Credo Technology Group Holding Ltd (CRDO) Earnings Call Transcript & Summary

Good morning, everyone. Thank you so much for joining. My name is Toshiya Hari. I cover the semiconductor space at Goldman Sachs. Very excited, very honored to have the team from Credo Technology with us today. We have Bill Brennan, President and CEO; and we have Dan Fleming, CFO. I do have a list of questions, but we'll try to keep it interactive.

Sure.

So we'll open it up to Q&A in a little bit.

Bill, it's been a pretty crazy year if we go back to January. I was hoping we could kind of take a step back and maybe share with us your view of the year at the beginning of the year. What happened in Feb and then how things have evolved since then?

Sure. Yes, it has been quite a fun year kind of a roller coaster. So if we go back to February, I think we found ourselves in a position where we had customer concentration with a customer that really has been leading in this pivot towards spending on AI. And so naturally, we were really involved with their general compute side of the business. And so there was a reset that we did. I didn't get as much color as I wanted in February and March. But I think looking back, 2020 hindsight, it's pretty clear that we're going to be talking about 2023 as the year that AI really started the deployment. And I believe that it's going to be more revolutionary than evolutionary. I think this is going to impact the spend for a long time. I do think there's going to be a balance. But I think for our business, I think that if we look at our business outside of our largest customer, what we're seeing is more than 100% growth year-over-year. And so with our largest customer, we might be taking an adjustment of more than 50%, if I compare year-over-year. But the hidden really positive news is that we're seeing growth in many different areas across the board. And I do think we're benefiting generally short term as well as long term from the move to AI cluster deployments.

Got it. That's a great place to start. So obviously, AI is extremely topical. Every single session AI comes up as sort of a driver enabler, what have you. You participate in both sort of traditional spend, if you will, as well as AI compute. When you think about the net impact, and I guess you sort of answered my question, but is the net impact positive? Is it neutral? I think investors are trying to understand, given the dynamics around the largest customer, it's less clear from the outside. But how should we think about the net impact as both AI compute grows, but also general compute catches up at some point?

Yes. I think that we look at it a bit differently. And of course, long term, you'll see us participating in the general compute as well as AI. My expectation is that we'll have a good footprint in both applications. And so longer term, I think the balance between the workloads or the spend might be something that's one layer deeper than we go since we're going to participate in both. So I think that the world we see is really we see bandwidth and the need for more bandwidth and lane speeds in particular. And so I think the best thing that comes from AI deployments is there's an acceleration in the bandwidth that needs to be deployed with these systems. So it means an acceleration from 50-gig lanes to 100-gig lanes to 200-gig lanes over the next few years. And that application moving towards faster speeds and more connections. There's -- in AI deployments, there's a significantly higher density of connectivity. And if you really look at the point-to-point connections that are being made in these RDMA back-end networks, just the sheer density and the sheer bandwidth of these applications is a great driver for our business. And so I think for the first time, we're talking about interconnects and connectivity being the bottleneck for the entire system deployment. That's a good thing for a company that is pure play on connectivity.

Got it. That makes sense.

So I think it's definitely going to be a catalyst for our business. And as it relates to the near term, sure, I can point to many different specific things. But I think longer term is where we really play itself out.

Got it. Maybe a couple of questions on your AEC business. And I know you don't want to get too specific with specific customers. But with the largest customer, I think when you made the revision back in February, there were -- we were getting questions, Oh, did the customer drop AECs, did someone else take their business? Is it permanent share loss? Is it fair to say in hindsight, given the information that you have today, it was a push out and your positioning and none of that is really...

Yes, there's no question that I don't think our relationship has changed at all. I think that it was merely a shift in spend. And I think long term, I think we'll be well positioned for both general compute and when that recovers and AI when that ramps. I feel great about the relationship.

Got it. Got it. And your visibility on the general compute side in terms of potential timing of recovery? I know it's not easy, but what are your thoughts on that?

So it's a bit tough for me to talk about, but I think it's really a calendar year '24 type of time frame, and we can -- it's hard to get specific whether that's midyear or after.

Got it. And then the second hyperscale customer in AEC that you often talk about on your calls, and I feel like your tone around that has gotten more positive and constructive. As you sort of compare and contrast how significant of a customer they could become relative to your first customer, like as outsiders, how should we think about the opportunity set as you ramp into late '23 and calendar '24?

