Lam’s Q3 report was nothing too spectacular, with a slight revenue beat in the quarter and a solid EPS beat. Q4’s guide pointed to relatively flat revenue and a slight sequential decline in EPS.

We have a 4% placeholder on Lam, which may be a tad early for the material rebound that is expected 2025-ish. Primarily, Lam’s rebound is dependent on NAND recovering. Discussions around the incoming NAND rebound were important, as well as the discussions on DRAM.

China is both an opportunity and a risk for Lam. China’s revenue contribution remained above 40% in the quarter, though Korea’s contribution increased 500 bp sequentially to 24%, suggesting major memory manufacturers may be increasing WFE (wafer fabrication equipment) spend. Given the high exposure to China, there is risk in more customers being added to the banned entity list, which would result in a loss of revenue for Lam.

Overall, this is not the standout quarter for Lam and we didn’t expect it to be. Instead, we were provided important clues as to when the standout quarter might occur. The story is intact, the fundamentals have likely bottomed, yet the stock is overvalued and has been for some time. Therefore, primarily due to valuation concerns, we realize the allocation we currently have is unlikely to be our lowest entry.

Revenue and EPS:

Lam’s revenue peaked in Q2 FY2023, with the current FY2024 Q4 guide pointing to flat revenue for three straight quarters as Lam digests a trough in NAND spending coupled with strong China and DRAM demand. Fiscal Q1 is expected to break this trend with revenues projected to push back to $4 billion and higher.

• Revenue of $3.79 billion beat estimates by 1.6%, representing a YoY decline of (2.1%) but a QoQ increase of 0.9%.
• For fiscal Q4 (June 2024 quarter), Lam guided for revenue of $3.8 billion, +/- $300 million, representing YoY growth of 18.5% and approximately flat QoQ growth at midpoint. Prior to earnings, our information shows QoQ growth in the September quarter of 6% and December quarter of 7%.
• GAAP EPS of $7.34 beat estimates by $0.50, representing YoY growth of 22.1%. Non-GAAP EPS of $7.79 beat estimates by $0.49.
• Q4’s GAAP EPS was guided at $7.20, +/- $0.75, representing YoY growth of 20.6% and a QoQ decline of (1.9%) at midpoint. Non-GAAP EPS was guided at $7.50, +/- $0.75, implying YoY growth of 25.4% and a QoQ decline of (3.7%). Same as revenue, the September quarter and December quarter is when QoQ growth returns.

Margins:

GAAP operating margin contracted slightly on a QoQ basis despite GAAP margin expanding due to customer mix in China. Q4’s margin outlook was also mixed, pointing to operating margin expansion and gross margin contraction.

It’s important to note that 46% is the normalized gross margin for Lam although customer mix can result in as high as 48% gross margin. Per management: “You're absolutely right, and thanks for mentioning the 46%. That's sort of where gross margin was after we had done some of the Malaysia stuff and before China popped up with those smaller customers. And so the fact that we're above that level is largely customer mix.”

• Fiscal Q3’s GAAP gross margin was 47.5%, representing a 70 bp QoQ and 600 bp YoY expansion from 41.5%.
• For fiscal Q4, Lam guided for a GAAP gross margin of 46.7%, representing an 80bp QoQ contraction but a 120 bp YoY expansion.
• GAAP operating margin was 27.9% up 350 bp YoY from 24.4%.
• Q4’s GAAP operating margin was guided at 28.3%, for a 40 bp QoQ and 170 bp YoY expansion compared to 26.6% in Q4 of last year.
• GAAP net margin was 25.4%, essentially flat QoQ and expanding 440 bp YoY.

Cash and Debt:

• Operating cash flow was $1.38 billion in Q3, compared to $1.76 billion in the year ago quarter. Lam’s OCF margin contracted from 44.6% a year ago to 36.5%.
• Free cash flow was $1.28 billion, compared to $1.61 billion in the year ago quarter. FCF margin contracted from 41.5% a year ago to 33.7%.
• Cash and equivalents totaled $5.67 billion.
• Debt and finance leases totaled $4.98 billion.

The company allocated $860 million to share repurchases and paid $263 million in dividends in the March quarter. Management also added: “And I would just mention, we continue to track towards our long-term capital return plans of returning 75% to 100% of our free cash flow.”

Key Metrics:

DRAM Revenue Dips QoQ:

We highlighted DRAM as one of the primary growth drivers for Lam coming out of this memory trough over the course of the next few quarters as Samsung, SK Hynix, and Micron work to significantly boost HBM3 and HBM3e production to meet elevated demand from Nvidia and AMD’s GPUs.

However, DRAM contributed only 23% of systems revenue in fiscal Q3, or ~$551 million, compared to 31% of revenue, or ~$713 million, last quarter.  Through the first three quarters of FY24, DRAM revenue totaled ~$1.737 billion, an increase of ~73% YoY.

Management stated the following about the sequential weakness in DRAM: “I do just want to mention one thing. We are characterizing 1 customer's investment in specialty DRAM as a nonvolatile investment since it has a nonvolatile component to the device.”

The weakness is also relative as during peak revenue in the Q2 FY2023 quarter, DRAM was 11% of revenue. So, even with this sequential weakness, it’s more than doubled in percentage of revenue from what it was at the cyclical top.

Non-Volatile Memory (NVM) Sales Pick Up:

Though DRAM’s contribution dipped sequentially, NVM sales offset much of this, rising from 17% of systems sales last quarter to 21% in Q3. Overall, memory accounted for 44% of Lam’s total systems sales in the quarter, down from 48% last quarter but up from 32% in the year-ago quarter.

Overall, systems sales rose to a ~63% contribution to total revenue, up from 61% in the prior quarter and marking a third consecutive quarter of increasing contribution. This suggests demand remains healthy.

Earnings Call:

Key Product Commentary and Timing for 2025-ish:

HBM and DRAM:

Our thesis is two-fold and management explained both points nicely in the call. The first is that we want to participate in the high bandwidth memory (HBM) boom being driven forth by AI acceleration. Our Members are quite aware of this trend as we’ve been hammering on it for a few quarters.

Here is what management stated about how Lam participates in this trend: “With respect to DRAM, AI servers use high-bandwidth memory or HBM to increase read write speed and reduce server power consumption. HBM stacks multiple DRAM dies using TSVs enabling 15x more data throughput than standard DRAM. However, HBM also requires an approximately threefold increase in wafers per bit compared to conventional memory. With this in mind, it's important that our SABRE 3D and Syndion tools not only provide best-in-class plating and etch capabilities, but also deliver industry-leading throughput and productivity to keep overall costs low for our customers. We are the leading player in TSV applications for HBM and expect our HBM related shipments to grow more than 3x in calendar year 2024.”

It was stated on the call that HBM is only 1-2 points of overall bit demand, and thus it’s “small today but growing quite rapidly.”

In terms of timing, especially as it relates to the CHIPS Act, which in turn will drive more equipment sales, the following was stated:

“And so we've always said these are more of a 25, 26, 27 time frame for — from the equipment side, especially the shorter lead time tools like we provide. So you see the fab coming up a lot of construction connectivity, you see long lead time tools go in. And then we know that our time will come. I mean — and so I think it's still a '25, '26, '27 opportunity for us. more of a 25, 26, 27 time frame for — from the equipment side, especially the shorter lead time tools like we provide. So you see the fab coming up a lot of construction connectivity, you see long lead time tools go in. And then we know that our time will come. I mean — and so I think it's still a '25, '26, '27 opportunity for us. 

But the important thing is, while that's a lot of extra money maybe what's really exciting about is most of that is targeted towards to the leading-edge nodes […], but it's at nodes where we believe that we will actually do better from a SAM and market share perspective. And so we're patiently waiting. But we know it's going to come. You can go visit the sites, the fab buildings are there, and they're feverishly working to get them ready for equipment.”that we will actually do better from a SAM and market share perspective. And so we're patiently waiting. But we know it's going to come. You can go visit the sites, the fab buildings are there, and they're feverishly working to get them ready for equipment.”

The bigger picture at full utilization is that GPUs and AI servers will drive 8X DRAM and 3X NAND, which will equal “$1 billion to $1.5 billion incremental WFE” for every 1% server penetration, according to Lam.

NAND/Storage:

Non-volatile memory’s (NVM) acceleration this quarter could imply that the NAND uptick is already beginning, with a greater contribution expected in 2025. Since Korea commands a significant global share in both DRAM and NAND, its increased revenue share, at 24% in Q3 (up from 19% last quarter and 16% two quarters ago), hints at NAND spending and utilization resuming given that DRAM sales were weaker. 

According to management, “More advanced AI applications need faster, more power-efficient and higher-density NAND storage. NAND-based enterprise solid-state drives or eSSDs, are 50x faster in read write capability, 2 to 5x more power efficient and use 50% less space at the system level compared to hard disk drives or HDDs. Today, over 80% of enterprise data is stored on HDDs. And we expect this mix to shift in favor of SSDs as NAND capability and cost continues to improve.”

In terms of timing and the 2025 rebound that is expected industry-wide, Lam stated 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.”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.”

Gate All Around Technology Nodes:

In August, our deep dive discussed how gate-all-around transistors are replacing FinFET transistors. The company stated that shipments for gate-all-around nodes will exceed $1 billion this year. Per management, this is just starting:

“we're really just starting at gate-all-around. Our comment was $1 billion of shipments into the gate-all-around nodes this year. And it's across all of our types of products that help enable gate-all-around smaller technology nodes. And so what we've said is that every technology node, etch and depth intensity grows and our SAM opportunity expands.”

Utilization is Improving, Further Supports 2025 Recovery

Lam offered a lucid discussion around how utilization rates are showing signs the 2025 recovery is on track.

In the opening remarks it was stated: “In NAND, we continue to expect year-on-year growth in WFE spending in calendar 2024. Encouragingly, we have seen an uptick in fab utilization. And in the March quarter, this has translated into double-digit percent growth quarter-over-quarter in our spares revenues. As supply and demand continues to normalize through the remainder of the year, we see a strong setup developing for 2025 NAND spending. As supply and demand continues to normalize through the remainder of the year, we see a strong setup developing for 2025 NAND spending.”

There was follow-up on this in the Q&A:

However, through this downturn, the cuts in fab utilization were so severe that we actually saw spares revenue come down, which surprised us a bit, so maybe to your point of expectations.

