China’s 2001 entry into the WTO marked the beginning of the golden age of globalization. This was the catalyst that led to the global outsourcing of domestic manufacturing capacity to lower costs regions in the world. As a result, world economies became more interlinked. In 2016, President Trump began his administration by imposing tariffs on China, one of the United States’ largest trading partners. This signaled globalization’s peak and the beginning of a shift downward. This shift has continued with the Biden administration and the passing of the Bipartisan Infrastructure Law (BIL) ($550B) and the CHIPS and Science Act ($53B). The legislative goal is to improve US economic competitive, innovation, and industrial productivity.

On August 16, 2022, Biden signed the Inflation Reduction Act (IRA). It directs new federal spending toward reducing carbon emissions, lowering healthcare costs, funding the IRS and improving taxpayer compliance. The IRA’s primary objective is to spur investments in US domestic manufacturing capacity. This most recent legislative action is another step toward the “Made in America” goal and increasing manufacturing national security. We have written about it and its key provisions here and here.

Here in Part One, we’ll go into more detail on the key characteristics of the IRA and the earnings impact by examining one company – First Solar (FSLR). Next week, in Part Two, we’ll discuss other companies that may benefit.

What is the IRA?

Based on an analysis by Mckinsey and Company , the IRA directs nearly $400B in federal funding to clean energy, with the goal of substantially lowering the US’s carbon emission by the end of this decade. The funds will be dispersed via a mix of tax incentives, grants and loan guarantees. Clean electricity and transmission will receive the highest funding, followed by clean transportation, including electric-vehicle (EV) incentives.

In the past, the US has generally relied on imports for solar equipment. This law will encourage more production at home with incentives for domestic solar panels and inverter manufacturing. It is also designed to support the construction of renewable electricity plats.

Who benefits from it the most?

The majority of the $394B in energy and climate funding will be in the form of tax credits. Corporations with US manufacturing capacity are the biggest beneficiaries with an estimated $216 billion worth of tax credits available. The tax credits are meant to provide an incentive for private domestic investment in clean energy, transport and manufacturing. Many of the tax incentives are direct pay, meaning they can claim their credit in that tax year and be paid the following year.

In addition to higher energy prices, the IRA’s corporate tax incentive has contributed to the Solar sector’s outperformance. 

How does this impact earnings?

The IRA has created a tailwind for the clean energy sector. Companies are now just beginning to discuss the potential earnings impact in their most recent Q4 commentary. Some have provided more details than others.

From an investment perspective, the key is to identify companies with US based manufacturing capacity that can collect these tax credits and whose earnings will benefit in a meaningful way.

We’ve identified First Solar (FSLR) as one of the biggest beneficiaries of the IRA. Due in no part to the fact that they have provided the most visibility as to how the IRA will impact their earnings. In doing so, they have provided a useful investment framework to assess how other companies may benefit. We will discuss this next week and cover Enphase and Tesla, just to name a few.

We also want to emphasize that tech will see very few tailwinds this year, so it makes sense to take our time and to drill deep into one tailwind we have identified.

How does the IRA Tax Credit (IRATC) work?

This is how First Solar described how the IRATC will work. 

“And finally, a few words on the Inflation Reduction Act. The IRA offers, amongst other incentives, production tax credits for solar modules and solar module components manufactured in the U.S. and sold to third parties. Although we continue to await guidance from the IRS and Treasury regarding these credits under Section 45X of the statute, based on our view of both the intention of the credit and the language of the legislation, we intend to begin recording a corresponding benefit in our financial statements in Q1 of 2023. Following consultation review with outside advisers, our auditors and the SEC, we expect to recognize these credits as a reduction to cost of sales in the period such modules and the integrated eligible components are sold to customers.”

In their 2023 guidance, they went on to say

“I’ll now cover the full year 2023 guidance ranges. Our net sales guidance is between $3.4 billion and $3.6 billion; gross margin is expected to be between $1.2 billion and $1.3 billion, which includes $660 million to $710 million of advanced manufacturing production tax credits under Section 45X of the IRA; and $110 million to $130 million of ramp and underutilization costs.

This results in a full year 2023 earnings per diluted share guidance range of $7 to $8”

FSLR’s guidance provides insight on the impact of the IRATC. To simplify the analysis, we’ve taken the mid-point and excluded the ramp-up related costs.

In the case of First Solar, the IRATC has a significant impact on profitability – gross margins double. Another way to look at it is that in addition to the estimated 2023 average sales price of $0.29 per watt, First Solar will receive $0.17 per watt in the form of the IRATC.  This is how FSLR breaks down the IRATC:

“Given our fully integrated thin film manufacturing process, we expect that this guidance will entitle us to integrated tax credits for wafers, cells and module assembly, which we estimate will equal approximately $0.17 per watt for modules produced in the United States and sold to a third-party.”

First Solar has been advised to treat the IRCTC as a reduction in costs of sales. As a result, it’s important to focus on their growth in earnings per share. Assuming other companies adopt the same reporting standard, the same investment parameters will apply.

Consensus earnings are expected to increase 80% from 2023 to 2024. Comparing it to 2022 is not an apples-to-apples comparison as there was no IRCTC benefit in 2022 while gross margins were impacted by higher-than-expected logistic related costs. There were mainly penalty costs related to exceeding dock waiting times due to Covid supply-chain issues. FSLR has indicated that these and other costs will trend back down toward pre-pandemic levels over the course of the year.

Not every company will capture a similar level of profitability uplift. Generally speaking, those with higher domestic content can claim more of the IRATC. Companies will seek to capture as much of the IRATC as possible. And from an investment perspective, companies that have existing domestic capacity and can claim the IRATC in 2023 will be the stocks that benefit the most in the short-term.

FSLR provided insights on domestic capacity expansion as it relates to collecting the IRATC.

“… we believe that the intent of IRA is to create enduring long-term supply chains, which would therefore motivate and align the incentives to true manufacturing in the U.S., more than just final module assembly with all the build material being sourced from international locations.

And if everything lines up along those lines, then that sort of helps inform our view there as it relates to the inherent value of more domestic manufacturing, plus we want to make sure that, while we believe we're fully entitled to the vertically integrated manufacturing tax credit, to the extent that we can get confirmation through guidance from IRS and Treasury, that would be very beneficial as we think about factory expansion.”

The key word is “vertically integrated”. The more that a company’s US based manufacturing is vertically integrated, the more of the IRATC it can claim 

Making of a National Champion

We’ll now take a closer look at FSLR and examine how they will benefit. But first let’s see how FLSR spoke about IRA after it was signed into legislation. This is what FSLR said in their Q322 call.

“I would like to discuss the U.S. policy environment, which has evolved significantly over the past quarter. As you may recall, the joint announcement from Senators Manchin and Schumer regarding the Inflation Reduction Act preceded in our last earnings call by just 1 day. Since then, we have seen the Act signed into law and First Solar had the privilege to be part of the White House event in September, celebrating the groundbreaking piece of legislation.

In our view, by passing and enacting the Inflation Reduction Act of 2022, Congress and the Biden-Harris administration has entrusted our industry with responsibility of enabling and securing America's clean energy future, and we recognize the need to meet the moment in a manner that is both timely and sustainable. Thanks to our strong foundation, including a repeatable, vertically integrated manufacturing template, proven technology platform and solid balance sheet, we were able to respond rapidly to enact — to act by accelerating the decision to expand our U.S. manufacturing base.”

“Broadly speaking, 2022 placed us on the cusp of significant growth in domestic solar manufacturing within our core markets.”

It goes without saying that IRA is an important piece of legislature. First Solar is positioning themselves as one of the National Champions to help IRA’s implementation. As we’ve seen internationally, National Champions typically get to provide input into and receive beneficial treatment from the government and other regulatory bodies. We believe the amount of IRATC visibility that FSLR has provided, in contrast to others thus far, is a reflection of that.

What does FLSR do?

FSLR manufactures solar modules based on thin film Cadmium Telluride (CadTel) photovoltaic (PV) technology demonstrated to have lower cost, superior scalability, and a higher theoretical efficiency limit over conventional technologies, like crystalline silicon (c-Si). Solar module sales represented 93% of total sales and the majority of sales were to developers and operators of systems in the United States. A few of its largest customers include Intersect Power, Lightsource BP, and NextEra Energy. FSLR will benefit as their clients have an incentive to build out their own capacity to capture the IRATC. This is how FSLR described the IRATC opportunity for its customers.

“The opportunity for everyone, whether you're the developer or whether you're the module manufacturer or whether you're the IPP or the utility who's going to own the generating asset over time, there's opportunity for everybody.”

“And so the question is, do you want to sort of secure your business plan and take risk off the table? And if you're willing to do that and do that at a fair price, then First Solar is a great option to do that. If you're trying to take some risk and you're wanting to find opportunities to avail yourself to potentially alternative supplies that maybe will still allow you to benefit to the maximum potential under IRA, then that's a risk that some may want to take and wait. But what we see right now is that we've got more than enough opportunity to engage. Yes, it's an item that is in some of our customers' thought process. But for the most part, most people aren't paying a lot of attention to it in that regard.”

Where does FSLR manufacture?

Currently, the US is 36% of their 9.8 GW manufacturing capacity. By 2024, this will expand to 50%. Total manufacturing capacity is estimated to reach 21.4 GW by 2026. FLSR will also benefit from India’s Incentive Production Scheme to encourage domestic based solar manufacturing. 

Is there demand to this utilize this increase in capacity?

Below is the amount of GW has booked through 2/28/23. FSLR has booked 67.7 GW of future deliveries. Clients typically put up to 20% down payment to secure that order – the contracted backlog is 61.4 GW.

Q422 Investor Presentation

Regarding the contracted backlog, FSLR stated the following

“We had a total contracted backlog of 61.4 gigawatts with expected future revenue of $17.7 billion for a portfolio average base ASP of $0.288 per watt, before the application of potential adjusters”

Put another way, their contracted backlog is 6x their current manufacturing capacity. This is a product of FSLR’s customers preparing to build their capacity to capture the IRATC. This type of secular demand provides FSLR great visibility on future sales and pricing power. FSLR is sold out through 2025 (excluding India). FSLR’s focus is negotiating solely for 2026 volume and working with customers who are looking to secure multiyear contracts over the remainder of the decade. This is how FLSR described the current demand environment:

“We also began the year with a record contracted backlog, a significant pipeline of bookings opportunity and a robust demand in our core markets. This momentum is driven by our points of differentiation, including a unique CadTel technology, vertically integrated manufacturing process, domestic production, strong balance sheet and commitment to responsible solar, placing us in a position to respond to emerging opportunities, particularly those enabled by the rapidly evolving policy environment. 

