The bulk of Nvidia Corp.'s (NVDA, Financial) revenue has come from sales of its graphics cards for the video and personal computer gaming industry. To date, the results from sales in this sector have been disappointing. For the intermediate term, many signs point to slower earnings growth, absent a quantum leap in performance for its new graphics cards for gamers.
The current dilemma for Nvidia is that its short to intermediate term fortunes are inextricably linked to robust demand for its graphic chips for gamers, who are fastidious about price-performance ratio. As the tepid reception of its latest graphics card demonstrates, gamers aren’t going to pay more for processing power that, in the end, proves to be merely incremental.
To much fanfare and hype, the company rolled out its Turing graphics card, promising performance improvements and new features that purportedly would enhance lighting and shading capabilities. Gamers squawked at its price-performance shortcomings. The card was priced 20% to 30% above previous versions with only a theoretically modest 35% gain in frame rate enhancement. The price-performance of Nvidia’s previous card over its predecessors represented a quantum leap in performance, offering a 50% to 100% boost in all measures of performance. In short, Nvidia completely misread the market for its new Turing card.
Additional challenges are that the company has been the object of perennial diminished analyst expectations, as earnings figures have consistently been downgraded over the past year. Last November, the Street consensus for quarterly sales ending January was $3.4 billion; Nvidia recently posted $2.2 billion — 35% lower than anticipated.
The company’s guidance for 2019 relies heavily on increased sales in the gaming sector, a rather dubious proposition given the performance requirements demanded for any profitable new cards. In addition, it should be noted there has been a recent and pronounced shift of video gaming to the cloud. Should this trend continue, it would have a deleterious effect on the company’s premiere product, which has been responsible for the vast majority of its profits over the years.
Those who have a more sanguine, long-term view must hope the claims of CEO Jensen Huang that the company’s recent purchase of Mellanox Technologies Ltd. (MLNX, Financial) will not only have an immediate positive impact on earnings, but will position it well for establishing a high-profile presence in the cloud computing sector. The company is placing a big bet on Mellanox, hoping to piggyback on its unquestioned prominence in the interconnectivity and network switching sector of the cloud services computing industry.
Mellanox supplies connectivity products for servers, storage and complex network infrastructure. Its switches, specialized cables and processers reduce latency and increase throughput for massive computing networks and cloud computing systems. Its products are considered the gold standard within the industry. The numbers support this contention: Mellanox’s 2018 sales increased 26% to $1 billion; profits increased to $134.3 million, an astounding 791% increase. Clearly, Nvidia will be able to benefit from this growth.
Despite its lethargic recent performance due to a pronounced decline in cloud computing capital spending and overreliance on the gaming industry that was unimpressed with its latest iteration, promising signs are appearing on the horizon. The company has been investing in artificial intelligence since 2006, where it is now a prominent player.
Huang repositioned Nvidia’s core video graphics card for performing AI tasks for software applications. Although AI is still in its incipient stages, its projected growth is slated to increase dramatically as companies incorporate processing power and complexity within their overall database and data networking needs. Huang believes the company’s acquisition of Mellanox will facilitate its ability to become an established player in the AI cloud computing sector.
One drawback, however, is Nvidia’s graphics cards cannot perform as well as semiconductors architected exclusively for AI-intensive tasks. A challenge for the company is there are a new crop of companies with venture capital funding that are slated to manufacture AI-specific computing chips.
Given these imponderables, some may find the stock’s current price-earnings ratio of 25.6 too rich for their tastes. The shares are selling at 32 times next year's estimated earnings, another figure that seems unwarranted given the challenges noted above. GuruFocus notes the company’s forward price-earnings ratio is higher than the trailing price-earnings ratio and that the company's earnings are in decline.
However, there are positive signs of encouragement for resolute investors.
As indicated by the chart below, the company’s free cash flow position has increased to $3.14 billion from approximately $2.9 billion for the same period last year. Additionally, operating margins have consistently been high, far surpassing the median for the industry. GuruFocus notes Nvidia's margin ranks 97% higher than 849 companies in the Global semiconductor industry; the company has a 32.47% margin compared to the industry median of 6.76%. This is an enviable number few companies in the sector can emulate.
Future growth for the company is going to rely on its success in repositioning its principal revenue source away from the gaming industry toward AI applications and the continuing projected rapid growth of the cloud computing services business.
For enterprising investors with the stomach for the long term, Nvidia is a stock that is worthy of consideration.
Disclosure: I have no positions in any of the securities referenced in this article.
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