We knew that as soon as customers started to utilize the fabs and bring some of the tools back online, we would see spares increase. We said that would be the first sign that the end market was really starting to improve. And so the reason we called it out was that, obviously, it's — it further confirms, I think, what you're hearing from our customers, which is that utilization is starting to improve.it further confirms, I think, what you're hearing from our customers, which is that utilization is starting to improve.

It doesn't tie to WFE because utilization of what you have is one issue. When you choose to spend more to either upgrade technology or add capacity is a second decision. We've said that, that is likely still more of a 2025 event on the equipment spend side. But you have to get the first indication, which is utilization improvement, spares improving and then the rest would comeWhen you choose to spend more to either upgrade technology or add capacity is a second decision. We've said that, that is likely still more of a 2025 event on the equipment spend side. But you have to get the first indication, which is utilization improvement, spares improving and then the rest would come.

China Sales Remain High

It was discussed in-depth that China is first-half weighted and revenue from this region is expected to declining as the year progresses.

In the Q&A, it was brought up that perhaps management is expecting more weakness as the year progresses due to customers being added to the blacklist. It was not confirmed directly but also was not denied.

Question
Timothy Arcuri (Analysts)Question
Timothy Arcuri (Analysts)

So I wanted to ask about China. So it's going to modulate through the year, the mix, but it sounds like it's still going to be up year-over-year for domestic China this year. So I guess my question is, we've seen some headlines on a few entities being potentially added to the entity list. And I'm wondering if these comments reflect the potential addition of these entities? Or does it basically say, hey, if the status quo remains, this is what your assumption is, meaning that if there were entities added that, that would be downside to these comments?And I'm wondering if these comments reflect the potential addition of these entities? Or does it basically say, hey, if the status quo remains, this is what your assumption is, meaning that if there were entities added that, that would be downside to these comments?

Answer
Timothy Archer (Executives)Answer
Timothy Archer (Executives)

Yes. Tim, I mean, obviously, we can't forecast changes in U.S. trade policy with respect to China that we don't know about. And so we're basically giving you our best view of what we think our China business will be through the rest of the year and recognizing that there could be changes that we don't foresee. And so we're basically giving you our best view of what we think our China business will be through the rest of the year and recognizing that there could be changes that we don't foresee. 

Well, what I will say is we — obviously, we've built up what we believe is a strong government affairs team were plugged into all the relevant discussions. And I think over the last couple of years, you've seen we have a pretty strong track record of working with the U.S. government responding to export control policy and that's just what we plan to do going on into the future.

Conclusion:

Lam has broken key support and it’s likely we trim some of the position with the goal of adding back at lower levels. Across the board, Lam is trading about 2X higher than its median top line and bottom-line valuations. The PE Ratio is 34 compared to a 3-year median of 19. The forward PE Ratio of 30 is easily the highest it’s traded in three years. It’s the same scenario for the top line. This report may not be enough to justify these valuations in the near-term. Therefore, you can expect us to actively manage this position as we try to seek whatever alpha we can find in the current market.

For reasons clearly outlined above, we expect this will be a high allocation for 2025. The company carries a level of complexity that we are comfortable navigating, and it’s to our benefit that management is being quite clear on when to expect their largest segments to rebound. Therefore, whatever we trim will be added back at lower levels.

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

Recommended Reading:

• ServiceNow Overview: Key Metrics are Strong
• Lam Research: Eyeing Strong 2024 Exit Boosted by Memory Rebound
• Netflix Q1: Large Paid Net Adds Beat, Yet Important Key Metrics Dropped Starting in 2025
• Micron Q2: Memory Rebound in Full Force with HBM3e

ServiceNow’s upcoming earnings report is of high interest to us. There are many key metrics to highlight, including the company’s ability to re-accelerate subscription revenues to 27% YoY in the previous quarter, up from 22% a year ago. RPO also accelerated nicely to 29% YoY growth up from 22% in the year ago quarter. Net New ACV (NNACV) was up 33% YoY compared to 30% in the year ago quarter with the number of transactions over $1M in NNACV more than doubling QoQ from 83 to 168 transactions.

The CFO stated that the company’s generative AI product, Now Assist, contributed to the recent raise for FY2024 guidance of $165 million. However, gen AI’s contribution is very new and not too impactful yet, per management.

ServiceNow is the rare cloud company that is GAAP profitable and has a strong free cash flow margin of 30% for FY2023.

This report dives deeper into the elements that underpin ServiceNow’s optimism, including an examination of its financial health, strategic initiatives, and the anticipated impact of its AI-driven products on the market.

Key Points:

• Q4 2023 Revenue Performance: ServiceNow reported a 25.62% increase in Q4 revenue, reaching $2.44 billion. QoQ growth improved by 6.6%, with expected Q1 revenue of $2.59 billion, marking a 23.5% year-over-year increase.
• Robust Subscription Growth: ServiceNow's subscription revenues reached $2.37 billion, growing 27% YoY and exceeding revenue guidance of $2.32 billion and growth of 24.75% at the mid-point and $2.32 billion, while professional services declined by 10% YoY in Q4 and 18% for the year.
• Expansion and Strategic Alliances: ServiceNow enhanced its OT management capabilities with acquisitions of 4Industry and Smart Daily Management, collaborated with Hugging Face and NVIDIA on the StarCoder2 LLM, expanded its partnership with NVIDIA for telco-specific AI solutions, deepened its alliance with EY for AI compliance, and launched new payment and AI-powered solutions through strategic alliances with Visa and AWS.
• Mixed Margin Performance: ServiceNow experienced mixed margins year-over-year, with improvements in operating and net margins, while gross and subscription margins saw slight declines.
• Operational Efficiency and Investment Strategy: The company is raising its full-year operating margin target from 28% to 29% due to continued operational efficiencies. Investments are focused on innovation in AI, particularly Gen AI, with significant hiring in R&D to drive these initiatives.
• Strong Growth Outlook with GenAI Focus: According to management, the newly launched Gen AI product, Now Assist is contributing to the company’s largest net new ACV. This segment saw 168 deals greater than $1 million, up 33% YoY.
• Strategic Gains Across Segments: Despite challenges in the market environment, ServiceNow closed numerous large deals globally, including a record number of new $1 million+ deals and major wins in the public sector such as with the US Army and Australian Department of Defense.

Revenue and Earnings:

ServiceNow reported fiscal Q4 revenue of $2.44 billion for an increase of 25.62% YoY. This is a 6.6% improvement QoQ from $2.29 billion in revenue. The growth rate was 24.96% in the September quarter, and thus, December marked a slight acceleration. In terms of being seasonal or not, this did not occur last year, rather the December 2022 quarter decelerated by 90 basis points in growth rate.

ServiceNow is expected to see slightly slower growth next quarter at 23.5% for revenue of $2.59 billion. For the full year, analysts are expecting growth of 21.4% for revenue of $10.89 billion.

The performance in Q4 was packed with milestones for ServiceNow, spanning the full breadth of their portfolio. Each of their workflow businesses, technology, customer, and creator, are over $1 billion in annual contract value (ACV). And the company has 11 individual product lines with north of $250 million in ACV.

ServiceNow ended Q4 with 1,897 customers paying over $1 million in ACV adding 108 customers compared to the prior quarter. This is the addition in $1M customers in the past five quarters.  

The company closed 168 deals greater than $1 million in net new ACV (NNACV) in the quarter, a 33% increase year-over-year, that includes five deals over $10 million. Interestingly, this was over 100% growth QoQ.

For the full year 2023, ServiceNow saw an approximate 30% increase in deals greater than $1 million in net new ACV.

Despite this, total ACV only increased 15% in Q4 2023 compared to the prior year period. This is down from 17% growth in the previous quarter and down from 22% in the year ago quarter.

Remaining Performance Obligations (RPO) and current Remaining Performance Obligations (cRPO) are two popular metrics to track for ServiceNow.

RPO ended the quarter at approximately $18 billion representing an acceleration to 29% YoY. This compares to growth of 26% in the previous quarter and compared to growth of 22% in the year ago quarter.

cRPO was $8.6 billion, representing 24% YoY which was down from 27% in the previous quarter although was up from 22% in the year ago quarter.

Gen AI products, via Now Assist, drove the largest net new ACV contribution for the first full quarter of any of ServiceNow’s new product family releases ever, including the original Pro SKU.

ServiceNow topped analyst estimates on both the top line and bottom line. Analysts were expecting GAAP EPS of $1.43, non-GAAP EPS at $2.78 and revenue of $2.4B, while the company reported GAAP EPS at $1.46, non-GAAP EPS at $3.11and revenue at $2.44B. Even though the company’s earnings growth is expected to slow in 2024, management is still anticipating solid double-digit growth for the year.

Revenue Segments:

In Q4, subscription revenues were $2.37 billion, growing 27% YoY, exceeding the high end of the company’s guidance. ServiceNow closed out 2023 with $8.68 billion in subscription revenues, also representing 27% growth compared to fiscal 2022 subscription revenues. The CFO Gina Mastantuono had this to add on subscription revenues, “All organic at a scale that hasn't been accomplished by any other enterprise software company.”

Professional services and other revenues were $72 million for Q4, a (-10%) decrease YoY. For the full year of fiscal 2023, professional services and other revenues amounted to $291 million, representing an (-18%) decline YoY.

With regards to ServiceNow’s total addressable market (TAM), the CFO commented on a major milestone: “For the first time in a decade, IT services will become bigger than communication services in 2024. Gartner estimates that by 2027, nearly all of the growth in worldwide IT spending will come from software and IT services. And when you drill deeper into the Gartner forecast between 2023 and 2027, $3 trillion will be spent on AI.” This speaks to size and growth of the total addressable market for ServiceNow.

Margins:

Margins were mixed YoY as the company's focus on low-margin AI products is evident in its financial outcomes. Operating margin and net margin improved, while gross margin and subscription margin declined slightly YoY.

Non-GAAP subscription gross margin dipped to 84% in Q4 2023, flat QoQ but a decrease from 86% in Q4 2022. The company expects this margin to improve slightly to 84.5% in 2024, reflecting investments in data centers and emerging growth opportunities, partially offset by a change in useful life in data center equipment from four to five years. ServiceNow is also raising its full year non-GAAP operating margin target from 28% to 29% driven by continued operational expenses efficiencies.

Margins were a topic in the conference call with one analyst congratulating the company on the performance in 2023, with the CFO adding the expectation those margins will continue to expand in 2024.