And I think generally, the opportunity can be bigger. And I would say that the different areas of business that we can participate in might be broader in the sense that, yes, we've got a position that will be growing in the general compute area. We've got a position that will be growing for AI deployments. But a third area is in switch racks, so in the kind of the front end switching and routing network. Their strategy is to build their own switch racks. And for sure, there's going to be an AEC opportunity that's significant. So I would say collectively, it can be a larger relationship than our first customer.

Got it. Got it. And as we think about broader AEC adoption, as your customers transition to 800 gig, is it a must to transition to AECs? Or can they still sort of stay on their conventional [ technology decks or AOCs ] or what have you?

Yes. So we're seeing that as applications move from 25 gig per lane to 50 gig per lane, we're seeing that the bulk of our customers are transitioning to AECs versus trying to stick with passive copper technology. As we talk about moving from 50 gig lanes to 100 gig lanes, we really see it becoming a de facto standard where our architectures have short in-rack cabled connections. It's really driven by signal integrity. It's driven by form factor. It's more and more for the designs we're involved with, we see it driven by special functionality that we can build into the cabled solution.

Got it.

So for many, many reasons, we think at 100 gig per lane, it's really going to become the de facto choice for short cable connections. We don't see DAC really existing for 100-gig per lane. And we think for optical, for many reasons, it's much higher power, much higher cost, and there's less flexibility with implementing special features.

Right. Right. So I mean we spent a lot of time talking about your largest customer and your second customer, but given what you just described, I'm guessing your customer engagements are significantly broader what...

Yes, we've got conversations with really all of the hyperscalers in different stages from different stages in the engagement, but I think it's playing out very well in kind of line with what we've always thought over the last several years.

Right. Right. And is there any pushback on AECs as a technology as you sort of conversely...

I think the product category is being well accepted. There was the natural pushback when we first started talking about this, going back 4 to 5 years, there may be a little chuckle because everybody was assuming that the thought for the last many, many years has been when passive copper runs out of gas, it's going to be an all optical world, and that's simply not the case. And I think it's well accepted in the industry now.

Right. Got it. I think at the time of your IPO, you had estimated roughly half of hyperscale servers will use [ Nictator-AECs ] by 2025. Is that still the right sort of framework? Or have things evolved over the last several years?

So I think actually -- first of all, the forecast that we referenced, this particular one came from the 650 Group, and we look at other forecasters as well that have picked up the market. And I think that the way that we view things is really on a bottoms-up design by design, hyperscaler by hyperscaler. And the top down view looks like it may have shifted a year. So we were talking about 2025, maybe it's '26 now. But I think the trend towards faster speed is happening. And as that trend happens, the AEC product category will grow, and it could be even beyond what the forecasters say.

Right. You pioneered this technology, the segment. There is some competition or there could be some competition in the future, maybe not so much today. Can you remind us how you're different? Obviously, you're vertically integrated and we get all those points. But when you go to a customer, why do they choose you as opposed to your peers -- maybe product availability?

Well, it's -- I think it boils down to delivering what they want, when they want it, and they typically want it quickly. And so the way that we're organized is we take ownership of the entire system solution. So of course, we developed the chip and I've got more than 100 people that are focused exclusively on the AEC system development at some stage, whether it's defining the product, engineering the product, qualifying the product and ultimately being responsible for the product in production. Our competition is typically the cable manufacturers that are trying to transition from building passive copper cables to building something that's got a lot more intelligence. And so the natural idea is help go buy a chip from a chip supplier in the market, and I'll integrate it. And so what we find is, for our largest designs, the customers we're closest to, we're on almost a daily iterative loop with our engineering team directly with theirs. And that just simply doesn't exist with the collection of companies that's trying to compete with us. So I think it's -- I think the first place we'll see competition is in a standard type of product, maybe in the 800-gig product where it's got 2 connectors, it's a straight cable. It's a fixed target. And so that will -- I think that's an easier target to aim at versus a target that's moving where we're implementing custom features kind of on the fly with our customers. But those are the higher volume opportunities from our perspective.

Right. Right. So the standard stuff, is that more enterprise or which sort of...

I would say it might be in the switching network as an example.

