Antonio Bordunovi
Investment thesis
I think that NVIDIA (NASDAQ:NVDA) could see a strong and fierce recovery in the Gaming segment as the segment has fallen below levels seen in previous down cycles, while the channel inventory has been reduced significantly, and the new product launches will drive an acceleration to growth.
For Nvidia’s data center segment, there are some concerns about China cloud and the charges relating to the business in the quarter. However, guidance for the business remains strong and there is no concrete evidence of any material slowdown in the Data Centre segment.
From the GTC event, I like that the platform is expanding into infrastructure-as-a-service and the thoughtful approach to new product launch should bode well for the near-term growth of the company.
All in all, I continue to think that Nvidia looks attractive given its product roadmap, strong competitive position as well as solid demand drivers.
Review of results and guidance
In the FY2Q report, we saw that gaming led the weakness in the print, as expected due to higher-than-normal inventory levels at their partner channels, causing the Gaming segment to fall by 33% year on year and 44% sequentially. Also, revenues from Professional Visualization were also down 4% year on year and 20% sequentially due to the lower desktop revenues. On the other than, the data center and automotive revenues held up well. Data center revenues increased 61% year on year to $3.81 billion as a result of strength in US cloud, although there were weaknesses in China cloud. Automotive continues to grow at 45% year on year to $220 million, as a result of growth in the self-driving and AI cockpit solutions business, while the legacy cockpit business continues to decline.
Gross margins fell 21 percentage points to 45.9% in FY2Q as a result of a $1.22 billion charge caused by the negative outlook for Data Center and Gaming. The breakdown for the charge includes $570 million for current inventory while $650 million for inventory purchase obligations. These surpassed the company’s expected and forecasted demand and cancellations. EPS came in at $0.51, slightly above market expectations.
For the guidance for FY3Q, management guided for revenues to be $5.90 billion, which is down 17% year on year and 12% sequentially. This guidance was almost 15% below expectations and was driven by weaker than expected revenues from Gamine and Pro-Visualization due to the current correction in inventory. The implied FY3Q EPS is thus $0.72, which is also about 15% below market consensus.
Gaming weak but the rebound will be fierce
As we can see rather clearly from the FY2Q print as well as the guidance for FY3Q, I don’t think that there are any debates on how weakness in consumer sentiment will affect the gaming business. I think investors have realised that the Gaming segment could remain soft in the near-term as long as the weakness in the consumer remains. However, as investors we should be looking forward to see what opportunities lie ahead.
I think that investors may not be aware that given revenues for the Gaming segment are now down about 60% from the peak and are down more than the previous down cycle. In fact, based on the historical performance of the Gaming segment, I think that we will see the segment generate a very strong recovery as there has been large amounts of channel inventory reduction in advance of a new platform launch. As such I would argue that Wall Street typically is behind the curve in recognizing the speed and the timing of the recovery of the Gaming business, which could be an opportunity for other investors.
As a result, I think that for the Gaming business, I will be monitoring for when and how fast the recovery in the gaming segment could be. I think while Gaming is suffering in the near-term, investors need to start thinking about how fast it can recover and what margins will look like in the following year as the macroeconomic environment looks set to worsen. Also, after this recovery in the Gaming segment, I think there are some uncertainties in the investment community about what constitutes a more normalized revenue growth in Gaming after 2 years of what we can agree are somewhat outsized growth years for the business.
All in all, I see an opportunity in the Gaming business given that the negative sentiment around the segment has resulted in Wall Street analysts revising their numbers down too aggressively. With the large amount channel inventory reduction that has been done, as well as the Gaming segment being down more than the previous cycles, the recovery in the Gaming will be swift and fast.
While signs of cracks appear, Data Centre remains resilient
All in all, for FY2Q, the Data Centre business looks to me to continue to be strong and resilient, at least in the near-term. In addition, I think that Nvidia remains attractive given their strong through-cycle growth profile as well as solid competitive position.
The key concern for the Data Centre segment is exactly how it will perform in a recession and whether it can be more protected from a recession than the Gaming segment given that we are seeing some ongoing weakness around the Professional Visualization segment. That said, I think that it was a good sign that the guidance for Data Centre remains rather strong relative to the Gaming segment, although as I have mentioned earlier, there were some charges relating to the Data Centre business. While I think that this does suggest that the demand outlook might be slowing, I think that it might not necessarily indicate a decline in Data Centre revenues any time in the near-term.