Cash Flow:

Operating cash flow of $1.61 billion in fiscal Q4 represented a margin of 66%. Free cash flow of $1.34 billion represented a FCF margin of 55%.

There is $8.1 billion in cash and investments on the balance sheet and $1.49 billion in debt. Debt has remained constant since Q4 2022 with no amounts due in the next twelve months.

ServiceNow announced that the company repurchased 400,000 shares of its common stock for $256 million as part of its share repurchase program.

Earnings Call:

ServiceNow is expecting strong growth yet again in 2024 with GenAI being a central part of the bullish view for the stock. Analysts had a lot of questions on the topic.

GenAI

ServiceNow’s new Gen AI product, Now Assist, was stated to have “drove the largest net new ACV contribution for our first full quarter of any of our new product family releases ever.” Therefore, it’s not surprising to see it as a key topic during the Q&A.

And despite the very strong performance in Q4 and fiscal year 2023, it brought out a few interesting takes from management, specifically on the environment they face as we head into 2024.

Here is what the CEO stated when asked about the Gen AI product driving the largest net new ACV contribution:

“What's really happening and I can say this after 186 CEO meetings in the last six months, the CEOs are now getting very involved with the Gen AI revolution. They realize there has to be architectural adjustments to their environment and the manner in which they manage their data and the platforms they're beholden to actually take advantage of Gen AI.

 And if you think about the half a century mess that exists out there with legacy systems, in many cases, multiples of the same system, we have one unifying force in these conversations, which is the Now platform because we cooperate with the complexity of this landscape without putting people in a position to rip and replace […]

As I said, that SKU has outsold any other new introduction we put into the marketplace. So, there's a real appetite to invest in Gen AI, and there's no price sensitivity around it because the business cases are so unbelievable. I mean if you're improving productivity, 40%, 50%, it just sells itself.”

Overall, this is an encouraging note on the sales environment along with the potential of the Gen AI segment for ServiceNow. It’s not a huge revenue driver at the moment, but the trajectory means it could become a key driver of growth in 2024 and beyond.

Here’s what Gina had to add about Gen AI during the call.

I get the question often, do we see the adoption curve to be steeper for our Pro Plus than our Pro. Certainly, in the first full quarter of launch, it absolutely has shown that.

That being said, it's very early days. And so from a revenue contribution perspective, it's not going to be huge, but it's certainly helped when I thought about my guide for 2024 and that increase of $165 million at the midpoint, right? So Gen AI, early days, but the adoption curve so far is steeper than the original Pro. We will keep an eye on it.but it's certainly helped when I thought about my guide for 2024 and that increase of $165 million at the midpoint, right? So Gen AI, early days, but the adoption curve so far is steeper than the original Pro. We will keep an eye on it.

Net New ACV

ServiceNow’s new logo count continued to accelerate in Q4, with a record 10 new customers signing deals over $1 million in NNACV, including a $10 million win with a very large global financial services firm, which is their largest new customer logo in history.

Chipotle, Air France, TIAA, NTT, Data Group Corporation, and Busch are some of the brands that are utilizing ServiceNow to enhance their operations.

Additionally, in Q4 ServiceNow built on a record Q3 with the public sector, with key wins including in the United States Army, US Postal Service, and Australian Department of Defense Digital Delivery Group.

During the call, one analyst wanted more details on the drivers of the momentum in ACV.

Bill McDermott:

Just a couple of statistics on the customer workflows, 18 of our top 20 deals, what we're seeing is there's a tremendous opportunity to really take ServiceNow and squarely place it on the Customer Relationship Management category.

When you think about front, mid and back office and the fact that we can align all three of those things, and nobody has to lose for us to win. We could fill in all the blanks for what the current participants don't do, especially with their integration problems. It's just a fantastic opportunity for our customers.

And I think it's important to note, when I gave the Field Service Management example, our net new ACV in Field Service Management, specifically was up over 50% and year-over-year.

So, I think it's important to recognize that we have a whole list of new logos in this space. And employee workflows, nine of our top 20 deals and was kind of interesting. Every single CEO now is looking to make the people packed far more productive than it is and with natural language to have your employees seek the data and the information they want and have it reported back to them in just a very nice paragraph of content and data so they can do their jobs better, is kind of like in the no-brainer category.

RPO and cRPO

RPO and cRPO are key indicators of growth and future projections for ServiceNow. Analysts were zeroing in on what the upside is for the current quarter, Q1 2024, and how much is due to Gen AI adoption.

Gina Mastantuono:

So, we beat our Q4 cRPO growth guidance by 200 basis points as you know. And I would say it's driven probably half and half by net new ACV outperformance and certainly, Gen AI is in there, but it's not all Gen AI.

So, our core business is also doing well. And then we also did see higher early renewals than we had assumed in our guidance. And I would say it's about half and half of the total beat.

Government:

The government is a very strong potential growth area for ServiceNow. A few analysts wanted more details.

They asked about cyclical spending at the public sector and what their AI adoption cadence is going to look like.

Here’s Bill’s take:

Our federal business is really outstanding. And for the benefit of our shareholders, I think that there's a tremendous opportunity to replicate what we're doing in the United States federal and many other governments around the world. That is clearly an ambition that we have, and we have many use cases and many references to back that up.

Recent AI Announcements:

On March 18, 2024, ServiceNow announced it has signed an agreement to acquire 4Industry, a Netherlands‑based partner whose manufacturing technology application is built on the Now Platform, and has completed the acquisition of  Smart Daily Management, a connected digital worker application from EY. Together, the deals augment ServiceNow’s existing operational technology (OT) management capabilities, adding Connected Worker solutions and enhancing expertise across key industrial markets such as manufacturing, energy and transport & logistics.

On February 28, 2024, ServiceNow, Hugging Face, and NVIDIA, announced the release of StarCoder2, a family of open‑access large language models (LLMs) for code generation that sets new standards for performance, transparency, and cost‑effectiveness.

On February 26, 2024, ServiceNow and NVIDIA announced that they are broadening their relationship with the introduction of telco‑specific generative AI solutions to elevate service experiences.

On January 24, 2024, ServiceNow announced a broader strategic alliance with EY to empower responsible AI use for enterprise customers, deliver unified solutions for AI compliance and governance, and bring AI‑enhanced experiences to EY employees and clients with ServiceNow Now Assist.

Additionally, ServiceNow and Visa announced a five‑year strategic alliance to transform payment services experiences. The initial phase includes the launch of ServiceNow Disputes Management, Built with Visa–– a single, connected solution for disputes resolution.

ServiceNow also announced a five‑year Strategic Collaboration Agreement with Amazon Web Services (AWS) to offer the ServiceNow Platform and full suite of solutions in the AWS Marketplace. The two companies will also co‑develop and launch industry‑specific, AI powered applications.

Conclusion:

The key metrics on ServiceNow help to create a picture that something special is going on at this company compared to many cloud peers. As with nearly every stock in the market right now, investors must contend with valuations. This is one thing if you’ve owned a stock for some time and are sitting on gains, but is a bigger risk if you’re wanting to enter now for the initial entry. We’d like to keep ServiceNow in our pipeline to buy at lower levels, while also keeping an eye on the upcoming earnings report to see if any new information changes that decision. As always, each investor must determine their own unique risk profile for themselves. For our purposes, we view ServiceNow as fairly valued at 17 PS ratio compared to a 17 PS ratio 5-year median and 15.5 PS ratio 3-year median. The bottom line is only recently GAAP profitable and trades at a 88.6 PE Ratio compared to 5-year median of 1826 (noisy signal). Price to free cash flow is at 56 compared to a 5-year median of 52.6. Therefore, for our purposes, it makes sense to try and get the stock lower since the probability it can stretch higher (and sustain a higher valuation) is low. 

Chad Shoop, Equity Analyst for the I/O Fund, contributed to this analysis

Recommended Reading:

• Lam Research: Eyeing Strong 2024 Exit Boosted by Memory Rebound
• Netflix Q1: Large Paid Net Adds Beat, Yet Important Key Metrics Dropped Starting in 2025
• Cloud Earnings Review: AI a key driver for growth

We’re seeing early shoots of the memory market rebound unfolding a bit earlier than expected, with strong results from Micron and a positive outlook from Samsung on its HBM output this year due to GPU growth.

This is following a rather steep cyclical downturn in NAND and DRAM in 2023, and this rapid recovery offers a growth opportunity for both memory chip makers and WFE suppliers including Lam Research, though it should be approached carefully with a chance for oversupply in 2025.

Despite a rather soft guide for the March 2024 quarter, Lam’s management alluded to multiple pockets of strength arising through the back half of the year, with positive commentary on HBM and DRAM as well as a brighter outlook for WFE spend. Memory is a mission-critical component for AI accelerators and the newest battleground in the market, and Lam is a major equipment supplier and beneficiary of capital intensity that follows each new generation of HBM.

This memory ‘arms race’ is forecast to translate into strong revenue growth to potentially a record level, improved leverage and >35% EPS growth in fiscal 2025 (June 2024 to June 2025) From there, growth is expected to continue at a high-teens, low 20% rate through fiscal 2026. We look at this and more below.

For a deeper overview of Lam and its products and segments, refer to our August 2023 deep dive here.August 2023 deep dive here.

DRAM Market Overview: Rebound Unfolding

The DRAM market is exhibiting signs of rebounding from 2022 and 2023’s steep decline:

• Industry revenues declined more than (35%) YoY from $80.1 billion in 2022 to $51.9 billion, according to TrendForce.
• DRAM industry revenue in the fourth quarter rose 29.6% to nearly $17.5 billion, setting the stage for growth throughout 2024 as prices rise.
• DRAM prices were projected to rise 13% to 18% QoQ in Q1, followed by a more modest 3% to 8% QoQ projected increase for Q2.

Micron is expecting DRAM pricing to increase throughout the calendar year, as surging HBM and DDR5 demand tightens leading-edge DRAM supply.

These strong pricing trends and a surge in HBM revenue, from 8.4% in 2023 to 20.1% this year, are expected to aid DRAM revenue growth for the full year, with growth estimated at over 62% YoY to $84.2 billion – this is 5% higher than 2022’s level.

