camera Company.” Look for Snap to evolve away from social media by leveraging the lens software seen in the app today.

In February of this year, Snap had 150,000 lens creators globally, which is not a bad start considering Apple came out with the first features in 2017 with a bigger push when the iPhone 12 was released with LiDAR last year.

By the Partner Summit in May, Snap had updated the number of global creators to 200,000 at the Partner Summit in May, or 33% growth sequentially. I’m very keen to see what this number is by this time next year. 1 million lens creators should be tipping point and I imagine will connect the dots at that time as to the potential Snap has.

Snap is making it clear that the camera is the company’s biggest opportunity due to augmented reality Lenses. The CEO stated, “In the past few years, our substantial investments against our vision for augmented reality have put us in a position to lead the industry, and we’re doubling down on this strategy in 2021.

Augmented reality has evolved from something fun and entertaining into a real utility. Our camera can solve math equations; scan wine labels to find ratings, reviews, and prices; tell you the name of the song you’re listening to; and so much more… And we’ve barely scratched the surface of what’s possible.”

From the list above, #2 is demographic, and this is the primary reason Snap has true staying power. I had said in the Top 10 LTBH webinar that I’ve been watching this company closely because Millennials are a demographic we want exposure to. We first covered Snap for the premium site in July of 2019 when I was anticipating the launch of the Audience Network product. Audience Network didn’t happen, and instead, something much bigger is coming down the pipe. 

The company boasts 90% of the 13 to 24-year old population in the high-spending regions of the United States and leading countries in Europe. Millennials and Gen Z have very high purchasing power with a combined value of direct spending power of $1 trillion. As Snap points out on slide 6, Millennials “are expected to drive over half of the increase in expenditure growth over the next decade.”

Snap held its Partner Day on May 20th when the company announced the launch of AR-enabled spectacles for creators only (not for purchase). The frames feature four built-in microphones, two stereo speakers, and a built-in touchpad. The frames have front-facing cameras to detect objects and surfaces for interacting with graphics (such as when Snap’s CEO caught a butterfly during the presentation). The glasses weigh 134 grams and can be worn indoors or outdoors. There is also a feature called Connected Lenses that allow for multiple people to interact.

The key thing to understand is that Snap is leading in the area of software due to its mobile phone Lenses and Snap’s software should continue to lead with its growing community of creators.

The NFL is an example of a brand that has partnered with Snap during the Superbowl when customized team lenses were offered. Another example is Disney, who is using Snap’s Camera kit to build geo-located branded lenses for its theme parks. Sticker kit offers the ability to build personalized Bitmoji avatars into games and Snap Map allows for geolocated AR experiences.

Brands embrace AR because it leads to higher engagement in ads. Dior recently partnered with Snap and saw 3.8X higher return on ad spend and 6.2X on Lens Carousel. 

Management anticipates the advertising inventory potential for a fully integrated AR camera application within Snapchat will potentially lead to a flywheel effect:

We still have a lot of upside in terms of the level of optimization and efficiency that we can deliver, and are investing heavily across the board to both improve our ad platform and support our growing global advertiser base. This has developed into a positive flywheel where our improved efficiency has driven more advertisers and larger budgets to our platform, leading to more impressions and learnings, which in turn increases the rate at which we are able to further improve efficiency and ROI.

Despite all of the very important points made about Snap, the main issue is when consumers will adopt AR/VR hardware. Here is the statement the CEO made in 2019 on timing: “So I think it’ll be roughly ten years before there’s a consumer product with a display that could be really widely adopted.”

Experts from Gartner agree it can be a five to ten-year process before we see a big consumer hit in terms of hardware in this space.

This is why the iPhone and iPad are critical for Snap’s immediate-term distribution. Brands will pay for iOS users and Snap can build new revenue streams right now even without a widely adopted consumer hardware product.

iOS 15 Update: AR/VR

For the next 1-2 years, we are primarily interested in iPhone upgrades and iOS updates for our Snap position. In fact, the iPhone 12 release with LiDAR was probably one of the more bullish things to happen for Snap in its history as a public company. You can view some cool examples of how Apple’s LiDAR works here.

The latest version of Apple’s operating system added new experiences for FaceTime including Spatial Audio to position the location of sounds heard in a video call. Maps has added AR-enabled turn-by-turn walking directions and there are improved Siri features and voice input. This allows Safari browsing and other applications to be used by voice control. Visual lookup and live text allows you to dial numbers and recognize objects by looking them up online.

For developers, the release featured object capture for developers to create AR objects by taking pictures of the physical item to help speed up the time it takes to make virtual content. Spatial Audio was opened up to third-party developers and gaming also got an upgrade.

Apple’s N301 Prototype

According to reports, Apple plans to release a development kit and limited number of AR/VR headsets available as early as 2022. The prototype is named N301. The AR/VR chips have beat the M1 Mac processor in testing as Apple will attempt to deliver something with higher resolution than the competitors. Apple also plans to release AR glasses with codename N421 which could be unveiled as soon as 2023. The headset is not the final product, however, as Apple’s final consumer product will be smart glasses.

The beta headset is the size of the Oculus Quest, according to sources that spoke with Bloomberg. There are cameras to enable the AR features and gesture control. Apple has also been making acquisitions, such as NextVR, that records events such as concerts and sports games. Apple will also build an App Store for the device known as “rOS.”

Releasing AR/VR glasses will require years as Apple will be testing and iterating on how to serve the creation of app developers and how to overcome the hesitancy of consumers who don’t care to wear hardware on their face. There is also the technical challenges of supporting an internet connection with a long battery life and the various electronics that are required. As the article points out, “getting to that point requires years of work on lenses, hardware and software, component miniaturization, production techniques and content creation.”

The statement and general understanding that smart glasses are years out is one of a few reasons we like Vuzix, who is already delivering smart glasses to early adopter industries.

Unity:

In our analysis of Unity, we saw many forecasts that AR/VR would grow from nearly $0 to $100 billion in a short time frame of 3-5 years, depending on the source. We had stated in September that Unity will be a great way to participate in this trend as the company could have a near monopoly on 3D application development.

Notably, Unity and Snap are teaming up for in-game ads. The partnership allows Unity developers to use Snap Kit and tools like Snap Map, Bitmojis and other AR features. In return, advertisers on Snap can also access Unity’s inventory. This is likely the start of an important synergy on AR-related advertising across gaming and social media audiences.

Meanwhile, Unity’s primary competitor, Unreal Engine by Epic Games, is in a heated battle with Apple. This bodes well for Unity as this battle could be viewed as a risk by AR/VR app developers who want to get on Apple’s devices.

In this study done in 2019, Unity was the third most popular AR mobile platform ahead of Facebook and Amazon. ARKit from Apple is number one and ARCore from Google for Android was number two.

With that said, software will need ample hardware distribution. Therefore, we think Vuzix could see AR/VR growth sooner than Unity. We have a placeholder position in Unity, however, will look for bigger positions in Snap and Vuzix in the more immediate term.

Vuzix: Lightweight Glasses for the Enterprise

What Vuzix offers are smart glasses that are lightweight, comfortable and wireless. The company has two main products: the M4000 and the M400 wearable computers (or smart glasses). The products are backwards compatible with the M400 applications working on either device.

The M4000 Series is lightweight at 3.5oz[1], which the company says is comparable to a deck of cards. The upgraded wearable allows for see-through display and is powered by a lithium polymer battery that you can switch out during long jobs without powering down. The run time is between 2 to 12 hours depending on the battery choice and application. Other specs include PDAF 12.8mp auto-focus camera and 4K 30fps for video streaming output. The cost is $2499.

The M400 Series is the base model and drove the most revenue growth in the recent quarter with sales that tripled YoY. This model offers gesture control, voice commands and a high-performance camera for video streaming. This model also allows for a battery swap without powering down. Price is $1799.

Vuzix M4-Series is run on Android and uses the XR1 Qualcomm Snapdragon processor for AR and 4K phased-detect auto-focus camera. The glasses are IP67-rated, which means they’re waterproof and dust proof. The lightweight glasses are ideal compared to a bulky headset for industries ranging from medical work to utility work to automotive.

This has led to the adoption of the glasses for surgeries. Here are some of the recent partnerships Vuzix has made:

· Medacta International is using Vuzix glasses and the NextAR platform for knee, shoulder and spine applications. The platform uses algorithms alongside the preoperative scan to create a personalized biomechanical model for each replacement.

· Rod & Cones placed $1.2 million in orders for the M400 Smart Glasses “beginning immediately” to provide 4K broadcast imagery that allows more supported surgeries in a single day.

· Pixee has achieved FDA approval to use the M400 smart glasses for total knee replacement surgery. Pixee’s platform allows surgeons with little robotics training for better positioning of instruments using the field of view provided by Vuzix smart glasses.

· Medtronic uses Vuzix in the operating room and to also allow visiting surgeons to have the view of the operating surgeon for training purposes.

Here is a snapshot of the health care customer list which accounts for 25% of Vuzix’s revenue in the most recent quarter:

The company also mentioned a leading insurance company has become a customer with a $400,000 order and CooperVision is a manufacturing company that uses Vuzix for their warehouses.

Vuzix recently announced an advanced microLED display-based technology to be released in Q2 2021. The video here shows the microLED is the size of a pencil eraser and can be used in cameras, smart glasses and helmets.

Vuzix’s release of a microLED is important because weight is a primary issue with AR/VR hardware and an area that Vuzix is well ahead of Big Tech. This is one of 191 patents the company holds.

5G is Critical for AR/VR

Please note, we covered 5G on the premium site in anticipation for ramping up in 2020. Most 5G rollouts are delayed from Covid yet we are keeping an eye on this area. You can access 5G reports by going to the Dashboard on the Premium site and typing in “5G” in the search bar.

Commercialized AR/VR is a big challenge as the devices require heavy rendering, on-device processes and split workloads between the device and edge cloud. Because 5G is 100 times faster than 4G, the success of AR/VR is linked to the success of 5G.

For the optimal experience in AR/VR, graphics are ideally rendered on the edge cloud to reduce latency for on-device head tracking, controller tracking, hand tracking, motion tracking and photon processing. The ideal split rendering process in the cloud requires 5G in order for the intended, final experience.

Therefore, not only will it take ten years for consumer hardware to reach critical mass, yet it’ll take equally as long before 5G consumer networks are set up for network slicing on top of public networks with edge cloud infrastructure and also native core functions. Undoubtedly, telecom companies will own this space as they will own the 5G network. Qualcomm is seeing some early mover advantages in on-device processing for the headsets and Nvidia is seeing the early mover advantages across its RTX graphics processing units (GPUs), CloudXR and GPU virtualization software for the edge cloud VR servers.

With that said, urban areas are already set up for 5G with small cells in cities. Hospitals will be one of the first in terms of facilities to be 5G-enabled due to the immediate impact that will be seen in remote surgeries, the transfer of large files, and real-time monitoring. In a smart hospital, AR/VR, AI and robotic equipment that is linked to databases and sensors can aid in complex operations by recommending procedural steps based on the latest medical knowledge and data.

5G-enablement in hospitals was beginning to pick up prior to Covid with the first VA hospital in California becoming 5G-enabled in February of 2020. The first academic health system in Chicago, named Rush, is also a pioneer for 5G connectivity in medical facilities. Many forecasts project APAC to lead 5G including for hospitals and medical facilities. In January of 2000, Samsung and KT Corporation announced a partnership to build a 5G smart hospital.

Vuzix works with either 4G or 5G and has even struck partnerships with last-mile connectivity company Inseego on 5G (we covered this company here on our premium site). Vuzix is also an early partner with Verizon on Blue Jeans where the smart glasses offer support for the remote collaboration platform. Zoom Video has a blog about how AI, AR and VR will impact meetings written in 2018.

KDDI Asia is another early 5G partnership that Vuzix has with the relationship focused on remote support, facial recognition and language translation. KDDI Asia is a Fortune 3000 company that has 40 million mobile subscribers in Japan and Singapore.

Why the Enterprise is Important:

Enterprise drives 2/3 of the current revenue in AR/VR and is expected to lead through the forecast period, according to ARInsider. The forecast made in 2017 specifically points towards hardware as the main contributor as it sets up the install base for software to follow. According to more recent data, the enterprise is expected to generate more than 70% of AR/VR revenue through the end of 2022. (Please note, some of this needs to be adjusted by a year due to Covid delaying this category).

Here’s a snapshot from Perkins Coie as to the leading sectors in AR/VR:

Source: Finances Online

Although a bit outdated, this article on Medium drills down into the challenges around consumer AR/VR and why enterprise will be the first market to adopt the technology. It helps solidify our understanding, which is that consumer AR/VR is a nice-to-have while enterprise is a must-have. According to the survey of 750 respondents, 88% said AR/VR had a positive impact on their business.

Financials:

As stated in the blog from Monday, the company is small in terms of revenue and market cap. Last quarter’s revenue was $3.9 million compared to $1.5 million in the year-ago quarter, or an increase of 156%. Smart glasses sales rose by 177% year-over-year to $2.4 million. The company was break even in terms of gross profit in the past yet posted $1 million in profit in the most recent quarter. 

We also pointed out that gross margins are slim at 28% with product gross margins at 45%. As with many small cap companies, the bottom line is a bit ugly as the company has a net loss of $6.6 million. If the company continues to grow the top line, then some of this should resolve on its own as R&D is around $2 million per quarter and sales and marketing is $1.2 million.  

Despite being a small cap, the company showed significant improvement year-over-year:­

The company closed a public offering of 4,768,293 shares on April 1st for $97.75 million. The shares were priced at $20.50 while the stock was trading at $24.85. The companies proforma cash is $145 million as of April 1st. As with most small caps, the balance sheet and the need for future capital raises is the primary risk. Not only is this a concern for us investors but for larger customers who are buying into Vuzix’s technology and deserve longevity.

In addition to hardware, the company sells software for recurring SaaS revenue. This doesn’t drive meaningful revenue now but good to know there are more revenue streams in the future: “We expect that in the future, for every hardware sale that includes one of our vertical SaaS solutions, we would see an even more significant recurring revenue stream from the application itself.”

There are larger OEMs in the negotiation phase, including a Tier 1 aerospace and defense contractor in Phase 4 of contract negotiations for the company’s Waveguide-Based technology. An example of a completed OEM partnership in production phase is with Jade Bird Display, which manufacturers LED panels.

On June 9th, it was announced that Vuzix will be added to the Russell 3000 and Russell 2000 indexes on June 28th.

Valuation & Risks:

Valuation is an important risk to discuss with Vuzix. The company’s forward price-to-sales was a whopping 85 before correcting to the 50-60 range. This means the company competes with Snowflake and UiPath for the highest valued company in our portfolio.

However, when we look at 1-year forward P/S, then Vuzix looks more attractive at 28 whereas Snowflake trades at a 1-year forward P/S of 40. The consensus among the three analysts covering Vuzix is that revenue will roughly double year-over-year in 2022 at 90% growth from $22 million in fiscal year 2021 to $42 million in fiscal year 2022 ending in December.

We covered AR/VR in Q3 2020 and this was when we estimate the trend began with iOS 14. If the smart glasses market will be $13 billion by 2024, then Vuzix only needs to own 1/26 of the market to 10X revenue if we figure $40-50 million in FY 2022 and we invest in this company with the goal of reaching $500 million in revenue by 2024.

When a small cap has this kind of valuation, there is more pressure for the small cap to perform. The last earnings report had a slight $0.02 EPS miss and a beat on revenue, yet the stock fell from $17 to $15 off the report.

Investors in this company should be aware that this company has a streak of missed earnings estimates between 2016-2019. 

There is about 18% institutional ownership, which is on the low side, although 3% increased institutional ownership in the past month.

Intel bought 30% ownership of the company in 2015 and gradually reduced its share of the company to 15% before selling all shares earlier this year. The loss of a large backer is a risk.

Competitors:

Vuzix has many competitors if you look at the broader AR/VR market. Specifically for the enterprise market, the main competitors are Microsoft’s HoloLens and Magic Leap, which has Google backing. Here’s a picture of Vuzix compared to those two, as seen in ZDNet.

Vuzix will need to work diligently to own 1/26 of the market, but as you can see above, it’s a doable. goal. We like the 24 years of experience the management has as it’s usually seen in these incremental product improvements over the competitors. For instance, according to some product analysts, Magic Leap One is inferior in terms of battery life offering only 3 hours before needing to power down the device to change the battery. We also put in a footnote above the comparison in weight to Apple and Microsoft with Vuzix being the lightest smart glasses among the top competitors.

Conclusion:

Enterprise (check).

Passionate and long-term Founder (check).

Early adopter market – medical industries, etc. (check).

Lightweight able to overcome the major hurdle of headsets (check).

Small caps are not without risk.  However, we like that enterprise AR/VR is becoming a post-covid play and the forward consensus in the 90% range is certainly investable. We understand that Vuzix and our other small caps will be volatile at times, yet to get a $1 billion market cap entry into this space is worth the risk, in our opinion.

 

Ethereum Network: Premium Analysis

Posted on by io-fund

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Ethereum Network: Premium Analysis

We began covering cryptocurrency and the blockchain after a month of launching our premium site because we felt it was an important component to any tech portfolio. The debate around crypto/blockchain is distracting investors from the opportunity that the blockchain will deliver. 

Below is a full-length analysis on Ethereum as the Ethereum Network is going through extensive iteration that will propel the platform to become the backbone for crypto payments and decentralized apps. If you like my Nvidia thesis on the CUDA platform for AI development or if you understand the Apple thesis over the past ten years which centers around developers supporting the iOS ecosystem (rather than only the iPhone) – then you should like Ethereum. 

