The reason that AI semiconductors were deep in the green is because Microsoft announced strong QoQ increase to its capex for AI infrastructure. Microsoft’s capex increased 36% sequentially and 78% YoY to $19 billion in Q4. Capex was $14 billion last quarter, where it grew 22% sequentially.

Full year 2024 capex was up 75% YoY to $55.7 billion, yet this quarter’s run rate suggests we could see up to $80 billion in capex in FY2025. Notably, management is guiding for a further YoY increase in capex in FY’25. We’ve covered the importance of Big Tech’s capex for our AI stocks in an analysis here.an analysis here.

With Azure AI forming a larger percentage of Azure’s growth and Azure customers growing 60% YoY, there seems to be no slowdown in sight for capex growth, a positive for the AI data center stocks in our portfolio which saw strong rallies following the report.

Copilot is also showing very strong growth, with Copilot accounting for over 40% of GitHub’s revenue growth this year and is already a larger business than all of GitHub when Microsoft acquired it, with Microsoft being optimistic about seeing similar adoption trends in Copilot for Microsoft 365.

This quarter, Microsoft beat on both the top and bottom lines with margins above guided levels. The stock was initially brought down by a headline miss as Azure growth of 29% and 30% YoY on a CC basis came in at the lower-end of its guidance range due to some softness in Europe during the last month of the quarter and continues to be impacted by capacity constraints.

However, while management guided for a slight deceleration in Azure growth in Q1’25, with growth of 28% to 29% in CC (vs 30% this quarter), they expect an acceleration in H2’25 as their capital investments increase AI capacity.

Microsoft Fiscal Q4 Financials:

Revenue and EPS:

Fiscal Q4 revenue grew by 15% and 16% in CC YoY to $64.7 billion. It beat expectations by $260 million, driven by a 19% increase in Intelligent Cloud revenue and the Activision acquisition that contributed 3% to revenue growth. Azure growth was 29% (30% in constant currency), which came in at the lower end of their guidance range but was consistent with Q3 when adjusting for the leap year. Azure growth included 8 points from AI services, up from 7 points last quarter, and demand continues to remain higher than available capacity.

The company guided for Azure growth of 28% to 29% percent in constant currency next quarter. Management expects Q4 consumption trends to persist through the first half of FY’25 with an acceleration in the second half as AI capacity increases.

• For next quarter, management guided to $64.3 billion at the midpoint, which is below analyst estimates of $65.30 billion
• GAAP EPS of $2.95 beat estimates by $0.02, representing YoY growth of 10%. Non-GAAP EPS of $2.95 beat estimates by $0.01.

Segment Revenue:

• Productivity and Business revenue was $20.3 billion, up 11% YoY, driven by 13% growth in Office 365 Commercial. Growth came in 140 bps ahead of the midpoint of the guided range.
• Intelligent Cloud revenue was $28.5B, up 19% YoY, driven by Azure and other cloud services revenue growth of 29%. Growth came in in-line with the midpoint of the guided range.
• More Personal Computing revenue was $15.9 billion, up 14% YoY. Windows revenue increased 7% with OEM revenue growth of 4% and Commercial products and cloud services revenue growth of 11%, while devices revenue decreased (11%). Xbox content and services revenue increased 61% YoY driven by 58% of net impact from the Activision acquisition. Growth came in 320 bps ahead of the midpoint of the guided range.

Guidance on Segment Revenue:

• Productivity and Business revenue guided to $20.45 billion at midpoint for growth of 9.2% to 10.8% YoY. This would be a QoQ deceleration of 100 bps in growth rate, at the midpoint.
• Intelligent Cloud revenue was guided to $28.75 billion at midpoint for growth of 17.9% to 19.1% YoY. This is a deceleration of 50 bps in growth rate, at the midpoint.
• More Personal Computing revenue was guided to $15.1 billion at midpoint for growth of 9% to 12% YoY. This is a deceleration of 350 bps in growth rate, at the midpoint.

Margins:

Margins topped management’s guide in gross margin, operating margin and net margin but fell across the board YoY. However, excluding the impact of an accounting estimate for useful lives, gross and operating margins would have been slightly up YoY. Operating margin for Q4 was 43.1%, 80 bps above guidance, and a 10 bps decrease YoY, helped by operating leverage and offset by the Activision acquisition.

Microsoft’s More Personal Computing segment experienced the largest QoQ operating margin decline, down 639 bp QoQ to 30.9% due to impact from the Activision acquisition.

Full year operating margins were up 287 bps, ahead of management’s guidance for 100 to 200 bps. However, management continues to expect operating margins to be down 1% in FY2025 due to increased expenses related to cloud and AI.

• Gross margin of 69.6% was down from 70.1% in the year ago quarter. The guide for next quarter is 68.8%.
• Operating margin was 43.1%, down from 43.2% in the year-ago quarter. Operating margin is guided for 45.1% next quarter.
• Net margin was 34%, down from 35.74% in the year-ago quarter. Net margin is guided to improve to 35.7% next quarter.
• Productivity and Business operating margin was 49.9%, down 191 bp QoQ but expanding 42 bp YoY.
• Intelligent Cloud operating margin was 45.09%, down 175 bp QoQ but expanding 120 bp YoY
• More Personal Computing operating margin was 30.9%, down 639 bp QoQ due to impact from the Activision acquisition

Cash and Debt:

Operating cash flow was $37.19 billion, up 29% YoY driven by strong cloud billings and collections.

Free cash flow was $23.3 billion, up 18% YoY reflecting higher capital expenditures to support cloud and AI offerings.

Microsoft returned $9.78 billion to shareholders in the form of dividends and share repurchases.

For Q4 2024, the company has $51.63 billion total debt, with $75.54 billion in cash and short-term investments compared to $65.44 billion in total debt and $80.02 billion in cash and short-term investments in the previous quarter. The company repaid $13.1 billion of debt in the recent quarter.

Key Metrics:

Bookings increased 17% YoY and 19% on a constant currency basis. This was significantly above expectations and driven by growth in the number of $10M+ and $100M+ contracts for Azure and Microsoft 365. This compares to 29% growth (31% on CC basis) in Bookings last quarter and compares to a -2% decrease (-1% on CC basis) in Bookings in the year ago quarter.

Commercial RPO grew by 20% YoY to $269 billion. This compares to 20% growth last quarter and 19% YoY growth in the year ago quarter.

Azure AI customers totaled more than 60,000, implying customer growth rate of nearly 60% YoY and up over 13% vs Q2’24 with average customer spend continuing to grow. The number of Azure AI customers using data and analytics tools also grew nearly 50% YoY. 

The next-gen analytics platform, Microsoft Fabric, has over 14,000 paid customers, up 20% QoQ.

Azure Arc, a tool that allows organizations to manage resources not hosted on Azure, has 36,000 customers, up 90% YoY and 9% QoQ.

GitHub now has an annual revenue run rate of $2B with GitHub Copilot accounting for over 40% of GitHub’s revenue growth this year and is already a larger business by itself than all of GitHub at acquisition. GitHub Copilot has been adopted by over 77,000 companies, up 180% YoY.

Power Platform, a collection of low-code development tools, saw MAUs rise 40% YoY to 48 million. 480,000 organizations have also used the AI-powered capabilities in Power Platform, up 45% QoQ.

In its second full quarter of availability, Copilot for Microsoft 365 continues to gain traction as the number of people using Copilot daily at work nearly doubled QoQ. Copilot customers increased 60% QoQ and the number of customers with over 10,000 seats more than doubled QoQ. Copilot Studio, a low-code tool for creating and maintaining copilots, saw a 70% QoQ increase in organizations using it to 50,000.

Earnings Call:

Azure AI Growth as a Leading Indicator of Capex Investment:

Microsoft stated capex was $19 billion this quarter compared to $7.8 billion in the year ago quarter, up 77.6% YoY. This compares to $14 billion in the previous quarter, up 35.7% sequentially. For FY’24, capex was $55.7B, up 74.6% YoY. Furthermore, Microsoft is guiding for a YoY increase in capex in FY’25.

Given this significant spending, analysts are questioning whether monetization is going to match the level of investment.

Question:

Keith Weiss (Analyst)

“Is CapEx still an appropriate leading indicator for cloud growth? Or does the shift in gross margin profile change that equation? Or said another way, maybe can you give us a little bit more help in understanding the timing between the CapEx investments and the yield on those investments?”

Answer:

Satya and Amy (Management)

Satya noted “So I would say – and obviously, the Azure AI growth, that's the first place we look at. That then drives bulk of the CapEx spend, basically, that's the demand signal because you got to remember, even in the capital spend, there is land and there is data center build, but 60-plus percent is the kit, that only will be bought for inferencing and everything else if there is demand signal, right?”the Azure AI growth, that's the first place we look at. That then drives bulk of the CapEx spend, basically, that's the demand signal because you got to remember, even in the capital spend, there is land and there is data center build, but 60-plus percent is the kit, that only will be bought for inferencing and everything else if there is demand signal, right?”

Amy further noted “[…] roughly half of FY2024's total capital expense as well as half of Q4's expense, it's really on land and build and finance leases, and those things really will be monetized over 15 years and beyond… they're incredibly flexible because we've built a consistent architecture”.half of FY2024's total capital expense as well as half of Q4's expense, it's really on land and build and finance leases, and those things really will be monetized over 15 years and beyond… they're incredibly flexible because we've built a consistent architecture”.

Given the flexibility of the underlying infrastructure that comprises half of current capex spend, Microsoft feels comfortable investing in land and data centers ahead of demand though only outfits them with infrastructure kits based on observed customer demand with the KPI being Azure AI growth.

In a further answer, management noted that they can adjust capex investment with little impact on revenue growth.

Amy noted “the pace at which we fill those builds with CPUs or GPUs will be demand-driven. And so if we see differences in demand signal, we can throttle that investment on the CPU side,…the same thing on the GPU side. And so you're right that you could see relatively consistent revenue patterns and yet see these inconsistencies and capital spend quarter-to-quarter.”if we see differences in demand signal, we can throttle that investment on the CPU side,…the same thing on the GPU side. And so you're right that you could see relatively consistent revenue patterns and yet see these inconsistencies and capital spend quarter-to-quarter.”

Factors Driving Soft Q4 Azure Growth Expected to Persist

Analysts noted that Azure growth of 30% YoY came in at the lower end of their provided range of 30% to 31%, which was driven by persistent capacity constraints and modest softness in Europe. They asked management to elaborate on that and how they factored that into Q1’25 guidance.

Answer:

Amy (Management)

“The distinguishing between being at the higher end or at the lower end, really was some softness we saw in a few European geos on non-AI consumption really made the difference in that number. And we've assumed that going forward into H1 inclusive of my guide 28% to 29% going forward. And then let me separate which was your larger point, which is what are the other factors you see ongoing. Number one, you're right, capacity constraints, particularly on AI and Azure will remain in Q4 and will remain in H1.”

Broader Applications of Copilot

With GitHub Copilot already accounting for 40% of GitHub’s revenue growth this year and pushing it to an annual revenue run rate of $2 billion, analysts are questioning if there is potential for it to drive similar growth for non-developers too.

Question:

Mark Murphy (Analyst)

“With a couple of quarters of Copilot for M365 availability under your belt now, how are you assessing the capability of Copilots to replicate the productivity gains that they've created for developers, which seem to be very high and to do something similar for the broader population of knowledge workers?”

Answer:

Satya (Management)

“So we think of this as really a new design system for knowledge and frontline work to drive productivity, which would be very akin to what has happened in software engineering. So when you think about marketing or finance or sales or customer service, we will effectively replicate what you just said, which is the type of productivity we've seen in developers, will come to all of these functions as they think about their work, workflow and workout effect, all being driven by Copilots.”

Management noted that they aim to extend the productivity benefits seen with GitHub Copilot to a broader population of knowledge workers through M365 Copilot.

Valuation

Microsoft could see about 10% to 15% upside from here, at which time, it will be trading at a forward PE where the stock has met resistance two times prior.

The same is true on the sales valuation where the stock is trading at a forward PS of 11 to where a PS of 12 or 13 mark its absolute maximum valuation. There’s some room left but not a lot to work with.

Conclusion

Microsoft’s report shows continued growth in all the right areas and supports our large allocation to AI data center stocks. Ultimately, we closed Microsoft following our July quarterly webinar where we expressed valuation concerns. Pausing Microsoft in our I/O Fund portfolio is likely to be short-lived as we see the company as a clear winner in AI, with AI driving an increasing amount of Azure’s growth and with Azure continuing to be capacity constrained. We’ve also been quite vocal that enterprise is where the growth in AI will come from, and Microsoft is unique among the FAANGs for its leading position with enterprise customers. We continue to see Microsoft as a quality company, yet we are rolling the dice to see if we can get a lower entry.

