Credo's Huge AI Growth Runway Is Confirmed By An Industry Bellwether

Seeking Alpha12-16

SummaryCredo Tech is poised to benefit from a multi-year scale-out in custom data center infrastructure markets, driven by AI workloads and hyperscaler demand for efficiency.Broadcom's strong AI ...

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But as AI workloads scale in volume and complexity, hyperscalers are hunting for vendors that help in customizing efficiency aspects of their AI infrastructure.Networking is a key efficiency aspect that hyperscalers are looking to customize, and industry leader Broadcom (NASDAQ:AVGO) reported stunning results that reemphasized the growth that lies ahead in customized networking solutions for the data center.With a serviceable market set to grow by a ~62% CAGR over the next three years, Credo looks set to further leverage the relationships with its hyperscaler customers, allowing its premium to keep expanding on an NTM basis.Prospects look robust for Credo, and I recommend a Buy rating on this custom-networking solutions company.The Custom Networking Industry Is Growing - So Will CredoBroadcom released its stunning Q3 results this week, where the company posted its strongest quarterly growth over the last five years, hoisted up by a 220% increase in AI revenue. On Broadcom’s Q3 earnings call, their management said that its AI revenue more than quadrupled in Q3, growing 220% to $12.4 billion.More importantly, Broadcom’s management revealed some crucial industry figures, which also hold the key to shaping Credo’s outlook.On Broadcom’s Q3 earnings call, their management said the company’s three hyperscaler customers have plans “to deploy 1 million XPU clusters across a single fabric,” which has enough potential to change the SAM size. Broadcom’s management now estimates its XPU+networking SAM to be “in the range of $60 billion to $90 billion in fiscal 2027 alone.” With the SAM currently in the range of $15-20 billion, this indicates a significant CAGR of 62% through 2027, with most of it being back-end loaded during this time.In addition, Broadcom’s management also revealed that networking solutions currently account for just 5-10% of that SAM. But the share of networking solutions will increase to 15-20% of the SAM as the buildout for the XPU clusters “hit 500,000 to 1 million XPU GPU clusters.” This points to a CAGR for AI infrastructure-centric custom networking solutions that is easily in excess of the 62% SAM that I pointed out in the earlier paragraph.Enter Credo.Credo had a somber fiscal 2024, which ended in April this year and saw the company grow its revenues in the mid-single digits only. This was after Credo had posted two strong years of growth, in excess of a 70% run rate, during FY22 and FY23. The reason for sluggish growth in FY24 was that many of its hyperscaler customers prioritized whitebox GPU and networking solutions, leading to slow volume shipments for Credo’s AEC product family (Active Electrical Cables). Hyperscalers use Credo’s AEC products to build customized networking products such as network switches to reduce network redundancy and improve efficiency.Credo’s revenues look to be back in acceleration mode as the architecture models for the AI data center are scaling out towards also achieving efficiency. AI data center racks are getting more dense, and a shift towards DLC-based data center racks is driving networking demand for Credo’s ALC products.Exhibit A: Credo’s Revenues Are Back in Acceleration Mode. (company sources via stockanalysis)The company’s Q2 results published this month show strong momentum in its $72 million revenue base, growing 64% y/y and ~21% sequentially. In addition to the revenue acceleration, its gross margins are also in expansionary territory. On a TTM basis, Credo’s gross margins rose to a massive 60%, which indicates the strength in the market that Credo is selling into.On the Q3 earnings call, management said they believe they are “still in the early stages of widespread market adoption.” They also added:Building on the adoption and engagements highlighted earlier, our second half revenue growth will be driven by our AEC products. Furthermore, we anticipate continued growth beyond fiscal '25 as market adoption expands across the data center ecosystem.Credo’s management outlook was only echoed by Broadcom’s management outlook this week and points to a robust runway for Credo’s revenue acceleration in the year ahead. One of the ways that I find encouragement in Credo’s outlook is by observing their accounts receivables, which reported the strongest growth in the company’s history, growing 127% to $101 million.Credo Valuation Premiums Are Not For The Faint-HeartedThis is where most investors may find it difficult to justify the premiums that Credo warrants.Credo’s management expects a slight sequential dip in Q3 revenues with next quarter’s revenues growing at ~67%. But management sees strong double-digit sequential accelerations in Q4. Management has also outlined their expectations for gross margins to exceed 60%, which indicates a strong demand environment for the rest of the year.Consensus estimates expect Credo to more than double its EBITDA, which is much faster than its larger peers. This implies Credo should actually trade at a forward valuation in excess of 80x at least with the superior EBITDA growth rates as compared to its peers. But it still continues to trade at ~64x forward EBITDA on an EV/EBITDA basis, implying at least 25% upside.Exhibit B: Credo’s valuation is quite cheap compared to its larger peers (Author's compilation)Risks & Other Factors To ConsiderThree main risks here are a reversal in business cycles, competition, and concentration.Given the outlook provided by Broadcom and other industry peers, I believe we are firmly in a strong demand environment for most players, but any reversal in demand will hurt the industry.In terms of competition, Broadcom and Credo cater to different hyperscaler customers. Credo counts Microsoft (MSFT) and Amazon (AMZN) as customers, with Oracle (ORCL) reportedly being a third hyperscaler to use Credo’s products. If these customers suddenly switch over to Credo’s peers, it will cause significant headwind to Credo.Credo’s hyperscalers revenue concentration also introduces the element of concentration risk. Per its filings, Credo’s top two customers accounted for 54% of its entire revenue in Q2, so investors should digest these risks as well.TakeawayCredo has been able to demonstrate a couple of things so far this year that are playing out in favor of the networking solutions company: a rapidly growing custom networking solutions market and a favorable customer mix that are allocating more budgets towards Credo’s AEC networking products. The ramp in product shipments is very encouraging and points to a strong outlook ahead, as echoed by industry leader Broadcom this week.I recommend a buy rating on Credo.","kind":"news","is_publish_news":true,"is_publish_highlight":true,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":0},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":3,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/1134673986"}