The I/O Fund built a position in Netflix with real-time trade alerts starting with an entry at $220.71 on August 30th and at $255.08 on November 7th.

After seeing gains of 43.8% from the first entry and gains of 24.4% from the second entry, Knox then trimmed some of the position to take profits.

For our Essentials Members, Knox will release a private video next week that discusses our plan for building this position and/or our plans to take profits in the future. This video will be similar to the information provided above regarding our positioning but will be forward-looking on what entries we plan to do next OR if we plan to trim and add again at a later time.

Below, is a fundamental analysis on Netflix including the specific reason that Q1 and Q2 could be “the quarters” for Netflix to become a stock market darling.

Please note: We are not financial advisors and our disclosure regarding this is at the bottom of the article.

Our goal is to do the following:

• Provide you with a December stock pick that we believe may be the top stock of 2023. We want to give you information around the specific catalysts we are expecting in Q1 and again in Q2 that has made Netflix a buy off the August lows.
• We want to provide real investment tools to our Essentials members by providing the same level of technical analysis we use for our portfolio and we use on the Advanced Market Signals service to time entries and exits. This includes allocations (the #1 tool for risk management) and will be provided early next week on a recorded video presented by Knox, the I/O Fund portfolio manager.
• We do not think blanket BUY recommendations are helpful as the market is tumultuous and complex. We are real investors and everything we do is actionable for stock investors. The material you receive on this site is anchored to real decisions we are making with our own portfolio. If it’s not impactful, we will not write the content or produce the video. This is different than other sites that simply fill content pipelines to “get something out” so their customers are satisfied. This is why we believe we offer some of the highest quality content across research sites — the content is being used for real investment decisions and there is zero fluff.

Background on Netflix in 2022:

Below is a brief overview of Netflix’s ad opportunity before we discuss the specific catalysts coming in Q1 and Q2 of 2023.

Netflix’s stock was down a staggering 71% this year. The stock’s fall from grace included dropping its FAANG-status as the company’s market cap has decreased from $300 billion to $75 billion. This was partly due to the company reporting it lost subscribers for the first time since 2011, with a loss of 200,000 subscribers in the most recent quarter. The company also forecast a decline of 2 million paid subscribers for the second quarter.

The earnings report caused the stock to lose 35% of its value over night. Bill Ackman sold his Netflix shares for a loss of $450 million in three months, with some critics goading him for his decision while others congratulated Pershing Capital for being bold and walking away from a losing position.

Meanwhile, our focus was elsewhere.Meanwhile, our focus was elsewhere.

In our Netflix coverage following its earnings report, we had stated “we can’t help but salivate” over which ad platform Netflix might choose to power ads to hundreds of millions of viewers. Primarily, this is because we have consistently discussed why the trend of CTV ads has plenty of runway even during an epic market selloff.

In other words, I would argue the day that Netflix’s stock price dropped 35% was consequently one of the most important days in the company’s history in terms of its chances for a boost in revenue and a renewed uptrend.

Patience, though, will be required, as Netflix has work to do. We prefer to get in front of the market instead of wait for the market to put the pieces together on what this global juggernaut is setting up to do.

The path to adding more subscribers is finally clear for Netflix and will pay off in 2023 especially during times of inflation or muted consumer confidence as it drives down household costs across fragmented subscriptions.

Ad-Supported Video on Demand (AVOD)

The acronyms AVOD and CTV ads (connected TV) should be added to your investment vocabular as this is the most investable trend in media today. Ad-supported video on demand (AVOD) refers to streaming subscription services that supplement with ads or streaming services that are entirely ad-supported. CTV ads are often synonymous with AVOD, however, it can also refer to Broadcast Video on Demand (BVOD) for when live broadcast content is streamed over the internet.

Mobile ads have flatlined yet AVOD is in its early stages of growth. This will become especially apparent during times of economic hardship as subscribers trim back on their many streaming subscriptions and turn to ad-supported content to drive down costs.

We had written an editorial a year ago on Forbes called the Crucial Difference between Netflix and Roku Stock. At the time, we pointed out that: “we believe first-party data for connected TV ads is a significant trend moving into 2021 and an important distinction from subscription-video on demand (SVOD) […] Ad-Video on Demand (AVOD) has an approximate ten-year runway as the trend began taking shape when Roku launched its ad platform in late 2018/early 2019. There were AVOD players in the space before this, but the budgets were negligible.”

Why was mobile capable of capturing such large budgets? Because of first-party data which traditional TV lacks. CTV ads are also capable of capturing large budgets because advertisers are willing to pay more for targeted ads.

Due to your viewing habits, Netflix knows a lot about you. Selling this to advertisers emulates more closely the level of ad demand a company like Facebook would see, who also powers ads with behavioral-level data.

The Market Mistakenly Thinks Netflix is Saturated

There is immense opportunity when a stock investor can prove the market is wrong about a company. With Netflix, a leading line item that investors must be confident on is that the company can grow its user base.

Source: Nielsen

Netflix is tied with YouTube on total viewing time but there’s a catch. Netflix has only 223 million subscribers and YouTube has over 2 billion due to its digital video app. For most purposes, these two are not truly competitors, rather YouTube is a hybrid between a social mobile app and a CTV streaming service. YouTube TV has a mere 5 million subscribers.

What matters most to advertisers is time spent watching content and Netflix clearly wears the crown in the streaming wars.

Netflix does not believe their market is saturated, rather that advertising opens up a new, sizable addressable market. The company offered the following information: “In the 190 countries in which we operate, our $30 billion-plus of annual revenue is roughly 5% of the combined estimated ~$300 billion pay TV/streaming industry, ~$180 billion branded advertising market, and $130 billion consumers spend annually on gaming. So, we believe that we have a long runway for growth if we can continue to improve our offering steadily over time.”

We had stressed in our previous coverage that the lagging discussion on Netflix is that there was a subscriber decline in Q1 of 200,000, excluding Russia and a subscriber decline of 970,000 in Q2.

While critics believe this is due to saturation, it’s much more likely the decline is coming from a pull forward due to Covid as all media stocks – both streaming and social media – demonstrated outsized audience growth through Q2 2021.

Therefore, Netflix is lapping some tough quarters for audience growth comps and announced in April their plan to have an ad tier to help combat this.

Management’s willingness to combat subscriber falloff with an ad tier is why we entered in August prior to the subscriber beat.

Another important point we had highlighted was there is already evidence that Netflix is taking more market share than its peers. In fact, Nielsen raised Netflix’s market share earlier this year for engagement to 7.7% from 6.6%, which puts Netflix in the lead over any other competing subscription service.

Q3 Netflix Earnings Results:

Netflix comfortably beat earnings estimates with 2.4M net adds compared to 1M to 1.2M expected. Consensus for next quarter was 4.1M with Netflix guiding for 4.5M. This will be the largest account growth since Q3 2021.

Why Q1 is Critical for Netflix’s 2023 Stock Trajectory

There are two chess moves on the table that can help propel Netflix to become a leading stock in 2023. The first is the moment when Netflix simultaneously cuts off password sharing while having the ad-supported tier available to the customers being cut off from sharing accounts.

Netflix has an estimated 100 million rogue subscribers who are sharing passwords with friends and family members. It’s this cohort of 100 million password sharing fans that the ad-supported tier is squarely aimed at converting.

Let’s look at what management has said:

“Finally, we’ve landed on a thoughtful approach to monetize account sharing and we’ll begin rolling this out more broadly starting in early 2023. After listening to consumer feedback, we are going to offer the ability for borrowers to transfer their Netflix profile into their own account, and for sharers to manage their devices more easily and to create sub-accounts (“extra member”), if they want to pay for family or friends. In countries with our lower-priced ad-supported plan, we expect the profile transfer option for borrowers to be especially popular.”

Translation: In early 2023, Netflix is going to cut off the 100 million and offer them two options: 1) pay to be an extra member on the family plan or 2) export your profile, keep your viewing data, and pay for a lower priced ad-supported plan.

Patience from investors is required because Netflix is the first tech company in our universe to report every quarter. Netflix will not have this rolled out for the Q1 guide coming in mid-January but we do believe it will show up by the full quarter Q1 report in April with an informed guide for Q2.

The Second Chess Move is called The Upfront Season

Every year, advertisers and agencies negotiate and sign year-long deals with TV networks as well as connected TV platforms to commit to spend an agreed amount on ads. They call this the upfront season. Last year, NBCUniversal clocked $7 billion in the upfront season and Roku grew it’s upfront spend from$500 million to $1 billion.

The 2023-2024 upfront season will take place in the late Spring and early summer of 2023.

