Credo Technology: AI Revenue Doubling In FY25; Initiate With ‘Buy’ (NASDAQ:CRDO)

Erik Isakson Credo Technology (NASDAQ:CRDO) is a leading player in the high-performance connectivity market, with rapid business growth driven by AI and data center expansions. I anticipate that Credo will significantly grow its comprehensive Ethernet connectivity solutions in the near future., doubling its AI related revenue by FY25. I am initiating with a ‘Buy’ rating with a one-year price target of $35 per share. Leadership in High-Speed Connectivity Market Credo Technology is a pure play in the connectivity market, specializing in high-speed connectivity products for data centers and hyperscalers. For AI computing, it is mission-critical that data be transferred and delivered to GPUs at high speeds within the data center, necessitating high-speed Ethernet connectivity solutions that provide substantial bandwidth. Credo offers several solutions designed for Ethernet port speeds ranging from 100 gig up to 1.6 terabits per second, and these solutions include HiWire AECs, Optical PAM4 DSPs, Line Card PHYs, SerDes Chiplets and SerDes IP. Credo’s growth drivers can be summarized as follows: The main factor driving Credo’s growth is the expanding AI market, which has spurred a surge in data center constructions. When data centre are being built, operators need to deploy software, hardware, GPUs and connectivity devices and wires. High-speed connectivity products, including copper interconnect cables and optical digital signal processors, are essential for connecting these devices and hardware. As one of the leading players in the interconnect market, Credo is well-positioned for rapid growth in the near future. During the Q4 FY24 earnings call, the management disclosed that 75% of the company’s total revenues were derived from AI workloads, with expectations to double the revenue by FY25. Credo’s HiWire Active Electrical Cables (AEC) are designed for data speeds of 100G, 200G, 400G, 800G and emerging 1.6T. AECs have already become a leading solution for in-rack cable connectivity. As emphasized over the earnings call, AECs offer superior signal integrity, power and reliability, giving Credo a competitive advantage in the market. Lastly, Credo optical digital signal processors (DSPs) are a key building block inside optical transceivers that are used in AI clusters, as described in their 10K. The company is targeting its DSP business to reach 10% of total revenue by FY25, as their PAM4 DSP business ramping up customer engagement increases. This growing engagement in the DSP sector could drive additional growth for the company in FY25. Outlook and Valuation The company is set to release its Q1 FY25 earnings on September 4th, guiding more than 70% year-over-year revenue growth. The management anticipates the revenue growth accelerating throughout the year, driven by an anticipated increase in AI-related revenue in the second half of FY25. As depicted in the chart below, Credo has experienced robust revenue growth in recent quarters, accompanied by notable margin improvement due to operating leverage. Having said that, Credo is still an early-stage growth company, and they have to invest heavily in R&D and sales & marketing to scale its operations. Credo Technology Quarterly Earnings I am considering the following factors for FY25’s growth: I estimate that Credo generated $140 million revenue in AI workloads in FY24. Given the ongoing AI investments by hyperscalers and data centers, I am confident that the company will double its AI-related revenue by FY25, reaching $280 million. Microsoft (MSFT) is the largest customer for Credo, accounting for around 26% of total revenue. As reported by the media, Microsoft plans to double new data center capacity this year. With its leadership in the AI sector through Windows 365, Azure, and its partnership with ChatGPT, Microsoft’s data center expansion is expected to drive significant demand for Credo’s connectivity products and cables. I assume Credo’s non-AI revenue will grow by 10% in FY24, driven by investments in traditional workloads. As such, the total revenue is estimated to increase by 80% in FY25. For the normalized revenue growth from FY26 onwards, I am considering: Credo remains a relatively small company, with revenue of only $192 million in FY24. I anticipate AI workloads will continue to drive the company’s growth in the near future. The AI related revenue is expected to grow by 60% annually for Credo in my DCF model, reflecting the company’s leadership in high-speed Ethernet connectivity solutions. I maintain a 10% growth for non-AI revenues. As such, from FY26 to FY30, I calculate the company’s revenue will grow by 50% annually. After FY30, I anticipate the AI boom to moderate, as the industry moves past data center expansion phase. AI is more likely to transition into inference stage, with reduced computing requirements for core data centers. I assume Credo will grow its AI revenue by 30% from FY31, and non-AI by 10%. As a small growth company, Credo is investing heavily in R&D costs, allocating more than 49% of total revenue towards R&D in FY24. I model 200bps annual margin expansion with the following assumptions: Gross margin: Credo has been expanding their traditional cable and optical business into adjacent markets, including the 5G communications market. The market expansion is leveraging their existing technology, potentially generating gross margin expansion opportunities. I assume a 50bps margin expansion coming from gross profits. SG&A: I anticipate the company will generate 50bps margin expansion from the operating leverage from SG&A, as the company could leverage existing sales force and marketing resources to distribute more products effectively. R&D: I anticipate 100bps operating leverage from R&D expenses. The DCF summary: Credo Technology DCF I calculate the free cash flow from equity as follows: Credo Technology DCF The cost of equity is estimated to be 17%, assuming risk-free rate 3.8% ((US 10Y Treasury)); beta 1.98 (SA); equity risk premium 7%. The one-year price target is calculated to be $35 per share, as per my calculations. Key Risks As discussed previously, Microsoft is the company’s largest customer, representing around 26% of Credo’s revenues. Over the earnings call, the management disclosed that their second-largest customer is an AEC hyperscaler, representing 20% of total revenue. The third-largest customer is a leading chiplet company, making up 15% of total revenue. The three largest customers account for more than 60% of total revenue. As such, Credo has significant customer concentration risk. The loss of any of these major customers would be detrimental to the company. Credo allocated more than 11% of total revenue towards stock-based compensation (SBC). While I think it makes sense for an early-stage growth company, the high spending on SBC would create headwinds for margin expansion. Credo is competing against Broadcom (AVGO) and Marvell (MRVL). I have to acknowledge that both Broadcom and Marvell are quite large companies, with substantial R&D and customer resources. However, as a pure play in the market, Credo’s focused approach could provide it with a competitive advantage. End Note I favor Credo’s technology leadership in the high-speed connectivity market, supported by structural growth drivers from the AI boom and high-performance computing. I am initiating with a ‘Buy’ rating with a one-year price target of $35 per share.

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