“After accounting for shipments of approximately 2.3 gigawatts during the fourth quarter, our future expected shipments, which now extend into 2029, are 67.7 gigawatts. Excluding India, and including our year-to-date bookings, we are sold out through 2025. We have, in recent months, pivoted from negotiating solely for 2026 volume to work with customers who are looking to secure multiyear contracts over the remainder of the decade.

From a commercial perspective, in 2022, we saw a precipitous shift towards long-term, multiyear module procurement. This record volume of multi-gigawatt deals spanning multiple years was driven by a combination of competitive pricing, competitive technology, agile contracting, shared values and trust in our ability to deliver the certainty that our customers are looking for. As a result, we had an excellent year from a bookings perspective, securing a record 48.3 gigawatts of net bookings in 2022. This was an increase of 30.8 gigawatts from our prior annual record of 17.5 gigawatts set in 2021. Our total backlog of future deliveries as of today's earnings call now stands at a record 67.7 gigawatts.”

“As it relates to converting the pipeline into future bookings, our record bookings in 2022 were driven by the favorable balance of near to mid-term available supply, aligned with customer demand for large volume multi-year procurement.”

“Our commercial strategy remains largely focused on supporting long-term multi-year customers who prioritize price and product availability certainty as well as ethical and transparent supply chains.”

This is how FSLR described the positive impact on profitability as they expand capacity to meet demand.

“I’d like to reiterate our approach to growth and gross margin expansion … this strategy includes our approach of contracting out our capacity several years in advance of production. The anticipated reduction of our cost per watt produced, the expected benefits from capacity expansion through scaling a largely fixed overhead structure in order to generate incremental contribution margin and our agile contracting approach would both provides the potential realization of incremental revenue and is expected to mitigate freight and certain commodity risks.”

Assuming, a return to pre-pandemic costs inputs levels (raw materials + logistics), the key drivers of earnings will be FSLR meeting GW expansion targets, ASP per watt and the IRATC combined with positive operating leverage. US pricing in particular may benefit from positive price adjusters that they can charge their customers based on the IRATC.

Can FSLR fund this?

One of FSLR’s competitive advantages is their financial position. Clients know that they are a financially stable partner. FSLR will not require external financing. 

“Operationally, in 2023, we’re expecting to produce 11.5 to 12.2 gigawatts of modules, and after taking into account reductions in inventory, fell 11.8 to 12.3 gigawatts. From a capital structure perspective, our strong balance sheet has been and remains a strategic differentiator, enabling us both to weather periods of volatility as well as providing flexibility to pursue growth opportunities including self-funding our Series 6 and Series 7 transitions.”

“We ended 2022 in a strong liquidity position. And coupled with strong forecasted operating cash flows, modular advance payments and our existing India credit facility, we expect to be able to finance our current capital programs without acquiring external financing. We are evaluating putting in place our revolving credit facility to support jurisdictional cash management as well as to provide short-term optionality and expect to address more details on our capital structure and liquidity outlook at our Analyst Day.”

Sales vs EPS

Given the accounting treatment of the IRATC, it is important to identify companies whose earnings will benefit from the IRATC. Sales will still be important, but it won’t capture the IRATC benefits. Here’s a consensus snapshot of FSLR’s EPS and Sales. 

Sales are still growing at a healthy rate due to capacity expansion while earnings are forecasted to grow at more than 2x that rate because of the IRATC. Recall that 2022 had no IRATC benefits and gross margins were severely impacted by logistic costs.

“Note from an earnings cadence perspective, we anticipate our earnings profile will be higher in the second half of the year, both due to contractual delivery schedules as well as the timing of first sales of our Series 7 products, which are forecast to begin shipping in Q3 of this year. This is forecasted to result in an increase in inventory at our distribution centers in the first half of 2023, which is expected to reverse in the second half of the year. Additionally, Section 45X credits, recognized, will increase after Q1, driven by both the timing of volumes sold as well as the inventory lag, whereby products sold in the early part of 2023 may have been manufactured in 2022.”

Given the recent rally after Q4, this timing effect may provide an opportunity to enter at lower levels.

How does valuation look?

Even after the recent rally, FSLR’s valuation is not demanding based on 2024 eps. Using 2024 EPS, price and multiple sensitivity indicates the valuation potential is between $275-325. We won’t start using 2025 EPS just yet. 

How do the technicals look?

We aren’t the first to appreciate the FSLR investment case. However, as long-term investors we believe this case will play out over several years and the market will provide us better entry points.

Per Knox:

FSLR is completing a symmetrical 3 wave uptrend. Note how the length of the second push higher (C wave) is nearly identical the in percentage gains from the first push higher (A wave).

The $235 region will be the exact symmetrical target for this move, and it is pushing towards this important resistance zone on weaker momentum. We will be looking for some kind of pullback from this region.

For those looking for a riskier buy, I’d look for the $175-$145 region, if we get there. The safest place to buy is if/when it can breakout above the $235 region. 

Conclusion

The Inflation Reduction Act is an important piece of legislature. Winners will emerge as a result. We’ve identified FSLR as a winner over the next few years.

In Part 2, we will apply the same IRATC investment framework to assess how other companies are positioned. As a sneak peak, Enphase has indicated they will capture a portion of the IRATC benefits but more likely toward the end of 2023 into 2024. Look for a follow up next week or so.

I/O Fund analyst team contributed to this article

Given Nvidia’s recent rally after it’s Q4FY23 results, we’d thought it be helpful to provide a fundamental and technical view, as well as a brief follow up on the other two stocks we have discussed within this service – AMD, NFLX. Both of which are positioned to capture market share from their competitors. We wrote about it  here,  here,  here and here.

As long-term investors, we firmly believe holding quality companies for at least 3 years is crucial. However, as you will see, there are times to buy, and times to take some gains. Last week we discussed why we are cautious right now based on our overall technical and macro view of the markets.

In summary, my current market outlook for 2023 has devolved since the start of the year. I have grown more bearish as time has progressed and remain rather cautious. Prompted by technical indicators that point to lower market index levels as the Fed’s fight against “supercore inflation”  has proved to be difficult. Previously, I wrote about my concerns over the US consumer here.

I think that the market will provide me an opportunity to buy Nvidia, AMD and NFLX at lower levels. 

First let’s take a look back at Nvidia. Below is a chart showing the buys and sells I’ve communicated to readers on a real time basis, which are moves we made in real-time. This is an example of how we actively manage a high quality position to help mitigate risk and boost returns. For reference, the percentage buys/sells are in reference to our portfolio value.

Fundamentally, we have written about the potential of AI in the past and potential beneficiaries of this secular trend. We identified Nvidia as a winner given its product offering and market position. The announcement of its H100 GPU in March 2022 to be available in 2h22 was a gamechanger. We wrote about that here.

However, in 2022 its cyclical gaming business was a significant earnings headwind. Nvidia Q3FY23 missed expectations mainly due to China related inventory write-downs, higher compensation expenses and excess inventory in the gaming channels. However, Nvidia’s gross margin guidance for Q4 suggested that the first two were isolated to Q3 and stated that gaming related inventory would be worked down in Q4. Importantly, H100 was gaining acceptance faster than expected. We wrote about it here. We bought shares the first trading day after the earnings release. 

As we entered 2023, we assessed Big Tech’s capex plans and all pointed to the prioritization of AI related capex. This gave us further confidence that Nvidia was well positioned, regardless of the macro headwinds.

Nvidia recently announced Q4FY23 and full year earnings. Gross margins improved sequentially, earnings beat expectations and the Q1FY24 revenue guidance was better than consensus. Gaming showed sequential growth and the inventory situation was no longer an issue. Clear signs that earnings had bottomed in Q3. Critically, management guided to sequential growth in all 4 of its businesses and talked about the benefits of AI related demand on the company. Pointing to their March GTC conference as a key event where they will update investors.

Fundamentally, we continue to like Nvidia. Technically, after its recent rally we would wait and look for better entry points.

Regarding the technicals, we are seeing a 3 wave uptrend, which is a warning. It’s pushing higher on weakening momentum (divergence). So, big warning. I do believe that we could see one more, push we believe the time to buy is not now. Our buy zone is in green, and we must hold $138 on any drawdown, or the odds start shifting towards us seeing a fresh low.

Taking a look at AMD and NFLX.

AMD (hold)

We are seeing the same symmetrical 3 wave pattern off the October low. I can see AMD making one more run higher, but it should not be bought. I believe AMD will retest the lows in the coming months, which will set up a great buying opportunity. (hold/trim)

NFLX (hold) 

Like NVDA, I believe THE low is in. However, like most stocks, the time to buy is not at these levels, unless one plans to be nimble. I do believe NFLX could set up for one more push to new highs, but after that it is due for a large retrace. We expect lower prices as we move into 2023, which will set up a great buying opportunity.

Conclusion

Given the macro backdrop, Winners and Losers will emerge within the technology sector. From a fundamental stock perspective, the team has been focusing on companies exposed to secular rather than cyclical growth with strong competitive moats.

Recent commentary from Big Tech indicates a prioritization of  AI related infrastructure capex through 2023 and beyond. We continue to look for companies benefiting from AI or other themes that can withstand these macro headwinds. I believe Nvidia will emerge as a winner.

Meanwhile, AMD and NFLX are well positioned to capture market share from their competitors.

I believe that the market will provide us with better entry points in all three.

Regarding the charts below, the vertical tan shades represent time factors. These are inflection points where we have high odds of something significant happening. More times than not, (3/4 of the time), they mark a turning point in the trend. So, what matters is the direction we are trending into these periods. Regarding the vertical lines, black lines represent strong support/resistance, while dark red lines mark very strong support/resistance.

Elliott Wave count are meant to provide context. 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

Broad Market

Last week we saw the market in extreme oversold conditions. As a result, we were expecting a short covering rally to target 4040 SPX, which is what we saw. However, what we were not expecting was a 125 point rally in two days that exceeded our target. Furthermore, the structure of the rally is a rather clean 5 wave move, which has added an interesting layer of complication into where this market can go.

As a result, I’m adding an alternative scenario to the larger picture, which we will start game planning for in this report. Before I dive into these scenarios, I want to be clear. Short of the FED starting a new liquidity cycle, which I see very unlikely considering the inflation data, coupled with the bullish posture in various food/energy commodities, I simply do not see the necessary support needed for a new multi-year bull market playing out. Long-term risk (6 months+), we are still quite defensive and will remain this way until new data changes this view. However, intermediate term risk (1-3 months) is quite different. There is now a potential +300 point move that could play out over the coming weeks-months, which we will likely position for, if confirmed.

– Primary (Blue) – we have either topped or are within 200 points away from topping. This will lead to a fresh leg in the bear market with a downward target towards SPX 3000.