Netflix is a $30 billion company and so something along the lines of a $7 billion upfront may seem small. However, if you go back to the Nielsen pie chart that shows viewing time, you’ll see that NBCUniversal doesn’t even make the list, representing less than 1% of viewing time. Disney makes the list at 1.9% and had a $9 billion upfront season.

I won’t give you an exact number on what this upfront season will pull for Netflix as their AVOD subscriber base will not be mature yet. Meaning, it may be more in the category of the lower percentage streaming services on the ad-supported side. What matters is that even a $7 billion or $9 billion up front (let’s think positive here based on the comps) would result in a 20%+ boost in revenue.

If the two chess moves line up, they will both be a strong statement the market is wrong on Netflix’s saturation. the market is wrong on Netflix’s saturation. 

Netflix is trading a historic low on both its sales valuation and earnings-based valuations. However, is now the time to buy or is it better to wait for a renewed uptrend? We fully believe the single most important time to buy is when the broad market participates (Nasdaq, S&P 500).

Next week, Knox Ridley will record a special Netflix webinar for you as part of your Essentials package going over Netflix’s technical setup in detail so our Essentials Members are as informed as possible.

As you know, we can’t control the market – what we can do is tell you what we do with our money including when we buy/sell/add/trim and why.

Look for that YouTube video published on our Essentials site next week.

Thank you for being a Founding Member to our Essentials Plan. We officially launched the plan last week are excited for this new tier to our analysis.

Disclosure: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. The I/O Fund owns Netflix at time of writing.

We are going to cut our Marvell position until next year. The company missed across the board on every line item and we think there are stronger horses in the stable (for now).

While I have your attention and before I lose anyone on the mundane numbers: Marvell is an exceptionally strong product story. That is hard to see right now … but it’s a top 5G semi and a top AI semi and has a solid entry into automotive and CXL. By 2024, the words “CXL” will be similar to 2022’s words “silicon carbide” for buzz and stock returns. I’m not wavering on conviction; I’m wavering on timing. Also, per the earnings call, 5G is closer than one might think as Nokia is expanding into India and Marvell is the exclusive infrastructure supplier.

So, Marvell is taking a commercial break in our portfolio and we will be back soon.

Q3 Earnings Report:

The current quarter came in slightly below expectations but the fiscal Q4 guide had a larger, unexpected miss.

Marvell reported revenue of $1.53 billion for growth of 27%. This compares to estimates of $1.56 billion and growth of 28.5%.

For fiscal Q4, Marvell is guiding for revenue of $1.4 billion compared to $1.61 billion expected. This will represent growth of 4.5% down from 20% expected.

GAAP EPS of $0.02 this quarter missed estimates of $0.05-$0.13 that was provided by management. Adjusted EPS of $0.57 was reported compared to $0.59 expected. Adjusted EPS guidance for next quarter at $0.46 missed estimates of $0.61, at the midpoint.

On average, there was a one point miss across the top line and bottom line margins. GAAP gross margin of 50.6% compared to 51.1% guidance. Adjusted gross margin of 64% compared to 65% guidance.

The GAAP operating income of 6.9% compares to 8% expected. The adjusted operating margin of 36.7% compared to 37% guided. This resulted in $105.8 million in GAAP operating income and $561 million in adjusted operating income.

The company has operating cash flow of $411 million and free cash flow of $363 million. There is $723 million on the balance sheet.

Revenue Segments:

Marvell beat/met on data center and carrier infrastructure and missed on enterprise networking and automotive.

• Data center grew 25% for revenue of $627M compared to 20% growth expected.
• Carrier infrastructure was in line and grew 26% for revenue of $271M compared to mid-20% growth expected.
• Enterprise networking missed with growth of 52% for revenue of $376M compared to 70% expected.
• Consumer declined (2%) compared to (10%) for revenue of $178 million
• Automotive missed for growth of 26.6% and revenue of $84.2 million compared to 40% growth expected.

Additional Notes:

China greatly impacted Marvell’s guide for next quarter, especially the enterprise networking segment. Per the opening remarks:

“Just to give you a sense of the magnitude of that change, we estimate that our revenue in the fourth quarter from our OEM customers based in China will decrease by over 1/3 compared to the second quarter. We expect revenue from China OEMs will account for less than 10% of our total company revenue in the fourth quarter.”

Despite the beat, storage weighed on the data center segment yet cloud was robust, per management:

“Our storage products, including fiber channel, HDD and SSD, all saw demand decline during the quarter. However, our cloud business continued to grow sequentially, driven by strength in our electro-optics and switch products.”

There is a disappointing guide for data center though for Q4:

“We are seeing the growth rate of the data center end market decelerate and customers have started adjusting their inventory to address the changing demand picture. As a result, for the fourth quarter of fiscal 2023, we are expecting our data center revenue to decline year-over-year approximately in the mid- to high teens on a percentage basis and sequentially decline in the mid-20% range [..] In particular, we are projecting a very large reduction in shipments of our HDD controllers and preamps, as HDD OEMs deal with a broad-based inventory correction.”

Carrier infrastructure is an area where Marvell is likely to positively surprise investors next year. Nokia is beginning to ramp using Marvell’s OCTEON 10 DPU, which we have covered in the past. In addition, Marvell helped pioneer OpenRAN for Layer-1 processing capabilities. Nokia/Vodafone and Samsung/Vodafone are partnering on OpenRAN with Marvell and using the company’s accelerator chip, the OCTEON Fusion processors.

Next quarter, automotive is expected to be strong with 30% YoY growth and mid-20% QoQ growth.

Carrier infrastructure is expected to grow mid-teens next quarter and to grow low single digits sequentially.

Marvell continues to provide clues on when it could possibly become a semiconductor leader again in the market. In addition to CXL ramping at some point next few years, the company also stated: “We expect that our cloud optimized silicon programs will build from the initial ramp that started in the second half of this fiscal year and continue to grow approximately $400 million in aggregate revenue in fiscal 2024 and $800 million in fiscal 2025 […] In addition to our cloud optimized programs, we expect that our 5G products in our automotive business will drive strong year-over-year revenue growth in fiscal 2024. Offsetting this growth to an extent, we expect a few quarters of inventory adjustments in some of our businesses as customers realign their demand.”

My translation: Give Marvell one to three quarters through Q2 of next year at the latest and come back to the stock somewhere in that window.

Marvell also gave us a good gauge on what to expect next year on Big Tech CapEx:

“Matt Murphy 

Yes. Great question. So let me take it from the top. So, first point would be that if you look over the last few years, cloud CapEx has been on fire. It's been growing 30% kind of plus for the last few years. This year, if you look at reports and kind of what we see is probably something in the 15% range for '22 and then it depends on who you talk to, but probably down in the low to mid-single digits or maybe mid-single digits for next year.”

Conclusion:

We will revisit Marvell again sometime next year. To understand why we like the company in the face of lumpy earnings reports, please reference our last deep dive here. Perhaps it’s because I know the stock well at this point, but it’ll be a top pick for us on 5G in the near term. They spoke about Nokia expanding into India, as well as Europe. Given we may see few growth stories next year, Marvell may be one that finds a new growth trajectory from deep telecom pockets. The other segments are also to not be overlooked, especially if the China headwinds clear.

The stock initially sold off about (13%) on lower product revenue, which went from 67% reported in Q3 to a guide in Q4 of 49% to 50%. This implies total revenue will follow as the two are closely related with product revenue making up 94% of total revenue. Technically, the product revenue guide implies a miss for Q4 as estimates were for 52.78% growth.

On the call, the stock regained some ground to finish at (6%) AH once management stated the full year 2024 product revenue would be 47%. Technically, this is also a miss as analysts had the number at 51% growth.

I'm not confident SNOW can resist further decel throughout FY2024; that's a bold guide with little to back it up.

It requires a lot of faith in management because they are essentially saying even though Q3 to Q4 dropped by 17% on product revenue growth (67% to 50%), they will only see a 3% drop for the following four quarters or an average decel of less than 1%.

It's also odd to get a FY guide right now as I looked at Q3 2022 call and it was not provided at that time. Yet, we are in even more uncertain macro backdrop than last year.

My concern is if the guide was intentionally provided to soften the blow for Q4’s product revenue meanwhile management has zero visibility to provide reliable guidance of this kind. I bring up zero visibility because at one point, management admitted to not having enough visibility to know how RPO will turn out for Q4, and yet they’re guiding early on FY2024 revenue.

The Q4 guide of 50% is only acceptable if there is no further decel. Otherwise, analysts will model a lower FY2024 and that would have hurt the price quite a bit. The motivation here is clear to me (give a full year guide that implies no deceleration) but how realistic is this? I discuss my thoughts in more detail below under Additional Notes.

