TSMC released its September monthly revenue, which grew 39.6% YoY and 0.4% MoM to NT$251.87 billion. The third quarter revenue grew 39% YoY to NT$759.69 billion, beating the LSEG estimates of NT$750.36 billion.

In US dollar terms, Q3 revenue grew by 36.2% YoY to $23.53 billion using the average exchange rate of $1=NT$32.28. We will get the official USD figures when the company releases its full results on October 17th. The company handsomely beat the upper end of the guidance of $22.4 billion to $23.2 billion.

The strong September results suggest surging demand for AI chips and with more details on full quarter performance coming this week. Due to its technological leadership, the company has over 90% market share in the manufacturing of advanced AI chips. TSMC's customer base includes leading companies like Apple, Nvidia, AMD, Qualcomm, Marvell, and Intel.

TSMC is the leading global foundry in terms of revenue. It has a market share of 62.3% in Q2 2024. Samsung ranks a distant second with a market share of 11.5% in Q2 2024. WSJ reported TSMC’s global foundry revenue share to hit about 64% in 2024, up from 51% in 2019 and Samsung’s share to drop to 10% from 16% in 2019.

Revenue

Strong revenue growth is expected in the coming quarters due to the robust demand for AI and smartphone chips. Revenue estimates have gone up over the past few quarters, 4.7 points for the current quarter and estimates have risen 7.6 points for Q1 of next year indicating analysts’ confidence in the company’s ability to maintain growth.

• Management’s guide for the third quarter is between $22.4 billion and $23.2 billion. This represents year-over-year growth of 31.9% at the midpoint. Based on the monthly TWD figures, Q3 revenue grew by 36.2% YoY to $23.53 billion using the average exchange rate of $1= NT$32.28. We will get the official USD figures when the company releases its full results on October 17th.
• Q2 revenue grew by 32.8% YoY and 10.3% QoQ to $20.82 billion, primarily driven by strong AI demand and partially offset by smartphone seasonality. Q2 reported a remarkable 19.9% acceleration from 12.9% growth in Q1.

• During the Q2 earnings call, management increased full-year 2024 revenue guidance from low to mid-20% to slightly above mid-20% in US dollar terms as strong AI and high-end smartphone demand will lead to an increased capacity utilization for the 3-nanometer and 5-nanometer process technologies in the second half of the year.

Margins

While many companies struggle with rising costs, TSMC has successfully navigated these challenges by controlling costs and negotiating better prices with its customers. Due to reducing costs during a growth phase, referred to as “economies of scale,” and its leadership position in the foundry industry, the company has been able to report strong profitability.

According to DigiTimes, TSMC has notified its clients that prices for its 3-nanometer and 5-nanometer process products will increase by 3 to 8% in 2025. In the last earnings call, management hinted that prices will increase due to cost escalation.

• Management has guided Q3 gross margin to increase 1.3 percentage points sequentially to 54.5% at the mid-point due to better capacity utilization, cost improvements, and productivity gains compared to 54.3% in Q3 last year. The margin is expected to be partially offset by the N3 ramp, N5 to N3 tool conversion costs, and higher electricity prices in Taiwan. Electricity prices in Taiwan increased by 17% last year and another 25% in April this year. Management is confident of achieving a long-term gross margin of 53% and higher.
• Operating margins are expanding, helped by operating leverage. Management guide for Q3 is 43.5% at the midpoint compared to 41.7% in Q3 2023.

• Net income was $7.66 billion or 36.8% of revenue which is lower than usual. This margin trends in the high 30% range and into the 40% range. Return on equity was 26.7% compared to 23.2% in the same period last year.

EPS

EPS is projected to rise significantly. Analysts expect Q3 GAAP EPS to grow 36.4% YoY to $1.76. For next quarter, EPS is expected to grow 34.7% YoY to $1.94 in Q4.

Compare this to Q2 GAAP EPS of $1.48, up 29.8% YoY, which beat estimates by 4.2% due to better capacity utilization, cost improvement and operating leverage. More importantly, analysts expect Q3 EPS to grow 18.9% sequentially.

• Analysts expect 2024 GAAP EPS to grow 26.4% YoY to $6.55.
• For FY2025, they expect GAAP EPS to grow 29.9% YoY to $8.51.

Cash Flows and Balance Sheet

The company’s financial stability is evident due to its strong operating cash flows, which have more than doubled in Q2. The foundry industry is capital-intensive and this is why you will notice a wide difference between operating cash flows and free cash flows for the company.

• Operating cash flow was $11.68 billion or 56.1% of revenue compared to 35% of revenue in the same period last year and 73.6% in Q1.
• Free cash flow was $5.32 billion or 25.5% of revenue compared to (-17%) of revenue in the same period last year and 43% in Q1. The company had negative free cash flows last year due to the income tax payment of $3.85 billion.
• Management expects strong AI demand to continue and raised the midpoint of the capex for 2024 to $31 billion from the previous $30 billion, up 1.8% YoY. About 70% to 80% of the capex will be allocated to the advanced process technologies.
• According to a report from Economic Daily News, Institutional Investors expect the capex to remain within the updated guide for this year. They also expect management to announce an increase in capex for next year during the January results due to the expected strong demand for 2 nm process technology.
• Cash and marketable securities were $63.05 billion and debt of $30.4 billion compared to $60 billion and $30.25 billion in Q1. The company paid $2.8 billion in dividends in Q2.

Revenue by Platform

As the leading foundry for AI accelerators, TSMC is riding the enormous wave of demand from Big Tech. The chipmaker’s high-performance computing (HPC) revenues rose 28% QoQ to $10.8 billion and accounted for 52% of Q2 revenue, up from 46% of revenue in Q1. The HPC segment is above the 50% mark for the first time.

We can also notice in the below chart that the HPC revenue (which are mainly AI-related) reached a record $10.8 billion in Q2.

Smartphone revenues declined (-1%) QoQ due to seasonality and accounted for 33% of revenue compared to 38% of revenue in Q1. In the Q2 earnings call, management mentioned that they are witnessing strong AI and high-end smartphone-related demand in Q3. We will get the exact mix this week.

Internet of Things revenue grew by 6% sequentially and accounted for 6% of revenue.

Automotive revenue increased 5% sequentially and accounted for 5% of revenue. Digital Consumer Electronics increased 20% sequentially accounting for 2% of revenue. Other revenue increased 5% and accounted for 2% of revenue.

Revenue by Technology

The Advanced nodes are defined as 7-nanometer and below. We discussed in our editorial on the advanced nodes and AI-related revenue reaching fresh records. Most of the AI chips produced by the company utilize 5-nanometer and 4-nanometer process technology. 3-nanometer revenue is expected to triple this year and Apple usually gets the preference for the most advanced node in production. Volume production for 2-nanometer is expected in 2025 and should have a meaningful revenue contribution in the first half of 2026.

• In Q2 2024, 3-nanometer process technology contributed 15% of wafer revenue, while 5-nanometer and 7-nanometer accounted for 35% and 17%, respectively.
• In Q1 2024, 3-nanometer process technology contributed 9% of wafer revenue, while 5-nanometer and 7-nanometer accounted for 37% and 19%, respectively.

Advanced Packaging

The AI wave has also boosted the company’s advanced packaging business, particularly Chip-on-wafer-on-substrate (CoWoS). Morgan Stanley expects CoWoS capacity to reach 80,000 to 90,000 wafers per month by the end of 2025, up from a prior estimate of 70,000. The 2025 production capacity would suggest an over 430% increase from 15,000 at the end of 2023.

Management said in the Q2 earnings call Q&A that supply is expected to continue to be tight next year. They also mentioned that they are working with OSAT (Outsourced Semiconductor Assembly and Test) partners to increase production capacity.

Valuation

The company trades at a P/E ratio of 34.4 and a forward P/E ratio of 29.1. The P/S ratio is 13 and a forward P/S ratio of 11.4. In the last five years, the P/E ratio peaked at 41.8 in February 2021 and hit a low of 10.3 in November 2022. The stock is now trading above its five-year average P/E ratio of 24.1.

Conclusion

Due to technological leadership, TSMC can capture a significant portion of AI business and is the common denominator to the biggest AI winners as it supplies to Nvidia, Apple, AMD, Marvell, and Qualcomm. The company is negotiating better prices with its customers, is making cost improvements, and is maintaining strong margins and cash flows. Since TSMC generates strong cash flows, it has the scale to invest for future growth, and barriers of entry are high as the foundry industry is capital-intensive. We look forward to adding this stock to our portfolio in the coming months and will provide the play-by-play for our entries and adds to Essentials Members.

Pro premium members receive deep-dive research on the stocks in the portfolio and quarterly earnings kickoff webinars. In addition, the Advanced Market Signals Members receive regular technical and broad market analysis and weekly webinars from our Portfolio Manager, Knox Ridley. We have also recently discussed with the Advanced Market Signals members an AI stock that is up 415% in the last three months. Learn more here.here.

Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.

Recommended Reading:

• TSMC: The Common Denominator to AI Stocks
• Broadcom Fiscal Q3: AI Revenue Outlook Raised, but Valuation is Stretched
• Nvidia Q2: Blackwell Shipments to Begin in Q4

Since July, Lumen Technologies is up over 500% and most of this rise occurred following the company’s Q2 earnings report. Given the exceptional and sudden performance, we looked at Lumen more closely.

The company provides fiber connections for high-speed transmission between data centers. Generative AI demands at least ten times more fiber connections within data centers, along with a strong fiber network to enable fast information transfer between these data hubs.

With the largest intercity fiber network in North America, Lumen is positioning itself as a key fiber provider for data centers and recently secured $5 billion in new contracts from clients, including Microsoft and the US Defense Information Systems Agency.

After suffering years of declining revenue and profits, Lumen is undergoing a turnaround as its fiber network provides the backbone for the AI economy. With that said, other segments weigh on Lumen and the company will not return to growth for some time.

Company Overview

Lumen Technologies is a telecommunications company that provides communications and data services to businesses, government agencies, and residential customers. Its business can be split into two sales channels: its business segment and its mass markets (primarily residential) segment.

The business segment operates under the flagship Lumen brand while the mass markets segment operates under Quantum Fiber for fiber-based broadband services and CenturyLink for copper-based broadband services. Lumen’s business segment has grown to 79% of revenue in FY’23, up from 72% in 2021.

The CenturyLink brand has been around since 1930, and was renamed Lumen Technologies in 2020 to reflect the shift away from the shrinking copper-based CenturyLink broadband business.

Largest Intercity Fiber Network

Lumen’s primary advantage comes from its scale with over 450,000 route miles of fiber optic cable globally that make it the largest ultra-low-loss intercity fiber network in North America.

It is further investing to more than double its intercity fiber miles by 2026, signing an agreement with fiber optic manufacturer Corning to reserve 10% of its global fiber capacity for each of the next two years.

Some of its key advantages include its use of a multi-conduit system which allows it to deploy fiber quickly and more economically than competition, and having 25% less optical loss than competition which decreases equipment costs.

The scale of Lumen’s fiber optic network was one of the key reasons it was able to secure $5 billion in new deals for its Private Connectivity Fabric (PCF) service, including with hyperscaler Microsoft. PCF is a custom network that includes dedicated access to existing fiber in the Lumen network, the installation of new fiber on existing and new routes, and the use of Lumen’s new digital services. Lumen notes that it is in talks to secure an additional $7 billion in AI-related sales opportunities and sizes the market as $50 to $60 billion, growing 4% to 5% annually.

The announcement of additional AI-related sales opportunities, as well as significantly raising its FY’24 free cash flow guidance from $100 to $300 million to $1.0 to $1.2 billion has contributed to Lumen’s outsized 3-month stock returns.

Business Segment (79% of FY’23 revenue)

As stated, Lumen is going through double-digit declines in revenue and it will be some time before the company returns to growth.

The business segment is comprised of four product and service categories denoting their stage of investment: Grow (a focus on new investments), Nurture (more mature offerings), Harvest (generating cash), and Other.

The Grow segment is the largest, comprising 41% of business revenue in Q2’24. If we back out international revenue, which experienced a (-70.5%) YoY decline due to the divestiture of Lumen’s EMEA business in November 2023, then Grow grew 1.5% YoY in Q2.

Nurture experienced the largest revenue decline at (-12.1%) YoY and is the second largest segment, comprising 29% of business revenue. The Nurture segment is comprised of mature offerings that are ex-growth where the focus is on improving margins.

Finally, the Harvest segment includes legacy services that have grown out of the Nurture phase and are managed to maximize cash. This segment experienced a (-10.6%) YoY revenue decline and comprises 22% of business revenue.

The Harvest segment has experienced the largest decline as a percentage of revenues over the last year, although all segments have seen revenue decline in absolute terms.

Mass Markets Segment (21% of FY’23 revenue)

The mass market segment is comprised of Lumen’s services for residential, small business, and government customers. This segment is split into three categories dependent on the type of service provided.

The Fiber Broadband (Quantum Fiber) segment serves high-speed internet through fiber infrastructure and is the fastest growing segment in the company at 14.6% YoY growth in Q2, comprising 26% of total Mass Markets revenue, up from 21% in the previous year’s quarter.

The Other Broadband (CenturyLink) segment uses slower, copper-based infrastructure under the legacy CenturyLink brand. This segment is rapidly shrinking as customers switch to fiber, seeing a (-16.1%) YoY decline in Q2.

Finally, the Voice and Other is comprised of phone services and government programs. This segment also saw an (-11.7%) YoY decline in Q2.

Financials

Lumen has seen years of declining revenues as the company failed to diversify itself away from its declining CenturyLink segment. Although revenue is expected to continue to decline in the coming quarters and years, Lumen’s Quantum Fiber business is growing and partially offsetting the decline in CenturyLink.

The over $5 billion in AI-related Private Connectivity Fabric (PCF) deals is also expected to reignite growth in the Business segment, with management guiding for the public sector to return to sustainable growth later this year, followed by mid-market then large enterprise. However, the overall business is not expected to return to growth until 2027 according to consensus estimates.

The cash flow from the AI-related PCF deals are also expected to close any FCF deficit between now and when the company reaches sustainable positive FCF, assuaging liquidity concerns despite the high debt load and decreasing margins.

Revenue 

• Q2 revenue fell by (-10.7%) YoY to $3.27 billion, beating expectations by 0.58%. This compares to Q1 revenue decline of (-12%) for revenue of $3.29 billion. Next quarter is expected to decline further at (-11.5%) YoY to $3.22 billion
• 2023 revenue fell by (-16.7%) YoY to $14.56 billion. This compares to 2022 revenue decline of (-11.2%) for revenue of $17.48 billion. In 2024, the revenue decline is expected to narrow to (-10.9%) YoY to $12.97 billion and (-4.3%) YoY in 2025 to $12.41 billion
• The majority of the $5 billion in Private Connectivity Fabric solution sales is expected to be recognized over the next 3 to 4 years

Margins

While Lumen has consistently generated positive adjusted EBITDA, its margins have consistently declined. The company has reported large one-time GAAP losses stemming from goodwill impairments in Q4’23 and Q2’23.

Management expects the trend to continue and guided for adjusted EBITDA to fall further in 2025 as they pull forward some expenses due to their improved liquidity profile. However, this is part of their goal to take out $1 billion in costs from the business by the end of 2027 by unifying four enterprise networks into one. As a result, they expect a significant rebound in adjusted EBITDA in 2026, followed by YoY growth.

• Q2’24 gross profit declined (-39%) YoY to $1.62 billion. Q2 gross margin was 49.4%, decreasing from 52.5% in the same quarter last year and 49.8% in the previous quarter
• Q2 operating income increased to $135 million from loss of (-$8.42) billion in the year ago quarter which was affected by goodwill impairment charges. Q2 operating margin was 4.10%, up from (-230%) in the same quarter last year when there was a loss of $8 million, but up from 1.40% in the previous quarter

Adjusted EBITDA declined (-17.7%) YoY to $1.01 billion, representing a 30.9% margin, down from 33.6% last year but up from 29.7% last quarter.

Management guide for FY’24 adjusted EBITDA is in the range of $3.9 to $4.0 billion, slightly down from their previous guide of $4.1 to $4.3 billion issued in Q1 as Lumen pulled forward some investments associated with its business transformation.

Lumen management guided for 2025 adjusted EBITDA below 2024 levels, with a significant rebound in 2026 and growing thereafter, they note that they will provide more detailed guidance in their Q4’24 call in February 2025.

• Net income was (-$49) million or (-1.5%) of revenue compared to (-$8.736) billion or (-238.6%) of revenue in the same period last year due to a non-cash goodwill impairment charge of $8.793 billion
• Adjusted net income was (-$124) million or (-3.8%) of revenue compared to $98 million or 2.7% of revenue in the same period last year

EPS

Lumen is expected to remain unprofitable on a GAAP and adjusted EPS basis due to its interest expense burden.

• Q2 GAAP EPS improved to ($0.05) from ($8.88) last year and beat estimates of ($0.11). Adjusted EPS fell from $0.10 last year to ($0.13) and missed estimates of ($0.04)
• Analysts expect adjusted EPS to grow 4.6% YoY to ($0.09) in Q3 and to ($0.06) in Q4
• Analysts expect 2024 adjusted EPS to decline from $0.20 in 2023 to ($0.32)

Cash Flow and Balance Sheet

One of the primary risks to Lumen has been its high debt load, with debt of $18.6 billion, for a debt-to-equity ratio of 39.9x.

However, Lumen has seen a significant improvement in cash flow and liquidity recently. Since Q2’23, it has addressed over $15 billion of debt and extended $10 billion of maturities as well as securing access to $2.3 billion in new liquidity.

With the company guiding for free cash flow guide of $1.0 billion to $1.2 billion for FY’24, liquidity is not much of a near-term concern.

The management guide for FY’24 FCF is in the range of $1.0 to $1.2 billion, significantly improved from their previous guide of $100 to $300 million issued in Q1.