HBM Shipments to Surge in 2024 and 2025

With a surge in demand for GPUs, the HBM market is poised to grow at a rapid pace in 2024, and then extend this growth into 2025. HBM bit shipments are estimated to rise 147% YoY to 1.18 billion GB, leading to a projected 156% YoY increase in HBM revenues to $14.1 billion. This follows a 93% YoY increase in bit shipments and a ~104% increase in revenue in 2023.

Commentary and outlook from the three major players in the market demonstrate just how strong this growth is that we’re beginning to see.

Micron’s management expressed how strong AI server demand was “driving rapid growth in HBM, DDR5 (D5) and data center SSDs,” adding that its “2024 volume as well as pricing is all locked up.” For 2025, HBM volumes “are largely allocated. A vast majority of our production supply is allocated, and some of the pricing is already firmed up. Keep in mind, this has never happened before, right, that we are talking about 2025, and we are sitting in CQ1, and we already have so much discussion around supply and pricing for 2025 getting locked up here as we speak.”

Micron also raised a crucial point, with comments regarding Nvidia’s new Blackwell GPU lineup – the architecture “provides a 33% increase in HBM3E content, continuing a trend of steadily increasing HBM content per GPU.” This trend for higher memory content to support larger and faster GPUs is likely to continue especially as chipmakers such as AMD work quickly to encroach on Nvidia’s share with comparable or faster GPUs.

Samsung is planning a “2.9-fold increase in HBM chip production volume this year, up from the 2.5-fold projection previously announced at CES 2024,” and is “projecting a 13.8-fold surge in HBM shipments by 2026 compared to 2023.”

Lam Well Positioned to Capture HBM and DRAM Growth

Lam is well positioned to capitalize on this growth in HBM and DRAM, as Samsung, Micron and SK Hynix work to significantly boost HBM TSV capacity this year.

The trio combined for an estimated capacity of ~93K units per month at the end of 2023, and are estimated to boost HBM TSV capacity to 270K to 275K units per month by the end of 2024. As a result, 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 had pointed out in our August 2023 deep dive that while all three segments are important to monitor for forward growth, for a true recovery, we would need to see memory and DRAM bottom as it’s a substantial part of Lam’s business.

HBM capacity expansion, the shift to DDR5, and shipments to China have kickstarted a strong rebound in DRAM sales – in the December quarter, memory systems revenue reached 48%, a 10-percentage point increase from 38% in the September quarter. Lam noted that DRAM reached “record levels on a dollar basis, coming in at 31% of systems revenue compared with 23% in the September quarter.”

Non-volatile memory (NVM) ticked up to 17% of systems revenue in the December quarter, up from 15% in the prior quarter, though this remained significantly lower than the ~40% the segment contributed through the end of 2022 as NAND customers aggressively cut capacity in response to oversupply and elevated inventory levels. Lam noted that this was at “historic lows” for NVM, and the “slight growth was predominantly related to investments in certain technology projects.”

This has marked a pretty significant mix shift over the past four, even six, quarters – in the first half of 2023, DRAM was at just 9% of systems revenue, before rising to 31% in the December quarter.

In dollar terms, here’s what this growth in DRAM looks like:

Essentially, in two quarters – June 2023 to December 2023 – Lam has seen DRAM revenues rise 363%.

As noted earlier, management is expecting “HBM-related DRAM and packaging shipments to more than triple” this year, suggesting that DRAM systems sales could push past $1 billion by the end of FY24 (June 2024 quarter). Such growth can help offset the near-term weakness in NVM until NAND spending and upgrades resume.

Positive WFE Spending Outlook

Lam’s management shared a rather cautious view on its WFE spending outlook for the first part of the year, but expressed optimism on a recovery and strong exit to 2024 leading to a “robust” setup for the WFE market.

Here’s what CEO Timothy Archer said in the December quarter earnings call:

“As we enter 2024, the business environment remains muted. However, we expect a modest recovery in memory spending to drive a stronger exit to the year. Our early view of WFE spending for calendar 2024 is in the mid- to high $80 billion range. Growth in DRAM will be driven by capacity additions for high-bandwidth memory as well as node conversions. NAND spending increases will largely come from technology upgrades. We see foundry logic spend growing in 2024 with higher leading-edge investment, offset in part by declines in mature node investment outside of China. Overall, we believe domestic China spending will be stable in 2024.early view of WFE spending for calendar 2024 is in the mid- to high $80 billion range. Growth in DRAM will be driven by capacity additions for high-bandwidth memory as well as node conversions. NAND spending increases will largely come from technology upgrades. We see foundry logic spend growing in 2024 with higher leading-edge investment, offset in part by declines in mature node investment outside of China. Overall, we believe domestic China spending will be stable in 2024.

Longer term, the setup for WFE investment is robust. With semiconductor revenues widely expected to reach $1 trillion around the end of the decade and device manufacturing complexity continuing to rise, we believe WFE spending will need to roughly double from today's levels. Lam's served markets of etch and deposition should outpace growth in WFE overall.”the setup for WFE investment is robust. With semiconductor revenues widely expected to reach $1 trillion around the end of the decade and device manufacturing complexity continuing to rise, we believe WFE spending will need to roughly double from today's levels. Lam's served markets of etch and deposition should outpace growth in WFE overall.”

Lam’s early view for the mid to high $80 billion range represents just single digit growth YoY, with a majority of the growth being driven by HBM, which we are seeing signs of within DRAM systems sales. NAND spending cuts are likely weighing down on WFE spend, as management noted that memory WFE fell nearly 40% in 2023 on greater than 75% spending cuts in NAND.

NAND Upgrades to Aid Beyond 2024

While 2023 was extremely tough for NAND and in turn the broader memory WFE market, Lam sees a rather large opportunity to capitalize as NAND capacity comes back online due to the fact that there will be a high percentage of technology upgrades this cycle. Archer was hard-pressed for details on how this NAND recovery would unfold in the December quarter earnings call, and his comments alluded to Lam being able to capture these tech upgrades.

Archer explained in response to Cantor analyst C.J. Muse about NAND’s recovery and timeline for normalization that “as we see NAND growing — recovering and growing at a certain percentage rate, Lam will actually significantly outperform that rate because of the fact that most of that is coming from upgrades.”

And in response to BofA analyst Vivek Arya about current NAND demand and the outlook for H2 this year, Archer said that there is “a tremendous amount of capacity that [has] been offline and we've said in the past that needs to be brought back online. And I think the question and the discussions we're having is [at] what technology node should that capacity be restarted. And in many cases, there is a very high likelihood that technology upgrade certainly will occur as that equipment is brought back into service.

And so in that case, we would actually begin to see a restart of some of the utilization driven revenue that we get from things like spares and services, as well as, at the same time, a restart of technology upgrade revenues. And that's why I think that from a NAND perspective this year, we think that will effectively represent the majority of the spend that occurs in this segment.”

These technological upgrades and resumed spending in NAND will help cement in a recovery to potentially record revenues in fiscal 2025 – while the near-term rebound is more DRAM-centered, NAND’s rebound may unfold as the bigger story, given that NAND’s best-ever quarter was larger than NAND revenue in all of last year.

Double Digit Revenue Growth Through FY26 to Drive Strong Earnings Leverage

While the March quarter guide (fiscal Q3) was soft, pointing to a ~(4.4%) YoY decline at midpoint, fiscal 2025’s outlook (beginning in July of 2024) is much brighter, boosted by DRAM’s surge and NAND’s recovery.

Fiscal 2024 is expected to see a (15.2%) revenue decline to just under $14.8 billion as a result of this sharp memory WFE decline in calendar year 2023. Fiscal 2025 (beginning in July of 2024) is expected to see an 18.7% increase to a record $17.55 billion on DRAM-fueled tailwinds.

Fiscal 2026 is projected to see revenues top $20.2 billion, representing an increase of 15.6% YoY; NAND technological upgrades and continued DRAM spending are likely the main drivers of this growth.

We noted in our August deep dive that an inflection in Systems’ revenue contribution would offer further evidence that Lam had bottomed — during periods of strong demand, the breakdown is about 65%/35% between Systems and CSBG. This reflects strong sales of new hardware and the steady growth of the aftermarket that follows. During periods of weaker demand, the percentage of hardware sales decreases and aftermarket increases because there are fewer new systems sales and the aftermarket is primarily done on existing capacity.

Systems inflected in September, contributing 59% of revenue before rising to 61% of revenue in the December quarter, likely aided by this strength in DRAM sales.

In addition, we’re seeing evidence that CSBG revenue may have bottomed in the September quarter, rising 2.3% QoQ in the December quarter. Reaching this inflection point serves as an early sign that customers are planning to increase utilization. Increased utilization and higher systems sales go hand in hand, as customers boost both to capture growth in periods of higher memory chip demand.

This path to possible record revenues in FY25 and $20B+ in FY26 sets the stage for strong EPS growth. Lam has demonstrated a tremendous ability to grow earnings in the past. For example, from fiscal 2019 to fiscal 2023, Lam grew its EPS from $13.70 to $33.21.

Despite a hit to EPS in fiscal 2024 from the revenue decline and margin pressure Lam is experiencing, earnings growth in fiscal 2025 and fiscal 2026 is expected to be robust, at 22% and 26% YoY – this is faster than Lam’s earnings growth in fiscal 2022. Fiscal 2026 is estimated to see Lam generate nearly $43 in GAAP EPS, almost 54% higher than its $28 estimate for fiscal 2024.

In addition, Lam said that its new Malaysian manufacturing facility is “poised to fully scale in the coming WFE upturn, providing us the capability to nearly triple the percentage revenue contribution from our lower cost manufacturing locations versus a few years ago.” Bringing more lower cost manufacturing online provides room for operating margin expansion, which paves the way for increased operating leverage as revenue accelerates over the next two fiscal years.

However, one thing to watch is whether we see a ‘V’ or ‘U’ shaped rebound for margins. In the last memory downturn in 2019, operating margin recovered in a U-shaped fashion, taking five quarters to reclaim its 2018 levels after bottoming in December 2019. We’ve seen a rather swift contraction in TTM operating margin through 2023, and subdued revenue growth in FY24 is likely to remain a headwind on this margin rebound.

China Risks

China presents a rather real risk to Lam, not only due to rising geopolitical tensions and export restrictions, but also because the country is a primary revenue driver, contributing 40% of revenue in the December quarter, up from 26% in the June quarter.

