Justin Sullivan
Nvidia (NASDAQ:NVDA) has lost more than 40% of its market value this year, as it reels from macro headwinds as well as industry-specific challenges in navigating through protracted supply chain bottlenecks, and more recently, newly imposed U.S. restrictions on the sale of advanced semiconductor technologies to China – a core revenue driver. And said impacts were evident in Nvidia’s latest fiscal third quarter results. Specifically, its performance in the just-completed quarter were largely mixed, though expected, with sales topping $5.9 billion (-17% y/y; -12% q/q) and earnings per share at $0.58 (-43% y/y; +81% q/q), compared with consensus calls for $5.82 billion (-18% y/y; -13% q/q) and $0.70 (-31% y/y; +119% q/q), respective. Meanwhile, management maintained a cautious tone on any optimism that lies ahead of elevated macro uncertainties.
Yet, we believe much of the fundamental bear case such as geopolitical and macro risks facing Nvidia has already been priced into the stock at current levels. The only moving piece that remains highly uncertain is the macro-driven valuation multiple component, as market sentiment continues to fluctuate on mixed economic data in which the Fed depends on for its monetary policy tightening agenda.
While we expect further volatility ahead for the Nvidia stock as it moves in tandem with ongoing turbulence and uncertainties in the broader market climate, any related downsides in the near-term will likely remain limited. This is consistent with the relatively modest declines observed as of late across chip peers in response to negative headlines. Although Nvidia continues to trade at a premium to peers, we believe the divergence has now contracted to a reasonable level following this year’s selloff, which is reflective of the company’s market leadership in AI hardware and software, as well as its potential in expanding market share on related long-term growth trends.
1. Geopolitical Risks
Nvidia highlighted challenges to data center sales during the fiscal third quarter pertaining to the newly imposed U.S. restrictions on the export of various advanced semiconductor technologies to China – a region that accounts for about 25% of the company’s quarterly revenues. The company reported a $702 million inventory reserve during the fiscal third quarter, primarily driven by softer demand in China and the A100 chips previously designated for the region that no longer is. This has mainly impacted Nvidia’s data center sales, though the segment remained largely resilient nonetheless with 31% y/y growth to $3.83 billion during the fiscal third quarter.
During the quarter, the U.S. government announced new restrictions impacting exports of our A100 and H100 based products to China, and any product destined for certain systems or entities in China. These restrictions impacted third quarter revenue, largely offset by sales of alternative products into China. That said, demand in China more broadly remains soft, and we expect that to continue in the current quarter…We expect our data center revenue to reflect early production shipments of the H100, offset by continued softness in China.
The results were largely consistent with our previous expectations that Nvidia may be able to dodge the worst-case scenario and materialize on management’s earlier commentary that ensuing impacts from the new U.S. export curbs will not place a “material impact on [the] business”. Mitigating efforts including Nvidia’s recent release of the China-exclusive Ampere architecture-based A800 data center GPUs in the fiscal third quarter is also expected to place a more evident positive impact on the segment’s sales going forward, as China does not the domestic technological capacity to make its own equivalent within the immediate term, while demand remains strong given the country’s growing cloud-computing aspirations.
For instance, Chinese big tech Alibaba (BABA) has recently turned to expanding its cloud-computing segment as a core growth driver to offset impacts from its maturing core commerce business, with aspirations to extend the service’s availability beyond China. And within China, the region’s demand for public cloud services is expected to “triple in size by 2025” into a $90+ billion market, primarily driven by increasing urgency for the nation’s key manufacturing and industrial sector to accelerate their respective transitions away from legacy IT infrastructures.
