This is a continuation of our article 2024 Trend: Memory and PC Rebound. 2024 Trend: Memory and PC Rebound.

Over the past year, the memory, smartphone, and PC markets have been experiencing inventory corrections. However, recent earnings commentary from major companies like Samsung, Microsoft, AMD, and Intel suggests that these markets are approaching a bottom.

This article provides insights into the specific stocks poised to benefit from the anticipated market rebound. First, we compared the sequential growth rates from Q3 to Q4 of last year with the projected growth rates for this year. The data reveals a remarkably positive outlook, with every company exhibiting sequential growth.

Micron stands out with the most significant improvement, transitioning from a (-39%) decline last year to an anticipated 14% growth this year. Silicon Motion, which experienced a (-20%) decline last year, is projected to rebound with 13% growth this year. Qualcomm, having faced a (-17%) decline last year, is forecast to experience 10% growth this year. The average growth rate has transformed from a sequential decline of (-7%) last year to an expected 11% growth this year.

Source: YCharts

Earnings Beats

Below, we look at companies that beat analyst consensus. Companies that consistently beat estimates have a higher probability of outperforming the market. Intel is the leading stock with a revenue beat of 4.1%, helped by the PC rebound. The company’s recent revenue declined by (-8%) YoY and up 9% QoQ to $14.2 billion. The company beat its own guidance by 5.7% and exceeded its guidance for all major segments.

Silicon Motion’s revenue exceeded analyst expectations by 4%. The company’s revenue was down (-31%) YoY and up 23% QoQ to $172.3 million. The sequential solid growth was helped by the normalization of inventory levels across most of its markets and from the pick-up of customer orders in the recent quarter.

Western Digital ranked third with a revenue beat of 3.3%. The company’s revenue was down (-26%) YoY and up 3% QoQ to $2.75 billion.

Source: YCharts

Intel’s adjusted EPS came in at $0.41 compared to $0.37 in the same period last year, with a beat of 87% on expected EPS. Rambus reported $0.56 compared to $0.45 in Q3 2022, with a beat of 37.5%, and FormFactor reported $0.22 compared to $0.24 in the same period last year, with a beat of 26.1%.

Source: YCharts

Bottom Line and Free Cash Flow

GAAP profitability is another crucial metric to monitor closely, especially with macroeconomic uncertainty. Apple leads with an operating margin of 30%. We have discussed in depth in our editorial how the services segment will further help the company’s margin expansion. The article highlighted that “FY21 was a breakout year for Apple’s gross margin, expanding from 38% to more than 42% because of that growth in Services. Apple is guiding for gross margin to expand further in fiscal Q1 next year, to the 45% to 46% range – an expansion of 200 to 300 bp YoY, with Services’ growth rate forecast to be in the high-teens again.”

Lam Research ranks second with an operating margin of 29%. We discussed Lam in our deep-dive analysis earlier this year. We had highlighted, “Over the past decade or so, Lam was considered lower risk because it was expected that memory manufacturers would continue to buy from Lam even during a low point in the cycle. This happened in 2015, when Lam was insulated from the last deep memory trough. However, due to the China ban, Lam did not escape the memory trough this time around.” Rambus ranks third with an operating margin of 17%.

Source: YCharts

Qualcomm has the highest free cash flow margin of 44%. It has improved from 7% in the same period last year and 28% in Q2. Rambus ranks second with a free cash flow margin of 41% and Silicon Motion ranks third with 28%.

Source: YCharts

Stock-Based Compensation

Stock-based compensation is a non-cash expense added back to adjusted earnings. However, in practice this is an expense as per GAAP rules. Warren Buffet said the following, which relates to the importance of GAAP earnings over adjusted earnings when stock-based compensation is involved. “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?”

The stocks in the list below have stock-based compensation of less than 10% of their revenues, which is ideal. Rambus has the highest percentage of stock-based compensation at 9.5%, followed by Qualcomm at 7%, and FormFactor at 6.3%. Often, having higher stock-based compensation will weigh on GAAP profits. In this case, the list below is GAAP profitable in the majority of cases, and so this is less of a concern.

Source: YCharts

Valuations

In the below chart, we ranked companies based on the forward P/S ratio. Rambus has the highest forward P/S ratio at 13.1, followed by AMD at 8.7 and Apple at 7.4.

Source: YCharts

FormFactor has the highest forward P/E ratio of 52.2, followed by AMD at 44.6, and Intel at 44.4.

Source: YCharts

Ranking based on revenue estimates change for next quarter

Micron’s revenue estimates for the next quarter have been revised up 5.3%, followed by Qualcomm at 3.1% and Western Digital Corporation at 1.9%. Western Digital also figured in the top three list of companies that beat the analyst revenue estimates in the recent quarter, as discussed earlier.

Source: YCharts

Ranking based on adjusted EPS estimates change for the next quarter

Qualcomm’s adjusted EPS estimates have been revised up 5.6%, followed by Silicon Motion at 1.3%, and Apple by 1.1%. Apple’s top line estimates have been revised down, yet the bottom line was revised up. We’ve discussed in detail here the increasing mix of Apple’s Services, which has helped improve the bottom line.

Source: YCharts

Highlights and Lowlights in Q3

Intel beats consensus estimates driven by PC rebound

Intel had an excellent revenue beat of 4.1% and an adjusted EPS beat of 87%. Analyst consensus is for QoQ growth of 7% in the next quarter compared to a QoQ decline of (8%) in the same period last year. The following comments from the management point to PC rebound optimism.

Pat Gelsinger, CEO of Intel, said in the recent earnings call. “As we expected, customers completed their inventory burn in the first-half of the year, driving solid sequential growth, which we expect will continue into Q4. We expect full-year 2023 PC consumption to be in line with our Q1 expectations of approximately 270 million units.”As we expected, customers completed their inventory burn in the first-half of the year, driving solid sequential growth, which we expect will continue into Q4. We expect full-year 2023 PC consumption to be in line with our Q1 expectations of approximately 270 million units.”

David Zinsner, CFO of Intel, said in the recent earnings call. “Now turning to Q4 guidance. We expect fourth quarter revenue of $14.6 billion to $15.6 billion, delivering on our January commitment to grow revenue sequentially throughout 2023. In the client business, we're encouraged by the return of historical purchasing cycles as our channel checks, partner feedback and ASPs all point to healthy inventory levels and growing demand.”In the client business, we're encouraged by the return of historical purchasing cycles as our channel checks, partner feedback and ASPs all point to healthy inventory levels and growing demand.”

Silicon Motion sequential growth rebound

Silicon Motion, which experienced a (-20%) decline last year, is projected to rebound with 13% growth in Q4 this year. The company also beat consensus revenue estimates by 4% and adjusted EPS by 10.2%, which is very good. It has an operating margin of 9% and a solid free cash flow margin of 28%.

The management of Silicon Motion also echoed similar thoughts to Intel on the normalization of inventory levels.