– Alternative (Red) – We have just completed the 2nd leg within a larger B wave (bear market rally). This will lead to the final 3rd leg of the bear market rally, which is targeting +4400 SPX.

If we zoom into the structure of the bounce off the October 13th low, you can see on multiple time frames 3 wave moves in all directions. We assumed that the January rally was the C wave, which appeared to collapse into a weak diagonal pattern. However, the 5 wave rally off of last week’s low has opened the door to this alternative scenario potentially playing out. Over the next 2 weeks, I expect one of the 3 scenarios below to be confirmed. This wil define the intermediate-term risk. What will matter most of all will be HOW the market retraces in the coming days – 3 waves down or 5 waves?

If we retrace in 5 waves down, and take out last week’s low, then either blue or green is playing out.

– Blue – we have topped, and will continue to trend down until the selling pressure gives way to a strong trend.

– Green – we bottom before breaking below 3765, then turn back up in a 5 wave pattern. This will imply that we are going to the 4200 region before a bigger top triggers.

If we retrace in 3 waves down, then red will start moving into position.

– Red – The overlapping mess of a market we have experienced since the December top has been part of a very complex B wave pattern. B waves (and 4th waves) are treacherous, as they tend to whipsaw emotions, grind down investment plans and wear down investors. We typically do not see B waves take such a complicated form, but considering that sentiment is in the basement, as well as the resilient credit cycle in the economy (more below), this scenario should be taken seriously.

Let’s zoom in a little more to a 15 minute chart. This will help us set up parameters and expectations for the week.

Note how the 5 wave move off the low started from a slightly lower low than the previous drop. This could easily be an expanded flat correction, which would support the blue/green above. However, because it started from a fresh low, we have to consider red, and the potential for a large push higher before we see a bigger top.

We topped today right into our minor time factor (6-7). We were trending up into it, and so far, the drop is only 3 waves. This can easily morph into a 4th and 5th down, which should be settled tomorrow/Wednesday. If this 3 wave pullback holds, and we push to make another high, the red count will then become my primary, as we set up a buying plan for the following 2ndwave pullback.

Our Updated Game Plan

We currently have about 30% cash and are 100% hedged. If we see this 3 wave drop hold, we will look to remove some of our hedge for a gain. Also, if the odds start favoring the red count, we will look to deploy some of our cash. As of now, ~ 2.5% in NFLX, ~ 2.5% in TSLA, 1.5% in ENPH, and ~10% in QLD once we close our hedge, and the rest in cash. For long-term investors who do not want to be this nimble, nothing has changed. Whether we see a top already in, or one that happens within the next +300 points, we believe that this bear market is not over. This will remain our outlook until we see evidence to the contrary.

Macro

The Liquidity Cycle

The phrase, “wall of worry,” continues to get thrown around in 2023. The new bull market, like all bull markets, is climbing a wall of worry. This phrase was golden in the last 12 year bull cycle, as stocks shrugged off countless events that pundits were certain would end it all – Downgrading US debt, Brexit, Grexit, Global Slowdown, China Collapse (1 and 2), Taper Tantrum, The 2016 Presidential Election, COVID, etc. Nothing serious manifested, as all drops were quickly brought back to new highs, leaving bears in the dust.

However, the one common thread within all of these events that allowed for equities to shrug off the news and continue higher was that we were either in the expansive part of a liquidity cycle (2011, 2015-2016), or the FED started a fresh liquidity cycle (2019, 2020), which saved equities.

How important is the liquidity cycle for stocks? After the COVID collapse, we saw some of the most abysmal economic data on record. Literally, high frequency data was off the chart, and appeared to only be getting worse as we entered a recession. In response, the FOMC started one of the most aggressive liquidity cycles on record. In 2020, stocks went on to have a record year, while economic data continued to shock investors. Without a new liquidity cycle, I simply do not see a new bull market starting up, which is why this is so important to track.

The below chart compares liquidity to the S&P 500 over the last 15 years. When liquidity is being pumped into the economy, stocks are able to shrug off terrible events, even contractions within the economy. On the other hand, when liquidity is being drained, we tend to go through periods of volatility – 2018-2020, 2022-present – until a new liquidity cycle starts back up.

The Credit Cycle

Recessions happen when banks shut the credit window. As the FED increases rates to slow inflation, the cost to buy homes, cars, business expansions, remodels, etc. all go up as well. This is why manufacturing sees a relatively quick reaction to rate increases. Like dominoes, layoffs lead to less spending, which leads to more layoffs. Banks increase their standards for loans, making it more difficult for struggling businesses and consumers to stay afloat. This eventually gives way to a recession, which destroys inflation, allowing the FED to lower rates. We then start a new credit cycle.

The question we have to address today is – how close are we to a recession? Manufacturing is clearly in a deep contraction and has been for several months. However, 85% of our GDP comes from Non-Manufacturing (Services). Unlike Manufacturing, this segment of the economy is continuing to expand.

If we dive down into Non-Manufacturing reading from last week, it did tick down to 55.1, beating the consensus expectation of 54.5 (any reading above 50 marks expansion, while below 50 marks contraction). New orders, which measures future demand, increased to 62.6 from 60.4 a month prior. Within the report, inflation concerns continued to be the predominate theme. This can be seen clearly in the prices index, which ticked down to 65.6. This is clearly off the peak, but still very elevated.

A basic metric that I use is measuring the trend in ISM numbers to their 12 month exponential average (in blue below). The below chart blends the ISM number along with the new orders number. Note how Services is back above this moving average for the first time since later 2021. This is great news for those worried about an imminent recession, as the credit cycle appears to be more resilient than most expect.

This is not only a US story, as recent global PMIs show the exact same scenarios playing out. All major countries are showing a contraction in manufacturing; however, the only major country that is showing a contraction in services is in Brazil. In other words, the likelihood of a H12023 global recession is unlikely. Why this matters for equities is because equities tend to bottom while in the middle of a recession. This further supports the red or green counts from above.

Why This Time is Different

The credit cycle is ready to extend, while the liquidity cycle continues to contract. Without the liquidity cycle, it is only a matter of time before credit, equities and the economy continue to contract into a recession. Why we think it is a pipe dream to assume the FED will pivot and start a new liquidity cycle to support equities? In one word – inflation.

We’ve been conditioned to expect the FED to save equities when they go down too much. Many, including myself, were shocked to see the most dovish FOMC in history pivot into becoming one of the more hawkish in recent history. This is because of how harmful inflation is to an economy. There is a reason that inflation pressures are more important to fix over decreasing asset prices.

Most investors have never experienced inflationary environments, while very few have experienced inflation of this caliber. We have entered a new macro regime where systemic global inflation is at odds with one of the most indebted global economies on record – global debt-to-GDP ratio of 338%.

As inflation builds, the fixed yield on bonds becomes less attractive. So, yields go up until buyers are satisfied with the new fixed yield relative to inflation. This will increase the cost to service debts, which is bad news for countries with a debt-to GDP ratio over 100%. If this cost goes too high, the bond market fails to believe that the debt will ever get paid back, which can cause a fiscal spiral. This is what we saw in England in late 2022, and this is what we want to avoid in Japan in 2023.

Furthermore, while a bear market in equities affects some members of a society, inflation affects all members of a society, especially the middle and lower classes. And, if the 1970s taught us (and the FED) any lesson about inflation, it is that once the genie is out of the bottle, it is very hard to get it back in. So, addressing inflation is the primary concern of this FED. They have stated this time and time again, and we do not believe the story with inflation is over, yet.

The below chart shows the 5 year breakeven rate. This is the difference in yield between the inflation projections 5 years out and the 5 year nominal yield. In other words, it’s a market-based gauge of where inflation will be in 5 years. Since January of this year, the 5 year breakeven is up 60 bps.

This is further backed up by the breakout in the 10 year yield. The bond market is diverging from equities, which will require a resolution.

This makes sense considering that the Services segment of the economy continues to expand in light of an aggressive FED. It also makes sense considering the “Super Core” segment of the economy, which we discussed last week, has been barely affected by the current rate cycle. What concerns me is that the 5 year breakeven is up this much while energy and food prices remain subdued. This, in my opinion, is not being priced into the markets, except maybe the bond market, which is very bearish right now.

The below charts are the price action in crude and gasoline. They are weekly charts, and appear to be consolidating just before a bigger breakout.

Gas

Crude

Furthermore, food prices appear to be setting up a fresh push higher. Cattle prices have been in a sharp uptrend and not far away from making new highs. Anecdotally, most carnivores have probably noticed the increased price of steaks, hamburgers, etc., as a result. This has been offset by wheat prices going down. Wheat appears to be putting in a bottom, as we trend down on decreased momentum, and into a major cycle cluster this week.

So, my concern is where will the breakeven go if energy and food make a new leg higher? What will the odds be that the FED starts a new liquidity cycle if the above futures do breakout? Can the rally ignore a higher terminal rate and continued draining of liquidity from the markets? How likely will the consumer be to increase discretionary spending if we do see another leg higher with inflation, and another leg lower in equities?

We are seeing a resilient credit cycle at odds with a decreasing liquidity cycle. It is my belief that the liquidity cycle is the most important element to justifying a new bull market. Without it, the current uptrend is on shaky ground. The FED has more than enough data without energy and food prices to continue draining liquidity from the system. It has to get inflation from 6.5% down to 2%, and the Services sector is making this goal very difficult with the current rate in place. This is without food and energy prices breaking out.

Hedge

The hedge is trending close to a flipping to a buy. We will likely close some of the hedge for a gain after we see weakness into this week. There has been a stark difference between the signal’s performance in 2023 and my manual performance. We continue to believe the signal, though will drag on returns in choppy markets, will help any that follow it avoid deep draw downs like we saw in 2022. This signal will help us to invest for a shorter time period and still find the necessary protection from another drop – whenever that happens. We plan to close some of our hedge in the coming weeks for a gain, and the remainder when the signal flips.

I/O Fund Portfolio

We are still holding about 30% cash, which we will likely deploy half if the coming pullback is 3 waves. These will be temporary allocations, until the market can prove to us that a new bull cycle is starting.

NVDA

The divergences are quite strong on the larger time frames. However, when you look at the daily chart, note how the Composite Index found support above the moving averages, that are starting to point up. This supports another push higher, but a limited one. No matter what, we still only have 3 waves up off the low, so any breakout should be bought with a stop that increases with price. This is not where a LTBH portfolio goes in.

NFLX

This chart is the most supportive of the OMH red count. A move to $300 will trigger a buy from our end. A push to new highs will also more than confirm NFLX has put in a major low back in May of 2022.

AMD

AMD is not as strong as NFLX. If we do see another leg in the bear market, we will likely see a fresh low here, but not in NVDA. The upper targets are listed as we complete 3 waves up off the October low.