• Operating cash flow was $511 million or 15.6% of revenue compared to (-$100) million or (-2.7%) of revenue in the same period last year
• Adjusted free cash outflow was (-$156) million or (-4.8%) of revenue compared to (-$896) million or (-24.5%) of revenue last year
• Capex was $753 million compared to $796 million in the same period last year. The management guide for FY’24 capex is in the range of $3.1 to $3.3 billion, up from their previous guide of $2.7 to $2.9 billion issued in Q1

The company had cash of $1.5 billion and debt of $18.6 billion compared to $1.58 billion and $18.68 billion in the previous quarter. The company is guiding for net cash interest of $1.15 to $1.25 billion in 2024

Valuation

Due to the stock being up over 500% in three months, Lumen is trading at its historic averages, which reflect revenue declines, unprofitability, and liquidity concerns with its high debt load. It currently trades at a P/S multiple of 0.42x and a forward P/S ratio of 0.46x which is below its 5-year average of 0.44x. Notably, telecom companies such as AT&T are trading at 1.3x and Verizon at 1.4x.

Lumen trades at a forward EV/EBITDA multiple of 6.0x. While Adjusted EBITDA is expected to decline further in 2025, management guided for a “significant rebound” in 2026, followed by growth thereafter as previously mentioned.

Risks

Lumen’s largest risk stems from its declining revenues in combination with the interest burden from its debt. The stock went through a 98% peak-to-trough drawdown as liquidity became a key concern prior to the large AI-related contracts it recently landed.

However, the details around the $5 billion of AI-related PCF contracts remain high-level and the contribution is front-loaded, meaning the majority of the revenue and cash flow associated with these contracts will be recognized in the next 3-4 years, so Lumen needs to continue to win new business to extend its growth.

Finally, Lumen operates in a very competitive industry with large competitors like AT&T and Verizon that are investing heavily in their own fiber networks. Both companies are much larger than Lumen and thus pose a significant threat to Lumen’s ability to land more contracts and continue to pay off debt.

Technical Analysis

Lumen is up over 600% since July. This is an unusually large move in such a short amount of time. To understand if this is the start of a new, multi-year uptrend, we will need to look at Lumen’s trend on a much larger timeframe.

LUMN has been trading since the 1979s (due to CenturyLink). From its IPO into the 2000 top, it traced a perfect 5 wave pattern that took decades to complete. What always follows a 5 wave pattern is a 3 wave retrace of the same degree. The problem with the retrace that followed was that it lasted 23 years and retraced 98% of the uptrend. This is a very deep and long, which warrants caution until Lumen can further prove itself.

We need to see the pattern off the 2023 low turn into another 5 wave pattern to signal a new uptrend is starting. So far, it’s only 3 waves higher. For now, we need to see any weakness hold over $2.70 and then make a new high to meet this criterion. If we can see a new 5 wave pattern develop off the 2023 low, it will imply a new and investable uptrend has started.

Conclusion

It is not often that you see a century-old company at the forefront of new secular trends, but Lumen’s large and hard-to-replicate network of fiber assets is proving important as data center customers look to ever-increasing amounts of data with fast transmission to train AI models.

After concerns of potential bankruptcy in recent years, Lumen has successfully capitalized on recent AI-related contracts to stabilize its liquidity position as the company looks to return to growth in coming years. While the idea remains speculative given the high leverage, competition, and the lack of details surrounding the new contracts, Lumen could see a continuation of its rally if management is able to execute.

The I/O Fund has no plans to enter Lumen at this time.

This analysis is a preview of what you can expect in our upcoming Discovery tier, which will provide additional analysis on new idea generation stocks that are not currently in the I/O Fund portfolio. We look forward to launching this tier November/December. There will be no changes to our current service tiers, rather I/O Fund Discovery is a service for those who want more new stock ideas beyond what our service currently provides. Stay tuned for more information!upcoming Discovery tier, which will provide additional analysis on new idea generation stocks that are not currently in the I/O Fund portfolio. We look forward to launching this tier November/December. There will be no changes to our current service tiers, rather I/O Fund Discovery is a service for those who want more new stock ideas beyond what our service currently provides. Stay tuned for more information!

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

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Since July, Lumen Technologies is up over 500% and most of this rise occurred following the company’s Q2 earnings report. Given the exceptional and sudden performance, we looked at Lumen more closely.

The company provides fiber connections for high-speed transmission between data centers. Generative AI demands at least ten times more fiber connections within data centers, along with a strong fiber network to enable fast information transfer between these data hubs.

With the largest intercity fiber network in North America, Lumen is positioning itself as a key fiber provider for data centers and recently secured $5 billion in new contracts from clients, including Microsoft and the US Defense Information Systems Agency.

After suffering years of declining revenue and profits, Lumen is undergoing a turnaround as its fiber network provides the backbone for the AI economy. With that said, other segments weigh on Lumen and the company will not return to growth for some time.

Company Overview

Lumen Technologies is a telecommunications company that provides communications and data services to businesses, government agencies, and residential customers. Its business can be split into two sales channels: its business segment and its mass markets (primarily residential) segment.

The business segment operates under the flagship Lumen brand while the mass markets segment operates under Quantum Fiber for fiber-based broadband services and CenturyLink for copper-based broadband services. Lumen’s business segment has grown to 79% of revenue in FY’23, up from 72% in 2021.

The CenturyLink brand has been around since 1930, and was renamed Lumen Technologies in 2020 to reflect the shift away from the shrinking copper-based CenturyLink broadband business.

Largest Intercity Fiber Network

Lumen’s primary advantage comes from its scale with over 450,000 route miles of fiber optic cable globally that make it the largest ultra-low-loss intercity fiber network in North America.

It is further investing to more than double its intercity fiber miles by 2026, signing an agreement with fiber optic manufacturer Corning to reserve 10% of its global fiber capacity for each of the next two years.

Some of its key advantages include its use of a multi-conduit system which allows it to deploy fiber quickly and more economically than competition, and having 25% less optical loss than competition which decreases equipment costs.

The scale of Lumen’s fiber optic network was one of the key reasons it was able to secure $5 billion in new deals for its Private Connectivity Fabric (PCF) service, including with hyperscaler Microsoft. PCF is a custom network that includes dedicated access to existing fiber in the Lumen network, the installation of new fiber on existing and new routes, and the use of Lumen’s new digital services. Lumen notes that it is in talks to secure an additional $7 billion in AI-related sales opportunities and sizes the market as $50 to $60 billion, growing 4% to 5% annually.

The announcement of additional AI-related sales opportunities, as well as significantly raising its FY’24 free cash flow guidance from $100 to $300 million to $1.0 to $1.2 billion has contributed to Lumen’s outsized 3-month stock returns.

Business Segment (79% of FY’23 revenue)

As stated, Lumen is going through double-digit declines in revenue and it will be some time before the company returns to growth.

The business segment is comprised of four product and service categories denoting their stage of investment: Grow (a focus on new investments), Nurture (more mature offerings), Harvest (generating cash), and Other.

The Grow segment is the largest, comprising 41% of business revenue in Q2’24. If we back out international revenue, which experienced a (-70.5%) YoY decline due to the divestiture of Lumen’s EMEA business in November 2023, then Grow grew 1.5% YoY in Q2.

Nurture experienced the largest revenue decline at (-12.1%) YoY and is the second largest segment, comprising 29% of business revenue. The Nurture segment is comprised of mature offerings that are ex-growth where the focus is on improving margins.

Finally, the Harvest segment includes legacy services that have grown out of the Nurture phase and are managed to maximize cash. This segment experienced a (-10.6%) YoY revenue decline and comprises 22% of business revenue.

The Harvest segment has experienced the largest decline as a percentage of revenues over the last year, although all segments have seen revenue decline in absolute terms.

Mass Markets Segment (21% of FY’23 revenue)

The mass market segment is comprised of Lumen’s services for residential, small business, and government customers. This segment is split into three categories dependent on the type of service provided.

The Fiber Broadband (Quantum Fiber) segment serves high-speed internet through fiber infrastructure and is the fastest growing segment in the company at 14.6% YoY growth in Q2, comprising 26% of total Mass Markets revenue, up from 21% in the previous year’s quarter.

The Other Broadband (CenturyLink) segment uses slower, copper-based infrastructure under the legacy CenturyLink brand. This segment is rapidly shrinking as customers switch to fiber, seeing a (-16.1%) YoY decline in Q2.

Finally, the Voice and Other is comprised of phone services and government programs. This segment also saw an (-11.7%) YoY decline in Q2.

Financials

Lumen has seen years of declining revenues as the company failed to diversify itself away from its declining CenturyLink segment. Although revenue is expected to continue to decline in the coming quarters and years, Lumen’s Quantum Fiber business is growing and partially offsetting the decline in CenturyLink.

The over $5 billion in AI-related Private Connectivity Fabric (PCF) deals is also expected to reignite growth in the Business segment, with management guiding for the public sector to return to sustainable growth later this year, followed by mid-market then large enterprise. However, the overall business is not expected to return to growth until 2027 according to consensus estimates.

The cash flow from the AI-related PCF deals are also expected to close any FCF deficit between now and when the company reaches sustainable positive FCF, assuaging liquidity concerns despite the high debt load and decreasing margins.

Revenue 

• Q2 revenue fell by (-10.7%) YoY to $3.27 billion, beating expectations by 0.58%. This compares to Q1 revenue decline of (-12%) for revenue of $3.29 billion. Next quarter is expected to decline further at (-11.5%) YoY to $3.22 billion
• 2023 revenue fell by (-16.7%) YoY to $14.56 billion. This compares to 2022 revenue decline of (-11.2%) for revenue of $17.48 billion. In 2024, the revenue decline is expected to narrow to (-10.9%) YoY to $12.97 billion and (-4.3%) YoY in 2025 to $12.41 billion
• The majority of the $5 billion in Private Connectivity Fabric solution sales is expected to be recognized over the next 3 to 4 years

Margins

While Lumen has consistently generated positive adjusted EBITDA, its margins have consistently declined. The company has reported large one-time GAAP losses stemming from goodwill impairments in Q4’23 and Q2’23.

Management expects the trend to continue and guided for adjusted EBITDA to fall further in 2025 as they pull forward some expenses due to their improved liquidity profile. However, this is part of their goal to take out $1 billion in costs from the business by the end of 2027 by unifying four enterprise networks into one. As a result, they expect a significant rebound in adjusted EBITDA in 2026, followed by YoY growth.

• Q2’24 gross profit declined (-39%) YoY to $1.62 billion. Q2 gross margin was 49.4%, decreasing from 52.5% in the same quarter last year and 49.8% in the previous quarter
• Q2 operating income increased to $135 million from loss of (-$8.42) billion in the year ago quarter which was affected by goodwill impairment charges. Q2 operating margin was 4.10%, up from (-230%) in the same quarter last year when there was a loss of $8 million, but up from 1.40% in the previous quarter

Adjusted EBITDA declined (-17.7%) YoY to $1.01 billion, representing a 30.9% margin, down from 33.6% last year but up from 29.7% last quarter.

Management guide for FY’24 adjusted EBITDA is in the range of $3.9 to $4.0 billion, slightly down from their previous guide of $4.1 to $4.3 billion issued in Q1 as Lumen pulled forward some investments associated with its business transformation.

Lumen management guided for 2025 adjusted EBITDA below 2024 levels, with a significant rebound in 2026 and growing thereafter, they note that they will provide more detailed guidance in their Q4’24 call in February 2025.

• Net income was (-$49) million or (-1.5%) of revenue compared to (-$8.736) billion or (-238.6%) of revenue in the same period last year due to a non-cash goodwill impairment charge of $8.793 billion
• Adjusted net income was (-$124) million or (-3.8%) of revenue compared to $98 million or 2.7% of revenue in the same period last year

EPS

Lumen is expected to remain unprofitable on a GAAP and adjusted EPS basis due to its interest expense burden.

• Q2 GAAP EPS improved to ($0.05) from ($8.88) last year and beat estimates of ($0.11). Adjusted EPS fell from $0.10 last year to ($0.13) and missed estimates of ($0.04)
• Analysts expect adjusted EPS to grow 4.6% YoY to ($0.09) in Q3 and to ($0.06) in Q4
• Analysts expect 2024 adjusted EPS to decline from $0.20 in 2023 to ($0.32)

Cash Flow and Balance Sheet

One of the primary risks to Lumen has been its high debt load, with debt of $18.6 billion, for a debt-to-equity ratio of 39.9x.

However, Lumen has seen a significant improvement in cash flow and liquidity recently. Since Q2’23, it has addressed over $15 billion of debt and extended $10 billion of maturities as well as securing access to $2.3 billion in new liquidity.

With the company guiding for free cash flow guide of $1.0 billion to $1.2 billion for FY’24, liquidity is not much of a near-term concern.

The management guide for FY’24 FCF is in the range of $1.0 to $1.2 billion, significantly improved from their previous guide of $100 to $300 million issued in Q1.

• Operating cash flow was $511 million or 15.6% of revenue compared to (-$100) million or (-2.7%) of revenue in the same period last year
• Adjusted free cash outflow was (-$156) million or (-4.8%) of revenue compared to (-$896) million or (-24.5%) of revenue last year
• Capex was $753 million compared to $796 million in the same period last year. The management guide for FY’24 capex is in the range of $3.1 to $3.3 billion, up from their previous guide of $2.7 to $2.9 billion issued in Q1

The company had cash of $1.5 billion and debt of $18.6 billion compared to $1.58 billion and $18.68 billion in the previous quarter. The company is guiding for net cash interest of $1.15 to $1.25 billion in 2024

Valuation

Due to the stock being up over 500% in three months, Lumen is trading at its historic averages, which reflect revenue declines, unprofitability, and liquidity concerns with its high debt load. It currently trades at a P/S multiple of 0.42x and a forward P/S ratio of 0.46x which is below its 5-year average of 0.44x. Notably, telecom companies such as AT&T are trading at 1.3x and Verizon at 1.4x.

Lumen trades at a forward EV/EBITDA multiple of 6.0x. While Adjusted EBITDA is expected to decline further in 2025, management guided for a “significant rebound” in 2026, followed by growth thereafter as previously mentioned.

Risks

Lumen’s largest risk stems from its declining revenues in combination with the interest burden from its debt. The stock went through a 98% peak-to-trough drawdown as liquidity became a key concern prior to the large AI-related contracts it recently landed.

However, the details around the $5 billion of AI-related PCF contracts remain high-level and the contribution is front-loaded, meaning the majority of the revenue and cash flow associated with these contracts will be recognized in the next 3-4 years, so Lumen needs to continue to win new business to extend its growth.

Finally, Lumen operates in a very competitive industry with large competitors like AT&T and Verizon that are investing heavily in their own fiber networks. Both companies are much larger than Lumen and thus pose a significant threat to Lumen’s ability to land more contracts and continue to pay off debt.

Technical Analysis

Lumen is up over 600% since July. This is an unusually large move in such a short amount of time. To understand if this is the start of a new, multi-year uptrend, we will need to look at Lumen’s trend on a much larger timeframe.

LUMN has been trading since the 1979s (due to CenturyLink). From its IPO into the 2000 top, it traced a perfect 5 wave pattern that took decades to complete. What always follows a 5 wave pattern is a 3 wave retrace of the same degree. The problem with the retrace that followed was that it lasted 23 years and retraced 98% of the uptrend. This is a very deep and long, which warrants caution until Lumen can further prove itself.

We need to see the pattern off the 2023 low turn into another 5 wave pattern to signal a new uptrend is starting. So far, it’s only 3 waves higher. For now, we need to see any weakness hold over $2.70 and then make a new high to meet this criterion. If we can see a new 5 wave pattern develop off the 2023 low, it will imply a new and investable uptrend has started.

Conclusion

It is not often that you see a century-old company at the forefront of new secular trends, but Lumen’s large and hard-to-replicate network of fiber assets is proving important as data center customers look to ever-increasing amounts of data with fast transmission to train AI models.

After concerns of potential bankruptcy in recent years, Lumen has successfully capitalized on recent AI-related contracts to stabilize its liquidity position as the company looks to return to growth in coming years. While the idea remains speculative given the high leverage, competition, and the lack of details surrounding the new contracts, Lumen could see a continuation of its rally if management is able to execute.

The I/O Fund has no plans to enter Lumen at this time.

This analysis is a preview of what you can expect in our upcoming Discovery tier, which will provide additional analysis on new idea generation stocks that are not currently in the I/O Fund portfolio. We look forward to launching this tier November/December. There will be no changes to our current service tiers, rather I/O Fund Discovery is a service for those who want more new stock ideas beyond what our service currently provides. Stay tuned for more information!upcoming Discovery tier, which will provide additional analysis on new idea generation stocks that are not currently in the I/O Fund portfolio. We look forward to launching this tier November/December. There will be no changes to our current service tiers, rather I/O Fund Discovery is a service for those who want more new stock ideas beyond what our service currently provides. Stay tuned for more information!

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TSMC is a leading foundry that manufactures the world’s most advanced chips. Most importantly, the company has over 90% market share in the manufacturing of advanced AI chips. The most advanced node in production today is the 3-nanometer process technology, which is primarily used by Apple for iPhones and MacBooks. Nvidia is also expected to use the 3nm for the new Blackwell architecture. The 5-nanometer process technology is popular for HPC and smartphone applications and will be moving to 3-nanometer and 2-nanometer process technology.

One of TSMC’s niches for success is its unique business model as a pure-play foundry. This approach, which focuses on manufacturing for its customers rather than designing or manufacturing semiconductor products under its own name, has been a significant factor in its growth. TSMC's customer base includes leading companies like Apple, Nvidia, AMD, Qualcomm, Marvell, and Intel.

We have revamped the Essentials Portfolio by including TSMC. The stock was previously in our I/O Fund Portfolio and we sold for +20% profits due to technical and geopolitical risk. Yet, we continue to monitor the company due to its strong revenue growth, profits, and cash flows. TSMC is benefiting from economies of scale and its leadership position in the foundry industry, best illustrated by the company maintaining strong profitability while increasing production. Many companies have struggled with rising costs, while TSMC has successfully navigated these challenges by controlling costs and negotiating better prices with its customers.

For our Essentials Members, we want to demonstrate that a successful entry is often planned months in advance. We will most likely enter in Q4 2024 to Q1 2025 for a long-term position. We think it’s a mistake to buy stocks without a strategy, and thus, we present our strategy on TSMC below. We crowned TSMC as the stock that got away for H1 2024. Our firm closed our TSMC position late last year for a +20% gain, when it was at $92.28. We decided to instead focus on stocks with heavier AI concentration with less geo-political risk.