The recent in-person meeting between President Biden and President Xi during the G-20 summit in Bali also appears to have improved sentiment over the increasingly rocky U.S.-China relationship this year. While it remains too soon to tell if said meeting will have any structural impact on both leading economies’ foreign policies going forward, we believe the latest anticipation for softer-than-expected China revenues for chipmakers, including AI technology leader Nvidia, going forward has already been factored into the company’s fundamental prospects. And the delivery of in-line results in the fiscal third quarter further corroborates that the situation is far removed from the worst-case scenario of severed business relations in China for Nvidia, precluding the stock from further material downside risks in the near-term.
2. Consumer Slowdown
As mentioned in our recent coverage of stocks with a consumer-centric business model, deteriorating retail sentiment is starting to materialize into real weakening of purchasing power.
Payment processing giant Visa (V) had recently noted that while aggregate consumer spending has remained resilient and consistent throughout the year, buying behaviour has rapidly evolved as a result of deterioration financial conditions and surging inflation, with data showing a decrease in purchasing power. Average U.S. household savings have also declined from an average of 3.5% in the second calendar quarter to 3.1% in the third calendar quarter, which is a significant downward adjustment from the “five-year pre-COVID average of [approximately] 7.7%”. Credit card debt is also racking up, “approaching the pre-pandemic peak of $916 billion in September”.
This will continue to place a drag on Nvidia’s gaming segment sales, which declined 51% y/y to $1.57 billion during the fiscal third quarter and is expected to remain muted over coming quarters as demand continues to slow and customer inventories enter correction phase due to protracted cyclical headwinds. As discussed in our previous coverage on the stock, the latest refresh of a crypto sector meltdown could also inject additional complexity to Nvidia’s gaming sales over coming months. On these considerations, we view management’s cautious tone on the segment’s near-term outlook as reasonable. Anything more positive would have been faced with further investors’ scrutiny and caution, which would have been worse for the stock under today’s fragile market sentiment.
In addition to challenges faced in Nvidia’s gaming segment, the near-term outlook on its automotive segment performance is also becoming increasingly uncertain despite the fiscal third quarter’s stunner showing of 86% y/y growth to $251 million. The company faces a difficult task in balancing ongoing supply constraints in the broader auto industry, as well as a potential slowdown due to looming consumer weakness. Used auto sales have already seen a significant decrease in demand, and inadvertently, pricing in recent months. Meanwhile, the more resilient electric vehicle demand in the core Chinese market is also starting to see cracks in response to China’s spiralling economy due to sporadic COVID restrictions and the protracted slump in its GDP-driving property sector. Growing uncertainties over China’s economic outlook has its population’s household savings reaching historical high levels of over 30%. This creates headwinds for Nvidia’s automotive segment, which currently sees China as its core market. Much of the current demand for Nvidia’s newest automotive offerings – including its NVIDIA DRIVE end-to-end technology stack for autonomous mobility – stems from Chinese automakers including NIO (NIO), Li Auto (LI), XPeng (XPEV), JIDU, Geely-owned ZEEKR (OTCPK: GELYF / OTCPK: GELYY) / Volvo (OTCPK: VLVOF / OTCPK: VLVCY) / Polestar (PSNY), Human Horizons, as well as BYD (OTCPK: BYDDF / OTCPK: BYDDY), which subjects the chipmaker to local macro risks. Meanwhile, the newly imposed U.S. export curbs discussed in the earlier also creates spill-over risks:
Even XPeng founder and CEO He Xiaopeng have recently expressed concerns about the future of autonomous vehicle technology development under the newly imposed U.S. chip export restrictions, underscoring the severity of uncertainties over how U.S.-China chip relations will play out…While the U.S. government has yet to disclose any export restrictions specific to NVIDIA DRIVE solutions, related regulatory risks remain a major overhang over the company’s next core growth driver. Although the automotive segment currently represents only a nominal portion of NVIDIA’s total sales mix, it has been viewed with high hopes as the next fastest-growing business for the company. This is because of the “mission critical” role that NVIDIA’s end-to-end hardware-software offerings play in the ongoing development of autonomous driving capabilities, an emerging technology trend that is expected to unlock a $60+ billion total addressable market by 2030.