ENPH

This one continues to trade like an energy commodity. If energy breaks out, I expect ENPH to have another stellar year. We will likely add to this position, as its posture is much more bullish than many of the other names we track.

MSFT

This stock is key for me. Some FAANGs have topped – GOOGL, AMZN. MSFT is the 2nd largest weighting in the S&P 500, and the jury is still out on whether it has topped. As of now, it is about 7.5% away from making new highs. Also, this rally is giving a strong sell signal. If we break below last week’s low, then we can see this market get ugly.

Now, if we compare this chart to APPL, you can see more divergences. AAPL is currently 2.5% away from a new high. So, if in the coming (potential) rally, we see AAPL make a new high without MSFT, this is a big warning. But, if MSFT can breakout to new highs with AAPL, this supports the larger red count where we can push towards 4400+ SPX.

AEHR

For AEHR to get another high, it cannot break this channel to the downside. That’s a lot of room to drop, and could set up a great buying opportunity.

TSM

TSM is 12% away from new highs. The same divergences with the FAANGs should show up in semis if/when we do top out in a larger B wave.

TSLA

TSLA could be in a 4th wave that’s targeting $180. This will be one of the places we park cash if we get more confirmation.

MGNI

Crypto

Can we get one more high? The setup is there as long as we hold $20K

In conclusion, I remain in the long-term bear camp based on my technical and macro analysis. I simply do not see a FED chair who is so obviously concerned about his legacy starting up a fresh liquidity cycle in light of the recent inflationary data just released. If energy and food do breakout, this will likely be the catalyst to push the 10 year yield to new highs, and finally align the equity market with the bond market.

However, this does not mean the equity market is seeing something 9 months in advance that I am not. Maybe the recession will be shallow, maybe energy does not breakout and continues lower? Or, maybe sentiment needs to be fully reset before we drop to new lows. This is why I always say, “price is king.” It is the only metric that makes you money, and if it is running counter to a great macro thesis, I will abandon that thesis to follow price.

The set-up is there in the stocks presented for another push, some to new highs and some not. If the red count is confirmed, or looks like it is getting confirmed, we will close some of our hedge (wait for the signal on the rest), and deploy some of our cash for this move. If not, we are hedged and will continue looking down for better buying opportunities.

We shot right out of the gate in 2023 on hopes of peaking inflation, China reopening and defensive positioning at the beginning of the year. The market ended February by giving back some of those gains. We have grown more bearish as time has progressed and remain rather cautious until we get better confirmation of a new bull cycle starting. This has been prompted by technical indicators that point to lower market index levels as the Fed’s fight against “supercore inflation” has proved difficult. In this article we outline some of the technical and macro analysis that has us cautious.

SPX

The major US markets continue to trace the complex corrective pattern we outlined weeks ago in our premium service. What this pattern calls for is a final 5 wave drop to new lows. For SPX, the downward targets are 3295, 3150, 2940. If we get confirmation of this pattern playing out, we will look to remove our hedges and commence buying around these key price targets.

From an Elliott wave perspective, the structure of the bounce from the October 13th low warrants caution. Anytime we see a 3 wave bounce, the odds favor this pattern being a correction within the larger trend, which is down. The above chart is clearly 3 waves up.

This trend is supported by other important markets I’m following. Typically, for a major bull market reversal to occur these markets have to participate. Instead, they seem to be confirming the bearish setup.

Financials (XLF)

The Banks have been very strong since the October low. However, the structure of XLF off the low is also an overlapping 3 wave structure. Note how this 3 wave bounce has retraced the majority of the 2022 drop. Also, note the weakening momentum as price moves higher. This pattern may have one more high in it, but it is clearly a B wave/bear pennant until proven otherwise.

Transports

The Transportation sector is also flashing similar warnings.

Canada

The Canadian TSX is an important market to track for US equities. More times than not, it leads the US. When these markets diverge, it is a big warning of an imminent trend change. This is not what we are seeing. Note the bear pennant forming. This triangle pattern is common with B waves, which the TSX appears to be tracing.

Taking these markets into consideration and looking back at the S&P 500. If we zoom in on the bounce off the October lows, the S&P 500 appears to have an incomplete uptrend. The 3 wave bounce is marked by an A wave up, B wave down, and C wave up, which completes the 3 wave pattern. The C wave always plays out in a 5 wave pattern, and it appears that we only have 4 waves in place. This suggests that we will see a final run towards a double top, or 4225 SPX in the coming weeks, but this is not guaranteed.

The above blue count has been my base case scenario for several weeks. In fact, we removed some of our hedge and have gone net long (25%) in an attempt to capture some of this potential move. This move needs to manifest this week, or it is in danger of not playing out.

If it does not, I will have to consider the red count as the new base case scenario. In this scenario, SPX already topped and is almost done with the 1st wave down in the final move towards the 3000 SPX level. If we push towards 3905 before breaking out over 4040, then this will become the base case scenario and will we look to fully hedge on the 2nd wave retrace. In both cases, we should see a larger bounce before the wheels fall off.

What are the Commodity futures telling us?

As technology investors, the Fed’s actions have raised the cost of capital for firms and impacted the valuation for technology companies. Hence, I believe it’s important to monitor those markets that are shaping the Fed’s inflation outlook for clues so that we can properly position. The most important to monitor is food and energy, both of which are suggesting higher prices into the near future.

Wheat

Wheat prices look to be completing the 5th wave in this large correction. It is trending down into major support with a cluster of cycles coming into play between Feb 28-Mar 3. Once we see a bottom, a large degree bounce should follow. This means food prices are likely going up.

Energy

Gasoline looks very similar to oil prices below. This very much looks like a consolidation before the next move higher. The next major cycle is in late April (this is a very big time frame to monitor). I doubt that we consolidate above the 1×2 line for that long. Look for energy prices to move higher in 2023, which will only put pressure on inflation.

Macro Analysis

Recent data growth has opened the door to the prospect of a “soft landing” or “no landing.” We discussed what a soft landing looks like last week – manufacturing contracts while services does not contract too much more. This last happened in 2014-2016, and most famously in the mid-90s. The idea of no landing means that we just continue to expand from here, avoiding a recession all together.

We would be onboard with this rosy outlook if it wasn’t for one key data point – inflation. All prior soft landings going back to the 80s had one factor in common – a supportive liquidity cycle. With inflation under control, the FED was able to allow the continuation of a supportive liquidity cycle (2014-2016), or start up a new liquidity (mid-1990s).

With talking heads focusing on stronger than expected growth metrics in the economy, they fail to acknowledge what this means for inflation. In short, inflation may have peaked, but the real battle will be getting it from 6.4% to 2%.

If you pay attention to what the FED is saying, they are now tracking something they are calling “Super Core” Inflation. This metric excludes food and energy, like regular core inflation, but goes one step further to exclude all other goods as well as shelter. Because the US GDP is ~85% tied to services, this gives the FED a look into how their policies are affecting the largest segment of the US economy.

In January, the Super Core prices rose at a 7.4% annualized rate. This is the fastest increase for any month since 2021. These prices are up 4.6%, which is just off its peak at 5%.

It is alarming how little effect the current aggressive rate campaign by the FED is having on services. While manufacturing remains in an on-going contraction, services continues to expand, proving that the economy is much more resilient than expected. This also means the FED will likely have to hike higher and for longer than the equity markets are pricing in.

So, the only questions an investor needs to ask – is it more likely or less likely that the FED will start up a new liquidity cycle soon, based on the overly resilient services segment of the economy? Will starting a new liquidity cycle hurt or help their primary goal to get inflation back to 2%?

Where could I be wrong?

Dow Jones Industrial Index (DJI)

The consolidation pattern in DJI broke to the downside, as it suggests a continuation of selling before a low takes hold. I’ve stated before, and will repeat, as long as the DJI holds its October low, no matter what else happens, it will set up a great buying opportunity. This still holds. However, for me to reverse course, the Dow needs to reclaim its December high.

Financials (XLF)

I’m adding XLF to the mix. Like the Dow, it needs to reclaim its February high.

Bonds

I’ll also want to see TLT take out its December high.

It point out these markets because if we are entering a new bull market, all of these markets will confirm it in unison.

Conclusion

Given the macro backdrop, Winners and Losers will emerge within the technology sector. From a fundamental stock perspective, the team has been focusing on companies exposed to secular rather cyclical growth with strong competitive moats. However, given the warnings and uncertainty within the macro backdrop, we prefer to be cautious right now, as we believe that the market will provide us with better entry points. Regarding our 3 stock portfolio of NVDA, AMD, NFLX, we will go into detail about these positions next week.

For reference to terminology used, please look at technical analysis under our resources section here. Regarding the charts below, the vertical tan shades represent time factors. These are inflection points where we have high odds of something significant happening. More times than not, (3/4 of the time), they mark a turning point in the trend. So, what matters is the direction we are trending into these periods. Regarding the vertical lines, black lines represent strong support/resistance, while dark red lines mark very strong support/resistance.here. Regarding the charts below, the vertical tan shades represent time factors. These are inflection points where we have high odds of something significant happening. More times than not, (3/4 of the time), they mark a turning point in the trend. So, what matters is the direction we are trending into these periods. Regarding the vertical lines, black lines represent strong support/resistance, while dark red lines mark very strong support/resistance.

Elliott Wave count are meant to provide context. 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

Broad Market

The major US markets continue to trace the complex corrective pattern we outlined weeks ago. What this pattern calls for is a final 5 wave drop to new lows. For SPX, the downward targets are 3295, 3150, 2940. If we get confirmation of this pattern playing out, we will look to remove our hedges and commence buying around these key price targets.

From an Elliott wave perspective, the structure of the bounce from the October 13th low warrants caution. Anytime we see a 3 wave bounce, the odds favor this pattern being a correction within the larger trend, which is down. The above chart is clearly 3 waves up.

This is backed up by various supporting markets that are important. In short, for a major bull market reversal to be underway, we need the below markets to participate. Instead, they seem to be confirming the bearish setup.

Financials (XLF)

The Banks have been very strong since the October low. However, the structure of XLF off the low is also an overlapping 3 wave structure. Note how this 3 wave bounce has retraced the majority of the 2022 drop. Also, note the weakening momentum as price moves higher. This pattern may have one more high in it, but it is clearly a B wave until proven otherwise.

Transports

The Transportation sector is also flashing similar warnings.

Canada

The Canadian TSX is an important market to track for US equities. More times than not, it leads the US. When these markets diverge, it is a big warning of an imminent trend change. This is not what we are seeing. Note the bear pennant forming. This triangle pattern is common with B waves, which the TSX appears to be tracing.

