Image Source: Nvidia Corporation – IR Presentation
By Callum Turcan
Nvidia Corporation (NVDA), like the rest of the semiconductor industry, has been on a wild ride over the past few years. On the one hand, the industry has benefited from the cloud-computing build out and the rise of smartphones, along with the emergence of autonomous driving, the internet of things (“IoT”), machine learning, and artificial intelligence. On the other hand, semiconductors are now contending with headwinds from the bust in the cryptocurrency craze, the sharp slowdown in data center investments due in part to ongoing trade wars, and other factors like excess inventory. Expectations were very low for Nvidia heading into its second quarter FY2020 earnings, released August 15, which is largely why shares moved up significantly after the report indicated things weren’t as bad as feared. Shares of NVDA yield 0.4% as of this writing.
Image Shown: Shares of NVDA jumped higher after its second quarter FY2020 earnings report was released on August 15.
Earnings Overview
In the second quarter of FY2020 (quarter ended on July 28), Nvidia generated $2.6 billion in GAAP revenue, down over 17% year-over-year while its GAAP gross margin dropped by ~350 basis points to 59.8%. The company is contending with declining data center demand (particularly from large-scale cloud services providers) and weaker demand for graphics cards. Here’s what management had to say during Nvidia’s quarterly conference call;
“Moving to data center[s], revenue was $655 million, down 14% year-on-year and up 3% sequentially. In the vertical industries portion of the business, expanding AI workload drove sequential and year-over-year growth. In hyperscale portion, we continue to be impacted by relatively weak overall spending at a handful of CSPs. Sales of NVIDIA GPUs for use in the cloud were solid. While sales of internal hyperscale use were muted, the engineering focus on AI is growing.”
Part of Nvidia’s rebound strategy involves building new partnerships with companies that need help modernizing operations. We don’t think it would be a controversial statement to say that Walmart Inc (WMT), until more recently (seen through its improving e-commerce segment which we covered here), has not made the necessary investments in technology to keep up with disruptors like Amazon Inc (AMZN), ipso facto for Amazon eating Walmart’s lunch in the US e-commerce arena. That’s made apparent through Amazon sales representing roughly half of the US e-commerce market, with Walmart representing less than 5% of that market according to some third-party research services like eMarketer. Keeping in mind Walmart, like Amazon, has its own massive domestic distribution, warehouse, and logistics network.
To keep up, Walmart teamed up with Nvidia and is utilizing the semiconductor company’s GPU offerings to forecast product demand within hours in order to keep the retailer’s warehouses stocked with goods in demand. Previously, it could take weeks to finish updating product demand forecasting models. Nvidia’s computing power takes out a lot of the legwork and most importantly, allows for much quicker changes to Walmart’s supply chain. Also, Walmart is utilizing Nvidia’s computing power to optimize and augment its e-commerce offerings including enhancing its logistics and last-mile delivery processes.
More broadly, Nvidia’s future is built on the integration of everything. Increasingly, investments in technology, and by extension investments in computing power, are what separate good companies from bad, well-run bureaucracies from inefficient nightmares, and so forth. Walmart can use Nvidia’s computing power to model consumer preferences and logistics networks like never before, allowing for the retailer to better optimize its inventory levels and supply chain management schemes (i.e. reduces the risk of ordering goods that won’t get sold unless discounted significantly, allowing for logistics systems to focus on supporting the transportation and storage of goods that are in demand, ultimately resulting in continuous improvements in Walmart’s cost structure, margins, and revenue trajectory). Governments can use Nvidia’s computing power to better respond to natural disasters and improve traffic conditions, saving lives and cutting down pollution in the process.
Back in July, Nvidia launched its GeForce RTX SUPER Series to revive its gaming segment’s financial performance, keeping in mind there are signs Nvidia is holding the line in the high-end PC gaming space. Looking ahead, Nintendo Co. Ltd.’s (NTDOY) upcoming Switch Lite console will be powered by an Nvidia processor, possibility its Tegra system-on-chip (“SoC”) offering.
In the third quarter of FY2020, Nvidia is targeting a GAAP gross margin of ~62.0% and revenue of ~$2.9 billion, indicating management expects sequential improvement in the company’s financial performance. Shares of Nvidia jumped after its latest earnings report because investors saw brighter skies ahead, highlighting how equities trade on future expectations and not their historical performance.
Acquisition in Progress
Nvidia is in the process of acquiring Mellanox Technologies Ltd. (MLNX), which makes computer networking products, in a transaction valued at $6.9 billion by enterprise value through an all-cash deal announced in March 2019. The transaction still needs approval from Chinese and European regulators, which will likely depend on the state of US-World geopolitical relations. From Nvidia’s latest quarterly conference call:
“Regarding our pending acquisition of Mellanox, we have received regulatory approval in the U.S. and are engaged with regulators in Europe and China. The approval process is progressing as expected, and we continue to work toward closing the deal by the end of this calendar year.”
We will see how the regulatory situation plays out moving forward. Shares of MLNX trade at approximately $108/share as of this writing, well below Nvidia’s cash offer of $125/share, largely due to fears that Chinese regulators won’t approve the deal. This is a good example of how investors can use the market to gauge expectations. If investors thought the deal was going to get approved, shares of MLNX would likely trade quite close to Nvidia’s all-cash offer.
Nvidia ended the second quarter of FY2020 with $8.5 billion in cash and cash equivalents on hand versus just $2.0 billion in total debt. We appreciate the company’s stellar balance sheet and note that the Mellanox deal can be fully funded with cash on hand. Historically, Nvidia has been very free cash flow positive and we expect those free cash flows to continue growing going forward as you can see in the picture below (from our 16-page Stock Report covering Nvidia, which can be accessed here).
Image Shown: Nvidia is very free cash flow positive and its growth outlook is promising.
Concluding Thoughts
Nvidia beat low expectations and its share price was rewarded accordingly, keeping in mind NVDA trades well off its 2018 highs. Our fair value estimate for NVDA stands at $184 per share, meaningfully above where shares are trading at, as of this writing. We are staying away from the name given risks associated with its purchase of Mellanox, weakness in data center demand in the face of trade war concerns and the synchronized slowdown in global economic activity, and in light of Nvidia’s low VBI rating. We think there are better investment opportunities out there, but we can respect that Nvidia is showing promising signs of improvement.
Integrated Circuits Industry – ADI MCHP MRVL NVDA SWKS TSM XLNX
Broad Line Semiconductor Industry – AMD AVGO FSLR INTC TXN
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Callum Turcan does not own shares in any of the securities mentioned above. Intel Corporation (INTC) is included in both Valuentum’s simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.