AMD’s earnings report this quarter was a win for our deep dive analysis as it confirmed our ongoing thesis from 2020-to date that AMD will continually take market share from Intel.

We discussed this in our original analysis in early 2020, our follow-up analysis in mid-2020, our 1-hour AMD webinar in 2021 and our most recent Kings of Tech special report. Most of this is summarized in the last earnings coverage from Q1 here.

Following Q2 of 2022, AMD’s product dominance over Intel has never been clearer.

AMD reported an 83% YoY increase in revenue in the data center compared to Intel’s 16% decline but under the hood, there is something much bigger going on than one quarter of performance. As an analyst pointed out, AMD appears to have gained 6% market share, which 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, Lisa Su stated: “So, I think your math is in the ZIP code from our point of view. And we are pleased that we are gaining share.”

I want to make sure that this enormous win is well understood because the market certainly didn’t reward AMD following the report. The price action will take care of itself over time.

Is our data center thesis now lagging? No – because we have the 5-nanometer line up being released in Q4 which includes Zen-4 architecture plus the Zen-5 architecture in 2024. The company also stated that the Zen-3 Milan Series is still outstripping supply with visibility six quarters out, implying for full year 2023. As a reminder, Zen-2 was Lisa Su’s comeback and Zen-3 is responsible for the current move in data center market share.

There’s also a lot to look forward to. I owe you a deep dive on AMD’s next 5 year thesis, which will include Xilinx. This acquisition is more offensive for growth rather than defensive (along the lines of how YouTube impacted Google or Instagram impacted Facebook). There is already evidence of the synergies between these two with 20% sequential growth from Xilinx in the most recent quarter.

Lisa Su and her team also quelled fears of a 2023 slowdown in the data center, and similar to Microsoft, was able to provide a “light at the end of the tunnel” type macro discussion as both are bellwethers in their respective sectors.

Brief Overview of Q2 Earnings

AMD reported revenue growth of 70% at $6.55 billion which came in at analyst expectations of $6.53 billion. EPS also came in as expected at $1.05 EPS reported versus $1.04 EPS expected. The market has given a muted tone to the earnings due to guidance provided of $6.7 billion compared to $6.83 billion expected. Meanwhile, full year revenue guidance was reiterated at $26.3 billion for 60% YoY growth.

Gross margin is a bright spot for AMD right now. The company is not only expanding its GM by 640 bps this year to 54% but the company is guiding for an additional 300 bps to 57% for next year. The company’s gross profits grew by 65% YoY to $3.03 billion.

The GAAP gross margin is at 46% and 47% last quarter. It was lower because of the amortization of intangible assets associated with the Xilinx Acquisition. Management also guided for adjusted operating margin of 24.5% for FY2022.

Certainly, the bottom line continues to be exceptional – although this may moderate in 2023 as more supply comes back online. Adjusted operating income of $1.9 billion was up 115% with an adjusted operating margin of 30% compared to 24% in Q2 2021. Adjusted net income of $1.7 billion was up 119% with an adjusted net profit margin of 26% compared to 20% in Q2 2021.

Adjusted EPS came at $1.05 (beat estimates by $0.01) compared to $0.63 for the same period last year. The company reported a total of $1.02 billion in expenses related to the amortization of acquired intangible assets in the recent quarter. The GAAP EPS was a miss due to Xilinx acquisition at $0.22 EPS compared to $0.58 EPS in the year ago quarter.

The company is reporting record operating cash flow of $1.04 billion and free cash flow of $906 million. The company has $6 billion in cash with $2.8 billion in debt. Buybacks are another bright spot for AMD with $920 million in the most recent quarter and $7.4 billion in buybacks remaining.

Overview of Segments:

Data Center:

Data Center revenue of $1.5 billion up 83% YoY was driven by EPYC processors for both cloud and enterprise customers. The company reported operating income of $472 million with AMD’s margin expansion driven primarily by this segment. The impressive growth was driven by 60 new instances across all major cloud providers.

At the time that Intel delayed its Sapphire Rapids release (againagain!), AMD stated they are “on track to launch Genoa and ramp production of Genoa” which will “position our data center business for continued growth and share gains.” The company confirmed that customer pull is very strong for their 5-nanometer CPUs for Q4 and into 2023:

“The visibility with our customers, especially our large cloud customers’ second half of this year into next year is very good. And we’re planning really for the next four to six quarters, and that gives us good visibility.”

Certainly, AMD is not getting off that easy on such a strong statement as most analysts were modeling and (loudly) predicting a slowdown in 2023 off the incredible growth both AMD, Nvidia and a few others have seen in the data center.

One analyst asked the following: “But we see all these media reports about the cloud players wanting to control their spending levels, etcetera. When do you think that shows up in their spending outlook? Or do you think you have enough of a share gain story with Genoa coming out later this year to offset any slowdown from just a broader spending environment perspective?”

Lisa Su’s answer was quite simple – to paraphrase, it’s product:

“But from our current view, I think we have a strong opportunity to continue to grow the Data Center business into 2023. And our view is we have an expanding portfolio as well. In addition to Genoa, we have our Bergamo, which is a cloud optimized capability as well that’s coming online early next year. So there is a lot of new products that are supporting sort of our growth ambitions.”

And this was followed up with a question on how much of AMD’s growth projections for 2023 are in contrast to Intel (if Intel continues to delay releases and/or Sapphire Rapids has perceived issues such as bugs, then this is a natural tailwind for AMD).

“Relative to your overall question, I think we do feel like we’re in a share gain position. I think the product positioning is such that Milan is very, very strong right now. And we think that Genoa as well is very well positioned into next year.I think we do feel like we’re in a share gain position. I think the product positioning is such that Milan is very, very strong right now. And we think that Genoa as well is very well positioned into next year.

So we’ll always spend time with the customer set and see what they’re seeing. But from our current view, I think we have a strong opportunity to continue to grow the Data Center business into 2023. And our view is we have an expanding portfolio as well. In addition to Genoa, we have our Bergamo, which is a cloud optimized capability as well that’s coming online early next year. So there is a lot of new products that are supporting sort of our growth ambitions.”In addition to Genoa, we have our Bergamo, which is a cloud optimized capability as well that’s coming online early next year. So there is a lot of new products that are supporting sort of our growth ambitions.”

Translation: Not only does AMD offer the highest performing general purpose CPUs for servers, which is primarily what is being discussed above, but the company’s lead will be further cemented when the 5nm is released in Q4. In addition, AMD’s strategy to diversify to workload specific CPUs, and also DPUs with the Pensando acquisition, and GPUs, will support continued growth in 2023.

Client Segment:

The Client Segment was up 25% YoY to $2.2 billion with operating income up 32% to $676 million. This is up 31% from $538 million. This was primarily driven by Ryzen mobile processors.

