NVIDIA

Recommendation: BUY

Rating: OUTPERFORM*

Price Range Using DCF Analysis: $250 - $270

Market Price (24 Nov 2017): $216.96

52-Week Price Range: $84.77 – $218.67

Investment Thesis

Strong Q3 FY17 & Multiple Catalysts Ahead:

• Q3 Results: NVIDIA once again exceeded expectations in its third quarter report, setting a record revenue of $2.64 billion, up 18% from the previous quarter and 32% from last year. Whilst revenues have rocketed, earnings per share (diluted EPS) hit a record $1.33/share, up $0.41 from the previous quarter. What this means is yet another increase in its gross margin, pushing up further from 57.9% to 59.5%.

• FY18 Guidance: The company expects a rough increase of $600 million in revenues in the next 12 months (until Q3 2018) from increased product and industry penetration. This includes improvements and further consolidation of its existing leading market share in its datacentre, chip and automotive sectors. We take an optimistic to very optimistic view on NVIDIA, forecasting a price range for the company in the $250 - $270 range, a potential increase of around $30 - $50 in price, within the next year, due to the increasing demand for GPUs in the automobile, retail, and banking sectors.

(DCF Valuation Attached on the last page of the report)

• Very Strong Growth Potential: NVIDIA has positioned itself so that any major developments in either AI, self-driving vehicles, or virtual reality could become powerful growth drivers for the company. In fact, their recent performance stemming from their datacentre business is already caused by an acceleration in the demand for AI technology. A solid upside from this product diversification from a cost-analysis perspective is that all three technologies utilises the same technology developed by NVIDIA’s experienced research and development group

• Current Industry Reach: As of publication NVIDIA work with Google, Facebook, Amazon, Microsoft, IBM, Alibaba, Tencent, Baidu, Lenovo, Huwawei, Volvo, Toyota, BMW, etc. This positions them for current and future market dominance, effectively providing measures of security in the face of potential risks.

Company Background

Formed in 1993, NVIDIA is a leading designer of graphics processing units (GPUs). Originally designing its products for only for the personal computer gaming market (GeForce GPUs), the company started by broadening its reach by expanding into making chips for use in professional work stations for fields such as the visual effects industry (Quadro GPUs).

In the recent decade they have been expanding into accelerated computing for datacentres and most importantly artificial intelligence (Tesla GPUs). Most recently it has tried to position itself to capture a sizeable role in the future transportation industry through the potential of self-driving vehicles (DRIVE PX chips).

Business model

NVIDIA has a simple and streamlined segmentation of its business functions. Through its diversification their Gaming business has stayed a competitive force with a clear revenue generating function of sales direct to consumers. Similarly their Professional Visualization business, and Datacentre products operates the same with the only difference being target demographic. The price of these products, and their demographics readiness to buy them rising, in ascending order, from their computer gaming to their datacentre business. Currently their Automotive business is does not reach a large consumer base because of the early stage of the field of self-driving transportation.

NVIDIA’s revenue generating functions are best understood once broken down to the following business segments:

1) Gaming with GeForce line GPUs

NVIDIA’s GeForce line of graphics cards are bought by consumers looking to enhance their gaming experience.

Nvidia’s historically main revenue generating function still accounts for 59.21% of their total revenue as of their Q3 FY18 report. Their presence in this market remains strong with a 70% market share, as compared to their main competitor AMD’s 30% market share, in addition to their GeForce Experience software being used by 77 million users.

Of not is the widespread use of consumer gaming graphics card in Bitcoin mining operations, a development that has recently affected both NVIDIA’s and AMD’s business. Furthermore, a significant factor of growth for this business segment depends on the commercial success of Virtual Reality products, based on VR headsets built by Facebook, Sony, or Samsung demanding more powerful GPUs for consumer’s home entertainment gaming systems.

Overall this business segment still shows solid growth with a 25% YoY revenue increase, the second highest behind their datacentre segment.

2) Professional Visualization with Quadro line GPUs

NVIDIA’s Quadro line of GPUs are used in professional workstations of digital artists working with visual effects.

Creating 9.06% of total revenue in Q3 FY18 NVIDIA’s Professional Visualization, this smaller business generating function does not show significant growth potential relative to NVIDIA’s other ventures, but with a 78% market share it will remain a reasonably certain source of revenue.

3) Datacentre with Tesla line GPUs

Representing NVIDIA’s currently fastest growing business segment, their datacentre products have widespread usage among prominent technology companies utilizing Supercomputers, AI, and Deep Learning.

