- Incredible growth record and prospects.
- Market-leading chip technology is helping fix the future.
- Near-term headwinds and massive year-to-date share-price fall.
- ‘The markets it is addressing are inestimably large and Nvidia is developing a systemically crucial role.’ – Stewart Heggie, Baillie Gifford.
A lot of what an investor needs to know about graphics chip company Nvidia can be gleaned from the origins of its name.
The name’s first two letters, ‘NV’, are a reference to the prefix used to save files by the company’s three founders – Jensen Huang, Chris Malachowsky and Curtis Priem – after they set up shop in 1993. ‘NV’ stood for ‘next version’.
The company operates in an industry where product improvement and innovation is paramount. Everything is always about the next version.
The obsession with product development extends to applying technology to new markets. Having started out targeting the fast-expanding gaming market, Nvidia has segued into data centres, automotives and the fledgling metaverse. At the same time, it has found applications for its technology in scientific research, supercomputing and artificial intelligence (AI).
The adoption of AI is driving eye-watering growth in demand from data centres, or ‘AI factories’ as Nvidia executives have called them. Nvidia’s data centre business should also benefit in coming years from a raft of major new product launches, including a high-performance central processing unit (CPU).
The division’s revenue has increased 50-fold since first being given its own line in the accounts in 2014 and sales are forecast to surge from $11bn (£8.6bn) to $23bn over the next three years.
‘Gone are the days when Nvidia monopolised the AI chip market, but… it has the potential to grab its fair share of the opportunities by leveraging its scale, vision and innovative culture as well as by catering to the needs of developers,’ says Stewart Heggie, who works with Lawrence Burns, the elite manager of the Baillie Gifford International Concentrated Growth Equities fund. ‘The markets it is addressing are inestimably large and Nvidia is developing a systemically crucial role.’
The ability to hop into new markets is aided by the fact Nvidia’s systems are programmable by both its own engineers and external developers. Software is becoming an increasingly important source of sales and provides a competitive edge, although these revenues are not reported separately.
To create ‘new versions’ of its technology, as well as internal investment, Nvidia has relied on acquisitions. The most significant to date was the $7bn purchase of data-centre specialist Mellanox in 2020. An audacious $66bn bid for rival Arm had to be canned earlier this year following competition concerns – the $1.4bn cost of the failed foray was booked in the three months to the end of April.
The other root of the company’s name is found in the Latin word for envy, ‘invidia’. Nvidia should certainly be the subject of envy from other companies.
It is the lead player in its key markets. Despite constant competitive threats, its research and development (R&D) efforts have kept it in pole position.
From the beginning of the millennium to early 2022, the company has spent $29bn on R&D, growing investment broadly in line with sales. R&D averaged a quarter of sales over the past five years. Because Nvidia outsources manufacturing, it can chiefly be seen as a play on its R&D prowess along with other intangibles investments.
Importantly for shareholders, Nvidia’s track record suggests its billions are being spent well. During the past decade, the company has achieved compound annual sales growth of 21%, taking revenues from $4bn to $27bn. This was helped by a substantial bump in demand during the Covid-19 pandemic.
And the returns Nvidia makes on the money it ploughs back into its business are way above its cost of capital. Last year’s gross margin was 65%, Ebit margin an eye-watering 40%, and return on capital employed (ROCE) 33%.
This truly is a record for others to envy.
In it for the long term
And there’s one more insight from the naming of the company. The founders only bothered with a name because one was needed to incorporate the business. The focus has always been the tech and the huge long-term potential for graphics processing.
This feeds into a culture that concentrates on project objectives rather than management hierarchies. It is also reflected in a 10-year planning horizon, which may help explain why the company now finds itself at the forefront of a range of emerging technological trends.
Adding to this impression of a consistency of purpose is the fact that Huang, the founder who took the hot seat back in 1993, remains chief executive today.
These attributes have made Nvidia hugely popular with many of the world’s best fund managers followed by Fix the Future.