The blockchain is coming … and debates over Bitcoin can’t stop the blockchain from maturing. If you don’t like Bitcoin, then that’s okay. But it shouldn’t deter you from considering blockchain investments. Ethereum is another choice and Chainlink is one I’ve been particularly keen on. In fact, Chainlink was my choice for the inaugural LTBH one-hour webinar because I think there could be notable upside and I don’t want my subscribers to overlook the technology because it trades as a crypto. 

In my opinion, Ethereum also has notable upside and we want the I/O Fund to have some allocation here. As many of you know, we lean heavily on Knox for entering, exiting, or trimming crypto as it’s especially volatile. We will not necessarily enter right away — and also be prepared for Knox to require more than one entry if the crypto market turns. However, it’s well worth the effort as its early days for the blockchain.

You could see us trim Bitcoin and add to Ethereum in an attempt to participate in the blockchain trend while having proper allocation as Bitcoin had neared 10% of our portfolio and it’s now at 7% through trimming. Ethereum also helps diversify us for decentralized applications and other tokens. Or, we could add more to LINKUSD.  

You can read our previous analysis on Bitcoin here and on Chainlink here.

The analysis below describes what Ethereum is setting out to achieve and why some of the best blockchain investments are not likely to come from a traditional stock (they’ll come from crypto). In other words, if you want to participate in the early blockchain trend, then you’ll have to get comfortable with crypto.  

History of Ethereum

In October of 2008, the markets came to the realization that the Lehman Brother’s bankruptcy was likely not an isolated incident. While the world was scrambling to discern the severity and extent of financial crisis, the stock market hit a new low that resembled a genuine panic. At the same time, a mysterious person or group of people, under the pseudonym of Satoshi Nakamoto quietly published a white paper. This report described a new monetary system that would rely on a decentralized network of computers to verify all peer-to-peer value exchanges through a digital token called bitcoin. 

Largely unnoticed at the time, while the centralized banking system was in a full melt down, Bitcoin was suggesting a new monetary system that could make the centralized banking system largely obsolete. It wasn’t until January of 2009 that Bitcoin was released with an initial market price of $0.08/bitcoin. Still, it took just over 10 years, and over 15,800,000% appreciation before Bitcoin’s stated thesis gained public acceptance from institutional buyers.

Next to Bitcoin’s dominance, the undisputed runner-up is Ethereum, which is the second most valuable coin in terms of market cap, as well as public mindshare. Without a full understanding of why this is, most people would assume that Ethereum must have been launched soon after Bitcoin. This is not the case.

The second cryptocurrency to launch in April of 2011 is known as Namecoin. Nearly identical to bitcoin, including the same number of coins in existence, it’s stated goal was to improve anonymity for miners. Roughly six months later, Litecoin was launched and was able to take on the moniker of being known as silver to bitcoin’s gold. It also was similar to bitcoin, but offered double the number of coins, and allowed for quick mining transactions.

Most altcoins track a similar path – using the same, if not closely identical mathematics in an attempt to provide slight variation of bitcoin and compete as the dominant cryptocurrency of choice. We saw hundreds of these alt coins hit the markets prior to Ethereum’s launch in 2015, including Ripple, Monero, and Dash. Unlike the previous altcoins, what Ethereum offers is a network and platform for developers to expand the use of blockchain rather than to compete with Bitcoin as a cryptocurrency.

Ethereum Network 2.0

The primary difference between Ethereum and Bitcoin is that Ethereum is not trying to compete as a currency. The focus of Ethereum is on its network, not the coin. Butkin’s vision is to create an open network for decentralized applications (dapps[1]) and smart contracts based on the Turing complete programming language Solidity. 

The main issue that Ethereum has had to overcome is the constraints in transactions per second (TPS) and how to overcome the high energy costs of mining that comes with decentralized security. The network simply couldn’t scale without the recent release of Ethereum 2.0. 

To understand this further, we need to break down Proof of Work (PoW) and Proof of Stake (PoS). The previous method for decentralization was run through PoW, which is an algorithm that requires a miner and large amounts of computational power to create blocks and to confirm transactions. Due to the high costs in terms of both speed and energy, the Ethereum Network struggled to scale. Last November, Ethereum 2.0 was released and introduced PoS. Instead of a large consumption of energy, PoS requires a financial commitment of 32 ETH to become a validator. The network required 524.224 ETH or 16.384 validators by December 1st in order to start the new phase of Ethereum 2.0. As of mid-December, more than 1.1 million ETH had been staked from 33,000 validators. The most recent number is 1.6 million ETH.

The Ethereum that is staked in the new protocol receives interest with early yields up to 20%. The more Ethereum that is staked, the lower the interest. Interestingly, Ethereum has not built the algorithm that will allow you to unstake them, so this is a long-term bet on Ethereum for anyone that is staking their coins. 

Shards are another critical improvement for network bandwidth and the low transactions per second (TPS) as Ethereum 2.0 (ETH2) allows for improved data processing. Nodes in the previous network must download a transaction, calculate it, archive it and read every transaction in Ethereum’s history, which is terribly inefficient. Shards create a subset of the network where nodes are dispersed for more efficient processing. The Beacon Chain ensures the nodes are synchronized and the validators are reporting the blocks of transactions. 

The original Ethereum network will run in parallel with ETH2. 

Phase 0 of Eth2 went live on December 1st and there are a total of four phases. Phase 0 included the launch of Proof of Stake Beacon Chain. 

The most recent road map released by Ethereum does not show the subsequent phases. The shaded green shows the current progress in the link provided. Missing deadlines is an issue with Ethereum so perhaps the removal of these phases is to make it easier on the team/network.

The term Rollups refers to ZK Rollups, which allows for hundreds of transfers to be rolled into a single transaction. This will replace Plasma, the current option where only a single transfer is made per transaction. In this case, the smart contract will verify all of the transfers in the Rollups. The goal is to reduce computing and storage resources by reducing the amount of data held in a transaction. 

In the ZK-Rollup scheme, a transactor and relayer are needed. The transactors create a transfer and broadcast it to the network. In this case, a shortened 3 or 4 byte indexed version of the address helps to reduce resource needs. The relayers collect hundreds of transfers and roll them up, essentially, to generate a hash that compares a snapshot of the blockchain before the transfers and a snapshot of the blockchain after the transfers. In most cases, the transfers will be recorded by a change in the wallet values. The hash that represents the wallet values or the delta to the blockchain is called SNARK proof. The changes to the hash are reported to the blockchain.

Relayers are established by staking a required bond, or token amount, in the smart contract. The result will be fewer transaction fees that are processed faster than the previous Plasma framework. In the ZK-Rollup framework, blocks are computed in a parallel computing model that lends itself to decentralization. There will be less data than the previous framework which increases throughput and scalability. 

Zero-knowledge proof techniques use mathematical equations for authentication without requiring passwords or sensitive information. The words “Zero-knowledge” means that the verifier can prove the first party can be trusted without revealing sensitive information. This is done through probabilistic assessments where the validity has a high probability. 

Zero-knowledge is essential to cryptocurrencies because a crypto transaction can be verified without revealing information about where the payment came from, where it was sent or how much currency was exchanged. Bitcoin does not use zero-knowledge as all of this information is revealed and recorded. 

The Ethereum network has more security risks than the Bitcoin protocol. The initial setup of ZK-Rollups assumes a trusted state and relies on a small group of developers to establish this initial trusted state and one of the developers could manipulate the code. The initial setup is not a decentralized.  

Quantum computing could crack ZK-Rollups if the correct hash is guessed by the computer. This is more likely than guessing an encrypted protocol. 

Ethereum is becoming the blockchain of choice through the Enterprise Ethereum Alliance, which is a list of over 200 companies, including AMD, Banco Santander SA, FedEx, Intel, JP Morgan, Microsoft, and VMWare. These companies have agreed to build smart contracts on the Ethereum blockchain, further increasing the value of Ethereum. We think the number of endorsements as Ethereum 2.0 is built out.

Decentralized Finance (DeFi)

DeFi, or decentralized finance, began in a telegram chat between Ethereum developers in August of 2018. The term refers to the open ecosystem of financial applications built on the Ethereum blockchain. Peer-to-peer (P2P) is used interchangeably as the network is verified by peer computing systems rather than one centralized source.

The basic tenants of DeFi applications are:

1) No Custodian. In other words, there is no bank or custodian in-between transactions. Each individual controls access to their own crypto, transactions and data around their activity. 

2) The network is Global. There are no borders, exchange rates, currency differentials, or waiting for global transfers. Everyone on the network, regardless of country, will be able to transact instantly with anyone else in the world with ease.

3) The network is open source. This allows developers to view the code of any and all applications on the Ethereum blockchain and for the ecosystem to evolve.  

4) Decentralized network. The Ethereum blockchain is run off of thousands of “nodes.” These nodes are constantly computing the transactions within the blockchain from around the world, making it nearly impossible to hack as well as regulate. 

There is $24 billion locked into DeFi projects as of 2020.

Decentralized applications (dapps)

We discussed the difference between centralized and decentralized in the Chainlink webinar and why decentralized results in a more secure protocol or transaction. Ethereum’s network is often called a platform or the “world’s computer” because it allows for decentralized applications. Rather than having backend code on a centralized server, backend code is run on a decentralized network when built for the Ethereum platform. Developers use the Ethereum blockchain for data storage and smart contracts for the app logic.

We also discussed smart contracts on the Chainlink webinar. Ethereum is primarily set up for currency right now while Chainlink addresses off chain data for non-currency smart contracts. However, the principal is the same where there is a set of rules which self-execute like a vending machine. Dapps will rely on smart contracts. 

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

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

There are a few key benefits to dapps:

•       Dapps are more secure and inherently protected from denial-of-service attacks.

•       Censorship will be nearly impossible as a single entity will not be able to block users from utilizing the blockchain. 

•       Fraud and other malice will be prevented as the data has complete integrity from the decentralized and cryptographic qualities of the blockchain. 

•       Because smart contracts are self-executing, they remove the need for a centralized institution. Realworld identities can also be anonymous with dapps.

There are also some drawbacks to dapps:

•       Most developers do not want to relinquish complete control over their creation*.

•       If there is a bug that need to be fixed, that developer is unable to take back control of the dapp once it’s launched onto the Blockchain*.

•       Dapps will need Ethereum 2.0 to achieve its final phase as applications will create too much network congestion at the 10-15 transactions per second.

•       User experience needs to evolve in order for users to interact with the blockchain in a secure fashion.

•       Some developers may utilize centralized servers for the frontend or to store business logic which could eliminate many of the decentralized security/anonymity benefits of the blockchain.

There are some applications that are decentralized but not built on the blockchain, like BitTorrent for peer-topeer file sharing. Tor is open-source software that enables anonymous communication and is also decentralized.  

Some of the early DeFi applications allowed for seamless swapping of coins for Ethereum and lending of collateralized loans with built in interest payments to the borrowers. Contracts can also be created between crypto and non-crypto assets like gold, silver, stock, currencies, etcetera. People are allowed to deposit what are known as “synths”, or synthetic coins that allows for the contract to be written and then exchanged. This allows individuals to trade assets on Ethereum without the intermediary of exchanges and broker/dealers.

There are even applications known as yield farms that allow investors to deposit their crypto into liquidity pools, which are loaned out, which allows them to receive yields on their crypto. 

Conclusion:

The Ethereum Network is becoming the backbone for decentralized finance and decentralized applications. Ethereum 2.0 needs another year minimum or about three years maximum to reduce energy use and increase throughput for transactions per second (TPS). Once this is achieved, Ethereum will be able to process payments faster than Visa, Mastercard or Paypal combined– going from 15 transactions per second to 100,000 transactions per second. For reference, most major credit card companies process about 2,000 TPS with 5,000 TPS as the upper limit. 

Cardano and Polkdot are competitors yet Ethereum is receiving global acceptance among developers and major endorsements from companies who are likely to be the first to develop dapps and embrace defi, as well. If Ethereum 2.0 delivers what it promises to, I believe ETH will become the backbone for the blockchain and this will be hard to disrupt.

 

Electric Vehicles: Premium Analysis

Posted on by io-fund

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Electric Vehicles: Premium Analysis

Electric Vehicles

The electric vehicle trend seems bubble-like because of the valuations compared to traditional carmakers. However, these are growth companies where traditional carmakers are value stocks. Therefore, you'll need to decide if you see EVs as innovative tech that is pressing the envelope or if EVs should be valued like traditional automakers. 

I had made a comment in my free newsletter about playing pickle awhile back with a trend. I was referencing Tesla, of course, where we have remained on the sidelines. Tech growth investors should figure out – do you plan to own Tesla or one of its competitors –or do you plan to not participate in the EV market? When there are significant gains in one company and this marks the start of a trend, then not making a decision is making a decision. 

Moving forward, we will allocate a portion of our portfolio to "EVs" and this may include any of the companies listed below. This is a real trend that we want to participate in. David is leaning into Lucid Motors, and I am covering China's EV market. 

Here is the summary of the analysis below:

•       David is keen on Lucid Motors as a long-range EV that rivals Tesla founded by the former Chief

Engineer at Tesla. Although the initial price point is very high the company plans to release lower-priced models in the near future.

•       I am interested in the lower price point that Xpeng offers and for its strategy to target the mid-tier and lower premium market. This makes sense to me in light of China's subsidies, especially since Tesla, Lucid, Nio, BMW, Mercedes – and now Apple will compete in the higher price range.

•       Nio is appealing for its battery-as-a-service program and ability to compete with Tesla head-on in China as a domestic car company. Battery charging stations are a serious issue in China and Nio stands out for the battery swap described below.

•       We also cover Li Auto, which is more family-oriented. 

•       Please also look for Knox’s coverage of Tesla from a technical analysis standpoint on the forum and any future webinars – especially as Tesla has added Bitcoin onto its balance sheet. We don't have much to add to this story fundamentally as the stock is well covered by other analysts but if Knox sees a breakout, then he may take it.

Part 1: Lucid Motors by David Marlin

Lucid is a disruptive, innovative company and we think there is more than enough hype and buying interest for this momentum to continue far longer than people expect. Knox is monitoring CCIV for an entry as the latest report shows that the merger with Lucid Motors is essentially done and will be formally announced as soon as this week.  

A quick note on valuation …   

 Many investors will look at Lucid Motors, see they have $0 current revenue and dismiss the stock. It's important to know the market is always forward-looking. Money managers, analysts, and professional investors will typically look 1-2 years out when researching a company.  

In the current market environment, they seem to be looking 3-5 years out in some cases. Why?  The main reason is the Fed’s policy coupled with the low risk-free rate.  

Professional money managers know the risk-free rate is the guaranteed return they can achieve by taking zero risk. When buying equities, investors are making a conscious decision that their returns will be worth the extra risk they are taking.

It’s important to note that the 10-yr rate has risen to 1.29% from 0.66% over the past few months putting some short-term pressure on the market.  However, 1.29% is still a historically low rate and not yet a cause for concern for investors. If the 10-yr continues to rise, it will become a much bigger concern, but we are not at that point right now.  

Lucid Motors Product Overview …

Somewhere over the last 10-15 years, the auto industry became the tech industry. It started with Tesla disrupting the traditional auto manufacturers by developing extensive proprietary technology for electric vehicles. The relentless rally in TSLA stock has sent every auto company in the world scrambling to produce EVs to capture the industry-wide shift. Even Apple has entered the arena with reports that they are actively working on car tech and plan to produce a vehicle in the next 3-6 years. 

As in other subsectors within tech, we expect the company that produces the best and most advanced technology to capture the most market share. That is the case right now, as no company has been able to successfully challenge Tesla’s EV lead. The gap in innovation and technology could not be clearer as Tesla is essentially lapping its competition.  

Enter Lucid Motors. Lucid’s CEO Peter Rawlinson said in an interview with CNBC last month that he was “disappointed the traditional auto industry hasn’t taken up the baton to compete with Tesla.” He went on to call the industry a “technology race”, which is exactly how we see it.   

Lucid plans to deliver the Lucid Air, its first car, this spring from a new factory in Arizona. The first version of the Air — the Dream Edition — will go for $169,000 (see below for future pricing strategy).  

CEO Peter Rawlinson was the former Chief Engineer of Tesla when the company first produced the landmark Model S. He told Forbes that in 2012, nobody believed him when he said the Tesla Model S would be lauded as the world’s best electric car. He said that he is receiving similar disbelief and hostility in response to claims that the Lucid Air will be a big breakthrough.

Even before they have delivered a single car, Lucid Motors is the only legitimate competitor to Tesla in the technology race. In his CNBC interview, Peter Rawlinson noted that the most important metric for measuring EVs is efficiency. The Lucid Air can achieve more than 4.6 miles per kWh versus the Tesla Model S record of 4 miles per kWh. Rawlinson has said that Lucid's efficiency is so much better than any other EV that the car uses 17% less energy to go a certain distance than their closest competitor. 

The upcoming 2021 Lucid Air EV has a battery capacity of 113.0 kWh and a range as high as 517 miles.  In comparison, Tesla’s 2021 Model S Plaid + announced a range as high as 520 miles, but the car will not be available until the end of 2021. The Lucid Air will also be the fastest charging battery-electric car in the world.  The car can charge for 20 miles in one minute, or 300 miles in 20 minutes.    

Below, we take a look at a more detailed comparison of the Lucid Air Dream Edition versus the Tesla Model S Plaid Plus: 

As you can see, Lucid is a very real competitor to Tesla.  We did not put a third automaker for comparison because there is not a third automaker that is even close technologically.  

So, what about the valuation?

It is difficult to value Lucid right now because there is no revenue and have not delivered any vehicles. According to Forbes, Lucid could generate $900 million in 2021 revenue by making 6,000 Airs. Rawlinson told Forbes that volume could “top 25,000 units in 2022 as versions of Air priced at $77,000 arrive.”  