Richard Chu, Equity Analyst at I/O Fund, contributed to this analysis

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The reason that AI semiconductors were deep in the green today is because Microsoft announced strong QoQ increase to its capex for AI infrastructure. Microsoft’s capex increased 36% sequentially and 78% YoY to $19 billion in Q4. Capex was $14 billion last quarter, where it grew 22% sequentially.

Full year 2024 capex was up 75% YoY to $55.7 billion, yet this quarter’s run rate suggests we could see up to $80 billion in capex in FY2025. Notably, management is guiding for a further YoY increase in capex in FY’25. We’ve covered the importance of Big Tech’s capex for our AI stocks in an analysis here and also in a previous webinar.an analysis here and also in a previous webinar.

With Azure AI forming a larger percentage of Azure’s growth and Azure customers growing 60% YoY, there seems to be no slowdown in sight for capex growth, a positive for the AI data center stocks in our portfolio which saw strong rallies following the report.

Copilot is also showing very strong growth, with Copilot accounting for over 40% of GitHub’s revenue growth this year and is already a larger business than all of GitHub when Microsoft acquired it, with Microsoft being optimistic about seeing similar adoption trends in Copilot for Microsoft 365.

This quarter, Microsoft beat on both the top and bottom lines with margins above guided levels. The stock was initially brought down by a headline miss as Azure growth of 29% and 30% YoY on a CC basis came in at the lower-end of its guidance range due to some softness in Europe during the last month of the quarter and continues to be impacted by capacity constraints.

However, while management guided for a slight deceleration in Azure growth in Q1’25, with growth of 28% to 29% in CC (vs 30% this quarter), they expect an acceleration in H2’25 as their capital investments increase AI capacity.

Microsoft Fiscal Q4 Financials:

Revenue and EPS:

Fiscal Q4 revenue grew by 15% and 16% in CC YoY to $64.7 billion. It beat expectations by $260 million, driven by a 19% increase in Intelligent Cloud revenue and the Activision acquisition that contributed 3% to revenue growth. Azure growth was 29% (30% in constant currency), which came in at the lower end of their guidance range but was consistent with Q3 when adjusting for the leap year. Azure growth included 8 points from AI services, up from 7 points last quarter, and demand continues to remain higher than available capacity.

The company guided for Azure growth of 28% to 29% percent in constant currency next quarter. Management expects Q4 consumption trends to persist through the first half of FY’25 with an acceleration in the second half as AI capacity increases.

• For next quarter, management guided to $64.3 billion at the midpoint, which is below analyst estimates of $65.30 billion
• GAAP EPS of $2.95 beat estimates by $0.02, representing YoY growth of 10%. Non-GAAP EPS of $2.95 beat estimates by $0.01.

Segment Revenue:

• Productivity and Business revenue was $20.3 billion, up 11% YoY, driven by 13% growth in Office 365 Commercial. Growth came in 140 bps ahead of the midpoint of the guided range.
• Intelligent Cloud revenue was $28.5B, up 19% YoY, driven by Azure and other cloud services revenue growth of 29%. Growth came in in-line with the midpoint of the guided range.
• More Personal Computing revenue was $15.9 billion, up 14% YoY. Windows revenue increased 7% with OEM revenue growth of 4% and Commercial products and cloud services revenue growth of 11%, while devices revenue decreased (11%). Xbox content and services revenue increased 61% YoY driven by 58% of net impact from the Activision acquisition. Growth came in 320 bps ahead of the midpoint of the guided range.

Guidance on Segment Revenue:

• Productivity and Business revenue guided to $20.45 billion at midpoint for growth of 9.2% to 10.8% YoY. This would be a QoQ deceleration of 100 bps in growth rate, at the midpoint.
• Intelligent Cloud revenue was guided to $28.75 billion at midpoint for growth of 17.9% to 19.1% YoY. This is a deceleration of 50 bps in growth rate, at the midpoint.
• More Personal Computing revenue was guided to $15.1 billion at midpoint for growth of 9% to 12% YoY. This is a deceleration of 350 bps in growth rate, at the midpoint.

Margins:

Margins topped management’s guide in gross margin, operating margin and net margin but fell across the board YoY. However, excluding the impact of an accounting estimate for useful lives, gross and operating margins would have been slightly up YoY. Operating margin for Q4 was 43.1%, 80 bps above guidance, and a 10 bps decrease YoY, helped by operating leverage and offset by the Activision acquisition.

Microsoft’s More Personal Computing segment experienced the largest QoQ operating margin decline, down 639 bp QoQ to 30.9% due to impact from the Activision acquisition.

Full year operating margins were up 287 bps, ahead of management’s guidance for 100 to 200 bps. However, management continues to expect operating margins to be down 1% in FY2025 due to increased expenses related to cloud and AI.

• Gross margin of 69.6% was down from 70.1% in the year ago quarter. The guide for next quarter is 68.8%.
• Operating margin was 43.1%, down from 43.2% in the year-ago quarter. Operating margin is guided for 45.1% next quarter.
• Net margin was 34%, down from 35.74% in the year-ago quarter. Net margin is guided to improve to 35.7% next quarter.
• Productivity and Business operating margin was 49.9%, down 191 bp QoQ but expanding 42 bp YoY.
• Intelligent Cloud operating margin was 45.09%, down 175 bp QoQ but expanding 120 bp YoY
• More Personal Computing operating margin was 30.9%, down 639 bp QoQ due to impact from the Activision acquisition

Cash and Debt:

Operating cash flow was $37.19 billion, up 29% YoY driven by strong cloud billings and collections.

Free cash flow was $23.3 billion, up 18% YoY reflecting higher capital expenditures to support cloud and AI offerings.

Microsoft returned $9.78 billion to shareholders in the form of dividends and share repurchases.

For Q4 2024, the company has $51.63 billion total debt, with $75.54 billion in cash and short-term investments compared to $65.44 billion in total debt and $80.02 billion in cash and short-term investments in the previous quarter. The company repaid $13.1 billion of debt in the recent quarter.

Key Metrics:

Bookings increased 17% YoY and 19% on a constant currency basis. This was significantly above expectations and driven by growth in the number of $10M+ and $100M+ contracts for Azure and Microsoft 365. This compares to 29% growth (31% on CC basis) in Bookings last quarter and compares to a -2% decrease (-1% on CC basis) in Bookings in the year ago quarter.

Commercial RPO grew by 20% YoY to $269 billion. This compares to 20% growth last quarter and 19% YoY growth in the year ago quarter.

Azure AI customers totaled more than 60,000, implying customer growth rate of nearly 60% YoY and up over 13% vs Q2’24 with average customer spend continuing to grow. The number of Azure AI customers using data and analytics tools also grew nearly 50% YoY. 

The next-gen analytics platform, Microsoft Fabric, has over 14,000 paid customers, up 20% QoQ.

Azure Arc, a tool that allows organizations to manage resources not hosted on Azure, has 36,000 customers, up 90% YoY and 9% QoQ.

GitHub now has an annual revenue run rate of $2B with GitHub Copilot accounting for over 40% of GitHub’s revenue growth this year and is already a larger business by itself than all of GitHub at acquisition. GitHub Copilot has been adopted by over 77,000 companies, up 180% YoY.

Power Platform, a collection of low-code development tools, saw MAUs rise 40% YoY to 48 million. 480,000 organizations have also used the AI-powered capabilities in Power Platform, up 45% QoQ.

In its second full quarter of availability, Copilot for Microsoft 365 continues to gain traction as the number of people using Copilot daily at work nearly doubled QoQ. Copilot customers increased 60% QoQ and the number of customers with over 10,000 seats more than doubled QoQ. Copilot Studio, a low-code tool for creating and maintaining copilots, saw a 70% QoQ increase in organizations using it to 50,000.

Earnings Call:

Azure AI Growth as a Leading Indicator of Capex Investment:

Microsoft stated capex was $19 billion this quarter compared to $7.8 billion in the year ago quarter, up 77.6% YoY. This compares to $14 billion in the previous quarter, up 35.7% sequentially. For FY’24, capex was $55.7B, up 74.6% YoY. Furthermore, Microsoft is guiding for a YoY increase in capex in FY’25.

Given this significant spending, analysts are questioning whether monetization is going to match the level of investment.

Question:

Keith Weiss (Analyst)

“Is CapEx still an appropriate leading indicator for cloud growth? Or does the shift in gross margin profile change that equation? Or said another way, maybe can you give us a little bit more help in understanding the timing between the CapEx investments and the yield on those investments?”

Answer:

Satya and Amy (Management)

Satya noted “So I would say – and obviously, the Azure AI growth, that's the first place we look at. That then drives bulk of the CapEx spend, basically, that's the demand signal because you got to remember, even in the capital spend, there is land and there is data center build, but 60-plus percent is the kit, that only will be bought for inferencing and everything else if there is demand signal, right?”the Azure AI growth, that's the first place we look at. That then drives bulk of the CapEx spend, basically, that's the demand signal because you got to remember, even in the capital spend, there is land and there is data center build, but 60-plus percent is the kit, that only will be bought for inferencing and everything else if there is demand signal, right?”

Amy further noted “[…] roughly half of FY2024's total capital expense as well as half of Q4's expense, it's really on land and build and finance leases, and those things really will be monetized over 15 years and beyond… they're incredibly flexible because we've built a consistent architecture”.half of FY2024's total capital expense as well as half of Q4's expense, it's really on land and build and finance leases, and those things really will be monetized over 15 years and beyond… they're incredibly flexible because we've built a consistent architecture”.

Given the flexibility of the underlying infrastructure that comprises half of current capex spend, Microsoft feels comfortable investing in land and data centers ahead of demand though only outfits them with infrastructure kits based on observed customer demand with the KPI being Azure AI growth.

In a further answer, management noted that they can adjust capex investment with little impact on revenue growth.

Amy noted “the pace at which we fill those builds with CPUs or GPUs will be demand-driven. And so if we see differences in demand signal, we can throttle that investment on the CPU side,…the same thing on the GPU side. And so you're right that you could see relatively consistent revenue patterns and yet see these inconsistencies and capital spend quarter-to-quarter.”if we see differences in demand signal, we can throttle that investment on the CPU side,…the same thing on the GPU side. And so you're right that you could see relatively consistent revenue patterns and yet see these inconsistencies and capital spend quarter-to-quarter.”

Factors Driving Soft Q4 Azure Growth Expected to Persist

Analysts noted that Azure growth of 30% YoY came in at the lower end of their provided range of 30% to 31%, which was driven by persistent capacity constraints and modest softness in Europe. They asked management to elaborate on that and how they factored that into Q1’25 guidance.

Answer:

Amy (Management)

“The distinguishing between being at the higher end or at the lower end, really was some softness we saw in a few European geos on non-AI consumption really made the difference in that number. And we've assumed that going forward into H1 inclusive of my guide 28% to 29% going forward. And then let me separate which was your larger point, which is what are the other factors you see ongoing. Number one, you're right, capacity constraints, particularly on AI and Azure will remain in Q4 and will remain in H1.”

Broader Applications of Copilot

With GitHub Copilot already accounting for 40% of GitHub’s revenue growth this year and pushing it to an annual revenue run rate of $2 billion, analysts are questioning if there is potential for it to drive similar growth for non-developers too.

Question:

Mark Murphy (Analyst)

“With a couple of quarters of Copilot for M365 availability under your belt now, how are you assessing the capability of Copilots to replicate the productivity gains that they've created for developers, which seem to be very high and to do something similar for the broader population of knowledge workers?”

Answer:

Satya (Management)

“So we think of this as really a new design system for knowledge and frontline work to drive productivity, which would be very akin to what has happened in software engineering. So when you think about marketing or finance or sales or customer service, we will effectively replicate what you just said, which is the type of productivity we've seen in developers, will come to all of these functions as they think about their work, workflow and workout effect, all being driven by Copilots.”

Management noted that they aim to extend the productivity benefits seen with GitHub Copilot to a broader population of knowledge workers through M365 Copilot.

Valuation

Microsoft could see about 10% to 15% upside from here, at which time, it will be trading at a forward PE where the stock has met resistance two times prior.

The same is true on the sales valuation where the stock is trading at a forward PS of 11 to where a PS of 12 or 13 mark its absolute maximum valuation. There’s some room left but not a lot to work with.