Lam’s China revenue increased nearly 14% YoY in the first half of fiscal 2024 to $3.18 billion, while sales to Lam’s second largest segment, Korea, declined almost (35%) to $1.26 billion. It’s not necessarily that Lam is driving much higher revenue from China, as revenues are well within historical norms, but rather than China’s strong demand in the first half of the fiscal year is offsetting global weakness – the revenue trough has been significantly minimized by China. Should Lam face increased difficulties selling to China in the remainder of FY24 and into FY25 due to export restrictions, the revenue recovery may be at risk. 

However, this is not solely isolated to Lam, as peers are also seeing increasing China contributions. ASML’s China systems sales reached 49% in its first quarter, versus a single-digit percentage just a year ago, while KLA’s China sales reached 41% in the December quarter, versus 23% in the prior December quarter.

Fiscal Q3 Earnings Preview

Lam’s fiscal Q3 (March 2024 quarter) is expected to be the last quarter of its revenue trough, with revenue expected to inflect back to YoY and QoQ growth in the June 2024 quarter. Sentiment in semis was weak last week heading in to Lam’s report this week. Primarily, the lackluster response to TSMC’s solid top and bottom line beat, the selloff following ASML’s weak bookings and a sharp industry-wide selloff to end last week.

Here are our notes for the upcoming earnings report:

Revenue and EPS:

• Lam guided for $3.7 billion, +/- $300 million in revenue for the March quarter, pointing to a YoY decline of (4.4%) at midpoint.
• GAAP EPS was guided  at $6.90, +/- $0.75, representing YoY growth of 14.8% at midpoint. Non-GAAP EPS was guided at $7.25, +/- $0.75, representing YoY growth of 3.7% at midpoint.
• Analysts expect revenue of $3.73 billion and non-GAAP EPS of $7.30, slightly above the midpoint of both figures. The EPS figure has been revised 9.32% higher over the last 3 months, revised 9.32% higher over the last 3 months, suggesting analysts are looking for improved operating leverage aiding bottom line growth.

Margins

• Lam guided for GAAP gross margin of 47.2%, +/- 1%, and non-GAAP gross margin of 48.0%, +/- 1%. This would represent a 570 bp expansion for the GAAP margin and a 400 bp YoY expansion for the non-GAAP margin at midpoint.
• am guided for a GAAP operating margin of 28.1%, +/- 1%, and non-GAAP operating margin of 29.5%, +/- 1%. This would represent a 370 bp YoY expansion for the GAAP margin and a 120 bp expansion for the non-GAAP margin.

This YoY improvement in GAAP margins is aiding the earnings leverage that Lam is seeing, calling for double-digit YoY GAAP EPS growth on a decline in revenue. GAAP operating margin is approximately flat QoQ, hinting that the margin recovery may take more of a U-shaped pattern.

What to Watch:

Systems sales mix: Systems sales have steadily increased from 53% of revenue in the June quarter to 61% of revenue in the December quarter, suggesting healthy demand for new hardware in the market. Ideally, systems sales will maintain this 61% mix or increase it slightly in the March quarter.

DRAM systems revenue: Given management’s commentary about tripling HBM-related DRAM and packaging revenue this year and DRAM’s surge from 9% to 31% of systems revenue, we’re watching for continued growth here. DRAM systems sales have increased by $550 million, from $155 million to $718 million, and while a $1 billion quarter in Q3 is unlikely, strong double-digit sequential growth further supports the story that we will see a $1B+ DRAM systems revenue quarter in the next couple of quarters.

Q4 guide: Though this is rather obvious, Q3’s guide will ultimately be one of the more important pieces of the report, as Lam is expected to shift back to double-digit YoY revenue and EPS growth in fiscal Q4 (the June quarter) – however, QoQ growth is minimal, estimated at less than $60 million, so ideally we would like to see Q4’s revenue guide pointing to a QoQ increase. Analyst estimates are projecting 17.9% YoY revenue growth to $3.78 billion and 22.2% YoY EPS growth to $7.31, just $0.01 higher than the $7.30 estimate for Q3.

Conclusion

Lam is a primary beneficiary of this memory upcycle driven by GPU upgrades, with memory being the current battleground rather than computing power. Q3 is expected to be the inflection point for revenue and EPS growth before Lam returns to double-digit growth rates. DRAM systems sales have been surging as memory chipmakers work to rapidly expand HBM3 and HBM3e production, while NAND sales have been sluggish over the past couple quarters as spending has not yet resumed.

Lam Research reports after the bell on Wednesday.  This research helps us get ready regardless of what’s reported. Our goal over the next few quarters is to build a bigger position in Lam Research. However, we need to see what comes from this report before we determine when to layer-in. As you know, we initiated a starter position this past quarter. This refreshes our analysis from August and we look forward to updating you post-earnings Wednesday evening.

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

Recommended Reading:

• Q2 2024 Earnings Kickoff Webinar Replay
• Netflix Q1: Large Paid Net Adds Beat, Yet Important Key Metrics Dropped Starting in 2025
• Netflix Q1 Pre-Earnings: Looking to ARM and Net Additions
• Micron Q2: Memory Rebound in Full Force with HBM3e

Regarding the horizontal lines, black lines represent strong support/resistance, while dark red lines mark very strong support/resistance.

Elliott Wave counts are meant to provide context. Each colored count represents the most probable paths given the current price data. There is a pattern unfolding in real-time, one of which will play out. By monitoring price levels that are held/broken, it will help us figure out which one is in play, so that we can better manage risk.

Nvidia (NVDA)

Nvidia appears to be setting up for one more high into the $1050 – $1200 range. Note the pattern from the high is a clear 3 wave move. This looks corrective, which suggests the larger uptrend isn’t over. This is accompanied with the composite index making a lower low, while price is making a higher low. This tends to happen in on-going uptrends.

Below $880 will be the first warning to the bullish case, but this drop can really go as low as $785 and still hold the pattern that would take us higher. As long as any further weakness holds above $785, I still expect to see another high. Below $785 and the top is in, which would have us shift toward setting up buy targets.

Bitcoin (BTCUSD)

While many alt-coins saw a big sell-off over the weekend, which altered their counts, Bitcoin has yet to test even the upper support for this minor 4th wave pullback. So far, it appears that we are in a bull flag, which still needs to chop around above $57,000 before completing. A break below $57,000 will be the first warning that something else might be playing out. However, as long as any additional weakness holds above $48,000, we are treating this as a buying opportunity. Below $48,000 and the larger uptrend pattern is at risk of invalidating.

Microsoft (MSFT)

MSFT is tracing a wedge pattern for the final 5th wave push. I keep going back and forth between the larger 5th wave being a standard 5 wave pattern or a large degree ending diagonal. Based on recent price action, I tend to favor the later. Regardless, both counts have MSFT potentially pushing higher for a final 5th wave swing. Below $397 and the odds favor a top being in. Below $365 and the top is in.

Broad Market Technical Analysis

Price Analysis

Last month, we took a deep dive into the long-term trends that appear to be approaching an inflection point. This analysis positioned the bull market that started in 2023 as part of a much greater bull market that started in 1933. For those that would like this context, please read the opening section in last month’s report here.

We are in a secular bull market, and when this bull run will end is an important question. There are 3 interpretations of the secular bull market that started in 2009.

If we zoom in on the 2022 top through today, we can get a better context on where the market is. These three scenarios are outlined below.

• Red Count – This count suggests that the secular bull market that started in 2009 ended in early 2022 for the S&P 500. This would make 2022 the (A) wave in the first corrective move down in a new secular bear market. This would then make 2023-2024 the (B) wave bounce, or a cyclical bull market within a larger secular bear market. How we will know this count is playing out is that the next larger drop will be a more direct, 5 wave pattern. This would mean that 2025 will be a sharp, and devastating drop for those not prepared, as we retrace all of the 2023 cyclical bull market and likely go beyond.
• Blue Count – This count has us in the final moves of a blow off top. This blow off top is the 5th wave of an ending diagonal pattern. Within a larger context, this ending diagonal pattern is the 5th wave of the bull market that started off the COVID low. How we will know this count is playing out instead of the red count is that the next larger drop should be a 3 wave pattern, followed by a final push for the bulls that will retrace most of the drop. This count will give us a ~10% trading range into 2025, before seeing the bigger drop.
• Green Count – This count has us halfway through with the final 5th wave in the secular bull market. If this is playing out, we will need to hold 4960 and then turn back higher in a direct move that is 5 waves. If this happens, and we break out to new highs, it will make this count a higher probability.

The major support regions 5080, 5055 and 4960. So far, we have taken out 2/3 of these supports, which builds the case for a top being in. We should see a bounce soon, the structure of which will be very important for what follows.

Advanced Market Signals Members receive in-depth technical analysis from our Portfolio Manager, Knox Ridley.  Learn more here.here.

Recommended Reading:

• Broad Market and Positions Update
• AI's Opportunity: Growth, Investment, and the Future
• Cloud Earnings Review: AI a key driver for growth
• Positions Report – March 2024

For reference to terminology used, please look at technical analysis under our resources section here. Regarding the horizontal lines, black lines represent strong support/resistance, while dark red lines mark very strong support/resistance.here. Regarding the horizontal lines, black lines represent strong support/resistance, while dark red lines mark very strong support/resistance.

Elliott Wave counts are meant to provide context. Each colored count represents the most probable paths given the current price data. There is a pattern unfolding in real-time, one of which will play out. By monitoring price levels that are held/broken, it will help us figure out which one is in play, so that we can better manage risk.

I/O Fund Positioning

We continue to hold a sizable cash position; however, not as large as last month. We have been taking gains in various positions as they hit our technical and valuation targets, while not liking many great companies based on current technicals and fundamentals, at this moment. This tactic has naturally put us into cash close to tops.

The one exception we have found continues to be in the AI, specifically the AI memory space. Micron’s (MU) recent report was stellar, and it is showing up in the charts and fundamentals. We made a large move into MU and decided to begin layering into Lam Research and Broadcom, as well.

We always prefer to layer into names that we want to own based on several scenarios playing out. Though we only added 2% in Broadcom, we could easily see this moving into a 10% position. If something changes and we break critical supports across the board, we may stop out of both Broadcom and Lam Research, reduce our risk, and target lower levels. We plan to hedge Micron if this happens.

We also continue to accumulate crypto based on technical levels getting hit. Until critical support levels break, or we start seeing overheating with on-chain metrics, we will continue to follow our game plan and buy the dips.