Snowflake Financials Overview:

Snowflake beat on product revenue in Q3 with revenue of $522.8 million, and growth of 67%. Management had guided for $502.5 million, at the midpoint. Total revenue tracks in line with product revenue for revenue of $557 million and growth of 67%.

I’ve got a miss on Q4 in my notes as the product revenue growth of 49% to 50% will cause total revenue to fall short of estimates at 53.4%. MarketWatch also confirmed this is miss on product revenue with management guiding for $537.5 million at the midpoint while analysts were expecting $553 million.

The full year is in line with management guiding for $1.91 to $1.92 billion in product revenue, compared to analyst expectations of $1.92 for growth of 68%. Total revenue for the fiscal year is expected to be $2.04 billion for growth of 68%.

GAAP EPS was in line at ($0.63) although this is steeper than the ($0.51) EPS in Q3 last year. The adjusted EPS of $0.11 beat estimates of $0.04.

There were no surprises with the gross margins, GAAP and adjusted GM across total revenue and product revenue were all in line.

GAAP operating margin of (37%) was better than previous quarters. Adjusted operating margin of 8% was also better than previous quarters and came in higher than the 2% guidance offered by management.

GAAP net margin of (36%) was also better than previous quarters.

Snowflake silences the debate on if stock-based compensation affects stock price. The company paid SBC of $229 million in the most recent quarter, or 43.8% of revenue. Yet, the market overlooks this high SBC margin and Snowflake trades at the highest valuation in the cloud universe.

Key Metrics:

RPO was in line at $3 billion with a slight acceleration from last quarter, at $2.7 billion. As stated on the forum prior to the earnings report, “For Snowflake, the market has accepted flat sequential growth on RPO as it really comes down to Q4 for Snowflake — this is where the majority of RPO growth happens sequentially. Last year, the company had sequential Q3-Q4 RPO growth of 30%.”

Net retention rate of 165% is lower than 171% reported last quarter but still a category leading number.

Within customer growth, Global 2K customers accelerated from 15% last quarter to 18% this quarter. The customers with TTM > $ 1million decelerated although still healthy at 94% growth.

Total customer growth was at 34% compared to 36% growth last quarter.

Additional Notes:

My contention is that with the 51% growth estimates — and now management’s guide for 47% — this assumes consistent consumption as we move into a possible recession.

The estimates pictured above help to reveal how little variation there is built into throughout FY204 estimates, and yet this year has shown us Snowflake is capable of wide variability. There are some flat quarters, such as Q1 to Q2, but inevitably there was a strong decel and it’ll require serious trust in management to assume no further material decel from Q4.

Here is what was discussed in the call:

“Sanjit Singh

This is Sanjit Singh for Keith. I wanted to go back, Mike, to some of the guidance framework that you laid out for us, particularly with respect to fiscal year '24, I think you talked about 47% growth. Is there any way you can sort of draw the bridge for us in terms of next quarter you're guiding to think about 49% at the high end; and then for the full year next year, approximately 47%. What sort of gives you the confidence that your Q4 exit growth rate is going to be durable going into next year?

Mike Scarpelli

Sure. Well, I'll say Q4 is — it is a quarter that has a lot of holidays in it, and we do think we've lived through COVID that people are traveling more. There is a big human component as well, too. So we all along have been forecasting that Q4, we'd see the impact of that, but we also have a number of significant customers that we have signed up, that we see them ramping up next year on Snowflake as well as some of the things we're doing with Snowpark with Python, we're starting to see traction in that as well, too. But we think that's going to be more of a 2024 impact.”

Product revenue is expected to grow 3% between Q3 and Q4. Last year, it grew 15.3% sequentially. So, even with the holidays being in Q4, the slowdown is much more prevalent this year than last year’s comps.

Notably, we covered Snowpark with Python last quarter and agree it’s a strong offering that investors should pay attention to. General availability went live Nov 7th.

There was a moment that Snowflake discussed October being weaker than expected, which further complicates a bold FY2024 guide.

“Gregg Moskowitz 

Congratulations on delivering very healthy product revenue in this environment. My question relates to Q4, where obviously the product revenue guidance was below where consensus was. And I'm curious, how much of this Mike is a reflection of a moderation in consumption in the month of November or over the last six weeks, as you said, in APJ and across the SMB as opposed to embedding more conservatism amid the existing macro uncertainty. Would you say it's tilted more towards one versus the other?

Mike Scarpelli

Well, the way we do our forecast is based upon historical performance, and we definitely did see a slowdown in the month of October, not that dramatic, but we typically would see week-over-week growth and we saw a number of weeks where it was pretty flat. I will say November is starting to tick back up again, and that's all factored into the guidance given the macro backdrop we have right now.”

Conclusion:

Thankfully Snowflake is not down 20%+ right now like many of its cloud peers. Yet, I can’t quite get comfortable with the FY2024 guide as it assumes no further decel from a company that decelerated quite a bit from the last year’s Q4.

As you saw today, we are not looking to go to the river with a stock that is priced 30% higher than its peers in a cloud-conscious market and that has now provided a guide that is hard to believe. Snowflake is capable of exuberant price action so we will us technicals for entries and exits.

The question of “why did Crowdstrike sell-off” doesn’t seem to be satisfied by the $10 million miss on forward revenue and ARR.

Forward Q4 revenue was expected to be $634M and the company guided $619M to $628M for a miss of about $10 million, if we take a midpoint of $624 million (about 1.5% miss). ARR was $2.34 billion compared to analyst expectations of $2.35 billion, for a $10 million miss (less than 1% miss).

Although this likely contributed, I believe the analyst we quoted in our Pre-ER write-up that was modeling for net new ARR of $224M to $230M-plus may be providing a missing link between analyst expectations for this key metric and actual results of $198 million. At the midpoint, this would be more of a miss of 14.6%.

Here is what was said in the Pre-ER write-up:

“An analyst note from Barclays’ Saket Kalia is modeling ARR net addition of $224 million “but thinks upside could be $230M-plus given strong pipeline commentary.” At $230M, it would represent 5% sequential growth and 35% YoY growth. This would be down from 15% sequential growth in the previous quarter and 45% YoY.”

The reason we flagged this is because the net new ARR at high point of $230M would still mark a strong deceleration to 5% sequential growth down from 15% sequential growth last quarter. This means this would have to be met or we would be nearing flat to negative sequential growth on net ARR.

With the actual of $198 million reported, this drops the net new ARR at negative sequential growth of negative (9%) down from $218 million last quarter. This marks a change compared to the comp of 13% in sequential growth from Q2 2022 to Q3 2022.

The market is nervous with cloud becoming the other shoe to drop as enterprise budgets will slow long after consumer slows due to annual billing cycles, annual budget reviews (i.e., likely to produce budget cuts) and due to higher switching costs (or in cloud’s case, slower to switch off than consumer or ad spending, for example).

In my opinion, this is why outsized pressure is being placed on sequential growth. The market does not care about YoY because it’s assuming enterprise spending wasn’t affected yet.

CrowdStrike Q3 Overview:

CrowdStrike beat both top line and bottom line for Q3. In fact, an area where CrowdStrike continues to stand out from its peers is the health of the bottom line and both Q3 actual and Q4 guide was no exception in this regard. For example, the free cash flow margin of 30% is exceptional.

The company reported revenue of $581 million for growth of 53% compared to revenue of $574 million expected for growth of 51%. This is a slight deceleration from 58% last quarter.

For Q4, the company guided for revenue of $619 million to $628 million compared to expectations of $634 million. At the midpoint of $623.5 million, this is a $10.5 million miss.

The GAAP EPS of ($0.24) compares to ($0.22) EPS from the year ago quarter and ($0.25) EPS last quarter.

Adjusted EPS for Q3 came in at $0.40 compared to $0.32 expected. This compares to $0.36 last quarter and $0.17 in the year ago quarter.

Adjusted EPS guide for Q4 also beat at $0.42 to $0.45 compared to $0.34 EPS expected.

GAAP gross margin was 72.7% which was in line with a range of 73% to 74% over the past five quarters. The adjusted gross margin this quarter was at 75% compared to 76%-77% over the past five quarters. Subscription gross margins were also in line.

GAAP operating margin of (9.70%) compares to (9%) last quarter and (10.5%) in the year ago quarter. This resulted in GAAP operating loss of ($56.4) million which is a tad higher than the $48 million losses last quarter and the $40 million losses in the year ago quarter.

The adjusted operating margin was a beat in Q3 and Q4. This was a bright spot in the report with adjusted OM of 15.4% compared to 13% estimated. This compares to 16% Adj OM last quarter and Adj OM of 13% last year. This was essentially flat and it’s important it did not contract.