There were so many headlines over past three months about the impending “PC slowdown.” Here is what the boogeyman was:

“We have taken a more conservative outlook on the PC business. So a quarter ago, we would have thought that the PC business would be down, let’s call it, high single digits. And our current view of the PC business is that it will be down, let’s call it, mid-teens. And that’s contemplated into our third quarter guidance. And then as we go into the fourth quarter, what we see is, again, the sequential growth there will be led by the Data Center, as well as our Embedded business, with the same view of the PC business.”So a quarter ago, we would have thought that the PC business would be down, let’s call it, high single digits. And our current view of the PC business is that it will be down, let’s call it, mid-teens. And that’s contemplated into our third quarter guidance. And then as we go into the fourth quarter, what we see is, again, the sequential growth there will be led by the Data Center, as well as our Embedded business, with the same view of the PC business.”

There was additional breakdown regarding the guidance and how it takes into account PCs:

“And we are being more conservative in our PC outlook. Our PC outlook now at mid-teens would kind of put the market at somewhere around, let’s call it, 290 million to 300 million units. So I do think we’ve appropriately de-risked the PC business.”

AMD stated again the company is forecasting the PC supply (for their company) will be balanced by the second half of the year:

“I think there was a bit of buildup in PC inventory, and we’ve taken that into account in the second half. We think the AMD portion of that is modest. And as a result, it will rebalance itself in the second half of the year.”

Gaming Segment:

AMD’s gaming segment was up 32% YoY for $1.7 billion in revenue with operating income of $187 million, or 11% of revenue, compared to $175 million, or 14% a year ago. The lower operating margin was due to lower graphics revenue. The company stated that gaming graphics declined in Q2 and the gaming graphics market is expected to be down in Q3. However, management also stated they are expecting sequential increases in gaming at/around Q4.

“We do expect, as we go into the fourth quarter, though, that we’ll see some sequential increase in that business [gaming] because we’ll have new products that are launching in that timeframe.”

Embedded Segment:

This is the “Xilinx segment” and certainly this earnings report made that evident as Embedded grew 2,228% to $1.3 billion as a result of combining the two companies.

AMD did state that on a pro-forma basis, the Xilinx portfolio grew 20% sequentially. This was accelerated by AMD’s manufacturing scale and other large-scale resources for the supply chain. The company stated that both Data Center and Embedded are expected to grow fast enough to make up for the softer PC market. Embedded also helps strengthen the gross margins and Xilinx was accretive to AMD in that regard.

Although no other specifics were provided, the company pointed out there was “record core market revenue” for Xilinx, including aerospace and defense, industrial vision and health and test and measurement. Xilinx is also strong in 5G and automotive. In automotive alone, AMD believes there is a $10 billion opportunity by combining the two companies.

Macro Outlook:

AMD mentioned many times on the call that they believe supply will more evenly match demand by Q4 and into the early part of next year. This could be AMD-specific due to a strong management team along with Taiwan Semiconductors output resulting in outlier levels of supply, but generally speaking, more supply should result in deflationary pressure. AMD does not see more supply as a headwind to growth, rather the company believes it will result in more sales as demand is better matched with supply.

“And to your question about supply, we have spent basically the last 12 months building our capacity across the world to support the type of growth that we think the product can handle. So there is a large step-up in supply that we expect to see over the next four, five quarters.”there is a large step-up in supply that we expect to see over the next four, five quarters.”

“Certainly, on the Embedded side, we were supply constrained in the second quarter. And even on the Server side, we were tight in the second quarter. We have additional supply that’s coming online, especially as we get towards the end of the year. That will help us really meet more of the demand from customers. So we feel pretty good about all of those puts and takes.”, especially as we get towards the end of the year. That will help us really meet more of the demand from customers. So we feel pretty good about all of those puts and takes.”

“But overall, the 7% increase [in gross margin], I think, is very well supported given all of the new product ramps that we have going on in addition to some additional supply that’s coming in as we get into the fourth quarter.”in addition to some additional supply that’s coming in as we get into the fourth quarter.” 

“As we look into the second half of the year, we are still a bit constrained in certain areas, certain parts of the Xilinx portfolio, although we continue to make good progress. And I expect additional supply to come on, especially towards the latter part of the year, into 2023. Our view of the business, again, I think the quality of the design wins, the quality of the overall – when you look – the diverse market is very strong. And so I think as we are able to continue to relieve some of those supply constraints into the second half of the year, I think see a good growth trajectory for the business.”And I expect additional supply to come on, especially towards the latter part of the year, into 2023. Our view of the business, again, I think the quality of the design wins, the quality of the overall – when you look – the diverse market is very strong. And so I think as we are able to continue to relieve some of those supply constraints into the second half of the year, I think see a good growth trajectory for the business.”

Conclusion:

AMD’s comeback is truly historic and this quarter did not disappoint. Not only did AMD report the highest share gain in the data center business going back to 2005 but Intel’s revenue declined 22% year over year and missed consensus by 14%, which was Intel’s largest top-line disappointment since 1999, according to Refinitiv data. Intel ended the quarter with a $454 million net loss, compared with net income of $5 billion in the year-ago quarter.

This is not a coincidence. It’s due to AMD’s product excellence and gravity-defying management. Maybe the stock didn’t get the attention it deserves following Tuesday’s report, but from my estimation, it’s only a matter of time until price catches up to the market leader that is executing at scale.

“It’s the Economy, Stupid,” is a famous line about focusing a political campaign on one central focus. It was used by Clinton during a recession when George Bush was out of touch on what Americans were experiencing during 1992.

Management teams over the last 24 hours are saying it’s the economy and it’s out of our control. I used that headline because there is one central focus right now and its probably time to set nuances and other explanations aside.

Today, it was announced that GDP declined for two quarters in a row, which technically puts us in a recession. This happened around the same time that three management teams said ad spend on their platforms was paused (Meta, Snap last week, Roku). Not only did ad spend halt suddenly in Q2 but it has not gotten better one month into the third quarter.

What do Roku, Snap and Shopify have in common? They are ad-tech and e-commerce related but otherwise there’s not much in common product-wise. Snap and Roku have little to no overlap in advertisers or audience being mobile vs CTV ads and Roku has zero effects from Apple’s iOS changes. In fact, one thing that bothers me about Roku’s report is we now know that Snap’s Q3 miss was not due to the Ukraine war or Apple’s IDFA changes. We also know that Shopify’s margins are not worsening due to the fulfillment center or something management did. We also now know that tough Q2 Covid comps are not the issue or else the guidance would have been strong.

The common thread across these management teams is that the economy is greatly affecting them and there’s no way to manage this except to cut headcount and muscle through it. What they are also saying is that a recovery is not on the horizon at this time.

Roku actually had surprising account growth of 1.8 million — higher than Q2 of last year. Snap also grew 18% despite tough audience growth comps. Shopify believes their Merchant growth in the second half will accelerate from the first half. Yet, this is not translating to more revenue, and in all cases, is translating to more losses on the bottom line.

This is because we are in a recession.