Wallace Kou, CEO of the company, said in the recent earnings call. “With that, I will turn to our results for the third quarter. Our business continued to gain momentum with revenue growing 23% sequentially to $172 million and earnings per ADS growing 67% sequentially to $0.63. We saw inventory level begin to normalize across the majority of end markets and OEM order activity pick up in the third quarter leading to a strong revenue growth in the quarter.We saw inventory level begin to normalize across the majority of end markets and OEM order activity pick up in the third quarter leading to a strong revenue growth in the quarter.

We expect this trend to continue and are confident they will lead to strong sequential growth in the fourth quarter. While the first half of 2023 was challenging due to the global macro economy weakness and excess inventory in the channels the inventory level across our end market are normalizing and OEM demand continue to improve.

He further said, “By end market standpoint excess inventory in the PC and smartphone markets have plagued the industry since late 2022 when the global economy weakened and demand lowered. It has taken nearly a year, but we believe the inventory level in both the PC and smartphone markets are normalizing.”we believe the inventory level in both the PC and smartphone markets are normalizing.”

Micron benefitting from memory rebound

Micron beat the revenue estimate by 2.2% and adjusted EPS estimate by 9.2%. Micron stands out with the most significant sequential improvement in the next quarter, transitioning from a (-39%) decline last year to an anticipated 14% revenue growth this year. On the flip side, as seen in the earlier part of our analysis, the company ranks lower on the operating margin and cash flows from the list of PC and memory-related companies.

The company recently boosted guidance for next quarter. The company has increased its revenue guidance by 6.8% and expects its non-GAAP gross margin to approach break-even levels from the previous guidance of negative (4%).

In the recent UBS Technology conference, the management confirmed that the pricing is starting to increase. The company’s CEO, Sanjay Mehrotra said, “So last update that we had provided was at the time of our earnings call at the end of September in the Q4 earnings call. And in that update, we have said that, industry environment was improving, inventories were improving and that we were seeing pricing bottoming out. In fact, pricing is starting to increase.”And in that update, we have said that, industry environment was improving, inventories were improving and that we were seeing pricing bottoming out. In fact, pricing is starting to increase.”

Conclusion:

We are monitoring memory closely as the use of HBM3 and HBM3e becoming a central focus in the competition between AI accelerators in the data center. Per our write-up:

“If 2023 was the year AI accelerators made their importance known, then 2024 will be the year that memory and HBM3/HBM3E makes its importance known as the competition is going head-to-head at memory capacity and bandwidth per GPU rather than compute performance […] In fact, to drive the point further as to how important memory will be in the next generation of GPUs, the compute performance from the H100 to the H200 is not changing much. According to what the industry has seen so far from Nvidia’s GPU HGX 200 systems, there will be “32 PLOPS FP8” performance, which would be achieved through eight H100s with 3,958 teraflops of FP8 each. The translation is that Nvidia’s H200 upgrade is strategically focused on memory, which also translates to AMD having a strong sense of direction on design as it forced Nvidia to answer to the MI300X’s memory capacity and bandwidth.”then 2024 will be the year that memory and HBM3/HBM3E makes its importance known as the competition is going head-to-head at memory capacity and bandwidth per GPU rather than compute performance […] In fact, to drive the point further as to how important memory will be in the next generation of GPUs, the compute performance from the H100 to the H200 is not changing much. According to what the industry has seen so far from Nvidia’s GPU HGX 200 systems, there will be “32 PLOPS FP8” performance, which would be achieved through eight H100s with 3,958 teraflops of FP8 each. The translation is that Nvidia’s H200 upgrade is strategically focused on memory, which also translates to AMD having a strong sense of direction on design as it forced Nvidia to answer to the MI300X’s memory capacity and bandwidth.”

In addition to this, the AI-powered PC is going to be a massive trend, and may be the next domino in AI’s race toward a $15 trillion impact on GDP. Per the write-up on memory and PCs:

“AI-powered PCs will ultimately change the trajectory for AI, to where more people can access AI-powered applications, which in turn, will help AI developers be able to build a bigger ecosystem. There is a major bottleneck right now for AI applications to where client devices are not powerful enough or energy efficient enough to leverage AI capabilities.”

We are looking more closely at what stocks may benefit from the next leg up in AI, which is memory for AI accelerators and AI-enabled PCs. The goal is to line up the stocks we want to buy should semis see a pullback.

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

Recommended Reading:

• Marvell Q3 Earnings: The Market Wants More on AI
• Nvidia Fiscal Q3 Earnings: The China Impact
• 2024 Trend: Memory and PC Rebound
• Apple Q4: iPhone Revenue Accelerates while Services Shine
• Supermicro Fiscal Q1: “Conservative” Guide
• AMD Q3 Earnings: $2B in GPU Revenue for 2024

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

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

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

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

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

Financials

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

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

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

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

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

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

Revenue Segments:

Data Center:

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

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

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

Enterprise Networking:

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

Carrier Infrastructure:

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

Consumer:

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

Automotive:

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

Earnings Call:

AI Revenue:

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

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

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

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

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

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

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

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

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

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

Fiscal Q1:

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

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

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

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

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

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

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

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

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

Conclusion:

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

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

Recommended Reading:

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

We encourage you to read our previous post-ER write-up found here and also the pre-ER found here as it goes through the pros/cons of Marvell’s fundamental profile, and our motivation in adding the stock back to our portfolio.

Per our last write-up, the bull case is this:

“Marvell doubled its AI revenue from $400 million to $800 million. This means AI is now 14.4% of revenue, up from roughly 7% (on an annual run rate). This is bullish for our CY2024 thesis, and was not expected so soon. The most important statement on the call was this: 

“Based on our latest demand outlook for our electro-optics products, we now expect revenue from AI to exit this year at over a $200 million quarterly revenue run rate or $800 million annualized. This is well above what we had outlined last quarter. Put this in perspective, this would put us at the run rate we had previously communicated for all of next year.”

However, the bottom line is in bad shape as it’s not an ideal time to have to access the debt capital markets. Per our last write-up:

“Where the report is concerning is the increasing net debt to EBITDA ratio, which has increased from 1.6X to 1.8X. You can expect us to risk manage this position depending on FED actions. It was stated in the call: “we will opportunistically explore accessing the debt capital markets to refinance our upcoming debt maturities.”

This is an important quarter for Marvell to step up and improve its bottom line as the market has overlooked this given the AI story is quite strong. The ingredients are there as revenue and EPS is expected to nicely rebound over the next few quarters, it’ll be up to management to prove they can give the market what it wants in terms of profits and cash flow margin.

Revenue and EPS

• Q2 revenue declined by (-11.6%) YoY to $1.341 billion
• Management Q3 revenue guidance and consensus is $1.4 billion, representing a YoY decline of (8.9%) at the mid-point. It’s expected that the revenue YoY decline will bottom in Q3 and a return to growth is expected in Q4.