We believe the best way to value Lucid is as a percentage of Tesla. Tesla has a current market cap of $755B, while CCIV’s implied market cap is around $70B. This would value Lucid at 10-11% of Tesla.  Tesla should obviously be valued much higher than Lucid because they have proven the ability to scale, mass produce, and have built one of the best brands in the world.  The question is, do those factors mean Tesla should be worth ~11x Lucid, a company that appears to be its equal in terms of technological development? We believe Lucid can be valued at 10-25% of Tesla for now, and potentially more in the future when they start successfully delivering vehicles.  

In any event, Tesla may very well hit a $1T market cap at some point this year.  At that point, Lucid should command a market cap north of $100B.  I am expecting both companies to reach these milestones at some point this year.  

The Future of the EV Industry

Elon Musk has said many times that his mission for Tesla is not to produce EVs for wealthy individuals, but to drive EV adoption globally and on a grand scale. Tesla has made great strides in making more affordable vehicles but still has a way to go. 

Peter Rawlinson shares a similar mission for Lucid, as noted in Forbes: “He plans to use the Air’s 1,080-horsepower propulsion technology to “power cheaper electric vehicles [enabling Lucid to sell] hundreds of thousands of mid-

$40,000 electric cars and help big automakers sell $25,000 mass-market EVs” by 2026.”

Lucid is starting out as a premium, luxury EV that will appeal to wealthy individuals. However, the company plans to produce cheaper cars ultimately and use its technology to help other automakers produce EVs.

We believe the auto industry will consolidate over the next 5-10 years as companies with inferior technology are squeezed out of the market.  Similar to the mobile phone industry where Blackberry, Nokia, and others could not keep up technologically, we will likely see a similar scenario play out in the EV market. It would not be surprising to see the global EV market dominated by a few companies that offer the best capabilities.  

In the past, automakers like Mercedes and BMW would target a certain area of the market while Honda and Toyota would target another. With Tesla and Lucid planning to ultimately target the mass market, that will no longer be the case. Many legacy automakers targeting niche markets will likely fail because it will become abundantly clear which companies produce the best product.  We would not expect consumers to pay a similar price to buy a mobile phone that has 50% the battery life that an iPhone has. The same will be true in the EV industry, as well.         

Tesla has been called the Apple of the EV market as the innovative leader in the industry.  In Lucid, Tesla has its first real challenger. We believe Lucid is positioned to be one of the few EV companies that dominate the industry along with Tesla.  May the best technology win.  

Part 2: Chinese EVs Continued by Beth Kindig

You can access our first blog post on Xpeng here.

Quick update on Xpeng:

Xpeng has dipped about 25% since we first covered the stock. We think now is a good time to expand on EVs and why we are bullish on this company. 

As noted in the original Xpeng blog post, please keep in mind the company's lock-up expires on February 23rd with earnings out on March 8th. We’ve kept some dry powder for this position to allocate after the lock-up. We do expect volatility in this category as Tesla has proven is par for the course. 

The company released January 2021 results with 6,015 vehicles delivered, a 470% increase year-over-year. The delivery consisted of 3,710 P7s and 2,305 G3s. This compares to 5,700 EVs in December and 8,500 vehicles sold in Q3. 

At this rate, Xpeng will grow annual deliveries (and implied revenue) by 266% if you assume 6,000 deliveries a month for FY2021 at 72,000 vehicles compared to FY2020 at 27,050 vehicles. There will be new record months in 2021 and we believe the annual run rate of 72,000 vehicles is low. The estimated deliveries will put revenue at around $2.2 billion for Xpeng in 2021, which puts us at a 14.5 forward P/S. There will be times we see a 10 forward P/S or lower and a 20 forward P/S or higher in this category. 

The goal here is for Xpeng to beat 6,000 deliveries a month because this will lead to revised estimates for 2021, which then leads to a higher stock price. That's the number we want to meet or exceed. I won't be too concerned if this isn't met every single month (i.e., we all saw the Tesla ups and downs tied to deliveries) but I also think Xpeng is more than capable of exceeding this number which is why we are invested.

The main catalyst that should help Xpeng meet these numbers is the lidar-equipped XPILOT sedan coming out in 2021. This will be the first electric vehicle equipped with lidar for autonomous driving and is based the Nvidia Xavier Drive system. Notably, Nvidia is releasing a more powerful drive system called Orin which is scheduled for production in 2022.

According to the deputy chief engineer of China Association of Automobile Manufacturers, China’s EV sales might reach 1.8 million units in 2021, up 40% from a year earlier due to economic growth, continuous stimulus policies, and sales promotions from manufacturers.

The company recently added assisted highway autonomous driving through the Xmart OS 2.5.0 on January 26th. 

NIO:

The key driver for Nio is that China’s well-off and affluent population has exceeded 500 million.

NIO provided a delivery update on January 3rd with 17,353 vehicles delivered in Q4, representing an increase of 111% year-over-year and exceeded the quarterly guidance. 

For FY2020, the company delivered 43,728 vehicles for an increase of 113% year-over-year. Cumulative delivered reached 75,641.

In the month of December, the company delivered 7,007 vehicles compared to the previous record in October of roughly 5,000 vehicles. The company continues to show strength in doubling its numbers. 

In Q3 2020, NIO reported revenue growth of 146% year-over-year for $666 million. This represented quarterover-quarter growth of 22%. The company reported 13% gross margins compared to (12%) in the year-ago quarter. Vehicle margins also improved at 15% compared to (6.8%). 

As with Tesla, the losses are the more concerning issue with electric vehicle manufacturers. Nio reported an adjusted net loss of $147 million which equates to an adjusted loss of ($0.12) EPS. The company had $3.3 billion in cash and $1.2 billion in debt as of September 30th. On January 19th, the company closed $1.5 billion in Convertible Senior Notes. 

Battery Swaps and Battery-as-a-Service (BaaS)

NIO designs its cars around the battery pack with an interchangeable tray for 70-kWh and 100-kWh battery packs. The three models the company offers all use the same battery packs which helps facilitate battery swapping and battery leasing. Although a handful of attempts at battery swaps and battery leasing have failed, NIO is making this strategy work by offering free battery exchanges that are strategically located near their customers. The company is currently swapping over 4,000 batteries a day. 

In August, NIO launched Battery-as-a-Service which provides car owners with the choice to either buy the battery or to lease the battery. Leasing the battery will cut down the price of the vehicle by 20% from around $52,000 USD to $42,000 USD. This means you can buy a luxury NIO for less than a BMW, Audi or Mercedes with the battery lease. 

The monthly lease costs $140 per month for the 70-kWh battery pack. There is a flexible upgrade offering to the 100 kWh for a longer trip at $230 per month. Keep in mind, the fuel costs nothing so the lease is equal to the cost of gas.

In November, NIO launched the 100-kWh battery pack with 37% higher energy density than the 70-kWh battery. According to the press release, the 100-kWh battery can reach up to 615 kilometers compared to Tesla’s roughly 500 kilometers for its most expensive model. 

NIO delivers a faster battery than a charging station. The strategy of battery swaps is popular in China where many residents live in apartment buildings. 

As stated, various companies have attempted this before such as Renault. However, NIO connects all of the dots to offer a complete ecosystem supporting the battery swap and leasing programs. NIO also offers performance parity which means the customer does not need to worry about battery degradation as NIO guarantees the EV will perform years later as if its brand new. 

NIO has formed a partnership with CATL to handle the battery business. CATL is the supplier that will repair and replace battery packs and also recycle cells. After the life of the battery has been used, they will be repurposed for bikes and scooters.  

Valuation and Forward Guidance

The median analyst’s revenue estimate for 2020 is 63% year-over-year to $2.46 billion and for 2021 is 94% growth to $4.77 billion. The median EPS estimate for 2020 is ($0.58) and for 2021 is ($0.33).

Total revenue for Q4 is estimated between $921.8 million and $947.9 million for approximately 120% to 126% growth YoY and 38% to 42% QoQ.

On January 9th, NIO Day was held in Chengdu, China where the first sedan model ET7 was introduced with autonomous driving features and a larger 150 kWh battery pack for a range of 621 miles. Tesla’s Model S has a range of 402 miles and Lucid Motors has the longest range on the market of 517 miles. Nio’s ET7 will start at $69,000 with a 70kWh battery pack or $58,000 with battery-as-a-service (BaaS).

The ET7 is enabled by a sensor system called NIO Aquila and a super computing platform called NIO Adam. NIO Aquila has 33 sensing units and 11 high-res cameras and one long-range lidar laser. NIO Adam features four Nvidia's DRIVE Orin SoCs with over 1,000 TOPS of performance. Per this press release, Nvidia and NIO will work together on future fleets. 

Nio has a high forward P/S of 17 although if the growth continues in the 100% range then there will be room in the valuation as the quarterly results come in. We fully expect to see EVs trade at a forward P/S of 10 at times and forward P/S of 20 at times although it’s becoming apparent the market is valuing EVs (and AVs) as tech companies with growth valuations. 

EVs will be hard to time which is why we initiated in Xpeng and prefer to layer in. They are hard to time because the growth is phenomenal and the tailwinds are strong yet there is major volatility in this category. We think the information presented above justifies having exposure to this category and to continue layering in.  

Analyst views

Nomura has a buy rating on Nio Limited. They like the company’s top-down launch of its EV pipeline – starting with luxury flagship model ES8, followed by more consumer-friendly models and variants. 

As a first mover in BaaS, Nio "should benefit from the price advantage over other OEMs." The analyst believes that by "improving swapping time to only three minutes without human-labor, and with plans to add minihotspots (around the size of three parking spaces) covering most parts of the major cities in China, NIO hopes to redefine the whole user experience of owning an EV.”

Citi downgrades Nio to a neutral rating from Buy. It warns of potential competition for ET7 from Tesla Model S facelift. Citi turns cautious on its shipments forecast for Nio and now expects 2021 shipments of 82K vs. 92k prior and sees 2022 shipments of 144K vs. 162K prior. 

Li Auto

Li Auto’s lockup expired January 26th.

Li Auto released its delivery update on January 1st with 6,126 Li Ones delivered in December 2020 for an increase of 530%, which is not very relevant given the first delivery started on December 4th of last year. However, the company did grow quarterly revenue by 67% quarter-over-quarter with 14,464 deliveries in Q4. 

The first quarterly release as a new company was Q3 with total revenues of $369 million, up from 29% in Q2. Gross profit margins are better with Li Auto than peers Nio and Xpeng at 19.8% when compared to 13.3% in Q2 2020. Adjusted loss from operations was $6.6 million and adjusted net income of $2.4 million. The (thin) profit margin separates Li Auto from its EV peers. 

The company has cash of $2.79 billion and debt of $380,000 as of September 30th. 

Guidance for Q4 is between $457.8 million and $499.4 million representing an increase of 23.9% to 35.1% from Q3. The median analyst revenue estimate for 2020 is $1.41 billion to $2.94 billion for growth of 109% year-overyear. The median EPS estimate for 2020 is ($0.11) and for 2021 is $0.01. 

Li Auto Key Differentiators

Li Auto announced the adoption of NVIDIA’s next generation autonomous smart driving chip Orin. According to the company, Li Auto will be the first OEM equipping its vehicles, the full-size extended smart SUV to be launched in 2022 with the powerful NVIDIA Orin SoC chip.

Li Auto is focused on SUVs priced between $20,000 USD and $70,000 USD.

One of the key differentiators for Li Auto is extended range EV technology (EREV) which allows drivers to charge the battery pack with electricity or gas. Battery EVs (BEV) are the more popular EV in China per Li Auto’s S1 filing with 81.3% of the sales volume in 2019 with Li Auto being the “first successfully commercialized EREV in China.”  

In the S-1 Filing, Li Auto points out that Battery EVs face challenges, such as a lack of charging stations and limited residential parking spaces compounds this issue. The ratio of parking to car is 2 to 1 in first-tier cities with less than 25% of families in China having access to a suitable space for home charging compared to 70% in the United States. This causes Chinese EV customers to rely on public charging infrastructure with EV to public charging station ratio of 7.4 to 1.

Li Auto also highlights their early profitability as an advantage over its battery-powered competitors with bill of materials being 40% to 50% higher than ICE vehicles. the cost of lithium-ion batteries has decreased from $855 per kilowatt-hour in 2010 to $166 per kilowatt-hour in 2019 – yet the cost is only expected to decrease to $111 per kilowatt-hour in the next five years. The end result is that Li Auto can be more competitive on pricing compared to EVs while also more profitable. Li Auto also benefits from the 10% extra vehicle purchase tax on ICEs in China. 

Li Auto provides this plot graph showing its range and cost is competitive in the SUV segment. Nio also looking good here with Xpeng not pictured. 

In my opinion, one drawback is the lack of a sedan. Xpeng is an attractive stock for the P7 (and the growth that followed this release) and Nio for its upcoming sedan. Li Auto makes a case that China is relaxing the one-child rule yet having two children does not necessarily require a SUV. Despite relaxing this rule, the number of births in 2018 was at its lowest rate since 1961.

The sales numbers for sedans illustrated by Xpeng don’t agree with the statistics that the SUV segment is expected to become the largest segment by 2020 as measured by sales volume with a penetration rate at 45.4% now and growing to 49.2% by 2024.

ByteDance has invested $30 million in a Series C round.

H1 2021 Cloud Software Update

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H1 2021 Cloud Software Update

Don’t forget about cloud software!

In the excitement about SPACs and the flood of IPOs that have listed recently, it'd be easy to forget about the tried-and-true. 

Quick Note on the Current Climate … 

My main thesis about cloud has not changed: it's secular and insulated from geopolitical risks and economic drawdowns. Generally speaking, cloud software reduces costs for enterprises and SMBs. Therefore, the category is more insulated from economic drawdowns. You can read more about my views on cloud’s resiliency here. 

There's a caveat to this, which is that the market is flooded with cloud software solutions and tools – both in the public markets and private markets. This is because cloud software has a low barrier to entry. The costs to develop cloud software and go-to-market is very low compared to hardware or a solution that requires specialty engineers, like AI, ML, robotics, etcetera. Venture capitalists are drawn to cloud software because it's relatively cheap to create, and the margins are healthy due to recurring subscription revenue. 

The window of time that you have to be wary is between years 8 and years 12 for a software company. Prior to year 8, it's common for software and new tech startups to report rapid growth. VCs know this and are taking companies public sooner to capitalize off momentum traders (and trading machines), that indiscriminately pile into companies with high growth rates. 

In this case, a VC firm can see a very large exit and move onto another company while the public markets sort out the long-term growth rate and the company's ability to scale. Every startup looks strong at the beginning of the marathon but which ones endure past mile 13? VCs don't have to worry about this as the goal in today's market is to exit before the marathon is half-over.

The ramp-up period for startups is exciting because the product finds early adopters. Can the product sustain long-term after year 8 and continue to take market share? This is a much more complex question. Private investors exit before the long-term viability of a company surfaces and (us) public investors have to extrapolate the longerterm trajectory.  

Consider the fact that 9 out of 10 startups fail. If you’re a VC, you’re going to get the startup to the public markets as fast as possible to get your exit. If the company fails or the growth slows down, as it does for most tech startups, then it's of no importance as the exit was made. Because of this dynamic (that startups are essentially experiments) and there are many new SPACs bringing to market roughly 165 unvetted companies, I believe we will see a string of failures at the peril of public investors. According to these statistics, we could see 148 fail out of the 165, or on the low-end, 132 of the 165 fails. The low-end is the 80% failure rate for VC-backed companies indicated by the statistics. 

SPACs are not inherently wrong (and David pointed out a few benefits compared to IPOs). However, young companies fail very frequently and the public markets are becoming the exit grounds for pre-revenue companies. This piece is new and public investors aren’t prepared for the high failure rate that is a daily reality in the private markets. 

That’s a bit of a tangent to say we will continue to have plenty of exposure to cloud in our portfolio as a hedge against any high-fliers we take. The fact that cloud is out of favor in the market right now is not a concern to us because we know cloud has a resilient growth rate. 

We also want to communicate that we are well-diversified. We have exposure to SPACs and small caps, but we use cloud and semis as a safe haven. I think these comments will become more apparent as we move through the year. Basically, I am contrasting why cloud deserves attention right now despite the fact speculative trading in SPACs and Momentum has been in the driver’s seat.  

Regarding valuations — I've stressed this point with companies like Snowflake because we will see more of this as time goes on and investors need to be careful of merely providing exits for VCs at sky-high valuations. Being patient is an important tool in a retailer's arsenal when a valuation is high. 

Please keep in mind, that we discouraged readers from buying Zoom Video when trading in the forward P/S range of 50 despite owning this stock at a lower cost basis. Therefore, I am not singling out Snowflake but instead using it as an example to illustrate why we have not bought this excellent company as "growth at any price" can lockup your money for a few quarters while the financials catch up to the valuation. This is exactly what has happened with Zoom Video (it took a long breather) although the forward P/S is much more reasonable now.

Our Focus: Product-Market Fit and Valuations

For our portfolio, cloud is a hedge as valuations may fluctuate, but growth will march onward for the companies with product-market fit in this resilient category. The best illustration of product-market fit is Shopify and Zoom Video as both their top and bottom lines prove they are efficiently meeting market demand. 

An example of a company that I have picked on for not having product-market fit is Uber and Lyft as they must subsidize rides. The market price that customers will pay is lower than its operational costs. The market may still move the stock based on the promise of autonomous vehicles or robotaxis but today's financials do not suggest there is product-market fit. 

Opendoor has a similar issue. The financials are upside down as the more the company makes, the more the company loses, and this is inherent to the current business model (not a one-time event or the cost to scale). 

Opendoor was hoping to charge 10% in commissions which is about 4% more than Realtor fees for the convenience of buying the house in cash. The market will not pay this extra 4% and Opendoor is forced to match Realtors at 6% commissions. Like Uber, the price does not cover the operational costs. However, we are in a period of historic liquidity and QE. The market may pile in based off sentiment or other speculative reasons (we’ve entered this stock ourselves and it’s performed well), but the financials today do not show a company that has achieved product-market fit. 