Market Dominance

According to Trend Force research, TSMC is the leading global foundry in terms of revenue. It has a market share of 62.3% in Q2 2024. Samsung ranks a distant second with a market share of 11.5% in Q2 2024. SMIC ranks third with a market share of 5.7% and UMC ranks fourth with a market share of 5.3%.

Product and business model

Fabless semiconductor companies benefit from outsourcing their fabrication of chips to companies like TSMC. They hereby save the high costs of building and maintaining facilities for chip manufacturing. The fabless companies instead spend their resources on R&D for designing chips. There is a third category of semiconductor companies which are called integrated device manufacturers (IDMs), who design and manufacture chips like Samsung and Intel.

TSMC was founded by Morris Chang in 1987. He is known as the father of Taiwan’s chip industry and is credited to the concept of the foundry business. The company successfully developed a business model that ensures it will not compete with its customers as it does not manufacture under its own name. The company was able to win Apple’s business from Samsung since the latter is a direct competitor of Apple.  The company’s chips are mainly used in five platforms: smartphones, high-performance computing, Internet of Things, Automotive, and Digital Consumer Electronics.

Revenue

The analyst revenue estimates are trending higher reflecting strong AI demand.

Q2 2024 revenue grew by 32.8% YoY and 10.3% QoQ to $20.82 billion beating guidance of $19.6 billion to $20.4 billion, driven by strong AI demand and partially offset by smartphone seasonality.

Management guide for the third quarter is between $22.4 billion and $23.2 billion. This represents year-over-year growth of 31.9% at the midpoint, primarily driven by anticipated strong demand for smartphones and AI-related technologies.

Analyst consensus estimates are trending higher. They expect revenue to grow 38.8% YoY in the next quarter, up from the 32.5% YoY growth expected in mid-June.

Note: The below analyst consensus estimates will differ slightly from the actual reported numbers in the company IR due to the currency conversion. However, we use the estimates below to understand the expected growth rate trend.

TSMC’s Aug monthly revenue grew by 33% YoY and down (-2.4%) MoM to NT$250.87 billion. It recorded its highest ever August sales and second highest monthly sales this year suggesting strong AI and smartphone demand. July monthly revenue grew by 44.7% YoY and 23.6% MoM to NT$256.95 billion.

During the Q2 earnings call, management increased full year 2024 revenue guidance from low to mid-20% to slightly above mid-20% in US dollar terms. “Over the past three months, we have observed strong AI and high-end smartphone related demand from our customers, as compared to three months ago, leading to increasing overall capacity utilization rate for our leading-edge 3-nanometer and 5-nanometer process technologies in the second half of 2024. Thus, we continue to expect 2024 to be a strong growth year for TSMC. We are raising our full-year guidance and now expect our 2024 revenue to increase slightly above mid-20s percent in US dollar terms.”

Margins

Due to the economies of scale and its leadership position in the foundry industry, the company maintained strong profitability. Despite the rising costs, the company has mitigated these challenges through cost controls and negotiating favorable pricing with its customers. Management is confident of achieving a long-term gross margin of 53% and higher.

According to DigiTimes, TSMC has notified its clients that prices for its 3-nanometer and 5-nanometer process products will increase by 3 to 8% in 2025. In the last earnings call, management hinted that prices will increase due to cost escalation.

“To ensure a proper return from our investment, both pricing and cost are important. TSMC's pricing strategy is strategic, not opportunistic to reflect the value that we provide […] Today, we are investing heavily in leading-edge specialty and advanced packaging technologies to support our customers' growth and enable their success. If customers do well, TSMC should do well. For example, we are happy to see many of our customers' structural profitability improving in these past few years. At the same time, we face rising cost challenges due to increasing process complexity, a leading load, higher electricity costs in Taiwan, global fiber expansion in higher cost regions, and other cost inflation challenges. Therefore, we will continue to work closely with our customers to share our value. We will also work diligently with our suppliers to deliver on cost performance.”

The Q2 gross margin was 53.2% compared to 54.1% in the same period last year and 53.1% in Q1. It beat the management guide of 51% to 53%, primarily helped by better capacity utilization, cost improvement, favourable foreign exchange rate, and partially offset by margin dilution from N3 ramp. TSMC will see headwinds in the initial ramp phase before ultimately realizing higher margins once 3nm has scaled. The price increase and yield improvement is expected to improve the margins next year.

Management has guided Q3 gross margin to increase 1.3 percentage points sequentially to 54.5% at the mid-point due to the better capacity utilization, cost improvements, productivity gains. The margin is partially offset by the N3 ramp, N5 to N3 tool conversion costs, and higher electricity prices in Taiwan. Electricity prices in Taiwan increased by 17% last year and another 25% in April this year.

The Q2 operating margin was 42.5% compared to 42% in the same period last year and Q1. Due to the operating leverage the operating expenses were lower at 10.5% of revenue compared to 11.1% in Q1 that helped to expand the margins. Management guide for Q3 is 43.5% at the midpoint.

Net income was $7.66 billion or 36.8% of revenue compared to $5.9 billion or 37.8% of revenue in the same period last year. Return on equity was 26.7% compared to 23.2% in the same period last year.

EPS

EPS is expected to increase substantially moving forward.

Q2 GAAP EPS was $1.48, up 29.8% YoY and beat estimates by 4.2% due to better capacity utilization, cost improvement and operating leverage. Analysts expect GAAP EPS to grow 36.4% YoY in Q3 to $1.76 and $1.94 in Q4.

Cash Flows and Balance Sheet

The company’s financial stability is evident in its cash flow growth, which has more than doubled YoY.

Operating cash flow was $11.68 billion or 56.1% of revenue compared to $5.45 billion or 35% of revenue in the same period last year and 73.6% in Q1. The operating cash flows was lower in Q2 last year due to the income tax payment of $3.85 billion.

Free cash flow was $5.32 billion or 25.5% of revenue compared to (-$2.72 billion) or (-17%) of revenue in the same period last year and 43% in Q1. Capex was down (-22.2%) YoY to $6.36 billion in Q2. The foundry industry is capital-intensive and free cash flows could be lumpy as capex could vary each quarter. The company had negative free cash flows last year due to the income tax payment of $3.85 billion and also higher capex of $8.17 billion.

Management expects strong AI demand to continue and raised the midpoint of the capex for 2024 to $31 billion from the previous $30 billion.

Inventories were $8.39 billion compared to $8.35 billion in Q1. Inventory turnover days decreased seven days sequentially to 83 days due to higher N3 wafer shipment.

Cash and marketable securities were $63.05 billion and debt of $30.4 billion compared to $60 billion and $30.25 billion in Q1. The company paid $2.8 billion in dividends in Q2.

Revenue by Platform

As the leading foundry for AI accelerators, TSMC is riding the enormous wave of demand from Big Tech. The chipmaker’s high-performance computing (HPC) revenues rose 28% QoQ to $10.8 billion and accounted for 52% of Q2 revenue, up from 46% of revenue in Q1. It is above the 50% mark for the first time.

Smartphone revenues declined (-1%) QoQ due to seasonality and accounted for 33% of revenue compared to 38% of revenue in Q1. In the Q2 earnings call, management mentioned that they are witnessing strong AI and high-end smartphone-related demand, suggesting strong HPC and smartphone revenues in Q3.

Internet of Things revenue grew by 6% sequentially and accounted for 6% of revenue.

Automotive revenue increased 5% sequentially and accounted for 5% of revenue. Digital Consumer Electronics increased 20% sequentially accounting for 2% of revenue. Other revenue increased 5% and accounted for 2% of revenue.

Advanced Nodes

The Advanced nodes are defined as 7-nanometer and below. We discussed in our editorial on the advanced nodes and AI-related revenue reaching fresh records. Most of the AI chips produced by the company utilize 5-nanometer and 4-nanometer process technology. However, 3-nanometer revenue is expected to triple this year. Volume production for 2-nanometer is expected in 2025 and should have a meaningful revenue contribution in the first half of 2026.

We mentioned, “Currently, AI accelerators use TSMC’s 5nm process. Nvidia’s Hopper and Blackwell are built with a N4X process that is tailored for high-performance computer applications. This is a customized variant called “4N” that Nvidia uses, yet TSMC recognizes this as 5nm revenue in their earnings report. AI accelerators are expected to quickly move to smaller nodes to help lower power consumption. TSMC’s 3nm process is more energy efficient, and energy efficiency will improve further with the 2nm process.”N4X process that is tailored for high-performance computer applications. This is a customized variant called “4N” that Nvidia uses, yet TSMC recognizes this as 5nm revenue in their earnings report. AI accelerators are expected to quickly move to smaller nodes to help lower power consumption. TSMC’s 3nm process is more energy efficient, and energy efficiency will improve further with the 2nm process.”

Due to its leadership position, management has been optimistic about the long-term opportunity in the manufacturing of AI chips. C.C. Wei said in the Q1 earnings call, “In summary, our technology leadership enable TSMC to win business and enables our customer to win business in their end market. Almost all the AI innovators are working with TSMC to address the insatiable AI-related demand for energy-efficient computing power. We forecast the revenue contribution from several AI processors to more than double this year and account for low-teens percent of our total revenue in 2024.Almost all the AI innovators are working with TSMC to address the insatiable AI-related demand for energy-efficient computing power. We forecast the revenue contribution from several AI processors to more than double this year and account for low-teens percent of our total revenue in 2024.

For the next 5 years, we forecast it to grow at 50% CAGR and increase to higher than 20% of our revenue by 2028. Several AI processors are narrowly defined as GPUs, AI accelerators and CPU's performing, training and inference functions and do not include the networking edge or on-device AI. We expect several AI processors to be the strongest driver of our HPC platform growth and the largest contributor in terms of our overall incremental revenue growth in the next several years.”For the next 5 years, we forecast it to grow at 50% CAGR and increase to higher than 20% of our revenue by 2028. Several AI processors are narrowly defined as GPUs, AI accelerators and CPU's performing, training and inference functions and do not include the networking edge or on-device AI. We expect several AI processors to be the strongest driver of our HPC platform growth and the largest contributor in terms of our overall incremental revenue growth in the next several years.”

• 3-nanometer process technology contributed 15% of wafer revenue, while 5-nanometer and 7-nanometer accounted for 35% and 17% respectively in Q2 2024.
• 3-nanometer process technology contributed 9% of wafer revenue, while 5-nanometer and 7-nanometer accounted for 37% and 19% respectively in Q1 2024.

Advanced Packaging

The AI wave has also boosted the company’s advanced packaging business, particularly Chip-on-wafer-on-substrate (CoWoS) services. Taiwan Semi’s CoWoS capacity is expected to rise to 85,000 wafers by the end of next year. This lines up with recent estimates from Morgan Stanley, with analysts now expecting CoWoS capacity to reach 80,000 to 90,000 wafers per month by the end of 2025, up from a prior estimate of 70,000. The 2025 production capacity would suggest over 430% increase from 15,000 at the end of 2023.

Management said in the earnings call Q&A that the supply is expected to continue to be tight next year. They also mentioned in the Q2 earnings call they are working with OSAT (Outsourced Semiconductor Assembly and Test) partners to increase production capacity.

Gokul Hariharan

“How do you think about supply demand balance for AI accelerator and CoWoS advanced packaging capacity? And I think in your symposium you talked about 60% CAGR, component growth for CoWoS capacity in the next four, five years. So, could you talk a little bit about how much capacity for CoWoS would you be planning to build next year as well?”

C. C. Wei

“Gokul, I also try to reach the supply and demand balance, but I cannot today. The demand is so high, I have to work very hard to meet my customers' demand. We continue to increase, I hope sometime in 2025 or 2026 I can reach the balance. You're talking about the CAGR or those kind of increase of the CoWoS capacity. Now it's out of my mind. We continue to increase whatever, wherever, whenever I can. Okay. The supply continues to be very tight, all the way through probably 2025 and I hope it can be eased in 2026. That's today's situation.”

Gokul Hariharan

“Any thoughts on next year capacity? Are you going to double your capacity again next year for CoWoS?”

C. C. Wei

“The last time I said that, this year I doubled it, right? More than double. Okay. So next year, if I say double, probably I will answer your question again next year and say more than double. We are working very hard, as I said. Wherever we can, whenever we can.”

—End Quote

The company’s other advanced packaging technology, system-on-integrated chips (SoIC), is also in robust demand. According to TrendForce, the company is expected to increase the monthly capacity to 5,000 to 6,000 units by the end of this year, up 2.5x to 3x from 2,000 units in 2023. Furthermore, by the end of next year, it is expected to scale to 10,000 units. According to the Economic Daily News, the company has secured Apple as the second major customer of SoIC.

The gross margin for advanced packaging was previously lower than the corporate average. However, due to cost controls and economies of scale, it is now close to the corporate average.

Due to the strong demand TSMC is expected to assign the orders of the initial stage of CoWoS packaging, Chip on Wafer (CoW) to OSAT partner SPIL. This is the first time the company is outsourcing this process since the demand is high and previously WoS (Wafer-on-Subtrate) process was outsourced while keeping the higher margin CoW process in-house. This is line with the management comments in the earnings call to increase production by collaborating with OSAT partners.

Valuation

The company trades at a P/E ratio of 32.8 and a forward P/E ratio of 27.8. The P/S ratio is 12.4 and a forward P/S ratio of 10.9. In the last five years, the P/E ratio peaked at 41.8 in February 2021 and hit a low of 10.3 in November 2022. The stock is now trading above its five-year average P/E ratio of 24.1.

TSMC Technical Analysis

By Portfolio Manager Knox Ridley

Since the 2022 top, every time the S&P 500 makes a new high while semiconductors make a lower high, we have seen a correction follow. In June and July of 2024, most semiconductors put in a top and have since made a series of lower highs. When we compare this to the S&P 500 that is currently pushing to new all-time highs today, we are seeing the largest divergence between semiconductors and the broad market on record.  This does not guarantee volatility, but the history of this pattern, especially considering the importance of semiconductors in the new AI economy, warrants patience.

Like most AI related semiconductor stocks that we track, TSM appears to be setting up for one more drop in this on-going correction. All corrections, whether we are dealing with a multi-year secular bear market, or an intraday pullback, consists of 3 waves: The initial drop down (the A wave), followed by a corrective bounce (B wave), and then the final drop lower, which tends to be the most dramatic part of a correction (C wave).

Based on the pattern analysis, TSM, like most semis, put in a top in June/July, and is currently completing what appears to be the B wave bounce. Note the 3 waves higher off the August low. It looks like the B wave needs one more minor swing to the $190 – $207 region to complete. This should lead to the final C wave drop into the $138 – $125 region, which is where we will target our entry. If this plays out, it will complete multi-month correction pattern, which should lead to the next push to new highs. If TSM instead drops below $168 before making a swing high, then we will consider the B wave complete.

The alternative scenario that we are tracking is that the correction ended at the August lows. This would mean that the current pattern taking us to the +$230 region is an ending diagonal pattern, which needs to prove itself to us before we buy into it. Once this bounce completes, we will need to see a larger corrective drop that makes a higher low, or a direct breakout on heavy volume over the $207 region. If this plays out, we will likely pivot our buy plan to accommodate this scenario.

Conclusion

TSMC is the common denominator to the market’s biggest AI winners as it supplies Nvidia, Apple, AMD, Marvell, and Qualcomm. As the AI economy continues to grow, Taiwan Semi’s importance will only increase. The HPC segment recently soared to its highest levels ever, and although TSMC is lumpy at times within particular revenue segments, it is remarkably consistent on margins and earnings growth.

The company is negotiating better prices with its customers, is making cost improvements, and is maintaining strong margins and cash flows. We look forward to adding this stock to our portfolio in the coming months and will provide the play-by-play for our entries and adds to Essentials Members.

Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.

Recommended Reading:

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The I/O Fund recently entered Coinbase primarily based on technicals. Coinbase offers investors a rare glimpse into the fundamentals of a crypto-related company, yet it’s clear to see Coinbase’s fundamentals are not a reliable indicator of future performance. Rather, asset prices and volatility in crypto are more important than traditional fundamentals for Coinbase because the company charges trading fees for each transaction.

Below is a clear picture that Coinbase trades in lock-step with Bitcoin. Due to it being a publicly traded stock, Coinbase can exceed Bitcoin at crypto peaks due to the ease of trading a stock compared to crypto assets.

Coinbase has primarily been a spot trading exchange, to where crypto traders buy the asset at current market prices. In November of 2023, Coinbase added derivatives trading which will help the exchange participate in a higher percentage of trading activity. Derivatives trading is roughly 2/3 of all crypto trading compared to spot trading at 1/3. Sometimes, derivatives trading is as high as 70% or even 75% of crypto trading volume, which means for the first time this year, Coinbase is able to participate in this lucrative space.

Equally as important (if not more so), Coinbase has launched a Layer 2 called Base over the past year, which has been growing in popularity and ranks #6 across both Layer 1 and Layer 2 chains in terms of total value locked (TVL). At one point, Base surpassed Solana in its first year of launching. Base facilitates faster and cheaper transactions, which is the most critical problem for the crypto complex to solve. If Coinbase has truly solved this pain point with Base, and it appears it has, then the company is setting up a nice future for itself by not only diversifying away from asset prices and crypto volatility, but is also opening up a new revenue stream that theoretically could eclipse platform revenue once the blockchain ecosystem is fully mature.

Before we sound the bull horn, Coinbase has an important hurdle to clear. Bitcoin ETFs are impacting Coinbase’s core business model of charging high fees for crypto transactions. It’s clear from the data we pulled below that ETFs are not additive for Coinbase, which is the opposite of what management had promised earlier this year. Instead, Coinbase is participating at a lower percentage when comparing to the last time Bitcoin reached an all-time high.

We look at these key points below. Please note, crypto is highly volatile. The I/O Fund plans to trade Coinbase as a momentum play and this stock is for Advanced Members only. Should Coinbase break key levels, we will close the position with no hesitation. As stated, technicals carry higher importance than fundamentals for crypto, and this is true for Coinbase due to its correlation with Bitcoin. You can find critical notes from Knox on his trading plan below.

Coinbase Overview

Coinbase is best known as a crypto trading platform, which accompanies high volatility and an overabundance of competition. The company charges transaction fees for each trade with fees up to 0.50% up to 4.5%. This is quite high when you consider money managers typically charge on average a 1% recurring fee to manage an entire account. The high fees are further brought into focus when you consider that equities, including ETFs, no longer charge transaction fees.