If we zoom in on the bounce off the October lows, the S&P 500 appears to have an incomplete uptrend. The 3 wave bounce is marked by an A wave up, B wave down, and C wave up, which completes the 3 wave pattern. The C wave always plays out in a 5 wave pattern, and it appears that we only have 4 waves in place. This suggests that we see a final run towards a double top, or 4225 SPX in the coming weeks, but this is not guaranteed.

The above blue count has been my primary analysis for several weeks. In fact, we removed some of our hedge and have gone net long (25%) in an attempt to capture some of this potential move. This move needs to manifest this week, or it is in danger of not playing out.

My alternative count (red), which is quickly becoming my primary. This suggests that we already topped and are almost done with the 1stwave down in the final move towards the 3000 SPX level. If we push towards 3920 before breaking out over 4040, then this will become my primary, as we look to fully hedge on the 2nd wave retrace. In both cases, we should see a larger bounce before the wheels fall off.

Futures

It may seem odd that a tech service covers futures; however, I am always looking for clues in many markets so that we can properly position. Futures are very important right now because they track commodity prices, which is the underlying pressure within inflation. The most important to monitor is food and energy, both of which are suggesting higher prices into the near future.

Wheat

Wheat prices look to be completing the 5th wave in this large correction. It is trending down into major support with a cluster of cycles coming into play between Feb 28-Mar 3. Once we see a bottom, a large degree bounce should follow. This means food prices are likely going up.

Energy

Gasoline looks very similar to oil prices below. This very much looks like a consolidation before the next move higher. The next major cycle is in late April (this is a very big time frame to monitor). I doubt that we consolidate above the 1×2 line for that long. Look for energy prices to move higher in 2023, which will only put pressure on inflation.

Macro Analysis

Recent data growth has opened the door to the prospect of a “soft landing” or “no landing.” We discussed what a soft landing looks like last week – manufacturing contracts while services does not contract too much more. This last happened in 2014-2016, and most famously in the mid-90s. The idea of no landing means that we just continue to expand from here, avoiding a recession all together.

We would be onboard with this rosy outlook if it wasn’t for one key data point – inflation. All prior soft landings going back to the 80s had one factor in common – a supportive liquidity cycle. With inflation under control, the FED was able to allow the continuation of a supportive liquidity cycle (2014-2016), or start up a new liquidity (mid-1990s).

With talking heads focusing on stronger than expected growth metrics in the economy, they fail to acknowledge what this means for inflation. In short, inflation may have peaked, but the real battle will be getting it from 6.4% to 2%.

If you pay attention to what the FED is saying, they are now tracking something they are calling “Super Core” Inflation. This metric excludes food and energy, like regular core inflation, but goes one step further to exclude all other goods as well as shelter. Because the US GDP is ~85% tied to services, this gives the FED a look into how their policies are affecting the largest segment of the US economy.

In January, the Super Core prices rose at a 7.4% annualized rate. This is the fastest increase for any month since 2021. These prices are up 4.6%, which is just off its peak at 5%.

It is alarming how little effect the current aggressive rate campaign by the FED is having on services. While manufacturing remains in an on-going contraction, services continues to expand, proving that the economy is much more resilient than expected. This also means the FED will likely have to hike higher and for longer than the equity markets are pricing in.

So, the only questions an investor needs to ask – is it more likely or less likely that the FED will start up a new liquidity cycle soon, based on the overly resilient services segment of the economy? Will starting a new liquidity cycle hurt or help their primary goal to get inflation back to 2%?

Counter Analysis/Bail Out Levels

My current outlook for 2023 has evolved (or devolved) since the start of the year. I have grown more bearish as time has progressed, and would rather remain cautious until we get evidence that the above analysis is being shrugged off. The levels I need to see reverse, which would have me reverse my analysis is below.

Dow Jones Industrial Index (DJI)

The consolidation pattern in DJI broke to the downside, as it suggests a continuation of selling before a low takes hold. I’ve stated before, and will repeat, as long as the DJI holds its October low, no matter what else happens, it will set up a great buying opportunity. This still holds. However, for me to reverse course, the Dow needs to reclaim its December high.

Financials (XLF)

I’m adding XLF to the mix. Like the Dow, it needs to reclaim its February high.

Caterpillar (CAT)

I’m also adding CAT to the mix. CAT is a key stock to track for early signals. It put in a major top according to Gann – multiple time clusters coming together at the 1×1 line off the 2016 low. If it can reclaim its February high, then I will start looking to buy.

Bonds

I’ll also want to see TLT take out its December high.

It may seem like I’m adding more criteria to my reversal pivot; however, if we are entering new bull markets, all of these markets will confirm it in unison.

Hedge Signal

Our signal nailed this swing in both directions. We remain in the basement, and a long way from turning back to a buy.

Time Analysis

These are the dates to monitor for a trend reversal/big break put. The most important aspect of these dates is how the market is trending into them. These dates will be inflection points that can help determine swings.

• Small Cycles in March: 6-7, 15-17
• Medium/large Cycles: February 27 – Mar 3. Note how we are trending down into these dates. It should mark a low in red 1 or blue 4.
• Notable Events: March 22-23 is the next FOMC meeting.
• Late April will be one of the biggest time factors of the year.

I/O Fund Portfolio

Though it may seem that we are heavily concentrated, as of now, our biggest position is really cash, which nearly double the percentage of NVDA.

NVDA (17%)

NVDA tagged the 100% extension (this is where the length of the C wave is identical to the length of the A wave). This is the most common spot that a 3 wave bounce terminates. It is now struggling to break above this level, while momentum continues to fade at these heights. This is not where you buy a stock. After this 3 wave pattern is complete, we should see a drop back towards our target region. We plan to make NVDA a larger position, so expect buys in the coming months.

NFLX (14%)

I’m starting to question the below bullish count. I’m looking for a big drop in equities, while NFLX is close to the lower trend line. Another 16% drop towards $270 is as far as I would give NFLX. If we do see a more bullish outcome in the markets (my red count, where SPX tags 4225), then NFLX can complete the large degree diagonal for wave 1. That would make more sense, but that’s a big ask. Long-term, I believe NFLX has put in a major low, but we could see a deeper pullback in the coming months than previously expected.

AMD (13%)

The top is in for AMD. One more low and we have 5 waves down from the high. There should be a larger bounce that follows, for anyone looking to hedge/unload. We will plan to buy more at lower levels.

TSM (9%)

A crash scenario for TSM would likely be due to geo-political tensions. This would create a great buying opportunity, as this company is likely not going anywhere. Like all semis, it has completed a 3 wave bounce up, and now we get to see how deep the pullback takes us.

AEHR (9%)

Look for us to take more gains in AEHR on the next bounce. My confidence in the chart is fading.

ENPH (9%)

Without question the most interesting chart we track is Enphase. It continues to trade like an energy commodity. In other words, it appears to be bottoming while NDX/SPX appear to be topping. If correct, we could see a repeat of 2022.

MSFT (8%)

Regarding the FAANGs, first Google topped, then AMZN, NFLX, MSFT, and AAPL is now hanging on by a thread. MSFT is the key, right now. It looks like it has a 4th wave then one more drop to complete the larger 1st wave of the larger C down. We should see a corrective 2ndwave bounce before the wheels fall off.

TSLA (5%)

The 1st buy zone will be between $160-$140. My primary is that we visit $92, but we will begin layering in based on the red count. When technicals are calling for a drop that appears to be dramatic, especially when it runs counter to a recent positive earnings report, I prefer to set up buying plans based on both scenarios playing out.

MGNI (2%)

The top is likely in for MGNI. We need to get back over $14.30 to change my mind.

Crypto (14%)

One more swing high is possible from here, but that should be it. Then we have a very full pattern, which should lead to a deep retrace that holds the lows, at minimum. The next deep pullback should set up the buying opportunity we have been waiting for. Late March and late April will be the time cycles to monitor for Bitcoin.

Note: We’ve written a lot about Nvidia this month for our Essentials Members. One thing that differentiates the I/O Fund from other services is that we are an actively managed portfolio that is audited and traded in real-time. This means, we will gladly discuss a stock many times in one month if it means we will make money.we will gladly discuss a stock many times in one month if it means we will make money.

Other services need to fill a meaningless, content pipeline. This means they will cover four, eight or even more stocks per month! This does not lead to making good money, it’s distracting and noisy, at best. Instead, we provide a strong, fundamental picture alongside thorough technicals. After a setup plays out, we will gladly tell you a stock we think is quite strong fundamentally may need to take a breather. This work is not quick, it’s not easy, and very sites are good at it. I wanted to illustrate for our Essentials Members in the Month of February how our site operates differently. We are here to make money; we are investors – not marketers. We look forward to providing more strong calls like we did with Nvidia prior to earnings. Notably, we may trim this position now. So, stay tuned next week of 2/26 for a Positions Update including a broad market stock tip from Knox. Click here for more information on our Advanced Plan. This work is not quick, it’s not easy, and very sites are good at it. I wanted to illustrate for our Essentials Members in the Month of February how our site operates differently. We are here to make money; we are investors – not marketers. We look forward to providing more strong calls like we did with Nvidia prior to earnings. Notably, we may trim this position now. So, stay tuned next week of 2/26 for a Positions Update including a broad market stock tip from Knox. Click here for more information on our Advanced Plan.Click here for more information on our Advanced Plan. 

Nvidia Q4 Earnings:

Nvidia stock has reacted positively to an adjusted EPS Q4FY23 beat of $0.88 vs $0.80 and a Q1FY24 revenue guide of $6.5B vs $6.32 consensus. The most important on the call was the statement: “We expect sequential growth to be driven by each of our 4 major market platforms led by strong growth in data center and gaming”We expect sequential growth to be driven by each of our 4 major market platforms led by strong growth in data center and gaming” as it supports the H2 rebound.

Nvidia’s current quarter weakness is already priced in, yet the anticipation is high that Nvidia nails the turnaround come the October quarter. This quarter — especially with the comment on sequential growth comment across all four quarters — makes this outcome a bit more likely.

We had recently written about Big Tech’s prioritization of AI related infrastructure and how Nvidia was well positioned to benefit from this secular trend here. We listened for further evidence of this from the conference call. Big Tech capex can’t be overestimated in terms of how Nvidia will perform, and the comments about re-allocating for AI investments was further reflected in Nvidia’s report.

Financials 

$6.05B revenue came in line with prior guidance and consensus estimates, up 2% sequentially and down 21% year-over-year. For the full year, total revenues came in at $26.9B, flat year over year.

Next quarter’s revenue guide was $6.5B, better than consensus of $6.32B.

Adjusted eps came in $0.88 which beat consensus of $0.80.

