CRDO - Credo Technology Group: Valuation Is Still Not Cheap Enough

Summary

• Credo Technology Group stock has issued forecasts for 4Q23 and FY24 that are in line with its previous forecasts.
• I am optimistic about CRDO's long-term development prospects, particularly as a key enabler of high-speed connectivity solutions in a low-cost, low-power framework.
• I am not comfortable with its current valuation and would not be investing in it until it comes down.

Investment thesis

Credo Technology Group ( CRDO ) issued forecasts for 4Q23 and FY24 that were in line with its previous forecasts. Although there is expected to be a decline in the consensus EPS in the near future due to gross margin pressure, I expect that performance will gradually improve, starting in 1Q24 and continuing throughout the fiscal year of 2024. The basis of my expectation stems from the stabilization at CRDO's largest customer, an increase in from the second-largest AEC customer, and also possible demand from a new hyperscaler. In addition to the increase in revenue, I anticipate a return to more typical levels of gross margin and roughly stable operating costs, which combines to improving earnings. In the long run, I still have hope for CRDO's development prospects, especially as a key enabler of high-speed connectivity solutions in a low-cost, low-power framework. However, consistent with my previous posts and updates, I am not comfortable with the valuation CRDO is trading at today. Until it comes down, I would not be investing in it.

Business updates

When it comes to AEC revenue, I'm confident in a rebound because I think the value proposition is still sound. Despite uncertainty in the near future caused by project delays at CRDO's largest customer, Credo's value proposition of AEC remains intact. In my opinion, the benefits of AECs will become more widely known over time, and its opportunity set will grow to include not only compute but also AI and switching.

The fact that the company is making an effort to diversify its clientele makes me feel reassured, especially since shipments to the second volume customer will increase rapidly in FY24 and possibly to others in FY25. This is significant because it frees CRDO from its dependence on its largest customer, resulting in higher quality revenue (i.e. less volatility) and the possibility for CRDO to increase price (i.e. more margin) as a result of improved bargaining power. With regard to the largest customer, since inventory-induced headwinds have begun to abate and projects (that were on hold) have resumed, I anticipate a pickup in shipments within the next six to twelve months.

Finally, the $12.6 million in IP revenue in 3Q23 was above my projections. Although I find it challenging to forecast this revenue source from quarter to quarter, I am heartened by its continued strength because I believe it reinforces CRDO's n-1 advantage. As an example, customers who are still using n-1 process technology can remain competitive by utilizing CRDO SerDes IP to improve power and performance.

Margin

Management has decided to keep quarterly operating expenses low for the rest of the year in light of the impending revenue headwinds. This should increase the model's operating leverage, especially considering I expect that quarterly revenue bottoms out this quarter and grows sequentially through FY24.

My concerns

On the earnings calls, management explained the factors that contributed to the steep decline in guidance issued last month and elaborated on the forces that will likely boost sales in 2H24. Despite the explanation, I remain skeptical about the speed and scope of the recovery. After last month's unexpectedly negative revision, I believe other investors will not give CRDO the benefit of the doubt. Keeping investors abreast of product developments is, in my opinion, the best way for management to allay these concerns. The trust that the investment community has in CRDO must be protected at all costs, so there must be no further major guide downs. On the other hand, an upward revision in guidance coupled with positive feedback from end customers could serve as a powerful catalyst for a re-rating of the stock price and the consensus opinion.

I'm also worried about pressure on the gross margin. Because of a less-than-ideal product mix and larger-than-anticipated inventory reserves, the company's gross margin performance is falling short of my expectations. While I anticipate a recovery to previous levels, a failure to do so could cause investors to doubt CRDO's ability to meet its long-term financial goals and thus spark yet another round of mistrust.

Conclusion

In conclusion, while I remain optimistic about CRDO long-term development prospects as a key enabler of high-speed connectivity solutions, I am not comfortable with its current valuation and would not be investing in it until it comes down. However, I anticipate that CRDO's financial performance will improve sequentially beginning in 1Q24 and continuing through FY24. Nevertheless, my concerns about the speed and scope of the recovery, as well as pressure on the gross margin, need to be addressed to regain the trust of the investment community. Overall, CRDO has the potential to be a strong investment opportunity in the future, but caution and due diligence are warranted in the current market conditions.

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