Coinbase’s success is tied to trading volumes, as higher volumes lead to higher fees for Coinbase.  Even though we are seeing Coinbase successfully diversify their revenue, trading volume still accounts for the bulk of their revenue, and likely will for the time being. The arrival of Bitcoin ETFs is impacting Coinbase’s primary source of revenue, as ETFs offer an easy alternative to Coinbase’s fee driven trading platform. The ways in which Coinbase successfully pivots and differentiates its trading platform will be crucial for its ability to grow in the crypto space as the high trading fees will continually become disrupted.

We are seeing Coinbase’s trading platform to evolve to meet these challenges. Advanced Trade, previously called Coinbase Pro, is a platform for more advanced crypto traders that offers staking, decentralized app wallets, the ability to trade crypto derivatives and even a Coinbase credit card.

As discussed, the ability to trade derivatives on Coinbase is new this year. Derivatives are a large portion of daily crypto market activity. According to CoinDesk, derivatives were at 68% of the market in March of 2024, reaching a high of $6.18 trillion of $9.12 trillion in total trading volume. This is when Bitcoin was at all-time highs of $73,000+. Last month, CoinNess reported that derivatives reached a total of $5.22 trillion with $3.68 trillion or 70% being from derivatives trading.

Spot trading (which is your typical crypto trading) accounted for $1.54 trillion of crypto exchange volumes last month, or about 30% of volume. In March, spot trading reached a peak of $2.94 trillion for the highest monthly volume since May of 2021.

Coinbase reported a decline in spot trading volume of 28% QoQ citing volatility in crypto pricing. This quarter will be important for spot trading volume growth and derivatives growth as competitors Crypto.com have been reporting growth MoM on spot trading and up to $1 billion in open interest in derivatives, up 4X since January. Crypto.com has significantly lower trading fees of 0% to 0.075%, so it’s not too surprising it's gaining market share while Coinbase is struggling considering that spot traders will often use whichever platform offers the most competitive trading fees. Binance offers 0.1% fees on spot trading.

Coinbase One is a subscription plan that removes trading fees for $29.99 a month for the first $10,000 traded every month. This can work for investors who dollar cost average every month, yet is unrealistic for most crypto investors. One of the premiere features of Coinbase One is that it offers up to $1 million in insurance under certain terms and conditions.

The offer for no trading fees (or “gasless transactions”) is accomplished through Base, which is a Layer 2 built on the Ethereum network. Base offers 1 cent, 1 second transactions with the company currently seeing $20 billion per week in USDC transactions. By bundling hundreds of smaller transactions and processing them as one large Ethereum transaction with Ethereum as the settlement layer, Base reduces the transaction fee. The OP stack that Base is built on helps to deploy Rollup blockchains. We’ve discussed Rollups before in an Ethereum analysis as a key feature for the merge to Proof of Stake. Rollups allow hundreds of transactions to be rolled into one.

Base is compatible with the Ethereum Virtual Machine (EVM), which is the runtime layer that executes smart contracts on the Ethereum network. By being an EVM-compatible Layer 2 chain, Base offers interoperability with other EVM-compatible applications and the security and decentralization of Ethereum’s Layer 1 while improving on the Ethereum network’s scalability issues. We’ve covered the scalability issues in a previous analysis that discussed high gas fees on the Ethereum network. Due to lowering transaction fees, Base saw 300% QoQ growth in the number of transactions last quarter.

Due to Base resulting in faster transaction times, lower fees and offering compatibility with Ethereum, the Layer 2 chain is open sourced for developers to utilize these features for custom decentralized apps (dapps). The plan is to increase Base’s revenue potential after building a developer ecosystem around Coinbase’s unique ability to develop a Layer 2 that addresses gas fees: “We believe that this growth will then add users to develop products, we'll add developers and apps on Base. And that in turn will drive transaction volume and will drive down sequencer fees, and we will then see revenue as a result of those efforts.”

Coinbase is the sequencer, which manages the collection and publication of user transactions. For now, Coinbase controls the transactions, which will need to change in the future to adhere to blockchain’s ethos of decentralization. Coinbase is clearly profiting from Base with an estimated $52.5 million in the current quarter – exceeding even custodian ETF fees. By combining many transactions into one payment, Base can collect an arbitrage between the transaction fees and the network gas fees. There is also interest income from USDC on Base.

The Coinbase Developer Platform is a much larger initiative to become the backbone for financial-based decentralized apps (dapps). The platform offers APIs such as: building programmable crypto wallets to transfer crypto between two parties, or the ability to send, receive, trade and stake crypto. There are software development kits (SDKs) that help to integrate onchain AI, trading bots or automated payouts.

Bitcoin ETFs Having a Negative Impact on Coinbase

This year, the SEC approved 11 spot Bitcoin ETFs on January 10th, opening the door for more investors to gain exposure to Bitcoin without directly holding it. We stated at the time that the approval and subsequent widespread access for institutions and retail investors would shape up to be one of the most bullish fundamental moments in Bitcoin’s history.

Our paid research site has been anticipating this moment since 2019 when we stated: “One of the biggest hurdles for institutions, however, is not the idea of a world run on digital currencies, but rather the decentralization concept and the need for cryptocurrency storage. Institutional investors need to know the assets are secure, insured, and under the care of a trusted third party, per SEC rules, which requires advisers to keep client funds with a qualified custodian.”

Due to ETFs, the demand for Bitcoin has increased. Spot Bitcoin ETFs have seen a surge in net inflows, surpassing more than $30B AUM in mid-April after amassing $17B in funds in less than two months after a launch in mid-January. Trading volume on the ETFs nearly tripled in March, reaching $111 billion – for an asset class that had launched only two months prior, that’s a significant figure.

By mid-July, BlackRock Bitcoin ETF (IBIT) surpassed Invesco QQQ in year-to-date net flows despite total assets in IBIT being only a fraction of the Qs at $22 billion compared to $287.2 billion. At the time, two Bitcoin ETFs were in the top 10 including Fidelity.

In late August and early September, investors pulled roughly $1.2 billion or 3% of total assets from Bitcoin ETFs in the “worst string of outflows yet.” At eight of the eleven ETFs, this was the most consecutive days of net outflows that ETFs have experienced since the Jan 2024 launch. The 3% shows resiliency and may be leading to higher lows for Bitcoin, given the ETF outflows were not higher.

Since then, Bitcoin ETFs have seen their second consecutive week of inflows while Ethereum ETFs are seeing outflows. Since Ethereum ETFs were listed, Bitcoin has seen $5 billion of inflows while ETH products have seen $500 million of outflows (from Grayscale).

In the first eight months of the year, Bitcoin recorded its highest ever trading volume to-date, exceeding even the crypto bubble of 2021.

Source: CoinDesk and Kaiko

The most recent data from Dune shows Bitcoin ETFs having cumulative onchain holdings of $59.2 billion with BlackRock having 38% market share with $22.5 billion.

At the time of the ETFs launching, our team covered Coinbase and Robinhood in an analysis where we examined the impact of spot ETFs. Coinbase’s management team stated at the time:

Q: “Will Coinbase consider reducing transaction fees to make them more competitive with other platforms where ETFs are being traded at significantly lower prices?”

A: “We have no current plans to reduce transaction fees because of ETFs. If you just zoom out a little bit, spot ETF should be a positive catalyst for the entire crypto space. They should add credibility to the market, and we should see increased liquidity and market stability as we've seen with other asset classes such as gold.”have no current plans to reduce transaction fees because of ETFs. If you just zoom out a little bit, spot ETF should be a positive catalyst for the entire crypto space. They should add credibility to the market, and we should see increased liquidity and market stability as we've seen with other asset classes such as gold.”

It was our hypothesis at the time that lower volatility would mean fewer transactions for Coinbase, resulting in ETFs having a net impact on Coinbase.

In the Q4 call, Coinbase’s management team also asserted the ETFs will have a positive impact on the company’s revenue: “This will unlock new pools of capital to flow into the crypto space with Coinbase playing a key role here. We are earning revenue, not just on custody, but also on trading and financing.” It was also stated: “And we've always said that ETFs would be a win-win for Coinbase, and we're starting to see that play out on our platform.”

Being even more direct in the Q4 call held in February, it was stated: “For anybody worried about cannibalization, ETFs have been positive for the industry, which has been additive for Coinbase. We're seeing elevated engagement and net inflows across both retail and institutional Q1 to date” and also “ETFs are a massive way to get more capital to come in. So far, we have not seen any cannibalization. As Alesia said, it's been additive for Coinbase, and we're seeing elevated engagement and net inflows on both retail and institutional Q1 to date.”

However, the data we have pulled shows ETFs are not additive, and are instead, having a negative effect on Coinbase.

Source: I/O Fund

Description: Bitcoin hit all-time highs in Q4 2021 and again in Q1 2024. We can see from the data above that Coinbase is participating at a lower percentage of trading volume.

We would want to see higher institutional volume than the last ATH for the narrative that Coinbase is participating in institutions driving forward Bitcoin’s asset price in Q1 2024. Instead, we see it’s flat while consumer is more than 50% lower than Bitcoin’s last all-time high. The interpretation is that Bitcoin ETFs are not an additive for Coinbase at this time.

Similar to volume, we would want to see growth in institutional revenue help to offset a decline in consumer revenue.

Source: I/O Fund

Description: Transaction revenue from institutions was similar between Bitcoin’s previous all-time high, yet consumer is revealing that Coinbase’s fees are not attractive compared to the $0 trade fees from ETFs (albeit ETFs come with management fees).

The custodial fees of roughly $35 million, are up about $20 million since before the ETFs launched but do not help to absorb the combined $1.256 billion difference in transaction revenue between Bitcoin’s last ATH in Q4 2021 and Bitcoin’s ATH in Q1 of 2024.

The Bitcoin ETFs are cheaper to trade on stock trading platforms at $0 fees. As Bitcoin’s reputation has greatly increased with institutional participation, there may also be a psychological hurdle to trading and owning other cryptos, which in contrast, are high risk and have little to no institutional adoption. This would weigh on Coinbase compared to the last crypto boom as Bitcoin’s rising popularity erodes Coinbase’s value proposition to offer tokens that are hard to find on other exchanges.

Keep in mind, if this was purely a fundamentals play, the decoupling of Coinbase’s transaction revenue with the bellwether’s new all-time high would be concerning. However, Coinbase represents a means of trading crypto as a stock, and thus, even with a much lower revenue correlation to Bitcoin’s asset price, we expect Coinbase will continue to trade in lock-step with the bellwether.

ETF Custodian

Coinbase is the custodian for 10 out of 11 spot ETFs and eight of the nine approved Ethereum ETFs. In addition to being paid custodian fees, Coinbase can monetize ETFs through trading fees on the Prime product for institutions and financing for trade settlements.

We only have a two-quarter glimpse at results, yet the custodian fees are not able to offset the losses in transaction revenue. The custodial fee revenue for Q4 was $19.7 million, and grew 64% QoQ to $32.3 million in Q1. However, in Q2, the QoQ growth was only 6.8% QoQ.

Notably, this week, Blackrock has amended its custody agreement with Coinbase to require 12 hour withdrawals. According to the amendment, Coinbase Custody must now process a withdrawal of digital assets to a public blockchain address within 12 hours of receiving instructions from the Trust. This follows social media rumors that Coinbase was not purchasing Bitcoin with funds from ETFs, and was instead, issuing letters of debt. The pushback on these rumors is that Bitcoin’s price has been depressed due to other causes, and that Coinbase settles transactions on-chain even when some wallet addresses are concealed. The outcome is that there will be more liquidity and faster settlements for ETFs and institutions, and it’s likely Coinbase has to follow similar settlement times for consumers, as well.

Coinbase Financials:

Coinbase has tricky financials since it’s a crypto-related company. It would be tough to rely on fundamentals for an entry as it can change quickly in either direction. The metric that tends to track the best with Coinbase’s price action is asset prices and monthly transaction volume for crypto. However, the crypto market is largely dictated by sentiment, and we’ve found that Coinbase’s price is as an extension of this reality. The best indication of Coinbase’s trend is to track Bitcoin’s trend. They have been moving in lockstep since COIN’s IPO.

Coinbase’s forward estimates are meaningless as the estimates require predicting where crypto will trade in any given quarter. This is impossible for any analyst to do. Rather, for investors in Coinbase, importance should be placed on crypto transaction volumes, volatility indicators and pricing.

The company is also cyclical as it laps tough comps more often than a typical growth stock. By virtue of Bitcoin and crypto reaching a new high in March of 2024, the company is expected to see negative growth of (-12.08%) the following year in the March quarter of 2025.

Again, estimates are meaningless. If crypto is trading at all-time highs in March, then Coinbase will report growth – this company has seen growth of 1,100% in one quarter in 2021. During periods of crypto selloffs, the company has reported up to (-75%) revenue decline. As you can probably guess, this was in 2022.

Where Coinbase has seen a remarkable turnaround is with the cash flows, from (-51.6%) in 2022 to 27.7% in 2023. The company is prudent at keeping cash on its balance sheet with $7.23 billion in cash and $4.23 billion in debt for net cash of $3 billion. This is helpful as a stock, yet also helpful given the counterparty risks crypto exchanges carry; with nearly every competitor being private and not regulated by the SEC, the transparency of having $3 billion in cash and reporting quarterly is likely to attract institutional interest.

Revenue:

This quarter, the company is expected to report revenue of $1.28 billion for growth of 89.7%. Due to lapping tough comps, the growth rate is expected to slow considerably in early 2025 with current estimates expecting a bottom in Q1 2025 with growth of (-12.08%).

Notably, on a QoQ basis, Coinbase will be nominally up in revenue from Q4 2024 to Q2 2025 whereas it’s a tough YoY comp from Bitcoin reaching all-time highs in March of 2024.

Last quarter, Coinbase reported revenue of $1.45 billion for growth of 105%, beating estimates by 6.2%. This declined from the March quarter with growth of 112% and revenue of $1.64 billion.

If you look further out, you see that analysts shy away from predicting too much growth in either direction. This is why technicals matter quite a bit with Coinbase:

Pictured Above: Analyst estimates are essentially flat due to an inability to predict crypto trading volumes.

Key Segments:

Coinbase’s trading volume was $226 billion, up 146% YoY yet down (-28%) QoQ. This compares to $312 billion in the March quarter when Bitcoin was at all-time highs.

Coinbase’s transaction revenue was $781 million in the most recent quarter ending in June, representing growth of 138.7% YoY and a decline of (-27%) QoQ. During Bitcoin’s peak in March, the company reported transaction volume of $1.08 billion. Compare this to 2023’s transaction volumes, which were less than $500 million and often down up to (-50%).

Management stated that there is beginning to be a disconnect between revenue and volume due to wallet fees and derivatives being counted as consumer revenue yet do not contribute to consumer volume.

• Within Transaction revenue, Consumer is the main driver at $664.8 million compared to Institutional volume of $63.6 million. The institutional percentage has been growing rapidly from $39 million in H1 2023 to $149 million in H1 2024 for 282% growth. Consumer grew 159% in the same period.
• Base revenue has been moved to Other transaction revenue and was at $52.5 million in the current quarter. From H1 2023 to H1 2024, Base and other transaction revenue grew 145%. This means that Base revenue is higher than custodial fees.
• Management stated they saw $210 million in transaction volume for July, pointing toward mid-$600 millions for transaction volume. This compares to $110 million for July of last year in the same period.
• What we’ve extrapolated above is that Coinbase is not a beneficiary of Bitcoin ETFs as both trading volumes and transaction revenue are significantly lower than Bitcoin’s previous all-time highs but that institutions, derivatives and Base may (over time) help make up for consumer-related spot trading losses.

Subscription and services revenue was $599 million, compared to the guide for $525M to $600M, reporting growth of 78.6% YoY and 17% QoQ. This is an all-time high for Coinbase in this segment and helps to diversify from being dependent entirely on transaction volume. The growth was due to stablecoin revenue and a one-time blockchain validator reward of $8 million.

Within Subscription and Services:

Looking forward, subscription and services are expected to be “within a range of $530 million to $600 million.”

• Stablecoin revenue of $240.4 million was up 59% YoY and reached an all-time high. The segment was up 17% QoQ. According to management, they are seeing almost $20 billion per week in USDC transaction volume. USDC is a 1:1 with the dollar and is used for global transfers. Advanced crypto traders and institutions will also settle a high-dollar token swap with USDC rather than token-to-token or transferring into cash to avoid high spreads and high fees.
• Blockchain rewards was at $185.1 million, up 111% YoY and up 22.6% QoQ. This segment opens up an interesting opportunity as interest rates go lower. Staking yields are not determined by FOMC policy; instead, by the participation rate of coins being staked. As demand increases for crypto, yields will increase to entice more coins to be staked. As a non-correlated yield to traditional financial instruments, which are mostly tied to central bank policy, this creates an opportunity for portfolios to diversify incomes in an interesting way, and adoption should increase as rates go lower.
• Interest and finance fee income of $69.4 million, up 34% YoY. This segment is tied to interest rates, as Coinbase offers loans against the coins being held in house. This is unlikely to sustain now that the FED has lowered rates. Yet, segments such as these can help stave off losses since crypto as an asset class tends to underperform in a high interest rate environment.
• Custodial fee revenue was $34.5 million, up 103% YoY.
• Other subscription and services revenue of $69.6 million was up 153% YoY.

Margins:

Coinbase does not provide a gross margin on their income statement. The operating margin fluctuates wildly aligned with revenue fluctuations. Last quarter, the operating margin was 23.7% compared to 46.4% in the previous quarter. A year ago, the operating margin was (-10.4%).

The operating expenses increased 26% QoQ to $1.1 billion primarily due to a loss of (-$31 million) on crypto assets held for operations in Q2 compared to a gain of $86 million in Q1 and Technology & development, G&A, sales & marketing expenses increased by $106 million due to higher USDC reward payouts, performance marketing spend, and policy spending.

Net margin last quarter was 2.5% for $36.1 million in profits. This was down considerably from 71.9% in the previous quarter with profits of 1.18 billion. In the year ago quarter, the net margin was (-13.8%) for losses of ($97.6) million.

