Interactive Investor

Stockwatch: why I’ve tweaked my rating on microchip star Nvidia

An amazing set of quarterly results added further excitement to the Nvidia story, but analyst Edmond Jackson has had another think about the stock of the moment.

29th August 2023 12:03

by Edmond Jackson from interactive investor

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Nvidia CEO Jensen Huang

Last June, I argued a “buy” case for NVIDIA Corp (NASDAQ:NVDA) as it tested $400, sensing a parallel with ARM Holdings some 25 years ago when its leading microchips were the go-to choice for myriad devices. 

Similarly on price/earnings multiples, the stock’s forward rating respectively is/was big, the trailing multiple horrendous. As to Benjamin Graham’s “margin of safety” concept as defining an investment; he would have hid under the bed.  

Interestingly, though, and as ARM’s re-flotation looms, if you believe such a tech company can stay at the forefront, then it can pay to tolerate a big valuation. A very strong position in microchips is especially appealing given mass-market scope. 

Back in 1998, ARM spun out of Acorn Computers and its stock traded in hundreds of pence – with a trip into four figures at the height of the tech-stock bubble. In 2016 it was acquired by the Japanese conglomerate Softbank for $32 billion (£25.4 billion) at 1,700p. 

In September 2020, a deal was nearly consummated for Nvidia to buy ARM for $40 billion, but regulators thwarted it by early 2022. Happily for Softbank as a vendor, the imminent re-flotation of ARM on Nasdaq is mooted to achieve a circa $70 billion value. 

A sceptic would say: beware both these valuations currently, which are based on market psychology. Euphoric values persist in the tech sector, the ultra-low interest rate years having created them originally. Now, scarcity of growth stories keeps them propped up, for the time being at least. 

An optimist would point to the extent of revolutionary change which artificial intelligence (AI) represents – and Nvidia’s leading position with its graphics chips. Even if more hardware competition materialises, Nvidia has already mapped out scope to repeat such progress in enterprise software. 

Is checked response to blow-out results sign of flagging sentiment? 

After Nvidia’s second-quarter numbers on 23 August, the stock rose from around $455 to $470 on the day; spiking above $500 next day. But by close of 25 August, it was back near $460. 

Given huge revenue and earnings beats this seems a tame response. 

Yet various times in the histories of say Apple Inc (NASDAQ:AAPL), Inc (NASDAQ:AMZN) or Microsoft Corp (NASDAQ:MSFT), investors’ response to updates became more considered – which did not negate the stocks as quality long-term holds.  

Notwithstanding volatility over years, on a multi-decade view US tech behemoths have outperformed for the chief reason they command huge product strength globally. 

In the short term, I acknowledge why be cautious as to further advances? From the second half of 2019, Nvidia started a bull run from around 50p to 325p, slumped to 150p, then went on a tear from a year ago to where it trades now at $468.  

Overall, it represents a parabolic chart, which defenders would say is justified by realisation at the scope for AI and Nvidia’s dominant position – but the latest market action shows investor wariness too. 

At least the lack of another re-rating has not set up the risk of a slump, should the wider market dive.     

One of the best financial releases in corporate history 

In its second fiscal quarter to 30 July, revenue jumped 88% on the first quarter to $13.5 billion, or by 101% from a year ago, representing a 21% beat on consensus.  

Growth is being driven by Nvidia’s data centre platform revenue (for example, driving chat-bot applications) soaring 171% year-on-year to represent 76% of group revenue.  

Guidance is for $16 billion revenue in the third quarter, a 15% increase on the second and 269% year-on-year.  

Earnings per share (EPS) soars 150% on the first quarter, or 429% year-on-year for a near 30% surprise to the upside. 