Conclusion

Microsoft’s report shows continued growth in all the right areas and supports our large allocation to AI data center stocks. Ultimately, we closed Microsoft earlier this month following our July quarterly webinar where we expressed valuation concerns. Pausing Microsoft in our portfolio is likely to be short-lived as we see the company as a clear winner in AI, with AI driving an increasing amount of Azure’s growth and with Azure continuing to be capacity constrained. We’ve also been quite vocal that enterprise is where the growth in AI will come from, and Microsoft is unique among the FAANGs for its leading position with enterprise customers. We continue to see Microsoft as a quality company, yet we are rolling the dice to see if we can get a lower entry.

Richard Chu, Equity Analyst at I/O Fund, contributed to this analysis

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Cloudflare will report its results on August 1st. Management guided revenue in the range of $393.5 million to $394.5 million, representing YoY growth of 27.7% at the midpoint. Despite the Q1 revenue beat of 1.4%, management did not raise the FY guidance due to the mixed macroeconomic environment and geopolitical uncertainty. They remained cautious and said that the short term is uncertain, and the long term is bright.

Cloudflare is at an advantage as the company has visibility into many industries and had rightly given early warning of the slowdown in 2022. They reassured investors in the last earnings call during the Q&A that the level of concern is not the same as in Q1 2022 but remains prudent.

We see pockets of weakness (Tesla, for example, continues to face the effects of high interest rates), yet we will need to look to more commentary from Cloudflare to understand if the situation has grown worse or better as it’s not clear from our vantage point what spooked the CEO last quarter.

Revenue

The analysts expect Q2 revenue to grow 27.9% YoY to $394.5 million. Revenue growth will decelerate from 30.5% YoY to $378.6 million in Q1. It will further decelerate to 26.1% YoY growth in Q3 and 25.9% in Q4 and then accelerate to 26.2% growth in Q1 FY 2025. This is actually quite strong for best-of-breed cloud as many >40% revenue growth cloud companies have dipped <20% in recent years.

Margins

The Q1 gross margin improved 180 bps YoY and 50 bps sequentially to 77.5%. The adjusted gross margin improved 170 bps YoY and 60 bps sequentially to 79.5%. This was higher than the management’s long-term target of 75% to 77%.

The operating margin was (-14.4%) compared to (-16.3%) in the same period last year and (-11.8%) in the previous quarter.  The adjusted operating margin improved 450 bps YoY and 20 bps sequentially to 11.2%. The operating expenses as a percentage of revenue were reduced by 300 bps YoY due to the focus on higher productivity and greater efficiency in the operations. Sales and marketing expenses as a percentage of revenue reduced by 100 bps, R&D expenses reduced by 200 bps and general & administrative expenses reduced by 100 bps YoY. The adjusted operating margin guide for the next quarter is 9%, up 240 bps YoY and down 220 bps sequentially.

The net loss was (-$35.5) million or (-$0.10) per share compared to (-$38.1) million or (-$0.12) per share in the same period last year. The adjusted net income was $58.2 million or $0.16 per share compared to $27.2 million or $0.08 per share in the same period last year and beat estimates by 22.6%. The guide for the next quarter is $0.14.

The analysts expect adjusted EPS to grow 40.7% YoY to $0.14 in Q2 and decline by (-6.3%) YoY to $0.15 in Q3.

Cash Flow and Balance Sheet

• Q1 operating cash flow was $73.6 million or 19% of revenue compared to $36.41 million or 13% of revenue in the same period last year.
• Free cash flow was $35.6 million or 9% of revenue compared to $13.9 million or 5% of revenue in the same period last year as it benefited from an uptick in collections on accounts receivable. Network capex was 8% in the recent quarter. Management expects network capex to be 10% to 12% of revenue in 2024, including the rollout of GPU capacity to every location.
• The company has cash and available-for-sale securities of $1.72 billion and debt of $1.28 billion compared to $1.67 billion and $1.28 billion in the December quarter.

Key Metrics

RPO

RPO increased 8% QoQ and 40% YoY to $1.343 billion. This is an acceleration from growth of 37% YoY in the previous quarter.

Billings

The company’s primary focus is on RPO as a more comprehensive measure of its business. We track billings since they are reported for other cybersecurity stocks. Billings grew by 24% YoY and declined by (-7%) sequentially to $387.6 million and a deceleration from 28% YoY growth and 15% sequentially in the previous quarter.

DBNRR

The dollar-based net retention rate was 115% in Q1, flat QoQ but down from 117% in the year-ago quarter. Management expects the decelerating trend to stabilize around the current levels.

Customers

Customers with greater than $100,000 annualized revenue grew by 33% YoY to 2,878. The number of customers has been trending higher sequentially even though the growth decelerated from 35% in the previous quarter.

Matthew Prince, CEO and co-founder, said in the earnings call, “We added 122 new large customers, those that pay us more than $100,000 per year, and now have 2,878 large customers, up 33% year-over-year. Revenue contribution from our large customers during the quarter increased to 67%, up from 62% in the first quarter last year. Digging into our largest customers, we added a record number of net new customers year-over-year spending more than $100,000, $500,000 and $1 million on an annualized basis. We are successfully moving upmarket and becoming a larger and more strategic vendor to more and more of our customers.”

Paying customers grew by 17% YoY to 197,138 and have been growing at a similar rate in the last three quarters.

Cloudflare is reporting 2 million developers on their Workers platform. This is up from “more than a million” in a press release in November of 2023 and is up from 450K developers in May of 2022 per a corporate blog. Per the opening remarks: “The last few months were incredible for the entire workers' ecosystem. First, we crossed over 2 million active developers building applications on Cloudflare Workers. Second, in April, we GA-ed a number of key products like DY, our serverless SQL database; hyperdrive, which makes any traditional database perform like it's globally distributed; and Workers AI, which allows developers to run and tune AI models across our global network.”

Other key points to watch

FY Outlook

Cloudflare has good visibility in various industries since the company is a leading CDN player. Management has been cautious due to macroeconomic uncertainty and geopolitical tension, maintaining the FY 2024 guide of $1.648 billion to $1.652 billion, representing a YoY growth of 27.3% at the midpoint. However, the market expected a rise in the FY 2024 guide, particularly after the strong Q1.

Matthew Prince said in the earnings call, “I feel extremely confident and clear in the long-term opportunity that Cloudflare has in front of us. In the short-term, however, my crystal ball is less clear. We see a lot of signals based on our privileged position running a good chunk of the Internet. Even without that visibility, if you've been watching the news at all, it's clear that the near-term outlook for the world is uncertain, increasing tensions in the Middle East, no end in sight from the Russia-Ukraine war and potential signs of instability in Asia. It's not at all certain on anything we see that things will get worse, but we do know from even recent history that macro factors can impact short-term sales trends.”

During the Q&A, Matthew Prince clarified that they didn’t see a clear signal of a slowdown that they saw in 2022. He described the crystal ball as cloudy. “We see things that worry us, but we also see things that give us some level of optimism. And so, I think describing the crystal ball as cloudy is the right thing.”

Customer wins

The management highlighted strong customer wins during the Q1 earnings. Some of the notable include:

“The National Cyber Security Centre, the UK's technical authority for cyber threats, signed a three-year contract with Cloudflare to deliver its protective domain name service. PDNS protects over 1,400 UK organizations in central government, local government, healthcare and emergency services from malware and cyber threats.”

“A leading technology company expanded their relationship with Cloudflare, signing a three-year, $40 million pool of funds contract, $8.5 million of which are expansion.”

“A large international energy company signed a five-year, $4.5 million contract. This new customer is going all-in with Cloudflare's SASE platform with 6,000 Zero Trust seats along with CASB, DLP, browser isolation, Magic WAN and Magic Firewall.”

Network capex

The company has been efficiently managing capex despite the GPU rollout and benefitting from the uniqueness of its platform to onboard new workloads. Management mentioned that they don’t need capex like the hyperscalers. Matthew Prince highlighted in the earnings call that they sell more high-margin products like Zero Trust and SASE that require lesser capex. They also made the right decision to reserve space, sensing the AI opportunity. The company now only needs to plug the GPU cards into the servers, freeing up the capex to invest in other areas. Also, they note that the inference tasks do not require cutting-edge GPUs that are in short demand, so the company has more flexibility in choosing between different GPU vendors.

Network capex was 8% of the total revenue in Q1 and has been at the same level in the last three quarters. Management expects network capex to be 10% to 12% of revenue in 2024, including the rollout of GPU capacity to every location.

Valuation

The company trades at a P/S ratio of 18.9 and a forward P/S ratio of 16. The average P/S ratio since the company’s listing in September 2019 is 33. We continue to monitor the 20x forward P/S level that ‘best-of-breed’ cloud stocks struggle to maintain, particularly when the macroeconomic conditions worsen.

Conclusion

The company sits in an enviable position for AI inference at the Edge. The developer growth of Workers to 2 million was the highlight in the last earnings report. We continue to monitor the key metrics and the outlook for the year. We liked the management’s response on network capex as it shows they have a strategy. It’s showing up today with cash flows remaining at an acceptable percentage of revenue – although, notably, we want to stay neutral here regarding what the network capex reports in the future and continue to scrutinize cash flow margins.

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

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Lam Research followed in the footsteps of WFE peer KLA with a top and bottom line beat in fiscal Q4, while guiding fiscal Q1 revenue slightly above consensus. Margins rebounded in fiscal Q4 with management forecasting fiscal Q1 GAAP operating margin to expand from Q4’s print. China’s revenue contribution dipping sequentially, which was a main focus on the call.

Lam slightly boosted its WFE outlook for calendar 2024, now seeing WFE spending in the mid-$90 billions, compared to its view for the low to mid-$90 billions in the March quarter. Management said the increased view was primarily driven by domestic China shipments, though recent news with the US targeting more restrictions on China’s ability to access HBM may play a negative role down the line, if implemented.

Lam sees foundry, logic, DRAM and NAND to all rise YoY in calendar 2024. Management noted that memory’s WFE will be “biased” towards tech upgrades, meaning the recovery still may not yet be fully under way as memory’s contribution dipped QoQ.

Overall, we are likely to close Lam as we are not comfortable with high exposure to China, combined with the decline in DRAM.

Revenue and EPS:

Lam returned to topline growth in its fiscal Q4, reporting YoY revenue growth of 20.6%, though QoQ growth was marginal, at just 2.1% QoQ. Lam’s fiscal Q1 guide points to revenue growth in the high-teens, or approximately 16.4% YoY at midpoint.

• Q4 revenue of $3.87 billion beat estimates by $40 million, with Lam reporting YoY revenue growth after five consecutive quarters of declines.
• FY24 revenue was $14.91 billion, down (14.5%) YoY.
• For fiscal Q1 (September 2024 quarter), Lam guided for revenue of $4.05 billion, +/- $300 million, for YoY growth of 16.4% and QoQ growth of 4.6%. This was slightly ahead of analyst estimates for $4.02 billion.
• This quarter, GAAP EPS of $7.78 beat estimates by $0.42, representing YoY growth of more than 30% and QoQ growth of 6%.
• Adjusted EPS of $8.14 beat estimates by $0.55, representing YoY growth of more than 36% and QoQ growth of nearly 4.5%.
• FY24 GAAP EPS was $29.00, down (12.7%) YoY.
• For Q1, Lam guided GAAP EPS of $7.79, +/- $0.75, for approximately flat QoQ growth and 17% YoY growth.
• Adjusted EPS was guided at $8.00, +/- $0.75, for a QoQ decline of (1.7%) but YoY growth of nearly 17%.

Margins:

Lam’s margins expanded sequentially down the line, as operating leverage improved while gross margins remained flat QoQ. This came despite China’s revenue contributing shrinking 300 bp to 39%, with management previously citing China customer mix as a gross margin tailwind. As stated, there were many questions about China’s revenue being smaller this quarter.

• GAAP gross margin was 47.5% in Q4, flat QoQ but up 200 bp YoY. Management guided to a gross margin of 47% next quarter, and an incremental headwind in December.
• Adjusted gross margin was 48.5% in Q4, down 20 bp QoQ but up 280 bp YoY. Both figures came at the high end of management’s guided range for the quarter.
• For Q1, GAAP gross margin was guided at 46.9%, for a YoY and QoQ contraction of 60 bp. Adjusted gross margin was guided at 47.0%, a 150 bp QoQ and 90 bp YoY contraction.
• GAAP operating margin was 29.1%, a 120 bp QoQ and 250 bp YoY expansion. 
• Adjusted operating margin was 30.7%, a 40 bp QoQ and 340 bp YoY expansion — this was the highest adjusted operating margin since Q2 2023.
• For Q1, GAAP operating margin was guided to be 29.4%, for a QoQ expansion of 30 bp while remaining flat YoY. Adjusted operating margin was guided to be 29.5%, a 120 bp QoQ and 60 bp YoY contraction at midpoint.
• GAAP net margin was 26.3%, up 80 bp QoQ and 130 bp YoY, and reaching the highest level since Q2 2023, as improved operating margin aided bottom line growth. Adjusted net margin was 27.6%, up 60 bp QoQ and 260 bp YoY.