Within the main business segments, Data centers came in at $3.6B, down 7% sequentially, and up 11% year-over-year. Gaming revenue was $1.8B, up 16% sequentially and down 46% YoY. Importantly, gaming’s sequential improvement showed further evidence that it had bottomed. We wrote about this in November here.

Gross and adjusted gross margins came in at 63.3% and 66.1%, in-line with guidance. Operating and adjusted operating margins came in at 20.7% and 36.8%, in-line with guidance.

Both gross and operating margins showed sequential improvement as China related inventory write-downs and higher compensation related expenses were limited to Q3.

Net income improved to $1.4B vs $0.7B in the previous quarter for a net income margin of 23.3% vs 11.5%. Adjusted net income improved to $2.2B vs. $1.5B in the previous quarter for an adjusted net margin of 35.9% vs 24.5%

For the full year, total revenues came in at $26.9B, flat year over year. Within full year sales Data center sales were up 41% and gaming sales was down 27% y/y. Gross margins were 56.9% vs 64.9% the prior year while adjusted gross margins were 59.2% vs 66.8% prior. Operating margins were 15.7% vs 37.3% prior while adjusted operating margins were 33.5% vs 47.2% prior.

Regarding Gaming, Nvidia added the following.  “The year-on-year decline reflects the impact of channel inventory correction, which is largely behind us.” This is important because it is exposed to the consumer and was facing cyclical headwinds last year that impacted group earnings. Rather than a detractor, it should be a contributor to group earnings going forward. Management provided a Q1 outlook compared to Q4 for all business segments. ,

“Let me look to the outlook for the first quarter of fiscal '24. We expect sequential growth to be driven by each of our 4 major market platforms led by strong growth in data center and gaming.”“Let me look to the outlook for the first quarter of fiscal '24. We expect sequential growth to be driven by each of our 4 major market platforms led by strong growth in data center and gaming.”

Looking at the balance sheet. Cash, cash equivalents and marketable securities were $13.30B.  Inventory increased, primarily to support the ramp of new products in Data Center and Gaming. Meanwhile, free cash flow was $1.74B compared to $2.74B a year ago and negative $156 million a quarter ago. Fiscal-year free cash flow was $3.76B, down from $8B a year ago.

Earnings Call:

The main write-up on Nvidia’s product side will come following GTC at the end of March. However, on the call, Nvidia’s AI-as-a-service was mentioned, so I want to provide that quote for you, as it was one of the most important parts of the earnings call.

I’ve discussed in the past that the H100 is an important leap forward for enterprise AI when stating: “the A100 GPU is what led the company’s gains since Q2 2020 (detailed here) and the Hopper H100 GPU is what will lead the company’s gains for the next two years (detailed here). 

The company has stated the following in regards to H100 sales:

“Adoption of our new flagship H100 center GPU is strong. In just the second quarter of its ramp, H100 revenue was already much higher than that of A100, which declined sequentially.” 

I feel like I’ve talked quite a bit about the H100 and its importance, so we won’t rehash that right now.

However, per our July write-up here, there is an important point to what was discussed on the call and what Nvidia investors can expect to hear about in the coming quarters in regards to software monetization. I’m repeating here what we wrote in July before I elaborate on what I think was the most important part of the earnings call: 

“According to Nvidia, the H100 delivers 9X more throughput in AI training, and 16X to 30X more inference performance. The company also states in HPC application-specific workloads, the H100 is 7X faster. The goal of the H100 was not only to add more transistors and make the H100 faster, but to also offer function-specific optimizations. This is achieved through the transformer engine.

The architecture aims to answer one of the bigger challenges facing superfast compute, which is that moving data into traditional servers overloads the CPU and system memory and becomes bottlenecked by PCI-Express.

By improving the bandwidth issue, Nvidia’s goal is to create more demand for their DGX Pod and SuperPod Systems, which in turn, will create more demand for their software.”

The comments in the earnings call that pertain to the H100 and DGX Pods and SuperPods is this – it’s important because it can mark the beginning of Nvidia’s software revenue. So, I’m including this as a bigger quote from the earnings report:

“Generative AI's versatility and capability has triggered a sense of urgency at enterprises around the world to develop and deploy AI strategies. Yet, the AI supercomputer infrastructure, model algorithms, data processing and training techniques remain an insurmountable obstacle for most […] 

We are partnering with major service — cloud service providers to offer NVIDIA AI cloud services, offered directly by NVIDIA and through our network of go-to-market partners, and hosted within the world's largest clouds. NVIDIA AI as a service offers enterprises easy access to the world's most advanced AI platform, while remaining close to the storage, networking, security and cloud services offered by the world's most advanced clouds […]

AI supercomputers are hard and time-consuming to build. Today, we are announcing the NVIDIA DGX Cloud, the fastest and easiest way to have your own DGX AI supercomputer, just open your browser […]

With our new business model, customers can engage NVIDIA's full scale of AI computing across their private to any public cloud. We will share more details about NVIDIA AI cloud services at our upcoming GTC so be sure to tune in.” 

The takeaway is that not only will Nvidia begin to monetize through software on the DGX systems but accessibility will improve through CSPs, or cloud service providers. This is an attempt to democratize AI development while driving software sales.

In the call, management stated the following about CSPs, or cloud service providers:

“With cloud adoption continuing to grow, we are serving an expanding list of fast-growing cloud service providers, including Oracle and GPU specialized CSPs. Revenue growth from CSP customers last year significantly outpaced that of Data Center as a whole as more enterprise customers moved to a cloud-first approach. On a trailing 4-quarter basis, CSP customers drove about 40% of our Data Center revenue.”

This is important as it links back to the comment about Nvidia’s AI as-a-service and cloud service providers helping to move DGX Cloud. It also helps to illustrate how DGX Cloud can be successful, given the strong CSP partnerships and revenue growth in the data center segment.  

Here is another quote in regard to DGX Cloud and why it’ll be important for a lower barrier to entry for AI development:

“The accumulation of technology breakthroughs has brought AI to an inflection point. Generative AI's versatility and capability has triggered a sense of urgency at enterprises around the world to develop and deploy AI strategies. Yet, the AI supercomputer infrastructure, model algorithms, data processing and training techniques remain an insurmountable obstacle for most. Today, I want to share with you the next level of our business model to help put AI within reach of every enterprise customer.

Moving along, this was the Q&A piece that is most important to Nvidia investors long-term:

“Timothy Arcuri

Jensen, I had a question about what this all does to your TAM. Most of the focus right now is on text, but obviously, there are companies doing a lot of training on video and music. They're working on models there. And it seems like somebody who's training these big models has maybe, on the high end, at least 10,000 GPUs in the cloud that they've contracted and maybe tens of thousands of more to inference a widely deployed model. So it seems like the incremental TAM is easily in the several hundred thousands of GPUs and easily in the tens of billions of dollars. But I'm kind of wondering what this does to the TAM numbers you gave last year. I think you said $300 billion hardware TAM and $300 billion software TAM. So how do you kind of think about what the new TAM would be?

Jensen Huang

I think those numbers are really good anchor still. The difference is because of the, if you will, incredible capabilities and versatility of generative AI and all of the converging breakthroughs that happened towards the middle and the end of last year, we're probably going to arrive at that TAM sooner than later.”

Today, Nvidia trades at less than 1X that TAM at $515 million compared to what this analyst believes will be an easily-achieved TAM of $600 billion. This would suggest the stock price does not yet fully reflect the future market opportunity.

Conclusion: 

There are some upset investors today on social media who shorted Nvidia going into the print. This was based on Nvidia’s current weak financial profile coupled with its valuation. As pointed out in our Q1 webinar, we are entirely focused on the H2 rebound, which can arguably be easier to predict with semiconductors due to the longer-term supply chain visibility this industry has. At least for today, Nvidia proved it’s on track for the H2 rebound.

As you know, we track Nvidia very closely due to its leading allocation in our portfolio. We saw evidence of a gaming bottom in November, which we published about here. We also felt Nvidia had masterfully timed it’s RTX40 Series with the Ada Lovelace architecture plus the H100 release to drop exactly when the crypto mining selloff would be most felt. We discussed this here in September. These points were entirely overlooked by Nvidia critics. 

Yes, that revenue miss in the Fall was crazy – but what was lying beneath the surface for chances of a quick recovery?

Basically, the devil is in the details and not a lot of investors or analysts care to look into Nvidia’s complex hardware products. Jim Cramer got 1M views on his tweet here that admitted it was tough to listen to this particular company’s earnings calls. It works in our favor that talking heads prefer to discuss consumer tech, and that the masses are collected around those who have not taken the time to get to know his company.

We know Nvidia is not pushing a buzzword to move stock, as we’ve been covering Nvidia’s AI angle for going on five years. It’s the headlines that changed; not Nvidia.

To remain balanced here, we agree that Nvidia is likely due for a pullback. The shorts were probably right in that regard. That is Knox’s territory. He had written here that $230 has a lot of resistance and also on the forum. He plans to update everyone on Nvidia in his webinar this afternoon.

Your bigger product update will come post-GTC as we begin to lay a strong foundation for 2024 and onward for this exciting company.

Nvidia stock has reacted positively to an adjusted EPS Q4FY23 beat of $0.88 vs $0.80 and a Q1FY24 revenue guide of $6.5B vs $6.32 consensus. The most important statement on the call was: “We expect sequential growth to be driven by each of our 4 major market platforms led by strong growth in data center and gaming”We expect sequential growth to be driven by each of our 4 major market platforms led by strong growth in data center and gaming” as it supports the H2 rebound. 

Nvidia’s current quarter weakness is already priced in, yet the anticipation is high that Nvidia nails the turnaround come the October quarter. This quarter — especially with the comment on sequential growth comment across all four quarters — makes this outcome a bit more likely. 

We had recently written about Big Tech’s prioritization of AI related infrastructure and how Nvidia was well positioned to benefit from this secular trend here and here. We listened for further evidence of this from the conference call. Big Tech capex can’t be overestimated in terms of how Nvidia will perform, and the comments about re-allocating for AI investments was further reflected in Nvidia’s report.

Financials:

$6.05B revenue came in line with prior guidance and consensus estimates, up 2% sequentially and down 21% year-over-year. For the full year, total revenues came in at $26.9B, flat year over year. 

Next quarter’s revenue guide was $6.5B, better than consensus of $6.32B.

Adjusted eps came in $0.88 which beat consensus of $0.80. 

Within the main business segments, Data centers came in at $3.6B, down 7% sequentially, and up 11% year-over-year. Gaming revenue was $1.8B, up 16% sequentially and down 46% YoY. Importantly, gaming’s sequential improvement showed further evidence that it had bottomed. We wrote about this in November here.