There’s no reason to discuss the nuances of the products, the management teams, or too many details if we are in the midst of a fierce, macro headwind that is not letting up. We know macro is challenging but the headlines want to make it about the actual company.

“Tiktok is taking too much market share.” Well, Snap had strong user growth of 18% and this will be the highest across all media by the time the reports come in. In a normal economy, dollars follow eyeballs. “Roku faces too much competition” – well, the company added 1.8 million active accounts in a quarter when juggernaut Netflix was negative roughly 1 million this quarter. Netflix’s guide next quarter is for 1 million, so Roku’s Q2 is two times Netflix’s Q3 guide right now. All around, the evidence is not there it’s a competitive issue.

I’m not going to elaborate on product because it’s in the rear seat right now and the economy is in the driver’s seat.

Here’s the question — will these three companies be the only ones to discuss broad economic headwinds that they’re not able to overcome evidenced by flat to negative revenue growth and worsening margins?

Our analysis on SHOP and ROKU is fairly similar which is that Q2 was a miss on the top line and management in both cases said Q3 is faring worse than Q2 in terms of revenue at this time. In addition to the top line issues, the losses on the bottom line are increasing.

I’ve pulled out quotes about what was said in terms of a potential recovery (it’s not going to be a Q3 rebound and Q4 is in question). It’s easy to fall into black and white thinking (one stock is bad because it’s down right now and another stock is good because it’s up right now), but I think something broader is going on.

The earnings calls over the past 24 hours have been nearly identical in tone and statements:

Here is Meta from Q2 call:

“That said, we seem to have entered an economic downturn that will have a broad impact on the digital advertising business. And it's always hard to predict how deep or how long these cycles will be, but I'd say that the situation seems worse than it did a quarter ago.”but I'd say that the situation seems worse than it did a quarter ago.”

Meta also said this:

“Now of course, the third challenge that we're facing here is the macro economy. And we can't control the timing of when things will bounce back, but I'll note that periods like this are when marketers reevaluate their budgets and are even more focused on finding the highest-performing advertising. And in the last recession, we invested in our ads business through the downturn and came out stronger on the other side, and I'm focused on making sure that we do the same today.”but I'll note that periods like this are when marketers reevaluate their budgets and are even more focused on finding the highest-performing advertising. And in the last recession, we invested in our ads business through the downturn and came out stronger on the other side, and I'm focused on making sure that we do the same today.”

I was encouraged by Big Tech’s earnings but now it’s looking like Google and Microsoft are simply more defensible.

With that said, we are likely to reconsider quite a few of our positions — not because a product is weak or a conviction of ours is gone for good. It’s because management teams across the board are saying that Q3 is worse than Q2 right now and as tech investors we’re not going to ignore that message.

Shopify:

I want to pull out only a few numbers for easy comparison:

This means Shopify’s revenue is essentially flat across a six-month period. There is year-over-year growth, but sequentially, it’s not moving much.

 Here are the operating margins:

The adjusted operating loss for the second quarter of 2022 was $41.8 million, or 3% of revenue, compared with adjusted operating income of $236.8 million or 21% of revenue in the second quarter of 2021.

I was earnestly hoping for a bottom on these margins, but management said the opposite:

“Factoring in these expectations, we expect to generate an adjusted operating loss for the second half of 2022 with Q3 adjusted operating loss, excluding severance costs expected to materially increase over Q2.”we expect to generate an adjusted operating loss for the second half of 2022 with Q3 adjusted operating loss, excluding severance costs expected to materially increase over Q2.”

“As we significantly decelerate operating expense growth into Q4 and with Q4's higher seasonal GMV and revenue, we expect an adjusted operating loss in Q4 that is significantly smaller than in Q3, but larger than in Q2.”, we expect an adjusted operating loss in Q4 that is significantly smaller than in Q3, but larger than in Q2.”

Net margin is a bit of a mess for Shopify because they have investments in Affirm, Global-E and Slivergate. The unrealized losses are at $1.2 billion this quarter and were at $1.5 billion last quarter. However, adjusted net losses were at $38.5 million compared to income of $285 million last quarter. The company missed on EPS with expected adjusted EPS of $0.03 versus ($0.03) EPS reported.

Stock Based Compensation increased from $151 million in H1 2021 to $257 million in H1 2022. The company stated that SBC plus payroll taxes is at $750 million for the full year.

In the call, an analyst asked if the company was planning on exceeding the $1 billion investment that was already discussed in regard to Shopify Fulfillment Network and the CFO said there are no plans to expand that amount at this time.

Comments on the Economy:

“While the macro environment exited tough COVID year-over-year comps in mid-Q2, consumer spend on services and in-person shopping remained high and persistent inflation at 40-year highs dampened online sales globally. In the face of rapidly escalating prices for essential goods and energy, consumers have been favoring discount retailers and reducing their spend on other goods categories.”consumers have been favoring discount retailers and reducing their spend on other goods categories.”

“Consistent with this, we are taking actions to recalibrate our investment spending to build for long-term success. We are keenly aware of what's happening around us. We anticipate that inflation and the continued softness in consumer spending on goods will persist through the remainder of the year. Throughout the organization, our teams are mindful of the macro environment and have been rigorously evaluating and adjusting our spending priorities. And we have taken this time to also make adjustments to ensure we have an efficient, productive and highly motivated team.”We anticipate that inflation and the continued softness in consumer spending on goods will persist through the remainder of the year. Throughout the organization, our teams are mindful of the macro environment and have been rigorously evaluating and adjusting our spending priorities. And we have taken this time to also make adjustments to ensure we have an efficient, productive and highly motivated team.”

“We expect 2022 will be different, more of a transition year in which e-commerce is largely reset to the pre-COVID trend line and is now pressured by persistent high inflation.”more of a transition year in which e-commerce is largely reset to the pre-COVID trend line and is now pressured by persistent high inflation.”

“Our financial outlook for the rest of 2022, which includes the impact of Deliverr and our new compensation system, assumes that higher inflation will persist for the foreseeable future and, combined with rising interest rates, will pressure consumers' wallets for purchases of goods.”assumes that higher inflation will persist for the foreseeable future and, combined with rising interest rates, will pressure consumers' wallets for purchases of goods.”

Note: Microsoft said FX headwinds are expected to ease Jan-June of next year.

Roku: 

Roku’s current quarter came in strong all things considered. The problem is the Q3 guide is a substantial miss of $200 million with management guiding for 3% growth to $700 million compared to $902 million expected.

This is surprising given the company had secured $500 million last year and secured $1 billion in the current upfront season in committed ad spend. What Roku calls the scatter market, or ad spend that can be turned on/off, is what is weighing on the current guide.

The company missed on gross profit for a guide of $395 million and reported gross profit of $355 million.

The company reported operating losses of ($110.5) million and net income losses of ($112) million.

Adjusted EBITDA also went negative to ($12.1) million so that’s weighing on the report. The guide is for ($190) million in net losses and Adjusted EBITDA of ($75) million.