Graphics processing units (GPUs) were originally developed to cater to video games’ exorbitant demand for graphics data, which remains a growth market.
But graphic chips have proved truly disruptive technology, because as well as processing image data, they have been found to be superior at sifting large volumes of other types of data compared with traditional central processing units (CPUs).
CPUs’ strength lies in switching between the jobs they do whereas GPUs offer speed and focus. What’s more, while CPU development now lags Moore’s law (a doubling in capability every two years), GPU development is running ahead of it.
With the advent of AI, the ability to process data at speed has become central to computer applications. GPUs are the perfect workhorses for data-guzzling, machine-learning programmes. Nvidia has also developed data processing units (DPUs) for this market.
As the business has developed, Nvidia has pushed further into supplying new software and products, including plans to launch its first CPU this year.
‘The company has redefined modern computer graphics, with GPUs acting as the brain of computers, robots, medical imaging equipment, gaming consoles and self-driving cars,’ says Claudia Quiroz, the elite manager of the Quilter Investors Ethical Equity fund. ‘Notably, over 90% of the supercomputers around the world are powered by Nvidia… [including] the most powerful AI supercomputer dedicated to predicting climate change.’
Just keep growing
|Year End 31 Jan||Sales ($bn)||Pre-tax profit ($bn)||Free cash flow ($bn)||EPS (c)||DPS (c)|
Source: FactSet, adjusted earnings figures, data as of 26 May 2022
After such an exceptional run over three decades, it’s tempting to ask whether there is anything left in the tank for Nvidia. While there are reasons to fear a temporary slowdown (more on that later), from a longer-term perspective, if Nvidia can continue to stay ahead of the competition, there is reason to think the tank could be brimming with rocket fuel.
As well as the incredible forecast growth from the data centre division, the company believes other massive new markets are opening up for it. These include $300bn of potential future sales related to the automotive market as spending moves from chips for in-car entertainment to self-driving technology.
Meanwhile, what the company calls the ‘omniverse’ is seen as another $150bn opportunity. This encompasses the automation of warehousing and logistics along with other aspects of commerce and the creation of virtual environments. This venture overlaps with the existing professional visualisation business, which recently received a boost from lockdowns and increased virtual working.
Along with other chips, systems and software, Nvidia reckons its markets are set to grow to $1tn in value. This compares with previous estimates of a $250m total addressable market in 2023.
And while there is every reason to be cynical about grand corporate claims about total addressable market (TAM) size, Nvidia should get some credit for its history of finding massive growth opportunities.
The good stuff
Nvidia’s products can claim to help fix the future from both their direct and indirect uses.
‘From a thematic viewpoint we like that Nvidia promotes “resource efficiency”, as its GPUs are 40 times more energy efficient than traditional servers,’ says Quiroz.
‘We also like that Nvidia’s business is in line with several United Nations Sustainable Development Goals (SDGs). In particular, Nvidia’s products are used in a wide range of applications supporting the development of modern digital infrastructure, including the computers used in autonomous cars, which aim to improve road safety and transport efficiency.
‘Its products also serve healthcare, education and transport and… are used in many medical instruments including CTs, MRIs, ultrasound, X-rays and mammography. In addition, it helps scientists and medical professionals to use AI for drug discovery, disease detection and personalised healthcare.’
While pleased with many of the group’s internal efforts to encourage diversity and use of renewable power, Quiroz would like to see more detail on its decarbonisation strategy and more disclosure on the effects of cryptocurrency mining.
Share price reckoning
While Nvidia may be a company that is easy to look at in wide-eyed wonder for its growth, return on capital and global impact, its share price chart this year is more likely to make one wince.
The company’s shares got caught up in the froth and speculation during the pandemic. It was a big holding in some of Cathie Woods’ Ark funds (although not anymore) and the subject of two- and three-times leveraged products designed to allow traders to enjoy wild speculations on daily price moves. The reckoning has come this year, with the price roughly halving.