The below pie chart represents our invested assets, not including cash or hedges. As of now, we are ~35% hedged, and may stop out of this hedge if the green path outlined above starts to build in probabilities.

Nvidia (NVDA)

Nvidia appears to be setting up for one more high into the $1050 – $1200 range. Note the pattern from the high is a clear 3 wave move. This looks corrective, which suggests the larger uptrend isn’t over. This is accompanied with the composite index making a lower low, while price is making a higher low. This tends to happen in on-going uptrends.

Below $880 will be the first warning to the bullish case, but this drop can really go as low as $785 and still hold the pattern that would take us higher. As long as any further weakness holds above $785, I still expect to see another high. Below $785 and the top is in, which would have us shift toward setting up buy targets.

Micron (MU)

MU is still in the middle of an incomplete uptrend pattern. Note how we have gone vertical, which tends to be around the halfway point of a 5 wave pattern. At some point, maybe a little higher from where we are, we will see a 4th wave correction take hold. This pullback needs to hold above $100 to keep the pattern valid. If this happens, we will look to add on the 4th wave pullback, and targeting around $150 – $160 for the 5th wave, as of now.

Bitcoin (BTCUSD)

While many alt-coins saw a big sell-off over the weekend, which altered their counts, Bitcoin has yet to test even the upper support for this minor 4th wave pullback. So far, it appears that we are in a bull flag, which still needs to chop around above $57,000 before completing. A break below $57,000 will be the first warning that something else might be playing out. However, as long as any additional weakness holds above $48,000, we are treating this as a buying opportunity. Below $48,000 and the larger uptrend pattern is at risk of invalidating.

Advanced Micro Devices (AMD)

So far, this pullback appears to be corrective within a larger uptrend. Note how the pattern is a 3 wave drop on decelerating selling volume. Also, the downside is losing momentum, as noted by the divergence in the composite index. At minimum, it appears that we are setting up for a bounce.

What concerns me is that we are below important price supports at $191 and again at $173. If the next bounce is a 3 wave move higher that fails at one of these price levels, it will be a warning sign that we may not get another high. If we can reclaim these levels in a more direct/5 wave move higher, then we can certainly see the uptrend continue.

In order for any of these moves higher to manifest, we need to find support above $158. Any decisive close below this level, would put this count in jeopardy of not playing out.

Netflix (NFLX)

NFLX has been tracing the leading diagonal pattern for 2 years. We are in the final 5th wave of this larger 5 wave pattern, and as long as any additional weakness holds $605, I expect to see one more swing higher before completing. Below $605 is a warning that this may not happen. Below $544 and the top is in for NFLX.

Ethereum (ETHUSD)

The breakdown below $3000 was significant for Ethereum’s structure. This invalidated the classic 5 wave pattern we have been tracing, which was pointing toward $10,000. At best, I see a diagonal pattern playing out, which should see one more high to complete the large 3rd wave.

This is a risky count, and the only bullish interpretation I can find. The reason is because it has the C wave of 3 as a diagonal, and the larger structure is a diagonal. So, this specifies uncertainty within the markets. The current minor 4th wave can drop as low as 2450 and still be valid. Below this level will be concerning.

Regarding the red count, it is very much alive in Ethereum and not in Bitcoin. But, we would need to see a large 5 wave pattern drop below 2015 to make this more likely. As of now, we only have 3 waves down from the high.

Supermicro (SMCI)

So far, we are only seeing 3 waves down from the high. As long as we stay above $775, we can push higher in a final 5th wave push. We need to see a vertical bounce above $775 to give me confidence this might happen. If we break below $775, then the top is in.

Chainlink (LINKUSD)

We only have a 3 wave drop from the high, so far. This is what we wanted, as this correction is following a clean 5 wave move off the 2023 low. We hit our target box, and began buying again. There is a chance that we are only at the bottom of the A wave in this correction. If that is the case, the next larger bounce will be a 3 wave move that fails below $19.80. If we go above $19.80, the odds will start favoring a low. If we go below $8.75, then the larger bullish count we have been tracking could be in trouble.

Broadcom (AVGO)

AVGO is in a rising wedge. It either topped in a 3rd wave or has one more small swing to $1527 before topping. When wedges break, it's usually a sharp drop back to the start of the wedge, which takes us into our buy zone at $1015 – $900. Below $1275 is the first warning and below $1200 will put the top in.

Lam Research (LRCX)

The green count below has LRCX still in the larger 3rd wave. Above $1007 and this is what I believe is playing out. The blue count has LRCX topping in the larger 3rd wave. A break below $900 will confirm this. Either way, I believe LRCX has more room to run, which lines up with the fundamental outlook. So, we will continue to look for places where we can add.

Solana (SOLUSD)

This drop in Solana actually explains the messy structure in the most recent swing higher. It, now, best fits as an ending diagonal, which means that we should see fresh highs. This means that we are in the final push of a 5th wave. The real question will be – what wave is this 5th wave ending? If it is the end of a larger 3rd wave, then the following 4th wave correction will be another great buying opportunity. However, if this is ending the 5th wave, then that will be the top in Solana. Regardless, both counts suggest volatility after we get a fresh high, so we will likely take significant gains if this happens. For this to play out, we must hold last weekend’s low at $119.

If we break $119, then that leads us to the other interpretation, which states that we have topped in the larger 3rd wave and still working through the 4th wave. This would mean that the next several weeks – months will be a range followed by another low below $100. In this scenario, we must hold $77 – $70 or a bigger top will likely be in.

Crowdstrike (CRWD)

CRWD appears to be in a 4th wave. It should find support around $270 if this is a shallow 4th wave, exhibited by the blue count below. However, if we break below $270, we should see a more conventional 4th wave, which should take us the $238 region. This 4th wave can go as low as $218 and still be valid. Below $218 and a bigger top is likely in.

Microsoft (MSFT)

MSFT is tracing a wedge pattern for the final 5th wave push. I keep going back and forth between the larger 5th wave being a standard 5 wave pattern or a large degree ending diagonal. Based on recent price action, I tend to favor the later. Regardless, both counts have MSFT potentially pushing higher for a final 5th wave swing. Below $397 and the odds favor a top being in. Below $365 and the top is in.

Cloudflare (NET)

NET just broke the critical support level at $90. Below here and the odds favor a top being in. I’d prefer to see a more direct drop for confirmation, which we are not getting. Instead, the price action is quite messy, which has me open to another high in a final swing. This is outlined by the green count below. If the next bounce is a 5 wave move, it will become my primary.

Broad Market Technical Analysis

Price Analysis

Last month, we took a deep dive into the long-term trends that appear to be approaching an inflection point. This analysis positioned the bull market that started in 2023 as part of a much greater bull market that started in 1933. For those that would like this context, please read the opening section in last month’s report here.

We are in a secular bull market, and when this bull run will end is an important question. There are 3 interpretations of the secular bull market that started in 2009.

If we zoom in on the 2022 top through today, we can get a better context on where the market is. These three scenarios are outlined below.

• Red Count – This count suggests that the secular bull market that started in 2009 ended in early 2022 for the S&P 500. This would make 2022 the (A) wave in the first corrective move down in a new secular bear market. This would then make 2023-2024 the (B) wave bounce, or a cyclical bull market within a larger secular bear market. How we will know this count is playing out is that the next larger drop will be a more direct, 5 wave pattern. This would mean that 2025 will be a sharp, and devastating drop for those not prepared, as we retrace all of the 2023 cyclical bull market and likely go beyond.
• Blue Count – This count has us in the final moves of a blow off top. This blow off top is the 5th wave of an ending diagonal pattern. Within a larger context, this ending diagonal pattern is the 5th wave of the bull market that started off the COVID low. How we will know this count is playing out instead of the red count is that the next larger drop should be a 3 wave pattern, followed by a final push for the bulls that will retrace most of the drop. This count will give us a ~10% trading range into 2025, before seeing the bigger drop.
• Green Count – This count has us halfway through with the final 5th wave in the secular bull market. If this is playing out, we will need to hold 4960 and then turn back higher in a direct move that is 5 waves. If this happens, and we break out to new highs, it will make this count a higher probability.

The major support regions 5080, 5055 and 4960. So far, we have taken out 2/3 of these supports, which builds the case for a top being in. We should see a bounce soon, the structure of which will be very important for what follows.

Supporting Markets and the Alternative Bullish Count

The majority of price and time information suggest that we are approaching a top, of sorts. However, some charts can be worked into a larger uptrend that can take us into 2025 before topping. This month, we will discuss what I want to see in order for us to pivot our positioning, as well as some problematic markets for the green count.

Small Caps (IWM)

Small caps are the biggest concern that I have regarding the green count. If we are about to embark on the 5th wave of a large degree 3rd wave, typically, we’d be able to see this type of move, to some degree, in all major charts. This is simply not the case in small caps.

IWM is seeing an important confluence of time, price and pattern with IWM. The below Gann chart shows price struggling underneath a confluence of major angles and a cluster of important cycles. Note how the trend was moving into this region, which suggests a reversal is most likely.

If we analyze the pattern going into this important region, it appears that we have already put in a top. I have been discussing for many months how IWM, since bottoming in 2022, has been tracing what appears to be a large degree (B) wave in a much larger correction. The final move of this (B) wave is a 5 wave move higher. This has taken place, and is now breaking the support region that should have held if we are going to push higher.

In the chart below, you can see that we have gaped below the lower trend channel in what appears to be an ending diagonal pattern for the final 5th wave. Since then we are tracing what looks like a 5 wave pattern lower. If we get a small bounce for 4 that holds $200, followed by a 5th wave lower, then we will have strong evidence that our thesis is playing out. This is one of the key charts to watch.

The alternative count is that we have a leading diagonal pattern that just completed. This would also be a 5 wave pattern, and should be followed by a 3 wave bounce that can go above $200, but should hold below $205.

So, the next bounce will be very telling for IWM. If we get a corrective/3 wave move, it will increase the odds of a top being in place.

Semiconductors (SMH)

One of the most important markets, right now, is semiconductors. The reason for this is because this segment of the market has been largely compensating for the weakening Mag 7 from 2023. As long as the AI push holds, and semis lead, we can keep this bull market going.

What’s interesting is that on March 8th, Semiconductors topped while the broad market pushed higher. It’s always concerning when the market leaders do not confirm a new high, which is why we are cautious now. More times than not, the cycle leaders will lead on the way down, when the market reverses.