The guide on adjusted operating income of $87.2M to $93.7M implies an adjusted operating margin of 14.5%.

The GAAP net margin of (9.4%) and adjusted net margin of 16.5% was in line with previous quarters. The guide for adjusted net margin is also in line at 16.6%.

CrowdStrike is very strong on cash flow margins and is one of the top ranking cloud stocks in this regard. This quarter the company reported a free cash flow margin of 30% for FCF of $174 million. The company is guiding for a FCF margin of 28% to 30% next quarter. The operating cash flow was $242.9 million for a margin of 41.8%. There is $2.47 billion in cash on the balance sheet.

The company paid $140 million in stock-based compensation for a margin of 23.7%.

Key Metrics:

As stated in the Intro, the key metrics are likely causing the sell-off.

RPO was up 44% year-over-year for $2.797 billion and was up 11.6% sequentially. However, management reminded analysts that ARR is the leading key metric for their business.

Ending ARR grew 54% year-over-year to $2.34 billion and grew 9.3% sequentially. Therefore, because ending ARR was strong, the net new ARR could be easily underestimated in terms of impact. The net new ARR at $198 million in fiscal Q3 compared to $218 million net new ARR in fiscal Q2 indicates a 9% sequential decline.

The market has the jitters right now so the sequential decline is important to pay attention to especially because management said to expect further weakness in the upcoming Q4 quarter. Here is what the CFO said:

“Even though we entered Q3 with a record pipeline, we are expecting the elongated sales cycles due to macro concerns to continue, and we are not expecting to see the typical Q4 budget flush given the increased scrutiny on budgets. While we do not provide net new ARR guidance given the current macro uncertainty, we believe it is prudent to assume that Q4 net new ARR will be below Q3 by up to 10%.”

If I understand the CFO correctly, then this implies a net new ARR of $178.3 million for Q4 (10% lower than the current quarter at $198.1M) compared to net new ARR of $216 million in the year ago quarter. This is important because it’ll mark not only a sequential decline but a year-over-year decline in net new ARR. The market had already sold off for what I presume was a sequential decline in Crowdstrike’s leading key metric, and management then stated the decline would be steeper for Q4 on the call. Once the comment above was made, we were certainly not going to see a reversal in the stock price from the earnings call.

Customer count was strong at 44% growth. The mix of domestic versus international was slightly lower than usual for North America at 69% with EMEA being slightly higher at 15%.

Deferred revenue grew 56.4% year-over-year and backlog grew 19%.

Additional Commentary:

CrowdStrike was transparent about the importance of ARR even in the face of net new ARR being lower than expected. Here is what was said by the CFO:

“And then finally, just to comment on ARR. You pointed out that's how we run our business. ARR, though, is really an X-ray into the contracts themselves. And as we view that as the most important — or most transparent metric into the outlook for our business, that's the one where we're focused on. So, hopefully, that gives some more clarity on how we think about cRPO and ARR.”

Later on, an analyst did zero-in on the (9%) decline.

“Andrew Nowinski

Great. Thank you for taking the question this afternoon. So total ARR of $2.3 billion, growing 54% is still absolutely amazing, I was – and it's at scale. But I was wondering, were you surprised that the net new logos that you added were down 9% this quarter?

Burt Podbere

Thanks, Andy. So when we think of the net new logos, it really corresponds to what we talked about in terms of what we saw in that SMB space. The SMB space is the one that drives the velocity of our net new logos. And as we talked about, we saw an 11% increase in our sales cycle in the SMB space. And that actually equated into $15 million in terms of deals in that space that could push out. And so when you think about 15 million in that space and what it means in terms of logos, where you can do the math, it's a pretty big number.

So that's how we think about net new logos corresponding to what we saw in net new ARR from the SMB space. So from that perspective, we weren't surprised at the end of the day when we saw that what happened with respect to the increased sales cycles and the amount of money that got pushed out in the SMB space.

My note: Just to be clear, when they say “push out” they are referring to a delayed sales cycle for an impact of $15 million.

The CFO did reiterate the 10% further sequential decline in net new ARR between Q3 and Q4 when he said:

“When we do talk about net new ARR, I did talk about in the prepared remarks about how we think about up to 10% headwinds going into Q4 from Q3, and that's just to coincide with some of the headwind activity that we saw accelerated at the end of this quarter. So that's how we think about that.”

Conclusion:

Given the tough macro, our goal is to fully understand why the market may favor some stocks and deeply discount others after an earnings report. The market is getting nervous on cloud. We talked about this with Microsoft and also saw this following Datadog’s report.

As a reminder, here is a brief overview of Microsoft’s report:

“Microsoft is guiding down for next quarter with analyst expectations for the December quarter at $56.04 billion compared to management guidance on the call for revenue of $52.75 billion, at the midpoint. This represents 2% growth. […] That’s a 11% deceleration over the next few months. Some of this may be coming from Azure as the company is expected Azure to decline 5% next quarter for its current growth rate. This will be 37% growth on a constant currency basis, down from 42% this quarter.”

Here is a snippet from our Datadog ER write-up:

“RPO decelerated and is a concern. The deceleration we noted in our last earnings report and our pre-earnings write-up where we noted the deceleration went from 85% to 51%. This quarter, the deceleration steepened to 31% year-over-year growth for $941 million. RPO is still up on a sequential basis with $858M in RPO in Q1, $881M in RPO in Q2 and $941M in RPO this quarter. If it were to decline on a QoQ basis, the stock would be deeply penalized, so we will monitor this as we go along.”

What we saw today from CrowdStrike sounded very familiar, in my opinion. The market is nervous about cloud and is swiftly discounting these stocks on slowing revenue plus any additional signs revenue may slow in the future. We will need to see more information to draw any conclusions, most especially we will need SentinelOne’s report coming next week.

Most recent coverage on product:

Forum: Crowdstrike’s Pre-Earnings Report

https://io-fund.com/premium/crowdstrike-cybersecurity-is-techs-leading-sector

https://io-fund.com/premium/cybersecurity-stock-faceoff-crowdstrike-vs-zscaler-vs-cloudflare

https://io-fund.com/cloud-software/cybersecurity-continues-to-lead-cloud-stocks

There were a few key things discussed on the call:

• Why the H100 will ramp faster than the A100 with Q1 being the estimated time when we should see the H100 driving forward data center growth (we should get an acceleration this quarter in the DC segment).
• How the H100 helps drive enterprise software revenue as it’s been optimized with Nvidia’s software stack.
• The strength of Nvidia’s networking business following the acquisition of Mellanox.
• The CEO believes even if hyperscalers slowdown spending in 2023, that Nvidia is more insulated because their systems are optimized for AI acceleration, which is a top priority within capex spending, and because their systems reduce costs and improve efficiency.

My specific investment thesis is this: “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.”I detail what I think is the most important Q&A from the call below plus other moments that provide a glimpse into what Nvidia investors can expect from here.

Note: I did not cover gaming in this analysis because I am covering Nvidia’s gaming bottom for my free newsletter. I’ll make sure to post this separate analysis on the forum early next week. The H100 will be absent since we are entering an actionable phase with the CEOs discussions about Q1. Actionable analysis, for the most part, is reserved for premium.

Financials:

Note: calendar months are provided to avoid confusion due to Nvidia’s off calendar fiscal year. This upcoming report will be Q3 FY 2023

Nvidia reported as expected for Q3 ending in October with revenue of $5.93 billion for growth of (17%) which matched management guidance of $5.90 billion. Analyst consensus for revenue was $5.85 billion, or (17.7%) growth. 

Fiscal Q4 ending in January was a slight miss with guidance of $6 billion compared to analyst consensus of $6.17 billion. This represents growth of (21%). The guidance has led to slightly lower estimates for Q1 ending in April with revisions from (19.8%) to (22.5%) for revenue of $6.41 billion.

As stated on the forum in the pre-earnings write-up, analysts have Nvidia returning to positive growth by July 2023 and to strong growth of 35%+ by October of 2023. This is helped by the low comps that we are currently experiencing.

Nvidia reported adjusted EPS of $0.58 which missed adjusted EPS estimates of $0.71. This compares to the July quarter of $0.51 adjusted EPS. Management indicated that profitability will increase from here: [GAAP and non-GAAP operating expenses were] primarily due to higher compensation expenses related to headcount growth and salary increases and higher data center infrastructure expenses. Sequentially, both GAAP and non-GAAP operating expense growth was in the single-digit percent, and we plan to keep it relatively flat at these levels over the coming quarters.”

An analyst did bring up that stock based compensation has been increasing each quarter at $700 million in the current quarter, up from $648 million and $578 million in the two previous quarters.