You could argue Fubo does not have product-market fit as seen in the financials. The cost of licensing the content does not cover the cost of operations. So, why am I invested? Because this is the yearthe year for CTV ads and OTT live content so we think the trend is so early and so massive that we are comfortable taking a flier on this company. I’ve said before that OTT live sports is the holy grail and cable networks/media conglomerates will do what it takes to own this transition. There are many market forces at play here and Fubo is centered perfectly in the middle. Therefore, this is an investment in the trend of Live Sports OTT. 

Product-market fit is important to this discussion because finding the gems will protect us from any downside in the market. Even if the market temporarily sells-off in certain names, we can rest easy if we stick to quality. 

The best examples of product-market on the public markets are the FAANGs – where the top line defies the odds, and the bottom line continues to deliver. There are others in the $200B+ market cap range that illustrate this: Salesforce for CRM, Adobe for design and its developer moat, Nvidia for the CUDA platform and its developer moat, etc. Sticking with these companies through market ups and downs did well for early investors. 

Cloud investing was fairly predictable in the previous years because there were clear winners in terms of forward growth. Due to tougher comps, nearly half of all cloud stocks guide between 20% and 40% with very few above this range and priced dearly if they are (see the chart below).

The other factor we will be considering as we move into 2021 is valuation. There is a disconnect in a few names where the market has not been perfectly efficient. Below, we pull out a few names that have room and rely on Knox for any breakouts in valuation. 

As was posted on the forum last week, those with room in valuation include Bandwidth, Asana and Crowdstrike. We are also pleasantly surprised to see Kingsoft Cloud having quite a bit of room although some of this likely represents the risk in China. In the Macro section, you'll see that China's Cloud IaaS is set to take off with Alibaba surpassing Google Cloud for the number three spot. We think this foreshadowing growth for Kingsoft.

Macro Outlook:

The big takeaway from the cloud market going into 2021 is that hybrid work-from-home is here to stay. The market is pricing cloud productivity software as a temporary COVID tailwind but the analysis shows a permanent shift that will accelerate this year. 

According to IDC, the cloud market will grow at a CAGR of 15.7% through 2024 to become a $1 trillion market in 2024. This forecast includes software-as-a-service (SaaS), platform-as-a-service (PaaS), and infrastructure-as-aservice (IaaS). 

The research firm also states that by 2021, 90 percent of enterprises will be relying on a mix of onpremise/dedicated private clouds, multiple public clouds and legacy platforms. Therefore, IDC predicts this to be the year of multi-cloud, which we covered in our Microsoft earnings report write-up here. We see multi-cloud as the first step towards edge computing to where servers from various hyperscalers or CDNs work cooperatively to deploy 5G workloads. 

On a trailing basis, cloud spending grew from $183 billion in 2018 to $233.4 billion in 2019. This puts the $1 trillion prediction into context as IDC calls for roughly 400% growth over the next five years. In 2019, SaaS accounted for $148 billion, or about 64% of the public cloud market.   

SaaS dominating the IT spend for cloud is important because it means there will be many winners in this category as it marches onward to the $1 trillion mark.

According to IDC, more than half of the global revenue in the PaaS and IaaS markets was captured by AWS (33.6%) and Microsoft (18.0%) leaving 34.90% for the rest of the market. 

This is not the case with SaaS where the rest of the market captured 73.9% and the top two vendors, Salesforce and Microsoft, caught 7-8%. 

This is also important for perspective as smaller companies own the SaaS market while Big Tech dominates IaaS and PaaS. Therefore, there is a solid opportunity for investors in cloud software now and into the future. The graph below helps to visualize the opportunity for smaller players:

Source: IDC 2019 Report

According to Gartner, worldwide public cloud spending will grow 18% in 2021 to total $304.9 billion. Relative to overall IT spend, cloud still has a long runway and is projected to make up 14.2% of total global enterprise IT spend in 2024 compared to 9.1% in 2020. 

Gartner’s survey indicates that there is still quite a bit of growth ahead despite the harder comps the cloud software leaders face in 2021. The data shows that 70% of organizations using cloud services plan to increase their spending, stating “the proportion of IT spending that is being allocated to cloud will accelerate even further in the aftermath of the COVID-19 crisis.”  

The analyst firm points towards mobility, remote working and hybrid workforces as trends that will lead to further market growth. 

Source: Gartner CIO Survey

In the graph above, we see survey respondents and Gartner forecast an increase in work-from-home. Meanwhile, the market has been cautious about cloud software post-vaccine, which may be unwarranted with hybrid workforces. 

Here is what Gartner states, “For example, customers and citizens shifted their activity online during the lockdown, but that shift will increase, not reverse, in 2021.”

Forrester’s recent survey showed similar results with 47% of North American managers anticipating a permanently higher rate of full-time remote employees and 53% of employees wanting to work from home postpandemic. 

Although budgets will only increase 2% in 2021, according to Gartner, CIOs' top priorities are digital workplace technologies to support work-from-home, and then AI/ML, robotic process automation (RPA), distributed cloud and multi-experience platforms.

Forrester states 35% of companies will double down on workplace AI with one in four workers supported by automation either directly or indirectly by the end of 2021. B2B sellers will rely on AI and automation with predictions that 60% will rely on tools with these functionalities embedded.  

The analyst firm also states the hyperscale cloud market will “return to hypergrowth” of 35% to $120 billion in 2021. This is up from the original prediction that cloud IaaS would grow 28%. The analyst firm also predicts Alibaba will take the number three spot instead of Google Cloud. 

Adopting serverless apps and containers will continue to grow with increased demand for multi-cloud container development platforms and public-cloud container/serverless services. Forrester also believes a leading trend will be disaster recovery moving to the public cloud. 

Cloud Stocks for H1 2021

I wrote my first thematic PDF on cloud in December of 2019 during an intense cloud sell-off. The First Trust Cloud Computing ETF (SKYY) had posted 22% returns YTD at time of writing in December and closed the year with 24.55% returns for full-year 2019.

Last year, cloud performed much better due to its fundamental, secular strength during COVID with the SKYY ETF closing out with 57.41% returns in 2020. 

We covered many cloud names at their lows during Q3 and Q4 2019 due to our thesis that cloud is insulated and secular. At the time, we pointed out that cloud services were expected to grow 4.5 times more than the IT industry and that future growth through 2022 would be 3 times higher than IT (page 3 from this report).

I believe we are here again in a very similar spot. The market thinks cloud is going to be stunted and forward guidance isn't saying otherwise. However, the analyst firms are predicting we will accelerate and are raising forecasts. We will side with Gartner, IDC and Forrester who do a particularly great job in the cloud category. 

Prior to COVID, our thesis was this: “cloud software is more sheltered from overseas economies, supply chains, trade wars and shifting government policies” and “truly, there is few safer places to invest in technology if the trade war resumes or we see the recession that many economists are predicting.” 

My thesis this year is that work-from-home and hybrid work environments will be the new norm which will keep cloud growth steady and that AI and ML will be another catalyst. You simply can’t compete with AI and ML with on-premise servers and software. Edge computing and 5G is another accelerant for cloud IaaS, PaaS and software. 

Below are the top 35 cloud stocks listed by revenue growth that we consider to be in our universe. The top 10 are shaded in yellow. 

In a Motley Fool podcast, I had said that this would revert to about a 30 forward P/S and we are here now.

 

Some Conclusions:

•       Kingsoft Cloud has a compelling risk/reward ratio as the company will deliver Snowflake-level revenue at rock-bottom valuation.

•       Bandwidth has the ingredients to pass the pack of cloud stocks stuck in the sub-40% growth range. Let’s see if the company can do this – and if the valuation will finally match its potential. 

•       Asana is not in our top 10 due to competition across productivity tools, but we see room here in the valuation. This will be something Knox spearheads as he sees the right setup including this one from last week.

•       Crowdstrike and Zscaler are both leaders in revenue growth and EPS growth. 

•       Zoom Video and Shopify are both strongest in terms of a large base in EPS and we think the products will perform well in the face of tough comps this year. 

•       This year is very unique for cloud software because so many stocks are sub-40% growth and tightly ranked (see the chart above). We are not surprised to see mixed-reactions to the earnings reports as the market is holding its breath to see what the covid comps will be for the March quarter.  

•       We are not too concerned about the market taking a breather or responding to uncertainty. There is only one way forward for SMBs and enterprises (which is adopting cloud IaaS, platforms and software).

Traditional IT is expensive and will only hinder a company from taking advantage of AI and 5G. Competitively it can be very harmful to not transition to cloud right now as we've seen in my past reports citing McKinsey.

•       The last time I talked about cloud on the Motley Fool podcast, I thought valuation was a serious risk as we saw many names trading in the 50 forward P/S range whereas 30 forward P/S is the mean for highgrowers and 20 P/S is the mean for average growers. 

•       Now that we have reverted to the mean, we plan to allocate for cloud while the trend is out of favor. 

My Top 10:

We stand by Zoom Video and Shopify as the relationship between the top-line and the bottom-line proves product-market fit. We understand there will be harder comps this year but these companies are releasing new products to grow market share and continue to be centered in important trends. These were strong companies prior to COVID and we thnk they will be strong companies post-COVID.

Crowdstrike and Zscaler are stocks that David follows closely and are the best positioned cybersecurity companies to benefit from the growing security spending cycle.  The Covid-19 pandemic and the Sunburst hack uncovered a number of major gaps, highlighting the need for organizations to transform their legacy security architectures.  Credit Suisse’s recent CIO survey suggests that security spending is the top spending priority in 2021, even more so than in July.    

Kingsoft Cloud and Bandwidth are both undervalued in terms of forward-growth. China's cloud IaaS should be in the breakout year as Alibaba takes over Google Cloud as number three. Bandwidth is centered in the hardwareas-a-service trend, which may not be as exciting as EVs or SPACs but is essential to the digital transformation we've seen this past year and a hybrid work environment.

We could not be more bullish on Twilio’s long-term trajectory. The company has a moat in cloud communications for native apps and the management is taking on the omni-channel marketing to increase the addressable market. Should the management pull this off (and we think they will), then Twilio is setting up to be a leader in marketing and sales data with Adobe/Salesforce long-term potential.

Datadog has auspicious positioning for hybrid cloud and multi-cloud. The three analyst firms agree that the public cloud is going to accelerate this year and we want exposure. The market taking a breather does not affect our conviction and we think DDOG is the best way to participate in the growth of Azure, AWS and Google Cloud plus the trend towards multi-cloud (which also directly relates to edge computing).

Teladoc’s low forward P/S (comparatively) is a mystery as this is a mega-trend that will be unstoppable as artificial intelligence continues to merge with health care. We can't think of an industry more ripe for disruption as health care costs have risen 400% in the last decade while wages have stagnated. AI and genomics are able to cure terminal diseases, although TDOC is centered in the first problem (health care costs).

DocuSign is a steady performer with solid top-line and solid bottom-line growth. The market tends to overlook this one, but we like DocuSign as the primary choice for legal, real estate and financial industries. There is very little room for competitors as DocuSign delivers a superior product that can become the universal standard. We do not think the world will reverse to paper.

We continue to want exposure to telehealth and so have allocated to Amwell as an 11th position in cloud.

Voyager Digital: Premium Analysis

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Voyager Digital: Premium Analysis

Voyager Digital

Voyager Digital is a high-risk/high-reward opportunity that offers exposure to the Bitcoin and crypto trading trend. The company is part of a consortium for stable coins, including USD Coin (USDC) and Tether’s USDT, which in total have surpassed $7 billion in circulation. 

In other words, Voyager provides exposure to both decentralized coins (Bitcoin, Ethereum, Litecoin, Chainlink, etc.) and coins based on the fiat system. 

Big Tech and the Fed will push for stable coins based on the fiat system, while crypto enthusiasts and developers will want blockchain to remain decentralized. Although I am personally in the decentralized camp (you can read my Facebook Libra article here), I am also aware that the powers-to-be are likely to put immense pressure on adopting stable coins. This company allows exposure to both at a $2.15 billion market cap.

Voyager Digital strives to offer more coins than its competitors, including the $30 billion market cap Coinbase that is going public soon, Kraken and Gemini.

Voyager does not charge commissions on crypto trades and offers 9% interest on stable coins. We break down how this is possible below. 

Please note, the I/O fund does not hold large amounts of crypto on trading platforms. Instead, we do this in wallets and use trading platforms for trading only. We explain the nuances of why and various choices if you do want to hold coins in “hot storage.”

Below, we offer a thorough analysis of how Voyager stacks up against Coinbase and Gemini. Crypto-related stocks and assets are more volatile than others – although less so over the recent year. 

We think it's essential to go through this company thoroughly and how it stacks up to its competitors as anything crypto-related promises to be volatile — although less so over the recent year.  

Financial Overview

We published a quick blog on Voyager two days before the company released a substantial report on its recent growth, which can be found here. 

Voyager is on a growth streak fueled by the Robinhood issues and a rise in brand awareness from offering the meme-token Dogecoin. The company solves one of the more significant pain points for crypto investors, which is commissions. To illustrate, a $5000 crypto trade on Coinbase can cost as much as $80 ranging from 4% to 1.5% commissions. These are not small stock trading fees of $4.99. Although Coinbase was first to market, there is plenty of room for competitors to disrupt the non-existent customer service and excessive commissions. We discuss Gemini below as a better alternative to Coinbase if you do choose a commission-based platform. 

Voyager is FDIC-insured. However, the crypto held with Voyager is not insured. Gemini, which operates as a trust, has private insurance. For the most part, crypto investors (including ourselves) store their assets on a "cold storage" crypto wallet.

 The risk is minimal in this case in the event there is no insurance.

Significant Growth from Robinhood Tailwinds

Voyager reported roughly 400-500% growth from December to January and roughly 1000% growth from December to early February from the most recent report released in early February. Crypto is a tight-knit niche and we think word-of-mouth will grow nicely in this community as it actively looks for new platforms. 

In December, the company reported $1.7 million in revenue and has grown to $8.5 million in January of 2021, for roughly 600%. The company reported $2.5 million in revenue between February 1st and February 4th — which could lead to $17 million in revenue in February.

Assets under management (AUM) grew from $200 million in December to $800 million by early February.   

Trades per day averaged more than 30,000 for the month ending January 31st, up from approximately 6,500 in December of 2020, representing 450% growth in daily trade volume. By early February, daily trades averaged 60,000 trades per day or nearly 1000% growth.

In January, the value of customer trades increased over 500% to $840 million, up from $150 million in December of 2020. 

Over twelve months, the overall number of trades increased from 8,500 trades in December of 2019 to 1 million trades in January of 2021, an increase of 117,000%. This number may be irrelevant as most of this is priced in, yet we think it's important to look at the ongoing strength before the Robinhood issues.

Basic users grew from 150,000 in December to 440,000 by early February. The company has a pipeline of 80,000 customers the company is trying to onboard. 

Here is the management’s statement in full regarding the Robinhood catalyst and what investors can expect moving forward:

"While we believe our recent business metrics reflect the growing interest in the cryptocurrency ecosystem and long-term benefits of our business model, the unprecedented external events over the past week, including decisions made by competitive products, have brought significant upside to our metrics," said Steve Ehrlich, Cofounder and CEO of Voyager.  the unprecedented external events over the past week, including decisions made by competitive products, have brought significant upside to our metrics," said Steve Ehrlich, Cofounder and CEO of Voyager. 

"While we don't expect a repeat of the unprecedented external events of the past few weeks that have catalyzed the recent growth, we anticipate continued meaningful growth in our business, including from the pipeline of approximately 80,000 customers who have signed up and that we are presently onboarding.  While we don't expect a repeat of the unprecedented external events of the past few weeks that have catalyzed the recent growth, we anticipate continued meaningful growth in our business, including from the pipeline of approximately 80,000 customers who have signed up and that we are presently onboarding. 

We remain focused on executing our long-term business plan and expect Voyager will continue to grow the business in a more traditional pattern throughout the balance of 2021. To support this growth, we anticipate increased expenditures to materially increase our employee headcount during this period, while also growing our technology architecture stack in the near-term to accommodate significantly more users." expect Voyager will continue to grow the business in a more traditional pattern throughout the balance of 2021. To support this growth, we anticipate increased expenditures to materially increase our employee headcount during this period, while also growing our technology architecture stack in the near-term to accommodate significantly more users."

The company closed a private placement of $46 million on January 21st, 2021.

Per the Investors Presentation, Voyager has an ambitious goal of reaching $20 billion AUM based on $500 million AUM as of Q1 2021 (this was achieved and more so with currently $800 million AUM).

The presentation also points out that Voyager has seen 75%+ sequential quarter growth with increasing operating margins in 2020. The company also states it takes $35 to acquire an account, and the company makes $30 per account in monthly revenue – which is excellent unit economics. 

According to Stifel Research, the customer acquisition cost has averaged $20 to low $30s per new account. In contrast, monthly revenue per account has accelerated to $80/month in C2021 from $40/month at the calendarend of 2020. 

You can read a catalog of research reports from various funds and analysts covering the company, which might help see the fairly extensive coverage considering the company's small market cap.

Voyager is a strong choice for alternative coins as the app allows you to trade many tokens that Coinbase or Kraken does not support. Dogecoin, for instance, which is a meme coin pushed by Elon Musk is offered on Voyager. The company offers interest on Bitcoin, Ethereum, Polkadot and Chainlink. 

Quarterly Financials 

Fiscal Q1 2021 results were reported on November 30th for the period ending September 30th.  The company had

$2 million with $1.6 million in fees and interest income of $400,000. There was a net and comprehensive loss of $3.97 million or ($0.04) EPS. 

The company had cash and cash equivalents of $7.48 million and debt of $1.12 million at the last earnings report, which includes a PPP loan. 

