Justin Sullivan
Nvidia (NASDAQ:NVDA) shares plunged more than 6% in Monday’s trading, one of its worst intraday declines in recent months, after reporting preliminary fiscal second quarter results that fell short of the already-weak guidance provided in May. The weak showing is heightening investors’ concerns of a slowing cycle after three years of rapid gains in the semiconductor industry, especially given the added pressure from broad-based macro uncertainties spanning inflation, rate hikes, and consumer slowdown.
Nvidia’s disappointing preliminary F2Q23 results, driven primarily by weakness in its gaming segment, underscores its susceptibility to macro challenges ahead despite being the leader of graphics processors. The segment represents close to half of its quarterly revenues, and has historically been a leading contributor to consolidated sales until the up-and-coming data center segment took over again in F1Q23 (first time being F2Q21). Meanwhile, Nvidia’s data center sales, which has been regarded as a compensatory factor to near-term headwinds in gaming, also fell short of expectations during the fiscal second quarter due to ongoing supply chain snarls.
The following analysis will briefly go through the three primary headwinds facing Nvidia that will weigh on its near-term fundamental performance and valuations – 1) consumer slowdown, 2) lingering crypto impact, and 3) ongoing supply chain snarls.
From an operational perspective, it is messy times for the broader semiconductor industry. But the long-term bullish thesis for Nvidia’s stock, built on the company’s best-in-class innovation, remains intact. Nvidia’s strong balance sheet also facilitates continued share buybacks in the meantime to maintain shareholder value. It also provides flexibility for the company to engage in investments required for sustaining capitalization on long-term next-generation computing opportunities, particularly in AI capacities in which Nvidia’s expertise resides.
While we anticipate further turbulence for Nvidia’s stock given broad-based market volatility over coming months as the industry navigates through the near-term slowdown in consumption on discretionary goods, as well as a looming economic downturn, the company’s long-term valuation prospects remain favourable on expectations of a long-term growth trajectory sustained by continued market leadership in enabling innovation.
Breaking Down Nvidia’s Near-Term Headwinds
1. Slowing Consumer Sentiment
Consumer sentiment remained at one of the lowest levels on record in July, underscoring the impact of tightening financial conditions on household budgets. Retail spending on discretionary goods is seeing a prominent slowdown in recent months, with many withholding their purchase decisions until deals and discounts are available to “maximize their spending power”.
Global PC shipments have already shown accelerating declines in the first half of the year – first quarter volumes dropped by 6.8% compared to the prior year to 78 million units, while second quarter volumes dropped by more than 15% to 71 million units, as consumer discretionary spending power weakens due to rising inflationary pressures. Global PC shipments are on track towards a 9.5% decline this year, led by an estimated 13.1% drop in consumer PCs and 7.2% drop in enterprise PCs.
As a result, the market expects related chip demand to contract by more than 5% this year. We view this as a still-evolving figure, given the fluid situation over macro uncertainties that has been further complicated by ongoing supply chain constraints.
Industry peers like Intel (INTC) and AMD (AMD), as well as Nvidia itself, which have previously warned of an “anticipated” slowdown in take-rates due to near-term macro challenges, are now experiencing an increasingly pronounced real adverse impact on their respective fundamental performances. Specifically, Nvidia’s weaker-than-expected gaming segment revenues in the fiscal second quarter underscores the chipmaker’s susceptibility to slowing demand for processors used in products catered to the consumer end-market. Nvidia’s fiscal second quarter gaming revenues totalled $2.04 billion, a whopping 44% q/q and 33% y/y decline. Nvidia CEO Jensen Huang noted the segment’s “sell-through projections declined significantly as the quarter progressed”. The company also pointed to the segment’s underperformance for its fiscal second quarter’s consolidated revenue shortfall compared to guidance, as well as already-lowered consensus estimates.
In addition to consistency with warnings from semiconductor peers like Intel and AMD as mentioned earlier, Huang’s observations are also in line with recent results released by reputable names within the gaming industry. Sony (SONY), Microsoft (MSFT) and Take-Two Interactive Software (TTWO) have all warned of slowing demand from the consumer end-market ahead of rising recession risks, as well as a shift in consumer preference away from gaming in the post-pandemic era as some return to work in offices and in-person social interactions.
Based on the correspondence observed to date between market movements and results from the latest corporate earnings season, investors’ expectations remain reasonable given mounting macroeconomic uncertainties, and have rewarded those that have demonstrated resilience favourably. But Nvidia’s preliminary F2Q23 results on its gaming segment demonstrates it has not been any more resilient than peers, let alone meeting the high market expectations that have been priced into the stock’s premium multiple of approximately 13.8x forward EV/sales compared to the peer average of 5.5x.