So, not only has Roku firmly been in negative territory on their margins but these losses are increasing for Q3. The player gross margin weighs on this, which we knew would happen and this is not a deterrent as we want the audience growth that has come from keeping player prices low. However, the slowing revenue growth puts pressure on these margins and that’s not something management prepped investors for.

Roku also pulled full year guidance which I can’t recall has happened in the past.

The first analyst had the same question I have – where did this dramatic pullback in ad spend come from?

Cory CarpenterCory Carpenter

Hey, thanks for the question. Hoping you could expand a bit on what you're seeing in the ad market. It sounds like you saw a pretty dramatic, broad based pullback, but any color on when you started to see the market turn or what verticals perhaps were most impacted would be helpful. Thank you.It sounds like you saw a pretty dramatic, broad based pullback, but any color on when you started to see the market turn or what verticals perhaps were most impacted would be helpful. Thank you.

Anthony WoodAnthony Wood

Hey Cory. This is Anthony, I'll take that and then turn it over to Steve to add some more color. So, at a high level, of course we are seeing advertisers worried about a possible recession, and so we're seeing them reduce their spend in places that are easy for them to turn off and turn back on. So for example, the scatter market which is, an important source of ad revenue for Roku is an easy market for advertisers to turn off and turn back on, and so that's one of the big factors we're seeing from the macroeconomic environment and that's impacting the growth rate in the short term.So, at a high level, of course we are seeing advertisers worried about a possible recession, and so we're seeing them reduce their spend in places that are easy for them to turn off and turn back on. So for example, the scatter market which is, an important source of ad revenue for Roku is an easy market for advertisers to turn off and turn back on, and so that's one of the big factors we're seeing from the macroeconomic environment and that's impacting the growth rate in the short term.

Steven LoudenSteven Louden

Yeah. Just adding some color on the advertiser pullback in the scatter market overall. Certainly that was a significant factor in the quarter in progress as the quarter went on, but an advertiser perception survey noted that almost half of advertisers in Q2 made pauses on their ad TV spend on TV streaming, which was similar to the amount that passed on digital video and traditional TV.but an advertiser perception survey noted that almost half of advertisers in Q2 made pauses on their ad TV spend on TV streaming, which was similar to the amount that passed on digital video and traditional TV.

So this is definitely a broad scale, significant pullback that that happened within the quarter itself and one that's pretty similar to other historical times of a degree of uncertainty or advertisers worried about impending economic downturns. For example, at the start of the pandemic, this is very similar to when a lot of advertisers paused or greatly detailed their spend and then once they got a better handle on which way the world was going, they added those budgets back.So this is definitely a broad scale, significant pullback that that happened within the quarter itself and one that's pretty similar to other historical times of a degree of uncertainty or advertisers worried about impending economic downturns. For example, at the start of the pandemic, this is very similar to when a lot of advertisers paused or greatly detailed their spend and then once they got a better handle on which way the world was going, they added those budgets back.

Additional Comments on the Economy:

“In Q2, we saw a significant slowdown in TV advertising spend due to the macroeconomic environment, which is pressuring Roku's platform business growth in the short term.”

“The current economic state is causing TV advertisers to pause and reconsider spend, which is painful in the short term, but it also causes them to seek greater efficiency and ROI, which will benefit Roku in the mid and long term. This reminds us of when advertisers pause spend during the 2008 recession, but it became a catalyst that accelerated the shift of ad spend from print publishing to digital.”The current economic state is causing TV advertisers to pause and reconsider spend, which is painful in the short term, but it also causes them to seek greater efficiency and ROI, which will benefit Roku in the mid and long term. This reminds us of when advertisers pause spend during the 2008 recession, but it became a catalyst that accelerated the shift of ad spend from print publishing to digital.”

“Going forward, we expect reduced consumer discretionary spend to pressure Roku TV and player unit sets.”

“As we look ahead to the third quarter, we are facing an increasingly difficult and uncertain environment. Recessionary fear, inflationary pressures, rising interest rates and ongoing supply chain issues will continue to impact both consumers and advertisers. We believe consumers are going to continue to moderate discretionary spend and the ad scatter market will remain pressure.”We believe consumers are going to continue to moderate discretionary spend and the ad scatter market will remain pressure.”

“Our player margins will continue to be pressured as we insulate consumers from cost increases caused by ongoing headwinds from supply chain disruptions and inflationary pressures.”

“Given the volatility and uncertainty of the current macroeconomic environment, we are withdrawing our previous full year revenue growth outlook for 2022. Our outlook has always been based on our assessments of both our business and the broader macroeconomic environment and at this point we feel that there is too much macro uncertainty for us to provide a full year outlook.”

Here is a quote from Snap’s earnings report where the company said the same as Roku and also why digital ads can often be more forward-looking than other areas that are slower to respond to economic pressures:

“You alluded to this in your question in terms of it making — when it turns — it's easier to turn on. It's definitely easier to turn off. So as companies are reevaluating their priorities and their cost structure, they are looking at things like digital ad spend. It's easy to pause, reevaluate and move forward there. So those same tools and services that make it easy to ramp up, make it easy to ramp down. And we know that our advertising partners are facing significant uncertainty, and we talked about that a few times. So I'll focus on the others.”So as companies are reevaluating their priorities and their cost structure, they are looking at things like digital ad spend. It's easy to pause, reevaluate and move forward there. So those same tools and services that make it easy to ramp up, make it easy to ramp down. And we know that our advertising partners are facing significant uncertainty, and we talked about that a few times. So I'll focus on the others.”

This is a longer quote that has increasing importance in terms of when the slowdown occurred.

“And then beginning — later in Q4 and certainly through the first half of this year, we've seen macroeconomic challenges have built. While there have been lingering supply chain and labor supply issues impacting certain segments that began during the pandemic, more recently, we've seen the impact of persistently high inflation, then rising interest rates and rising geopolitical risks associated with the war in Ukraine. Those macro headwinds have disrupted many of the industry segments that have been most critical to the growing demand for advertising solutions over prior years.

We're seeing these various headwinds put pressure on the earnings of a wide variety of companies, and this is directly impacting the demand for advertising. Specifically, advertising spending, in particular, auction-driven direct response advertising is among the very few line items in a company's cost structure that they can reduce immediately in response to pressure on their top line or their input costs. As a result, as many industries and verticals have come under top line or input cost pressure, advertising spending has been amongst the first areas impacted.”We're seeing these various headwinds put pressure on the earnings of a wide variety of companies, and this is directly impacting the demand for advertising. Specifically, advertising spending, in particular, auction-driven direct response advertising is among the very few line items in a company's cost structure that they can reduce immediately in response to pressure on their top line or their input costs. As a result, as many industries and verticals have come under top line or input cost pressure, advertising spending has been amongst the first areas impacted.”

If you recall, Snap also reported a flat Q3 along with Meta and now Roku – with a specific mention of the slowdown happening in the last 90 days.