There was an update for fiscal Q2 2021 on January 5th with quarterly revenue expected to reach $3.5 million. 

Voyager also completed a private placement during the quarter, which increases gross proceeds raised during fiscal 2021 to C$13.8 million. It completed the acquisition of LGO, SAS, an AMF regulated entity that provides Voyager with a fully licensed European entity to accelerate its European strategy.

How does Voyager Make Money?  

Voyager’s revenue is not dependent on commissions or fees. The company plans to introduce a debit card, credit card, margin, loans, and advisory products over the next year or so. 

Right now, the business model creates revenue in two specific ways:

1)      Smart Order Routing: When you place an order to buy or sell a cryptocurrency, they will provide a listed price at which you accept. They will then connect your order to 12 exchanges. Unlike securities, which by law, must have the same price across all domestic exchanges, cryptocurrencies are priced at variable levels. In other words, the same coin can be listed at two different prices at the exact same time. 

Voyager uses your order to capitalize on this inefficiency by performing an arbitrage across various exchanges. The profits from such a move would typically surpass any commission or fee, allowing them to provide exceptional pricing. Voyager will thus share the profits from this arbitrage with you in an attempt to execute your order at a lower price than you agreed to.

This specific business model will likely remain profitable until either regulations change or there is too much competition in the arbitrage. Changes to the process would appear in the margins.

2)      Voyager also operates like a bank. In their terms and conditions, they very clearly state “We will lend, sell, pledge, rehypothecate, assign, invest, use, commingle or otherwise dispose of funds and cryptocurrency assets to counterparties, and we will use our commercial best efforts to prevent losses.”  

Basically, if you receive a loan from a bank, the loan is used by the bank as collateral for other investments. This creates multiple derivatives on a single asset. 

This piece is similar to Robinhood in that the users take on counterparty risk. Should Voyager become insolvent, you will need to stand in line behind other creditors to receive your money back.

For taking on this risk, Voyager offers significant yield in a yield-starved economy. Like a bank, a minimal deposit must be kept to receive this interest payment, which can be as high as 9%. As part of this program, it may take up to 7 days for you to withdraw any crypto from your account.

Voyager Digital is engaging in fractional lending practices, which banks have been doing for centuries. However, unlike banks, Voyager is not considered a bank or a broker-dealer, so it does not provide FDIC or SPIC insurance for your crypto if there is a run on the bank, per se, or if something occurs that would prevent them from meeting obligations. 

To conclude, FDIC insurance applies to the cash you hold at Voyager, but there is no insurance for the crypto held there. 

Catalysts: Stablecoins and Global Expansion

Last March, Voyager acquired Circle Internet Financial’s trading app which gave them a boost of 40,000 clients. The acquisition strengthens Voyager in offering the USDC stable coin that has $7 billion in circulation. Circle is backed by Goldman Sachs and is the founder of the consortium for USDC. The USDC coin allows global transfer of dollars at an instant and for a very low transaction cost. The stable coin is part of a consortium that is also sponsored by Baidu, IDG Capital and Bitmain with participation on trading apps, such as Voyager and Coinbase. The supply of USDC has grown by 41% since the start of 2020.

A recently announced acquisition of France-based digital asset exchange LGOUY expands Voyager Digital’s reach into Europe. Similarly, the firm is targeting to grow its footprint in Canada. We believe this global expansion should further boost Voyager's platform in terms of customers and revenue.

Valuation

If we assume Voyager has doubled its revenue to $5 million (which we think is a very low estimate), the company is trading at a forward P/S of 100. There's a possibility that Voyager reports a 400% sequential increase due to the numbers presented above. 

If so, Voyager is trading at a forward P/S of 50 if we assume $40 million in revenue for FY 2021 at a $2.15 billion market cap. It is plausible that Voyager will achieve this with the critical metrics provided on February 5th.

This is obviously a very high forward P/S but we think its growth will continue at an attractive trajectory due to the information presented above.

Management:

In our brief blog last week, we mentioned that the management checks out and we don't see any flags there. The CEO, Stephen Ehrlich, has experience running brokerages and financial companies. He was the CEO of E-Trade Professional Trading arm before it was bought out by Lightspeed and was then the CEO of Lightspeed Financial, the CEO of PennTrade and CEO of Tradier.

Oscar Salazar is a Co-founder and he was early in Uber as the CTO. The one issue that I do see is that they are involved in another company called Pager, a digital health startup. I prefer a founding team that has only one focus.

Risks:

It would not be a proper analysis on a crypto exchange unless we discussed the risks involved. Hacks that result in a loss of assets are no longer as likely due to enhanced security measures and custodians, yet it bears mentioning that Mt. Gox was hacked in 2014. 

At the time of the hack, Mt. Gox was the largest crypto exchange globally, handling around 70% of all transactions worldwide, totaling $3 billion. The hack resulted in a loss of about 6% of all bitcoins in existence at the time. The company went bankrupt as all remaining assets were frozen. An investor who held their crypto at the Mt. Cox exchange lost most, if not all, of their investment.

Voyager Digital was hacked as recently as December of 2020, but no customer data or assets were lost as the company shut down its systems when the vulnerability was detected.

Since then, most major exchanges like Coinbase and Gemini have become custodians, addressing the security risks. Coinbase, for example, keeps 98% of cryptocurrencies held in cold storage, where it is held securely offline. The remaining 2%, which are held in hot storage, comes with insurance. 

Gemini takes these security features a step forward. Being classified as a trust, Gemini adheres to strict fiduciary capital reserve and cybersecurity standards by one of the toughest financial regulators, the New York Department of Financial Services. They further secured the SOC for Service Organizations Type 1 examination typically reserved for the most stringently run financial services or technology firms.

A SOC 2 review from an independent, third-party like Deloitte validates that Gemini is holding itself to high security, availability and confidentiality standards. Because of these additional measures, Gemini has become a favorite exchange/custodian for intuitional investors. 

As mentioned above, cryptocurrencies do not come with FDIC or SPIC insurance. FDIC protects depositors from banks becoming insolvent, providing guaranteed insurance of up to $250,000. The SPIC protects investors from a broker-dealer going bankrupt, providing insurance up to $500,000 in the unlikely occurrence of a broker-dealer becoming insolvent.

Counterparty risk is a reality for any crypto investor holding their coins at an exchange/custodian. If a custodian does not segregate coins and provide unique private keys that the company cannot access, the risk remains that an investor could lose a portion of their coins in the event of insolvency.

This happened to BitGrail in 2019, an Italian exchange. The courts declared that because all crypto deposits were directed towards the primary address of the exchange, and were not segregated, it was impossible to determine the coins' ownership. Thus, the remaining coins were used to pay off creditors, wiping out most of the individual investors using that exchange.

To be clear, we don't think this will happen with Voyager but are providing a 360-degree view of the risks. We think the crypto landscape has become much more secure since Mt. Gox and BitGrail, and these old stigmatisms prevent many investors from participating in this sweeping trend.

Coinbase, for example, clearly states that they do not segregate coins and control all private keys. In their terms and conditions, they say that "Coinbase may use shared blockchain addresses, controlled by Coinbase, to hold

Digital Currencies held on behalf of customers and/or held on behalf of Coinbase." 

On the other hand, Gemini does segregate coins and states that not even the founders, CEO or president can access coins held in cold storage. They are further in the process of securing privately backed FDIC-like insurance for further protection and safeguards in the unlikely case of insolvency. 

Also – please note, Voyager Digital is a thinly traded over-the-counter (OTC) stock. The OTC markets come with higher risk as there are no central brokers compared to stocks traded on the Nasdaq. 

Voyager promises to be a roller-coaster ride as a small-cap OTC stock that is tied to crypto moves. 

Conclusion:

Voyager Digital's growth is largely undetected by the market at this time and we think this is a boon to our readers. With Goldman Sachs leading the IPO, Coinbase will be fully priced by the time it hits the market. Coinbase's IPO is expected this year at a $28 billion to $32 billion market cap on the low end with some Silicon Valley insiders suggesting it will reach $70 billion to $100 billion (I won’t a buyer of those crumbs … cough .. I mean at that price). This is at annualized revenue at $2.3 billion ($600 million a quarter) or a P/S of 50. 

Yet, there is now a competitor (Voyager) undercutting them on commissions and on the breadth of tokens. For most crypto investors, the process of holding tokens securely in cold storage is second-nature, and therefore, Voyager Digital is likely to be very popular despite the lack of insurance on crypto.

In our opinion, Voyager is a viable (or should i say formidable) competitor to Coinbase. For our goals and desired gains in the I/O fund, we will take the 50 forward P/S on a company growing 500% right now and small market cap rather than an overpriced IPO demanding the same valuation. Eventually, Voyager’s growth will settle but we think the value proposition of undercutting Coinbase on commissions will continue to help the app take market share in the word-of-mouth community of crypto traders. 

Gemini does well for the high-dollar crypto traders, but this is not the same crowd as Voyager Digital, per se. We see Voyager Digital as a competitor to Robinhood and Coinbase at an attractive market cap. We like the management and the diversification with stablecoins as the Fed and Big Tech are likely to support stablecoins as time goes on. Therefore, Voyager offers exposure to both and has global expansion on the horizon.

 

 

Shopify Premium Analysis for 2021

Posted on by io-fund

2536843c-2d08-4b42-8fa9-d362f83f8268_Shopify-Premium-Analysis-for-2021.pdf

Shopify Premium Analysis for 2021

Introduction:

As the market attempts to sort the companies that have temporary covid tailwinds from the more permanent and long-lasting growth, we want to separate Shopify from the pack. You can view our October 2019 analysis here where we discussed the strength of the company’s product-market fit and the catalyst of the Fulfillment Center. 

One major update from the last report is that Shopify overtook eBay as the largest online retailer in the United States. When our last report was written, Shopify was the third largest retailer and a sizable portion of our analysis focused on eBay as the one to overtake. 

I think we will see Shopify significantly close the gap due to Shopify's global opportunity. Shopify is more localized by allowing the merchant to have a localized domain rather than weaken under one domain as detailed in the October 2019 analysis. 

Amazon is customer-centric which sacrifices the merchant-side of the equation. We covered this in 2019 when we stated:

Shopify counts over 800,000 merchants as customers compared to Amazon’s 5 million marketplace sellers. Shopify charges the sellers 2-3% compared to 26.5%. Amazon is also predominantly a United States presence with about 3⁄4 of sales occurring domestically. Shopify does not break out these numbers but it is widely understood to have a global strategy.  

As mentioned previously, an important distinction between Shopify and Amazon is that Shopify places the importance on the merchant while Amazon places the importance on the retail customer. While Amazon builds out 1-day shipping, Shopify is building out tools for platforms and tools for merchants.  

Amazon’s main value proposition is the convenience, which is why we will likely see Shopify attack this at various angles over the next few years (starting with the Fulfillment Network). Amazon’s e-commerce moat is about the same as Wal-mart’s retail moat; they are behemoths but these behemoths can be disrupted. Amazon took market share from Wal-Mart, and nearly two decades later, we think Shopify is a serious contender to Amazon. 

However, it should be noted by not providing the traffic for the merchant, Shopify’s GMV is substantially lower than Amazon’s. We noted this before in the 2019 write-up:

Shopify makes 2.63% of GMV, or $361M of the $13.8 billion. Compare this to Amazon.com who makes 26.7% of GMV ($42.7 billion on $160 billion GMV, in 2018) and eBay who makes 11.7% of GMV ($10.86 billion on $92.6 billion, in 2018). 

Percentage of GMV illustrates the power of owning the domain …  

How will Shopify catch-up to Amazon? Two specific ways.

1.       International Growth: Globally, Shopify has a better chance of penetrating various regions as the merchants (and lack of walled garden) localizes the content and offerings. There is also stigmatism towards Big Tech globally and Shopify works quietly in the background while letting the merchants remain in the spotlight. This will be popular globally — and perhaps even domestically if Shopify can deliver on the Fulfillment Center and close the gap on convenience. Point being, keep an eye on Shopify’s international growth. 

The best evidence for this is Shopify’s recent partnership with AliPay. Although this does not meaningfully contribute to revenue right now, it could by next year across the key markets mentioned the press release: The new Alipay payment gateway is available now to Shopify merchants in the U.S., with more markets to come in the future, including Hong Kong, India, South Korea, Indonesia, the Philippines, Malaysia, Thailand, Pakistan, and Bangladesh.

Right now, it’s hard to predict Shopify’s success with AliPay in these regions but it’s easy to see that Shopify is welcomed in geographies where Amazon is not. Therefore, we see global as an important piece to our thesis as merchants who want to reach global audiences will likely choose Shopify over Amazon. We think this is an important competitive edge. 

2.       The merging of social media and e-commerce as a means for monetization. We’ve belabored the point of Apple’s IDFA changes to first-party vs third-party ads. For social media companies, the answer to weaker data will be to move away from behavioral targeting for ads and move towards direct response and e-commerce. Amazon is weak here as social media companies don’t partner with the behemoth (see below for SHOP’s partnerships). Expect to see additional tailwinds from social media driving more e-commerce traffic. 

Market Forces: e-Commerce is eating Retail

There are two market forces driving the success of Shopify right now. The first is the covid pandemic grew ecommerce penetration in the United States from 15% to nearly 35% representing the same level of growth (3X) as the previous ten years combined (5% to 15%). Retailers are now online in an unprecedented number and are able to successfully compete with Amazon. 

The more permanent trend will be driven by Millennials and Gen Z with 91% and 89% stating that they shop online, respectively, according to a survey conducted in June. Additionally, data from Morgan Stanley shows Millennials and Gen Z will overtake Baby Boomers as the dominant US spenders in the coming years, meaning the major US consumers of the future will prefer to shop online.

The additional outside force is the remaining addressable market. The statistics above suggest e-commerce will overtake retail while data from Stripe suggests only 5% of global commerce happens online today. This will be compounded by the overall growth in retail. 

To summarize, we think the transition towards e-commerce is more permanent long-term than the market is pricing in at this time as retailers have been forced to adopt online stores and younger generations prefer this method. 

Below you can see what product-market fit looks like as Shopify takes over eBay in a banner year for e-commerce. 

Fundamentals:

In its most recent quarter, Shopify grew revenue 96% YoY to $767.4 million up from $714.3 million in the previous quarter and $390.6 million in the year-ago quarter. GMV grew 109% which was slightly down from the previous quarter of 119% GMV growth. 

Merchant solutions revenue increased 132% YoY while subscription solutions advanced 48%. EPS of $1.13 came in 122% above the consensus estimate calling for $0.13 as the company showed its ability to earn sizable profits. Adjusted operating margins of 17% and is up from 3% in the year-ago quarter. 

TTM revenue was $2.5 billion, net income of $196.5 million, and adjusted net income of $342.5 million. Here is the company’s growth over the last few quarters:

Q3 2019                Q4 2019                Q1 2020                Q2 2020                Q3 2020

GMV $14.8 billion $20.6 billion $17.4 billion $16.3 billion $30.9 billion

GMV Growth (y-o-y) 48% 47% 46% 119% 109 %

Revenue $390.6 million $505.2 million $470 million $714.3 million $767.4 million

Revenue Growth (y-o-y) 45% 47% 47% 97% 96% 

Heading into Q4, Shopify is on pace to record over $100B in GMV in 2020. The company has over 1 million merchants in 175 countries with a breakdown of United States of America 52%, United Kingdom 7%, Canada 6%, Australia 6%, and 29% rest of the world.

Monthly recurring revenue as of September 30, 2020 was $74.4 million. The company has cash and marketable securities of $6.12 billion and debt of $750.5 million. 

The increase in cash was due to $2.03 billion of net proceeds from Shopify’s offering of Class A subordinate voting shares and convertible notes in the third quarter of 2020 and $1.46 billion of new proceeds from Shopify’s offering of Class A subordinate voting shares in the second quarter of 2020.

An early glimpse into Q4 shows Shopify is likely to have a big quarter as the holiday shopping season unfolds. The company announced record Black Friday sales of $2.4B, up 75% from Black Friday 2019.  

Over the past two years, Shopify has doubled its share of Black Friday sales. Most impressive is the acceleration of market share gains the company demonstrated this year.    

The median analyst forecast for FY 2020 is $2.85 billion (up 81% YoY) and for FY 2021 is $3.74 billion (up 31% YoY). The median analyst’s EPS estimate for FY 2020 is $3.70 to $3.31.  

The harder comps for next year is one reason the stock has cooled off but I suspect that we will see stronger forward guidance as the year goes on. 

Here is how Shopify’s forward growth next quarter compares to other popular e-commerce companies:

Fulfillment Center

In June 2019, Shopify introduced the Shopify Fulfillment Network, a fulfillment network that will offer timely deliveries, lower shipping costs, and provide a better customer experience for merchants and customers  Last year, the company acquired 6 River Systems to help build out its warehouse automation technology.  

The Shopify Fulfillment Network is a 5-year build process for Shopify that remains in the product market fit phase.  At this point, Shopify is focused on building out the software but management expects to prioritize the build out into 2021.

COO Harley Finklestein remarked in the company’s Q3 Earnings Call: 

“our focus in 2020 around SFN is to achieve product market fit, which we plan to continue up to — into 2021. We want to ensure that the foundation of the fulfillment network is strong and the merchants experience is outstanding before we enter sort of the scale phase.” 

Shopify is focused on the long-term opportunity and does not expect to accelerate its SFN investment, as they want to take their time on such a large venture ($1B). 

Ultimately, the Shopify Fulfillment Network will utilize machine learning to improve supply chain economics and logistics. The company believes a significant portion of US GMV is addressable by the Shopify Fulfillment Network.  

This will help Shopify compete with Amazon as a value add for merchants to make deliveries more streamlined and cost-effective, and will also improve the customer experience for buyers by ensuring faster deliveries.       