• GAAP EPS was (-$0.24) last quarter and is expected to be ($-0.07) +/- $0.05 this quarter. The negative to thin profit margin is one of the primary concerns with Marvell.
• Last quarter, adjusted EPS was $0.33. Management’s Q3 guidance ranges from $0.35 to $0.45, mid-point of $0.40. This represents a YoY decline of (29.7%). The YoY decline in earnings will also bottom out in Q3 with a return to growth expected in Q4.

Margins

• Management guidance for Q3 gross margin is 46.8%. Adjusted gross margin guidance is 60.8%. It was stated that adj. gross margin will reach 64% in Q4 helped by a recovery in data center storage. The gross margin is also expected to benefit from cost cutting initiatives like optimizing headcount and continuing to partner with the suppliers to drive more efficiency in the supply chain.

o   The Q2 gross margin was 38.9% compared to 42.2% in Q1 and 51.8% in the same period last year. The gross margin was down due to lower percentage of data center revenues in the revenue mix.

• Management has guided for GAAP operating margin of (-1%) compared to (-15.3%) in the previous quarter. Management guidance on adjusted operating margin is 29.6% compared to 25.2% in Q1. 
• The adjusted net margin improved 164 basis points sequentially to 21.64% and was down from 32% in the same period last year.

Cash Flow and Balance Sheet 

The operating cash flow margin was 8.4% compared to 15.8% in Q1 and 21.8% in the same period last year.  The operating cash flow margin was low primarily due to an increase in DSO (days sales outstanding) and severance-related cash restructuring charges. Management mentioned that they expect DSO to improve in the next quarter.

The CFO, Willem Meintjes, replied to an analyst’s question.

“Yes, so this quarter certainly DSO was impacted somewhat by linearity. We do expect a nice back — bounce-back in Q3 and some normalization.”

It is crucial for the company to improves its cash flows in the coming quarter. The free cash flow dropped to $1.2 million compared to $105.8 million in Q1 and $256.3 million in the same period last year. The lower operating cash flows and higher capex of $111 million led to the drop in the free cash flow.

The company has cash of $423.4 million compared to $1.03 billion at the end of Q1. Debt is $4.15 billion, which includes short-term debt of $1.02 billion. The company used $572 million to repay debt in the recent quarter. Due to the lower cash flows, the company had to repay its debt entirely from the cash balance. This was contrary to what management had indicated in the Q1 earnings call when they stated they would repay debt from free cash flow and cash balance.

They have resumed buybacks as indicated in the last earnings call and it doesn’t seem ideal the company would take this route when the net debt to EBITDA ratio has increased from 1.6x in Q1 to 1.83 in Q2. Per the earnings call, “we will opportunistically explore accessing the debt capital markets to refinance our upcoming debt maturities.”

This is our primary concern with Marvell in the near term given elevated interest rates.

Key Metrics

Data center revenue was down (-29%) and was up 6% QoQ to $459.8 million, which should be marking a bottom, as long as storage recovery doesn’t get pushed out further. This exceeded guidance of 0% QoQ growth. The beat was due to the AI networking products. We’ve covered additional datapoints on the storage recovery and memory rebound here. This compares to being down (-32%) YoY last quarter and (-12%) QoQ decline.

On a QoQ basis, data center is expected to accelerate to “mid-teens” growth. Per management: “Demand for our AI products continues to grow at an extraordinary rate and we are working very closely with our customers to meet rapidly evolving needs. On the other hand, enterprise on-premise is expected to continue to trend down. As a result, we are projecting overall data center revenue in the third quarter to grow in the mid-teens sequentially on a percentage basis.”

Carrier infrastructure end market was down (-3%) YoY and down (-5%) QoQ to $275.5 million due to wired networks whereas 5G was strong at 25% QoQ growth. The carrier end market is expected to grow in low single digit sequentially helped by wireless.

Enterprise networking declined (-4%) YoY and (-10%) QoQ to $327.7 million. This is expected to decline further into the low teens QoQ next quarter. Per management, enterprise networking will take a few quarters to normalize: “We expect this inventory re-normalization to take a few quarters to resolve as customer balance sheets get worked down over time.”

Consumer end market is up 2% YoY and up 18% QoQ to $167.7 million. Revenue is expected to grow sequentially in the low teens next quarter.

Automotive and industrial end market was up 32% YoY and 23% QoQ to $110.2 million driven by increased adoption of Ethernet in cars. This segment is expected to be up 30% YoY and flat sequentially.

Conclusion:

We are watching tonight’s report with anticipation as we hope to see the product story overcome the challenges seen in the bottom line, — if not this quarter than at least in the company’s guidance for next quarter. There is an incoming, material rebound, as detailed above. What we want to see is if the rebound is strong enough to result in a decent cash margin and GAAP profits. If so, we will have a win-win to where the fundamentals are improving and a nice product story is setting up for 2024. If not, we will go back to the drawing board to figure out how to risk manage in a way that instills persistence for the longer-term thesis.

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

Recommended Reading:

• Nvidia Fiscal Q3 Earnings: The China Impact
• 2024 Trend: Memory and PC Rebound
• Big Tech companies continue to invest in AI
• Cloudflare 3Q23 Earnings Summary

The word “record” was emphasized in the opening remarks as CrowdStrike put up a record quarter in many regards: record net new ARR of $223 million, record non-GAAP subscription gross margin, record GAAP and non-GAAP operating profitability, and record free cash flow.

What is weighing on CrowdStrike after hours is the deceleration in billings. CrowdStrike prefers to focus on ARR and Net New ARR, yet the market is keeping an eye on billings, especially this earnings season, considering we’ve seen mixed results on billings from cybersecurity peers. We detail this for you below.

The other blemish, if you will, was when the CFO stated: “our dollar based net retention rate was slightly below our benchmark in Q3.” This means DBNRR was below 120. Looking back, the July 2022 quarter was at 120%. However, I believe this is the first time that DBNRR was below 120.

Beyond this, the company had a solid report. It was the first quarter the company was profitable from operations (as you’ll recall, CrowdStrike was profitable from interest income in the past). Net new ARR also accelerated nicely from (-10%) last quarter to +13% this quarter. This helps to set the stage for more growth in the future.

Key Takeaways:

CrowdStrike delivered a 1.1% revenue beat and 10.8% EPS beat relative to consensus estimates, and guided fiscal Q4 marginally above consensus; however, the quarter was relatively strong, as net new ARR rose to a record at $223 million. ARR growth decelerated slightly to 35%, but topped the $3 billion mark for the first time. CrowdStrike re-emphasized its goal to reach $10 billion in ARR over the next five to seven years. The company also stated “we are maintaining our net new ARR assumptions which call for in-line to modestly up net new ARR for the full year and double-digit year-over- year net new ARR growth in the second half.” This implies net new ARR will be strong again next quarter.