Conclusion:

I wanted to connect the dots here because two days ago, it looked like Snap was a turbulent product with a management team that had become hard to rely upon.

If you recall, analysts had slated a Q3 rebound and Q4 rebound for many ad-tech stocks while being wary of Snap’s ability to overcome Apple’s changes. Shopify was similar to ad-tech with consensus of 26% growth for Q3 and 29% growth for Q4. Those estimates have been lowered since this morning.

Some investors will want to make this a Snap problem, a Roku problem, a Shopify problem and a Meta problem (side note: Meta might have a product specific problem ….).

You can see what I’m getting at – how many companies does it take to have slowing growth before it stops being about the company and instead is seen as a problem with the economy? The issue with the current earnings reports is this was not slowing growth; it was halted growth. I very much want this to be an insulated case but there’s at least a 50/50 chance that the abrupt pause in digital ad spend will translate to more companies and industries as we move along.

Note from Knox: If we continue to receive broad confirmation of the developing thesis, expect us to strategically raise cash while in the current bounce. I’ve been providing daily levels and targets, which we will continue to use if we see a larger bear market rally as the most likely outcome over the coming weeks-months.

Positioning changes we are considering:

• Reducing our Roku position to 3% range and we will buy back in when we see evidence of a rebound
• It’s likely we close Twilio before earnings
• It’s likely we close Asana before earnings
• We may close Magnite as it’s tough to foresee this company doing well given the issues across ad spend
• Across cloud, Snowflake has exposure to discretionary spending and we might reduce our position here. We would likely wait for Datadog to come in although SNOW had more exposure last quarter

We will put this money into the companies that show strength given tough macro and we will revisit our thesis on any closed or heavily trimmed positions once the economy bounces back. I’m aware it’s natural to want to make this about a company or a product or “Covid winners,” but we are not in consensus with this.

To complicate matters, the market is forward looking so Knox’s technicals are likely to front run fundamentals on a recovery. This means the market will start buying again before management teams provide strong earnings reports.

We want to be very careful with this decision and will wait for technical triggers to act. If we do get the signal to raise cash, we will buy/re-enter when a renewed uptrend begins, and our hedge signal is flashing all-clear.

Lam Research reported strong Q4 FY2022 results as revenue grew by 12% YoY and 14% QoQ to $4.64 billion. The company beat Wall Street analysts' estimates by $422 million (10% beat). It reported adjusted EPS of $8.83 and beat estimates by $1.50 (20% beat).

The Systems revenue which includes sales of new leading-edge equipment in deposition, etch, and clean markets grew by 8.8% YoY to $3.0 billion. Customer support business group revenue grew by 18% YoY to $1.6 billion.

The company is seeing increased demand in new advanced packaging architectures. Tim Archer, CEO of the company, said in the earnings call, “Our Kiyo plasma etch products with Hydro have a proven record of delivering the productivity and uniformity requirements needed for cost effective front-end device scaling. Leveraging this expertise in high-volume manufacturing, we have now achieved multiple new etch tool of record positions for advanced packaging at a leading foundry logic customer. As customers further develop these architectures in support of greater system performance, we see a growing opportunity for Lam’s etch and deposition solutions.”

The company’s gross margin was 45.3% compared to 44.7% in the Q3 FY2022 and 46.2% in the same period last year. The adjusted gross margin was 45.2% compared to 44.7% in the Q3 FY2022 and 46.5% in the same period the previous year. The gross margin was close to the higher end of the management’s guidance of 43.5% to 45.5%, as strong sales helped to overcome the rise in costs.

The gross margins could be under pressure in the near term due to inflation and increased expenses due to supply chain issues. The management expects it to improve in the long-term. The company is also moving closer to its customers in Asia by building facilities there, which is another point mentioned in the earnings call that could be a hedge for rising freight and logistics expenses.

The operating margin improved to 31.9% compared to 29.4% in Q3 FY2022 and 31.7% in the same period last year. The adjusted operating margin was 31.5%, which was up 210 bps helped by strong sales and was above the management’s guidance of 28.5% to 30.5%. The company’s adjusted net income rose 5.2% YoY to $1.2 billion. The adjusted EPS was $8.83 compared to $8.09 for the same period last year.

The company had cash and investments of $3.9 billion compared to $4.6 billion in the March quarter. The company repurchased shares of $868 million and paid dividends of $208 million in the recent quarter. The operating cash flow were $443.9 million in the recent quarter. It was down from the March quarter of $757.7 million as the company increased the level of inventory in the recent quarter. The company has a debt of $5.0 billion.

The company’s deferred revenue balance was $2.2 billion at the end of the quarter, up from $2.07 billion at the end of Q3 FY2022. The deferred revenue grew by $129 million in the recent quarter compared to $610 million in the previous quarter. It was higher in the last quarter due to part shortages which negatively impacted the recognized revenue in the last quarter.

WFE and guidance

The management has lowered the wafer fab equipment spending outlook for the calendar year 2022 to be in the range of low to mid-$90 billion range on the back of supply chain issues. This is lower than the management’s earlier forecasts of $100 billion. In the earnings call, Tim Archer CEO of the company said, “As suggested by our guidance today, we expect to see incremental improvement in supply chain conditions in the September quarter, but our view is that industry-wide output will continue to be constrained through the rest of this year. Consequently, we are lowering our outlook for calendar year 2022 wafer fab equipment spending to be in the low to mid-$90 billion range.”

In the last earnings call, Tim Archer said, “While continued supply-related delays could potentially limit how much wafer fabrication equipment investment can be executed in 2022, our current WFE view is still in the $100 billion range. We see unconstrained demand exceeding $100 billion in 2022 and any unmet demand should flow into next year.”

The management expects revenue of $4.9 billion at the mid-point of the guidance in the next quarter, representing a 14% YoY growth. It was above the Wall Street analysts’ estimate of $4.6 billion. The adjusted gross margin is expected to be in the range of 44% to 46% after taking into consideration the inflationary pressures due to supply chain issues, adjusted operating margin in the range of 30.5% to 32.5%, and adjusted EPS of $9.50 at the mid-point.

Recent analysts notes:

Wells Fargo analyst Joe Quatrochi raised the firm's price target to $475 from $460 and kept an Equal Weight rating on the shares. While Lam Research's better-than-expected Q4 results/Q1 guide reflect improving supply chain dynamics and execution, the analyst expects investors to focus on expanded China export restrictions and WFE commentary.

DA Davidson analyst Thomas Diffley lowered the firm's price target to $550 from $575 and kept a Neutral rating on the shares. The company posted a beat-and-raise Q4 results amid robust demand and improved operational execution, but the management also lowered its outlook for WFE spending to be in the low to mid $90B range – lower than initial expectations of $100B – due to ongoing supply constraints, the analyst tells investors in a research note. The risk-reward on Lam Research shares looks balanced, Diffley adds.