Other tools and services that Shopify provides includes Shop Pay and Shop Email. Shop Pay allows customers to check out faster the next time they shop by saving the email address and credit card information. More than 60 million buyers opted-in at the end of Q3. Keep an eye on this for an indication of strength under-the-hood.

Shop Email lets subscription plans send emails through Shopify’s system rather than adding another vendor for email. 

Notable Partnerships including Social Media

Shopify has several major partnerships that differentiate its platform from competitors. One is Shopify’s sales channel integration with Instagram that allows merchants to sell directly to consumers through product tagging.  This allows shoppers to discover and purchase products all within the Instagram app, shortening the path to purchase.  

Instagram is a crucial component of a successful ecommerce marketing strategy as it is the 5th most popular app in the US. Shopify’s integration with Instagram allows merchants to market their products and sell those products directly through the app.  

Shopify is also partnered with Wal-Mart which was recently announced in June.  The deal opens Walmart's Marketplace to Shopify's small business sellers, giving these merchants access to sell their products on the 4th largest ecommerce marketplace in the US.  

Early indications show that Walmart Marketplace seller additions have increased 3x from January, demonstrating that Shopify merchants are eager to take advantage of this new opportunity. 

A third major partnership Shopify has is with Facebook, recently announced in May. In Facebook’s expansion into ecommerce, they partnered with Shopify to launch Facebook Shops. Facebook Shops is a free tool designed to help merchants create customized online storefronts for Facebook and Instagram.  This partnership allows Shopify merchants to control customization and merchandising for their storefronts inside Facebook and Instagram while managing their products, inventory, orders, and fulfillment directly from within Shopify.  

Shopify is also partnered with TikTok which was announced in October. Shopify’s new channel integration with TikTok allows sellers to connect their TikTok for Business account and feature in-feed shoppable video ads within Shopify.  

Shopify merchants can easily download the TikTok channel app from Shopify’s app store and begin to run and optimize TikTok marketing campaigns straight from the Shopify platform.  For now, the TikTok channel is available in the US, but sellers in other North American countries as well as Europe and Southeast Asia will be able to access the service in early 2021. 

TikTok was the 2nd most downloaded free app in 2020 with a surging young audience that ecommerce companies covet.  Shopify merchants are now able to tap into that global audience.    

These partnerships represent a tremendous value-add for merchants and prospective merchants, giving Shopify a big advantage over competitors. At this point, an entrepreneur looking to sell products online is likely to choose Shopify for the reach the company offers, as well as the tools Shopify is frequently releasing (SFN, Shop Pay, Shop Email, etc). 

Valuation 

SHOP continues to trade at a premium – 32x 2021 revenue, which has remained relatively stagnant over the last five months. In comparison to peers, many of which have seen their valuations continue to climb, Shopify has become more attractive.  

In July, SHOP briefly had the highest forward multiple among SaaS stocks. It is now outside the top 10. 

Here is the adjusted valuation EV/1-year forward revenue when adjusted for the 3-year growth rate. This helps to put the valuation in better perspective for Shopify.

Below is how Shopify compares on sales efficiency which measures the output of sales and marketing compare to annual recurring revenue. A ratio above 1 indicates a sustainable business model. 

Also, here is a comparison looking at consensus projections 2 years out. We feel that Shopify can easily clear these 2-year projections.

Analyst Statements:

SHOP has 14 buy/outperform recommendations, 18 hold recommendations, and 3 underperform/sell recommendations.  

Wedbush analyst Ygal Arounian raised the PT of Shopify to $1,300 from $998 in September. “We continue to like the short-term trends and Shopify’s position to capture them, but this call is a longer-term one in addition to those trends, driven by Shopify’s position to capture share of the total retail [addressable market] as it builds out its retail OS,” he wrote.

KeyBanc Capital Markets analyst Josh Beck, who has an overweight rating on the stock, raised the PT from $1,150 to $1,250, said the Shopify Fulfillment Network, which was launched last year, "is a full-fledged, tightly integrated fulfillment solution for Shopify merchants and includes order/inventory management solutions, branding and data controls, and access to scalable, flexible warehousing space to sell across multiple channels."

Morgan Stanley analyst Keith Weiss said “We see SHOP growing the merchant base from 1 million today to 4.6 million by 2030 (Subscription Solutions reaching $4.2 billion), while also expanding the take rate and further powering the Merchant Flywheel (GMV reaches $737B, Merchant Solutions grows to $21 billion),” he said.

12/4 – Cleveland Research Initiated Shopify with a Buy. The analyst expects Subscription Solutions and Merchant

Solutions to experience growth better than consensus expectations in FY22

12/2 – Susquehanna Initiates Shopify at a Hold stating, “The company’s two revenue units of Subscription Solutions and Merchant Solutions have different revenue drivers and can be compared to (mostly) pure-plays in the market. For each business unit, we use a price-to-sales growth valuation given SHOP's high revenue growth levels vs. peers. We value Subscription Solutions at $200 per share and Merchant Solutions at $750 per share."

12/1 – Credit Suisse Rates Shopify Neutral with $1,100 PT, stating “Our $1,100 target price and Neutral rating for SHOP is based on our DCF analysis and implies a 2021 EV/Revenue multiple of 33x. While we remain positive on SHOP given numerous LT drivers, including: the secular shift to eCommerce, Shopify Plus, International, and adoption of additional merchant services (such as Fulfillment) we see risk reward more balanced at these levels.” 11/19 – Jefferies Upgrades to Buy from Hold stating: "We have a greater appreciation for SHOP's ability to deliver robust growth for the next several years and reach ~$10B of revenue in 2025 powered by a structural pull forward in e-commerce activity and better monetization of gross margin value."

10/30 – Argus Rates Shopify Buy with $1,200 PT stating “Although SHOP has run up sharply year-to-date, the company has a strong runway for growth in the small to mid-sized merchant market, which is only lightly penetrated.”

 

Marvell and Inphi: Acquisition Analysis

Posted on by io-fund

Previous Analysis Referenced in this Report:

b69daa12-bd66-49dd-b78b-e97240767c9f_Marvell-and-Inphi-Acquisition-Analysis.pdf

Marvell and Inphi: Acquisition Analysis

It’s not every day that we see this level of consolidation across key players in the semiconductor industry.  

As stated in the AMD-Xilinx PDF, Marvell’s ASICs were becoming favored in 5G for various reasons, including power consumption and lower cost over time. The 5G product-market fit compliments Inphi’s recent trials with Verizon, which were deemed successful in September for supplying interconnects across its content delivery network. 

Many of my readers ask me about edge computing in relation to momentum stocks. Marvell-Inphi with customers like Samsung and Nokia on infrastructure and Verizon or AT&T for the network are at the center of edge computing. 

On that note, Marvell-Inphi promises to be a challenging acquisition to analyze. For one, it is not a common household name or even among the most recognized in semiconductor names (although we have already tackled both separately). For two, Marvell’s fundamentals do not show its potential – and this is key to understanding the opportunity. Three, Marvell is taking on a sizable debt load to acquire Inphi. Fourth, the market may take time to figure out the potential of this acquisition as the synergy is forward-looking.

The conclusion here is that we are very bullish and this PDF serves as our investment thesis.

The $10 Billion Strategy Behind Inphi

I’ve seen editorials written by some journalists believe that Nvidia “wants it all” as the Arm acquisition takes the GPU-leader outside of the data center for AI and ML workloads. 

Well, AMD-Xilinx and Marvell-Inphi are here to say that Nvidia will not “have it all.” Perhaps Nvidia will lead in general artificial intelligence use cases, and now edge devices with Arm if the acquisition is approved, but AMDXilinx will be a serious player in more complex AI and ML computing tasks, for example space and autonomous vehicles. These are two areas where Xilinx shows strong growth and AMD can lower the barrier to entry for developers. The exact use cases and demand for AMD-Xilinx would be hard to predict but will be greater than the two parts of owning CPUs and AI acceleration with FPGAs. 

However, for Marvell, the door is wide open on 5G and this has been confirmed by customers in the critical hour for 5G infrastructure. The Nokia Q3 2019 earnings call, which I have referred to many times, is not to be taken lightly as it sets the stage for an important shift in the chip of choice for major 5G players. Below, we see Intel’s ongoing stock price decline and AMD and Marvell’s positive price action.  

Due to the timing of this acquisition and the product road map for both Marvell and Inphi, I see this as a big move by Marvell to own 5G base stations and compute plus now photonics for edge computing (intricately linked to the 5G buildout). 

The majority of analysis written on this acquisition will discuss how it strengthens Marvell’s position for the data center due to silicon photonics as Marvell is mainly copper right now. Data centers are a core market to help stabilize Marvell against competitors but the growth opportunity for Marvell (and the reason I am investing) is for the lead Marvell currently has in 5G.

We have covered both Marvell and Inphi on this site with full-length reports. You can access them here:  

Marvell Technology: 2019 Analysis

Inphi: Premium Analysis

Acquisition Overview:

Last week, Marvell announced an agreement to acquire Inphi in a cash and stock transaction for $10 billion for a combined enterprise value of $40 billion. The transaction will generate an annual run-rate of $125 million within 18 months after the transaction closes. 

The deal is expected to be accretive to Marvell’s adjusted EPS by the end of the first year after the transaction closes with an anticipated date in the first half of 2021. Ownership will be 83% Marvell and 17% Inphi.

Inphi is expected to add more than $750 million in annual revenue with operating-EBITDA margins in the mid-30% range. The proforma gross margins will be an estimated 63.5%. 

Marvell will finance part of the transaction through JP Morgan Chase which will increase the debt on the balance sheet. The proposal is for $4 billion of new debt with $1.5 million in a committed term loan and $2.5 billion in a bridge loan commitment. Despite this, Marvell has stated in the Investors Presentation that the company plans to maintain the current dividend policy.

The new addressable market is placed at $23 billion with an acceleration in market growth of 12% CAGR. 

Source: Investor Presentation

Financials:

Marvell:

Marvell released Q2 results on August 27 with revenue growth of 11% year-over-year to $727.3 million. EPS was $0.21 on adjusted income of $140.4 million compared to $0.16 EPS on $110 million last year. 

For Q2, the company had cash of $831 million and debt of $1.4 billion. Free cash flow in Q2 was at $205.2 million. The company stated Q3 revenue would be $750 million +/- 5%. The next earnings release will be on December 3rd.

TTM revenue was $2.80 billion with net income of $1.41 billion and EPS of $2.09.

Inphi:

Inphi released results on October 29th. Revenue grew by 92% year-over-year to $180.7 million. Adjusted EPS was $0.88 on adjusted income of $47.9 million compared to $0.45 EPS on $21.5 million last year. 

Management forecasted Q4 revenue to be in the range of $185 million to $189 million. Adjusted net income in the range of $47.2 million to $50.6 million at $0.85-$0.91 EPS.

TTM revenue was $598.1 million with an adjusted loss of $61 million for EPS of ($1.29).

Inphi had cash and marketable securities of $223 million and debt of $508 million as of September 30th. Free cash flow in Q3 of $13.4 million. 

More on Valuation …  

The acquisition to acquire Inphi will be paid in 60% stock, with the remaining 40% in cash.  The transaction will include $66 in cash and 2.323 shares of the combined company for current Inphi shareholders.  

The cash and stock deal will value Inphi at approximately $10B at its purchase price. Marvell shareholders will have an 83% stake in the combined company and Inphi shareholders will command a 17% stake on a fully-diluted basis.  

Marvell plans to close the acquisition in H2 2021, financing the deal with current cash on hand and obtained debt financing. At the $10B purchase price, Marvell will be paying 12.4x 2021 revenue to acquire Inphi. This valuation is on the steeper side, but Inphi recorded 92% YoY sales growth in its most recent quarter compared to just 11% growth for Marvell. In this sense, the deal will be accretive to revenue growth, gross margins, and operating margins.  

On a Pro Forma basis, the acquisition of Inphi will improve Marvell’s growth rate, gross margin, operating margin, and EBITDA margin. The acquisition will also double Marvell's number of $100M+ cloud & networking customers to 8.  

Marvell currently trades at 7.4x 2021 revenue and the acquisition of Inphi to drive higher growth should eventually lead to a higher multiple. As stated under Financials, the deal is expected to expand Marvell’s TAM to $23B in 2023 and accelerate market growth to 12% CAGR.  

1-year returns for Inphi and Marvell:

1-year forward price-to-sales across semiconductors:

What Analysts Have to Say:

10/30: Marvell upgraded to Buy from Hold at Craig-Hallum Craig-Hallum analyst Christian Schwab upgraded Marvell (MRVL) to Buy from Hold with a price target of $48, up from $44 following the company's announcement to acquire Inphi (IPHI). Schwab agrees with management that the acquisition of Inphi will help transform Marvell into a faster growing cloud and 5G player. The acquisition improves Marvell's long term growth outlook to 12%16%, from 10%-15% alone, Schwab says, adding that with synergies, the combined company offers long-term investors an attractive long-term model.

10/29: Morgan Stanley downgrades Inphi, raises Marvell price target after takeover deal.  As previously reported, Morgan Stanley analyst Joseph Moore downgraded Inphi (IPHI) to Equal Weight from Overweight with a price target of $159, down from $162, following Marvell's (MRVL) announcement of a cash and stock deal to acquire the company. Moore, who thinks the two businesses "fit together nicely," raised his price target on Marvell shares to $40 from $37 following the deal announcement. He keeps an Equal Weight rating on Marvell shares, stating that although the company has used M&A to put themselves in a better position, its legacy Marvell businesses are "struggling."

10/20: Keybanc analyst John Vinh resumed Marvell coverage with overweight rating and $55 price target due to $1 billion 5G revenue potential stating "MRVL is one of the best-positioned companies to benefit from the inflection in 5G infrastructure deployments." The analyst cites 35%+ operating margins and believes Marvell will achieve over $1 billion in 5G revenues by FY23-24.

Note: this analyst is guiding up from $600M in annual 5G revenue that Marvell’s management guided previously.  

Fitch: In addition to the analyst comments, Fitch Ratings revised Marvell from Positive to Stable with a credit rating of BBB-. The outlook takes into consideration that the combined revenue growth “may fall short of forecasts, and provide insufficient profitability and cash flow to return elevated leverage metrics.”  

Despite Fitch expecting strong design wins and annualization of acquisitions during fiscal 2020 that drives the FCF margin into the teens from 4.2%, the debt to operating EBITDA will nearly double from 1.9X to 3.5X pro forma. 

Fitch believes Marvell is stronger in market position than both Micron and Broadcom and is in-line with NXP. The key assumptions include strong design wins for Marvell especially in networking, driving growth acceleration to mid-to-high single digits compared to the overall semiconductor industry growing at low-single digits in the forecast period. Fitch also forecasts operating EBITDA and cash flow margins to expand. The company also forecasts shareholder returns to be “flattish” until debt-to-operating EBITDA returns to 2X. 

Patrick Moorhead, a semiconductor specialist for Moor insights, has positive things to say about the data center opportunity with Marvell’s strong positioning in copper networking and now adding Inphi’s silicon photonics for networking. He references Marvell’s DPU and storage networking as a solid synergy with Inphi’s photonics interconnects. 

Product Overview:

Inphi will add silicon photonics to Marvell’s copper-based networking. Both companies are in the networking layer with Inphi stronger on data centers and Marvell stronger in 5G (competitively speaking). Together, they will expand the footprint in both the data center and 5G arenas. 

Some analysts critiqued AMD as having less-than-desirable M&A history. Marvell, on the other hand, pushed into 5G very successfully following the Cavium acquisition. This leads many analysts to believe the Marvell-Inphi acquisition will follow the same path to strengthen Marvell’s positioning in the data center.  

However, as stated, I believe the impetus could be Marvell’s 5G and edge networking strategy. Networks like Verizon badly need Inphi’s interconnects to drive high-speed connections between its content delivery network servers, which are expanding their footprint for 5G. The data center is an all-out battleground with lots of big tech throwing around muscle. However, specifically in 5G, Inphi can help solidify Marvell’s lead and perhaps help dig a moat for Marvell’s ASICs.  

When it comes to data center networking, however, there is no moat of any kind to be had. For example, Mellanox is a competitor on networking ethernet and has the 800-pound weight of Nvidia behind the company. Therefore, did Marvell take on a 3.5X debt-to-EBITDA ratio to be a small fish in a big pond? I don’t think so when Marvell can be the big fish in the 5G pond. 

Data Center:

We discussed Inphi at length in this PDF but will summarize a few points below. You can access the Inphi full-length report here. e Inphi full-length report here.

Inphi is the leader in PAM4 electro-optics. This market has seen tailwinds due to data center spending and the need for more bandwidth from COVID’s streaming and traffic usage. As stated in the PDF, we expected Inphi’s growth to continue on an investable trajectory due to its aggressive product road map for fiber optics that connect both short distances (PAM4 DSP) and long distances (coherent DSP). 

Regarding the product road map, Inphi currently supplies 400-gigabit PAM4 pluggables that are made with a 7nm process compared to a 16 nm process which reduces power consumption. Artificial intelligence and data center switching will drive the demand for 800-gigabit PAM4 modules to increase the speed of input-output and to process the data flows. Inphi announced the industry’s first 800-gigabit client-side pluggable modules earlier this year. 

Part of the 2021 story for Inphi is the release of the Spica DSP (the aforementioned 800-gigabit PAM4) which is expected to be deployed in volume. This will double the throughput (bandwidth) due to an 8x100Gpbs optical transceiver. The main application for the 2021 story is the transition of optical connectivity inside and between AI clusters. 

COLORZ II is the other half to the 2021 story for Inphi as the silicon photonics technology increases metro-access bandwidth to facilitate edge computing through a “network fabric.” COLORZ allows regional data centers to be linked together in the same metro region to function as one single mega data center. Verizon recently completed an important trial using Inphi’s COLORZ II optics.    