Revenue growth remained strong at +35%, but billings growth looked to decelerate to the high-single-digit range YoY, compared to prior growth rates above +20%. A key item in the report was that Q3 marked CrowdStrike’s first quarter with positive operating income. CrowdStrike now has to prove that it can continue to expand operating margin further into positive territory.

Financials:

Revenue and EPS:

• Revenue of $786 million beat consensus estimates by $8.6M. This represented growth of +35% YoY
• Subscription revenue was $733.5 million, up +34% YoY.
• ARR increased +35% YoY to $3.15 billion, marking the first time that ARR has surpassed $3 billion.
• Net new ARR reached a record at $223.1 million, and was +12.6% higher compared to $198.1 million in the year-ago quarter.
• Adjusted EPS of $0.82 beat estimates by $0.08, or 10.8%. This represented YoY growth of +105%.
• GAAP EPS of $0.11 compares to a GAAP loss of ($0.24) in the year-ago quarter.

Margins:

• Gross margin of 75.2% increased ~240 bp YoY ~20 bp QoQ.
• Subscription gross margin of 78.2% increased ~270 bp YoY and ~40 bp QoQ.
• Operating margin of 0.4%, compared to an operating margin of (9.7%) in the year-ago quarter and (2.1%) in fiscal Q2.
• Net margin of 3.4% expanded ~225 bp QoQ, and marked the third straight quarter with a positive net margin.

Cash & Debt:

• Cash and short-term investments of $3.17 billion.
• Total debt was $742.1 million.
• Operating cash flow reached a record at $273.5 million, representing an increase of +12.6% YoY from $242.9 million. Operating cash flow margin was 34.8%.
• Free cash flow reached a record at $239 million, an increase of +37.3% YoY from $174.1 million. Free cash flow margin was 30.4%.

Noteworthy:

Net new ARR growth and a first quarter with positive operating income were the two major positives from Q3’s report. Net new ARR rebounded to a record $223.1 million after falling to $174.2 million in fiscal Q1, a strong recovery and setting the stage for another possible record to close out FY24.

CrowdStrike also recorded its first quarter to generate operating income, albeit at a razor-thin 0.4% operating margin. However, this shift to a positive margin benefited the bottom-line, allowing net margin to expand ~225 bp QoQ to ~3.4%. This marked CrowdStrike’s third straight quarter of GAAP profitability, with sequential growth in each of the three quarters.

We had mentioned in the pre-ER write-up that while CrowdStrike had begun to post GAAP profitability, it was preferable that the company be GAAP profitable from operations – now, the next task is for CrowdStrike to show further growth in operating income. You can read our last earnings report write-up following Q2 earnings here.

Another interesting snippet was an increase in the number of customers deploying 7+ modules. Whereas customers deploying 5+ remained the same QoQ at 63%, the amount deploying 7+ increased from 24% last quarter to 26% this quarter. Those deploying 6+ modules also increased by 1 percentage point to 42%. CrowdStrike has done an excellent job of upselling existing customers to higher amounts of deployed modules, so this 2 percentage point increase was a healthy figure to see.

Billings:

However, there was one glaring negative from the report – billings growth has decelerated to the single digit range. Billings was calculated to have fallen (2%) QoQ and +9% YoY to $821.5M for Q3, a significant slowdown from the +13% QoQ and +22% YoY growth rate recorded in the prior quarter.

Pictured Above: I/O Fund calculations for CrowdStrike’s Billings growth/decline

This deceleration matches what peers are reporting:

• Fortinet guided for billings to decline (-1%) to (-9%) in its upcoming quarter after reporting just +5.7% YoY growth.
• Palo Alto lowered its full-year billings forecast while it reported a slowdown to +16% growth compared to +27% in its year-ago quarter.
• Zscaler reported +34% YoY billings growth on Monday, but maintained its full year guidance calling for +24% to +26% YoY growth, suggesting that a deceleration is set for the next few quarters.

Earnings Call:

Billings:

Given Billings is where the potential weakness resides, there was a question from an analyst regarding the decline. Since this was the most important question on the call in regards to the price action, I’m quoting it below.

Q: “And then quarter was phenomenal. But I do see some weakness across the board of cyber companies with billings. In your case it was down about 2%. I also see some weakness in deferred revenues. How do I reconcile what I see with billings with deferred, with the underlying drivers that are very strong and your strong execution? Why is why are we seeing weakness not just with you, maybe with the entire space, but why are we seeing weakness with billings across the board? Thanks.”

A: CFO: I'm going to start with billings. Yeah. You're correct. For us specifically, we don't manage the business to billings. And we feel ARR gives you the absolute best proxy to revenue. And we felt that that's the right metric. As you know, since we went public to give you more transparency into the health of our business. And that's the metric that really guides you on health.

[…] We think that billings has certain things that just are not as relevant as a metric like ARR, you're comparing a balance sheet item to a P&L item and for us, the P&L is going to dictate the health of the business. So for us billings obviously is going to be impacted by duration and there are many things that go into that. And remember also that when you think about on a year-on-year basis, we're still up on billings. And I think that's the one thing that you want to take away. For us, when we think about how we want to continue to be transparent, ARR really gives you that notion of where we're going and how we're doing. And I think that that's the focus and it has been, by the way, since we've been public. Even as a private company, that's the one that we manage the business to, that's how we look at how to give out quotas to our reps, et cetera, et cetera. So for us that's not going to change. And, I hope that answers that question.”

Translation: CrowdStrike’s CFO did not really answer the question, such as perhaps seasonality contributed or some deferred revenue will be realized in Q4 that would have been realized in Q3 (these are hypothetical answers). Instead, the CFO answered that analysts should focus on ARR instead of Billings, but the problem is that ARR is not a GAAP metric and this is why Billings remains important for an apples-to-apples comparison with peers. This is something to monitor, yet given net new ARR accelerated, the market may conclude these two cancel each other out. 

Macro Environment Weak:

The other takeaway was CrowdStrike’s discussions that the current environment is tough. CrowdStrike may be less susceptible, yet management made it quite clear they are facing challenges. Here is what the CEO said when asked if October was strong (given other cybersecurity peers have stated it was a weak month for them):

“Yeah, we certainly had a strong October. I think as I said in my prepared remarks, the macroenvironment is still is still challenging. And we make no mistake about that. Deals take longer, a lot more scrutiny a lot of sign-offs, and there's a lot more work that goes into these larger enterprise deals. Getting deals done, even like Falcon Flex, which are more enterprise-like in their nature, takes time. So, we had a great October, but in general, buyers are still cautious. And I think the fact that we're able to provide a real platform play that allows them to consolidate in other technologies and ultimately save money accrues values to us, but it certainly takes a lot of time and effort to get the deal over the goal line, but team did a great job, and October was strong for us.”