Okay. Okay. Understood. And have you sort of seen or identified any progress on the part of your competitors [ in come ] to market.

We've heard it a lot. We've seen very little in the field.

Okay. Okay. Got it. In the optical DSP place marketplace, the positioning is kind of reversed, right? You're coming in as the follower, the disruptor. I think earlier on, you had talked about very strong progress in China. That market unfortunately weakened. And then more recently, you talked about a win with the U.S. space hyperscale customers. So maybe talk about the engagements there, again, your differentiation in optical DSP relative to the incumbent?

Sure. Yes. So the rules are a bit flipped here. And so we find ourselves as the challenger or the disruptor. And what we're bringing to the market, I think we're almost liberating the market from a supply chain standpoint where the supplier that has incumbency is very much acting like an incumbent. And what we can bring is we can bring a sharpening of the competitive factors. Of course, it's equal or better performance, it's equal or better power. But from a commercial standpoint, I think we can bring a lot of positives to our optical module partners and our end hyperscaler customers.

Okay. And I think you talked about the business being potentially 10% of revenue next year or...

Yes. The objective internally is that we drive 10% of our revenue next year in optical is kind of a first starting point.

Okay. Okay. And you can get there with the current customer base? Or are you kind of contemplating further wins in hyperscale?

So we've got lots of activity going with many optical module makers as well as hyperscalers. We feel that those activities will drive that number in fiscal '25.

Got it. And like your other products, the N minus 1 aspect of your business is a big differentiating factor, right?

Sure. Just to make sure everybody understands, I'll reiterate N minus 1. And so 12-nanometer is our workhorse process now. And so when we're competing with a product that's built in 12-nanometer, we're competing against the product in 7 or 5. It's a little bit counter to kind of think that we've got an advantage. But we make our decisions -- primary decisions based on connectivity. And so we look at the -- what's needed in the design and if we can do it in a process that is less expensive to develop, if I can deliver equal or better performance, equal or better power, do it with small die size in a process that cost a fraction for tape-out costs and a fraction for wafer costs I'm going to deliver a really strong commercial advantage. I'm going to have a real cost advantage. And so that N minus 1 means that we've got to be fundamentally better at a core SerDes level, and that's really what we've proven over time. We've proven that, that advantage extends to 5-nanometer, where the SerDes we've delivered in 5-nanometer are 40% to 50% lower power than competition. It will extend to 200 gig per lane in 3-nanometer. And the idea is to compete with us head-to-head, you'll need to go to a more advanced process and that advanced process would be the end. We're in a minus 1 geometry. So absolutely, it's delivering the kind of advantage commercially that we expected. And so if you're going to play the role of disruptor against that incumbent, that is the main factor that you've got to bring. And we're not talking about a market. The market we're serving is not a rich market. You look at the financials of the optical module companies. And they suffer from being commoditized. They're in a very much commodity competition. And what happens there is the price is kind of -- who can go lower faster. And so if we're helping fuel that competition and helping the winners of that competition be more profitable, gain market share, that's really key to our success.

Right, right. I guess if I'm a customer and to your point, I'm suffering from relatively permanent challenged margins. It feels like an no-brainer. So what's the pushback? Is it a competitive response? Or is it just time that solves this? Or how should we think about that?

Yes. I think the end customer really matters. I mean I think the hyperscaler is the loudest voice in the room. And so it's making sure that they're included in the early conversations, they're included in the execution. And the bottom line is that's the big hurdle that we cleared recently in ramping our first hyperscale customer here in the U.S.

And your presence in the AEC market, I would assume helps progress on DSP side, right?

Yes, absolutely. Absolutely. So collectively, if you look at all of our solutions from optical DSPs to AECs to line card 5s to SerDes Chiplets, even to IP. Collectively, I think Credo is being recognized as a connectivity leader. And so there's no question that our footprint elsewhere leads people to absolutely believe that we can help them with optical.

Right. Right. And then you talked about SerDes Chiplets. I feel like this is a business that gets less airtime relative to AECs and optical. You've talked about 2 very large customers, and you've had a lot of success there. Maybe talk about the opportunity set as it pertains to SerDes Chiplets and how you see the business evolving going forward?