If SMH decisively breaks below $218, then it is a strong warning that this sector has topped. This will be a warning to broad market, which will likely follow. On the other hand, if SMH can break above $241, then it will support this bull market pushing higher, at least into late April/early May.

NASDAQ-100 (NDX)

Regarding NDX, this chart best shows how the alternative green count will likely play out. In order for this to manifest, we need to not only see SMH break above $241, but I’d also like to see NDX break above 18,606.

If we instead, break down below 17,810 – 17,265 then the odds will start building that a top is building in NDX.

As you can see, we are just above the final support for the green. So, we will need to see a reversal soon, and it needs to be in the shape of a direct/5 wave pattern. If it is instead a 3 wave pattern, it will build the odds that a top is in place.

I’m not sure if you want me to talk about Inflation or Rates. If so, I can coble together those sections from the original report here.

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• Netflix Q1: Large Paid Net Adds Beat, Yet Important Key Metrics Dropped Starting in 2025

Netflix logged its largest EPS beat since Q3 2022 with phenomenal 83% YoY EPS growth, as it reported an acceleration in both revenue and global membership growth in Q1. This was driven by strong paid net adds of 9.33 million in the quarter, far above consensus estimates for 4.11 million net adds.

However, Netflix guided Q2 revenue slightly below consensus, though it still points to revenue acceleration continuing for at least one more quarter. In addition, the fiscal year revenue growth guide was a bit soft and hinted at a back half deceleration.

Netflix also announced a change in its reporting metrics. Starting next year in Q1 2025, Netflix will no longer report quarterly membership numbers and ARM, though it will continue to report revenue by region. In addition, Netflix will begin guiding full-year revenue numbers and provide updates on “major subscriber milestones” as they occur. The markets do not like changes like this, and it likely contributed to the weak price action. We detail what we think is the motivation behind these key metrics being dropped below in the Q&A section.

Revenue and EPS:

• Revenue of $9.37 billion beat estimates by less than 1%, representing YoY growth of 14.8%. This was Netflix’s highest revenue growth since Q4 2021.
• EPS increased more than 83% YoY to $5.28 versus consensus of $4.54, beating estimates by 16.8%. Netflix reported $2.332 billion in net income, more than 18% higher than mgmt’s guide for $1.976 billion.
• For Q2, Netflix guided revenue of $9.49 billion, representing YoY growth of 15.9%. This was slightly below consensus of $9.53 billion for 16.3% YoY growth.
• Netflix guided EPS of $4.68 in Q2, representing YoY growth of more than 42%.
• For the full year, Netflix called for “healthy” revenue growth between 13% to 15%, versus analyst estimates for nearly 14.4% growth. This is construed as a miss at the midpoint. It also indicates a lower rate in H2 since Q1 and Q2 were growth rates of 15% to 16% growth.

Margins:

Netflix reported an operating margin of 28.1% in Q1, its highest ever as margins continue to expand across the board. Netflix boosted its full year operating margin guide by 100 bp to 25%, which would represent a solid 440 bp improvement from 20.6% in 2023.

• Gross margin was 46.9%, a 580 bp YoY expansion as gross profit rose nearly 31% YoY.
• Operating margin was 28.1%, a 710 bp YoY improvement as Netflix reported 54% growth in operating income. Timing of content spend and the higher-than-anticipated revenue also aided this operating margin expansion.
• Net margin was 24.9%, a 900 bp YoY expansion due to the strong 79% YoY increase in net income.
• Operating margin for Q2 was guided at 26.6%, a 410 bp YoY expansion though slightly 150 bp lower sequentially. For the full year, Netflix boosted its operating margin guide to 25% from a prior view for 24%, suggesting that while margins are strong in 1H, a deceleration in 2H to the low-20% range is likely.  
• Net margin for Q2 was 21.7%, a 610 bp YoY improvement, but again a 320 bp sequential decline.

Cash and Debt:

• Operating cash flow in Q1 was $2.21 billion for a margin of 23.6%. This is Netflix’s second-highest quarterly OCF margin and only its third OCF margin to be above 20%.
• Free cash flow was $2.14 billion for a margin of 22.8%. Similar to OCF, this was the second-highest quarterly FCF margin and the third above 20%. Despite the strong FCF number, Netflix maintained its $6 billion guide for the full year.
• Cash and short-term investments totaled $7.04 billion, while gross debt totaled $14.0 billion, as Netflix paid down $0.4 billion in senior notes in the quarter.

Netflix reported a cash spend of $17 billion. Content spend is often asked about given the budget can be quite large for Netflix. Management stated: “So we believe we can manage to that roughly 1 to 1 of cash content spend relative to expense on the P&L.”

The company repurchased $2 billion shares this quarter.

Key Metrics:

Paid Net Adds Blow Past Consensus

Though we had noted in our pre-earnings report that management’s commentary pointed to a wide possible range for net adds (between 2M and 13M), Netflix reported paid net adds at the high end of that range at 9.33 million. This compared to just 4.11 million expected by some analysts, and some as high as 5.11 million from TD Cowen’s bullish view – essentially, Netflix blew it out of the water with paid net adds in the quarter.

This pushed global paid memberships up to nearly 270 million, or a YoY increase of 16%. This is the fastest growth in global paid memberships since Q4 2020 – Netflix is one of the few, if only, pandemic beneficiaries to return to pandemic growth rates. This also marks a sharp acceleration from less than 5% growth in Q1 last year.

Breaking down paid net adds geographically shows that the growth was well rounded. EMEA saw paid net adds of over 2.91 million, while UCAN added 2.53 million and APAC nearly 2.16 million. Here’s a snapshot of the regional highlights:

• EMEA has reported >2 million paid net adds for four consecutive quarters. Paid net adds in the region totaled nearly 8 million in the past two quarters.
• APAC has reported >2 million paid net adds for two consecutive quarters, and more than 5 million paid net adds in the past two quarters combined, for total membership growth of nearly 12% since Q3 2023.
• UCAN’s 2.53 million paid net adds were more than 40% of 2023’s paid net adds for the entire year.

For Q2, Netflix guided paid net adds to be down sequentially, following seasonal trends. Given the wide range of possible outcomes again, this will be an important metric to track next quarter.

ARM: 1% YoY Increase

We had noted that ARM would be one of the more important metrics coming out of this report, on expectations for an inflection back to growth in 2024.

ARM increased 1% YoY in Q1, and 4% on an FX neutral basis, compared to 1% on a reported and FX neutral basis in Q4. Management expects ARM to increase YoY in Q2.

• This growth in ARM was driven primarily by UCAN, which saw ARM increase 7% YoY to $17.30.
• EMEA’s ARM was flat YoY, breaking four quarters of declines on an FX neutral basis.
• LATAM continued to face headwinds from the major devaluation of the Argentine peso, reporting a (4%) YoY decline in Arm but a 16% increase on an FX neutral basis.
• APAC provided the largest headwind to ARM, with a (8%) YoY decline or (4%) on an FX neutral basis.

Earnings Call

Cutting Off Password Sharing Will (at some point) Reach Saturation

One analyst is probed into how far along Netflix is into cutting password sharing off. Management did not give a straight forward answer but this is important to consider if management is wanting to phase-out key metrics that may have been bolstered by this. Typically dropping key metrics is a flag, so analysts were trying to figure out indirectly what the cause could be.

Our next question comes from Alan Gould of Loop Capital. Which inning are we in with respect to enforcing paid sharing? Two years ago, you said 100 million subscribers were sharing passwords with 30 million in UCAN. How many do you estimate still borrow passwords? And I'll turn the floor over to Greg to answer that question.

The answer was long but vague, and offered no transparency into the potential saturation of cutting-off PW sharing: “I think worth noting that while we're fully anticipating continuing to grow subs, the overall business growth now has extra levers and extra drivers like plan optimization, including things like extra members, ads revenue, pricing into more value, which is important. So those levers are also an increasingly important part of our growth model as well.”

Another analyst snuck this in and it was not refuted. It’s subtle that management didn’t state otherwise but important to note. “Could you please provide an update on engagement trends now that paid sharing is mostly behind you? So I'll kick it over to Ted first, and Greg, you can feel free to add on.”now that paid sharing is mostly behind you? So I'll kick it over to Ted first, and Greg, you can feel free to add on.”

On that last question, management did mention that cutting off password sharing will weigh on viewing metrics:

“As we have said, due to the work that we've been doing on password sharing, we're essentially cutting off some viewers who are not payers, and therefore, we're going to lose some viewing associated with that. So when you see our next engagement report, you are going to see some impact to our overall absolute view hours as a result of that.”“As we have said, due to the work that we've been doing on password sharing, we're essentially cutting off some viewers who are not payers, and therefore, we're going to lose some viewing associated with that. So when you see our next engagement report, you are going to see some impact to our overall absolute view hours as a result of that.”

Therefore, if password sharing becomes saturated, this could lead to paid net adds potentially flatlining as its been the primary growth lever for some of these knockout reports on paid net adds.

Demand Problem on Ad Tier

In the call, management pointed to there not being enough demand for the ad tier, which means not enough advertisers. This may change next month in the upfront season where top tier content providers court advertisers for upfront commitments in a highly publicized event, but for now, it’s creating a drag on ARM.

“In terms of how we're doing now relative to what we discussed when we first launched business, as Greg said, we've been growing our inventory at quite a fast clip. And so monetization hasn't fully kept up with that growth in scale and inventory as we're still early in building out our sales capabilities and our ad products. But that is an opportunity for us because this — we're still a very premium content environment, very highly engaged audience that's at an increasing scale. So our CPMs remain strong.

And we're building out our capabilities, as Greg talked about. So the revenue is going to follow engagement over time, and it's already kind of growing nicely, which is great just off a small base. So then really, as Greg said, what that means for ARM is right now, it is a bit of a drag on our ARM because of we're kind of under-monetizing relative to supply.”what that means for ARM is right now, it is a bit of a drag on our ARM because of we're kind of under-monetizing relative to supply.”

Therefore, the ad tier seeing a lag on demand could be the motivation for dropping ARM as a key metric come Q1 2025.

Lower Revenue Guide

The revenue guide being slightly lower at the midpoint was addressed on the call in terms of why there may be a slowdown by one or two points. Here is what management stated: “So our growth in the back half of '24 is really kind of comping off of those hard comps. And at the high end of our revenue forecast, our growth in the second half is consistent with our growth in the first half even with those tougher comps.”