In Q3, the GAAP gross margin was 53.6% and the adjusted gross margin 56.1%. This was a miss from management Q3 guidance of 62.4%. The reason for the miss related to China: “Gross margins reflect $702 million in inventory charges largely related to lower data center demand in China, partially offset by a warranty benefit of approximately $70 million.” Nvidia is signaling the gross margin will return to normal next quarter with a guide for GM of 63.2%.

The company reported operating profit of $601 million for an operating margin of 10.1%.  This compares to management’s guidance for an operating margin of 18.5% with Nvidia’s typical OM at 37% to 38%.

The adjusted operating margin of 25.9% is down from the typical range of 47%.

GAAP net margin of 11.5% for net profit of $680 million was up from a GAAP net margin of 9.8% in the previous quarter. The adjusted net margin of 24.5% for an adjusted profit of $1.46 billion compared to 19.3% in the previous quarter.

For the most part, Nvidia’s bottom line showed signs that last quarter was a bottom for the company with marginal, yet crucial improvement sequentially.

Nvidia had lower cash flow margins than it did last quarter at a 6.61% operating margin for operating cash flow of $392 million compared to a margin of 18.9% last quarter for operating cash flow of $1.27 billion. The free cash flow margin was (2.6%) for free cash flow of ($156) million compared to a 12% margin last quarter for free cash flow of $824 million.

The company had stock-based compensation of $745 million in the quarter, up from $648 million last quarter. There is $13.14 billion in cash and $10.95 billion in debt. The company returned $3.75 billion to shareholders with share repurchases and cash dividends. There is $8.3 billion remaining under the share repurchase authorization through December 2023.

 

Nvidia Discusses Why the H100 Will Ramp Faster than the A100

Since our thesis is that the H100 will drive sales and the stock price over the next couple of years, similar to the A100, we want to make sure we are getting confirmation of how the H100 is performing now that it has been on the market for about a month.

 

Why the H100 is Special

1.     Enterprise Software

The first question from C.J. Muse discussed how the H100 is bundled with Enterprise Software, and the timing of when software monetization will begin to occur. The answer from the CEO was effectively “now.”

Here is what Huang said:

“Every company we’re talking to would like to have the agility and the scale, flexibility of clouds. And so, over the last year or so, we’ve been working on moving all of our software stacks to the cloud – all of our platform and software stacks to the cloud. And so today, we announced that Microsoft and ourselves are going to standardize on the NVIDIA stack, for a very large part of the work that we’re doing together so that we could take a full stack out to the world’s enterprise. That’s all software included.

If they would like to use it in the cloud, it’s per GPU instance hour; if they would like to utilize our software on-prem, they could do it through software license and so — license and subscription. And so, in both cases, we now have software available practically everywhere you would like to engage it.

2.     The CEO stated H100 is going to Ramp faster than the A100

This was the discussion I felt was most important to Nvidia investors on the call. Second place would be the discussion around the Gaming bottom. Enterprise software is certainly important to as the software stack will eclipse hardware at some point. However, today, Nvidia is a hardware company and visibility into the pace of H100 adoption is key for our 2023 position and allocation.

Notably, I believe there will be positive surprises in the data center segment as we go along into 2023. It’s prudent for analysts to be cautious as we don’t have big tech capex numbers yet and the H100 has only been out for a month. Eventually, enthusiasm for Nvidia will return and it’ll the H100 that drives the positive sentiment. 

Here was the question, which is being quoted in full due to its importance to our thesis:

William Stein:

I’m hoping you can discuss the pace of H100 growth as we progress over the next year. We’ve gotten a lot of questions as to whether the ramp in this product should look like a sort of traditional product cycle where there’s quite a bit of pent-up demand for this significant improved performance product and that there’s supply available as well. So, does this rollout sort of look relatively typical from that perspective, or should we expect a more perhaps delayed start of the growth trajectory where we see maybe substantially more growth in, let’s say, second half of ‘23?”

Jensen Huang

H100 ramp is different than the A100 ramp in several ways. The first is that the TCO, the cost benefits, the operational cost benefits because of the energy savings because every data center is now power limited, and because of this incredible transformer engine that’s designed for the latest AI models.

The performance over Ampere is so significant that I — and because of the pent-up demand for Hopper because of these new models that are — that I spoke about earlier, deep recommender systems and large language models and generative AI models. Customers are clamoring to ramp Hopper as quickly as possible, and we are trying to do the same. We are all hands on deck to help the cloud service providers stand up the supercomputers. 

Remember, NVIDIA is the only company in the world that produces and ships semi-custom supercomputers in high volume. It’s a miracle to ship one supercomputer every three years. It’s unheard of to ship supercomputers to every cloud service provider in a quarter. And so, we’re working hand in glove with every one of them, and every one of them are racing to stand up Hoppers. We expect them to have Hopper cloud services stood up in Q1. And so, we are expecting to ship some volume — we’re expecting to ship production in Q4, and then we’re expecting to ship large volumes in Q1. That’s a faster transition than Ampere. And so, it’s because of the dynamics that I described.

My translation: Per the CEO, Q1 should be good to us Nvidia investors!

3.     Grace Hopper and the CPU, GPU, DPU Trifecta

Grace Hopper is Nvidia’s new CPU that is meant to further accelerate and be integrated with Nvidia’s GPUs and DPUs. Notably, AMD is doing the same – where their CPUs are optimized and integrated to further accelerate AMD’s GPUs and DPUs.

Mark Lipacis

Jensen, I think for you, you’ve articulated a vision for the data center where a solution with an integrated solution set of a CPU, GPU and DPU is deployed for all workloads or most workloads, I think. Could you just give us a sense of — or talk about where is this vision in the penetration cycle? And maybe talk about Grace — Grace’s importance for realizing that vision, what will Grace deliver versus an off-the-shelf x86 [CPU], do you have a sense of where Grace will get embraced first or the fastest within that vision? Thank you.

Jensen Huang

Thanks Mark. Grace’s data moving capability is off the charts. Grace also is memory coherent to our GPU, which allows our GPU to expand its effective GPU memory, fast GPU memory by a factor of 10. That’s not possible without special capabilities that are designed between Hopper and Grace and the architecture of Grace […] It all needs to be fast, so that you can make a recommendation within milliseconds to hundreds of millions of people using your service.”

 

Networking is Showing Surprising Strength

According to an analyst on the call, their calculations show networking driving most of the sequential growth. He is referencing Mellanox acquisition which we covered a few years ago in this analysis.

Ambrish Srivastava

I actually had a couple of clarifications. Colette, on the data center side, is it a fair assumption that compute was down Q-over-Q in the reported quarter because the quarter before, Mellanox or the networking business was up as it was called out. And again, you said it grew quarter-over-quarter. So, is that a fair assumption?

Collette Kress

So, looking at our compute for the quarter is about flattish. Yes, we’re seeing also growth, growth in terms of our networking, but you should look at our Q3, compute is about flattish with last quarter.

Additional comments on Networking:

“Your data center networking business, I believe, is driving about $800 million per quarter in sales, very, very strong growth over the past few years” – Harlan Sur

“Jensen, can you help us understand like where your InfiniBand networking sits relative to like traditional data center switching?” – Aaron Rakers

“Yes. Thanks, Aaron. The math is like this. If you’re going to spend $20 billion on an infrastructure and the efficiency of that overall data center is improved by 10%, the numbers are huge. And when we do these large language models and recommender systems, the processing is done across the entire data center. And so, we distribute the workload across multiple GPUs, multiple nodes and it runs for a very long time. And so, the importance of the network can’t be overemphasized.”

For more information on networking, reference our Mellanox analysis here.

 

Will Big Tech Capex Continue to Grow?

We’ve been using Big Tech capex as a proxy for our semiconductor positions. According to one analyst on the call, the presumption is capex from the Big 3 will be flat in 2023. These are still sizable budgets, but the concern is if capex flatlines in 2023, what level of growth will the data center segment be capable of?

Here was the question on the call from Vivek Arya:

“And then, Jensen, the question for you. A lot of concerns about large hyperscalers cutting their spending and pointing to a slowdown. So if, let’s say, U.S. cloud CapEx is flat or slightly down next year, do you think your business can still grow in the data center and why?”

The answer from the CEO focused on Nvidia driving growth from AI acceleration, rather than general purpose compute, which implies that Capex can be flat while Nvidia will be serving the most valuable piece in the stack. AI acceleration, according to the CEO, will not be flat or down.