Stock based compensation was $217 million or 15% of revenue last quarter. This is down considerably from 28% of revenue last year. However, management stated: “We expect technology & development and general & administrative expenses to increase Q/Q to $700-$750 million, largely driven by the non-linear expense recognition of our stock-based compensation.” This would imply a $40 million increase at the midpoint for $257 million in SBC or about 20% of revenue.

Earnings and EBITDA:

GAAP EPS of $0.14 last quarter compared to GAAP EPS estimates of $0.92. This compared to GAAP EPS of $4.40 last quarter and adjusted EPS of ($0.42) in the year ago quarter.

Adjusted EPS of $0.14 last quarter compared to estimates for $0.80 EPS.

Coinbase is expected to report adjusted EPS of $0.43 next quarter and GAAP EPS of $0.48. The expectation is that Coinbase remains GAAP profitable although this will depend on the level of drawdown seen in any future crypto selloffs.

The company reported adjusted EBITDA of $595.5 million for a margin of 41.1% compared to adjusted EBITDA of $1.01 billion last quarter for a margin of 61.9%.

Notably the company was adjusted EBITDA positive even in Q2 and Q3 of 2023 when it reported negative YoY revenue. At that time, adjusted EBITDA was in the range of 26% and 27% for $188.7 million and $178.3 million. When including stock-based compensation, the company would not be adjusted EBITDA positive as SBC was $199.8 million and $218.2 million, respectively, in those two quarters.  

Coinbase Additional Notes:

More on Derivatives:

As stated, derivatives are about 70% of the trading market for crypto. A derivative contract is an instrument, such as a futures contract, option or perpetual contract, whose price is based on the underlying crypto currency. Unlike spot trading, where you are buying the asset and mostly participating on the long side, derivative trading allows the owner of the contract to speculate on both up and down price movements, hedge a spot position, or add leverage to a position. This allows an investor to bet on the inevitable downtrends in crypto, and therefore allows institutions, or retail traders, to hedge their positions.

Derivatives are a key element to attract savvy retail and institutional investors. Having a user-friendly platform to trade these instruments is an important piece to Coinbase’s evolution with institutional adoption. In the medium-term, derivatives will help to compensate for the lower consumer spot trading volumes on Coinbase’s platform.

Here was a question about derivatives on the most recent earnings call:

Devin RyanDevin Ryan

Great. Thank you. Hi, Brian. Hi, Alesia I just want to ask a question about the derivatives platform and we're tracking just quarter-to-date, a continuation of building volumes there. And I know you're not breaking it out in revenues separately yet, but it sounded like it was a positive contributor in the second quarter.

Brian ArmstrongBrian Armstrong

Yes. So I'll start off and then maybe I'll hand over to you, Alesia on some of the margin questions. So just zooming out, derivatives is about 75% of all crypto trading activity by volume. And so it is the majority of trading volume. Now the take rates are lower on it, but it's really a key part of the market overall. And so I'm really glad that we are now in market, both the U.S. with Coinbase financial markets and then internationally with our international exchange as well

For Coinbase International Exchange, we also expanded our asset coverage quite a lot in Q2. We added 25 additional perpetual futures contracts. The volume has been really good today, actually, on Coinbase International Exchange. So you can check out at international.coinbase.com.

And so you can kind of just see Coinbase following this path of we're not always first-to-market, but we do it the do it the right way. We compliant way, the secure, trusted way. And so we're the trusted counterparty that many of these folks have been waiting for to enter the market. And I think that's going to pay off as a really good long-term strategy. Alesia, anything you want to add?

–End Quote

Base Layer 2

As stated above, the offer for no trading fees (or “gasless transactions”) is accomplished through Base, which is a Layer 2 built on the Ethereum network. Base offers 1 cent, 1 second transactions with Coinbase reporting there is $20 billion per week in USDC transactions taking place on the Layer 2. Base offers interoperability with other Ethereum network-compatible applications, offering the security of Ethereum’s Layer 1 while improving Ethereum’s scalability issues (primarily gas fees). Coinbase’s goal is to decentralize Base to make transactions faster while leveraging the security of Ethereum mainnet.

Total value locked (TVL) for Base was at $8 billion as of July 2024, making Base the second largest Layer 2 by TVL after Ethereum’s Dencun upgrade. Crypto has settled a bit since July, yet Base remains the second largest Layer 2 by TVL with $1.965 billion TVL. Base has seen trading volumes of up to $1 billion per day with up to 3 million transactions per day, whereas Coinbase sees about $2 billion in trading volume and Ethereum sees about 1 million to 2 million transactions per day. This means at the onset, Base exceeds Ethereum in number of daily transactions.

Base is further interesting for I/O Fund Members as the Layer 2 offers Data Streams from Chainlink, which is low-latency data that allows developers to build DeFi apps. Base also offers Chainlink VRF, the leading random number generator across Web3 with more than 21 million transaction requests completed and with a latency of about two seconds. We’ve covered Chainlink automation with up to 90% reduction in gas fees, Cross-chain Interoperability Protocol (CCIP) and Price Feeds in the past here. Our original Chainlink thesis is a must-read for anyone new to the I/O Fund, as LINK is an asset our firm has held since launching our research site in 2019.

Over the past few months, Base has been integrated by Stripe and Shopify, which is an important step forward to see onchain versions of Fortune 500 applications. Stripe uses Base for faster and cheaper money transfers by adding USDC to crypto payouts, and fiat-to-crypto for currency conversions. There is also an integration with Coinbase Wallet to allow users to purchase crypto with credit cards and Apple Pay. Stripe originally offered crypto payments in 2014 but ceased doing so in 2018.

The company has stated its focus is to build a developer ecosystem around Base first and foremost: “Our focus, as I mentioned in my opening remarks, is driving developer activity, we're driving those transaction volumes that we commented on. We're doing this by driving down fees, increasing the scalability and creating a powerful developer platform that's enabling anybody to build these onchain products.

We believe that this growth will then add users to develop products, we'll add developers and apps on Base. And that in turn will drive transaction volume and will drive down sequencer fees, and we will then see revenue as a result of those efforts.

Regulations

For institutions, there is a product called Coinbase Prime. This is a full-service prime brokerage platform, which facilitates trades as well as custodian services for large institutions. Management has stated institutions have maybe 1% to 3% of their funds in crypto. This is a low allocation, which has a lot of potential for growth. However, it is being stymied due to the lack of much needed regulations within the crypto space, which has been fraught with fraud.

For example, On November 11th, 2022, FTX, one of the largest crypto exchanges in in the world, filed for bankruptcy. At the time, it was the 18th crypto exchange to file for bankruptcy, and by far the largest, with an estimated $9 billion lost. One of the many fraudulent practices, which wasn’t limited to FTX, was that FTX would not register an internal transaction until a customer wanted their coins out of the exchange. This led to a scenario where 28 million Bitcoins had been bought with only 19.8 million in supply. Therefore, FTX created a crypto-version of a ponzi scheme that suddenly ended.

There have been a total of 20 crypto exchanges that have failed through 2024. The reason for their failures range from hacking events, mismanagement due to faulty business models, to outright fraud. We’ve even seen exchanges attempt a fractional reserves model where loans were offered based on a fraction of the total coins being held on their exchange.

These exchanges are all private businesses, except for Coinbase, so there is no way to see their financials. Furthermore, there are no mandatory audits to prevent fraud or mismanagement. When you factor in that over 50% of all cryptocurrencies have failed, it’s no wonder institutions managing millions to billions have been hesitant to explore this asset class.

As of now, Canada, UK, Switzerland, El Salvador, and China have regulations around crypto currencies. The United States is expected to follow, as the House just passed a meaningful crypto bill that defines regulations. The 200 page bill helps categorize a cryptocurrency and thus determines if should be regulated as a security by the SEC or as a digital commodity by the CFTC, through well-defined oversight. Furthermore, the bill would remove exchanges from comingling coins, as well as removing conflicts of interest, such as trading as an entity while also acting as a broker between buyers and sellers.

Whether it gets passed by the Senate is yet to be seen. With some of the world’s largest financial institutions now involved in the crypto space through Spot ETFs, it’s only a matter of time before much needed regulations will settle the nerves of money managers looking to diversify into this space. When this happens, it should act as a tailwind to Coinbase’s current business model.

Strong Cash on the Balance Sheet

As stated, free cash flow was $484.2 million or 33.4% of revenue compared to $151.1 million or 21.4% of revenue in the same period last year and 25.1% of revenue in Q1.

Cash was $7.23 billion and debt of $4.23 billion compared to $6.7 billion and $4.23 billion in Q1. The company issued $1.3 billion of convertible notes in Q1 and plans to use the net proceeds of $1.1 billion to repay the outstanding debt at or prior to maturity, depending on the market prices. Management also clarified in the earnings call that the other reasons for maintaining large cash balances were to support the ETF launches and for potential investment opportunities.

Here was a question on the earnings call:

Benjamin BudishBenjamin Budish

Hi. Good evening, and thanks for taking the question. I was wondering if you could give us an update on your balance sheet strategy. We noticed the cash build continues to really grow. And it seems like with the — the business generating cash and spending really kind of ramped down from a few years ago, there may not be as much of a need for it. So any update there? And then kind of along the same lines, you've been generating now a lot of your gross profit from interest income. And just curious, if there's any thoughts around the hedging strategy should rates start to come down. What's your kind of philosophy there? Thank you.

Alesia HaasAlesia Haas

Thanks for those questions. Yes, we're really pleased with the balance sheet strength. We are using cash, as we've mentioned in our prime financing business. A large amount of that cash was used to support the ETF launches in Q1 and Q2 with the Bitcoin ETF and now hopefully be a Ethereum ETF where you can see a lot of day-to-day or week-to-week volatility of those loan balances.

We did grow prime financing fees within the quarter. And so you can see while the balance at the end the end of quarter was down versus of Q2. We saw growth intra-quarter for those balances. So using our cash to support our products is a primary use case for us.

Technical Analysis

Coinbase appears to be working through a very large 5 wave pattern off its early 2023 low.  If this is accurate, any additional weakness will need to hold $113, and then start making higher highs to the 5th wave target between $294 – $217.

As of now, the larger correction that started in March of this year appears to be supporting this. It is a 3 wave correction that has room for one more swing lower to complete. If the current bounce fails to break over $172 – $181.50, then we can see a final drop into the $137 – $127 region. If we can instead breakout above $181.50, the odds will start supporting that the 4th wave low is in, and we will likely be in the early stages of wave 5 to new highs.

This lines up with Bitcoin’s chart, as well. The pattern off the late 2022 low appears to be an unfinished 5 wave pattern. Note the current correction. It is messy, with many overlaps, which is typical of corrections within larger uptrends. The bigger pattern suggests that we should be heading to $78,000 – $85,000 next, which would give us the minimum waves required to complete the 5 wave uptrend. Once we get to this region, or beyond. How we correct from there will determine just how high into the $100,000 region we will go.

For now, the probabilities favor a swing higher. As long as we hold $42,750 on any additional weakness, this remains our expectation from the technical patterns in both Coinbase and Bitcoin.

Conclusion:

Publicly, our firm has become known for our Nvidia AI thesis, and how we have positioned our readers for this trend before 2023. Yet behind the paywall, our premium subscribers are well aware that our active management with crypto since 2019 is equal in terms of its performance. By championing active management for tech investors — which means weighing the probabilities to cut or trim at specific times with the goal of buying lower — the I/O Fund stands out in a crowded, noisy crypto space by offering tools to navigate the volatility in this asset class.

Coinbase’s move into the derivatives market, as well as being a trusted custodian for institutional investors in the crypto space, will continue to entice institutions to their platform. Being a publicly traded company, Coinbase is the only exchange that allows its financials to be analyzed and monitored. This is crucial for investors considering the lack of FDIC and SPIC insurance in this space. These exchanges are businesses that can be mismanaged, and if this happens, all the coins being held there will be appropriated and redistributed to creditors in the event of a bankruptcy. This is a risk that Coinbase offers a solution to through their business model and publicly issued quarterly financials. This makes Coinbase stand out amongst its peers in a way that creates a moat for institutions looking to expand into the crypto space beyond the limited and costly spot ETF options.

Coinbase’s stock pattern lines up with Bitcoin, as both continue to suggest another swing higher is likely. If COIN can continue to evolve with the crypto market, and continue to lead as a trusted institutional platform, it will likely continue to appreciate with Bitcoin over time.

Given Chainlink is becoming a beneficiary of Layer 2s like Base and Arbitrum, you can expect an updated 2024 deep dive on our favorite blockchain asset coming soon!

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• Alpha & Omega Q4: Revenue in Line, All Segments Rebound Sequentially
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• Lumentum: Strong Data Center Tailwinds, Telecom Headwinds

The I/O Fund recently entered Coinbase primarily based on technicals. Coinbase offers investors a rare glimpse into the fundamentals of a crypto-related company, yet it’s clear to see Coinbase’s fundamentals are not a reliable indicator of future performance. Rather, asset prices and volatility in crypto are more important than traditional fundamentals for Coinbase because the company charges trading fees for each transaction.

Below is a clear picture that Coinbase trades in lock-step with Bitcoin. Due to it being a publicly traded stock, Coinbase can exceed Bitcoin at crypto peaks due to the ease of trading a stock compared to crypto assets.

Coinbase has primarily been a spot trading exchange, to where crypto traders buy the asset at current market prices. In November of 2023, Coinbase added derivatives trading which will help the exchange participate in a higher percentage of trading activity. Derivatives trading is roughly 2/3 of all crypto trading compared to spot trading at 1/3. Sometimes, derivatives trading is as high as 70% or even 75% of crypto trading volume, which means for the first time this year, Coinbase is able to participate in this lucrative space.

Equally as important (if not more so), Coinbase has launched a Layer 2 called Base over the past year, which has been growing in popularity and ranks #6 across both Layer 1 and Layer 2 chains in terms of total value locked (TVL). At one point, Base surpassed Solana in its first year of launching. Base facilitates faster and cheaper transactions, which is the most critical problem for the crypto complex to solve. If Coinbase has truly solved this pain point with Base, and it appears it has, then the company is setting up a nice future for itself by not only diversifying away from asset prices and crypto volatility, but is also opening up a new revenue stream that theoretically could eclipse platform revenue once the blockchain ecosystem is fully mature.

Before we sound the bull horn, Coinbase has an important hurdle to clear. Bitcoin ETFs are impacting Coinbase’s core business model of charging high fees for crypto transactions. It’s clear from the data we pulled below that ETFs are not additive for Coinbase, which is the opposite of what management had promised earlier this year. Instead, Coinbase is participating at a lower percentage when comparing to the last time Bitcoin reached an all-time high.

We look at these key points below. Please note, crypto is highly volatile. The I/O Fund plans to trade Coinbase as a momentum play and this stock is for Advanced Members only. Should Coinbase break key levels, we will close the position with no hesitation. As stated, technicals carry higher importance than fundamentals for crypto, and this is true for Coinbase due to its correlation with Bitcoin. You can find critical notes from Knox on his trading plan below.

Coinbase Overview

Coinbase is best known as a crypto trading platform, which accompanies high volatility and an overabundance of competition. The company charges transaction fees for each trade with fees up to 0.50% up to 4.5%. This is quite high when you consider money managers typically charge on average a 1% recurring fee to manage an entire account. The high fees are further brought into focus when you consider that equities, including ETFs, no longer charge transaction fees.

Coinbase’s success is tied to trading volumes, as higher volumes lead to higher fees for Coinbase.  Even though we are seeing Coinbase successfully diversify their revenue, trading volume still accounts for the bulk of their revenue, and likely will for the time being. The arrival of Bitcoin ETFs is impacting Coinbase’s primary source of revenue, as ETFs offer an easy alternative to Coinbase’s fee driven trading platform. The ways in which Coinbase successfully pivots and differentiates its trading platform will be crucial for its ability to grow in the crypto space as the high trading fees will continually become disrupted.

We are seeing Coinbase’s trading platform to evolve to meet these challenges. Advanced Trade, previously called Coinbase Pro, is a platform for more advanced crypto traders that offers staking, decentralized app wallets, the ability to trade crypto derivatives and even a Coinbase credit card.

As discussed, the ability to trade derivatives on Coinbase is new this year. Derivatives are a large portion of daily crypto market activity. According to CoinDesk, derivatives were at 68% of the market in March of 2024, reaching a high of $6.18 trillion of $9.12 trillion in total trading volume. This is when Bitcoin was at all-time highs of $73,000+. Last month, CoinNess reported that derivatives reached a total of $5.22 trillion with $3.68 trillion or 70% being from derivatives trading.

Spot trading (which is your typical crypto trading) accounted for $1.54 trillion of crypto exchange volumes last month, or about 30% of volume. In March, spot trading reached a peak of $2.94 trillion for the highest monthly volume since May of 2021.

Coinbase reported a decline in spot trading volume of 28% QoQ citing volatility in crypto pricing. This quarter will be important for spot trading volume growth and derivatives growth as competitors Crypto.com have been reporting growth MoM on spot trading and up to $1 billion in open interest in derivatives, up 4X since January. Crypto.com has significantly lower trading fees of 0% to 0.075%, so it’s not too surprising it's gaining market share while Coinbase is struggling considering that spot traders will often use whichever platform offers the most competitive trading fees. Binance offers 0.1% fees on spot trading.

Coinbase One is a subscription plan that removes trading fees for $29.99 a month for the first $10,000 traded every month. This can work for investors who dollar cost average every month, yet is unrealistic for most crypto investors. One of the premiere features of Coinbase One is that it offers up to $1 million in insurance under certain terms and conditions.

The offer for no trading fees (or “gasless transactions”) is accomplished through Base, which is a Layer 2 built on the Ethereum network. Base offers 1 cent, 1 second transactions with the company currently seeing $20 billion per week in USDC transactions. By bundling hundreds of smaller transactions and processing them as one large Ethereum transaction with Ethereum as the settlement layer, Base reduces the transaction fee. The OP stack that Base is built on helps to deploy Rollup blockchains. We’ve discussed Rollups before in an Ethereum analysis as a key feature for the merge to Proof of Stake. Rollups allow hundreds of transactions to be rolled into one.