Yes. We've been believers in the SerDes Chiplets market for maybe too long. It's -- we've spent a lot of resource, and we've been successful with bringing 2 big customers to production, Intel and Tesla. Tesla is maybe a little bit more notable because it's on a leading-edge AI deployment. I think that we're still believers long term in the benefit of looking at architecting systems differently. And I think we're seeing lots of interesting architectures come to market. The Tesla Dojo AI cluster is really impressive on many fronts. And if you look at that tile design that they've talked about publicly and they've talked about Credo being their connectivity partner, it's really probably the most advanced, highest bandwidth example that we can point to in the market. Every one of their [ D1A6 has ] 576 lanes of our 100-gig IP, making that 57.6 terabits per second of bandwidth per die, there's 25 of them in a 5x5 matrix on their tile. Surrounding the tile are chiplets. So there's 40 Credo chiplets on every tile that sit underneath those connectors and heat things that you see on the edge. And so really, really unique architecture and something we've been working on for actually several years. So it's great to see them successfully bring that to market.

And the breadth of your customer engagements, I mean, given where the market -- or the industry is headed from a chiplet kind of architecture perspective, I would assume your engagements must be...

[ The conversations ] are definitely broadening. So the chip -- any chip that we develop will have the rights to take it to market, even though it might have a lead customer. So you can imagine we've got a handful of other conversations happening around that same development. We've got another chiplet that's in design in 5-nanometer and I believe will probably -- that will be a good device to intersect a broader part of the market.

Got it.

But I'll also say that we're also looking at the network inside the box or inside the server or appliance, and it's really a PCIe/CXL network. We're part of the UCIe consortium. And we believe that although the chiplet designs we've been involved with have been very much tailored for the lead customer. We do believe that there is the possibility that standard chiplet can emerge, especially from this standards body that's really been in place for a year or so. So that would be a chiplet that would have UCIe on one side, we would connect to the die within the package and PCIe, that would be on the other side, off-chip facing.

Understood. That's fascinating. Maybe I will pause here and see if there are any questions from the audience. Right, I'll keep going. Maybe bring Dan into the conversation. A question on gross margins. In the July quarter, you exceeded the high end of guidance. I think you gave a couple of factors, and this was despite weaker IP revenue. So maybe remind us what were some of the key drivers? Were they transitory? Were they permanent? And how should we think about the go forward given the 63% to 65% target?

Yes. Let me start with just kind of the broader perspective. Nothing has changed in terms of our long-term expectations when it comes to gross margin, 63% to 65% is what we expect long term. And that's with IP being 10% to 15% of overall revenue. Fiscal year '23 last year, we ended at 58%. So there's 500 basis points minimum of expansion in the upcoming years. And what we've stated for this year at fiscal year '24 would be about 100 basis points year-over-year expansion. So 59% plus. And what's really driving that, revenue-wise, we have modest growth essentially FY '24 from '23. So there are some underlying product mix changes in the year that are really driving that expansion this year. And that's all relevant because that was -- it was visibly on display in our Q1. Our product gross margin expanded by 700 basis points sequentially, and that was really driven by increased contribution of some of these emerging product lines. Our chiplets, our optical DSP was material really for the first time on a quarterly basis. And as a result, we've always talked about AEC being at the lower end of our margin spectrum. So that was a lesser component of the total for the quarter. So there will be some quarterly variability throughout the year. But long term or for this year, we expect 59% plus for the entire year. And that's with IP being kind of right at the high end of that long-term expectation, call it, 15-ish percent of total revenue.

Right. So obviously, in the near term, product mix is probably the biggest driver of gross margins to the upside and the downside. But as you kind of look at your profitability on a product-by-product basis, where is the most sort of potential, if you will, as you think about your business over the next couple of years?

Well, if you look at -- if you just talk about gross profit, AEC, we've always said we'll be 50% plus of the overall revenue mix. And even though the gross margin percentage might be on the lower end from a gross profit from a dollar perspective, that's where a large contribution comes from the largest contribution comes from.

Got it. Got it. Bill, let me back to you. So wafer pricing has been relatively inflationary the past couple of years...

Yes, we're seeing it.

Right. Right, the past couple of years. I guess the outlook in the next year is probably still uncertain, but there are various views. Some people are saying it's going to be up. How do you think about your foundry strategy? Obviously, TSMC is a very strong supplier. You've got a very strong relationship there. But as you think about your business growing over the next several years, you think about the geopolitical backdrop, what's sort of the debate internally as it pertains to who you source from?