For the full year, GAAP gross margin was 47.3%, up from 44.6% in FY 2023; adjusted gross margin was 48.2%, up from 45.3% in FY 2023 as gross margins remained strong on China customer mix.

FY 24’s GAAP operating margin contracted 110 bp to 28.6%, as FY 23’s first half strength more than offset back half weakness.

Cash and Debt:

• Operating cash flow was $862.4 million in Q4, for a margin of 22.3%. OCF declined (23.2%) YoY, with the quarter seeing a ($260 million) detrimental impact from changes in operating assets and liabilities.
• Free cash flow was $761.7 million, for a margin of 19.7%, a nearly 1300 bp QoQ contraction, primarily as a result of the decline in OCF.
• Inventory was $4.22 billion, down slightly from $4.32 billion in the prior quarter.
• Cash and equivalents totaled $5.85 billion.
• Debt totaled $4.98 billion.

Key Metrics:

Interestingly, Lam reported DRAM and NVM revenue contribution shrinking QoQ, while logic/other revenue surged QoQ.

As a percentage of systems revenue, which was $2.17 billion:

• Foundry accounted for 43% of revenue, down from 44% last quarter.
• DRAM accounted for 19% of revenue, down from 23% last quarter. Two quarters ago, DRAM was 31% of revenue. 
• NVM accounted for 17% of revenue, down from 21% last quarter.
• Logic/other accounted for 21% of revenue, up from 12% last quarter.

Combined, memory accounted for 36% of systems revenue, down from 44% last quarter.

Geographically, Lam saw China revenues moderate QoQ, while Taiwan and US revenue contribution rose substantially QoQ.

• China accounted for 39% of revenue in Q4, down from 42% last quarter, and also reaching its lowest share of revenue in fiscal 2024.
• Korea accounted for 18% of revenue, down from 24% last quarter, potentially as one of the leading factors in memory’s weaker revenue contribution on a QoQ basis.
• Taiwan accounted for 15% of revenue, jumping from 9% last quarter.
• The US accounted for 10% of revenue, rising from 6% last quarter.

Earnings Call:

DRAM Decline is Odd

The decline in DRAM is a concern as demand is surging for HBM3 and HBM3e, driven by memory being the most critical component in the upcoming generation of GPUs and ASICs. We expected more from Lam in this report considering HBM3 and HBM3e is the catalyst for memory stocks Micron, Samsung and SK Hynix, who Lam supplies.

Management stated that “The decline in the memory segment was mainly attributable to DRAM. DRAM came in at 19% of systems revenue compared with 23% in the March quarter as investments in mature nodes declined in the June quarter.” Theoretically, this decline in mature nodes should be offset by growth in HBM.

Per a previous Lam analysis in April Lam was expecting DRAM to triple YoY: “Lam is expecting its “HBM-related DRAM and packaging shipments to more than triple year-on-year and outpace WFE growth in this segment by a significant margin” in 2024.

CEO Timothy Archer added that in HBM, Lam is seeing “very, very strong demand. I think that whether or not at some point, it's shipping above peak, I think that this AI market is continuing to evolve at a very, very fast rate. And all we're focused on right now is ensuring we are building out our own capacity and capabilities. And ensuring that we maintain that technology leadership that's allowing us to hold 100% market share of the TSV formation in HBM.”

We were not the only ones expecting more from the DRAM segment, as one of the first questions on the call asked for more discussion on why DRAM isn’t showing up in the report. The answer was not clear, rather answering with what their technology can solve rather than addressing what is likely a competitive issue, where another supplier is taking the business (my best guess).

Question
Timothy Arcuri (Analysts)

[…] Can you just talk about — I know your leverage to the advanced packaging part of the HBM dollars being spent but that's still a pretty small piece of it. So can you just maybe give a chance to kind of discuss some of the view that you're not very levered to DRAM and give us a sense of maybe where you're investing and where you think you can gain share in DRAM.”

Answer
Timothy Archer (Executives)

[…] The other side of it, a lot of the excitement around DRAM is related to HBM. And there, as you commented, we play extremely well with our strong position in both TSV, etch as well as the TSV electroplating. And I think that we don't see any change in that strong position going forward. So we get the benefit both from the scaling and architectural changes that are occurring in DRAM going forward and from the advanced packaging and HBM related expansion. And all of these — on both of those sides are multiplied by the fact that you get fewer bits per wafer. And so everybody recognizes you're going to need a lot more DRAM wafers processed going forward. And ultimately, that translates into more equipment from LAM.

-End Quote

Another analyst asked for clarification on if DRAM should “at some point, come back strongly.” The CEO stated that “we see DRAM demand for DRAM equipment continuing to grow through 2025 and probably well beyond that.”

China is the Opportunity; but also a Major Risk

As stated, China revenue was at 39% down from 42% last quarter. To help illustrate the importance of China to Lam, the word was stated 33 times in the earnings call compared to HBM being stated 14 times. Not only is China a risk politically, but the revenue can be lumpy for Lam.

Source: Lam’s Quarterly Earnings Slides

There was a solid question on the call that helps investors understand the risk in terms of losing a customer due to restrictions, and why Lam may be lagging some of its peers

Question
Atif Malik (Analysts)

Doug, if I look at the 2023 year-over-year China sales growth among the big 5 equipment makers. All of them are up quite well. ASML is up like 250% and the U.S. peers are up in teens or 20%, but you guys were down 11% total China sales in 2023. And this year, you're expecting China sales to be up. So I'm just trying to understand the dynamics last year. Were this just a function of maybe NAND spending and the NAND project not being active or are there competitive elements in China that are working against you?

Answer
Douglas Bettinger (Executives)

Atif, I'll remind you that perhaps our largest customer got restricted when the regulations came out, our NAND customer in China. That customer was pretty strong in '22, went away in '23. So the year-over-year comparisons you're making, you've got to factor that in. And then the strength we're seeing '23 to '24 is a different mix entirely, really not any NAND in China to speak of, at least not domestic China. I don't know if that helps you, but make sure you're thinking about that.

Conclusion:

The decline in DRAM could be short-lived, to where the segment bounces back quickly next quarter. However, being in the midst of such strong HBM growth, it feels odd to see DRAM decline in light of the strong commentary we saw in the first half of the year.

In addition, Lam’s exposure to China is problematic. Theoretically, it would be harder for Lam to replace China revenue than a memory company that is sold out of supply 6-8 quarters out, or a GPU design company that is also seeing outsized demand. For stocks that have China risk, we’d rather own TSMC, for example, or more of Micron if we seek exposure to memory, or even Nvidia for the clear capex raise we got from Microsoft and Meta.

Our plan is to close Lam and to give the I/O Fund team the task of re-allocating it to a stock with less risk, and with its AI-related segments reporting more growth.

Damien Robbins, Equity Analyst for the I/O Fund, contributed to this analysis.

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AMD confirmed a fundamental bottom with a beat this quarter and a beat for next quarter. Analysts were expecting revenue growth of 6.8% and AMD reported growth of 8.9%. Adjusted EPS marginally beat at $0.69 versus $0.68 expected. The results were aided by data center revenue reaching a record as growth accelerated to the triple digit range, at 115% YoY for $2.84 billion, marking a 35-percentage point acceleration from 80% in Q1. CEO Lisa Su said AMD’s “AI business continued accelerating and we are well positioned to deliver strong revenue growth in the second half of the year led by demand for Instinct, EPYC and Ryzen processors.”

We had stated on our most recent webinar and in the write-up AMD’s Future Looks Bright that we want to give AMD the space to fill the very big shoes an Nvidia contender has to fill. Data center growth in Q2 of 115% is a clue that AMD is a serious contender on AI accelerators. The only other companies that have posted triple digit growth from AI in a standalone segment are Nvidia and Super Micro. To be fair, some of the revenue is from EPYC CPU processors, but the majority of the growth is coming from Instinct GPUs. We can sparse out the growth as Instinct drove $1B in revenue this past quarter, with EPYC contributing $1.84 billion. Without Instinct, data center revenue would have grown 41.5% versus 115% with Instinct.

With AMD down (-6%) YTD while Nvidia is up 109%, the market continues to communicate “not good enough.” Yet, what makes these numbers intriguing is we are at the bottom for this company (not a top – this is key), with fundamentals improving and accelerating from here.

Revenue and EPS:

AMD’s revenue accelerated to 8.9% YoY in Q2, up from 2.2% last quarter due to data center revenue accelerating significantly this quarter.

• Q2 revenue was $5.84 billion, up 8.9% YoY and 6.6% QoQ from $5.47 billion last quarter.
• Adjusted EPS of $0.69 beat estimates by $0.01, representing YoY growth of 19% and QoQ growth of 11%.
• GAAP EPS of $0.16 missed estimates by $0.02 but represents 700% YoY growth and 129% QoQ growth as margins bottomed and turned up this quarter (this high growth is due to   
• For Q3, AMD guided revenue to be $6.7 billion, +/- $300 million, for YoY growth of approximately 15.5% at midpoint. Analysts were expecting Q3 revenue to be $6.61 billion, for YoY growth of approximately 14.1%, so Q2 and Q3 beat/raised by 1 to 2 percentage points.

Key Segments:

AMD reported record data center revenue in Q2, with growth accelerating to the triple digits on strong CPU and GPU demand and the “steep ramp” of Instinct GPUs.  The company stated it’s AI accelerator the MI300 contributed $1 billion in revenue.

Data center revenue was $2.83 billion, up 115% YoY and 21% QoQ. For reference, in Q1, AMD reported data center revenue growth of 80% YoY and 2.4% QoQ, so this is a rather sharp acceleration in just one quarter. Per management this was “driven by the steep ramp of Instinct MI300 GPU shipments and a strong double-digit percentage increase in EPYC CPU sales.” There is expected to be strong growth next quarter in the DC segment.

Client revenue was $1.49 billion, up 49% YoY and 9% QoQ, driven by sales of Ryzen processors. This was a solid print, as Client rebounded from a (6%) QoQ decline in Q1. This was “driven by strong demand for our prior generation Ryzen processors and initial shipments of our next-generation Zen 5 processors.” There is expected to be strong growth next quarter in the Client segment.

Gaming revenue was $648 million, down (59%) YoY and (30%) QoQ as the segment continues to weigh on growth. Management stated the gaming market remains soft and sales will decline further in the second half of the year, and will decline double-digit percentage next quarter.

Embedded revenue was $861 million, down (41%) YoY but up 2% QoQ as inventory levels normalize. Management guided last quarter for Embedded revenue growth to be flat, so the 2% sequential increase is slightly better than expected. Management expects Embedded to gradually recover in H2, and this segment will be up next quarter.

Margins:

AMD’s margins improved throughout, with data center driving a sequential improvement in GAAP operating margin.

• GAAP gross margin was 49% in Q2, up from 46% last year and 47% in Q1. Adjusted gross margin was 53%, in line with management’s guidance and up from 50% last year and 52% in Q1. Management said higher data center revenue was a primary driver of the gross margin expansion in the quarter.
• For Q3, AMD guided for adjusted gross margin of 53.5%, a slight 50 bp QoQ expansion; management has previously pointed to increasing data center mix as a gross margin tailwind.
• GAAP operating margin was 5% in Q2, up from 0% last year and 1% in Q1.
• This was driven largely by data center, which saw operating income rise more than 37% QoQ and 405% YoY to $743 million, for a 26.2% segment operating margin (up from 23.1% in Q1).
• Adjusted operating margin was 22%, up from 20% last year and 21% in Q1.
• Based on management’s expenses guide, adjusted operating margin is expected to come in just above 25% in Q3, a 300 bp QoQ expansion.
• GAAP net margin was 5%, up from 1% last year and 2% in Q1. Adjusted net margin was 19%, up from 18% last year but flat with Q1.

Cash and Debt:

• Operating cash flow was $597 million in Q2, a 10% margin. OCF rose more than 14% QoQ and 56% YoY.
• Free cash flow was $439 million, an 8% margin. FCF rose nearly 16% QoQ and 73% YoY as a result of higher operating cash flow generation.
• Inventory was $4.99 billion, an increase of 7.3% QoQ.
• Cash and equivalents totaled $5.43 billion, while debt totaled $1.72 billion. The company retired $750 million in debt with existing cash this quarter. The company will close Silo AI next quarter for $665 million in cash.

The company returned $352 million to shareholders, repurchased 2.3 million shares with $5.2 billion in share authorization remaining.