Management also stated they are not counting on a Q4 budget flush in their guide, which translates to a weaker environment: “As George outlined, strong demand for the Falcon platform is driving our pipeline to new heights. However, the macroenvironment remains challenging with continued increased budget scrutiny, and as a result, we are not expecting to see the typical Q4 budget flush.”

You can read our previous write-up on CrowdStrike’s product including AI-driven automation.

Conclusion:

As redundant as it may sound, we will rely on technicals to manage this position. We tend to rely heavily on fundamentals during pullbacks/selloffs or when the risk/reward is favorable for another leg up in the market. However, we use technicals for risk management when the market appears overextended. There were some weak areas in the report that were canceled out by a few metrics that really matter in terms of a strong foundation, such as operating profitability and accelerating/return to growth in net new ARR. We continue to see CrowdStrike as a strong choice within cybersecurity and this earnings report does not change our view.

You can read the current technical setup here in terms of what we want to see in terms of price levels.current technical setup here in terms of what we want to see in terms of price levels.

Equity Analyst Damien Robbins contributed to this analysis

 Recommended Reading:

• Nvidia Fiscal Q3 Earnings: The China Impact
• 2024 Trend: Memory and PC Rebound
• Big Tech companies continue to invest in AI
• Cloudflare 3Q23 Earnings Summary

The current theme for us within the broad market is caution. It is our belief that we are completing a cyclical bull market within a secular bear market. We are seeing narrow leadership while many unpopular stocks and sectors are now testing their October, 2022, lows. The resiliency of the US economy has kept this market trending up, but we are starting to see some cracks within the employment data, which is typically the last shoe to drop before stocks.

This is one of the primary themes within our Advanced service, which is really tailored to the more active investors. However, at times, we think it is important to share the broad risks with all of our subscribers. Based on our analysis, we believe that a bigger top was either put in in July, or we may have one more push into Q1 2024 before putting in a top. We manage this risk by hedging as well as through raising cash based on our interpretation of the macro economic backdrop and where we are within the business cycle. While we are still net long, we continue to raise cash into strength, and patiently wait for better prices on some choice AI names.

Every Thursday at 4:30 pm Eastern, our Portfolio Manager Knox Ridley holds a webinar for Advanced Signals Members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. Learn more here.here.

Recommended Reading:

• Essentials Key Articles: Three Stock Picks
• Nvidia Fiscal Q3 Earnings: The China Impact
• Big Tech companies continue to invest in AI
• November Positions Report
• Q4 2023 Webinar Highlights

Nvidia’s Fiscal Q3 earnings report was spectacular on all accounts. The data center growth for this quarter was bonkers againbonkers again with growth of 279% year-over-year. The FQ4 guide implies data center growth that will accelerate to roughly 370% next quarter.

Overall revenue beat by $2 billion this quarter for $18.12B in revenue, up 206%. For next quarter, the guide beat by another $2 billion for guidance of $20B compared to $17.9B expected.

EPS of $4.02 compares to $3.39 expected. Gross margin grew to 74% compared to 71.5% expected.

Yet, the stock is down 1.5% after hours. In our pre-earnings write-up that was published this morning in our free newsletter, I had stated: “The topping-out scenario is that Nvidia’s buying is exhausted, and there isn’t one fundamental analyst on earth that can help investors figure out when this will happen.” I explained this is best left to technical analysts as there are many forces which weigh on a stock. It was unlikely Nvidia missed due to the CFO’s visibility on supply, yet the win-win scenario is that we don’t need the market to continue to reward Nvidia. It already has rewarded Nvidia, and if the market is getting tired of Nvidia’s exceptional results, then we will simply take gains and buy again lower.

Essentially, what we are seeing after hours has nothing to do with the company’s financials. When buyers become exhausted, it means a story is well-known. It’s not logical, it’s merely what makes a market.

The flaw in Nvidia’s report is the loss of China revenue. It can be deceiving because demand is so high, that Nvidia will absorb those losses in the upcoming quarter. However, there are implications in the medium-term, which we had also written about in our pre-earnings report.

The long-term thesis is very much intact, which is that Nvidia is on its way to become the world’s most valuable company someday. Data center GPUs are only part of the story. Automotive has the potential to exceed data center GPUs, and there’s also software.

In the near-term, Nvidia investors should keep an eye on the broader semiconductor sector, which looks weak, and there’s a chance the China impact drags on FY2025/FY2026 estimates until we get a new fiscal year guide next quarter. I also touch base on a few positives that are important to keep an eye on.

Revenue and EPS:

Nvidia reported revenue of $18.1B, up 206% Y/Y and well above consensus of $16.1B and above guidance of $16B. However, the magnitude of the revenue beat of 12% was smaller than the 22% beat in the July quarter. Non-GAAP EPS was $4.02, well above consensus of $3.39.

Revenue Segments:

• Data Center revenue of $14.5B, up 279% YoY and up 41% QoQ
• Gaming revenue of $2.9B, up 81% YoY and up 15% QoQ
• Pro Visualization revenue of $416M, up 108% YoY and up 10% QoQ
• Automotive revenue of $261M, up 4% YoY and up 3% QoQ
• OEM & Other Revenue of $73M, flattish YoY and up 11% Q/Q

Nvidia provided revenue guidance of $20B +/- + 2% above consensus of $17.9B with adjusted GM guidance of 75.5% and Non-GAAP Operating Margin guidance of 64.5%.

More on Data Center Segment:

Our pre-earnings report highlighted the release of the H200. Major cloud players such as AWS, Google Cloud, Microsoft Azure, and Oracle cloud will be among the first CSPs to offer H200 inferences starting in Q2 of 2024. The H200 is likely to come with a higher ASP than the H100 due to HBM3e memory. The H100 has an ASP in the $30,000 to $40,000 range. The higher ASP may not contribute to margins necessarily, as HBM3e is costly.

At $40,000 per H100, that equals $29B in H100 sales alone, and when you add the A100 and other data center sales at a current run rate of $15B, the Data Center segment could report total revenue of $44B in FY24 (CY23). When you equal this out across the upcoming quarters, it looks something like this based on our estimates and Piper Sandler estimates.

Nvidia is expected to report approximately $16.5B in revenue for the January quarter. Keybanc has data center revenue at $101 billion for next year. If we assume China is $20 billion of this (and worst case, doesn’t get absorbed) then it will look something like this:

Scenario 1:

Q1 FY25: $18B

Q2 FY25: $19.5B

Q3 FY25: $21B

Q4 FY25: $23B

However, it’s likely the China revenue does get absorbed even if analysts are forced to revise estimates for now. This means that estimates may go down this quarter, and then be revised up again when management discusses the fiscal year guide. If so, it would look more like this:

Scenario 2:

Q1 FY25: $20B

Q2 FY25: $24B

Q3 FY25: $27B

Q4 FY25: $30B

That’s based on Keybanc’s fairly optimistic estimate of over $100B next year in data center revenue. Here are data center revenue numbers that are more conservative from Piper Sandler. Due to the QoQ growth in this model, next quarter’s fiscal year guide is paramount for us Nvidia bulls.