“Vivek, our data center business is indexed to two fundamental dynamics. The first has to do with general purpose computing no longer scaling. And so, acceleration is necessary to achieve the necessary level of cost efficiency scale and energy efficiency scale, so that we can continue to increase workloads while saving money and saving power. Accelerated computing is recognized generally as the path forward as general purpose computing slows. The second dynamic is AI. And we’re seeing surging demand in some very important sectors of AIs and important breakthroughs in AI.”

The CEO discussed deep recommender systems, large language models driven by Transformers, and generative AI for generating images and videos. He ended the answer with this: “And so, you could see that our company is indexed to two things, both of which are more important than ever, which is power efficiency, cost efficiency and then, of course, productivity. And these things are more important than ever. And my expectation is that we’re seeing all the strong demand and surging demand for AI and for these reasons.” 

My translation: Capex can be flat and the CEO foresees Nvidia will take a higher percentage of this capex because they’re serving demand where few companies can across the three major AI breakthroughs he pointed out. My other comment would be that we won’t have a full picture of capex for next year until we get Q1 reports and 2023 full year guides around end of January. This is when we did a deep dive analysis on capex spending last year, and we will revisit this. So, keep an eye out for that.

 

Note: Nvidia Expected to Change Reporting on Data Center

There was a discussion on the call that Nvidia plans to start breaking out the data center segment to account for internet service companies in addition to hyperscalers. My understanding is internet service providers would mean 5G providers or other internet services related to edge computing. This was not directly stated but it makes the most sense given where edge computing is headed, which could rival the hyperscalers.

Matt Ramsay

I guess, Colette, I heard in your script that you had you talked about maybe a new way of commenting on or reporting hyperscaler revenue in your data center business. And I wondered if you could maybe give us a little bit more detail about what you’re thinking there and what sort of drove the decision? 

Jensen Huang:

[…] And these are internet service companies that offer services, but they’re not public cloud computing companies. The second factor has to do with cloud computing […] [hyperscalers] are two things to us, therefore, a hyperscaler can be a sell to customer; they are also a sell with partner.”

 

Conclusion:

The market has been discouraging this year. The gaming selloff for Nvidia and PC selloff for AMD were brutal. But if you listen to these calls, it is crystal clear something monumental is going on. We want to capture this as fully as possible. Perhaps we will have 40% allocation in two positions (NVDA or AMD) or perhaps we will have to trim to 15% across two positions and layer back up to 30% allocation. We will do this as skillfully as possible.

If 2021 to 2022 taught us anything, it’s that only the strong survive. That goes for stocks/companies and investors. There is no doubt that NVDA and AMD will weather what’s ahead and we want to stay close to our AI bellwethers. Whatever the tide brings us, you can expect us to obsessively cover these companies and to actually increase our coverageincrease our coverage as we go along. There is no limit to the research needed if we are building positions with conviction.

 

We covered AMD’s pre-announcement in “The One Critical Reason I’m Still Feeling Zen.” The company has a lot of lost ground to recover and I believe it has enough horse power in its product line up to do so.

This was a stronger report than first glance because by guiding flat from Q3 to Q4 for 14% revenue growth, AMD stated data center and embedded will grow sequentially to absorb PC weakness. One analyst mentioned working with a number between $800M to $900M on Client Revenue for Q4, which would be down from $1 billion in Q3. It was also directly stated gaming revenue would be flat sequentially.

Rough Idea of Q4:

$850M Client Segment, at midpoint (hinted at)
$1,600 Gaming (confirmed)
$1,750 Data Center (rough estimate)
$1,350 Embedded (rough estimate)

This would mean sequential data center growth of 9% from Q3 to Q4 compared to 6.6% sequential growth from Q2 to Q3. Embedded was flat sequentially from Q2 to Q3.

I believe the timing of the Genoa product and the glimpse of Meta’s capex means we are setting up for a strong 2023 with data centers. I believe the analysts fully understood this point on the call as PCs were certainly discussed but was not the main focus. Data center discussions had more air time in the Q&A.

Note: we go into more specs and a great detail on AMD’s products on I/O Fund Advanced. Below is a summary.I/O Fund Advanced. Below is a summary.

Q3 Financials

Most notable from the Q3 report is that the company missed on Q4 revenue guidance with $5.97 billion for growth of 23.8% expected versus $5.5 billion reported for actual growth of 14%. The market shrugged this off as AMD stated data center and embedded would grow year-over-year and sequentially. I believe this was a solid reaction as AMD is becoming a leading AI company and holding the stock hostage to cyclical PC sales is missing the larger picture.

This brought the full year estimates down by $300 million from $23.8 billion to $23.5 billion. This will represent growth of 43% down from 44.9% expected. We can see that PCs will have a $2.8 billion drag on revenue this year as originally revenue was expected to be $26.3 billion.

Adjusted EPS of $0.67 missed estimates of $0.76 adjusted EPS. GAAP EPS was $0.04.

Where AMD had some positive surprises was in the adjusted margins and cash flow. The adjusted GM of 50% is higher than the year ago quarter at 48%. This is also true for Q4’s guide of 51% adjusted GM, which is higher than the year ago quarter at 50%.

The adjusted operating margin was also higher than what we had for expectations. It came in at 23% versus 13% expected and is flat from the year ago quarter. This led to adjusted operating income of $1.3 billion for 20% growth YoY and adjusted net income of $1.1 billion compared to $893 million a year ago for 23% growth YoY. Notably, this is down from $1.7 billion in Q2.

The GAAP GM was at 42% and GAAP OM was at ($64) million and both are lower than usual due to PCs/Client Segment.

The operating cash flow of $916 million is up from $849 million in the year ago quarter and free cash flow of $842 million helped maintain a steady FCF margin of 15%.

Apples-to-apples, I think this was a stronger report than Microsoft’s – a tech titan exposed similarly to PCs – because AMD’s other segments are so strong the company is able to maintain double digit growth of 14% next quarter compared to Microsoft’s low guide of 2%.

Data Center Strength:

This was an important comment regarding cloud spending specifically within the data center segment:

“Cloud revenue more than doubled year-over-year and increased sequentially as multiple hyperscalers expanded deployments of EPYC processors to power their internal properties and more than 70 new AMD instances were launched by Microsoft Azure and Amazon, Tencent, Baidu and others in the quarter.”

Analysts pressed AMD on if they expect 20% to 30% growth in the data center next year but management declined to comment “precisely” this early. Instead, AMD went on to call out North America hyperscale spending as a key driver for next year and mentioned China will not see a significant recovery (similar to 2022).

“Now it varies by segment, and so if I go through each of the segments, what we are seeing is I think North America cloud is, probably, the most resilient out of the segments within the Data Center market and this is where AMD is the strongest […] As we go into 2023, we expect growth in that market, particularly customers moving more workloads to AMD, just given the strength of our product portfolio, and overall, Genoa coming forward.

“Moving more workloads to AMD” = That’s a comment on Intel losing market share. Woohoo! Let’s gooooo!

Below is a notable conversation about how analysts are viewing Big Tech capex and cloud infrastructure growth as a leading indicator for AMD:

Harlan Sur

Great. Thank you. And despite the macro concerns, and as you mentioned, some near-term workload optimization, your North American cloud customers, I mean, they are still growing their cloud services business at a strong 30%, 40% year-over-year growth rate and I assume that these types of growth rates like the consumption of compute networking, storage workloads and therefore, installed utilization, like, this is all quite strong in driving the need to build out more compute capacity. Is this what’s driving the team’s sort of strong mid-term outlook for this segment or is it more a function of your strong product lineup with Genoa and continuing to capture greater compute share or both?

Dr. Lisa Su

Yeah. Right. Harlan, I would say, it’s a little bit of both and I think you said it well. In the very near-term, there is a little bit of optimization that each cloud vendor is doing. But in the medium-term, what our customers are telling us is they need more compute.

And the more compute is for additional workloads building out. It’s also for upgrade of, let’s call it, older compute, given our new products have very strong TCO, power efficiency, given the cost of power and energy around the world. We are actually seeing that also be a driver for some of the conversion to AMD in the cloud as we go into 2023.

Notably, one analyst stated the company missed their model and estimate for data center revenue. The CEO replied this is due to GPUs having a tough comp from last year due to the timing of a high-performance computing release – Frontier Exascale Supercomputer. She also pointed toward lower enterprise revenue.

In addition to Data Center, Embedded was strong and AMD called out 5G infrastructure specifically. I’m hoping this translates well for Marvell.

Information on PC Market for 2023

The data center may be resilient but certainly PCs are weighing on this company. I think this question and answer was important for AMD investors to hear so I’m quoting the conversation.