Earnings Call:

$4.5B in AI Revenue for FY2024, up from $4B

AMD’s AI accelerator, the MI300, is the fastest ramping product in AMD’s history. I said previously that this is saying a lot as it’s ramping faster than EPYC CPUs, which took a shocking amount of market share from Intel in the data center.

Per a previous write-up:

“My take is that the glass is 30% full and will likely exit the year half-full. Per the call, one analyst’s math is for $900M in GPUs next quarter. If we take $2.4 billion for the DC segment this quarter and assume strong double-digit growth, that puts us at a $3B data center segment next quarter (roughly). If this analyst’s math is correct, this means within two quarters of shipping; GPUs will be 30% of DC segment in Q2. I can’t think of another company that has ramped this fast outside of Nvidia.”If this analyst’s math is correct, this means within two quarters of shipping; GPUs will be 30% of DC segment in Q2. I can’t think of another company that has ramped this fast outside of Nvidia.”

This quarter, AMD seconded this by shrugging off rumors there may be issues with qualifying the MI300: “I think there's a lot of noise in the system. I wouldn't really pay attention to all that noise in the system. I mean this has been an incredible ramp. And I'm actually really proud of what the team has done in terms of just definitely fastest product ramp that we've ever done to $1 billion here in the — over $1 billion in the second quarter and then ramping each quarter in Q3 and Q4.”

EPYC took about 10 years to reach $1.7B in quarterly revenue. AMD will likely reach this quarterly revenue by 2025, or in less than two years with Instinct 300 Series GPUs.

The next MI300 Series release will be the MI325 due out this year with double the memory, and the highly anticipated MI350 will be out early next year to compete with Nvidia’s Blackwell. From there, AMD will continue with a one-year product road map. Look for rack scale systems in the MI350 release next year, which is critical for AMD to keep pace with Nvidia on Blackwell at the hyperscaler and Tier 2 OEM level.

AI Software

The Silo AI acquisition is big news as it will boost AMD’s ability to compete with Nvidia at the enterprise level. We covered the acquisition on our pre-earnings writeup here. Per management: “It's a great acquisition for us. 300 scientists and engineers. These are engineers that have experience with AMD hardware and are very, very good at helping customers get up and running on AMD hardware. And so we view this as the opportunity to expand the customer base with talent like Silo AI, like Nod.ai, which brought a lot of compiler talent. And then we continue to hire quite a bit organically.”

At the Big Tech level, AMD announced that Microsoft has announced the general availability of the MI300X instances. The Azure virtual machines combine AMD’s RocM software platform for “leadership-inferencing price performance.” Hugging Face has adopted the Azure instances “to deploy hundreds of thousands of models on MI300X GPUs with one click.”

On the developer side, Meta’s Llama 3.1 model is supported by MI300 accelerators, Stable Fusion announced they are working with MI300s for their image generation LLM, and AMD supports Flash Attention-2, an algorithm used to enhance efficiency for Transformer models.

RocM is AMD’s attempt to remove the CUDA roadblock the company faces in competing with Nvidia. We’ve covered this here in AMD is Ready to Rival on AI Acceleration. The following update was shared in terms of the progress that’s being made: “the exciting part of this is that the ROCm capability has really gotten substantially better because so many customers have been using it. And with that, what we look at is out-of-box performance, how long does it take a customer to get up and running on MI300. And we've seen, depending on the software that companies are using, particularly if you're based on some of the higher-level frameworks like PyTorch, we can be out-of-the-box running very well in a very short amount of time, like, let's call it, very small number of weeks. And that's great because that's expanding the overall portfolio.”

UALink: Standardizing GPU Interconnects

AMD is being tapped by a consortium of AI acceleration companies, such as Broadcom, Intel, Cisco and Big Tech to assist in creating an Ultra Acceleration Link (UALink) open standard for GPU interconnects to reduce dependency on Nvidia’s NVLink. NVLink is a GPU interconnect that scales GPUs into pods with their own data and computational domain. AMD is being tasked to create an open standard that will serve as an alternative to Nvidia’s NVLink based on AMD’s Infinity Fabric.

The takeaway is AMD is not only viewed as a runner-up to Nvidia, but is actively sought after by the industry to stave off its monopoly. If you read between the lines, this is an important nod to AMD’s capabilities.  Look for more updates in Q3.

AI PCs and Zen 5 EPYC Processors

A major part to AMD’s AI story is laptops, desktops and edge devices.  I can’t emphasize this enough!

The Ryzen AI 300 laptops and the Ryzen 9000 series for desktops are powered by the 5th generation of the Zen architecture. The Ryzen AI 300 laptop has a XDNA 2 neural processing unit (NPU) that is designed for Microsoft Copilot+ AI software. This will deliver 50 TOPS of AI performance. To put this into perspective, the Macbooks with the M4 chip from Apple – considered the most advanced AI laptop on the market – is capable of 38 TOPS of AI performance.

The laptops are already on the market as of now and the desktops will hit the market in August. Management stated investors can expect a strong H2: “As we go into the second half of the year, I think we have better seasonality in general, and we think we can do, let's call it, above-typical seasonality given the strength of our product launches and when we're launching. And then into 2025, you're going to see AI PCs across sort of a larger set of price points, which will also open up more opportunities.”

AMD’s Zen 5 architecture will have 128 cores and 256 thread count and will double the chiplets from eight to 16. The cache is getting a massive upgrade to 512 MB, which was not possible on the Zen 4 architecture at this core and thread count. 

In the data center, Turin EPYC processors will have 192 cores and 384 threads. Per the opening remarks: “We publicly previewed Turin for the first time in June, demonstrating our significant performance advantages in multiple compute-intensive workloads. We also passed a major milestone in the second quarter as we started Turin production shipments to lead cloud customers. Production is ramping now ahead of launch, and we expect broad OEM and cloud availability later this year.” Management stated they believe Turin will help them “continue to grow market share” in the second half of the year.

Conclusion:

At the close of the opening remarks, Lisa Su stated the company is “well positioned to grow revenue significantly in the second half of the year” and “our data center business is on a steep growth trajectory.” These are the words of a company at a fundamental bottom.

There is no doubt, this company ticked every box we have on our checklist this evening. We don’t chase price, rather we look for quality companies. This often means we are early to a move in either direction. You can expect this to be a leading position of ours into the foreseeable future as we patiently wait to see how this bottom unfolds, especially come 2025 for AMD.

Damien Robbins, Equity Analyst for the I/O Fund, contributed to this analysis.

Recommended Reading:

• AMD Q2 Pre-Earnings: The Future Looks Bright
• Hewlett-Packard Enterprise: Sleeper Stock with AI Potential
• Marvell: Tons of AI Potential Obscured by Underperforming Segments

Hewlett Packard Enterprise (HPE) has quietly undergone a business transformation over the last few years to position itself as a beneficiary in AI servers, networking, hybrid cloud and AI software. Last quarter, HPE’s AI systems revenue doubled sequentially to $900 million with a backlog of $3.1 billion. Compare this to Dell with AI server order revenue of $2.6 billion and AI server shipments of $1.7 billion. Super Micro has total revenue of $3.85 billion with “more than 50%” of this from AI or about $2 billion.

As a percentage of revenue, SMCI is certainly in the lead as a pure play. However, HPE is ahead of Dell in terms of percentage of revenue at 12.5% for HPE and 7% for Dell.

We’ve identified liquid cooling as a leading trend for the back half of 2024. Of those at the cross-section of servers and liquid cooling, HPE has the lowest valuation to the tune of being priced up to 67% lower.

HPE Overview:

HPE has over 13,000 patents, with 300 of these in particular in liquid cooling systems for data centers, and is the owner of four of the world’s top 10 fastest supercomputers.  It has also made a number of partnerships, such as with Microsoft Azure, Google Cloud, SAP, and Nvidia to offer seamless cloud experiences or more powerful compute capabilities. HPE operates globally with over 700 channel partners giving it a unique edge in go-to-market capabilities.

HPE has five business segments:

1. Server (53% of revenue in Q2’24): HPE sells servers for general-purpose use through their ProLiant line and more compute-intensive applications such as their Cray line, which is used in supercomputers.

2. Hybrid Cloud (17% of revenue): HPE offers cloud-native and hybrid solutions for customers that would prefer not to host their own servers on-premise. This includes data storage and management, hybrid and cloud-native services through HPE GreenLake, and AI infrastructure as a service.

3. Intelligent Edge (15% of revenue): HPE provides solutions that enable faster data transfer and improved data analytics through edge computing. AI workloads will eventually move to the edge. Intelligent Edge also offers security features like Zero Trust. This segment includes HPE Aruba which is a subsidiary focused on networking capabilities supported by HPE’s planned $14B merger with Juniper Networks, announced in January 2024.

4. Financial Services (12% of revenue): HPE provides investment solutions to allow businesses to deploy technology models and acquire IT solutions.

5. Corporate Investments and Other (3% of revenue): HPE provides consulting and implementation services.

HPE Cray’s supercomputers are high performance computing servers for AI workloads. They are available with both Nvidia and AMD GPUs, and currently rank as the world’s fastest and largest supercomputers. Cray was a supercomputer manufacturer founded in 1972 before it was acquired by HPE in 2019. Cray is roughly 80% government and agency contracts and 20% commercial, with the bulk of the line being used such for supercomputers for research labs within the Department of Energy, among others.

The ProLiant servers accelerate workloads from the data center to the edge, and are used by corporations for hybrid AI. The AI rack servers offer memory intensive AI inferencing and scalable GPU acceleration for enterprise AI. There are SKUs for virtualized workloads for edge applications that offer balanced bandwidth and memory, data intensive workloads for apps that require large storage capacity and high bandwidth, and compute and data storage demanding workloads that require a maximum core count, among others.

GreenLake cloud is a hybrid architecture that allows enterprises to maintain control of sensitive data, while leveraging the benefits of public and private clouds. HPE calls this an edge-to-cloud platform, which offers software-as-a-service for storage, a data control plane to have a complete view of data assets, data analytics, and the ability to scale AI pilots and large language models. The software platform offers the ability to create a private cloud alongside on-premise servers, which may become quite popular as it allows enterprises to balance the security and data sovereignty that on-premise offers with the agility and scalability of the cloud. Among other things, HPE GreenLake lets customer privately train and tune large language models.

HPE Edgeline offers edge computing and processing power in a compact server that is located close to where data is generated. Edgeline servers are important for edge computing where data is quickly turned into intelligence with AI, and to manage AI/ML applications while protecting and governing data.

Aruba ensures reliable and secure connectivity from the edge back to the servers at the datacenter. The most recent Juniper Networks acquisition expands HPE into ethernet networking and switches. HPE’s $14B merger with Juniper Networks is expected to close in late 2024 or early 2025 and will strengthen HPE’s portfolio in AI networking.

Financials:

Hewlett Packard Enterprise (HPE) surprised in its latest earnings report, posting revenue and non-GAAP EPS that both exceeded outlook in Q2 as AI systems revenue more than doubled sequentially. Management also raised full year revenue and non-GAAP EPS guidance, signaling confidence in their ability to convert the current backlog orders to revenue.

Revenue and EPS:

HPE is a low growth company that has promising, initial signs of AI demand.

The company reported $7.2B in revenue, representing 3.3% YoY growth (5.45% beat), which was the biggest revenue surprise in the last 6 quarters. The company guided for $7.6B in revenue at the midpoint for this upcoming quarter, representing 8.5% YoY growth (2.1% beat).

The company reported ARR of $1.5 billion, up 37% from the prior-year period and 39% in constant currency. Last quarter, ARR grew 41% year-over-year to more than $1.4 billion in Q1, with the company stating to expect ARR growth of 35% to 45%.

GAAP EPS of $0.24 was down 25% YoY and down 17% QoQ.

Adjusted EPS of $0.42 vs $0.52 last year (8.2% beat) is down 19% YoY and was down 13% QoQ. The company guided for adjusted EPS in the range of $0.43 to $0.48 vs $0.49 last year.

HPE’s FY24 revenue guidance represents 1.5% YoY growth at the midpoint, a slight rise from Q1’24 where they guided for 1% YoY growth at the midpoint in constant currency. Adjusted EPS guidance for FY’24 was in the range of $1.85 and $1.95, higher than the guidance given during Q1 results of $1.82 and $1.92.

Key Segments:

The revenue beat was driven by strong performance in AI-related revenues. AI system sales more than doubled sequentially to over $900M for 12.5% of revenue, and the number of enterprise AI customers tripled YoY. AI systems accounted for all of the QoQ growth given the QoQ declines in Hybrid Cloud and Intelligent Edge.

• Server Revenue of $3.9 billion dollars in Q2 represents a 16% increase sequentially and up 18% year-over-year, driven by AI servers and HPE Greenlake revenue.