Gross and adjusted gross margins came in at 63.3% and 66.1%, in-line with guidance. Operating and adjusted operating margins came in at 20.7% and 36.8%, in-line with guidance. 

Both gross and operating margins showed sequential improvement as China related inventory write-downs and higher compensation related expenses were limited to Q3.

Net income improved to $1.4B vs $0.7B in the previous quarter for a net income margin of 23.3% vs 11.5%. Adjusted net income improved to $2.2B vs. $1.5B in the previous quarter for an adjusted net margin of 35.9% vs 24.5%

For the full year, total revenues came in at $26.9B, flat year over year. Within full year sales Data center sales were up 41% and gaming sales was down 27% YoY. Gross margins were 56.9% vs 64.9% the prior year while adjusted gross margins were 59.2% vs 66.8% prior. Operating margins were 15.7% vs 37.3% prior while adjusted operating margins were 33.5% vs 47.2% prior. 

Regarding Gaming, Nvidia added the following.  “The year-on-year decline reflects the impact of channel inventory correction, which is largely behind us.” This is important because it is exposed to the consumer and was facing cyclical headwinds last year that impacted group earnings. Rather than a detractor, it should be a contributor to group earnings going forward. Management provided a Q1 outlook compared to Q4 for all business segments.

“Let me look to the outlook for the first quarter of fiscal '24. We expect sequential growth to be driven by each of our 4 major market platforms led by strong growth in data center and gaming.”“Let me look to the outlook for the first quarter of fiscal '24. We expect sequential growth to be driven by each of our 4 major market platforms led by strong growth in data center and gaming.”

Looking at the balance sheet. Cash, cash equivalents and marketable securities were $13.30B.  Inventory increased, primarily to support the ramp of new products in Data Center and Gaming. Meanwhile, free cash flow was $1.74B compared to $2.74B a year ago and negative $156 million a quarter ago. Fiscal-year free cash flow was $3.76B, down from $8B a year ago. 

Earnings Call:

The main write-up on Nvidia’s product side will come following GTC at the end of March. However, on the call, Nvidia’s AI-as-a-service was mentioned, so I want to provide that quote for you, as it was one of the most important parts of the earnings call. 

I’ve discussed in the past that the H100 is an important leap forward for enterprise AI when stating: “the A100 GPU is what led the company’s gains since Q2 2020 (detailed here) and the Hopper H100 GPU is what will lead the company’s gains for the next two years (detailed here).”

The company has stated the following in regards to H100 sales:

“Adoption of our new flagship H100 center GPU is strong. In just the second quarter of its ramp, H100 revenue was already much higher than that of A100, which declined sequentially.”

I feel like I’ve talked quite a bit about the H100 and its importance, so we won’t rehash that right now. 

However, per our July write-up here, there is an important point to what was discussed on the call and what Nvidia investors can expect to hear about in the coming quarters in regards to software monetization. I’m repeating here what we wrote in July before I elaborate on what I think was the most important part of the earnings call:

“According to Nvidia, the H100 delivers 9X more throughput in AI training, and 16X to 30X more inference performance. The company also states in HPC application-specific workloads, the H100 is 7X faster. The goal of the H100 was not only to add more transistors and make the H100 faster, but to also offer function-specific optimizations. This is achieved through the transformer engine.

The architecture aims to answer one of the bigger challenges facing superfast compute, which is that moving data into traditional servers overloads the CPU and system memory and becomes bottlenecked by PCI-Express.

By improving the bandwidth issue, Nvidia’s goal is to create more demand for their DGX Pod and SuperPod Systems, which in turn, will create more demand for their software.”

The comments in the earnings call that pertain to the H100 and DGX Pods and SuperPods is this – it’s important because it can mark the beginning of Nvidia’s software revenue. So, I’m including this as a bigger quote from the earnings report: 

“Generative AI's versatility and capability has triggered a sense of urgency at enterprises around the world to develop and deploy AI strategies. Yet, the AI supercomputer infrastructure, model algorithms, data processing and training techniques remain an insurmountable obstacle for most […] 

We are partnering with major service — cloud service providers to offer NVIDIA AI cloud services, offered directly by NVIDIA and through our network of go-to-market partners, and hosted within the world's largest clouds. NVIDIA AI as a service offers enterprises easy access to the world's most advanced AI platform, while remaining close to the storage, networking, security and cloud services offered by the world's most advanced clouds […] 

AI supercomputers are hard and time-consuming to build. Today, we are announcing the NVIDIA DGX Cloud, the fastest and easiest way to have your own DGX AI supercomputer, just open your browser […] 

With our new business model, customers can engage NVIDIA's full scale of AI computing across their private to any public cloud. We will share more details about NVIDIA AI cloud services at our upcoming GTC so be sure to tune in.”

The takeaway is that not only will Nvidia begin to monetize through software on the DGX systems but accessibility will improve through CSPs, or cloud service providers. This is an attempt to democratize AI development while driving software sales.

In the call, management stated the following about CSPs, or cloud service providers: 

“With cloud adoption continuing to grow, we are serving an expanding list of fast-growing cloud service providers, including Oracle and GPU specialized CSPs. Revenue growth from CSP customers last year significantly outpaced that of Data Center as a whole as more enterprise customers moved to a cloud-first approach. On a trailing 4-quarter basis, CSP customers drove about 40% of our Data Center revenue.”

This is important as it links back to the comment about Nvidia’s AI as-a-service and cloud service providers helping to move DGX Cloud. It also helps to illustrate how DGX Cloud can be successful, given the strong CSP partnerships and revenue growth in the data center segment.   

Here is another quote in regard to DGX Cloud and why it’ll be important for a lower barrier to entry for AI development:

“The accumulation of technology breakthroughs has brought AI to an inflection point. Generative AI's versatility and capability has triggered a sense of urgency at enterprises around the world to develop and deploy AI strategies. Yet, the AI supercomputer infrastructure, model algorithms, data processing and training techniques remain an insurmountable obstacle for most. Today, I want to share with you the next level of our business model to help put AI within reach of every enterprise customer.

Moving along, this was the Q&A piece that is most important to Nvidia investors long-term:

“Timothy Arcuri

Jensen, I had a question about what this all does to your TAM. Most of the focus right now is on text, but obviously, there are companies doing a lot of training on video and music. They're working on models there. And it seems like somebody who's training these big models has maybe, on the high end, at least 10,000 GPUs in the cloud that they've contracted and maybe tens of thousands of more to inference a widely deployed model. So it seems like the incremental TAM is easily in the several hundred thousands of GPUs and easily in the tens of billions of dollars. But I'm kind of wondering what this does to the TAM numbers you gave last year. I think you said $300 billion hardware TAM and $300 billion software TAM. So how do you kind of think about what the new TAM would be?

Jensen Huang

I think those numbers are really good anchor still. The difference is because of the, if you will, incredible capabilities and versatility of generative AI and all of the converging breakthroughs that happened towards the middle and the end of last year, we're probably going to arrive at that TAM sooner than later.”

Today, Nvidia trades at less than 1X that TAM at $515 million compared to what this analyst believes will be an easily-achieved TAM of $600 billion. This would suggest the stock price does not yet fully reflect the future market opportunity.

Conclusion:

There are some upset investors today on social media who shorted Nvidia going into the print. This was based on Nvidia’s current weak financial profile coupled with its valuation. As pointed out in our Q1 webinar, we are entirely focused on the H2 rebound, which can arguably be easier to predict with semiconductors due to the longer-term supply chain visibility this industry has. At least for today, Nvidia proved it’s on track for the H2 rebound. 

As you know, we track Nvidia very closely due to its leading allocation in our portfolio. We saw evidence of a gaming bottom in November, which we published about here. We also felt Nvidia had masterfully timed it’s RTX40 Series with the Ada Lovelace architecture plus the H100 release to drop exactly when the crypto mining selloff would be most felt. We discussed this here in September. These points were entirely overlooked by Nvidia critics. 

Yes, that revenue miss in the Fall was crazy – but what was lying beneath the surface for chances of a quick recovery? 

Most importantly, we discussed Nvidia’s entry into AI software here, which we stated was the important analysis we have ever written on Nvidia. I think “most important analysis” will be rivaled when I write about Nvidia’s automotive segment. 

Basically, the devil is in the details and not a lot of investors or analysts care to look into Nvidia’s complex hardware products. Jim Cramer got 1M views on his tweet here that admitted it was tough to listen to this particular company’s earnings calls. It works in our favor that talking heads prefer to discuss consumer tech, and that the masses are collected around those who have not taken the time to get to know his company. 

We know Nvidia is not pushing a buzzword to move the stock, as we’ve been covering Nvidia’s AI angle for going on five years. It’s the headlines that changed; not Nvidia.

To remain balanced here, we agree that Nvidia is likely due for a pullback. The shorts were probably right in that regard. That is Knox’s territory. He had written here that $230 has a lot of resistance and also on the forum. He plans to update everyone on Nvidia in his webinar this afternoon. 

Your bigger product update will come post-GTC as we begin to lay a strong foundation for 2024 and onward for this exciting company. 

Magnite beat on revenue in the current quarter and raised top line guidance for Q1. The expectation was that Magnite would report GAAP profitability this quarter. However, the company reported GAAP EPS of ($0.27) compared to GAAP EPS estimates of $0.02. The adjusted EPS also missed at $0.24 versus $0.32 expected.  

The bottom-line miss is due to the CTV ad platform that launched in February, which created “a $35 million accelerated amortization related to the CTV ad platform consolidation.”  

In the prepared comments, management also stated: “Total operating expenses, which includes cost of revenue for the fourth quarter, increased 29% to $204 million compared to $158 million in the same period a year ago. Adjusted EBITDA operating expense was $92 million, up 11% sequentially from Q3 and up from $75 million from the fourth quarter last year and slightly above our guidance range. The increases were driven by higher cloud and personnel expenses, T&E and higher engineering team expenses, partially due to lower internally developed capitalized software due to the completion of our new CTV platform.” 

Financials: 

Note: numbers below are reported as ex-TAC unless otherwise stated. This stands for “excluding traffic acquisition costs” for a better representation of actual revenue minus any payments to online partners or affiliates. 

Magnite reported revenue of $156.6 million, for growth of 10%. This beat estimates of $153.7 million. This led to a beat on FY2022 revenue of $514.6M compared to $511.7M expected. 

For Q1, Magnite is guiding for $109 million to $113 million, which implies a raise at the midpoint compared to consensus of $109.7 million for Q1. 

For Full Year 2023, Magnite provided a vague guide to “expect FY2023 revenue to grow from 2022.” Analysts have 7.5% growth for consensus of $550.3 million in revenue. 

GAAP EPS of ($0.27) missed estimates of $0.02 for the reasons stated above. Adjusted EPS of $0.24 missed estimates of $0.32.  