In March of 2019, Marvell released a new Ethernet switch solution for edge and private data centers. The solution uses compostable infrastructure, which allows for compute, storage and networking to be managed by software and removes the need to configure by hardware. This is one example of how Inphi and Marvell can complement one another. 

To elaborate more on PAM4-based connectivity …  

Hyperscalers are going through an ongoing upgrade cycle that requires high bandwidth and port density. PAM4 connects networking ASICs and machines, like servers and AI machines. Digital-based PAM4 uses analog-to-digital converters to clean up the signal in the digital domain before converting it back to analog to transmit. This allows developers to configure various deployment scenarios via software. This software configurability is a compatible match with Marvell’s ASICs.  

Semiconductor experts will tell you that silicon photonics connecting hyperscalers and network carriers are the future. This is the primary architecture for edge computing — hyperscalers and 5G networks connected regionally with solutions like what Inphi offers.

We mentioned in the PDF that Microsoft is a large customer for Inphi’s COLORZ DCI product including for global build-outs related to the Pentagon contract. I’ll place the quote here from the Inphi PDF – which should be strengthened under Marvell: 

“As I discussed on our prior earnings call, we're still consistently expecting our ZR solution to go to production in the first half of 2021 and ramp into volume starting in the mid-2021. And so you should expect the second half of 2021 to be a significant revenue driver coming from the 400-gig ZR solution at multiple cloud data centers as well as telecom operators.” And so you should expect the second half of 2021 to be a significant revenue driver coming from the 400-gig ZR solution at multiple cloud data centers as well as telecom operators.”  

Marvell supplies the data center with Thunder X2 Arm-based processors which provides the computational performance of an Arm server with I/O connectivity, memory bandwidth and capacity. Nvidia partnered with Marvell to port the CUDA-X AI libraries and tools to the platform. 

Marvell also offers DPUs, which require an analysis of their own as Nvidia plans to compete here. Briefly, DPUs stand for Data Processing Unit and will become more commonplace in the future as they move data around the  data center. Its roots are a system-on-a-chip (SoC) and is software programmable. Marvell will become a major player here and this is a future bull thesis for Marvell in addition to the current thesis outlined here.

5G Infrastructure:

As stated in the Investors Presentation, Marvell leads with base station compute. This sets the bandwidth bar and cadence while Inphi adds the fronthaul and backhaul interconnect. 

Marvell supplies components for 5G base stations with Nokia and Samsung as customers. Although Marvell has exposure to Huawei, these two suppliers can make up for this exposure in time. 

We have covered ASICs in detail in both the Marvell PDF and the AMD-Xilinx PDF. ASICs stands for applicationspecific integrated circuit and are customized to perform one very specific function. Recently, 5G infrastructure has favored ASICs over FPGAs – which is key to the success that Marvell has seen in 2020 and beyond. One driving factor is that ASICs cost less over time while rivaling FPGAs on efficiency and power.  

The main point here is that Marvell has a serious opportunity to be the front-runner in 5G infrastructure. The 5G network will soon rival cloud infrastructure on data and processing, and therefore, I believe quite a bit of Marvell’s strategy with Inphi resides in the interconnects increasing the speed of the 5G network and reducing capex by removing steps in the network layer. 

As stated in the Marvell PDF, the company is attempting to offer end-to-end network infrastructure with baseband DSPs, Arm multi-core SoCs (system on chips), purpose- built hardware accelerators, Ethernet connectivity engines and system-level security solutions. 

Although Marvell aims to offer specific-use ASICs and semi-custom ASICs, the 5G platform that Marvell offers will be adaptable for many use cases to expand on any ASIC limitations. Adding Inphi to this will strengthen the endto-end network infrastructure offering by Marvell. 

This matters when you analyze supply and demand. To me (as an investor), the data center with DPUs/Liquid IO, Thunder X Arm-based platform and now Inphi’s silicon photonics are the core business but the demand for 5G and edge networking are the tailwind and growth opportunity that I am primarily keen on for 2021. With that said, I don’t want to overlook Marvell’s potential with DPUs in 2022-ish. 

With Inphi, Marvell has the potential to own edge networking with very few competitors on ASICs and silicon photonics in this arena whereas the data center is highly competitive. Inphi’s solutions connect edge switches (and core switches) over both short and long distances (the long distances being more important for 5G), which along with Marvell’s lead on base stations, is a strong combination for the 5G build-out.

AMD-Xilinx Acquisition: Analysis

Posted on by io-fund

a947dd97-abc6-4aea-8ad9-4fcf40b83950_AMD-Xilinx-Acquisition-Analysis.pdf

AMD-Xilinx Acquisition: Analysis

You can access my original analysis on Xilinx here.

 It would be impossible to look at the AMD-Xilinx acquisition without doing an in-depth breakdown of FPGAs. The chips are powerful yet are challenging to program, and therefore, adoption has been slower than originally forecasted around 2016-2018.

 Around the time that I began writing on Nvidia, I was also covering Xilinx. At the time, the company was very promising as Microsoft was adopting FPGAs and the chips were slated to be a front-runner for 5G networks. This began to change, however, when Nokia announced they were moving away from Intel-Altera’s FPGAs after the poor results discussed in Q3 2019. 

Below, I compare GPUs with FPGAs and ASICs to help break down the potential strengths for the AMD-Xilinx acquisition, especially why a predominantly CPU-company would acquire a FPGA-company. We discuss the headwinds for FPGAs and Xilinx and how AMD could potentially alleviate these. 

For our purposes, we will call these chips data accelerator chips or AI chips. As you know, GPUs, ASICs/SoCs and FPGAs have many other uses (gaming, PCs, smartphones, electronics), but as tech growth investors, we are mainly interested in modern data centers and cloud IaaS infrastructure that can handle the increase of networking bandwidth and optimization of AI workloads. By accelerating the computing platform, these chips can power machine learning, deep learning and high-performance computing workloads. The leading chips will have quite the addressable market to capture and we want to be there when this happens.

The data center accelerator market was forecast to grow 49.47% CAGR between 2018-2023 from $1.4 billion in 2017 to $21.2 billion in 2023. At the time of the forecast, FPGAs were forecast to be the leading chip in terms of growth but this has not materialized (we cover this below). According to a more recent report in May of 2020, the global accelerator market will reach $38.9 billion with GPUs growing at a compounded rate of 47.1% 

The growing need for cloud resources is driving a healthy market for hyperscale data centers with an expected increase of 60% between 2016 and 2021. We are also seeing substantial investments in next-generation data centers due to the pandemic, such as Alibaba’s announcement to invest RMB 200 billion in core technologies and future-oriented data centers. 

When it comes to processors, the question is which chip will answer the demand. This is a question that has not been fully answered yet although GPUs are almost universal for general AI due to the ease of development for software engineers, ASICs are gaining popularity with Google and others who seek application-specific  advantages, and FPGAs are continually forecast to lead the growth but sees roadblocks in the learning curve for hardware configuration.

The competition between FPGAs and ASICs could also be alleviated by combining an Arm-based processor with an FPGA. The Zynq-7000 SoC allows for dedicated hardware blocs to split-up non-critical tasks from critical tasks. I imagine AMD fully comprehends the strengths and weaknesses of FPGAs and is set to solve the developer adoption uptake should the acquisition go through.

Overview of GPUs, FPGAs and ASICs:

General Definitions:

GPU: graphics processing unit with a highly parallel structure compared to CPUs. When training deep learning neural networks, GPUs are up to 250 times faster than CPUs. When compared to FPGAs and ASICs, GPUs continue to lead due to the learning curve for software developers and not requiring changes to existing code. Notably, GPUs originated as graphics cards used in gaming but now lead in general AI processors. Nvidia is the major GPU player.

FPGA: field-programmable gate arrays that can be programmed electronically “in the field” post-manufacturing after the chip leaves the foundry. The chip is made up of configurable logic blocks and programmable interconnects that allow for the chips to be reprogrammed. FPGAs are preferred for prototyping or for instances where the design may evolve. Designing with FPGAs are low cost but can become expensive over time. Intel and Xilinx are the major FPGA players.

A few points to note:

•       FPGAs increase real-time inference compared to CPUs and reduce latency compared to GPUs. 

•       FPGAs chips are also cheaper and also faster to bring to market than ASICs (although this is not an advantage for high production volumes — more below including a visualization of this). 

•       FPGAs are unique from ASICs and GPUs due to being customizable post-manufacturing. The “fieldprogrammable” piece is unique to FPGAs.

•       There are new products being released all of the time that aim to get an advantage between ASICs and FPGAs, but for the most part, these two are similar in latency and somewhat similar in power efficiency except ASICs technically lead here due to being application-specific. The design needs will often determine the decision between ASICs and FPGAs and the production volume. Notably, FPGAs will often be used for prototyping before switching to ASICs.

•       The drawback to FPGAs is the complexity in programming as software engineers are not as familiar with hardware-specific languages. 

ASIC: application-specific integrated circuit customized for a specific application. If an ASIC has more than one processor core and/or combines various computer components, then it’s considered an SoC. You’ll hear these words used interchangeably (ASIC/SoC) on earnings calls.

ASICs are preferred for large production volumes as the cost for design can be in the millions of dollars but then averages out over time.

•       Google is the perfect example of a company that uses ASICs as the company has many servers dedicated to solving specific problems.  

•       These chips, including Google’s TPU, can be designed for maximum efficiency by shifting the optimization and resource assignments to the CPU with the TPU/ASIC acting as a coprocessor for vertical instructions. 

•       Some companies may find ASICs to be too rigid and fixed. As of recently, Microsoft for example has preferred FPGAs as there is more flexibility in the design. 

Expanding on these Definitions:

For most design purposes, FPGAs (Xilinx) are considered superior to GPUs (Nvidia) when it comes to power efficiency. They offer a higher amount of on-chip cache memory to help reduce the bottlenecks from external memory, and are flexible enough to be reconfigured for various data types, such as binary, ternary, and custom data types, whereas GPUs must be modified at the vendor level. With that said, Nvidia will likely leverage Mellanox to speed up GPUs and close the gap on latency performance with FPGAs and ASICs.  

GPUs are programmed at the foundry and are restricted by Single Instruction Multiple Thread (SIMT), which provides an advantage over CPUs, but can also result in lower performance efficiency when enough parallels are not found for the workload. 

Despite FPGAs resulting in faster high-performance computing, they are harder to program due to hardware circuit configurations compared to GPUs for machine learning, which require less engineering resources due to being programmed through software. FPGAs are generally run with high-level languages such as VHDL or Verilog. GPUs are also more cost efficient. 

Source: GPU vs FPGA Performance Comparison

ASICs rival FPGAs on efficiency and power (and often beats FPGAs in these areas for specific workloads) and this is one reason why we’ve seen ASICs become more popular in recent years. The difference between these two is reconfigurability. This is a major advantage for end applications and workloads as the chip can be programmed “in the field” after it’s left the foundry. As discussed, the reconfigurability is what the acronym FPGA stands for – Field-programmable gate array. You can program the chip to be a microprocessor, graphics card or encryption unit.

ASICS are Application-specific Integrated Circuits and are designed to be application-specific for one purpose only. The circuitry cannot be changed because it is made up of permanent circuitry. You use ASICs every day in your smartphone, laptop and television. 

ASICs have high “non-recurring engineering” costs (NRE) and are more expensive at the onset.

However, FPGAs come at an increased cost after a certain time period and have limited analog functionality. Therefore, FPGAs actually cost more overall because the cost of ASICs becomes lower with higher production. 

FPGAs have limited analog functionality, such as Bluetooth and WiFi. This is why ASICs are the chosen chip for electronic devices. “Low power” is also a major advantage to ASICs which makes the chips ideal for specific battery-operated devices.

Here is a picture I provided in Marvell’s PDF. What this picture is showing is that it costs millions to begin with ASICs and less than $5000 to begin with FPGAs. However, over time, the cost of FPGAs exceeds that of ASICs.

FPGAs are used more for prototyping due to the reconfigurability and due to ASICs requiring more during the design process. ASICs take months longer to implement due to the manufacturing cycle, and as mentioned above, cost quite a bit at the onset. The R&D cycle for ASICs can become problematic when companies are competing neck-to-neck for market share. 

FPGAs in Real Use Cases

We want to be clear that we are ultimately bullish on the AMD-Xilinx acquisition as we believe AMD has what it takes to bridge FPGAs. In the use cases below, you will see there are some mixed results with FPGAs competitively which is likely leading to Xilinx looking at an offer. 

The Nvidia-Mellanox-Arm combination is a looming threat, as well, and if AMD can make FPGAs more accessible, then this will provide AMD with critical market share in data center acceleration/AI chips without having to compete with Nvidia head-on with GPUs.

Xilinx’s Segments

ABC: Automotive, Broadcast and Consumer

AIT: Aerospace and Defense, Industrial, Test and Measurement

DCG: Data Center Group

ISM: Industrial, Scientific & Medical

TME: Test, Measurement & Emulation

WWG: Wired and Wireless Group

Aerospace/Defense and Automotive:

Xilinx leads in aerospace/defense and automotive. These are industries where FPGAs have a clear advantage. 

In May, Xilinx announced the first 20-nanometer (nm) space-grade FPGA to deliver machine-learning for space applications. This allows satellites to update in real-time, deliver video-on-demand, and perform compute “onthe-fly” to process complex algorithms.

Although autonomous driving is very new and the market is wide open, FPGAs beat GPUs in many regards for this application. This is likely part of Intel’s motivation in buying Altera. This space is constantly evolving but here is a recent quote from a product manager in the field, “Autonomous vehicles rely a great deal on machine learning, and every new vehicle in every new situation may contribute to the shared knowledge base,” said Tobias Welp, product manager at OneSpin Solutions. 

FPGAs offer flexibility for many applications because both the hardware and the software can be reprogrammed. Reprogramming FPGAs when knowledge or algorithms are enhanced has the potential to keep autonomous driving in a state of continuous improvement.”

But there are tradeoffs. Verification in this case becomes a continuous process.“Every time the design changes, the full verification suite (static, formal, and simulation) must be run,” Welp said. “Formal equivalence checking also must be run to ensure that the FPGAs have no implementation errors, security vulnerabilities, or lurking hardware Trojans. Finally, the reprogrammed FPGAs must be extensively validated on test vehicles before updates are sent to the field.”

In regards to ASICs and how AVs are in constant flux, here is what Welp stated:

“When we started in this space and we were talking to automotive customers a year ago, everybody was going straight to Level 4 and Level 5 autonomous,” said Geoff Tate, CEO of Flex Logix. “They were all going to do their own custom chips. They were all looking to license IP for inference acceleration. That’s changed dramatically. I don’t know of anybody who’s looking to do an ASIC in the automotive space right now. Everybody that was telling us they’re going do their own chips has changed to buying off-the-shelf chips, and almost all the major car companies are focused more on driver assist.”

Therefore, we see that FPGAs have a serious shot here at being the chosen chip for AV development. 

Wired and Wireless Group:

Xilinx saw a significant slowdown in the wired and wireless group in the previous quarter due to supplying Huawei but some of this growth has returned. The Nokia-Intel FPGA flop in November 2019 has hurt the prospects for using FPGAs in 5G with Nokia turning more towards ASICs/Marvell. 

Originally, Nokia stated that FPGAs seemed like the best choice because 5G standards were not developed yet and the flexibility was key. However, as we’ve illustrated in this analysis and covered in the Marvell PDF, ASICs cost less over time and this is becoming a priority for Nokia to protect their bottom line on the already-expensive 5G infrastructure overhaul. In an earnings call, Nokia’s CEO lamented that FPGAs were more costly than anticipated.

The CEO discusses the situation in the Q3 2019 transcript and also the Q4 2019 transcript. Here are some excerpts:

So, what’s happening right now is when he moved to 5G, we chose FPGA-based products. They give you flexibility, they give you time to market advantage, but then they’re expensive. And so, what we’re doing is, we’re moving to equity SoC-based products, which we’ll progressively start shipping during 2020. -Q3 2019 earnings call

Like I said earlier, I mean, the System on Chip strategy has been put into motion already a while ago, diversified our supplier base. We are increasing the investments purely because we want to increase even more the SoC penetration in our products and continue that. And of course, we know how to do System on Chip. Yes, we started with FPGA with 5G because it’s gave us that time to market catch-up advantage, but we do that in much of our portfolio with FP4 and PSE-3. So, we’re just replicating that in mobile. –Q3 2019 earnings call

And Tal, on the question regarding to System on Chip, so we are transitioning from FPGA to System on Chip and this is the metric that will give you an update and this is that we got to 10% of the 5G product by ReefShark System on Chip portfolio. We started ramping up volumes and that will get to 35% by the end of this year or greater than 35% and then 70% by the end of ‘21 and then this whole thing will be complete about 100% in 2022.  -Q4 2019 earnings call, when an analyst asked for an update in moving from FPGA to SoC.

Despite Nokia’s decision, FPGA-proponents for 5G will argue that these chips are ideal for network infrastructure to prevent vendor lock-in and for futureproofing the network due to the ability to reprogram. In this way, FPGAs could reduce long-term operating expenses and reduce total cost of ownership. 

You can access a full list of Xilinx’s segments here and how the company serves each of these markets, including Industrial, Medical and Video Processing. 

High-Performance Supercomputing

FPGAs and high-performance computing (HPC) is an important part of data center acceleration that can benefit from easier programming options. This is because FPGAs are known to be pliable when involving interconnects and this is valuable for supercomputers. 

This will not replace GPUs rather it will serve applications with heavy computations. FPGAs can optimize purposebuilt architecture and there is a high probability we will see the supercomputers of the future powered by a combination of CPUs/GPUs and FPGAs. As of now, Nvidia is the undisputed leader in the data center. In fact, as of May 2019, Nvidia was employed in 97.4% of cloud IaaS compute instance types with dedicated accelerators with combined Xilinx and Intel at 1.6%. 