HPE continues to expect sequential growth in both their traditional and AI server business. Operating margins were 11% in this segment, down 340 bps YoY due to pricing headwinds on AI systems, but it is in-line with their long-term operating margin guidance range of 11% to 13%.

HPE has reduced lead times for delivering Nvidia H100 solutions to six to 12 weeks, from over 20 weeks in Q1’24, which it expects will further boost revenues in H2’24, along with more large enterprise orders.

The backlog remained stable at $3.1B, down from $3.4B last quarter but up from $1.4B in the prior year quarter. This acceleration in AI systems revenue comes alongside a recovery in traditional and cloud infrastructure markets, creating a strong set-up for further acceleration into H2. This was also discussed in the Q&A with excerpts below.

Management also pointed to a growing enterprise customer base as evidence of its products’ value proposition.

“Our differentiation – with liquid cooling, software, HPE GreenLake, and increasingly services – is resonating in the market. We have seen a threefold increase in our enterprise AI customer base in the past year.” We have seen a threefold increase in our enterprise AI customer base in the past year.”

• Hybrid Cloud revenue was $1.3 billion, down 8% from the prior-year period in actual dollars and 9% in constant currency, with 0.8% operating profit margin, compared to 1.9% from the prior year period.

This decline is being driven by two ongoing transitions. First is from hardware storage to HPE’s cloud-native Alletra storage solution, which reduces current revenues but leads to more predictable recurring revenues with storage ARR up 50% YoY.

Second is the transition from block storage to file storage driven by AI and is seeing strong progress with the pipeline of file storage deals tripling sequentially. Operating margins were down 110 bps YoY to 0.8% due to the decline in revenue as well as a larger mix of lower margin third-party products and traditional storage.

Management provided helpful insights around operational transitions the Company is working through:

“The business is managing two long-term transitions at once. We’ve talked about our migration to the more software intensive Alletra platform. This is reducing current period revenue growth though locking in future recurring revenue. Storage ARR growth of over 50 percent year-over-year offers early confidence in the migration. The second transition is from block storage to file storage driven by AI. While early, this is also on the right trajectory. Our new file offerings plus the sales force investment Antonio mentioned tripled our pipeline of file storage deals sequentially in Q2.”

The GreenLake as a service offering is expected to grow ARR at a 35-45% CAGR through FY’26.

HPE GreenLake, a leader in hybrid cloud infrastructure, is also attracting new customers to HPE’s portfolio with the number of customer organizations using GreenLake increasing 9% QoQ to 34,000 and ARR growing 39% YoY to over $1.5B. This increase is being driven by growth in AI systems and they expect high growth to continue to persist with a target 35-45% ARR CAGR from FY’22 to FY’26.

“We have strong momentum in HPE GreenLake. The number of customers that have adopted HPE GreenLake rose 9 percent sequentially. ARR grew 39 percent year-over-year to above $1.5 billion dollars in Q2. Storage and networking are typically the fastest growth elements of ARR and both retain robust growth rates. This quarter, AI was the fastest growth component of ARR. Our software and services mix rose approximately 200 basis points year-over-year to 67 percent. ARR is the best indicator of our model transformation to our as-a-service offerings. This growth validates what our customers are telling us – HPE GreenLake is a key differentiator. We expect HPE GreenLake’s value proposition to key customer, including enterprises and sovereigns, to sharpen with the advent of AI.”This quarter, AI was the fastest growth component of ARR. Our software and services mix rose approximately 200 basis points year-over-year to 67 percent. ARR is the best indicator of our model transformation to our as-a-service offerings. This growth validates what our customers are telling us – HPE GreenLake is a key differentiator. We expect HPE GreenLake’s value proposition to key customer, including enterprises and sovereigns, to sharpen with the advent of AI.”

• Intelligent Edge revenue was $1.1 billion, down 19% from the prior-year period with 21.8% operating profit margin, compared to 24.7% in the prior-year period.

This was driven by difficult comps in both periods as HPE went through its backlog and also by soft macro conditions. However, HPE believes that the segment will return to modest sequential growth moving forward. The segment reported a 21.8% operating margin which was down 290 bps YoY due to lower revenues and the high margin switching business forming a lower percentage of revenue. Moving forward, HPE has already lowered its opex for the segment and they expect operating margins to return to the mid-20s by Q4’24.

• Financial Services revenue was $867 million, up 1% from the prior-year period with 9.3% operating profit margin, compared to 8.9% from the prior-year period. Net portfolio assets of $13.2 billion, down 1.1% from the prior-year period.

Margins:

Margins contracted across the board with gross margin in Q2’24 the lowest since 2022. Gross margins were 33%, compared to 36% last quarter and in the prior year quarter. A shift from networking revenue to AI systems revenue is a headwind as AI servers are lower in margin (compared to the higher margin offerings i.e., Intelligent Edge). Management did revise forward guidance on adjusted gross margins downward based on the mix shift and expect to be below full year expectations of 35%.

• GAAP gross margin of 33.0%, down 300 basis points year-over-year.
• Q2 non-GAAP gross margin was 33.1%, down 310 basis points year-over-year.
• GAAP operating margin of 5.9%, down 160 basis year-over-year and down 190 basis points sequentially. This is driven by gross margin compression as operating expenses decreased YoY.
• Net Margin of 4.4%, down 160 basis year over year and down 130 basis points sequentially. The decreased net income margin is driven by gross margin compression and slightly offset by improvements in total operating expense year over year.

Cash:

HPE reported operating cash flow of $1.1 billion for an OCF Margin of 15.2%, up $204 million YoY.

Free cash flow of $610 million represents an 8.5% margin and an increase from a FCF margin of 4.1% last year due to prepayments for AI systems and the timing of working capital payments. HPE maintained guidance for at least $1.9B in FCF for FY’24, representing 6.4% FCF margins and noting that FCF is seasonally higher in the second half.

Management continues to target returning 65% to 75% of FCF to shareholders through repurchases and dividends. They repurchased $45M worth of shares in Q2’24 and noted that they expect a similar pace of repurchases going forward with an outstanding buyback authorization of ~$0.9B. The dividend yield as of July 10th, 2024 is 2.44%. The dividend yield has come down from >3% in 2019 as the amount of dividends paid has remained consistent at ~$619M since then despite an increase in stock price.

The cash conversion cycle was negative 4 days, which is a reduction of 28 days from Q2 2023. Inventory increased to $7.3 billion vs $4.6 billion in prior quarter. Management noted that “our days of inventory and days payable were both higher to support our expected growth in AI system revenue in the second half”.

Balance Sheet Discussion

HPE has a strong balance sheet despite having a seemingly high net debt balance of $8.6B as of Q2’24 relative to its current market cap of $27.8B as of July 10, 2024. This is because the Financial Services division is managed separately with Net Portfolio Assets of $13.2B which is the total amount of Financing Receivables and Operating Lease Assets, net of reserves against those assets. This is balanced against Gross Debt of $11.5B and Cash of $0.3B for the Financing Division. The actual Operating Company (i.e., HPE excluding Financial Services) has $2.5B of cash with no debt.

Overall, the debt balance has remained manageable with $11.3B of total debt as of Q2’24, down from $13.4B in Q2’23 and a peak of $19.5B in Q3’20. $7.5B of total debt is long-term, with the remainder being comprised of $3B of debt being current, $646M of commercial paper, and $121M of notes payable and lines of credit.

Earnings Q&A:

HPE’s IP Portfolio and Liquid Cooling:

On the call, an analyst asked how HPE separates itself given the large IP portfolio the company has with over 300 patents related to liquid cooling. Given we are Dell and Super Micro investors, this question was of importance to us. If we look at the sales we see today, these three companies are neck-and-neck in terms of total AI server $ revenue. However, HPE took the time to discuss how the company is differentiated, although we have yet to see that differentiation (or competitive edge) show up in revenue.

Question

Aaron Rakers – Wells Fargo:

Yes. Thanks for taking my question. I guess sticking on the AI topic, if I could first ask, when you referenced the AI enterprise customers starting to show up, and I think the comment on the conference call was…it's now north of 15% of your AI orders. Can you give a little bit more context of that? What has that been over the last couple of quarters? I'm just trying to think about the trajectory of that.

And then Antonio, on the liquid cooling side, as we and investors think about Blackwell product cycle from NVIDIA. I'm curious of…can you be a little bit more specific of exactly where, from a technology perspective, you differentiate at liquid cooling? Is there something unique that HPE does within the 300 patents that you would want to highlight for us, as sustainably differentiated. Thank you.

Answer:

Antonio Neri – CEO

As for the differentiation, HPE has three different ways to cool systems. So, one is the traditional way, which is called the liquid-to-air cooler, think about that, basically running water supply in chilled locations where basically cools the air around the systems. Everybody has done that for a long time. The second is what most of the industry is doing today, which is what I call 70% direct liquid cooling or hybrid liquid cooling. Those companies still use fans to cool aspects of the systems. Some of our competitors talk about direct liquid cooling, but that's exactly what they're doing, and they are doing only a hybrid direct liquid cooling. And HPE has…and by the way, in that environment, we have 10 systems already in market today that we are shipping and configuring for customers.

And then we have what I call 100% direct liquid cooling. And this is a unique differentiation HPE has because we have been doing 100% direct liquid cooling for a long time. And today, there are six systems in deployment, and three of them are for generative AI. And as we go to the next generation of the silicon and you talk about Blackwell, when you go to the B200, that will require 100% direct liquid cooling.

–End Quote

Here was another moment the CEO discussed the top 4 ways HPE is differentiated for AI:

“So Amit, on the differentiation, I will summarize this on four key elements. One is our ability to deliver and run systems at scale, so AI system scale, that's a unique expertise and we have decades of experience. Number two is our infrastructure cooling intellectual property. We actually have all the IP necessary to cool systems in three different ways for them other. Our manufacturing footprint, which is very unique. We have one of the largest water-cooled manufacturing footprints in the world with two very important locations in the US and in Europe, which are close to customers.

And then last but not least is services. What I think people are coming to realize that running the system of scale requires unique services capabilities. And that's why with Marie, we started showing you what the services pull-through is, which is also over time, a lever to improve the gross margin in this business. And we cover all aspects from day zero which consulting, to day one, which is advisory and professional services design and then — and build, and then day 2, which is a running part with our — in our operational services side and deep expertise when it comes down to this system of scale, including direct liquid cooling.”

Guidance Looks to Be Conservative:

An analyst called out that the guidance looks conservative. HPE could be setting up for a beat/raise in the second half of the year, which would be key to market enthusiasm and stock performance. Primarily, the key metrics including backlog support higher growth than management’s current guide. FY’24 revenue guide seems to assume no additional growth in the backlog, to traditional servers, or to intelligent edge, despite management noting their expectation for all three to experience sequential growth through year-end.

Management toned down expectations by noting that it takes longer than 6-12 weeks to install and that a decent percentage of AI system deals are in generative AI which are all GreenLake and therefore the services portion is deferred over the life of the contract. While this latter point may mean that the current backlog will take longer than 2 quarters to realize, expectations are still low enough to set for further large beat and raises.

Toni Sacconaghi:

[…] You talked about enthusiasm for the second half, but you beat revenues this quarter relative to your expectations by $400 million and by guiding up an additional percent, you're actually only guiding up the full year by $300 million. So, I'm wondering, are you just being conservative, given the commentary around enthusiasm and forces at work in the second half or how do we reconcile that discrepancy? And then also just on AI servers for the second half, I think you talked about six-week to 12-week lead times. So if you have $3 billion in backlog and lead times for six weeks to 12 weeks, why can't you deliver $3 billion in AI systems like next quarter or certainly in the second half? Thank you.

Marie Myers

[…] What I did point to though, Toni, is I pointed to the higher end of the range, so that's really what's giving us confidence based on the increase that we made on revenue. So you're seeing that higher top-line and then also the confidence I got around just the cost discipline […] So overall, Toni, keeping the guide at $1.85 to $1.95, but really pointing to the higher end of the guide in terms of just the confidence that you articulated. So I'll turn it over to Antonio to cover the second question.

Antonio Neri

Yes. Toni, I think there is an opportunity to potentially exceed that. I think the limiting factor is not the supply, to be honest with you, is the availability of data center space. I made this comment in Q1, if you recall, data center space and power and cooling. And so some — we are working with the customers to time everything correctly, 6 to 12 weeks, think about it, maybe less than a quarter, but then you have to go and install it.

And there is a nice percentage of our deals in generative AI, which are all actually GreenLake. And so while we can recognize the revenue upfront, we are deferring all the services piece of it. So it really is going to come down to the timing of the data center and the power and cooling. And if that all aligns correctly, then we may have an opportunity to do better. But we felt prudent at this point in time to keep it the way it is and raising by 1%.