The ARM in the UCAN region is a strong start as Netflix has recently raised prices in this region. EMEA may have broken it’s string of four quarters of decline due to increased prices in France and the UK being the remaining markets that saw price increases. However, it’s not going to be straight-forward ARM growth due to cutting-off password sharing leading to some lower priced tiers.

Per the call: “So mostly what you're seeing in our growth profile this year is the fact that we haven't taken pricing in most countries for the past 2 years really. And we also have some ARM kind of headwinds in the near term that you see in Q1. You'll probably see throughout most of this year, which is that, one, we have some — this plan mix shift as we roll out paid sharing. So it's — while it's highly revenue accretive, as you can see in our numbers, in our reported growth — strong reported growth in Q1 and outlook for the year, that – – as we spin off into new paid memberships, they tend to spin off into a mix of plan tiers that's a little bit of a lower price SKU than what we see in our tenured members […] And we're also growing our ads tier at a nice clip as you've seen and I'm sure we'll talk about. And monetization is lagging growth there.”

Conclusion:

This is a tough one because it’s a strong report at face value. This quarter was very impressive, and the nominally weaker full year guide feels a bit nit-picky to focus on. Overall, Netflix’s free cash flow guide of $6 billion and earnings growth over the next few quarters could sustain the stock, if needed. The company was wise to move toward efficiency and we have held the stock primarily for this reason as the foundation to our thesis while we participated in the speculative pivots of cutting off passwords and the ad tier. So far, one of those pivots has performed as planned (cutting of PWs) while the other pivot has been slow to monetize (the ad tier).

We are seeing important key metrics get dropped next year, which almost-always indicates an issue that management wants to get in front of. It’s interesting that Netflix rode out some tough quarters post-Covid with the pull-forward that occurred, yet kept these key metrics. In this case, it’s only natural to wonder if what’s ahead will be bumpier than the Covid pull-forward.

When you combine the fact that the key metrics could point toward the eventual saturation in cutting off password sharing coupled with a lag in demand on the ad tier, the next few quarters feel a bit like Russian roulette on when these two issues will intersect. It could be all blanks, and the juggernaut could march along and be rewarded especially for the bottom line, or these two could intersect and create a drag on both paid net adds and ARM at the same time. We are weighing these scenarios and our decision will ultimately be communicated in how the I/O Fund manages the position.

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

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Netflix kicks off tech’s Q1 earnings season on Thursday, and is setting a high bar after guiding for a first quarter revenue acceleration and nearly double-digit margin expansion. Netflix returned to double-digit growth in Q4, and guided to 13.2% YoY revenue growth, the fastest growth rate since Q4 2021.

We noted in Q4’s post-earnings report that average revenue per member (ARM) would be one of the more important metrics to watch this quarter, after Netflix raised prices for the first time in 18 months last October. Commentary from management implied we would see ARM return to growth in 2024 after being flat to negative throughout 2023.

Despite not yet being a substantial driver of growth, management was optimistic about the ad tier, saying they expect strong growth off a small base this year to transition ads into a “substantial revenue stream” in 2025 and beyond. Netflix has not updated its ad tier subscribers since January, so an update may be in store.

Notably, Netflix has gone through a phenomenal turnaround on the bottom line and this was the primary reason we added the stock to our portfolio about 18 months ago. Earnings continues to grow while cash flow is pausing on growth, per current estimates and commentary. We detail this and more below.

Revenue and EPS:

Netflix guided for $9.24 billion in revenue in Q1, representing YoY growth of 13.2%, with a three percentage point headwind from the devaluation of the Argentine peso relative to the US dollar. On a constant currency basis, this represents approximately 16% YoY growth.

Revenue growth is poised to continue accelerating through Q2, with estimates pointing to 16.3% growth in the June quarter before softening to the 14% range for the back half of the year. Q2 is still expected to mark ‘peak’ growth as was noted in January; however, revenue growth forecasts for 2025 have inched higher. Prior to Q4, revenue growth was projected to moderate to the 10% range, but now it is expected to hover in the 12% range.

Q1’s EPS guide called for more than 112% QoQ growth and 56% YoY growth to $4.49, which would be Netflix’s highest ever quarterly EPS print. Much of this EPS growth stems from margin expansion driving increased operating leverage – Netflix guided for operating income to increase nearly $1 billion sequentially to $2.42 billion, and that is flowing straight through to the bottom line with net income guided to rise by more than $1 billion sequentially to $1.98 billion.

This sets the stage for strong EPS growth for fiscal 2024 and into 2025. Current estimates call for EPS growth of 43.1% YoY to $17.22 in 2024, a strong double-digit acceleration from 20.9% growth in 2023. EPS growth in 2025 is projected to moderate to 23.2% YoY to $21.21.

Margins:

Operating margin expansion is one of the primary highlights for Q1’s upcoming report, with Netflix guiding for a 26.2% operating margin in the quarter, a ~930 bp expansion to the highest level in three years.

An operating margin in the mid to high-20% range is not out of the ordinary for Netflix in the first quarter, with margins in this ballpark in 2021 and 2022. However, Netflix increased its full year operating margin guide from 22.5% at midpoint to 24%, implying that margins through the remainder of the year will remain strong, and not as prone to sequential weakness as we had seen in 2021 and 2022.

Q2’s operating margin guide will provide clues as to how this will unfold – a guide for sequential growth would imply a weaker Q4 in line with historical trends, while a guide in the low 20% range points to steady margins and likely strong YoY expansion in Q4.

With this operating margin strength, net margin in Q1 is also expected to be very strong at 21.4%. This compares to 10.6% in Q4, and 15.9% in the year ago quarter.

Cash Flows and Balance Sheet

Cash flows have been a strong point throughout 2023, with Netflix more than tripling operating and free cash flows and driving more than 1500 bp expansion in operating and free cash flow margins for the full year.

Operating cash flow was $1.66 billion in Q4 and $7.27 billion in 2023, for a margin of 18.8% and 21.6% respectively. The 21.6% margin in 2023 marked a substantial 1520 bp expansion from 6.4% in 2022, as operating cash flow increased 259% YoY. For Q1, operating cash flow is expected to be just north of $2 billion, for a margin of ~22.0%.

Free cash flow was $1.58 billion in Q4 and $6.93 billion in 2023, for a margin of 17.9% and 20.5% respectively. Free cash flow increased 328% YoY last year, though growth is pausing – management guided for ~$6 billion in FCF this year, or a (13.4%) YoY decline with this lumpiness caused by the WGA and SAG-AFTRA strikes.

Netflix has more than $7.1 billion in cash and short term investments on the balance sheet, while debt totaled $14.5 billion.

Key Metrics: ARM, Paid Net Adds In Focus

Paid Adds:

Paid net additions were probably the strongest key metric in Q4’s report. Netflix reported 13.12 million paid net adds globally, driving global paid memberships up 12.8% to more than 260 million. This marked the fourth quarter of accelerating growth and the highest growth rate in eleven quarters for global paid memberships.

Management hinted that we would see strong paid net additions in Q1, saying that “similar to prior years, we expect paid net additions to be down sequentially (reflecting typical seasonality as well as some likely pull forward from our strong Q4’23 performance) but to be up versus Q1’23 paid net adds of 1.8M.” However, this leaves quite a wide range for where paid net adds could fall – Q4’s total paid net adds surpassed 13.1M, so technically, anything between 2M and 13M is fair game and would align with management’s commentary.

Consensus for paid net adds sits on the lower end of the range, at 4.11 million. Analysts from TD Cowen are expecting paid net adds of 5.11 million, noting the firm is “benefiting from a dual tailwind of paid sharing initiatives as well as strong underlying business demand from a robust, increasingly global content slate.” This 5.11 million expectation would correlate to global paid membership growth of almost 14.2%, suggesting analysts are looking for another quarter of acceleration in Q1.

ARM:

ARM also will be watched closely, given that it is expected to inflect back to growth and contribute to revenue growth instead of providing a headwind as it had in 2023. Netflix said for 2024, it expects “healthy double digit revenue growth…on a F/X neutral basis driven by continued membership growth as well as improvement in F/X neutral ARM as we adjust prices.” 

As Netflix’s largest region by paid memberships, EMEA’s return to growth in ARM will be critical, given that it declined (1%) YoY to $10.84 in Q4 on an F/X neutral basis. Return to growth in APAC may take an extra quarter of two, given that Netflix has been struggling to improve monetization with ARM declining for seven straight quarters. UCAN ARM accelerated to 3% growth in Q4 from 0% in Q3, and further acceleration will help offset residual weakness in APAC in Q1 and potentially lighter growth in EMEA.

Ads:

With management aiming to make ads a more substantial revenue driver in 2025, updates on ad-tier subscriber count could be in store, following strong growth over the past three quarters and potential for partner deals like that with T-Mobile further boosting growth.

We have seen strong adoption of Netflix’s ad-tiers so far: subscribers tripled from 5 million in May 2023 to 15 million in November, before rising another 53% to 23 million in early January. Ad-tier subscribers now account for nearly 10% of Netflix’s total paid memberships.

In late January, all of T-Mobile's subscribers to its Netflix on Us deal, which previously offered a free Netflix Basic subscription, will convert to Netflix's Standard with Ads tier unless subscribers pay the difference for a plan without ads. Management explained that these kinds of partner deals are “very effective, very useful for us because that lower consumer-facing price means that we got room now to bundle the ads plan into a set of lower-priced partner offerings where it was hard to make the economics work for everyone previously.” This provides two outlets for growth –a surge in ad-tier users from those who do not wish to upgrade, and extra revenue dollars from those that pay the difference to upgrade.

Conclusion

Netflix has been delivering on its promise to shareholders with accelerating revenue and subscriber growth, greatly improved margins and cashflows, and strong EPS growth. A few metrics we are watching closely include ARM and paid net additions growth, given the strong numbers Netflix has reported recently.

We are also on the lookout for whether the ad tier’s strong initial adoption will begin to slow and/or if Netflix will run out of growth levers, though this may become more of a concern for 2025. With that said, an ad tier should greatly improve margins as we go along and that’s also central to the story beyond paid net additions. We will keep you in the loop on how we view Netflix’s peak growth in Q2 and the inevitable slowing growth come 2025 (or perhaps 2026) in the face of its impressive and expanding margins and cash flows.

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

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