Sure. So we've been fortunate to have great supply partnerships, including TSMC. They've done a fantastic job of cultivating our business. And the situation -- the reality is that we can achieve our objectives with TSMC as a sole source. However, as we look out towards the future, it really becomes a conversation about resources and priorities. Obviously, I think it's pretty clear that having multiple sources is a good idea. And I think a lot of our customers that we talk about optical, I think there's a desire to have multiple sources, and that's really driving our business. So I think the same principles exist for us. I think it's a little more complicated when we think about the resources. But more and more, as we look at next-generation processes, there's not -- I think the gap can be bridged by the -- by our tool suppliers. And so it's hard to say. I don't -- I can't say anything regarding the near term. But obviously, we're looking at all options long term.

Right, right. But there's always an offset in that having multiple lanes from a foundry recipe perspective is expensive, right?

Sure.

Right, right. Okay. Got it. I guess from an OpEx perspective and is for both you, Bill and Dan, how should we think about the leverage going forward? I know you've got common R&D, it's a good platform. You leverage it across different applications and various customers. Should we expect -- is it fair to expect pretty healthy OpEx leverage as sort of business comes out of this correction and you start to grow into '24?

Yes. We expect to see that on a quarterly basis this year, that will be really on full display, right? We faced a decision 2 quarters ago on what to do OpEx-wise as we had our reset with our largest customer. And our choice was with all of the organic opportunities in front of us to continue to invest strategically in areas that will yield a nice ROI in the future. So that meant that we had a small loss in our Q4 of last year and Q1 of this year, that returns to essentially breakeven this quarter and return to profitability in the second half of the year. Our OpEx growth is really what we've termed modest sequentially throughout the remainder of this year. But the top line growth is at or near 20% sequentially. So we expect to return to double-digit operating income by our Q4 is what we had established as a goal. And so you'll see that leverage occur throughout this year, and that should continue in the future as we do have a very highly leveraged R&D organization.

Okay. Great. I'll pause here again. Any questions? Maybe in the last couple of minutes, Bill, as you spend time with investors and analysts, anything about the Credo story that people overlook or underappreciate or anything about the broader market that you feel like collectively, analysts and investors don't quite get or understand, if you will.

I think this group is a pretty smart group. I always learn a lot when I come to conferences like this. But I think that we've been talking about the applications that AI, in particular, we've been talking about this for several years, and we've been talking about it in terms of our business really is fueled by faster speeds. And the bottom line is we've been working on many, many different AI deployments. And I think up until 2023, it was hard really to draw a straight line from point to point saying, how is this really going to -- how and when is this going to benefit your business? But I think it's absolutely right in focus now when people talk about the application generally, although we don't track it that way, obviously, most of our business long term is going to be driven by AI because that's really the catalyst towards faster speeds. When in time, have we talked about connectivity being the big problem to solve, right? If we look at AI clusters and we look at the scale up and scale out that is on the road maps, there's a real catalyst to move to 200 gig lanes now. And so when in time has there been that catalyst. If we think back to the 400-gig market, all of the forecasters are saying it was going to be a hard cutover. There's only one customer that made the cutover and it was a form factor-driven decision. This is really the first time that I can remember that connectivity is in the spotlight. And so when you're a pure-play connectivity company, way, we find ourselves in a great spot right now as we look forward. And so I do think the investment community is right on as it relates to our business. And the fact that we see this 10-year megatrend that is going to continue, and it's really very clear to identify why it's being fueled and how it's being fueled.

Do you get the question, the Ethernet versus InfiniBand?

Yes, that's a popular question. And I think that coexistence is really what we see. I think you can build a model if you go data center by data center and you would say, "Hey, Amazon is InfiniBand big there?" I'd be interested in your model. It probably wouldn't be something you could say it's big there. As an example, you could go data center by data center. And I think that we -- our growth is really fueled, our business is really fueled by the hyperscalers. And we see Ethernet being very popular. So we're involved in lots of different deployments. And I think it's a function of time.

Great. So we enjoy the conversation. Thank you so much.

Yes. Thank you.

Appreciate the time. Thank you.