Conclusion

The company’s results were good as it beat both the top line and bottom-line Wall Street analysts' estimates by a wide margin. The guidance for the next quarter was also strong. The company’s management of rising costs and the slowdown in the WFE are two areas to watch in the coming quarters.

 

 

Google and Microsoft both flexed their muscle in terms of margins with nearly no impact over the past few quarters due to the macro headwinds. The quarter was stable in terms of both revenue and margins. 

There’s a chance the market is sniffing out that Q2 could be a bottom for financials. We need more information (this is not a statement written in stone) but there is evidence that some companies may have bottomed – Netflix’s return to (minimal sub growth), Tesla’s H2 deliveries guide, and Microsoft is a double-digit growth guide for FY2023 while predicting FX headwinds will ease between January-June. 

I believe Google’s rally is due to the company’s category leading strength in ads, specifically Google Search, and the prospects of what it will look like when YouTube bounces back. Due to lack of guidance, we don’t have any hints on whether Google bottomed or not, but comparatively the company is stronger than expected.  

You can watch my Bloomberg appearance here where I discussed this point Tuesday evening.

Alphabet Q2 2022 Earnings:

The company reported revenue of 13%, or 16% in constant currency, for a total of $69.7 billion. The operating margin was flat year-over-year, which is a win. Operating expenses grew 24% yet the operating margin was in line with previous quarters at 28% for $19.58 billion in operating income. 

The net margin was a bit weaker than previous quarters in 2021 at $16 billion yet in line with last quarter. The company has free cash flow of $12.6 billion. The company has $125 billion in cash and marketable securities.

Search was stable given the current environment at 13.5% growth to $40 billion and this provided relief that not all ad spend has been paused. Search was strong last quarter at 24% growth to $40 billion, and was flat sequentially. 

We covered the strength of search in our analysis: Alphabet is our Second FAANG.

“The strength in Search highlights the advantage that having first-party data provides. This is because Search is primarily done on a browser, allowing Google to capture valuable first party data from ownership of Google Chrome, Google Search and also from Android OS. Moreover, Google is releasing new products, such as Topics API, which enables behavioral targeting. This is a direct shot at Meta Platforms, who is known to be quite competitive on behavioral targeting through taxonomies.”

The effects of Google’s large R&D department and advances in AI cannot be overstated when it comes to the resiliency of Search in the current environment. We are getting a very slight glimpse of what’s to come for Google in terms of its advertising dominance. 

On the call, an analyst asked what is the company’s north star, given their margins are very strong. Later, the CEO discussed that his focus is using their cash to drive more R&D in AI, which flows through to Google Search and YouTube, which then generates more cash to drive more R&D, etc.

“So, for example, we are obviously investing deeply in AI. We do everything from pure research to applied research to research, which is now things AI work, which is actually happening very close or within the areas like Search and YouTube, et cetera.

And so, you can imagine a scenario in which we are prioritizing and on the margin moving resources to making sure we are driving product improvements, which flow through a moment like that. That would be an example of sharpening focus for me.

And when I think about the opportunities out of AI, just coming out of I/O this year, looking at the progress we have made, how much we have made progress with multisearch, how multimodal things are getting and the fact that people are now actually doing voice searches a lot, visual searches a lot, all that is a good example of how we are driving value in our core products.”

The expectations were that YouTube would weigh on the report yet YouTube provided a bit of growth at 5% year-over-year. The company was adamant that YouTube growth is low because of the tough comps. The tough comps was touched on many times, such as this: “the modest year-on-year growth rate primarily reflects lapping the uniquely strong performance in the second quarter of 2021.” 

The other issue is that just like hiring is seeing a reversion to 2019 levels, so is ad spend. The levels of ad spend seen in 2020-2021 are not sustainable which is why we are reverting back to 2019 in many of these growth rates. Regardless, the overall tone was positive about YouTube especially as YouTube shorts alone now has 1.5 billion signed-in users per month and 30 billion daily views.

Retail was discussed on the call. Although the management team declined to be granular with analysts, they did feel their products are better positioned to serve retail, as evidenced by the current growth rates compared to competitors, due to Omnichannel. Retailers prefer to drive both offline and online sales through multiple channels for in-store, online, curbside pickup which Google helps with across Search both mobile and browser, YouTube, and location-based searches/maps. Google introduced a new way to buy ads across all of Google’s channels called Performance Max with a single campaign to help more retailers tap into omnichannel.

We discussed in our recent Q3 webinar the importance of Big Tech capex, especially for semiconductor investors. This will be something to closely monitor in Q1 reports of next year in terms of expected capex. 

So far, so good for this quarter. We got the following from Ruth Porat, CFO: 

“Turning to CapEx. The largest investments in the second quarter were in servers followed by data centers and office facilities. After several large transactions closed in the first quarter, investment in office facilities was once again focused on fit-outs and ground-up construction on existing projects. We continue to expect an increase in CapEx in 2022 versus last year. For the balance of 2022, the increase will be particularly reflected in investments in technical infrastructure globally with servers as the largest component.”

Google Cloud slowed to 35.6% growth down from 43.8% growth last quarter. This means Google Cloud is growing slower than Azure on a lower revenue base. This is something to monitor in the future.

The company announced $70 billion in buybacks last quarter which is up from $50 billion in the previous year. This is also a marked increase from 2019 which saw $25 billion in buybacks.

Conclusion:

We had said this the following in our last write-up which pulls the pieces together to answer why Google has demonstrated stability in the face of ad-tech headwinds:

“Google also reiterated this point during their Q1 Conference Call when CBO Philipp Schindler explained that being able to fully measure what users do after they click on an ad is critical to measuring ROI. He added that “Measurement is also obviously a key component to success [in CTV], and we want to make sure that advertisers can fully measure their YouTube CTV video investments across YouTube and YouTube TV for an accurate view of true incremental reach and frequency and so on.”

CBO Schindler’s comments highlight the importance of measurement, a key aspect of digital advertising that has been challenged following the changes to iOS cookies. If advertisers cannot measure ROI, they tend to limit their ad expenditures, so it's critical that ad platforms find solutions to measure ROI in order to sustain growth.”

Ultimately, in addition to Google’s many channels, Google is resilient right now due to AI driving stronger ROI for advertisers. For example, AI-powered Performance Max has grown 5X year-to-date with case studies driving 60% more revenue. 

The company is also more defensible following Apple’s attribution and measurement changes as the Google can provide this on their OS and browser while offering an omnichannel strategy.

Microsoft released its Q4 FY2022 results for the period ending June 30th. Revenue grew by 12% YoY to $51.9 billion (missed Wall Street analysts' estimates by 0.94%) and EPS came at $2.23 (missed estimates by 2.9%). The strong US dollar negatively impacted the revenue by $595 million and EPS by $0.04. Net income grew by 2% YoY to $16.7 billion. Microsoft Cloud revenue grew by 28% YoY to $25 billion. The company’s results are good considering the various macro uncertainties, China lockdown, and the strong US dollar. FY2022 revenue grew by 18% YoY to $198.3 billion and net income increased by 19% YoY to $72.7 billion.