At NVIDIA’s Q3 FY18 report their datacentre business accounts for 19% of their total revenue, this is up from account for a 11.976% share of their earnings in Q3 FY17 after a 109% YoY growth in revenue. Their current market position looks very strong for benefitting from a potential boom in the implementation of AI technology, with Amazon, Facebook, Google, IBM, Microsoft already using their technology. Only in Q3 this year Alibaba, Baidu, and Tencent all adopted NVIDIA’s latest Tesla GPU, representing a remarkable adoption of NVIDIA products within the Chinese technology industry.

Besides companies buying Tesla GPUs, in Q3 NVIDIA also provides other chipmakers with their NVIDIA Volta HGX Partner Program, allowing these companies to work with and use NVIDIA’s latest GPU architecture. This means that these companies base their own products on NVIDIA’s already existing chip designs, connecting them directly to NVIDIA’s own Research & Development process. Partners in this area includes Foxconn, Inventec, Quanta Computer, and Wistron. Most noteworthy however is that in Q3 technology giants Inspur, Huawei, and Lenovo announced their partnership with NVIDIA in this program.

To add onto this picture, in this year’s Q3 Dell EMC, Hewlett Packard Enterprise, IBM, and Supermicro, unveiled servers based on the Tesla GPU.

4) Automotive with DRIVE PX chips

NVIDIA’s Drive PX represents a specific part of their AI business looking to integrate their chips into self-driving cars.

This segment currently stands for 5.46% share of revenue Q3 FY18 which, despite a 13% YoY growth in revenue, is a decreased share from the 6.33% of revenue in Q3 FY17. This is the lowest growth among NVIDIA’s business areas, but still worth considering because of the revolutionary growth potential self-driving automotives could bring to the transportation industry.

In terms of capitalising on this potential industry innovation NVIDIA’s DRIVE PX is currently being used by 70 companies working in the field of developing with self-driving cars. Among these companies there are BMW, Tesla, Volvo, Toyota, Bosch, ZF, and HELLA.

Summary of NVIDIA primary drivers of growth

Main driver:

• Datacentre business with Tesla GPUs, with the possible future expansion of AI into a multitude of industries and applications.

Secondary driver:

• Automotive business with DRIVE PX, while on a more long-term scale than their Datacentre business, NVIDIA is ready to become a significant player in the potential future of self-driving transportation.

Tertiary driver:

• Gaming with GeForce GPUs, in comparison with their Datacentre and Automotive businesses Gaming does not appear likely to perform as well, but there is still solid potential for growth based on possible developments in virtual reality, and to a lesser extent cryptocurrencies.

Catalysts

• GPUs are in high demand.

• Tesla has been embraced as the standardised GPU by every major internet and cloud service provider - NVIDIA gets almost one fifth of its revenue selling GPUs for data centres. Big cloud players line up to armour their infrastructure with high-processing chips to prepare for the era of AI. Further consumer reach and commercialisation lies in technology such as the “internet of things”.

• Virtual reality entertainment has the possibility to revolutionise entertainment, and NVIDIA is currently producing both the GPUs professionals require to produce virtual reality entertainment (Professional Visualization business) and consumers require to consume said entertainment (Gaming business and Tesla GPUs).

• Carmakers are racing to develop self-driving vehicles.

• NVIDIA’s DRIVE PX has potential both in personal transportation and in the use of self-driving transportation for any firm’s supply chain that utilises trucking.

Investment Risks

• The main uncertainty affecting NVIDIA’s future performance lies in how the three following technological shifts develop: the commercialisation of AI, the adoption of self-driving vehicles, and the shift in digital entertainment towards virtual reality products. The following factors are figures into this:

• How well consumers receive these products

• How well companies that use NVIDIA’s chips in their products can cater to consumer demand

• How governments will react and regulate these technologies

• It is also important to consider potential competitors that may develop superior chips for uses in AI and data centres. Of most note is Google’s Tensor Processing Unit chips (TPUs) which claims to be more powerful than NVIDIA’s GPUs, however these claims are currently disputed by NVIDIA

• Risks in a more short-term perspective mainly lies in how Bitcoin performs in the near future as the use of NVIDIA’s GPUs ties up their largest Gaming business segment with Bitcoin miners

• Our comparable analysis also suggests a marked overvaluation of NVIDIA, having an EV/EBITDA ratio of 40.65 that trails nearly 20 points higher than the comparables company average and a Forward PEG ratio of 4.67, almost double the average of 2.44. This data suggests that NVIDIA might be maxing out in terms of its growth potential compared to its sector rivals.