Ahead of Nvidia’s earnings call later this month, investors will remain focused on how Nvidia plans to mitigate impacts from its gaming segment’s exposure to weakening consumer end-markets and limit inventory build-up. We anticipate a lackluster forward guidance considering Huang’s comments that the macro headwinds impacting gaming sales will “continue”, which means there is likely little respite in the near-term for the stock. As such, Nvidia’s stock is likely in for some turbulence in coming months as it continues to move in tandem alongside broader market volatility. It will take some time for Nvidia to prove its resilience against near-term macro challenges and demonstrate it can outperform peers in navigating through related headwinds.
2. Lingering Crypto Impact
Fluctuations in the cryptocurrency sector, as well as upcoming changes to mining activity on the Ethereum blockchain are also further complicating the picture for Nvidia’s gaming segment. As discussed in our previous coverage on the stock, Nvidia’s role in enabling the burgeoning crypto sector has gradually expanded in recent years.
The recent turmoil in crypto performance though is now drawing questions on whether the situation will add additional pressure on Nvidia’s fundamental performance going forward, as it risks compounding pains from waning consumer demand on PC/gaming ahead of a potential recession as discussed in the earlier section. While Nvidia’s preliminary F2Q23 results release does not provide any commentary on the extent to which slowing crypto demand has contributed to its gaming segment’s fiscal second quarter shortfall, the company’s crypto-linked business is still prominent enough to warrant existing/potential investors’ attention.
The biggest headwind currently facing Nvidia’s foray in crypto mining opportunities remains on the sector’s volatility amid near-term macro uncertainties, as well as the Ethereum network’s fast-approaching transition from a proof-of-work to proof-of-stake system, known as the “Merge”, will eliminate Ether mining altogether. This has already significantly reduced crypto-related demand for Nvidia’s gaming GPUs, which is corroborated by the recent drop in resale prices – according to Bitpro Consulting, the resale prices on GPUs have “dropped by more than half since the start of the year”.
Demand for Nvidia’s crypto-mining processors, “CMP”, which were designed to optimize Ether mining, is also expected to decrease dramatically going forward. The $1.32 billion in additional charges booked by Nvidia during the fiscal second quarter related to “inventory and related reserves” is likely partially due to a write-off on related CMP inventory value due to obsolescence.
3. Supply Chain Snarls
Supply chain recovery from pandemic-era disruptions continue to be thwarted by the ongoing war in Ukraine and sporadic COVID lockdowns in China, adding fresh pressure on the already-fragile imbalance between input supply and demand. While demand at Nvidia’s data center segment has proven resilient against the near-term macro headwinds, related sales in the fiscal second quarter have also fallen short of management’s expectations, which has already baked in a ~$500 million negative impact related to Russia-Ukraine and China lockdown headwinds.
And although management has yet to provide commentary over the preliminary F2Q23 results released on its automotive segment, we expect related revenue growth has also been impeded by ongoing supply chain headwinds. As discussed in our recent commentary on auto sales trends, the industry has yet to sound alarms on any signs of demand destruction despite looming recession risks. Although the average price of a new car has surged 13% from the prior year to $47,000 as of May, demand has remained resilient, with dealership inventories remaining at all-time lows. This is consistent with the acceleration observed in Nvidia’s F2Q23 automotive segment sales, which grew 59% q/q and 45% y/y to $220 million in the period.
We expect data center and automotive segment sales to remain a function of supply availability in the near-term, as related end-market demand remains resilient. Global demand for data center processors will remain elevated in coming years, as cloud-computing continues to be a critical need in the corporate sector with no signs of slowing in adoption. Specifically, the market for data center processors is expected to expand by at least 20% this year, defying near-term macroeconomic weakness. Similar demand trends are expected from the automotive sector for Nvidia’s auto processors and related software solutions, which are primed for application in next-generation mobility (e.g. electric vehicles and autonomous vehicles) – a segment that has been especially resilient against the deteriorating state of the economy.
Key Takeaways
Admittedly, the near-term outlook for Nvidia is going to be a tough one as it tries to mitigate impacts from slowing consumer sentiment, volatility in digital assets, an inflationary environment, and ongoing supply chain constraints. The stock will likely trend lower in coming months, especially given the expectation for a weak forward guidance during the August 24th earnings call based on management’s conservative commentary in the preliminary F2Q23 results press release.
But Nvidia remains a core long-term technology investment in our books at current levels. We remain confident in Nvidia’s fundamental and valuation prospects over the longer-term once broad-based market risks wear off. The company’s diversified product portfolio and market dominance makes it uniquely positioned for accretive fundamental growth still, which commands further valuation upside in coming years.
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