The main weakness for the Data Centre business today has to be the soft demand from China cloud, causing the mix of enterprise to shift to 50% of its Data Centre revenues. As a result, I think that investors are increasingly concerned that with a larger mix in enterprise, this exposes the company to weaknesses in enterprise IT budgets. If we were to draw some inferences from the Professional Visualization business, given that the business is on average more tilted to enterprises, the recent quarter’s weakness in the segment is definitely not a good sign for the Data Centre segment, in my view.
That said, I still remain positive on the Data Centre segment although there are some uncertainties as I think that the demand opportunity for the Data Centre segment for Nvidia remains very strong given a new CPU roadmap.
GTC takeaways
Nvidia making the right steps for revenues in Gaming to recover at a rapid pace with its approach in preparing the channel for the successful product launch. First, it announced the RTX 40 series, including its Ada Lovelace architecture and DLSS 3 neural rendering technology, with only the high-end products being launched while the other products will likely have to wait until the additional reduction in channel inventory. While the pricing for the new cards is actually about $100 to $200 higher, this is likely Nvidia passing on some inflation pressures to customers. As a result, I think that Nvidia has a strong confidence in the demand for the RTX series launch and in conjunction with the launch, it is also cutting prices for the RTX 30 series cards significantly. As a result, I came out of the GTC thinking that Nvidia’s approach has been rather thoughtful in ensuring that the channel is ready for the new product launch for it to be successful.
Also, another key theme in the GTC was the push towards becoming an infrastructure-as-a-service company to becoming more like a software company where it can generate recurring revenues by offering cloud-based solutions like Omniverse Cloud Services and BioNeMo. This new cloud offering is designed for enterprises and 3D designers and engineers for working on metaverse applications. The company also announced new key partners for Omniverse, to about 150 connectors today, that should drive further quality and network effect on the platform.
Valuation
I continue to take the view that Nvidia has a strong competitive position with a product cycle story with deep and untapped demand pools that will drive revenues in the future.
My 1-year price target for Nvidia is based on an equal weight DCF method as well as a P/E multiple method. I assume a P/E multiple of 35x for FY2024 P/E. This is in-line with Nvidia’s 10-year average P/E. I assume a discount rate of 10% for the discounting of cash flows while my terminal multiple for the company is 20x.
As a result, my 1-year target price is $205, representing 72% upside from current levels.
Risks
Competition from other players in different segments
There is a risk that competitors may drive up pressures in its key markets and improve on their technology to be able to compete meaningfully with Nvidia. AMD (AMD) may bring more competition in the GPU space, where Nvidia has historically made most of the company’s gross profits. On the other hand, there is competition from ARM-based applications that aim to overtake Nvidia’s lead in dual-core technology. Lastly, there is emerging competition from Intel (INTC) with its Knights processor family that may bring challenges to Nvidia in the long-term.
Demand for Gaming GPUs
Although the management is reducing channel inventory, if the demand for Gaming GPUs is less than expected or if they continue to fall materially, then this will bring downside revisions to Nvidia’s forecasts.
Macroeconomic environment
As Nvidia is ultimately in the semiconductor industry, while it has some segments that are high growth and relatively secular, there is the risk that its business segments are materially and negatively affected by the macroeconomic environment. As we have seen with the Gaming segment, changes in consumer sentiment can result in huge declines in revenues and elevated inventory levels for the company. If even the Data Centre segment falters, this could result in a significant downward revision in the valuation multiple and analyst forecasts for Nvidia.
Conclusion
I think that the opportunity set for Nvidia looks attractive at current levels as sentiment has been negative and much of the negative news around the Gaming segment has been priced in. I am of the view that we could see a strong and fast recovery in the Gaming segment given the strong product launches we are seeing along with the reduction in channel inventory before the launches as well as the decline in Gaming segment being worse than previous down cycles. In addition, while concerns remain over China cloud and the charge related to the Data Centre segment, I remain confident on the segment given the relatively strong guidance given by management and the secular nature of the segment. Lastly, I am encouraged by the company’s recent approach to its new product launch to take into account the current environment, as well as its expansion into infrastructure-as-a-service. My 1-year target price is $205, representing 72% upside from current levels.
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