“Vivek Arya

[…] what does client recovery look like, do you get back to the $2 billion quarterly rate, do you get to $1.5 billion? And I asked that because your competitor was suggesting that next year the PC TAM would only be down 4% or 5%, which seems a little bit optimistic. What do you think AMD is kind of — what kind of PC TAM does AMD have in mind for next year so that we get a sense for how this de-risk the model is from a PC perspective?

Dr. Lisa Su

Yeah. So, a couple of different points, Vivek. Let me just answer the sort of the expectations around Q4. I would say, we are guiding, let’s call it, modestly down for Client and Gaming, and obviously, we are coming off of what is already a low base in Q3. We want to do that to correct the sort of the inventory situation as quickly as possible, and as a result, we are going to under ship consumption again in the fourth quarter to do that.

As it relates to next year, I think, there are a lot of factors. I mean this year PCs will be down quite a bit, let’s call it, high-teens, close to 20%. As we go into next year, I think, the industry is calling mid-single digits. I think that would be a good case. I think we should model down to minus 10%.

And again, within our PC business, we expect as we get through this inventory correction, I mean, we have very good products, and I feel very good about our product portfolio and very good about our platforms overall. So I do think the PC business will recover as we go into 2023, but we will have to work through these dynamics over the next quarter or so.

My translation: Perhaps I am being optimistic but I believe AMD is saying the recovery will happen earlier in 2023 (H1) rather than later in 2023 (H2) per the language chosen and that AMD plans to be on the earlier side within H1 by under shipping in Q4.

Conclusion:

AMD had a better earnings report than Microsoft and a better report than Nvidia is expected to have. These companies are comparable because of the one-time event hitting a non-thesis segment. Where they are not comparable is that AMD’s strongest segments are keeping the company in double digit growth territory.

I like Microsoft and Nvidia very much but it is uncanny how AMD continually finds a way to unexpectedly have a good report. I get to call this stock The Dark Horse for a little longer until it surpasses Intel on the data center; which means the name will likely be retired by 2024.

There's a lot to look forward to. If you’re looking for more than I/O Fund Essentials is providing, learn more about becoming an advanced member today.

Magnite provided a stark reminder that the bottom line is more important than the top line in current market conditions as the stock moved 80% off the earnings report with low revenue growth yet the small cap has rare strength with its improving bottom line and 20% cash flow margin.

Low Growth; Strong Bottom Line

The company reported Q3 revenue of $127 million, which grew 12%, and beat estimates by 2.8%. This is down from 23% last quarter.

For Q4, management is expecting revenue to be $154 million for growth of 8.3%. Perhaps Magnite also benefited by being the last to report as many ad-tech companies guided lower than 8.37%. Analysts were expecting growth of 8.25% for Q4.

CTV ad revenue grew 29% year-over-year to $55.8 million, and represents 44% of revenue. Management is guiding for 10% CTV ad revenue growth next quarter for $64 million in revenue, at the midpoint.

Mobile weighs on the company’s growth with 7% this quarter for $44 million, compared to 14% last quarter for $44 million. The segment was flat sequentially. Mobile represents 35% of revenue. 

Desktop is the weakest segment at (7%) growth this quarter for revenue of $27 million compared to 1% drop last quarter for revenue of $27 million. This segment was also flat sequentially. Desktop represents 21% of revenue.

Magnite breaks down United States and International growth with both regions growing YoY. The United States represents 78% of GAAP revenue.

The United States region GAAP revenue grew 9% YoY to $114 million, up from $106 million last quarter. International grew 18% YoY to $32 million, and was flat sequentially, with $31.2 million last quarter.

The company reported GAAP EPS of ($0.18) and Non-GAAP EPS of $0.18. This is an improvement from Q2 and also an improvement from the year ago quarter. In fact, this was the strongest EPS on GAAP and Non-GAAP basis over the past five quarters excluding the holiday quarter.

Analyst estimates for adjusted EPS next quarter are $0.32. Assuming the company reports this EPS, it will exceed last year’s holiday season with adjusted EPS of $0.26 and it will also beat Q4 2020 with adjusted EPS of $0.19.

This improvement is important to note and to continue to track as few companies are able to improve bottom lines right now let alone a small cap. 

Pictured Above: Magnite stands out for its improving bottom line.

The GAAP gross margin was down from 53% in Q2 to 51%. However, the GAAP operating margin has improved to (15%) in Q3 from (17%) in Q2. The improvement is more evident when you compare to Q1 at (34%) and the year ago quarter at (18%). Excluding the holiday period, Q3 2022 had the strongest GAAP operating margin from the past five quarters.

Down the income statement, the GAAP net margin of (17%) mirrored the operating margin with a 1 point improvement sequentially and YoY. This resulted in $24.4 million in net losses.

On an adjusted basis, the company reported a profit of $25.6 million, up from $20 million last quarter and up from $20 million in the year ago quarter.

Where Magnite shines is the cash flow margins. Operating cash flow of $28.6 million represents a margin of 20% on GAAP revenue. The company stated that it will have free cash flow of “over $105 million” which is up from the previous guide of $100 million. This will represent a FCF margin of 20.5%

Please note the following I/O Fund internal note on Magnite’s FCF calculations which deduct cash interest payments from operating cash flow. 

“Some companies calculate FCF in a different manner. If the company does not provide FCF, we can calculate using operating cash flows minus capex from the cash flow statement. In this case, the operating cash flow calculation itself is different which is a rare case. The operating cash flow is adjusted EBITDA less Capex. The FCF involved the deduction of cash interest payments which is available in the supplemental disclosures of other cash flow information as the recent earnings call provided the interest payments for this quarter, however, they did not provide cash interest separately.” 

The company has $253 million on the balance sheet and $725 million in debt. The debt is less of a concern as long as the company is FCF positiveas long as the company is FCF positive and doesn’t pursue anymore acquisitions. The debt includes $400 million in convertible senior notes and a term loan of $355 million due to the SpotX acquisition.

The company’s net leverage has greatly improved from 6.2X in Q2 2021 to 2.6X in Q3 2022. This also improved from 3.1X in Q1 to 2.8X in Q2.

Magnite reported stock based compensation of $17.4 million, or 13.7% of revenue. 

Magnite Proves the Valuation Trade is Alive and Well

Despite Magnite being comfortably profitable on an adjusted basis and free cash flow positive with a 20% margin, the stock was priced for bankruptcy or another fatal risk at 1.5 forward P/S going into earnings. I believe the stock rallied because the risk/reward didn’t reflect the valuation, rather reflected the broader “small cap” bucket where most small caps have serious profitability issues. 

The low valuation coupled with clear evidence Magnite is unlikely to go out of business anytime led to the stock rallying.

Magnite helps to illustrate that 2022 market conditions continue to be more favorable for stocks with strong bottom lines. This is a critical adjustment for growth investors as Magnite’s top line does not fall into a growth definition at 12% this quarter and 8% next quarter.

Note: All numbers quoted ex-TAC unless otherwise stated. GAAP margin is calculated on the GAAP revenue of $145.8 million. Please note, we do not own Magnite at time of writing but plan to enter if we can find the right technical setup.

 

At I/O Fund, we provided deep dive research and two 1-hour webinars that predicted AMD would take away a huge chunk of Intel’s market share to have double-digit market share in the data center. At the time, AMD had only 4% market share. The prediction was bold as Intel is the 800 lb. gorilla — yet the prediction fully materialized and AMD today has “low 20 percent” market share in the data center.

AMD’s comeback is nearly unheard of, with only Apple posting a comeback of this proportion in the history of the tech industry.

 If you’re interested in hearing more beyond this write-up, I recommend our exclusive webinar provided to I/O Fund Members where we discussed in great detail AMD’s “EPYC” improbable comeback: AMD Webinar

The abbreviated version is that AMD plans to take even more market share from Intel — and then will take this new lead over Intel to help fill the role of duopoly in AI accelerator chips.  

Note: by the time you’re reading this, AMD comeback over Intel is more evident than when we first discussed it as we began discussing this and built a leading position with real-time alerts when AMD had 4% share in the CPU-data center and the company has grown this market share over 5X since our original prediction. In fact, the strategic comeback was so little recognized by industry analysts that we nicknamed AMD “the Dark Horse” which means an unexpected competitor who secures victory.

How Did “The Dark Horse” Get Here?

AMD’s Zen architecture was introduced in 2017. The company proved it wasn’t down for the count by offering a chipset-free design, resulting in energy-efficient processors capable of executing more tasks per cycle and more cores than Intel.

AMD’s first-gen Zen architecture helped prove AMD had a pulse and a heartbeat— however faint it may have been with a tiny 2% CPU market share— but it was circa 2020 when the company found its wings again. In that phase, it grew by 400%, catapulting to 8% of the CPU market. Today, its share stands at an estimated 20%-24% and while the company is unlikely to increase six times over again, with continued excellent management, market dominance of 50% market share or greater is very much in the real realm of possibilities. This is the move we want to capture in 2023/2024.