Nvidia Corp - second quarter fiscal 2024 summary
to 30 July
GAAP: $ millions

Q2 FY24Q1 FY24Q2 FY23Q/QY/Y
Revenue13,5077,1926,704Up 88%Up 101%
Gross margin70.1%64.6%43.5%Up 5.5 ptsUp 26.6 pts
Operating expenses2,6622,5082,416Up 6%Up 10%
Operating income6,8002,140499Up 218%Up 1,263%
Net income6,1882,043656Up 203%Up 843%
Diluted earnings per share $2.480.820.26Up 202%Up 854%

Guidance for Q3, fiscal 2024: 

Revenue of $16 billion, plus or minus 2%
Gross margin around 71.5%
Operating expenses: $2.95 billion
Other income: $100 million

Source: Nvidia newsroom

Gross margins are over 70%, with guidance next for 72% - this being more akin to what leading software companies achieve than hardware. 

It reflects Nvidia’s strength in graphics processing units (GPUs), with rapid advances looking set to dominate AI for a while. Very few other companies have scale and capability to challenge. 

For example, if data centres were to switch from using central processing units (CPUs) made by Intel Corp (NASDAQ:INTC) or Advanced Micro Devices Inc (NASDAQ:AMD), to Nvidia’s GPUs, they could do 44 times the same work while using one third of the energy.  

This potentially locks in Nvidia customers for years, given the cost of switching to rival hardware will be very high. 

Another 18% of revenue derives from chips for gaming, up 11% on the second quarter and 22% year-on-year. This was an early base for Nvidia when founding in 1993: how advancing demands on graphics meant devices need a dedicated processing unit beyond a CPU. Having become the premier GPU provider for gaming, Nvidia expanded into chips for high-performance computing and AI. 

Its remaining 5% or so of revenue is from enterprise AI software. Management contends this is just as big an opportunity as its AI hardware business today. Professional software tools can be connected, such that for example when one achieves an upgrade then so does its entire chain across different industries. 

Scope to become world’s largest semiconductor company 

Presently, Nvidia is sixth by way of revenue, behind Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM) as leader, Intel and Qualcomm Inc (NASDAQ:QCOM). Yet it is already number one by way of market value, edging towards $1.2 trillion. 

Mind the risk how Nvidia outsources all its manufacturing to Taiwan Semiconductor, which has not only exacerbated chip shortages due to limited production capacity, but exposes Nvidia to huge risk should China make a concerted move on Taiwan someday. 

But if AI becomes established as a major paradigm shift in the way we live, Nvidia has potential to lead the semiconductor industry. Its earnings guidance currently implies its stock trades on a forward price/earnings (PE) ratio more like 30 times – similar to smaller peer Advanced Micro Devices – which is arguably fair for the leading company already in AI applications. 

True, Intel’s average historic PE over the last decade is only 13 times, albeit in context of reduced earnings and recently huge losses. 

Comparisons with Cisco are largely invalid 

Sceptics recall the 1999-2000 tech-stock boom at Cisco Systems Inc (NASDAQ:CSCO), which was touted as infallible given its “picks and shovels” strategy of being an infrastructure provider to the dot-com industry, and not trying to monetise speculative websites.  

Yet when the bubble burst, Cisco plummeted from near $80 to $10 over two years. Over two decades later, the stock trades at $56.  

A key reason Cisco slumped, however, was changing industry trends that meant a $2.2 billion inventory write-off in May 2001. Product manufacture was sub-contracted which led to supply-chain issues, with scarce components over-ordered on the basis of Cisco’s bullish sales expectations.

A more relevant critique, I believe, is this showing the risks with sub-contracting. Nvidia will need to manage this capably.  

Adjust my view to ‘hold’ 

You could say, why hesitate and downgrade to ‘hold’ after an exceptional earnings release affirms the ‘buy’ case I made at the end of May? Despite volatility, the stock is up nearly 18% to $468 as if affirming a bull market. 

Yet sentiment is running high relative to when it was against Apple and Microsoft years ago – remarkably, on PE’s around 12 and 8 times, respectively.  

Unless China turns yet more belligerent on Taiwan, keep Nvidia in the frame and buy material drops. Hold. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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