CRDO - Credo Technology: Rating Upgrade As I Focus On FY26 Numbers

2023-12-28 07:57:10 ET

Summary

• I upgrade my rating to buy due to CRDO's strong growth outlook.
• Recent results show sequential revenue growth of 24.5%, driven by increased demand for connectivity solutions in computing and AI applications.
• The company has potential for market share growth in the optical DSP space and the probability of turning a profit has improved.

Overview

My recommendation for Credo Technology Group Holding (CRDO) is a buy, as I roll over my model and start valuing CRDO based on FY26 estimates. I think the growth outlook is strong with CRDO, and if it grows as expected, even if valuation reverts to historical mean (being conservative), the upside is quite attractive. Note that I previously rated a hold rating for CRDO due to my expectation that valuation re-rating is likely going to be a headwind to returns.

Recent results & updates

For 2Q24 , CRDO posted revenue of $44 million, growing 24.5% sequentially. Growth by segment is as follows: IP revenue grew 1.65x sequentially to $7.4 million, while Product revenue grew 13% sequentially to $37.6 million. The increasing need for solutions that will provide fast connectivity for general-purpose computing and artificial intelligence applications was the primary factor driving the sequential acceleration. Non-GAAP gross margin also showed improvement sequentially to 59.9%, driven by a better product mix.

As we approach the end of CY2023, I think the market is going to place more focus on CY2025 (or FY26). Hence, I am giving an update on my view and why I have upgraded my rating. While I have been negative about CRDO's valuation, I must say its performance has continued to exceed my expectations. The near-term growth outlook remains bright as well, in particular in optical DSP. Despite the lack of product line revenue reporting, management did hint in 2Q24 that the optical DSP business finally surpassed 10% of total revenue. I think CRDO has a decent chance of increasing its market share in this space, particularly if the ongoing evaluations of its LRO (Linear Receive Optics) solution-which aims to cut costs by removing the DSP from the receive path-attract customers. This is a strong and visible near-term catalyst that supports FY25 growth, as revenue associated with LROs could begin to materialize in FY25. Zooming out, the long-term growth tailwind remains intact for CRDO. The need for increased bandwidth and density in networking has been highlighted by management as a result of shifting data center workloads, particularly in relation to generative AI applications. I don't see a reason for this trend to slow down anytime soon, as we are just getting started using AI applications. To be honest, I believe the demand for higher bandwidth and density networking will accelerate from here, as more sophisticated use of AI should drive faster iterations of next-generation AI applications.

Looking into the FY25 revenue growth potential, the outlook remains positive. Although HiWire AEC (Active Electrical Cables) revenue in 2Q24 was flat to down on a sequential basis and could remain muted in the near term due to macro uncertainties delaying deployment, CRDO continues to win deals. Upcoming development projects with two more hyperscale clients and expansion with Tier 2 data center operators were highlighted by management. Furthermore, I would not undermine the competitive position of CRDO AEC. My view is that CRDO's AEC will eventually become the industry standard, as the HiWire Consortium has pretty much all the major stakeholders in it. If all of them agree to CRDO being the de facto standard, then it is very likely that other industries will follow. When this happens, the CRDO growth outlook will be significantly improved.

Lastly, I think the probability of CRDO turning a profit has improved with solid gross margin execution. Although Product gross margins declined by around 400bps sequentially, note that 1Q24 had a high base due to product mix and an inventory-related charge. Note that CRDO actually did better than guided (exceeding the midpoint of guidance by 90bps). CRDO is on track to meet its long-term target of 63-65%, and I expect the increase in revenue scale will drive higher profitability in the coming quarters. If we look at other communications equipment peers, they typically have a gross margin of >75% and an EBITDA margin of >20%. CRDO should be able to reach a similar level of EBITDA profitability over time (probably lower because the gross margin is lower).

Valuation and risk

My growth assumption remains the same for FY24 and FY25, but I now roll over my model to value the stock based on FY26 numbers (since CY23 is coming to an end). My growth assumption is that growth on a percentage basis should decelerate at a similar pace. FY23 decelerated by 800bps, FY25 decelerated by 1100bps vs. FY23 (additional 300bps), FY26 should decelerate by 600bps (300bps following the 300bps incremental pace). Hence, I assume FY26 revenue will grow by 45%.

In general, the way I value CRDO remains the same, in that I expect the valuation to revert to mean as growth decelerates. I believe a key reason for the elevated forward revenue multiple is that CRDO revenue growth is expected to surge back to 62% (as per consensus estimates and also in line with the pre-FY24 trajectory). My take is that as CRDO grows bigger, it is unlikely to continue that >60% growth rate, simply because of its size. As growth decelerates on a percentage basis, so should its valuation multiple. As such, it is more conservative to assume the valuation will not stay at this elevated level. In my model, I assume valuation will revert back to the CRDO historical average of 8x forward revenue.

The risk is that the embedded growth assumption by the market for CRDO is huge; the consensus is that FY25 is growing by 62% and FY26 is growing by 45%. This is also well reflected in the valuation. If CRDO shows signs of cracks in growth weakness in the next few quarters, the market will not spare any mercy in revising its estimates. This could lead to a repeat of what happened in February this year.

Summary

To summarize, I've upgraded CRDO to a buy rating, as I shift my model focus on FY26 estimates. The near-term catalysts, especially in the optical DSP segment and the potential market acceptance of LRO solutions, position CRDO favorably for growth. Moreover, the long-term trajectory remains robust, driven by the rising need for enhanced networking bandwidth amid AI proliferation. While macro uncertainties may momentarily impact AEC revenue, ongoing deals and the potential establishment of CRDO's AEC as an industry standard provide growth potential.

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