The company’s CEO Satya Nadella sounded more confident about the company’s prospects. He said, “In this environment, we are focused on 3 things: first, no company is better positioned than Microsoft to help organizations deliver on their digital imperative so that they can do more with less. From infrastructure and data to business applications and hybrid work, we provide unique differentiated value to our customers. Second, we will invest to take share and build new businesses in categories where we have long-term structural advantage. Lastly, we will manage through this period with an intense focus on prioritization and executional excellence in our own operations to drive operational leverage.”

The company’s gross income increased 10% YoY to $35.4 billion. The gross margin was 68.3% when compared to 69.7% in the same period last year. Excluding the impact from the change in the accounting estimate, the gross margin was relatively unchanged.

The operating income increased by 8% YoY to $20.5 billion. The operating margin was 39.6% compared to 41.4% in the same period last year. Excluding the impact from the change in the accounting estimate and FX, the operating margin would be relatively unchanged.

The company’s cash flows continued to be strong in the recent quarter. Cash from operations grew by 8% YoY to $24.6 billion (47% of revenue) and free cash flow increased by 9% YoY to $17.8 billion (34% of revenue). The company has cash and investments of $104.8 billion and debt of $49.8 billion.

Segment results:

The Productivity and Business Processes revenue grew by 13% YoY to $16.6 billion. This was in line with the midpoint of the management’s guidance given in June. The Office Commercial revenue grew by 9% and Office 365 commercial revenue grew by 15%. Dynamics revenue grew by 19%, which was helped by Dynamics 365 growth of 31%. It was slightly below the management’s growth expectation. LinkedIn revenue increased by 26%, which was lower than the management’s expectation due to the slowdown in advertising revenues.

The operating income of this segment increased by 12% YoY to $7.2 billion. The segment accounts for 32% of the total revenue and 35% of the group’s total operating income. The management expects the Productivity and Business Processes segment revenue to be $16.1 billion at the mid-point of the guidance in the next quarter.

The Intelligent Cloud segment revenue grew by 20% YoY to $20.9 billion. The management’s guidance was $21.05 billion, the negative impact from the strong dollar led to the slight miss in this segment. The server products and cloud services revenue grew by 22% helped by Azure & other cloud services growth of 40%. On a constant currency basis, Azure grew by 46% and the management is guiding for a growth of 43% in the next quarter. Google Cloud revenue in the recent quarter grew by 36% YoY to $6.3 billion.

Some of the key wins in the recent quarter include American Airlines that chose the company’s cloud platform to run its operations. Telecommunications company, Telstra will use Microsoft Azure for its internal IT workloads. The operating income increased by 11% YoY to $8.7 billion. The segment accounts for 40% of the group’s total revenue and 42% of the total operating income. Intelligent Cloud revenue is expected to be $20.45 billion in the next quarter.

The More Personal Computing revenue grew by 2% YoY to $14.4 billion. It was below the management’s guidance of $14.69 billion. The slowdown in this segment was expected since there is weakness in the PC business. Windows OEM revenue fell 2% and despite the deteriorating PC market the company witnessed some share gains. Surface revenue grew by 10%, which was helped by commercial sales. The gaming revenue declined 7% and was in line with the management’s expectations. The operating income fell by 5% to $4.6 billion. The segment accounts for 28% of the total revenue and 22% of the operating income. The management expects More Personal Computing revenue to be $13.2 billion.

Guidance

The management expects Q1 FY2023 revenue to grow 9.8% YoY at the mid-point of the guidance to $49.75 billion. The strong dollar and PC weakness might be the reason for the company to give a cautious guidance for the next quarter that was lower than the analysts' initial estimates. They expect FX headwinds to be higher in the first half of the fiscal year when compared to the second half.

They sound more optimistic on the full year guidance as they expect revenue to grow double digits for the full year. Amy Hood, CFO of the company said in the earnings call, “We continue to expect double-digit revenue and operating income growth in both constant currency and U.S. dollars.” The management guidance does not take into consideration the impact from the acquisition of Activision Blizzard which they expect to complete by the end of the fiscal year 2023.

The company also made an accounting change in the useful life for server and network equipment assets from four to six years which will extend the depreciation expenses for the company. Amy Hood said in the earnings call, “First, effective at the start of FY '23, we are extending the depreciable useful life for server and network equipment assets in our cloud infrastructure from 4 to 6 years, which will apply to the asset balances on our balance sheet as of June 30, 2022, as well as future asset purchases.

As a result, based on the outstanding balances as of June 30, we expect fiscal year '23 operating income to be favorably impacted by approximately $3.7 billion for the full fiscal year and approximately $1.1 billion in the first quarter.”

Conclusion

Microsoft is in a better position to withstand the macro challenges with stable revenue, consistent margins and the company’s strength in Microsoft Cloud. The company’s forward guidance for the next fiscal year looks positive. Despite PC’s weakness, the company’s other segments continue to grow. Notably, Microsoft Azure’s growth is very solid and outpaced Google Cloud.

 

We saw with Shopify that this environment is not going to allow management slide by and not provide formal guidance. Shopify has not provided guidance for some time yet was penalized last quarter (23%) for continuing this pattern.

Snap did provide this in their investment letter:

“As we look toward Q3, we are pleased with the momentum we have observed in our community, and we estimate that DAU will be approximately 360 million in Q3. Thus far in Q3, revenue is approximately flat on a year-over-year basis.”

The story has changed since we first entered the stock, and that’s the #1 reason to close a position. You may recall, Snap was free cash flow positive last year +$223 million FCF in FY2021 and had provided 50% revenue guidance for the next few years during their Analyst Day. Q4 earnings was a blowout in terms of positive surprise to the upside – the stock gained 58% in one day. But Q1 was a slight disappointment with some complicated earnings call discussions over ads being paused during the Ukraine situation. You can read my write-up here. That Q1 earnings report caused us to cut the position in half from 6% to 3%. Due to Snap losing 50% of its value since Q1 earnings, that puts our position at roughly 1.5% when we close it tomorrow.

If this was due to tough Q2 comps, then it could have been forgiven if the company provided a strong guide. The guide was anything but strong. When Snap opens tomorrow, it will join other ad-tech companies such as Unity with its YTD losses. The goal is to find which one of these ad-tech stocks will lead us out of this rout and it’s not going to be Snap anytime soon. Unity now looks comparatively better, which is why earnings season requires flexibility as new information comes in daily.

The more important topic discussed on the call was that Snap stated they lack visibility because advertisers can turn on/off ads with very little friction. This affected other ad-tech stocks because investors are concerned it means Q3 will be weaker than expected on ad spend.

The other negative to Snap’s report included more losses on the bottom line. Free cash flow is at ($147) million in the most recent quarter. Adjusted EBITDA fell from +$117 million to +$7 million. GAAP net losses went from ($152) million to ($422) million.