Scenario 3:

My opinion is that Scenario 1 is a safe assumption as it combines continued growth in the data center with some China impact.

Margins:

Gross margin of 74% beat guidance of 71.5%. As stated in our pre-ER write-up, these are historic margins for Nvidia.

The company reported an operating margin of 57.5% for income of $10.4 billion. The adjusted operating margin of 63.8% compares to a margin of 26.4% last quarter.

Net income of $9.2 billion represents a margin of 51% compared to 11.5% net margin in the year ago quarter. This is a combination of data center strength and being at the cyclical trough last year for gaming.

Cash:

Cash flow margins are the best in the Mag 7 at 40.5% operating cash flow this quarter and 38.9% in free cash flow margin. Meta has the second best FCF margin at 34.7% followed by Apple at 29.7%.

Nvidia had $18.3B in cash and marketable securities, up from $16.0B last quarter and debt of $9.7B in-line with the July quarter of $9.7B.

The company utilized cash of $3.91 billion towards shareholder returns, including $3.81 billion in share repurchases and $99 million in cash dividends. Last quarter, an additional $25 billion was authorized for share repurchases.

Earnings Call:

The China Impact:

We had written the following in our pre-earnings report:

“The Red Scare:

What’s not to be forgotten in the excitement of the product road map is China, which has been the predominant risk for semiconductor stocks dating back to 2018. Last year, the government restricted Nvidia from selling its two most powerful chips to China, the A100 and H100. To circumvent these restrictions, Nvidia designed slightly less powerful chips called the A800 and H800. As reported by Reuters, the H800 has as much computing power as the H100 in certain settings. For the United States, these chips are important to block as they strengthen China’s military.

Last month, the U.S. Department of Commerce announced updated rules focuses on computing performance by removing the bandwidth parameter and focusing exclusively on how powerful a chip is, as well as performance density, which will prevent companies from working loopholes. According to an official who spoke to Reuters, “the U.S. will require companies to notify the government about semiconductors whose performance is just below the guidelines before they are shipped to China.” 

Although this is a medium-term issue for Nvidia, analysts believe the demand is high enough today that the company shouldn’t have any issues absorbing the 20% to 25% loss in its data center segment from tighter export restrictions to China. Looking further out for FY2025, Keybanc sees a $5 impact to Nvidia’s $25.62 EPS estimate, and up to a $20B impact to its data center segment with current estimates at $101B for the data center in FY2025.

Eventually, demand may settle – especially as more competitors step up – and investors should pencil-in losing China revenue as a risk that is materializing now, with the revenue impact likely to be felt in FY2025.”

It’s tempting to shrug off the loss of revenue given Nvidia beat/raised next quarter, which is the quarter when 20% to 25% of revenue from China and other restricted countries will be cut off.  However, the Street is likely to be cautious tomorrow because FQ4 will be seen as an outlier where demand can absorb the 20% to 25%. Basically, the outsized demand will be transitory whereas the U.S. Department of Commerce is cutting off 20% to 25% permanently. There was some talk about Nvidia serving these countries with a less powerful chip, but the restrictions are blacklisting Nvidia’s AI chips (specifically) so this workaround won’t be an easy feat.

By the time Nvidia comes up with a workaround, even if it’s acceptable, those countries will have designed their own domestic silicon. Even if this eventually does get absorbed, analysts will likely revised down their estimates for a few quarters out in FY2025 or next fiscal year FY2026. This may, in turn, impact Nvidia’s valuation. Per the CFO: “The export controls will have a negative effect on our China business, and we do not have good visibility into the magnitude of that impact even over the long term.” 

This does not derail Nvidia’s thesis by any means and the timing could not have been better with the restrictions happening during a period of outsized demand. As pointed out on the call, Nvidia will be tapped by many countries that are not blacklisted into the foreseeable future: “National investment in compute capacity is a new economic imperative, and serving the sovereign AI infrastructure market represents a multibillion-dollar opportunity over the next few years.”

InfiniBand up 500% YoY:

We covered InfiniBand a few years back for our premium members. Mellanox was an important acquisition as it helped Nvidia align its architecture with speed by supporting Virtual Protocol Interconnect (VPI), which allows the ubiquitous Ethernet to provide bandwidth as cheap as possible, and InfiniBand to deliver higher throughput and fewer bottlenecks during high loads. Today, this acquisition is paying off.

Per the opening remarks: “Networking now exceeds a $10 billion annualized revenue run-rate. Strong growth was driven by exceptional demand for InfiniBand, which grew fivefold year-on-year […] Azure uses over 29,000 miles of InfiniBand tabling, enough to circle the globe.”

InfiniBand growing five-fold exceeds overall data center revenue given the $15B in total data center revenue last fiscal year is expected to grow 200% to $45 billion at the exit of this fiscal year. Networking revenue tripled and data center compute grew four-fold.

The discussion on the call is that companies are standardizing with InfiniBand as the “computing fabric” increases the effectiveness of AI infrastructure by 20% to 30%. InfiniBand is nearly ubiquitous in supercomputing and is becoming popular with AI/Big Data applications on a large scale for high performance clusters. The benefits of the software defined fabric is that it’s low latency, high bandwidth and low management cost.

Recurring Software Revenue at $1 Billion:

Going off what we know, recuring software revenue may have doubled over the past few quarters CFO had stated: “hundreds of millions of dollars annually” and it’s now being stated the standalone software business will be worth $1 billion next quarter: “We are on track to exit the year at an annualized revenue run-rate of $1 billion for our recurring software support and services offerings.”

Keep an eye on this as it’s likely to be the leading story over the next few years – especially as automotive ramps.

AI Factories:

This was probably the most important question in terms of Nvidia’s growth potential. There’s nothing revelatory being said, per se, but it’s nice to hear some of the bigger picture repeated.

Question: “Because when I just look at the trajectory of your Data Center, it will be close to nearly 30% of all the spending in Data Center next year. So what metrics are you keeping an eye on to inform you that you can continue to grow? Just where are we in the adoption curve of your products into the generative AI market?” -Vivek Arya, Bank of America

Answer: “Generative AI is the largest TAM expansion of software and hardware that we've seen in several decades. At the core of it, what's really exciting is that what was largely a retrieval-based computing approach – almost everything that you do is retrieved off of storage somewhere – has been augmented now, added with a generative method. And its changed almost everything. […]

And one of the areas that is really impactful is the software industry, which is about $1 trillion or so, has been building tools that are manually used over the last couple decades. And now, there's a whole new segment of software called co-pilots and assistants. Instead of manually used, these tools will have co- pilots to help you use it, and so instead of licensing software – we will continue to do that of course, but we will also hire co-pilots and assistants to help us use the software. […]

But there's a new class of data centers, and this new class of data centers, unlike the data centers of the past, where you have a lot of applications running used by a great many people that are different tenants that are using the same infrastructure, and that data center stores a lot of files. These new data centers are very few applications, if not one application, used by basically one tenant, and it processes data. It trains models, and it generates tokens. It generates AI. And we call these new data centers AI factories.”

