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
Share on
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.
- Invest with ii: Buy US Stocks from UK | Most-traded US Stocks | Cashback Offers
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), Amazon.com 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.
- ii view: Nvidia earnings blast past Wall Street forecasts
- Top tech investor on how to profit from artificial intelligence
- Why tech has another great decade ahead of it
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 FY24 | Q1 FY24 | Q2 FY23 | Q/Q | Y/Y | |||
Revenue | 13,507 | 7,192 | 6,704 | Up 88% | Up 101% | ||
Gross margin | 70.1% | 64.6% | 43.5% | Up 5.5 pts | Up 26.6 pts | ||
Operating expenses | 2,662 | 2,508 | 2,416 | Up 6% | Up 10% | ||
Operating income | 6,800 | 2,140 | 499 | Up 218% | Up 1,263% | ||
Net income | 6,188 | 2,043 | 656 | Up 203% | Up 843% | ||
Diluted earnings per share $ | 2.48 | 0.82 | 0.26 | Up 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.
- Ian Cowie: how to buy AI stock winners on the cheap
- The funds and trusts profiting from Nvidia’s unstoppable rise
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.
- Listen to our podcast: why you may already be profiting from AI
- Artificial Intelligence: four UK shares to watch
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.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.
Disclosure
We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.
Please note that our article on this investment should not be considered to be a regular publication.
Details of all recommendations issued by ii during the previous 12-month period can be found here.
ii adheres to a strict code of conduct. Contributors may hold shares or have other interests in companies included in these portfolios, which could create a conflict of interests. Contributors intending to write about any financial instruments in which they have an interest are required to disclose such interest to ii and in the article itself. ii will at all times consider whether such interest impairs the objectivity of the recommendation.
In addition, individuals involved in the production of investment articles are subject to a personal account dealing restriction, which prevents them from placing a transaction in the specified instrument(s) for a period before and for five working days after such publication. This is to avoid personal interests conflicting with the interests of the recipients of those investment articles.