Artificial intelligence is all the rage and Nvidia is the stock to own. But should you buy now after the latest rally put it on eyewatering valuation multiples? Analyst Edmond Jackson gives his opinion.
I believe there are justified reasons why NVIDIA Corp (NASDAQ:NVDA) is suddenly a focus of investor fascination. Quite whether that justifies over 200 times trailing earnings is unclear, but this stock is no puff.
It rose 30% last week albeit in context of a steadily appreciating chart – up from $143 at the start of 2023 and now testing $400. This marks a fresh all-time high against $346 in November 2021, after which it slumped to $108 by October 2022.
Conservative analysts might say that sharp decline was a tremor in just one grossly over-valued tech stock, and another moment of truth beckons once the US tips into recession.
I think two factors were involved in the stock drop:
Macro: Nvidia’s pullback coincided with interest rate expectations shifting from ultra-low to materially rising, as the Federal Reserve belatedly tackled inflation. This impacted growth stock valuations especially. Current consensus is that the Fed will not raise rates further for fear of inducing recession, hence tech-stocks have been rallying again as investors believe the Fed will more likely cut rates next. We shall see.
Micro: Nvidia has not been immune to a recent gaming business setback, with consumers spending less on PCs and graphics cards after a pandemic-led boom.
Something of a parallel now, with the late 1990s
Do you recall how mass adoption of the internet meant companies were expected to re-invent as “dot com”? That mania ended with a tech-stock crash, yet online commerce was a pervasive shift.
Conservative investors were sceptical that Amazon.com Inc (NASDAQ:AMZN) would ever make a profit. Last year it made $4.3 billion (£3.5 billion) net, despite being down 80% on 2021.
A similar sea change is under way in artificial intelligence – AI – where despite elements of a mania, we can expect the world in five to 10 years’ time to be substantially more dependent on it.
It has gripped investors’ imaginations since the private firm OpenAI released ChatGPT last year, prompting Microsoft and Google to counter-offer with search engines, bots and AI-driven operations.
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Nvidia reminds me how microchip developer ARM Holdings emerged on the listed scene when it de-merged from Acorn plc in 1998 - to become a behemoth, its chips installed in myriad devices.
Nvidia founded in 1993 on a rationale that advancing demands on computer graphics would need a dedicated Graphics Processing Unit (GPU) rather than just a Central Processing Unit (CPU) for general operations.
Having established itself as the premier GPU provider for gaming, it expanded into chips for high-performance computing and AI.
The GPU market has consolidated around Nvidia and ATI which is owned by Advanced Micro Devices Inc (NASDAQ:AMD).
Yet after a decade of investment, Nvidia is regarded as market leader in AI, and unlikely to lose that title soon.
During ARM’s listed years, I recall its price/earnings (PE) multiple generally ranging from 30 to 60 times, which in time was justified by its earning power. It enjoyed operating margins around 30%, exactly what Nvidia achieved in its latest fiscal quarter to 30 April.
Amid the 1999-2000 tech stock bubble, ARM tested 200 times earnings just like Nvidia is doing now.
While Nvidia's valuation is undoubtedly risky, Wall Street rates promising tech on much bigger multiples than London; the key reason I suspect why ARM is currently re-listing from private ownership to Nasdaq.
Dramatically raised revenue guidance makes Nvidia unique
When Nvidia’s stock leapt from around $300 on 24 May, first quarter 2024 revenue (to 30 April 2023) actually fell 13% to $7.2 billion, despite being up 19% from the previous quarter. Earnings did advance 28% to $0.82 per share, or by 44% a year ago. It was still a beat on expectations.
|Nvidia Corp - first quarter ended 30 April 2023 for full year 2024|
|GAAP: $ millions||Q1 FY24||Q4 FY23||Q1 FY23||Q/Q||Y/Y|
|Diluted earnings per share $||0.82||0.57||0.64||44%||28%|
|Source: Nvidia newsroom|
The kicker was dramatically raised guidance for the second quarter: $11 billion revenue is 50% better than consensus for $7.2 billion. Is it possible to find surprises on this scale elsewhere?
It affirms how major technological change can deliver growth surprises at any stage of the economic cycle. As investors fret over a possible US recession raining on the vast majority of company earnings, here is a sunny spot.
Yes, the rating is huge and in the long-run unsustainable, but if revenues leap-frog while enjoying a circa 30% operating margin, then earnings growth will bring it down, the same as what happened with ARM.
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I concede to sceptics that Amazon trading on over 300 times 2022 earnings shows US tech ratings as stretched, although last year saw a plunge on Amazon’s 2021 result after exceptional revenue during the pandemic eased.
Investors are smelling the coffee at Nvidia; how in key respects it is a “defensive” stock more exciting than traditional industries such as consumer staples, utilities and smoking.
“Buying the upgrade break-out” is thus logical for momentum traders, on the basis Nvidia’s narrative remains far stronger than most other companies in the medium term.
Strong leadership in systems and software
It is not only microchips but the overall architecture for AI where Nvidia dominates as “solutions” company.
This has created a sense in the stock market of being the only game in town to play, at least in the short term.
Proof is in accumulated operating profit of over $40 billion in the last six years, with an enviable client base serving virtually every major tech companies.
While the likes of Google’s next generation Tensor chip could be competitive, it is not seen as likely to take share from Nvidia.
That risk appears to be presented by AMD and/or more hardware companies designing their own chips, like Tensor on Google phones. Everyone is in pursuit of margin and some operators could take a strategic long-term decision not to keep propping up Nvidia’s enviable 30%.
A search on Nvidia’s chips sold in the UK shows for example a circa £500 to £5,000 range for retail, although it’s unclear quite what that is like in the trade.
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Another possible risk is regulation if, in due course, Nvidia is considered enjoying monopolistic-type powers as AI expands. The US has a longstanding tradition of “anti-trust” regulation since the railroad barons. AI itself could be a target for compromising societal morals (from school essay writing onwards), or there is a backlash say if driverless vehicles cause chaos.
But I suspect it is Canute-like to try and stop this tide.
A strategic ‘buy’ but be mindful of volatility ahead
Now US Congressmen are coming together over the US debt ceiling deadline, investors are in the short term more likely to embrace risk.
The key medium-term risk remains a US recession manifesting later this year or in 2024, but unless consumer spending slumps it may just underline Nvidia as unique for prosperity.
With a news-sensitive stock like this, investors should properly allow last week’s excitement to cool; for there to be some kind of market setback perhaps.
Mind, in no way does a “margin of safety” exist here; yet I think it unwise to declare Nvidia off-limits due to valuation. The AI boom could last five years or more. Nvidia’s strength of positioning implies any share slides along the way are likely to attract buyers. Taking a multi-year view: Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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