Liftr Insights shows a slightly better picture for FPGAs at about 5% for Xilinx and a little under 5% for Intel across Alibaba, AWS and Azure in March of 2020. The analysis firm puts Nvidia at 86% in this study.  

Source: EETimes.com

In 2015, Intel acquired Altera in an all-cash transaction worth $16.7 billion. Altera was second to Xilinx as a leading provider of FPGAs. This acquisition occurred during the years that FPGAs were favored for data center growth over its counterparts yet Intel has not been able to penetrate data centers with this acquisition as originally estimated. This could be for two reasons: (1) FPGAs are more advanced and will rise in popularity after general AI is exhausted and more complexity is required by the market (2) ASICs are superior to FPGAs and are meeting the market demand with customizable that was once assumed would be met by field-programmable.

In 2018, Microsoft announced it would be phasing out Intel-Altera FPGAs for over half its servers in favor of Xilinx’s processors. This was confirmed again in October of 2019 by Microsoft at a Xilinx conference although no official update for two years now. At the time, I guessed this move by Microsoft was due to AI engineers preferring Xilinx over Intel, which I still believe to be the case when FPGAs are being considered. 

It should be noted that AMD is already solid in the supercomputer category with Epyc CPUs powering many of the supercomputers in the top 500 list. Here’s a great write-up from Moor Insights on AMD’s partnership with HP’s supercomputer manufacturer Cray. The partnership is expected to launch the second Exascale system in the United States costing over $600 million. The Frontier Supercomputer is expected to put AMD on the map for AI accelerators and as a competitor to Nvidia.

Constantly Evolving:

Xilinx’s SDAccel IDE has attempted to provide software developers the same experience no matter the cloud provider (AWS, Alibaba, etc). The goal was to copy Nvidia’s CUDA platform to enable a larger ecosystem. The tool platform is called “Vitis” and is designed to provide accessibility for hardware developers and software developers. The first release of SDAccel supported deep learning frameworks, such as Caffe, MXNet and TensorFlow through Python APIs. 

AMD backed Xilinx around this time for the Alveo model launch for machine learning, which was the first supported environment on Xilinx’s SDAccel IDE. Alveo was dubbed “the world’s fastest data center and accelerator cards” to increase real-time inference throughput by 20X compared to CPUs and 3X compared to GPUs. AMD offers Radeon Instinct accelerator cards built on Vega 7nm GPUs.

Xilinx also launched the “Versal” advanced computing acceleration platform. This is a fully softwareprogrammable heterogeneous compute platform that improves performance 20X over current FPGAs and 100X over CPUs (per Xilinx’s white paper). The SoC-like chips combine CPU cores, programmable logic and ASIC elements. This was around the time that Xilinx stopped referring to itself as a FPGA company and instead as a platform company with a focus on “whole application acceleration.”   

The Versal series includes AI engines in the device series, such as Versal AI Edge, Versal AI Core and Versal AI RF. Xilinx aims to not only accelerate the AI portion of the task but to combine AI engines with DSP engines and also adaptive engines to accelerate the entire task, such as beamforming for 5G radar wireless communications or for smart controllers for storage systems in data centers. 

Financials:

Advanced Micro Devices reported Q2 results on July 28th, beating comfortably on both the top and bottom lines.  Revenue came in at $1.93B (+26% YoY), representing a beat of $70M above consensus estimates.  Management attributed the revenue growth primarily to higher Computing and Graphics segment revenue.  

Non-GAAP EPS grew 333% YoY to $0.18 per share in the quarter.  Gross margin increased 3 percentage points YoY to 44%, primarily driven by Ryzen™ and EPYC™ processor sales.  For the 3rd quarter and FY, management is calling for an acceleration of revenue growth to 42% YoY and 32% for FY 2020. 

Xilinx reported Fiscal Q1 results on July 30th, reporting a slight miss on the top line and a slight beat on the bottom line.  Revenue decelerated 14% YoY to just under $727M, missing consensus estimates by about $1M.  Non-GAAP EPS decelerated 33% YoY to $0.65 per share, beating the consensus by half a cent.  The company made no adjustments to its outlook and expects to record $755M in revenue in its next quarter.

At a listed acquisition price of $30B, Xilinx would be valued at 10x sales.  Xilinx has 244.3M shares outstanding and the company is projected to deliver $3.54 in EPS in FY 2022, meaning they are on pace for $864M in net income in 2022.  

At an acquisition price of $30B, AMD would need to issue 361M shares in an all-stock deal for Xilinx.  In 2022, AMD is projected to deliver $2.20 in EPS.  With $1.17B shares outstanding, the company is on pace for approximately $2.6B in net income for FY 2022.  

In order for the deal to be accretive for AMD, the Xilinx business has to generate approximately $800M in 2022 annual net income. The Xilinx standalone business is projected to generate $864M in annual profits in 2022.  

If the acquisition price exceeds $30B, an all-stock deal may become dilutive.  At an acquisition price of $35B, AMD would need to issue 422M shares to acquire Xilinx. This would require the Xilinx business to generate $1B in 2022 net income for the deal to be accretive.  

Conclusion: 

On a technical level, workloads like machine learning, AI and 5G can benefit from a chip that is field-programmable and bridges the gap with customized chips that take too long to bring-to-market. Xilinx’s FPGAs allow algorithms to be adjusted for critical technologies and R&D processes. 

This space is constantly evolving. FPGAs also have SOC-chips that Xilinx calls “all programmable SOCs.” Hard-silicon processor cores are being combined with FPGAs to compete with ASICs. In this case, an ARM Cortex A9 and Xilinx Zynq become dedicated hardware blocs to split up non-critical tasks from tasks requiring high-speed acceleration. 

The question is can AMD do this for Xilinx versus Nvidia in key markets:

When it comes to efficiency, AMD is an unstoppable powerhouse. There are leaks that the 7nm Milan release will achieve a higher clock rate with performance increases of 10-20% between generations. This is virtually unheard of.

Lisa Su brought AMD from a $3 billion market cap to a $100 billion market cap in 5 years. As of now, we see Xilinx spread across too many segments and lacking focus. If AMD can popularize a platform for Xilinx/FPGAs that competes with CUDA and chooses the segments where FPGAs have the most promise, then we could see FPGAs finally live up to their true potential. 

AMD under Lisa Su as CEO has risen 2000% over the past 5 years

I believe there will be quite a few negative opinions about AMD’s move with Xilinx. Analysts will say Nvidia has the undisputed throne, there is no overlap with AMD-Xilinx, that the acquisition is too expensive and dilutes shareholder value and that AMD does not have enough successful acquisitions under its belt to gamble on this combination. 

Others may not see why AMD would acquire Xilinx, but I’ve been waiting for something to happen with FPGAs and this very well could be it. We had discussed AMD innovating past Intel prior to this happening in July. Our premium members were pretty happy about that call. On a similar note, I’ve been tracking Xilinx closely, waiting for a breakthrough of some sort. 

Of course, I am a mega Nvidia bull and this will not change. This will not be a winner-takes-all market, rather a market that compounds quickly for the top handful of companies. There are a few CEOs I won’t be against and Lisa Su is one of them. 

Grab some popcorn because it’s going to get pretty exciting between 2022-2025 as Su and Huang dual it out. My prediction is they will both take enough market share for my premium subs to remember these calls as some of my very best.

Amwell: IPO Analysis

Posted on by io-fund

5b24e693-08e2-4c1c-9f3a-b33b510925c4_Amwell-IPO-Analysis.pdf

Amwell: IPO Analysis

Introduction:

Please reference the Telehealth PDF which discusses why we are bullish on the telehealth trend and reviews three additional companies in the space: Teladoc, Livongo and Veeva. Telehealth PDF which discusses why we are bullish on the telehealth trend and reviews three additional companies in the space: Teladoc, Livongo and Veeva.

We are very interested in the Amwell IPO and will attempt to initiate on opening day. Please see the valuation section for the range we are targeting. 

Amwell’s mobile and telehealth platform connects patients with doctors over video and handles administration. As of June 30th, 2020, the company powers the digital care programs of 55 health plans – which equates to 36,000 employees and 80 million insured. The company also works with 150 of the nation’s largest health systems, encompassing more than 2,000 hospitals. 

Amwell’s growth has accelerated substantially from 31% year-over-year in 2019 to 77% year-over-year in H1 2020. Net losses increased in both the fiscal year and the first six months of 2020. We review this in more detail below.

There are three classes of shareholders with Class A common stock, Class B held by the founders at 51% of voting power and Class C common stock. Google Cloud has agreed to purchase $100 million of the Class C common stock in a private placement. 

There was an announcement in late August announcing Google Cloud’s partnership with Amwell. The announcement discusses how Google Cloud plans to merge AI with health care, including digital waiting rooms, language translations, offloading tasks from the provider to conversational AI and to help manage chronic conditions. The announcement is worth a read.  

Telehealth is a microtrend we covered in June with an increase of 3,000 to 4,000% in telehealth patient volume. Facilities such as NYU Langone Health saw 7,000 video visits per day or about 100,000 video visits in April compared to 300 visits per month pre-pandemic. According to American Telemed, three-quarters of U.S. hospitals are using digital technology to reach their patients via video, audio, chat, or email. You can read more here in the Telehealth PDF.  

According to Amwell’s S-1 filing, healthcare expenditures in the United States more than doubled from $1.3 trillion to $3.6 trillion from 2000 to 2018. In 2019, the average employer health insurance was $20,576 representing an increase of 54% over the last decade. Meanwhile, health system operating margins declined by 39% as margins were impacted by reimbursement pressures and increased cost structures. 

Telehealth addresses these issues and mitigates rising costs. An urgent care telehealth visits costs $79 before insurance compared to a visit cost of up to $150 for urgent care and $1,389 for the emergency room plus any additional services rendered on-site. Some plans will offer telehealth visits at $0 to avoid the high cost of these in-person visits.

The temporary federal policy changes that allowed health care providers to expand telehealth and mHealth for the covid-19 emergency had an expiration date that was extended by HHS secretary Alex Azar from July of 2020 to mid-October. 

There is pressure from all sides to approve a dozen or more telehealth bills that would make telehealth coverage permanent and/or to expand coverage for Medicare. For instance, the Telehealth Modernization Act, the CONNECT for Health Act, Protecting Access to Post COVID-19 Telehealth Act, and many more.  According to reports in July, there were 340 health care organizations that published an open letter asking Congress to enact permanent changes to telemedicine regulations. The pressure is bi-partisan. 

Anthem is a large client for Amwell and accounted for 23% of 2019 revenue. The risk of high concentration in one customer is muted as Anthem owns 3% of Amwell’s outstanding shares. Furthermore, AMG clinical visits represented 51% of H1 2020 revenue (see below).

We expect the telehealth trend to continue being a dominant trend this year and into next year due to patient demand, easing government regulations around telehealth coverage, and from more doctors and health care providers seeking to reach as many patients as possible as quickly as possible. 

Amwell Overview:

The Amwell platform is a complete “digital care delivery solution” that provides tools to enable new models of care for patients and members. Amwell’s primary function is to facilitate consultations between patients and providers.

The company sells the Amwell platform on a subscription basis. In order to support the Amwell Platform, the company offers professional services on a fee-for-service basis and a range of patient and provider access Carepoints that support hospital and home use cases. 

The company’s customers often deploy telemedicine through a variety of proprietary Carepoints, which are medical carts and kiosks designed for various clinical and community settings. This is digitized approach is likely why Google is interested as these access points range across desktop, mobile devices, console kiosks, enclosed kiosks, polycom-codec based carts and Cisco-codec based carts (pictured below).

Module offerings include Acute Behavioral Health, Urgent Care, Speciality Consult, School Health, Telestroke, Behavioral Health Therapy, Retail Health, Triage in the ED and Dialysis.

The company offers software development kits (SDKs) and APIs to integrate telehealth digitally and to embed into workflows. This includes web and mobile apps, 24-hour nurse and customer support, electronic health record (EHR) systems — including Cerner and Epic – with the ability to launch telehealth visits from within the EHR, and administration functions, like enrollment.

Subscription fees are recurring and are determined by the initial forecast of the number of overall consultations throughout the entire health system on the Amwell Platform and net patient revenue of the health system. 

Subscriptions include a maximum number of consultations, when it exceeds the contractual maximum, overages result in higher subscription fees in the following annual period.

The company also provides access to AMG, the company’s affiliated medical group that provides clinical services on a fee-for-service basis. Amwell’s contracts are typically three years in length or longer. AMG services are provided on a fee-for-service basis. These clinical fees vary significantly from $59 to more than $800 per consultation or case based on the specialty and may require an additional module subscription, such as telepsychiatry.

Amwell’s partner AMG has built a network of over 5,000 providers who are registered and credentialed to deliver care on the Amwell Platform. AMG earns fee-for-service revenue for each episode of care delivered on the Amwell Platform by its providers with fees varying by physician specialty or clinical program. Health systems often choose to purchase clinical services from AMG to deliver care for certain specialties, such as telepsychiatry, behavioral health therapy and general urgent care, or as backup for off-hours. 

Amwell’s Growth:

Here’s a visualization provided by the company in the S1 that shows how the telehealth microtrend is playing out on the provider level and the tailwinds this has provided to Amwell:

Here’s how monthly visits across customers has grown with some of the numbers retreating once shelter-in-home restrictions were lifted. Visits in April 2020 were as high as 40K per day compared to 3K per day in April 2019 and 5,500 visits in January and February.

There is overlap with Teladoc and Amwell, yet Amwell has more of a slant towards emergency and urgent care services. The company is also distributed across more kiosks and “care points” and is centered around two major partnerships (AMG and Anthem). Anthem began using Amwell for urgent care in 2013 with psychology and integrated EAP added in 2016 (this is where Teladoc competes). According to the S-1 filing, if the Anthem-Amwell product “LiveHealth” had not been offered, then 6% would have gone to the emergency room, 42% to urgent care and 33% to a physician’s office. 

Finances:

Amwell reported revenue growth of 31% year-over-year to $148.9 million in 2019. The company saw phenomenal revenue acceleration of 77% in the first six months of 2020 from $69 million to $122.3 million for an annual run rate of $244.6 million.

There are worsening losses in both periods. Net losses increased year-over-year from negative $52.7 million in 2018 to negative $87.2 million in 2019. For the first six months of 2020, net losses increased from negative $40.7 million to negative $111 million, or $222 million annual run rate for losses. This will represent an increase of over 200% year-over-year.

The company had cash and investments of $262.7 million and no debt as of June 30th.

Subscription fees received from health system clients totaled $27.3 million for the year ended December 31, 2018, and $38.8 million for the year ended December 31, 2019, respectively, and $17.9 million for the 1H 2019 ended June 30, 2019, and $23.6 million for the 1H 2020 ended June 30, 2020.

According to the S-1 filing, the subscription revenue market for health plan and health system customers is $8.7 billion and $3.7 billion, respectively. The company believes the 290 million that are insured in the United States are potential customers. They have identified 802 health systems that could benefit from Amwell. 

The urgent care market is $18.2 billion. According to a 2016 report referenced in the S-1, there are 883 million ambulatory care visits in the United States. Amwell states 35% of these visits, or 309 million could be handled through telehealth. 

Revenue Mix

The company has a mix of revenue from health systems, health plans and AMG paid visits. As of June 30th, the company had 55 health plans (covering 80 million lives) and 150 health systems (more than 2,000 hospitals). AMG’s active provider network grew 145% year-over-year to a total of 3,800 active providers. 

For the year ending 2019, where total revenue was $148.9 million, 57% was platform and 27% clinical visits. 

•       $38.8 million in Health Systems revenue, or 26% 

•       $30.6 million in Health Plans revenue, or 20.5% 

•       $40.7 million in AMG Paid Visits, or 27.3% 

•       11% Sales of additional services

•       5% Care Points/Hardware

In 2020, the Amwell platform (Health Systems and Health Plans) represented 38% of revenue while clinical visits represented 51% of H1 2020 revenue. Here we see that the 2020 growth was primarily driven by AMG. 

Risks:

The relaxation of regulatory and reimbursement barriers could be temporary without support from Congress, especially for Medicare. Telehealth is a new trend that could slow once there is a vaccine and treatment for the coronavirus. Amwell believes their partnership with AMG and adherence to HIPAA regulations will cause them to stand out over time and even in the face of a return to tighter regulations. 

AMG is a very large concentration of revenue although this partnership does not appear to be at risk at this time. Per the Revenue Mix section in this analysis, it should be noted the revenue acceleration we saw in H1 2020 came from AMG clinical visits rather than the platform. 

The net loss increase is substantial, with the net loss-to-revenue ratio increasing from 46% to 93% between FY2018 and H1 2020.

Valuation:

Amwell plans to raise $525 million by offering 35 million shares at a price range of $14 to $16. The company will raise an additional $100 million in the private placement with Google. At the midpoint, this places Amwell’s diluted market value at $3.6 billion.

Amwell Valuation Table

$3.6 billion $4.0 billion $4.5 billion $5.0 billion

TTM Revenue $202 million 17.8 19.8 22.2 25

Current Year 70% $330 million 10.9 12.2 13.6 15

Forward Revenue 70% $415 million 8.7 9.6 10.8 12

1-year Forward 60% $665 million 5.41 6 6.8 7.5

1-year forward 80% $747 million 4.8 5.4 6 6.69

We can comfortably go up to a $6.6 billion valuation and still trade at the forward P/S of Teladoc, which saw a similar range of revenue acceleration from 30-40% pre-covid to 85% post-covid. Livongo is not the best comparable as the company reported much higher revenue growth of 100%+ both pre-covid and post-covid.

Therefore, we will go as high as $6 billion market cap on opening day. The risk is that the addressable market is not very large at this time relative to market cap. We are comfortable with this risk in light of the strength in the telehealth trend.