–End Quote

With an AI backlog of $3.1B and lead times being reduced to 6-12 weeks, HPE can conservatively recognize their backlog over the next 1-2 quarters, resulting in at least $1.55B of AI systems revenue per quarter. This alone would meet consensus estimates for H2’24, and with management expecting sequential growth in traditional servers and intelligent edge as well as a backlog that is growing almost as fast as revenues, HPE is well-positioned to deliver a surprise or two over the next few quarters.

Valuation:

Despite top-line growth being positioned to accelerate from the low-single-digits over the last three years to the mid-single-digits and potentially higher going forward, HPE still trades in-line with its historical range on a NTM EV/EBITDA basis. With a NTM EV/EBITDA of just 6.6x, it trades below peers like DELL at 10.8x despite comparable growth (Dell is projected to grow in the high-single-digits going forward).

However, as previously mentioned, HPE’s enterprise value is overstated since it accounts for all of the liabilities of the Finance division and none of its assets. Backing out the book value of the finance division yields an EV of $23.3B as of July 11th, 2024, compared to EBIT of $297M in the division in the TTM. Backing out Financial Services EBIT yields non-GAAP operating profit of $2.6B for an EV/EBIT of 9x.

Comp Table

Assuming HPE meets consensus revenue expectations of $31.8B of revenue in FY’26 (3.5% CAGR) and maintains adjusted EBIT margins of 11%, it would generate $3.5B of EBIT. Assuming Financial Services forms the same percentage of EBIT as it does today and backing that out from total EBIT yields Operating Company EBIT of $3.1B. Assuming a similar pace of buybacks, HPE can reduce its share count by 0.8% annually, along with a 2.3% dividend yield. Assuming no multiple expansion, this would yield a high-single-digit IRR.

If we assume that HPE re-rates to 13.3x EV/EBIT by 2026, a valuation in-line with CSCO which is projected to see flat growth through 2026 and is the second cheapest in the group, then HPE would generate a low-20s IRR. This scenario could become more likely as AI systems revenue continues to accelerate and the market starts to recognize HPE as a direct liquid cooled server company. This scenario is still conservative as it doesn’t take into account the likely possibility that HPE will beat consensus estimates. 

Conclusion:

HPE will test mental flexibility as it’s a sleeper stock; viewed as an outdated tech company from the dot-com era. Yet, 1990s hardware players are auspiciously positioned to capture AI server revenue, and to also offer software platforms for hybrid AI architectures.

There will be many investors too set in their ways to consider the possibility that we are in a new era. Those who see HPE or Dell doing well will cry “dot-com bust.” AI servers will drive the revenue for these companies in the near-term, yet keep an eye on the AI software segments (GreenLake, etc.) for dot-com-defying longevity.

Our portfolio’s motto is the best AI hardware players will make the best AI software players, which gives a strong nod to how we plan to secure future gains as opposed to resting on our laurels with the current hardware-driven AI cycle. HPE is certainly a candidate that fits this motto, yet it’s too early to tell if HPE has what it takes to compete in what is shaping up to be a highly competitive space.

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 late August/early September. 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 late August/early September. 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!

Richard Chu, Equity Analyst for the I/O Fund, contributed to this analysis.

Recommended Reading:

• Lam Research FQ4 Earnings Preview: Eyes on 2025 Outlook
• Liquid Cooling Leaders: Super Micro, Dell, Vertiv and HPE
• Dell Q1 Earnings: AI Server Shipments up 113% QoQ, Margins Contract
• Nvidia Q1 Earnings: “We will see a lot of Blackwell revenue this year.”
• AMD Q1 Earnings: GPU Revenue Outlook Raised to $4B

Every quarter, we objectively review our portfolio for our earnings kickoff webinar to determine the strongest and weakest stocks. AMD topped our fundamental checks going into this earnings season due to its expected YoY and QoQ acceleration. The company is expected to post annual revenue growth of 13% for FY2024, accelerating to 28% growth in FY2025.

On a quarterly basis, the upcoming quarter is expected to be the bottom, with growth of 6.8% for June, growth of 14% in the September quarter, with further acceleration into the December quarter at 23% and the March quarter at 33%.

The future looks bright as the Client segment is expected to stabilize and the data center segment is expected to do its thing. Where there’s a will, there’s a way, and AMD is slowly making cracks in Nvidia’s Empire. The single most important announcement this quarter across our portfolio companies was the announcement of AMD’s acquisition of Silo AI. AMD plans to hit Nvidia where it hurts, which can be summarized in two words: open source.open source.

I fully expect AMD’s data center potential to take time to materialize, for the market to go through periods of doubting the stock, and for that to create immense opportunity for our portfolio. Those who have been with us for a while know that we are an incredibly patient analyst team; in fact, we first called AMD an AI stock about 4.5 years ago and the company is only now reporting actual AI revenue for the first time 2024. Per our analysis AMD: 2020 Premium Research:

“Nvidia remains my top AI choice as there is a better moat with the developer platform CUDA (in my opinion). AMD is my second choice in artificial intelligence and I find it fortunate the selloff has given me a second opportunity to build a position at a reasonable valuation.”

I can’t tell you exactly when the stock performance will match it’s AI potential, but I am uniquely skilled at finding semiconductor bottoms. We are at a fundamental bottom for AMD, and I doubt we return to this low of growth for the company for a very long time. 

Financials:

These numbers will be updated Tuesday night with a report hitting your inboxes after hours. For now, here’s a preview of what to expect:

Revenue:

Management guided for revenue of $5.7 billion +/- $300 million, for growth of 6.4% at the midpoint. Analyst consensus is for revenue of $5.72 billion for growth of 6.8%.

• September quarter is expected to report 14.1% for revenue of $6.6 billion.
• December quarter is expected to report 23.2% for revenue of $7.6 billion
• March quarter is expected to report 33% for revenue of $7.28 billion (December quarter is higher due to PC sales).

The rebound is also seen on a fiscal year basis where FY2023 reported growth of (3.9%) for revenue of $22.7 billion.

• FY2024 ending in December is expected to report growth of 12.6% for revenue of $25.5 billion
• FY2025 is expected to report growth of 27.6% for revenue of $32.6 billion
• FY2026 is expected to report growth of 18.4% for revenue of $38.6 billion

Key Segments:

Last quarter, AMD reported data center revenue of $2.34 billion, up 80% YoY and up 2.4% QoQ. The guide for GPUs was originally $2B coming into this year, and the company is now guiding for $4 billion. Per management: “Expect data center segment revenue to increase by double-digit percentage, primarily driven by the data center GPU ramp.”

Another key point is that AMD’s Client segment is expected to increase sequentially. Last quarter, Client reported $1.37 billion, which was up 85% YoY yet down 6% QoQ. This segment has seen nothing but bloodshed for many quarters. Consider that in 2022, AMD peaked at $2.8 billion in quarterly revenue for the Client segment. Management’s guidance communicates that last quarter was the bottom: “Client segment revenue to increase sequentially.” Client segment revenue to increase sequentially.” This is key for AMD’s price action as Client is too big of a hit to offset GPUs ramping.

Gaming continues to weigh on results, reporting $922 million last quarter. Per management: “Based on current demand signals, gaming revenue expected to decline by significant double-digit percentage sequentially.”

Embedded revenue of $846 million was down (46%) YoY and (20%) QoQ. This segment is tied to automotive weakness. Per management: "Given the current embedded market conditions, we're now expecting second quarter embedded segment revenue to be flat sequentially with a gradual recovery in the second half of the year."

Zooming out, this is what management stated to expect for FY2024: “Sequentially, we expect data center segment revenue to increase by double-digit percentage, primarily driven by the data center GPU ramp. Client segment revenue to increase. Embedded segment revenue to be flat. And in the Gaming segment, based on current demand signals, revenue to decline by significant double-digit percentage.”

EPS:

Last quarter, AMD reported adjusted EPS of $0.62 with consensus seeing adjusted EPS turning up from here; meaningfully so in late 2024 and early 2025. This quarter is expected to report $0.68 in adjusted EPS for growth of 17.4% YoY. Over the next two to three quarters, we will see nearly a doubling in adjusted EPS.

• September quarter is expected to report adjusted EPS of $0.94 for growth of 34.7% YoY.
• December quarter is expected to report adjusted EPS of $1.24 for growth of 60.4% YoY.
• March quarter is expected to report adjusted EPS of $1.15 for growth of 85.3% YoY.

Margins:

AMD’s gross margin last quarter was 47% versus Nvidia’s 78%. In 2022, before the AI boom, AMD’s gross margin was 45% versus Nvidia’s 65%. This is one of the reasons Nvidia has historically had a premium valuation. AMD undercuts Intel on price, and this is the strategy with Nvidia going forward, as well.

• AMD reported a gross margin of 47% last quarter.
• Management guided for adjusted gross margin of 53%, and if reported, will be a 100 bps improvement from last quarter. This will also mark the highest adjusted gross margin in two years. This will represent adjusted gross profits of $3.021 billion.
• Last quarter, AMD reported a GAAP operating margin of 1% for operating profits of $36 million. This is very low as AMD had a GAAP OM of 22% in FY2021.
• The adjusted operating margin guide is for 21%, which if reported, will be flat QoQ.
• Net margin last quarter was 2% for GAAP net profits of $123 million. We’ve seen up to a 26% GAAP net margin in FY2020.
• Adjusted net margin was 19% for adjusted net income of $1.01 billion.

Cash:

Last quarter, AMD reported $521 million in operating cash flow for a OCF margin of 10%. This was a nice 400 bps uptick from the previous quarter, which reported a 6% OCF margin. We’ve seen up to a 25% OCF margin for AMD in Q2 2021.

Last quarter, AMD reported free cash flow of $379 million for a FCF margin of 7%. The company has cash and short-term investments of $6.03 billion and debt of $2.46 billion.

Stock based compensation is 7% of revenue.

Silo AI Acquisition

We had stated on our most recent webinar that we want to give AMD the space to fill the very big shoes an Nvidia contender has to fill. A good example of AMD playing the long-game is the acquisition of Silo AI for $665 million. This is Europe’s largest AI-related acquisition, sizably larger than the acquisition of DeepMind by Google for $400 million in 2014.

The company is known for its pool of AI talent, with experience in training large language models on AMD Instinct GPUs. These custom, open source LLMs called Poro and Viking are multilingual and can be customized and applied to many end-markets. Poro is a 34 billion parameter model that is cross-lingual for Europe’s 24 official languages and offers AI sovereignty by allowing companies or countries to create proprietary models. Viking is a 7 billion parameter model and highlights Silo AI’s unique approach in developing smaller LLMs for Nordic languages. These low-resource languages lack large training data sets. There are also 13B and 33B parameter Viking models, but the point is to not have to use hundreds of billions of parameters or even trillion+ parameter models being developed by OpenAI and Deep Mind/Google’s Gemini. Instead, Silo AI rivals LLMs such as Mistral and Meta’s Llama in English, yet processes multiple Nordic languages and programming code.

The official announcement for the 7B Viking LLM provides a clear message on why Silo AI was acquired by AMD: “With a purpose-built software layer to train models on AMD, Silo AI and TurkuNLP possess unmatched experience with training on AMD at scale, having shown that their theoretical predictions for throughput scaling materialize in weak and strong scaling experiments. As one of the seminal initiatives on AMD GPUs, this shows how it’s possible to achieve good throughput on the AMD-based LUMI, training the models with their open source training framework and utilizing up to 4096 MI-250X GPUs simultaneously.”

Our original thesis on Nvidia centered around the CUDA moat. This moat is fully in tact today, and has helped Nvidia enjoy unrivaled pricing power. Silo AI greatly speeds up AMD’s open-source software effort, which is the critical piece to AMD’s strategy as CUDA is closed-source and proprietary.

As the Forbes article points out, Hugging Face has partnered with AMD to run AI models on Instinct GPUs. Meta and OpenAI have ordered AMD’s new GPUs. From there, these companies can also open source their frameworks and models to help speed up time to market for smaller teams.

These large R&D departments are sophisticated enough to circumvent CUDA and program custom silicon or program competing GPUs if the total cost of ownership (TCO) presents a compelling reason. AMD’s MI300s go for $15,000 and as low as $10,000 when sold in bulk. Meanwhile, Nvidia’s GPUs go for an average of $35,000.

I first covered this in March of 2020 when our analysis pointed out: “It’s estimated that for every $1.00 in Rome chip sales, Intel loses $2.25 on average in Intel Xeon SP sales. The savings are then deployed to buy more Rome chips, which can further depress Intel’s revenue.”$1.00 in Rome chip sales, Intel loses $2.25 on average in Intel Xeon SP sales. The savings are then deployed to buy more Rome chips, which can further depress Intel’s revenue.”