Base is compatible with the Ethereum Virtual Machine (EVM), which is the runtime layer that executes smart contracts on the Ethereum network. By being an EVM-compatible Layer 2 chain, Base offers interoperability with other EVM-compatible applications and the security and decentralization of Ethereum’s Layer 1 while improving on the Ethereum network’s scalability issues. We’ve covered the scalability issues in a previous analysis that discussed high gas fees on the Ethereum network. Due to lowering transaction fees, Base saw 300% QoQ growth in the number of transactions last quarter.

Due to Base resulting in faster transaction times, lower fees and offering compatibility with Ethereum, the Layer 2 chain is open sourced for developers to utilize these features for custom decentralized apps (dapps). The plan is to increase Base’s revenue potential after building a developer ecosystem around Coinbase’s unique ability to develop a Layer 2 that addresses gas fees: “We believe that this growth will then add users to develop products, we'll add developers and apps on Base. And that in turn will drive transaction volume and will drive down sequencer fees, and we will then see revenue as a result of those efforts.”

Coinbase is the sequencer, which manages the collection and publication of user transactions. For now, Coinbase controls the transactions, which will need to change in the future to adhere to blockchain’s ethos of decentralization. Coinbase is clearly profiting from Base with an estimated $52.5 million in the current quarter – exceeding even custodian ETF fees. By combining many transactions into one payment, Base can collect an arbitrage between the transaction fees and the network gas fees. There is also interest income from USDC on Base.

The Coinbase Developer Platform is a much larger initiative to become the backbone for financial-based decentralized apps (dapps). The platform offers APIs such as: building programmable crypto wallets to transfer crypto between two parties, or the ability to send, receive, trade and stake crypto. There are software development kits (SDKs) that help to integrate onchain AI, trading bots or automated payouts.

Bitcoin ETFs Having a Negative Impact on Coinbase

This year, the SEC approved 11 spot Bitcoin ETFs on January 10th, opening the door for more investors to gain exposure to Bitcoin without directly holding it. We stated at the time that the approval and subsequent widespread access for institutions and retail investors would shape up to be one of the most bullish fundamental moments in Bitcoin’s history.

Our paid research site has been anticipating this moment since 2019 when we stated: “One of the biggest hurdles for institutions, however, is not the idea of a world run on digital currencies, but rather the decentralization concept and the need for cryptocurrency storage. Institutional investors need to know the assets are secure, insured, and under the care of a trusted third party, per SEC rules, which requires advisers to keep client funds with a qualified custodian.”

Due to ETFs, the demand for Bitcoin has increased. Spot Bitcoin ETFs have seen a surge in net inflows, surpassing more than $30B AUM in mid-April after amassing $17B in funds in less than two months after a launch in mid-January. Trading volume on the ETFs nearly tripled in March, reaching $111 billion – for an asset class that had launched only two months prior, that’s a significant figure.

By mid-July, BlackRock Bitcoin ETF (IBIT) surpassed Invesco QQQ in year-to-date net flows despite total assets in IBIT being only a fraction of the Qs at $22 billion compared to $287.2 billion. At the time, two Bitcoin ETFs were in the top 10 including Fidelity.

In late August and early September, investors pulled roughly $1.2 billion or 3% of total assets from Bitcoin ETFs in the “worst string of outflows yet.” At eight of the eleven ETFs, this was the most consecutive days of net outflows that ETFs have experienced since the Jan 2024 launch. The 3% shows resiliency and may be leading to higher lows for Bitcoin, given the ETF outflows were not higher.

Since then, Bitcoin ETFs have seen their second consecutive week of inflows while Ethereum ETFs are seeing outflows. Since Ethereum ETFs were listed, Bitcoin has seen $5 billion of inflows while ETH products have seen $500 million of outflows (from Grayscale).

In the first eight months of the year, Bitcoin recorded its highest ever trading volume to-date, exceeding even the crypto bubble of 2021.

Source: CoinDesk and Kaiko

The most recent data from Dune shows Bitcoin ETFs having cumulative onchain holdings of $59.2 billion with BlackRock having 38% market share with $22.5 billion.

At the time of the ETFs launching, our team covered Coinbase and Robinhood in an analysis where we examined the impact of spot ETFs. Coinbase’s management team stated at the time:

Q: “Will Coinbase consider reducing transaction fees to make them more competitive with other platforms where ETFs are being traded at significantly lower prices?”

A: “We have no current plans to reduce transaction fees because of ETFs. If you just zoom out a little bit, spot ETF should be a positive catalyst for the entire crypto space. They should add credibility to the market, and we should see increased liquidity and market stability as we've seen with other asset classes such as gold.”have no current plans to reduce transaction fees because of ETFs. If you just zoom out a little bit, spot ETF should be a positive catalyst for the entire crypto space. They should add credibility to the market, and we should see increased liquidity and market stability as we've seen with other asset classes such as gold.”

It was our hypothesis at the time that lower volatility would mean fewer transactions for Coinbase, resulting in ETFs having a net impact on Coinbase.

In the Q4 call, Coinbase’s management team also asserted the ETFs will have a positive impact on the company’s revenue: “This will unlock new pools of capital to flow into the crypto space with Coinbase playing a key role here. We are earning revenue, not just on custody, but also on trading and financing.” It was also stated: “And we've always said that ETFs would be a win-win for Coinbase, and we're starting to see that play out on our platform.”

Being even more direct in the Q4 call held in February, it was stated: “For anybody worried about cannibalization, ETFs have been positive for the industry, which has been additive for Coinbase. We're seeing elevated engagement and net inflows across both retail and institutional Q1 to date” and also “ETFs are a massive way to get more capital to come in. So far, we have not seen any cannibalization. As Alesia said, it's been additive for Coinbase, and we're seeing elevated engagement and net inflows on both retail and institutional Q1 to date.”

However, the data we have pulled shows ETFs are not additive, and are instead, having a negative effect on Coinbase.

Source: I/O Fund

Description: Bitcoin hit all-time highs in Q4 2021 and again in Q1 2024. We can see from the data above that Coinbase is participating at a lower percentage of trading volume.

We would want to see higher institutional volume than the last ATH for the narrative that Coinbase is participating in institutions driving forward Bitcoin’s asset price in Q1 2024. Instead, we see it’s flat while consumer is more than 50% lower than Bitcoin’s last all-time high. The interpretation is that Bitcoin ETFs are not an additive for Coinbase at this time.

Similar to volume, we would want to see growth in institutional revenue help to offset a decline in consumer revenue.

Source: I/O Fund

Description: Transaction revenue from institutions was similar between Bitcoin’s previous all-time high, yet consumer is revealing that Coinbase’s fees are not attractive compared to the $0 trade fees from ETFs (albeit ETFs come with management fees).

The custodial fees of roughly $35 million, are up about $20 million since before the ETFs launched but do not help to absorb the combined $1.256 billion difference in transaction revenue between Bitcoin’s last ATH in Q4 2021 and Bitcoin’s ATH in Q1 of 2024.

The Bitcoin ETFs are cheaper to trade on stock trading platforms at $0 fees. As Bitcoin’s reputation has greatly increased with institutional participation, there may also be a psychological hurdle to trading and owning other cryptos, which in contrast, are high risk and have little to no institutional adoption. This would weigh on Coinbase compared to the last crypto boom as Bitcoin’s rising popularity erodes Coinbase’s value proposition to offer tokens that are hard to find on other exchanges.

Keep in mind, if this was purely a fundamentals play, the decoupling of Coinbase’s transaction revenue with the bellwether’s new all-time high would be concerning. However, Coinbase represents a means of trading crypto as a stock, and thus, even with a much lower revenue correlation to Bitcoin’s asset price, we expect Coinbase will continue to trade in lock-step with the bellwether.

ETF Custodian

Coinbase is the custodian for 10 out of 11 spot ETFs and eight of the nine approved Ethereum ETFs. In addition to being paid custodian fees, Coinbase can monetize ETFs through trading fees on the Prime product for institutions and financing for trade settlements.

We only have a two-quarter glimpse at results, yet the custodian fees are not able to offset the losses in transaction revenue. The custodial fee revenue for Q4 was $19.7 million, and grew 64% QoQ to $32.3 million in Q1. However, in Q2, the QoQ growth was only 6.8% QoQ.

Notably, this week, Blackrock has amended its custody agreement with Coinbase to require 12 hour withdrawals. According to the amendment, Coinbase Custody must now process a withdrawal of digital assets to a public blockchain address within 12 hours of receiving instructions from the Trust. This follows social media rumors that Coinbase was not purchasing Bitcoin with funds from ETFs, and was instead, issuing letters of debt. The pushback on these rumors is that Bitcoin’s price has been depressed due to other causes, and that Coinbase settles transactions on-chain even when some wallet addresses are concealed. The outcome is that there will be more liquidity and faster settlements for ETFs and institutions, and it’s likely Coinbase has to follow similar settlement times for consumers, as well.

Coinbase Financials:

Coinbase has tricky financials since it’s a crypto-related company. It would be tough to rely on fundamentals for an entry as it can change quickly in either direction. The metric that tends to track the best with Coinbase’s price action is asset prices and monthly transaction volume for crypto. However, the crypto market is largely dictated by sentiment, and we’ve found that Coinbase’s price is as an extension of this reality. The best indication of Coinbase’s trend is to track Bitcoin’s trend. They have been moving in lockstep since COIN’s IPO.

Coinbase’s forward estimates are meaningless as the estimates require predicting where crypto will trade in any given quarter. This is impossible for any analyst to do. Rather, for investors in Coinbase, importance should be placed on crypto transaction volumes, volatility indicators and pricing.

The company is also cyclical as it laps tough comps more often than a typical growth stock. By virtue of Bitcoin and crypto reaching a new high in March of 2024, the company is expected to see negative growth of (-12.08%) the following year in the March quarter of 2025.

Again, estimates are meaningless. If crypto is trading at all-time highs in March, then Coinbase will report growth – this company has seen growth of 1,100% in one quarter in 2021. During periods of crypto selloffs, the company has reported up to (-75%) revenue decline. As you can probably guess, this was in 2022.

Where Coinbase has seen a remarkable turnaround is with the cash flows, from (-51.6%) in 2022 to 27.7% in 2023. The company is prudent at keeping cash on its balance sheet with $7.23 billion in cash and $4.23 billion in debt for net cash of $3 billion. This is helpful as a stock, yet also helpful given the counterparty risks crypto exchanges carry; with nearly every competitor being private and not regulated by the SEC, the transparency of having $3 billion in cash and reporting quarterly is likely to attract institutional interest.

Revenue:

This quarter, the company is expected to report revenue of $1.28 billion for growth of 89.7%. Due to lapping tough comps, the growth rate is expected to slow considerably in early 2025 with current estimates expecting a bottom in Q1 2025 with growth of (-12.08%).

Notably, on a QoQ basis, Coinbase will be nominally up in revenue from Q4 2024 to Q2 2025 whereas it’s a tough YoY comp from Bitcoin reaching all-time highs in March of 2024.

Last quarter, Coinbase reported revenue of $1.45 billion for growth of 105%, beating estimates by 6.2%. This declined from the March quarter with growth of 112% and revenue of $1.64 billion.

If you look further out, you see that analysts shy away from predicting too much growth in either direction. This is why technicals matter quite a bit with Coinbase:

Pictured Above: Analyst estimates are essentially flat due to an inability to predict crypto trading volumes.

Key Segments:

Coinbase’s trading volume was $226 billion, up 146% YoY yet down (-28%) QoQ. This compares to $312 billion in the March quarter when Bitcoin was at all-time highs.

Coinbase’s transaction revenue was $781 million in the most recent quarter ending in June, representing growth of 138.7% YoY and a decline of (-27%) QoQ. During Bitcoin’s peak in March, the company reported transaction volume of $1.08 billion. Compare this to 2023’s transaction volumes, which were less than $500 million and often down up to (-50%).

Management stated that there is beginning to be a disconnect between revenue and volume due to wallet fees and derivatives being counted as consumer revenue yet do not contribute to consumer volume.

• Within Transaction revenue, Consumer is the main driver at $664.8 million compared to Institutional volume of $63.6 million. The institutional percentage has been growing rapidly from $39 million in H1 2023 to $149 million in H1 2024 for 282% growth. Consumer grew 159% in the same period.
• Base revenue has been moved to Other transaction revenue and was at $52.5 million in the current quarter. From H1 2023 to H1 2024, Base and other transaction revenue grew 145%. This means that Base revenue is higher than custodial fees.
• Management stated they saw $210 million in transaction volume for July, pointing toward mid-$600 millions for transaction volume. This compares to $110 million for July of last year in the same period.
• What we’ve extrapolated above is that Coinbase is not a beneficiary of Bitcoin ETFs as both trading volumes and transaction revenue are significantly lower than Bitcoin’s previous all-time highs but that institutions, derivatives and Base may (over time) help make up for consumer-related spot trading losses.

Subscription and services revenue was $599 million, compared to the guide for $525M to $600M, reporting growth of 78.6% YoY and 17% QoQ. This is an all-time high for Coinbase in this segment and helps to diversify from being dependent entirely on transaction volume. The growth was due to stablecoin revenue and a one-time blockchain validator reward of $8 million.

Within Subscription and Services:

Looking forward, subscription and services are expected to be “within a range of $530 million to $600 million.”

• Stablecoin revenue of $240.4 million was up 59% YoY and reached an all-time high. The segment was up 17% QoQ. According to management, they are seeing almost $20 billion per week in USDC transaction volume. USDC is a 1:1 with the dollar and is used for global transfers. Advanced crypto traders and institutions will also settle a high-dollar token swap with USDC rather than token-to-token or transferring into cash to avoid high spreads and high fees.
• Blockchain rewards was at $185.1 million, up 111% YoY and up 22.6% QoQ. This segment opens up an interesting opportunity as interest rates go lower. Staking yields are not determined by FOMC policy; instead, by the participation rate of coins being staked. As demand increases for crypto, yields will increase to entice more coins to be staked. As a non-correlated yield to traditional financial instruments, which are mostly tied to central bank policy, this creates an opportunity for portfolios to diversify incomes in an interesting way, and adoption should increase as rates go lower.
• Interest and finance fee income of $69.4 million, up 34% YoY. This segment is tied to interest rates, as Coinbase offers loans against the coins being held in house. This is unlikely to sustain now that the FED has lowered rates. Yet, segments such as these can help stave off losses since crypto as an asset class tends to underperform in a high interest rate environment.
• Custodial fee revenue was $34.5 million, up 103% YoY.
• Other subscription and services revenue of $69.6 million was up 153% YoY.

Margins:

Coinbase does not provide a gross margin on their income statement. The operating margin fluctuates wildly aligned with revenue fluctuations. Last quarter, the operating margin was 23.7% compared to 46.4% in the previous quarter. A year ago, the operating margin was (-10.4%).

The operating expenses increased 26% QoQ to $1.1 billion primarily due to a loss of (-$31 million) on crypto assets held for operations in Q2 compared to a gain of $86 million in Q1 and Technology & development, G&A, sales & marketing expenses increased by $106 million due to higher USDC reward payouts, performance marketing spend, and policy spending.

Net margin last quarter was 2.5% for $36.1 million in profits. This was down considerably from 71.9% in the previous quarter with profits of 1.18 billion. In the year ago quarter, the net margin was (-13.8%) for losses of ($97.6) million.

Stock based compensation was $217 million or 15% of revenue last quarter. This is down considerably from 28% of revenue last year. However, management stated: “We expect technology & development and general & administrative expenses to increase Q/Q to $700-$750 million, largely driven by the non-linear expense recognition of our stock-based compensation.” This would imply a $40 million increase at the midpoint for $257 million in SBC or about 20% of revenue.

Earnings and EBITDA:

GAAP EPS of $0.14 last quarter compared to GAAP EPS estimates of $0.92. This compared to GAAP EPS of $4.40 last quarter and adjusted EPS of ($0.42) in the year ago quarter.

Adjusted EPS of $0.14 last quarter compared to estimates for $0.80 EPS.

Coinbase is expected to report adjusted EPS of $0.43 next quarter and GAAP EPS of $0.48. The expectation is that Coinbase remains GAAP profitable although this will depend on the level of drawdown seen in any future crypto selloffs.

The company reported adjusted EBITDA of $595.5 million for a margin of 41.1% compared to adjusted EBITDA of $1.01 billion last quarter for a margin of 61.9%.

Notably the company was adjusted EBITDA positive even in Q2 and Q3 of 2023 when it reported negative YoY revenue. At that time, adjusted EBITDA was in the range of 26% and 27% for $188.7 million and $178.3 million. When including stock-based compensation, the company would not be adjusted EBITDA positive as SBC was $199.8 million and $218.2 million, respectively, in those two quarters.  

Coinbase Additional Notes:

More on Derivatives:

As stated, derivatives are about 70% of the trading market for crypto. A derivative contract is an instrument, such as a futures contract, option or perpetual contract, whose price is based on the underlying crypto currency. Unlike spot trading, where you are buying the asset and mostly participating on the long side, derivative trading allows the owner of the contract to speculate on both up and down price movements, hedge a spot position, or add leverage to a position. This allows an investor to bet on the inevitable downtrends in crypto, and therefore allows institutions, or retail traders, to hedge their positions.

Derivatives are a key element to attract savvy retail and institutional investors. Having a user-friendly platform to trade these instruments is an important piece to Coinbase’s evolution with institutional adoption. In the medium-term, derivatives will help to compensate for the lower consumer spot trading volumes on Coinbase’s platform.

Here was a question about derivatives on the most recent earnings call:

Devin RyanDevin Ryan

Great. Thank you. Hi, Brian. Hi, Alesia I just want to ask a question about the derivatives platform and we're tracking just quarter-to-date, a continuation of building volumes there. And I know you're not breaking it out in revenues separately yet, but it sounded like it was a positive contributor in the second quarter.

Brian ArmstrongBrian Armstrong

Yes. So I'll start off and then maybe I'll hand over to you, Alesia on some of the margin questions. So just zooming out, derivatives is about 75% of all crypto trading activity by volume. And so it is the majority of trading volume. Now the take rates are lower on it, but it's really a key part of the market overall. And so I'm really glad that we are now in market, both the U.S. with Coinbase financial markets and then internationally with our international exchange as well

For Coinbase International Exchange, we also expanded our asset coverage quite a lot in Q2. We added 25 additional perpetual futures contracts. The volume has been really good today, actually, on Coinbase International Exchange. So you can check out at international.coinbase.com.

