Justin Sullivan
Nvidia (NASDAQ:NVDA) is an industry leader in graphics cards for gaming, data center computing, visualization and automotive semiconductors. They’re known as a true “growth stock” as they’ve achieved sales growth of c.50% CAGR over the past five years (through Q421). However, the company recently announced its preliminary financial results for the second quarter ended July 31, 2022. Earnings fell far short of analysts’ estimates due to a lack of gaming revenue. I previously wrote a post about Microsoft (MSFT) and its second quarter earnings, which also showed weak gaming demand, so this post could have acted as a leading indicator of Nvidia’s poor results. Nvidia’s stock price has fallen ~6% on the news and has been butchered 46% from its all-time highs in November 2021. The good news is that the company still has world-class technology and has a strong chance of recovery due to the cyclical nature of the gaming market. In this post, I will break down the recent earnings report and calculate the valuation for Nvidia. Let’s dive in.
NVDA data from YCharts
Nvidia Q2 breakdown
Nvidia reported revenue of $6.7 billion for the second quarter of 2022, well below the previous guidance of $8.1 billion. Revenue is also down a whopping 19% since the most recent quarter and is up just 3% year over year. That revenue decline was primarily due to a sharp decline in gaming revenue, which totaled $2.04 billion, down 44% sequentially and 33% year over year.
Intel (INTC) has the largest share of the graphics processing unit (GPU) market with a 60% market share. However, Nvidia and AMD (AMD) have gradually eaten away Intel’s GPU market share. Nvidia is the leader in “high-performance” GPUs, with a 21% market share of the total market, up from just 15% in Q1 21. This is a testament to Nvidia’s top-notch technology.
GPU Market Share (Jon Peddie Research)
It’s easy to get caught up in a bad quarter with low gaming revenue for Nvidia, but I think it makes sense to zoom out. The gambling market is cyclical and is forecast to grow at a compound annual growth rate (CAGR) of 31.87% through 2028, when it is expected to reach $165 billion. As such, I believe Nvidia is in a strong position to recover over the long term, despite near-term macro headwinds. Additionally, part of Nvidia’s GPU revenue came from buying bitcoin mining rigs in 2020/2021. However, after the price of crypto has dropped sharply and we are now in a “Bitcoin winter”, sales in this space will naturally decline. Nvidia has been criticized in the past for not reporting its GPU revenue, which came directly from the sale of bitcoin mining rigs. The company was even recently fined by the SEC for failing to report Bitcoin-driven GPU sales in the first crypto bubble/crash of 2017.
“NVIDIA’s disclosure failure has deprived investors of critical information to evaluate the company’s business in a key market” – Kristina Littman, SEC Crypto Unit.
Therefore, if we expect above-average GPU sales in 2020 and 2021 due to both the gaming boom and the crypto boom, the correction now should not come as a surprise.
Nvidia management said the lower-than-expected game earnings reflected a “decline in distributor sales due to macroeconomic headwinds.” However, they have implemented inventory adjustments and “pricing programs” with channel partners to reflect market conditions. My guess is that these “pricing programs” are a series of rebates that will, of course, impact Nvidia’s finances.
Nvidia Segment Revenue (Q2 Financial Results)
Nvidia’s data center revenue was $3.81 billion in the second quarter. The growth rate slowed to just 1% sequentially, but it’s still up 61% year over year. The company says the recent slowdown was due to “supply chain disruptions,” but I also suspect macroeconomic conditions have prompted temporary cuts in corporate IT spending.
The good news is that the data center industry is expected to grow by a staggering $615 billion between 2021 and 2026, or a CAGR of 21.98%. This growth is expected to be primarily driven by the North American market as companies make the “digital transformation” to the cloud. Therefore, despite the recent headwinds, Nvidia has tremendous growth potential for its data center segment. Nvidia is also a specialist in artificial intelligence-based computing, another fast-growing industry.
Professional Visualization revenue was $500 million, down 20% sequentially or 4% year-on-year. However, automotive sales showed strong momentum, rising 59% sequentially and 45% year-on-year.
Revenue vs. Outlook (NVIDIA Earnings)
Nvidia’s ultra-high gross margin of ~65% was pushed down to 43.7% in the second quarter, but management believes its “long-term gross margin profile is intact.” Nvidia also managed its operating expenses very well, coming in at $2.42 billion, below its $2.46 billion outlook.
Nvidia’s CFO (Colette Kress) explained
“We plan to continue buying back shares as we anticipate strong cash generation and future growth.”
Management is expected to discuss full financial results and outlook on the pre-scheduled earnings call on August 24th.
Extended assessment
To rate Nvidia, I fed the latest financial data into my advanced valuation model, which uses the discounted cash flow valuation method. I’ve lowered my revenue growth forecast from previous rates of 30% to 40% to a conservative 15% revenue growth rate for next year. Then 22% revenue growth over the next 2 to 5 years. This assumes cyclical gaming revenue recovers, data center revenue continues to grow year over year, and auto revenue grows strongly.
Nvidia Stock Valuation 1 (Created by Author Ben at Motivation 2 Invest)
I’ve also forecast Nvidia’s operating margin to grow to a healthy 42% over the next 8 years as data center and visualization revenues grow strongly. To increase the accuracy of the assessment, I activated the company’s R&D costs.
Nvidia Stock Rating (Created by Author Ben at Motivation 2 Invest)
Given these factors, I get a fair value of $185/share. The stock is currently trading at $177, making it ~5% undervalued by these long-term growth estimates.
As an additional data point, Nvidia is trading at a Price to Sales (FWD) ratio = 14.23, which is ~2.75% below its five-year average. Therefore, the stock is “fairly valued” based on the K/S ratio. Nvidia trades at a higher price-to-sales ratio than AMD and Intel, but also has significantly higher margins.
NVDA P/E ratio data from YCharts
risks
Lower IT spending/recession
The environment of high inflation and rising interest rates increases input costs for businesses and therefore we could see a temporary decrease in IT spending at least in the next few quarters. A “recession” is also forecast, which will affect consumer sentiment and reduce spending. Low crypto prices are also negative for Nvidia as it means less GPUs are being bought for bitcoin mining rigs.
Final Thoughts
Nvidia is a huge technology leader and the second largest supplier of GPUs for gaming. The company’s high-performance technology is best-in-class, but I believe this quarter (and possibly the next) will be depressed due to macro headwinds. However, it’s worth remembering that the long-term growth trends in data centers, gaming, and even visualization are going nowhere with the “metaverse.” Nvidia is fairly valued at current levels, but I expect a lot of volatility over the next quarter until there is a recovery.