Source: “Nvidia: When It Rains, It Pours”
But over the longer-term, Nvidia’s AI expertise in driving the development of autonomous and electric mobility will likely benefit from increasing U.S. and European subsidies aimed at growing their respective auto industries and “onshoring trends in the renewable supply chain industry”.
3. Multiple Contraction
While the above two bear cases have already been reasonably factored into the stock’s current levels – or at least considered by investors – we view the broader semiconductor sector’s multiple outlook as the most uncertain component of Nvidia’s near-term valuation prospects. While much of the geopolitical and macro headwinds facing Nvidia’s operating environment has been priced into its fundamental outlook on determining the stock’s near-term performance, market sentiment remains fragile as the Fed remains unfinished with its monetary policy tightening trajectory. The recent release of mixed economic data key to the Fed’s decision-making process has added further uncertainty on the prospects of deteriorating financial conditions ahead.
While softer-than-expected CPI and PPI in October was a welcomed sight, the latest release of the strongest U.S. retail sales in eight months in October has sent shockwaves across the market. Retail sales, not adjusted for inflation, rose 1.3% in October (or 0.9% excluding gasoline and auto sales), beating consensus estimates for a 1% increase, which underscores resilient demand in the economy still. Although retail sales saw a decline “at department stores and electronics outlets”, which is consistent with observations of dwindling discretionary purchasing power in recent months as discussed in the earlier section, persistent strength in consumption is likely to encourage the Fed on proceeding with its plans for further rate hikes into restrictive territory until there is structural evidence that demand has slowed and inflation is under control. Paired with price increases that remain well above the Fed’s 2% target, financial conditions will likely slow further in response to continued monetary policy tightening, introducing more market turbulence over coming months.
However, the Philadelphia Semiconductor Index (SOX) has already seen the largest valuation correction this year, with “worst underperformance compared to the S&P 500 (SPY) since 2004”. And with the sector’s fundamentals having already adjusted with a heavy hand this year, any remaining downside risks pertaining to protracted market volatility is likely limited, even for stocks like Nvidia that continue to trade at a premium to peers.
This is consistent with recent observations of only modest declines in semiconductor stocks like Micron Technology (MU) in response to its latest negative headline on a weaker-than-expected 2023 market outlook compared to more violent downslides observed earlier in the year. The anticipation for limited downsides to semiconductor stocks in response to ongoing volatility across the broader market over coming months is further corroborated by Berkshire Hathaway’s (BRK.B / BRK.A) rare appearance in tech (with the exception of Apple / AAPL) via its latest stake in global foundry leader TSMC (TSM), underscoring value potential in the industry at current levels.
Final Thoughts
While it will take a few more quarters for Nvidia to work through its near-term operating challenges stemming from macroeconomic and geopolitical uncertainties, said bear cases have likely been already priced into the fundamental component of its valuation prospects at the stock’s current levels. We are more concerned over the protracted fragility in market sentiment as financial conditions continue to deteriorate with growing uncertainties over the Fed’s monetary policy tightening trajectory, possibilities of a recession, and where inflation is headed. Said uncertainties will likely remain a drag on the valuation multiple component driving the broader market’s near-term price performance, which could introduce further volatility to the Nvidia stock.
Although downside risks are looking to remain relatively limited for the semiconductor sector compared to other verticals that have experienced a relatively milder valuation correction in this year’s market selloff, they remain prominent. Nvidia still faces tangible risks of getting swept in tandem with broader market turbulence over coming months.
However, we view Nvidia as a well-positioned industry leader in capitalizing on multiple long-term digital growth trends buoyed by its critical role in enabling the development of key AI-driven technologies over coming years. While we are maintaining a near-term base case PT at the $150-level due to persistent macro uncertainties among other challenges facing Nvidia’s operating environment, broader market volatility over coming months could potentially push the stock lower and create a compelling entry opportunity for longer-term gains.
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