And so you can kind of just see Coinbase following this path of we're not always first-to-market, but we do it the do it the right way. We compliant way, the secure, trusted way. And so we're the trusted counterparty that many of these folks have been waiting for to enter the market. And I think that's going to pay off as a really good long-term strategy. Alesia, anything you want to add?

–End Quote

Base Layer 2

As stated above, the offer for no trading fees (or “gasless transactions”) is accomplished through Base, which is a Layer 2 built on the Ethereum network. Base offers 1 cent, 1 second transactions with Coinbase reporting there is $20 billion per week in USDC transactions taking place on the Layer 2. Base offers interoperability with other Ethereum network-compatible applications, offering the security of Ethereum’s Layer 1 while improving Ethereum’s scalability issues (primarily gas fees). Coinbase’s goal is to decentralize Base to make transactions faster while leveraging the security of Ethereum mainnet.

Total value locked (TVL) for Base was at $8 billion as of July 2024, making Base the second largest Layer 2 by TVL after Ethereum’s Dencun upgrade. Crypto has settled a bit since July, yet Base remains the second largest Layer 2 by TVL with $1.965 billion TVL. Base has seen trading volumes of up to $1 billion per day with up to 3 million transactions per day, whereas Coinbase sees about $2 billion in trading volume and Ethereum sees about 1 million to 2 million transactions per day. This means at the onset, Base exceeds Ethereum in number of daily transactions.

Base is further interesting for I/O Fund Members as the Layer 2 offers Data Streams from Chainlink, which is low-latency data that allows developers to build DeFi apps. Base also offers Chainlink VRF, the leading random number generator across Web3 with more than 21 million transaction requests completed and with a latency of about two seconds. We’ve covered Chainlink automation with up to 90% reduction in gas fees, Cross-chain Interoperability Protocol (CCIP) and Price Feeds in the past here. Our original Chainlink thesis is a must-read for anyone new to the I/O Fund, as LINK is an asset our firm has held since launching our research site in 2019.

Over the past few months, Base has been integrated by Stripe and Shopify, which is an important step forward to see onchain versions of Fortune 500 applications. Stripe uses Base for faster and cheaper money transfers by adding USDC to crypto payouts, and fiat-to-crypto for currency conversions. There is also an integration with Coinbase Wallet to allow users to purchase crypto with credit cards and Apple Pay. Stripe originally offered crypto payments in 2014 but ceased doing so in 2018.

The company has stated its focus is to build a developer ecosystem around Base first and foremost: “Our focus, as I mentioned in my opening remarks, is driving developer activity, we're driving those transaction volumes that we commented on. We're doing this by driving down fees, increasing the scalability and creating a powerful developer platform that's enabling anybody to build these onchain products.

We believe that this growth will then add users to develop products, we'll add developers and apps on Base. And that in turn will drive transaction volume and will drive down sequencer fees, and we will then see revenue as a result of those efforts.

Regulations

For institutions, there is a product called Coinbase Prime. This is a full-service prime brokerage platform, which facilitates trades as well as custodian services for large institutions. Management has stated institutions have maybe 1% to 3% of their funds in crypto. This is a low allocation, which has a lot of potential for growth. However, it is being stymied due to the lack of much needed regulations within the crypto space, which has been fraught with fraud.

For example, On November 11th, 2022, FTX, one of the largest crypto exchanges in in the world, filed for bankruptcy. At the time, it was the 18th crypto exchange to file for bankruptcy, and by far the largest, with an estimated $9 billion lost. One of the many fraudulent practices, which wasn’t limited to FTX, was that FTX would not register an internal transaction until a customer wanted their coins out of the exchange. This led to a scenario where 28 million Bitcoins had been bought with only 19.8 million in supply. Therefore, FTX created a crypto-version of a ponzi scheme that suddenly ended.

There have been a total of 20 crypto exchanges that have failed through 2024. The reason for their failures range from hacking events, mismanagement due to faulty business models, to outright fraud. We’ve even seen exchanges attempt a fractional reserves model where loans were offered based on a fraction of the total coins being held on their exchange.

These exchanges are all private businesses, except for Coinbase, so there is no way to see their financials. Furthermore, there are no mandatory audits to prevent fraud or mismanagement. When you factor in that over 50% of all cryptocurrencies have failed, it’s no wonder institutions managing millions to billions have been hesitant to explore this asset class.

As of now, Canada, UK, Switzerland, El Salvador, and China have regulations around crypto currencies. The United States is expected to follow, as the House just passed a meaningful crypto bill that defines regulations. The 200 page bill helps categorize a cryptocurrency and thus determines if should be regulated as a security by the SEC or as a digital commodity by the CFTC, through well-defined oversight. Furthermore, the bill would remove exchanges from comingling coins, as well as removing conflicts of interest, such as trading as an entity while also acting as a broker between buyers and sellers.

Whether it gets passed by the Senate is yet to be seen. With some of the world’s largest financial institutions now involved in the crypto space through Spot ETFs, it’s only a matter of time before much needed regulations will settle the nerves of money managers looking to diversify into this space. When this happens, it should act as a tailwind to Coinbase’s current business model.

Strong Cash on the Balance Sheet

As stated, free cash flow was $484.2 million or 33.4% of revenue compared to $151.1 million or 21.4% of revenue in the same period last year and 25.1% of revenue in Q1.

Cash was $7.23 billion and debt of $4.23 billion compared to $6.7 billion and $4.23 billion in Q1. The company issued $1.3 billion of convertible notes in Q1 and plans to use the net proceeds of $1.1 billion to repay the outstanding debt at or prior to maturity, depending on the market prices. Management also clarified in the earnings call that the other reasons for maintaining large cash balances were to support the ETF launches and for potential investment opportunities.

Here was a question on the earnings call:

Benjamin BudishBenjamin Budish

Hi. Good evening, and thanks for taking the question. I was wondering if you could give us an update on your balance sheet strategy. We noticed the cash build continues to really grow. And it seems like with the — the business generating cash and spending really kind of ramped down from a few years ago, there may not be as much of a need for it. So any update there? And then kind of along the same lines, you've been generating now a lot of your gross profit from interest income. And just curious, if there's any thoughts around the hedging strategy should rates start to come down. What's your kind of philosophy there? Thank you.

Alesia HaasAlesia Haas

Thanks for those questions. Yes, we're really pleased with the balance sheet strength. We are using cash, as we've mentioned in our prime financing business. A large amount of that cash was used to support the ETF launches in Q1 and Q2 with the Bitcoin ETF and now hopefully be a Ethereum ETF where you can see a lot of day-to-day or week-to-week volatility of those loan balances.

We did grow prime financing fees within the quarter. And so you can see while the balance at the end the end of quarter was down versus of Q2. We saw growth intra-quarter for those balances. So using our cash to support our products is a primary use case for us.

Technical Analysis

Coinbase appears to be working through a very large 5 wave pattern off its early 2023 low.  If this is accurate, any additional weakness will need to hold $113, and then start making higher highs to the 5th wave target between $294 – $217.

As of now, the larger correction that started in March of this year appears to be supporting this. It is a 3 wave correction that has room for one more swing lower to complete. If the current bounce fails to break over $172 – $181.50, then we can see a final drop into the $137 – $127 region. If we can instead breakout above $181.50, the odds will start supporting that the 4th wave low is in, and we will likely be in the early stages of wave 5 to new highs.

This lines up with Bitcoin’s chart, as well. The pattern off the late 2022 low appears to be an unfinished 5 wave pattern. Note the current correction. It is messy, with many overlaps, which is typical of corrections within larger uptrends. The bigger pattern suggests that we should be heading to $78,000 – $85,000 next, which would give us the minimum waves required to complete the 5 wave uptrend. Once we get to this region, or beyond. How we correct from there will determine just how high into the $100,000 region we will go.

For now, the probabilities favor a swing higher. As long as we hold $42,750 on any additional weakness, this remains our expectation from the technical patterns in both Coinbase and Bitcoin.

Conclusion:

Publicly, our firm has become known for our Nvidia AI thesis, and how we have positioned our readers for this trend before 2023. Yet behind the paywall, our premium subscribers are well aware that our active management with crypto since 2019 is equal in terms of its performance. By championing active management for tech investors — which means weighing the probabilities to cut or trim at specific times with the goal of buying lower — the I/O Fund stands out in a crowded, noisy crypto space by offering tools to navigate the volatility in this asset class.

Coinbase’s move into the derivatives market, as well as being a trusted custodian for institutional investors in the crypto space, will continue to entice institutions to their platform. Being a publicly traded company, Coinbase is the only exchange that allows its financials to be analyzed and monitored. This is crucial for investors considering the lack of FDIC and SPIC insurance in this space. These exchanges are businesses that can be mismanaged, and if this happens, all the coins being held there will be appropriated and redistributed to creditors in the event of a bankruptcy. This is a risk that Coinbase offers a solution to through their business model and publicly issued quarterly financials. This makes Coinbase stand out amongst its peers in a way that creates a moat for institutions looking to expand into the crypto space beyond the limited and costly spot ETF options.

Coinbase’s stock pattern lines up with Bitcoin, as both continue to suggest another swing higher is likely. If COIN can continue to evolve with the crypto market, and continue to lead as a trusted institutional platform, it will likely continue to appreciate with Bitcoin over time.

Given Chainlink is becoming a beneficiary of Layer 2s like Base and Arbitrum, you can expect an updated 2024 deep dive on our favorite blockchain asset coming soon!

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

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Micron beat estimates on the top and bottom line in Q4, driven by strength in data center DRAM/HBM and a record for NAND. In addition, the company’s Q1 guide far exceeded consensus estimates. Margins expanded sequentially primarily due to HBM and operating cash flow also saw significant sequential growth (whereas free cash flow was much lower due to higher capex).

The report looks to have eased concerns as there were quite a few analyst downgrades following the conferences held in August. We were net buyers in September of Micron, and so we are pleased to see the air cleared on this stock. Analysts had downgraded (and even double downgraded) the stock on comments that bit shipments would be flat to slightly up. The report revealed that despite flat DRAM bit shipments, prices increased in the mid-teens for DRAM, leading to the beat. For NAND, bit shipments increased in the high single-digit percentage and prices increased in the high single-digit percentage range. 

Management said they “forecast record revenue in fiscal Q1 and a substantial revenue record with significantly improved profitability in fiscal 2025.” Driven by strong HBM demand, management added that its “mix of data center revenue reached a record level in fiscal 2024, and we expect will grow significantly from here in fiscal 2025.”

Revenue

Micron reported revenue growth of 93% YoY to $7.75 billion in Q4, closing out FY24 with nearly 62% YoY growth to $25.1 billion in revenue. FY24’s recovery was broad-based, with DRAM and NAND both reporting substantial YoY increases.

• DRAM revenue increased 14% QoQ to $5.3 billion in Q4, representing 69% of total revenue. For FY24, DRAM revenue totaled $17.6 billion, increasing 60% YoY.
• NAND revenue rose 15% QoQ to a record $2.4 billion in Q4, representing 31% of total revenue. For FY24, NAND revenue was $7.2 billion, increasing 72% YoY.

For Q1, management guided for revenue growth of nearly 84% YoY to $8.7 billion at midpoint, easily surpassing the $8.2 billion consensus estimate. Q1’s guide still points to a 900 bp QoQ deceleration with Q4 remaining Micron’s peak growth quarter.

Current estimates for FY25 revenue sit at $37.6 billion for 50% YoY growth, though it’s likely that this gets revised higher in the coming days based on the size of Q1’s guidance beat.

Margins

Micron topped all of its guided figures for margins in the fourth quarter, with gross, operating and net margin all significantly expanding sequentially. For Q1, this expansion is set to continue, with management guiding for operating margin to expand to the mid to high 20% range.

• GAAP gross margin in Q4 was 35.3%, ahead of management’s guide for 33.5% and expanding from 26.9% the prior quarter. Adjusted gross margin was 36.5%, expanding from 28.1% last quarter and (9.1%) in the year ago quarter. Management said that in Q4, “HBM remained accretive to both DRAM and overall company gross margins.”
• For Q1, management guided GAAP gross margin of 38.5%, implying another sequential expansion of ~320 bp. Adjusted gross margin was guided at 39.5%, Management emphasized that Q1’s gross margin “is projected to improve sequentially primarily on better pricing and portfolio mix.”
• GAAP operating margin in Q4 was 19.6%, up 9 percentage points sequentially, and ahead of management’s guide for 17.8%. Adjusted operating margin was 22.5%, up from 13.8% last quarter and ahead of the guide for 20.5%.
• For Q1, management’s guided operating expenses implied a GAAP operating margin of 24.6%, another 5 percentage point sequential increase.

Micron closed out FY24 with significant improvement in both gross and operating margin:

• FY24 GAAP gross margin was 22.4%, up more than 31 points from (9.1%) in FY23.
• FY24 GAAP operating margin was 5.2%, up more than 42 points from (37%) in FY23.

Net margins also significantly improved due to the increased leverage.

• For Q4, net margin was 11.4%, up from 4.9% last quarter as net income rose more than 167% sequentially to $887 million. Adjusted net margin was 17.3%, up from 10.3% last quarter.

EPS

GAAP EPS was $0.79 in Q4, up more than 163% QoQ from $0.30 in Q3 and a substantial improvement from a loss of ($1.31) in the year ago quarter. Adjusted EPS was $1.18, up 90% QoQ from $0.62 in Q3 and again a significant improvement from ($1.01) in the year ago quarter. Management said this was “driven by better pricing and profitability.”

What these numbers reflect is that Micron has officially bottomed on EPS and is firmly returning to positive growth.

Micron guided for sequential growth to continue, expecting Q1’s GAAP EPS to be $1.54, up nearly 95% QoQ. Adjusted EPS was guided at $1.74, well ahead of estimates for $1.59, and it’s likely to push Q2 and Q3 estimates higher as well.

Cash Flows and Balance Sheet

Micron grew operating cash flow by nearly $1 billion QoQ; however, increased capex kept adjusted FCF growth to a minimum.

Q4’s operating cash flow was $3.41 billion, or 44% of revenue, up from $249 million or 6.2% of revenue in the year ago quarter. For FY24, operating cash flow totaled $8.51 billion, increasing more than 445% YoY from $1.56 billion in FY23.

Adjusted FCF in Q4 was just $323 million, or 4.2% of revenue, compared to $425 million in Q3, as Micron spent ~$3.1 billion on capex in the quarter. For FY24, adjusted FCF was minimal, at $386 million, or 1.5% of revenue, though this was a stark contrast to FY23’s adjusted FCF of ($5.44 billion), or (37.1%) of revenue.

It was stated capex would be meaningfully higher in fiscal 2025 at mid-30s percentage range to support “growth in both greenfield fab construction and HBM” investments, as Micron works to build out its fabs in New York and Idaho in FY25 and FY26. Capex totaled $8.1 billion in FY24, but management expects FY25 capex to be “meaningfully higher and at around the mid-30s percentage range of revenue,” suggesting capex easily surpasses $10 billion next year.

The company stated wafer capacity is below peak levels, partly due to an increasing mix of HBM that is reducing DRAM supply for traditional products. The capex spending is needed to continue to supply HBM. There is also a low-capex environment for NAND at the moment, and it was stated this would ultimately lead to healthy NAND supply-demand dynamics.

Inventory was $8.9 billion, or 158 days, and Micron expects to draw down this inventory to support revenue growth in FY25.

Cash, equivalents and investments totaled $9.16 billion, while debt totaled $13.4 billion.

Business Units

Compute and Networking (CNBU) revenue was $3.02 billion, up 14% QoQ and 152% YoY. This was significant growth acceleration, up from 85% YoY in Q3 and 59% YoY in Q2.

Management said that “data center server DRAM achieved a quarterly revenue record in fiscal Q4, driven by strong demand for high-capacity solutions as well as our continued ramp of HBM.” The company expects HBM TAM to grow from $4 billion in CY23 to over $25 billion in CY25. As a percent of overall DRAM, HBM will grow from 1.5% in 2023 to 6% in 2025. Micron reiterated it will be able to capture a similar market share of HBM as it has in DRAM, which was 21.5% of market share in early 2024.

Mobile (MBU) revenue increased 18% QoQ to $1.88 billion, though YoY growth of 55% decelerated from 94% YoY in Q3. Management said the growth was driven by seasonal product launches.

Micron provided a hint as to when investors can expect to see AI PC growth, which looks to be H2 2025: “PC unit volumes remain on track to grow in the low single-digit range for calendar 2024. We expect unit growth to continue in 2025 and accelerate into the second half of calendar 2025 as the PC replacement cycle gathers momentum with the rollout of next-gen AI PCs, end of support for Windows 10 and the launch of Windows 12.”

The timing was repeated again: “So that too plays a factor. And of course, I would just like to remind you that we have pointed out that overall smartphone and PC, unit growth will be occurring in 2025 and of course, increasing penetration of AI phones and second half, that acceleration, that growth will be obviously stronger than the first half.”

On average, PCs require 12GB of DRAM today with AI PCs needing a minimum of 16GB and up to 32 to 64GB of DRAM. We covered this previously here. Micron’s LP series for PCs offer are low-power DRAM modules that provide 60% lower power and up to 70% better performance with 60% space savings.

Mobile devices require 8GB of DRAM whereas AI-powered mobile devices will come with 12GB to 16GB of DRAM.

Storage (SBU) revenue rose 24% QoQ and 127% YoY to $1.68 billion, with the YoY growth rate accelerating from 116% in Q3. Management said the growth was “led by data center SSD, which reached a quarterly revenue record,” while NAND storage reached a record for the full year.

Embedded (EBU) was the only segment to record a sequential decline in Q4, with growth falling (9%) QoQ but rising 36% YoY to $1.17 billion. Management added that the “automotive segment achieved a new fiscal year revenue record for the fourth consecutive year.”

Earnings Call and Addt’l Commentary

The company stated they are upgrading their expectation for calendar 2024 industry DRAM bit demand growth to be in the high-teens percentage range. It was further stated: “In calendar 2025, we expect both DRAM and NAND industry bit demand growth to be around the mid-teens percentage range.”

The company also stated: “We see increasing DRAM and NAND content both in traditional as well as AI servers” and that “our mix of data center revenue reached a record level in fiscal 2024 and we expect will grow significantly from here in fiscal 2025.”