The positive was Snap’s audience growth. The company is likely to report the highest audience growth this quarter across all media – including streaming media and social media — with 18% growth in DAUs to 347 million. The guide for Q3 on DAUs was also strong at 17.6% growth from 306M to 360M DAUs.

We are laser focused on finding the ad-tech stocks that can emerge as leaders right now and our plan is to move quickly to build those positions and consequently cut any that under perform. You can expect to see Knox’s Sell Alert come through sometime soon.

Eyeing Netflix: Q2 Earnings

Netflix is trading at a 10-year historic low valuation, which means this is an opportune time to discuss the pros and cons of this stock should there be upside potential.

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.

Netflix management was clear that this quarter was “less bad” as they hinted the company is not exactly celebrating the results. The company technically returns to growth next quarter for subscribers with a guide of 1 million, yet this is a marked decline from the 4.4 million in the year ago quarter. As discussed, due to the overall impact across many media stocks from shelter-in-place, it would be hasty to believe there’s something inherently wrong with an individual company when the entire media industry was affected. It’s better to hold those conclusions until H2 2022 through H1 2023 after giving it a full year after tough Covid comps have cleared. Ultimately, media is very seasonal, and we should have a nice glimpse as to which companies emerge stronger by Q4 2022, as this is the strongest quarter seasonally.

With that said, there is already evidence that Netflix is taking more market share than its peers. In fact, Nielsen is raising Netflix’s market share for engagement to 7.7% from 6.6%, which puts Netflix in the lead over any other competing subscription service. This is due to high-quality content such as Stranger Things 4, which reported 1.3 billion hours streamed.

Advertising is not a 1:1 on users, rather Netflix’s revenue growth following the ad tier will be determined by engagement. Today, Netflix has more engagement with 220 million users than YouTube with 2 billion users. That’s key to the equation here.

Advertisers are also likely to pay a high premium for Netflix’s Hollywood-level content. It’s not only the 100 million people sharing passwords that illustrates what the uptake could be for a lower-priced tier, it’s also the high level of engagement the company’s content garners that could make for a nice equation for industry-leading ARPU due to demand from exclusive advertisers coupled with the supply, or premium content, that Netflix offers.

Due to FX headwinds, Netflix missed on revenue in the most recent quarter at 9% revenue growth compared to 9.7% expected. However, on a constant currency basis, revenue growth was 13%. The same was true for Netflix’s guide, it was a miss due to FX headwind at 4.7% for the upcoming Q3 quarter, yet on a constant currency basis, it is a 12% guide on revenue and a beat in that regard.

View Knox’s TD Ameritrade Appearance here discussing Netflix’s earnings.

Not surprisingly, the operating margin was also affected by the strong dollar at 20% in the current quarter and 16% for Q3. The strong dollar led to a slightly better EPS as Netflix saw a $305 million unrealized gain from F/X remeasurement on Euro debt.

The most important line item for Netflix is the company’s cash flow. Looking back, this has been troublesome for Netflix as the company lost $3.3 billion in cash in 2019 as it built up its original content pipeline. However, the company is on an entirely new trajectory with $1 billion in free cash flow expected this year and “substantial” free cash flow in 2023, per Netflix management.

The new and improved trajectory in free cash flow won’t change the company’s debt levels anytime soon. Netflix is firmly setting expectations for $10 to $15 billion in debt into the foreseeable future. This is necessary to continue to hold its place as the top media company in terms of revenue and engagement. Gross debt stands at $14.3 billion, when accounting for $5.8 billion in cash, net debt is at $8.5 billion. The company has been able to improve its cash content spend-to-content amortization ratio from 1.6X to 1.4X in 2021 and an expected 1.2-1.3X in 2022.

Source: Netflix’s Q2 2022 Investor Letter Netflix’s Q2 2022 Investor Letter

Forward-Looking Catalysts:

Netflix has a few new paths to monetization and to re-accelerate subscriber growth. The company is rolling out a new password-sharing plan and is also now partnered with Microsoft on ads to roll out in 2023. More time than not, cross-selling results in higher revenue where someone who would normally churn can now be monetized through ads. Likewise, viewers who can try out Netflix may decide to upgrade to remove ads. Ultimately, the move towards ads also helps Netflix to be more recession-proof in the event households decide to cut costs.

Risks:

We do not see the current soft subscriber numbers as a sign of saturation. Netflix has risen in market share over the past year. Instead, soft subscriber numbers are a result of the pull forward nearly all media companies experienced from Covid. We fully expect Netflix will return to normal subscriber growth due to the catalysts listed above.

Instead, the primary risk for Netflix is its debt in a rising rate environment. This may depress the company’s valuation more than its ad-tech peers who have strong cash flow and little to no debt during tougher macro conditions. Netflix cannot temper this debt if it intends to compete against other subscription streaming services and also the many broadcast networks that have migrated to streaming.

There is also execution risk with a pivot from subscription-only to also including the ad tier. We view the Netflix management team as perhaps the most capable in the industry of pulling off this pivot as they have consistently broken ground in areas much more challenging than introducing ads. In addition to this, CTV ads can monetize at $40 ARPU and we believe Netflix content will set a new record on ARPU. With that said, even if the execution risk is lower than it would be with other management teams, Netflix is likely to fetch a higher valuation after its proven the ad tier will be successful – ETA of H2 2023.

What to Watch: Price Action for Netflix Stock

By: Knox Ridley

The big picture question to ask is – has NFLX put in THE bottom? There are 3 scenarios that could unfold from the current price range, that would help us manage risk around this question:

Red: If NFLX breaks below $185, the odds favor one more low, which would be targeting the $147-$115 region. If this happens, it greatly reduces the odds that NFLX will see new highs in the next growth cycle.

Orange: The current swing up breaks above $250. If this happens, the odds favor a push into the $340-$405 region. If this scenario is playing out, we would see the uptrend stall in this region in a bear market rally. The same lower price targets would hold in this scenario.

Green: If any renewed uptrend can break above $405, the odds will shift towards a move to all-time highs.

Netflix bottomed in May while the rest of the market went on to make a new low. More times than not, stocks that bottom first, tend to lead into the next uptrend. This is a show of strength worth monitoring.

We only have 3 waves down from the 2021 high. This may not seem significant, but it is. If this 3-wave move down turns into 5 waves down (red scenario), the odds that we push deep into the orange range are low before the next leg down.

The Relative Strength Index (RSI) has reclaimed a significant level. Note the blue arrow on the RSI around 57. This was the spot where price topped just before the waterfall moment happened in this bear market. The fact that the recent push higher has reclaimed this level is a show of strength and an early sign that green/orange is likely playing out.

Conclusion: The odds favor a push into the $340-$405 region. As long as the next dip holds $185, the more aggressive play would be to buy into that dip. A safer play would be to wait for the breakout above $250.

Please Note: We have not forgotten about Unity as perhaps a better choice to re-allocate Snap’s position. The stock needs to breakout first.