Second Gen

Note: we go into more specs and a great detail on AMD’s products on I/O Fund Advanced. Below is a summary.I/O Fund Advanced. Below is a summary.

When the company released the second generation of its Zen architecture, AMD showed it was outpacing Intel in terms of computing power, memory and energy use. More importantly, it was doing all this at a lower cost, thanks to multi-chip modules that combine a 7nm with a 14nm to use the most advanced technology when and where it’s needed most by leveraging the more mature process node. 

At the time, Intel was still producing a 14nm chip, although it promised that a 10nm was on the way. Essentially, AMD leapfrogged their competitor with a more power-efficient product, and one that allows for more cores per chip. 

 Interestingly enough, Intel was expected to catch-up with a comparable 10nm release planned for Q2 or Q3 2020 called the Ice Lake Xeon Scalable. Then, at the height of the pandemic, just four months before Intel’s expected release, the I/O Fund covered AMD, calling it “the one that got away” in 2019. “It’s estimated that for every $1.00 in Rome chip sales, Intel loses $2.25 on average in Intel Xeon SP sales,” we noted. "The savings are then deployed to buy more Rome chips, which can further depress Intel’s revenue.”

The Milan EPYC Series announced in August of 2020 was officially launched in March of 2021. The Milan is built on 7nm technology and has up to 64 cores and 128 threads with increased clocks compared to the Rome series. At the time of launch, Milan had a 100% advantage over Intel’s Sky Lake on server processor scores, according to Geekbench.

This was the momentthe moment Intel was expected to go gangbusters but instead Intel drove into a brick wall. Ice Lake’s release was delayed for two years, finally launching with 40 cores, up from 28 cores, versus a whopping 68 cores for AMD.

When it was finally released, an unbiased analyst had this to say:

“We won’t rehash the delay, denial, and begrudging admittance cycle that is Ice-SP’s gestation, just be aware that it was a 2019 CPU and is now a mid-2021 CPU. We know it launches today and Intel is officially claiming, ‘We have shipped over 200,000 Ice Lake CPUs for revenue’ and the shipping parts are the D-2 stepping […] let’s do the math and assume those 200K Ice-SPs shipped in three months or about 66K CPUs/month. If the server market is about 30M CPUs/year, let's call it 32M for the sake of round numbers, that would be 8M/quarter for normal production. = or about 2.28 days worth of production. This is not a figure I would be mentioning in public if I was aiming to boost confidence.”just be aware that it was a 2019 CPU and is now a mid-2021 CPU. We know it launches today and Intel is officially claiming, ‘We have shipped over 200,000 Ice Lake CPUs for revenue’ and the shipping parts are the D-2 stepping […] let’s do the math and assume those 200K Ice-SPs shipped in three months or about 66K CPUs/month. If the server market is about 30M CPUs/year, let's call it 32M for the sake of round numbers, that would be 8M/quarter for normal production. = or about 2.28 days worth of production. This is not a figure I would be mentioning in public if I was aiming to boost confidence.”

In my world, that’s the equivalent of a good Comedy Central Hollywood roast!

Why 2023 will be AMD’s Year

When we first covered AMD, it had a 4% share of the data center; now, it sits at roughly mid-20% of the CPU data center over Intel, a spectacular comeback.

However, the move we want to capture is when AMD goes from owning “mid-20%” of the CPU data center to owning 40% to 50% of the market— and this is entirely possible due to Intel’s most recent stumble.

AMD has the 5-nanometer line scheduled for release in Q4, which includes Zen-4 architecture, and Zen-5 architecture planned for 2024 (reference our AMD Q3 2022 earnings update provided for you in the Blog updates). 

The company also stated that the Zen-3 Milan Series is still outstripping supply with visibility six quarters out, implying for full year 2023. Zen-2 was CEO Dr. Lisa Su’s comeback, while Zen-3 is responsible for the current move in data center market share.

Source: Tom’s Hardware’s Hardware

Pictured Above: AMD has grown from 2% market share to “mid 20-percent market share”

 

AMD’s Dominance Over Intel Has Never Been More Obvious

 

AMD reported an 83% year-over-year increase in data center revenue for Q2 2022. Meanwhile, Intel dropped 16%. AMD appears to have gained 6% market share, which, one analyst noted, is “the highest share gain in the data center business that [AMD] has reported even going back to 2005.”

We began covering AMD when it had 4% total market share versus 96% Intel and the recent gains places AMD now in the “mid 20%” total market share for the data center against Intel. When asked if this was the correct math, Su stated to the analyst: “I think your math is in the ZIP code from our point of view.”

We have been quite thrilled to see the team at AMD led by Lisa Su and Forrest Norrod overtake Intel at times. However, what happened last quarter with Intel’s stumble is an exponentially greater mistake than the last stumble that we prepared for in March of 2020, which later materialized that July.

 

Meta: You say Capex, I think AMD

You may have seen tech commentators poking fun at Meta’s recent keynote. Zuckerberg demonstrated adding legs to Metaverse avatars, “progress” that doesn’t quite match up with the company’s mammoth investment. Most investors look at Facebook’s cash and think “this will make a great stock,”— yes, the FCF margin has been impressive. Many of Meta’s newfound critics are wondering: “Will the Metaverse succeed?”

What we want as investors is second-level thinking. Where is Big Tech capex going? Regardless of whether or not Meta succeeds, AMD stands to greatly benefit.

 

Other Factors

Meanwhile, we have to consider that outside of cybersecurity, there are going to be very few growth markets in tech in 2023, and of the growth markets we are tracking, very few will hit double digits.

Note: for more information on cybersecurity stocks and growth trends, please upgrade to I/O Fund’s full service where we also provide real-time trade alerts.upgrade to I/O Fund’s full service where we also provide real-time trade alerts.

 Big Tech capex is important as it’s the one catalyst that can raise revenue estimates for next year for AMD, which subsequently raises bottom line estimates. We covered this in a free analysis going into earnings here:

“The news has been in an uproar about crypto mining and the consumer-related PC markets. However, it has been our stance for some time that Big Tech capex is the true leading indicator for AI semiconductor companies. Despite an enormous increase in Big Tech capex primarily driven by data centers, this line item does not get the attention it deserves in terms of follow-through to the semiconductor industry. Below, we look at FY2022 budgets to draw the conclusion that H2 spending on data center chips is equal if not greater than the first half of 2022 […] The Data Center Systems segment, however, is expected to grow fastest among all the segments. It is expected to grow 11% YoY to $212 billion, higher than the 6.4% growth in 2021.”

Where AMD Is Headed

Artificial Intelligence and Machine Learning Will Exceed the Mobile Economy

Smartphones had a 10-year cycle of maturation beginning with the iPhone in 2008 and the app economy proved to have a similar maturation for digital advertising. Following a decade-long run. 

·       The smartphone market was valued at $720 billion in 2019 and the global mobile application size was $155 billion.

·       The mobile advertising market was valued at $60 billion — Facebook

·       The total global ad spend worldwide is valued at $560 billion — Google

 

The mobile market is worth roughly $2 trillion yet the combined market cap of these companies is $4 trillion. Meanwhile, PricewaterhouseCoopers is predicting the AI market will reach $15.7 trillion, which some experts believe will put its impact on par with the advent of electricity. 

Semiconductors will not comprise the entire $15.7 trillion but according to McKinsey, they will “capture 40 to 50 percent of the total value from the technology stack. 

“These diverse solutions, as well as other emerging AI applications, share one common feature: a reliance on hardware as a core enabler of innovation, especially for logic and memory functions.”

The artificial intelligence economy will be four times larger than the mobile economy. Picture this: if mobile gave us companies with $2 trillion market caps, it makes sense that AI will give us businesses with $8-$10 trillion market caps.

Breakdown

There’s also a lot to look forward to. Should you choose to upgrade to become a I/O Fund Premium member, you’ll receive AMD’s next five-year thesis, which will include Xilinx, long before anyone else know what they’re up to. This acquisition is more offensive for growth rather than defensive (along the lines of how YouTube impacted Google or Instagram impacted Facebook).

Our premium site owns two lesser-known semiconductor names. The first is centered in an important shift for electric vehicles and is up 58% in our portfolio this year. The second is an up-and-coming AI stock that doubles as a 5G infrastructure stock. There is something very big on the horizon for the AI/5G semi company in H2 2023 and we believe now is the time to look more closely as this company. We reserve these stock picks for our Premium I/O Fund Members, which you can learn more about here.