There is a slight slowdown in management’s guide for DRAM for next year, as it’s being stated as growth in the high teens is expected for 2024 while growth in the low teens is expected for 2025. As we noted in our pre-earnings writeup, the slowdown is coming from AI PCs and smartphones.

“At 2024, we have increased the outlook to high teens based on the strength in the data center. And 2025, as we look at it, just keep, in fact — mind two factors: one is we are now comparing it to the higher base of 2024, which has gone to high teens. So that, of course, impacts the percentage of the '25. And second piece is that, as we have noted, that smartphone and PC, which at the end market level are continuing to do fine. 

But given for the 3 factors that we have mentioned in our earnings call script that the customers built some inventory. The sell-in is somewhat less than their sellout in terms of memory, and we have said that by spring of 2025, we expect in PCs customer inventory levels to get to healthier levels versus now, and these will continue to improve.”

Another factor is that HBM3e is leading to wafer capacity constraints. It has a 3:1 trade ratio, which which means it takes 3X more wafers to produce HBM3e.

High Bandwidth Memory (HBM)

We’ve covered the importance of HBM for some time now, which you can reference here.

This quarter, Micron started shipments of HBM3e which are 12 high, 36-gigabyte units. These units provide up to 20% lower power consumption and 50% higher DRAM capacity than its competitors’ 8 high, 24 gigabyte solutions. As Micron stated during the call when asked about competitors, the company’s strategy is to provide the best HBM on “planet earth.” Micron will continue to increase its mix of HBM3e 12 in early CY2025.

As GPUs move toward a 1-year road map, so will Micron. HBM4 will be shipping in 2026.

Last quarter, the stock sold off following commentary that Micron’s HBM is contracted 6-8 quarters out. The company reiterated this again, yet it’s clear the exact contract pricing details are not being disclosed. This was evident in the beat in today’s report. 

This was an important statement regarding next year’s setup:

“And we are looking at strong momentum, not just with HBM.  We have talked about multiple billions of dollars of revenue that we target to generate in our fiscal year 2025 from high-capacity DRAM modules as well as LP memory in data center, so these are all the elements that point to strong demand trends and demand trends driven by AI in data center as well as in smartphone and PCs where more and more content is required in an environment where the leading-edge supply is today tight. 

So I think the opportunity is tremendous, and we see healthy demand supply balance and a constructive environment for our financial performance in fiscal 2025. And that's why we say with confidence that we'll deliver a substantial revenue record in fiscal year 2025, the significant improvement in our profitability as well.”

DDR5 SDRAM memory products reduce power consumption while doubling bandwidth. The lower power DRAM is assisted with LP5 solutions that increase speed while lower power requirements. The LPDDR designs were originally designed for mobile yet have been optimized for AI server infrastructure.

Data Center Storage up 300% in One Year

Micron’s strategy for vertical integration of SSDs has resulted in Micron seeing a “quarterly revenue record” of over $1 billion in revenue and data center SSDs in fiscal Q4. The company stated “our fiscal 2024 data center SSD revenues more than tripled from a year ago.”

Conference Commentary

As we covered in our pre-earnings report, conferences in August led to many analysts downgrading Micron. The first question on the call was about the confusion this caused.

Timothy Arcuri   UBS Investment Bank

Mark, I guess my first question is, some of the assumptions in guidance. I think you've been saying kind of on the conference circuit that bits would be pretty flat in fiscal Q1 for both DRAM and NAND. Is that what you're still assuming so that most of the increase in the revenue is basically pricing? Is that correct?

Mark Murphy   Executive VP & CFO

Tim, what we see now and we had provided a slight update in August, but we now see that DRAM bits, we expect to be up somewhat higher than what we had said before. We had said before they were going to be flat and then we revised that to flat to slightly up, and in this latest guide, we now view DRAM to be up somewhat higher from that. NAND bits, we expect to be sequentially flattish.”

Conclusion:

Micron had a fantastic earnings report and is sitting at an attractive valuation, which cannot be said for many AI stocks right now. The company has been doubted by Wall Street for most of the year, and yet this report easily places Micron as a top choice among AI peers as we head into 2025.

It makes sense Wall Street would doubt Micron in CY2024 as the company had several millions in HBM3 revenue this year, with is low compared to some of the heavyweights. Yet, the AI-related portion of its revenue is not only going to ramp next year, but it’s also accretive to margins. It’s this last piece that is key as AI markets such as custom silicon or AI servers have the opposite effect and weigh on margins. Keep this in mind as we move along.

We are glad to have Micron in our portfolio and are looking forward to building a bigger position in time.

Recommended Reading:

• Micron FQ4 Earnings Preview: Attractive Valuation, Look for Non AI-Related Weakness
• Optical Interconnects Overview: Strong Growth Expected Ahead
• Broadcom Fiscal Q3: AI Revenue Outlook Raised, but Valuation is Stretched
• Dell Q2: AI Server Shipments Rise 82% QoQ; Pipeline Preparing for Blackwell

Micron will release tomorrow with management expecting revenue to grow 89.5% YoY to $7.6 billion at the midpoint, an 8-point acceleration from last quarter. The stock is up 10% YTD at the time of writing, below the 80% returns in mid-June. The stock has given up much of its gains due to the potential fears of a temporary slowdown in the non-high-bandwidth memory market and concerns that Micron’s upside is limited due to contracted pricing for the next 6-8 quarters. We covered this here stating: “The blemish in the report is the commentary that HBM is sold out for calendar 2024 and 2025, with “pricing already contracted for the overwhelming majority of our 2025 supply.”

The slowdown in non-HBM memory is expected to be from smartphone and PC customers who “have built some inventory,” according to comments from Micron’s management team at the Deutsche Bank conference in late August. Taken out of context, it could be a dire comment yet the overall tone was bullish, citing the increase in non-HBM inventory is to protect smartphone and PC OEMs from higher pricing and tighter supply due to the outsized demand for AI-related HBM. Essentially, the message is that AI-related HBM is going to crowd out non-HBM in the supply chain.

The not-so-bullish commentary from the DB conference is more economic related as Micron stated: “We have shared before and as is well known in the broad industry reports that consumer retail channels, industrial, automotive tend to be relatively weaker right now, as well as China has some weakness too.” China is important to Micron making up 25% of its revenue. The company had stated earlier at a Keybanc conference: “In China, economic activity and consumer buying patterns are weak or uneven at best, depends on the market.”

Previous commentary in the earnings call and also during Keybanc’s conference hint that Micron is expecting several hundred million of HBM revenue in fiscal ’24, multibillion HBM revenue in fiscal 2025 and “have HBM consistent with our DRAM share at some point in calendar '25.” However, the discussions regarding Q1 in the DB conference were a lackluster, stating: “So when we look at all of these factors and all of these trends, when we look at our FQ1 we think our bit shipments will be somewhat flattish to slightly up in FQ1 versus FQ4.” This has caused some analysts to downgrade the stock as the expectation is non-HBM is weighing on HBM if we will see bit shipments “only slightly up.”

When the analysts downgraded the stock, some of them cited an oversupply of HBM. We see no evidence of an oversupply of HBM, and in fact, Micron has stated the opposite, stating they are seeing “robust demand trends” and “these trends of AI and the tight supply environment we see that continuing in 2025 as well. And that's why we say that, we will have substantial revenue record in 2025, and of course, robust profitability in 2025 as well versus 2024.”

We will see if Micron’s call has any changes in tone on HBM-related inventory; it’ll be important to carefully distinguish what is causing the underperformance on bit shipments as Micron is trading at an attractive valuation – nearly 50% lower than its historic average.

The trim today is not Micron-specific rather Knox has not been liking SMH’s recent price action. We are sending a clear message to our members that we aren’t buyers of AI semis at this moment as we think there will be opportunities to buy lower. We aren’t heavy sellers either, although we have a strategy where this could be the outcome over the next 30-60 days. Real wealth is made during drawdowns, not by perfectly timing a top. We’ve covered this extensively in our webinars and have a thought leadership article on the free side coming out by Knox next week on the topic, as well.

Revenue:

FQ4 revenue is expected to accelerate to 90.5% YoY growth to $7.64 billion and decelerate to 75% growth to $8.27 billion in Q1 FY2025.

Last quarter, revenue grew by 81.5% YoY to $6.81 billion, up from 57.7% in FQ2 due to strong AI demand. The company reported a record high data center revenue mix with 50% sequential data center revenue growth.

• DRAM revenue grew by 13% QoQ to $4.7 billion, helped by about a 20% price increase and offset by a decline in bit shipments in the mid-single digits.
• NAND revenue grew by 32% QoQ to $2.1 billion, helped by an increase in bit shipments in the high single digits and a price increase of about 20%. Management expects DRAM shipments to be flattish and NAND shipments to increase slightly in FQ4.

• Analysts expect FY2024 revenue to grow 63.3% YoY to $25.37 billion.
• FY2025 revenue is expected to grow 50.2% YoY to $38.10 billion and 16.3% to $44.30 billion in FY2026.

Margins

Margins experienced a steep cyclical low and now appears to have bottomed. In FQ2, the company achieved its goal of positive adjusted operating margin a quarter ahead of expectations, primarily helped by the recovery in DRAM and NAND pricing.

Management expects gross margin expansion to continue, helped by price and also higher-value products like HBM, high-capacity DIMMs (dual in-line memory modules), and SSDs. The guide for FQ4 is 34.5%.

Management reiterated the sequential improvement in adjusted gross margin for the November quarter as they said in the KeyBanc forum, “On gross margin, sequentially August to November quarter, we expect gross margins to be up around 200 — or up around a couple of hundred basis points, consistent with what we've said before.”

• FQ3 gross margin was 26.9%, up from (-17.8%) in the same period last year and 18.5% in FQ2. Management guide for FQ4 is 33.5%. The adjusted gross margin was 28.1%, up from (-16.1%) in the same period last year and 20% in FQ2.

The improvement in gross margin was due to higher pricing, product mix, and cost reductions.

• Operating margin was 10.6%, up from (-46.9%) in the same period last year and 3.3% in FQ2. Management guide for FQ4 is 17.8%. Adjusted operating margin was 13.8%, up from (-39.2%) in the same period last year and 3.5% in FQ2.

Management guide for FQ4 is 20.6%. The operating expenses were at the lower end of the guidance due to cost controls and operational efficiencies. Management expects operating expenses to increase sequentially in FQ4 “due to an increase in R&D program expenses and a nonrecurring Q3 asset sale gain contemplated in our Q3 guidance.”

• Net income was $332 million or 4.9% of revenue compared to a net loss of (-$1.9 billion) or (-50.5%) of revenue in the same period last year. Adjusted net income was $702 million or 10.3% of revenue compared to an adjusted net loss of (-$1.57 billion) or (-41.7%) of revenue in the same period last year.

EPS 

FQ3 GAAP EPS came at $0.30 and beat estimates by 1.2%. Adjusted EPS was $0.62, up from an adjusted loss per share of (-$1.43) in the same period last year. The company beat adjusted EPS estimates by 17.3%, which was helped by higher prices, higher margin product mix, and cost controls.

• EPS guide for FQ4 is $0.61 at the midpoint and the adjusted EPS guide of $1.08 at the midpoint. Analysts expect adjusted EPS of $1.11 for FQ4 and $1.59 for FQ1.

• Analysts expect FY2024 adjusted EPS of $1.23, up from an adjusted loss per share of (-$4.45) for the FY2023.
• For FY2025 they expect adjusted EPS to grow 636% YoY to $9.04 and 34.5% YoY to $12.16 for FY2026.

Cash Flow and Balance Sheet

 FQ3’s operating cash flow was $2.48 billion or 36.4% of revenue compared to $24 million or 0.60% of revenue in the same period last year and 20.9% of revenue in FQ2. The cash flows have improved with higher revenue and profitability.

FQ3 adjusted free cash flow was $425 million or 6.2% of revenue compared to (-$1.36B) or (-36.1%) of revenue in the same period last year and (-$29 million) or (-0.50%) of revenue in FQ2. Capex was $2.1 billion in FQ3 compared to $1.4 billion in the same period last year and $1.2 billion in FQ2.

Management expects positive adjusted free cash flow in FQ4 despite a capex of about $3.0 billion. Capex would be $8.0 billion in FY2024, up from $7.0 billion in FY2023.

Management expects capex to rise around 35% of FY2025 revenue, i.e., comes to about $13 billion and the company is able to support it due to higher profitability. Mark Murphy, CFO, said in the FQ3 earnings call, “Record revenue and significantly improved profitability in fiscal 2025 will help support average quarterly CapEx in fiscal 2025 to be meaningfully above the fiscal Q4 2024 level of $3 billion. We expect CapEx around mid-30%s range of revenue for fiscal 2025, which will support HBM assembly and test equipment, fab and back-end facility construction, as well as technology transition investment to support demand growth.

As noted earlier, half or more of the expected CapEx increase in fiscal 2025 will be to support U.S. greenfield fab construction. As we have noted in the past, the CHIPS grants, ITC, and state incentives offset a significant portion of the U.S. fab CapEx investments.”

• Inventory was $8.5 billion or 155 days compared to $8.4 billion or 160 days of inventory in FQ2. Management expects days of inventory to decline in FY2025. (This also runs counter to what some analysts downgrades are stating, which is there’s an oversupply when management comments point to the opposite).
• Cash and investments were $9.22 billion and debt of $13.258 billion compared to $9.7 billion and $13.7 billion in FQ2. In FQ3, the company repaid $650 million in debt and paid $128 million in dividends. The company had also announced in early August that they might resume the stock repurchase program.

Business Units

Compute and Networking Business Unit (CNBU) grew by 18% QoQ and 85% YoY to $2.57 billion. This was an acceleration from 59% in FQ2.

DRAM data center revenue more than doubled year-over-year. We foresee this segment being strong yet there could be potential weakness in client-related compute.

Mobile Business Unit (MBU) grew by 94% YoY and down (-1%) sequentially to $1.59 billion due to a planned volume decline, which was partially offset by improved pricing. Look for potential weakness here given comments that the oversupply maybe coming from mobile and PCs.

Embedded Business Unit (EBU) grew by 42% YoY and 16% sequentially to $1.29 billion helped by record revenue in automotive. Look for weakness here given commentary about automotive, industrial and consumer-related end markets.

Storage Business Unit (SBU) revenue grew by 116% YoY and 50% sequentially to $1.35 billion with growth in all end markets. The company achieved record data center SSD revenue, which nearly doubled sequentially. There could be potential weakness in the client storage segment depending on PC demand.

Other noteworthy points to watch

HBM Revenue

The company reported HBM revenue of over $100 million in FQ3 and expects to generate several hundreds in FY2024 and multiple billions in FY2025. They also expect the HBM market share to match the overall DRAM market share sometime in CY2025, which they mention is in the low 20s. UBS expects HBM revenue to be $5.61 billion in FY2025 from the expected $603 million in FY2024.expects HBM revenue to be $5.61 billion in FY2025 from the expected $603 million in FY2024. Management said HBM revenue is accretive to FQ3 margins and expects this trend to continue.

HBM and NAND CAGRs

HBM’s bit growth CAGR is expected to remain strong and be above 50% for the next few years.

“Well, as we have said before, that we see the CAGR for HBM growth — in terms of bit growth CAGR to be well above 50% over the next few years. So certainly, HBM is a strong growth driver. And again, as we increase our mix of HBM going forward, it will, of course, be continuing to be accretive to our financial performance, including margins. And we are pleased that with the strong performance that we have we are sold out for '25 as well with overwhelming part of our output already committed in terms of pricing.”

During the Q&A, it was pointed out that the forecast for NAND CAGR growth was lowered from “the low 20s” to a new forecast of “growth in the high teens.” Management’s response was the following:

“And I'll also tell you that we basically revise the base here for the CAGR that we used. So this time, the CAGR that we used, we use the base year of 2023. And in 2023, as you know, we had bit demand growth in NAND that was higher, meaningfully higher than the CAGR. So that, of course, the larger base of 2023, just somewhat changed our outlook on the overall CAGR.”

AI PCs and Smartphones

The company expects to benefit from the AI PCs and smartphones. They expect AI PCs to have 40% to 80% more DRAM content than today’s PCs. Similarly, smartphones that are AI enabled will have about 50% to 100% more content compared to phones released last year. In the near-term, management has stated there could be an oversupply. We expect there to be more questions on the call about this comment from the DB conference. “PC and smartphone customers have built additional inventories due to the rising price trajectory, the anticipated growth in AI PCs and AI smartphones, as well as the expectation of tight supply as an increasing portion of DRAM and NAND output is dedicated to meeting growing data center demand.” There are additional China-related concerns for mobile and PCs.

Valuation 

On the top line, Micron is trading above it’s historic valuation at 4.85 compared to its five-year P/S ratio is 3.58. Notably, since the FY ends in August, the P/S ratio will be adjusted post-results and is trading at a 2.7 forward PS. The forward PS is the one that will reflect the valuation post-results.

On the bottom line, the forward PE Ratio of 10.5 will take effect post-results and is about 20% to 30% lower than the 3-year and 5-year median. These valuations are tricky because AI stocks are being re-rated. For example, Nvidia and AMD are trading about 50% lower than their averages, and yet are struggling to breakout. We think it’s important to weigh what the stocks have been trading at since the AI boom, or about early 2023. Micron has been trading considerably higher since the AI boom and we continue to watch the stock for the right entry over the next few months.

Conclusion

Micron is setting up to be an excellent buy over the next few months, yet we continue to watch the horizon to buy AI stocks at lower prices. Micron is perhaps the more complicated AI semi to time as it’s trading at an attractive valuation yet it’s also a bellwether of sorts for the economy. There could be a scenario where any AI bullishness is overshadowed by consumer-facing segments. Notably, the margins are expected to continue improving in FY2025 and we foresee Micron being more defensible than others when it comes to economic headwinds, albeit less defensible should we see China-related headwinds.

We are patient. We have time on our side. We will participate if Micron does well tomorrow, yet we also trimmed should Micron not do well tomorrow. Look for the I/O Fund to lean into defensibility while acknowledging inning one from AI (which started in 2023) has been a crazy-good run and our goal is to load up for inning number two in the coming months.

Royston Roche and Beth Kindig, Equity Analysts at the I/O Fund, contributed to this article.

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