Translation: If you separate AI from traditional data centers (and where data centers are headed), then Nvidia represents far more than 30%.

Conclusion:

We are tracking TSM, semiconductor indexes, and Nvidia’s chart for signs of exhaustion as outlined here. We are seeking a win-win scenario where we can lock-in gains, and then use that cash to buy Nvidia again at lower levels. As stated, Nvidia’s thesis is firmly intact. Rather, the issue is the market is seeing very narrow leadership and Nvidia is the defacto leader within that narrow leadership. The saying in Wall Street is that pigs get slaughtered. That’s a rough way of saying 200% gains YTD should be approached carefully as the goal is to make real money, not paper money. Of course, 200% will be nothing by the time we are done with this position. But for this year, it’s good enough.

Advanced Signals Members receive real-time trade alerts for our entries and in-depth technical analysis from the Portfolio Manager, Knox Ridley. Learn more here.here.

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• AMD Q2 Earnings: ETA for AI Ramp is Q4 & 2024
• Nvidia Q2 FY24 Earnings: 226% Q3 Data Center Growth is Bonkers

Nvidia’s Fiscal Q3 earnings report was spectacular on all accounts. The data center growth for this quarter was bonkers againbonkers again with growth of 279% year-over-year. The FQ4 guide implies data center growth that will accelerate to roughly 370% next quarter.

Overall revenue beat by $2 billion this quarter for $18.12B in revenue, up 206%. For next quarter, the guide beat by another $2 billion for guidance of $20B compared to $17.9B expected. 

EPS of $4.02 compares to $3.39 expected. Gross margin grew to 74% compared to 71.5% expected.

Yet, the stock is down 1.5% after hours. In our pre-earnings write-up that was published this morning in our free newsletter, I had stated: “The topping-out scenario is that Nvidia’s buying is exhausted, and there isn’t one fundamental analyst on earth that can help investors figure out when this will happen.” I explained this is best left to technical analysts as there are many forces which weigh on a stock. It was unlikely Nvidia missed due to the CFO’s visibility on supply, yet the win-win scenario is that we don’t need the market to continue to reward Nvidia. It already has rewarded Nvidia, and if the market is getting tired of Nvidia’s exceptional results, then we will simply take gains and buy again lower.

Essentially, what we are seeing after hours has nothing to do with the company’s financials. When buyers become exhausted, it means a story is well-known. It’s not logical, it’s merely what makes a market.

The flaw in Nvidia’s report is the loss of China revenue. It can be deceiving because demand is so high, that Nvidia will absorb those losses in the upcoming quarter. However, there are implications in the medium-term, which we had also written about in our pre-earnings report.

The long-term thesis is very much intact, which is that Nvidia is on its way to become the world’s most valuable company someday. Data center GPUs are only part of the story. Automotive has the potential to exceed data center GPUs, and there’s also software which we covered here.

In the near-term, Nvidia investors should keep an eye on the broader semiconductor sector, which looks weak, and there’s a chance the China impact drags on FY2025/FY2026 estimates until we get a new fiscal year guide next quarter. I also touch base on a few positives that are important to keep an eye on.

Revenue and EPS:

Nvidia reported revenue of $18.1B, up 206% Y/Y and well above consensus of $16.1B and above guidance of $16B. However, the magnitude of the revenue beat of 12% was smaller than the 22% beat in the July quarter. Non-GAAP EPS was $4.02, well above consensus of $3.39.

Revenue Segments:

• Data Center revenue of $14.5B, up 279% YoY and up 41% QoQ
• Gaming revenue of $2.9B, up 81% YoY and up 15% QoQ
• Pro Visualization revenue of $416M, up 108% YoY and up 10% QoQ
• Automotive revenue of $261M, up 4% YoY and up 3% QoQ
• OEM & Other Revenue of $73M, flattish YoY and up 11% Q/Q

Nvidia provided revenue guidance of $20B +/- + 2% above consensus of $17.9B with adjusted GM guidance of 75.5% and Non-GAAP Operating Margin guidance of 64.5%.

More on Data Center Segment:

Our pre-earnings report highlighted the release of the H200. Major cloud players such as AWS, Google Cloud, Microsoft Azure, and Oracle cloud will be among the first CSPs to offer H200 inferences starting in Q2 of 2024. The H200 is likely to come with a higher ASP than the H100 due to HBM3e memory. The H100 has an ASP in the $30,000 to $40,000 range. The higher ASP may not contribute to margins necessarily, as HBM3e is costly.

At $40,000 per H100, that equals $29B in H100 sales alone, and when you add the A100 and other data center sales at a current run rate of $15B, the Data Center segment could report total revenue of $44B in FY24 (CY23). When you equal this out across the upcoming quarters, it looks something like this based on our estimates and Piper Sandler estimates.

Nvidia is expected to report approximately $16.5B in revenue for the January quarter. Keybanc has data center revenue at $101 billion for next year. If we assume China is $20 billion of this (and worst case, doesn’t get absorbed) then it will look something like this:

Scenario 1:

Q1 FY25: $18B

Q2 FY25: $19.5B

Q3 FY25: $21B

Q4 FY25: $23B

However, it’s likely the China revenue does get absorbed even if analysts are forced to revise estimates for now. This means that estimates may go down this quarter, and then be revised up again when management discusses the fiscal year guide. If so, it would look more like this:

Scenario 2:

Q1 FY25: $20B

Q2 FY25: $24B

Q3 FY25: $27B

Q4 FY25: $30B

That’s based on Keybanc’s fairly optimistic estimate of over $100B next year in data center revenue. Here are data center revenue numbers that are more conservative from Piper Sandler. Due to the QoQ growth in this model, next quarter’s fiscal year guide is paramount for us Nvidia bulls.

Scenario 3:

My opinion is that Scenario 1 is a safe assumption as it combines continued growth in the data center with some China impact.

Margins:

Gross margin of 74% beat guidance of 71.5%. As stated in our pre-ER write-up, these are historic margins for Nvidia.

The company reported an operating margin of 57.5% for income of $10.4 billion. The adjusted operating margin of 63.8% compares to a margin of 26.4% last quarter.

Net income of $9.2 billion represents a margin of 51% compared to 11.5% net margin in the year ago quarter. This is a combination of data center strength and being at the cyclical trough last year for gaming.

Cash:

Cash flow margins are the best in the Mag 7 at 40.5% operating cash flow this quarter and 38.9% in free cash flow margin. Meta has the second best FCF margin at 34.7% followed by Apple at 29.7%.

Nvidia had $18.3B in cash and marketable securities, up from $16.0B last quarter and debt of $9.7B in-line with the July quarter of $9.7B.