In the July of 2023 I/O Fund analysis: “AMD is Ready to Rival on AI Acceleration” it was pointed out:

“From there, AMD undercuts Intel on price, which becomes a virtuous cycle as driving down costs means more chips will be bought from AMD. […] In the past, AMD advertised up to 20% Capex savings compared to Intel based on Epyc processors delivering more performance from a single chip compared to Intel’s dual-processor powered by two CPUs. Big Tech has capex budgets into the tens of billions. Although it’s not specifically disclosed exactly how much goes toward AI acceleration, we know that Big Tech is driving forward Nvidia’s GPU sales at $8 billion per quarter or $35 billion to $40 billion per year.$8 billion per quarter or $35 billion to $40 billion per year.

Here is the thesis in a nutshell: If a competitor can deliver 20% savings on this kind of budget with similar performance, then it will turn heads. We can geek out all day long on the computing performance of Nvidia’s H100 GPU, however, if the MI300s drive down total cost of ownership through low unit pricing, better power efficiency and reducing the number of GPUs required, then hyperscalers will line up to support this.

What Google, Amazon, Microsoft, Meta and large enterprises want most of all is to build incredible AI systems but at a manageable cost. This goes back to the virtuous cycle. The more they save, the more they can build.”

As Big Tech becomes pressured over their capex spend, it will only be natural that AMD is evaluated as an option to help alleviate this massive AI infrastructure spend.

Conclusion:

The future is bright for AMD. This company has what it takes to make cracks in the Nvidia GPU data center Empire. For our purposes, we think AMD could take up to 20% market share of the GPU data center, although it would take up to a decade for this to materialize. We are basing this estimate on what AMD has achieved in gaming GPUs, and the market share dynamic 80/20 on data center CPUs with Intel.

Equally important, AMD is a frontrunner on the Client side for AI. The company spans both x86 and Arm architectures for AI devices, and has the Xilinx acquisition waiting in the wings once automotive heats up again.

In our webinar, we had stated that a great tech story should have financials to match. AMD ticks this box, as well, with a rebound into the second half of this year and early next year. You will get an update from us post-earnings that looks at the gritty details of the report. But let me emphasize well ahead of time that we are in no rush for AMD’s AI story to materialize, as our sights our firmly on the horizon.

Recommended Reading:

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Lam Research reports its fiscal Q4 (June quarter) earnings next week on July 31, following a dismal market reaction to peer ASML’s report last week. Estimates are rather muted heading in to Lam’s report, though sentiment seems to have drifted sharply lower as semiconductor stocks declined 9% through the end of the week of July 19th.

Management has guided to $3.8 billion in revenue in Q4, approximately flat QoQ but up 18.5% YoY against weak comps from the rapid downturn in the memory market in 2023. Lam is expected to close the year with revenue and EPS both declining in the mid-teens YoY, with Q4’s strong YoY growth offsetting first half softness.

Revenue and EPS

Lam is expected to break its five-quarter streak of declining revenue on a YoY basis in Q4, with revenue growth accelerating more than 20 percentage points to ~18.5% YoY. EPS growth is expected to follow suit, with management guiding for operating margin to expand sequentially.

Analysts project Lam to report 19.4% revenue growth in the quarter to $3.83 billion, at the very high end of management’s guided range. This would represent a revenue acceleration of 2140 bp QoQ. Raymond James last month said that it expects “sector fundamentals to remain strong into 2025 due to secular growth from Gen AI, aggressive government subsidies around the world, multiple technology transitions, and intensifying competition among foundry suppliers.” Revenue is expected to increase sequentially by more than $200 million in each quarter in fiscal 2025.

• For Q4, management guided revenue at $3.8 billion, +/- $300 million, for a YoY increase of 18.5% and approximately flat QoQ growth.
• Management guided for GAAP EPS of $7.20, +/- $0.75 and adjusted EPS of $7.50, +/- $0.75, for adjusted EPS growth of 25.4% YoY. Analysts expect Lam to report $7.58 in adjusted EPS in Q4.
• For FY24, revenue is expected to be $14.87 billion, for a YoY decline of (14.7%).
• For FY24, adjusted EPS is expected to $29.75, down (12.8%) YoY.
• Current estimates for FY25 point to revenue of $17.66 billion, up 18.8% YoY, and adjusted EPS of $36.56, up 22.9% YoY.

As we had noted in April, Lam’s rebound through 2025 is primarily dependent on NAND recovering. Discussions around the incoming NAND rebound will be important, as well as discussions on DRAM given the surge in HBM we’ve seen to accompany rising GPU shipments.

Margins

Though management guided for gross margin to decline sequentially in Q4, there is some strength down the line, with operating margin expected to expand. China mix is also impacting margin positively, with Lam seeing gross margin as high as 48% compared to normalized levels of 46% when China’s revenue share is high.

• For Q4, management guided GAAP operating margin (above) at 46.7%, +/- 1%, implying a slight 80 bp QoQ contraction but a YoY expansion of 120 bp. Adjusted gross margin was guided at 47.5%, +/- 1%, a 120 bp QoQ contraction.
• GAAP operating margin was guided at 28.3%, +/- 1%, a 40 bp QoQ and 170 bp YoY expansion. Adjusted operating margin was guided at 29.5%, +/- 1%.
• Lam’s net margin has remained strong, with GAAP net margin at 25.4% to 25.5% in each quarter of FY24 so far.

Management shed some light on margins in the longer term as it begins to ramp up output in Malaysia, which is expected to be margin accretive due to cost advantages:

CEO Timothy Archer: “I think that we've built now a global footprint for our manufacturing and supply chain that makes us significantly more resilient. It allows us to scale much faster to the demand that we see coming in the future. And also improve our gross margin looking forward. And I think that as we move through these next cycles of industry upturn, companies and our output hitting new highs, the real power of that new manufacturing and supply chain infrastructure will really start to come to bear in our profitability.”And also improve our gross margin looking forward. And I think that as we move through these next cycles of industry upturn, companies and our output hitting new highs, the real power of that new manufacturing and supply chain infrastructure will really start to come to bear in our profitability.”

Cash and Debt

Cash flows have been strong for Lam despite the tough macro backdrop in the first half of the fiscal year.

• Operating cash flow was $1.38 billion in Q3, a 36.5% margin. YTD operating cash flow is $3.79 billion, down (6.6%) YoY, and for a margin of 34.3%. Operating cash flow for FY24 is projected to be $5.04 billion, implying $1.25 billion in OCF in Q4, a 11.3% YoY increase and representing a 32.9% margin.
• Free cash flow was $1.28 billion in Q3, a 33.7% margin. YTD free cash flow is $3.49 billion, down (3.9%) YoY, and for a margin of 31.6%.
• Cash and equivalents totaled $5.67 billion.
• Debt totaled $4.98 billion.

Key Metrics

For Lam’s upcoming Q4 report, memory sales mix will be closely watched, as non-volatile memory (NVM) recovers, a sign of the upcoming recovery in NAND.

Memory accounted for 44% of systems revenue in Q3, down from 48% in Q2, but up from 32% in the year ago quarter. DRAM accounted for 23%, with NVM accounting for 21%. NVM has recovered from 15% in Q2, but it remains far below its peak at the 40% range, seen during the prior cyclical peak in 2022.

In terms of geographic concentration, similar to its WFE peers, Lam has high exposure to China currently, with the nation accounting for more than 40% of revenue each quarter this year. While this has provided some margin tailwinds, it also presents a real headwind as export restriction tensions escalate.

It was discussed in-depth in Q3’s earnings call that China revenue is first-half weighted and revenue is expected to decline as the year progresses. Also, in the Q&A, it was brought up that management is possibly expecting more weakness as the year progresses due to customers being blacklisted – this was not confirmed directly but also was not denied.

Second to China in terms of revenue contribution is Korea, at 24%, followed by Japan and Taiwan at 9% each and the US at 6%. Korea is a key geographic market to track, given its significant global share in both DRAM and NAND. Over the past two quarters, Korea has increased its revenue share, rising to that 24% level from 19% in Q2 and 16% in Q1, hinting at NAND spending resuming and utilization ticking higher.

Noteworthy Points to Watch

As just mentioned, NAND’s recovery looks as if it is beginning to unfold with the first signs in NVM revenue share ticking higher. Management offered some perspective last quarter on what 2025 could look like for NAND, stating the following:

“I mean, clearly, we all know that the NAND spending has been incredibly weak for the last 12 to 18 months. And so we're in the very early stages of starting to see that recover. And I think if you look at what most of our — we rely on our customer commentary that they make publicly for a lot of this, but they talk about the fact that maybe 90% of the bits they're shipping are at the leading edge.

But when we look at the installed base of our systems, that was my comment. I believe that there is still going to be a large portion of the installed base that will move forward to the next technology nodes. It's the most efficient way for our customers to to do that is to upgrade what they already have. And I think you'll see that move forward and therefore, NAND WFE move up in '25. But because it comes through a large — to a large degree, through upgrades, Lam's capture rate of every dollar of WFE spend will be much higher than in a greenfield capacity added. So when I think about Lam's opportunity to outperform in 2025, in NAND, I think it is obviously with high confidence because of the type of spending we would expect to be seen in 2025. And in the other market segments, it's also pretty high because of the — as I mentioned, the technology inflections that are occurring […] And so I just feel like there are a number of growth drivers for the company besides the one that is the most obvious, which is a NAND recovery in 2025.”I believe that there is still going to be a large portion of the installed base that will move forward to the next technology nodes. It's the most efficient way for our customers to to do that is to upgrade what they already have. And I think you'll see that move forward and therefore, NAND WFE move up in '25. But because it comes through a large — to a large degree, through upgrades, Lam's capture rate of every dollar of WFE spend will be much higher than in a greenfield capacity added. So when I think about Lam's opportunity to outperform in 2025, in NAND, I think it is obviously with high confidence because of the type of spending we would expect to be seen in 2025. And in the other market segments, it's also pretty high because of the — as I mentioned, the technology inflections that are occurring […] And so I just feel like there are a number of growth drivers for the company besides the one that is the most obvious, which is a NAND recovery in 2025.”

In the upcoming report, management’s commentary on the NAND recovery will be closely watched, as will NVM’s revenue share, given the emphasis placed on NAND as one of the primary growth drivers in 2025.

While this may seem a bit obvious, ultimately, Lam’s revenue guide for fiscal Q1 2025 will be a crucial data point for both Lam and the WFE manufacturers. ASML’s results, which sparked that sharp selloff across semis last week, saw strong net bookings but a Q3 revenue guide short of consensus, with the EUV maker expecting €6.7B to €7.3B in revenue versus the €7.5B consensus estimate. Analysts are expecting a strong report for Lam, with the consensus estimate at the high end of management’s guidance, and Q1’s estimate for $4.03 billion pointing to a 5.2%, or $200 million, sequential increase.

Valuation

Lam is trading above its median top line and bottom-line valuations, even with its steep sell-off after ASML’s earnings.

On the top-line, Lam trades at 8.9x trailing sales, and 7.1x forward sales with the rebound in sight. Looking back to 2021, Lam peaked at a trailing 7x sales multiple, so it’s currently trading above its peak multiples withheld historically as well as more than 40% higher than its 5-year average multiple of 5.2x for both trailing and forward sales.

Lam’s bottom line strength offers a bit more breathing more in the valuation, though it does remain stretched with a thin margin for error. Lam is trading at 35.3x trailing PE and 26.3x forward PE, again with EPS expected to rebound 23% YoY to $36.56. Again, while these multiples are elevated compared to Lam’s 5-year average in the 20x to 21x range, on a forward basis, Lam is trading at the same valuation as it entered 2024, around 26x, despite a nearly 30% YTD rally.

Conclusion

Lam’s fiscal Q4 report next week will hopefully show more growth and progress in the unfolding NAND rebound, which we had said we were a tad early to in April this year.  We still see DRAM and HBM as a major growth opportunity in the AI semiconductor space, with Nvidia and AMD showing no signs of slowing in GPU development or revenue growth; however, NAND is expected to be a core growth driver for Lam moving through 2025.

Revenue growth is expected to be flat sequentially in Q4, before rising sequentially in each quarter of fiscal 2025, with earnings growth to follow. Cash flows also have remained quite strong despite the weak first half of the year. We’ll be keeping track of how this recovery will unfold next week, even if this report may not be enough to justify Lam’s elevated valuations in the near-term.

Damien Robbins, Equity Analyst at the I/O Fund, contributed to this article.

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