Nvidia – Intelligent Now? (NASDAQ:NVDA)

Two years ago, I last reviewed shares of Nvidia (NASDAQ:NVDA) at a time when the company was seeing incredible momentum coming out of the outbreak of the pandemic, at a time when it was willing to spent $40 billion to acquire ARM.

In the article called ¨With and without ARM¨ I saw the strategic rationale and a savvy deal structure behind the transaction, yet I was wary of the nosebleed valuation at which the company was trading, as little could I have known what was set to happen in 2021.

Some Background

Nvidia has seen great momentum over the past decade driven by impressive leadership, great positioning and decisive dealmaking at times. A $30 stock rallied to $300 in 2016/2018, suffered a setback amidst a pullback in crypto, but rose to $500 in September 2020. Ever since we have seen a four-for-one stock split in 2021, so that $500 level at the time is equivalent to $125 today.

Coming strong out of the initial setback of the pandemic, Nvidia announced a huge $40 billion deal for ARM in September 2020, to further enforce its dominance in AI computing, while riding the wave of other megatrends as well including the cloud, smartphones, self-driving cars, robotics, etc. With a mere $1.8 billion revenue contribution, albeit accompanied by steep 35% EBITDA margins, it’s safe to say that valuations for ARM were very high, but this as a strategic deal as well, and was actually applauded by the market.

To put some perspective we have to look at some fundamental numbers as the company posted its fiscal 2020 results early that year, with sales down 7% to $10.9 billion amidst the pullback in cryptocurrencies, as adjusted earnings fell 13% to $5.79 per share. A $9 billion net cash position was equal to about $15 per share. Trading at $500 at the time, these were nose-bleed valuations, but momentum already was improving ahead of the pandemic.

Valued at just over $300 billion in September, the company traded at 17-18 times sales as the annual run rate in terms of sales had risen to about $16 billion at the time with earnings coming in around $9 per share. Despite this huge momentum, valuations were very demanding at over 50 times earnings, too demanding to get involved.

Too Cautious, Or Not?

With the benefit of hindsight I have been far too cautious as Nvidia participated in the massive 2021 rally as well as shares peaked near $350 per share, that’s after the split in the summer of that year, corresponding to a near $1,400 price level ahead of the stock split. This marked shares nearly tripling from September 2020 amidst very strong market conditions, a boom in valuations and cryptocurrencies.

The same reversal in all these items has brought shares back to $125 now, or $500 ahead of the split, marking zero returns vs. September 2020. Export restrictions have been another driver, yet with zero capital gains over this two-year time period, shares have actually been an outperformer.

So what happened on the corporate front? In February 2021, the company posted its fiscal 2021 results and while revenues did indeed increase spectacularly to $16.7 billion, up 53% on the year, the run rate already came in at $20 billion as adjusted earnings came in exactly at $10 per share.

Fast forwarding another year, to February of this year, it was understandable why investors were upbeat with 2022 sales up 61% to $26.9 billion as non-GAAP earnings rose to $4.44 per share (after the split) equivalent to about $18 per share ahead of the split! That was great, yet share price advancements were stronger than the actual profit gains, as momentum was not keeping up with the share price run as the company terminated the deal with ARM, triggering a $1.3 billion charge.

A Slowdown – And Pullback

In May, Nividia posted strong first quarter results with revenues up 45% to $8.3 billion with adjusted earnings coming in at $1.36 per share. The company held nearly $10 billion in net cash, or about $4 per share. The company guided for second quarter sales at around $8.1 billion, albeit that the guidance involved some uncertainty related to Russia and COVID-19.

Second quarter results were a bombshell when released in August. While certain demand headwinds were on the horizon, supply chain issues hurt the business in a major way. Even as sales rose 3% on an annual basis, they fell about $1.5 billion short at $6.7 billion, a massive miss by all means. This had a massive impact on profitability as well, with adjusted earnings only coming in at $0.51 per share, falling way short of the >$5 earnings per share run rate as of the first quarter, down to just $2 per share.

It’s not just supply but demand as well as gross margins are down more than 20 points compared to the first quarter of this year, and the second quarter of last year. Furthermore, there’s no quick fix in sight with third quarter sales seen at just $5.9 billion and with operating expense expected to rise on a sequential basis, the outlook for the third quarter (in terms of profitability) is dismal by all means.

The most astonishing is the composition of revenues. This come as the core datacenter business saw revenues up more than 60% to $3.81 billion. This came as the company reported a 33% fall in gaming sales to $2.04 billion and a 4% fall in professional virtualization sales to $496 million. These declines hurt the business in a massive way with gaming revenues of course closely trending with the crypto craze and in this case bust as well.

In the meantime, net cash balances have fallen to $6 billion amidst reduced earnings power, as buybacks continued during the quarter, of course still marking a very comfortable position to be in. With 2.5 billion shares now translating into a similar $300 billion valuation as was the case in 2020, the situation is a bit different.

At the time, back in 2020, the company was on track to posted earnings close to $2 per share on sales of $16 billion. Revenues have peaked at a $30 billion run rate in recent quarters, now coming in at $22-$24 billion based on the first and second quarter earnings report, yet earnings are still stuck around $2 per share as the company is digesting the deleverage in terms of sales.

If the company can return to its profitability run rate of the past quarters at $5 per share, there is clear upside, yet the coming quarters will become quite rocky given the outlook and the wider macroeconomic and political environment. The long term picture remains intact as these are the times to get upbeat, although actual timing remains incredibly difficult of course.

That said, a buy the dip approach seems suitable here, based on the still solid long-term outlook and positioning, albeit that this is far from a certain investment here with quite some volatility to be expected.