The company utilized cash of $3.91 billion towards shareholder returns, including $3.81 billion in share repurchases and $99 million in cash dividends. Last quarter, an additional $25 billion was authorized for share repurchases.

Earnings Call:

The China Impact:

We had written the following in our pre-earnings report:

“The Red Scare:

What’s not to be forgotten in the excitement of the product road map is China, which has been the predominant risk for semiconductor stocks dating back to 2018. Last year, the government restricted Nvidia from selling its two most powerful chips to China, the A100 and H100. To circumvent these restrictions, Nvidia designed slightly less powerful chips called the A800 and H800. As reported by Reuters, the H800 has as much computing power as the H100 in certain settings. For the United States, these chips are important to block as they strengthen China’s military.

Last month, the U.S. Department of Commerce announced updated rules focuses on computing performance by removing the bandwidth parameter and focusing exclusively on how powerful a chip is, as well as performance density, which will prevent companies from working loopholes. According to an official who spoke to Reuters, “the U.S. will require companies to notify the government about semiconductors whose performance is just below the guidelines before they are shipped to China.”

Although this is a medium-term issue for Nvidia, analysts believe the demand is high enough today that the company shouldn’t have any issues absorbing the 20% to 25% loss in its data center segment from tighter export restrictions to China. Looking further out for FY2025, Keybanc sees a $5 impact to Nvidia’s $25.62 EPS estimate, and up to a $20B impact to its data center segment with current estimates at $101B for the data center in FY2025.

Eventually, demand may settle – especially as more competitors step up – and investors should pencil-in losing China revenue as a risk that is materializing now, with the revenue impact likely to be felt in FY2025.”

It’s tempting to shrug off the loss of revenue given Nvidia beat/raised next quarter, which is the quarter when 20% to 25% of revenue from China and other restricted countries will be cut off.  However, the Street is likely to be cautious tomorrow because FQ4 will be seen as an outlier where demand can absorb the 20% to 25%. Basically, the outsized demand will be transitory whereas the U.S. Department of Commerce is cutting off 20% to 25% permanently. There was some talk about Nvidia serving these countries with a less powerful chip, but the restrictions are blacklisting Nvidia’s AI chips (specifically) so this workaround won’t be an easy feat.

By the time Nvidia comes up with a workaround, even if it’s acceptable, those countries will have designed their own domestic silicon. Even if this eventually does get absorbed, analysts will likely revised down their estimates for a few quarters out in FY2025 or next fiscal year FY2026. This may, in turn, impact Nvidia’s valuation. Per the CFO: “The export controls will have a negative effect on our China business, and we do not have good visibility into the magnitude of that impact even over the long term.”

This does not derail Nvidia’s thesis by any means and the timing could not have been better with the restrictions happening during a period of outsized demand. As pointed out on the call, Nvidia will be tapped by many countries that are not blacklisted into the foreseeable future: “National investment in compute capacity is a new economic imperative, and serving the sovereign AI infrastructure market represents a multibillion-dollar opportunity over the next few years.”

InfiniBand up 500% YoY:

We covered InfiniBand a few years back when our site covered the Mellanox acquisition. Mellanox was an important acquisition as it helped Nvidia align its architecture with speed by supporting Virtual Protocol Interconnect (VPI), which allows the ubiquitous Ethernet to provide bandwidth as cheap as possible, and InfiniBand to deliver higher throughput and fewer bottlenecks during high loads. Today, this acquisition is paying off.

Per the opening remarks: “Networking now exceeds a $10 billion annualized revenue run-rate. Strong growth was driven by exceptional demand for InfiniBand, which grew fivefold year-on-year […] Azure uses over 29,000 miles of InfiniBand tabling, enough to circle the globe.”

InfiniBand growing five-fold exceeds overall data center revenue given the $15B in total data center revenue last fiscal year is expected to grow 200% to $45 billion at the exit of this fiscal year. Networking revenue tripled and data center compute grew four-fold.

The discussion on the call is that companies are standardizing with InfiniBand as the “computing fabric” increases the effectiveness of AI infrastructure by 20% to 30%. InfiniBand is nearly ubiquitous in supercomputing and is becoming popular with AI/Big Data applications on a large scale for high performance clusters. The benefits of the software defined fabric is that it’s low latency, high bandwidth and low management cost.

Recurring Software Revenue at $1 Billion:

Going off what we know, recuring software revenue may have doubled over the past few quarters CFO had stated: “hundreds of millions of dollars annually” and it’s now being stated the standalone software business will be worth $1 billion next quarter: “We are on track to exit the year at an annualized revenue run-rate of $1 billion for our recurring software support and services offerings.”

Keep an eye on this as it’s likely to be the leading story over the next few years – especially as automotive ramps.

AI Factories:

This was probably the most important question in terms of Nvidia’s growth potential. There’s nothing revelatory being said, per se, but it’s nice to hear some of the bigger picture repeated.

Question: “Because when I just look at the trajectory of your Data Center, it will be close to nearly 30% of all the spending in Data Center next year. So what metrics are you keeping an eye on to inform you that you can continue to grow? Just where are we in the adoption curve of your products into the generative AI market?” -Vivek Arya, Bank of America

Answer: “Generative AI is the largest TAM expansion of software and hardware that we've seen in several decades. At the core of it, what's really exciting is that what was largely a retrieval-based computing approach – almost everything that you do is retrieved off of storage somewhere – has been augmented now, added with a generative method. And its changed almost everything. […]

And one of the areas that is really impactful is the software industry, which is about $1 trillion or so, has been building tools that are manually used over the last couple decades. And now, there's a whole new segment of software called co-pilots and assistants. Instead of manually used, these tools will have co- pilots to help you use it, and so instead of licensing software – we will continue to do that of course, but we will also hire co-pilots and assistants to help us use the software. […]

But there's a new class of data centers, and this new class of data centers, unlike the data centers of the past, where you have a lot of applications running used by a great many people that are different tenants that are using the same infrastructure, and that data center stores a lot of files. These new data centers are very few applications, if not one application, used by basically one tenant, and it processes data. It trains models, and it generates tokens. It generates AI. And we call these new data centers AI factories.”

Translation: If you separate AI from traditional data centers (and where data centers are headed), then Nvidia represents far more than 30%.

Conclusion:

We are tracking TSM, semiconductor indexes, and Nvidia’s chart for signs of exhaustion as outlined here. We are seeking a win-win scenario where we can lock-in gains, and then use that cash to buy Nvidia again at lower levels. As stated, Nvidia’s thesis is firmly intact. Rather, the issue is the market is seeing very narrow leadership and Nvidia is the defacto leader within that narrow leadership. The saying in Wall Street is that pigs get slaughtered. That’s a rough way of saying 200% gains YTD should be approached carefully as the goal is to make real money, not paper money. Of course, 200% will be nothing by the time we are done with this position. But for this year, it’s good enough. 

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