Q4 CTV Ad Revenue grew 19.6% for revenue of $64.6 million. The Q1 guide for CTV revenue is $42.5 million to $44.5 million, compared to $42.3 million in the year ago quarter. One of the bigger issues in this report is that CTV ad revenue is expected to be flat YoY to up to 3% growth for Q1. (See below for the earnings call discussion.) 

Mobile revenue of $61 million, was up 18% YoY. Desktop also grew 18% YoY for revenue of $30.8 million. 

The United States and International mix remained the same at 78% of revenue and 22% of revenue, respectively.  

Margins: 

The adjusted EBITDA in Q4 was 41% which was lower than the Q4 EBITDA margin from a year ago at 48%. Management stated adjusted EBITDA would remain the same in 2023 as 2022, which was $178.8 million. Given the guide nodded toward nominal growth in 2023, this makes sense that EBITDA would be similar.  

·       Gross Margin of 37% is lower than usual with a FY2022 gross margin of 47%

·       Operating Profit Margin of (16%) compares to +2% OPM in the year ago quarter

·       Net Margin of (21%) compares to a flat net margin in the year ago quarter

·       Adjusted net income was slightly down at $34.7 million compared to $37.5 million in the year ago quarter.  

Cash: 

Cash flow was the strongest line item in Magnite’s report. 

The company reported operating cash flow margin of 32% compared to 37% last year for operating cash of $56.9 million.  

Free cash flow of 28% compared to 34% in the year ago quarter. This remained Magnite’s strongest quarter in 2022. Total free cash flow was $48.91 million. All things considered; this is a good report on cash. 

The free cash flow guide for next year is $100 million, which means Magnite intends to not lose ground here as FY2022 cash flow was $106 million.  

The company lowered its net leverage to 2.2X down from 3.3X in the year ago quarter. The company has $326.3 million in cash on the balance sheet with $726.4 million in debt for net debt of $400.1 million. 

Earnings Call: 

On the earnings call, the main discussion points were ad budgets and how macro affecting is affecting ad budgets this year. Magnite management sees the industry at a potential bottom but admits they don’t have a crystal ball. Also, within this topic, analysts wondered why Magnite’s CTV ad revenue would be flat to 3%, per guidance.  

On the positive side, Magnite pointed toward the upfront season as a potential turning point for the CTV ad tech segment. We’ve covered as a potential catalyst for our Netflix position, since this will be Netflix’s upfront season. By the time the next earnings season starts to roll-in, we will likely hear quite a bit about the upfront, committed ad spend each publisher or ad network is able to secure. Additionally, the Disney partnership is extended another year for Magnite’s ad server. 

Macro/Ad Budgets 

Below are two discussions that directly relate to what Magnite saw in Q4, which was a deceleration that seemed to be unexpected. I believe our analysis here on Ad Budgets Set to Slow Even More is in sync with this discussion. The deceleration we are seeing in ad-tech revenue growth across the board from Q1 2022 to Q1 2023E reflects this flat to minimal YoY annual budget growth. 

Shyam Patil

Nice job on the execution. I had a couple of questions. First question, for 1Q, as you guys talked about it, it seems like things have started off a bit slow for the industry in terms of ad spend growth. I was just wondering if you've seen any improvement or changes in the growth rates as we've kind of gone from early January to late February? 

Michael Barrett

Yes, sure. I'll start off and allow David to chime in or Nick. As far as improvements are concerned, I think what has us cautiously optimistic is there hasn't been further decline. So I think what we — and especially talking with our big buyers, agencies, marketers, the consensus seems to be that we've seen the worst, and that it should get better from here and out. That's not to say we're starting to see it, it get better overnight, but it is to say that I think that the notion that late Q4 into Q1 probably is we're bouncing along the bottom and hoping that things have freshen as we get into the Q2 and the upfront period of time.  

Jason Kreyer

Michael, I just wanted to ask about visibility. I mean it sounds like things kind of decelerated pretty quickly in Q4, have stabilized since. But just wanted some color on if the visibility has changed? Or how much visibility you have now into marketers may be pulling back on budget or reaccelerating budget or just things like that? 

Michael Barrett

Yes. And you're right, Jason. I mean no sooner do we finish our call, [indiscernible] around for the Q3 earnings. And it's universal across talking to every publisher sometime right around mid-December, Q4 stopped behaving like Q4, right? And it kind of limped across the finish line in December, and that kind of headwinds followed into Q1.  

Our visibility, generally speaking, comes more from the insight of our buyers from agencies. We do, as you know, have the demand facilitation team, and that's a little bit of a features market. Insertion orders tend to be more of a I'm willing to spend x amount over the next couple of months. And those bookings are quite strong.  

And so it leads us to believe, and I think this is kind of the industry rhetoric, that we're bouncing along the bottom with the hope that the recovery begins sooner than what some folks are hoping, which is second half of the year. But again, our crystal ball is no greater than anyone else's in that respect. 

CTV Ad Budgets Weak in Q1 

Outside of the bottom line miss, what was most surprising is the deceleration in growth on CTV ads. Magnite has consistently been growing this segment around 40% YoY and is now guiding for 0% to 3% growth YoY next quarter.  

In the opening comments, management stated “this slowing of growth is attributable to an industry-wide slow start to Q1.” 

When an analyst questioned the team about it, the following was stated: 

“CTV is 100% macro, and there's no question that CTV will be the fastest-growing segment as we exit 2023. It's just budgets that were more branding-oriented, that were TV-oriented are always the first to get paused as opposed to more performance-related advertising, which is typically the domain of the DV+ world.” 

Upfront Season 

That brings us to the potential time frame when CTV ad revenue could turn back up, and start growing again. Per our previous Netflix coverage:  

“I foresee Netflix doing quite well during next year’s upfront season, which is when prepaid inventory is contracted between high-paying brand advertisers and media companies. Assuming there are no changes, we fully expect to hold our position well into this time frame (Q2 2023). This is primarily because Netflix has very high-quality content and because Pay TV advertisers are in some pain right now with the need to find strong content to place ads.” 

Magnite is asserting they will also do well in the upfront season, which takes place in May. Notably, we wrote about Netflix and the upfront seasons prior to getting information on the flat 2023 budgets. Netflix being a new entry could take market share, however, as has been pointed out on the forum, this is speculative as the ad tier will not have had much time to accumulate many users. Ultimately, weaker 2023 budgets complicates things and Magnite’s report reminded us of this, in no uncertain terms. Technically, every ad-tech investor is speculating as the data (today) doesn’t support a strong 2023. This can change if budgets get revised.  

What management is saying below is that Buyers are in control for the 2023 Upfront season and auctions will be more n demand this year than presold inventory at a set price. He is hopeful that Buyers will be encouraged by the favorable conditions for a successful Upfront season. 

Michael Barrett

Yes, great question. These trends are hard to like kind of draw generalizations just given the needed nature of the marketplace. But I think that you're going to find going into the upfront a kind of record, which is a little embellished to talk about a record when there's been very little biddable inventory in the premium CTV categories of the plus services, the broadcasters, et cetera. 

But I think you're going to find a record amount as dictated by the buyers. The buyers — every dollar is going to go a lot further in this marketplace, and they have demanded, for quite some time now, the opportunity to be able to bring data to the foray and bid openly on it. And so I think this concept of the invite-only auction that who has done so incredibly well with, just no question that you're going to see the spread of that, just given the cloud that the buyer has coming into it.  

We're also seeing quite a bit of biddable inventory at CPMs that are quite different than perhaps CPMs were in Q3 in the fast service market and in the OEM market. So yes, a biddable is coming. It's probably coming faster because of this tough ad economy. And it does bode well for take rates for sure because of the amount of value that we contribute to conducting an auction versus just being the technology partner to process presold deals by the publisher. 

Disney Partnership 

In the opening remarks, Magnite stated the partnership had been renewed: 

“First, I'd like to highlight the news in late January that we expanded and renewed our agreement as Disney's global programmatic SSP partner. As you may recall, our relationship with them started with Hulu. We have since grown the relationship to include the full portfolio of Disney properties […] We are thrilled to be a partner with Disney in support of their audience and targeting capabilities, which leverage the Disney Select first-party data platform with more than 100 million U.S. household level ideas.” 

Here is a question from an analyst on the call. The answer pertains to the value Magnite adds, and why Disney prefers to outsource this, and Magnite’s expectation that others will follow suit in using them for biddable/auction side.  

“Michael Barrett

Sure, Ian. So as it relates to Disney, I think we've been pretty clear that — we are working with them primarily as a technology partner that helps facilitate programmatic buys that are sold by Disney. The belief is that it moves to a more biddable environment. With us running the auction piece of it, the economics increased in terms of take rates. And so I think that, that plays itself out over time. 

And there's no question that I think Hulu has shown the efficacy of having biddable inventory going up against what traditionally is upfront inventory guaranteed pricing. And I think that, that's the model that Disney is going to emulate. And I don't think they're an outlier by any stretch. They're just more advanced. They have more inventory, right? They're global, and they have Hulu. And they also had the learnings of Hulu being at this for 8, 9, 10 years doing programmatic.” 

Conclusion: 

Given Magnite remained strong on cash and has a fairly direct reason for missing on the bottom line, some of the price weakness is likely due to valuation and investors taking gains. We discussed the valuation concerns leading into earnings on the forum. 

This is one of the strongest stocks off the bottom in October in the tech universe and certainly in the ad-tech universe.  

·       For example, Magnite has been much stronger than TTD since October, at +80% versus +6.3%.

·       It’s also been stronger than TTD since Jan 1st, 2022 at (22%) versus (38%).

·       If you go back to Nov 1st, 2021 blowoff top, then TTD has been stronger at (51%) MGNI versus (26%) TTD. 

The point is that even a perfect earnings report (if we agree TTD had a perfect earnings report) may have been sold off due to the strong price action Magnite has seen recently as Magnite has been beating the ad-tech favorite (TTD) for going on 14 months in price action. Eventually, the market is going to take a breather. The strong price action is based on the stock often hovering in a 1 to 2 forward price-to-sales with a strong bottom line, unlike most small caps right now. Magnite didn’t lose any major ground on its bottom line. 

Most importantly, weak ad budgets in 2023 are a gale rather than simply a headwind. This is a powerful force that we are seeing across every single ad-tech name right now in terms of YoY deceleration (Q4 is always strongest quarter for ad-tech so the YoY is the important comp).  

Magnite is correct in that the bottom for budgets is likely to be hit when you least expect it, hence the comment we could be at the bottom right now.  Most investors may not care to time a bottom with their ad-tech stocks. We are going to attempt to time the bottom, and so it’s likely you see us exit Magnite, and then rely on technicals for when to re-enter.