It’s anyone’s guess how long the negative sentiment will continue and there are several headwinds the shares face.
Partly, the sell-off can be attributed to rising interest rates which do horrid things to investors’ valuation models for growth companies. But there are trading headwinds too, both real and potential.
Recent expectation-beating first quarter results for the three months to the end of April were tainted by second-quarter sales and gross profit guidance that was about 4% below consensus expectations. The company cited a $500m hit due to the impact on both supply and demand as a result of China’s Covid-19 lockdowns and the cessation of sales to Russia. Some of these issues could grind on into future quarters.
The gnarly global economic outlook and supply chain disruption could cause trading disappointment. And it is still hard to know how much of Nvidia’s exceptionally strong recent performance represented a pandemic bump that must reverse. There seems little doubt that Nvidia benefited as more people gamed and worked from home, not to mention mined for crypto.
This angst comes at a time when supply chain disruption has forced the company to increase risk by agreeing with manufacturers to extend both payment guarantees and order lead times – some have doubled from six to 12 months.
There is also the perennial fear that rivals in the ever-competitive chip market will find a way to steal significant share. There are credible threats from both listed peers such as AMD and Intel as well as tech giants such as Apple and Amazon.
One of the many unforeseen uses of GPUs is that they’re great for cryptocurrency mining.
Earlier this month, Nvidia announced it was paying $5.5m to US regulator the Securities and Exchange Commission to make accusation go away that it made insufficient disclosure about crypto-related sales in 2017. No fault was admitted.
The payment is small beer in itself. But Nvidia’s 54% peak-to-trough share price collapse in 2018 when it missed earnings expectations due to that year’s crypto slump highlights the bigger issue crypto demand represents for shareholders.
Recently Nvidia has created a special type of chip for mining while attempting to reduce the usefulness of its other chips to this market. It is hard to know how successful it has been in moving crypto demand away from traditional GPUs to its CMP crypto-chips. What is clear is that as cryptocurrencies have tanked, so too have quarterly CMP sales.
A new more environmentally friendly proof-of-stake process being launched by the ethereum cryptocurrency should also reduce demand.
Cheaper than you think?
Despite the current worries, long-term opportunities look immense. Even after the drop in second quarter guidence, a key worry for forecasters is whether manufacturers can keep up with demand from data centres.
And for those that are prepared to take the 10-year horizon that the company itself uses, it’s worth considering that the popping of Nvidia’s lofty valuation may be much further advanced than first appears.
At first sight, a valuation getting on for 30 times next 12-month forecast earnings looks potentially high, especially if those forecasts are in doubt. But that headline number is arguably deceptive.
Accounting rules means fast growing companies that principally invest in R&D and other ‘intangible’ assets, such as Nvidia, are systematically made to understate profits. That’s because the rules require that most investments in intangible assets are treated as a day-to-day expense rather than as spending that will create value in future reporting periods. Were intangible investments treated in the same way as tangible investments, such as buildings or machinery, the spending would be accounted for over its useful life with an appropriate amount of cost matched against sales in each relevant reporting period.
Accountancy wonks have a quick-and-dirty way to adjust for this quirk in the accounting rules – for readers who really want to know, it is to ‘capitalise’ R&D and spread the cost (depreciate) over five years along with 30% of operating costs spread over three years.
Using this standard but admittedly crude methodology for Nvidia, we have a company whose earnings were understated in its last financial year by about a quarter. Amend broker forecasts by an equivalent amount and we have shares valued at a bit over 20 times forecast earnings rather than a bit under 30 times.
Recent share price movements suggest it could be a bumpy ride ahead, but the business itself and the trends it is riding are truly tantalising. What’s more, the company is helping fix the future with low-impact computing products and by enabling projects in many different fields that could make the planet a better place. From that perspective, many elite managers believe there is no ‘new version’ of Nvidia required for their funds.