|Shares Out. (in M):||607||P/E||42.8||32.1|
|Market Cap (in $M):||151,337||P/FCF||32.27||30.86|
|Net Debt (in $M):||-5,300||EBIT||3,224||5,552|
|Borrow Cost:||General Collateral|
“The obscure we see eventually. The completely obvious, it seems, takes longer.”
- Edward R. Murrow
We believe NVIDIA Corporation (NVDA) is a short, poised for a significant decline in the share price (50%-75%) as several catalysts play out to re-rate the earnings trajectory and valuation over the next few months. The market has mistaken a major cyclical boom as a secular growth story, and the cyclical bust has already started in NVDA’s end-market as evidenced by excess inventory and dramatic price declines in NVDA’s products (discussed in further detail below).
A good writeup on VIC by afgtt2008, as well as various analyst reports, lay out the details on the business mix, so we don’t need to cover that ground here. Instead, we will lay out why the turning points for the NVDA story are increasing, and why the stock is likely to collapse on the coming earnings call (or prior, if current long holders and sellside analysts wake up to the problems).
We’ll address the thesis in four broad strokes –
1) Why does the opportunity exist?
2) What is our variant perception?
3) How will the crowd come to our view?
4) Fair value.
Why does the opportunity exist?
Over the past 3 years, NVIDIA has been the best performing stock in the S&P 500 index, having gained 1,143% since the beginning of 2015, far eclipsing the returns of Netflix or any of the other FANG or similar story stocks. It has been a momentum investor’s dream, and unlike many other momentum stocks that are just riding high on “story” without much tangible cash flow, NVDA has delivered accelerating growth in revenues, earnings and cash flows.
The growth trajectory has been explained by the Company as a variety of secular themes (artificial intelligence, driverless cars, etc.), and as a result, analysts have extrapolated the growth to continue. Earnings-based valuation metrics lead people to believe it is not “that” expensive at 42x trailing P/E or “only” 32x NTM P/E, a “reasonable” forecast assuming growth top line growth rates and margins based on recent history.
In addition, the stock is often promoted on CNBC by Jim Cramer, as well as pumped heavily into the retail channel through various banks’ private wealth management businesses (i.e. after recent Facebook “data scandal”, Bank of America Wealth Management replaced Facebook with NVIDIA on their “US Select 1” list for wealth management investors).
The investor base, and the narrative that NVIDIA management has created, combine to create a situation where the market is about to get blind-sided by a major cyclical bust in NVDA’s largest end market.
Our variant perception
Often the correct explanation for a situation is the most obvious one. We believe NVIDIA has undergone a major cyclical boom in demand for its core product (GPUs), due to a new source of demand (cryptocurrency mining, specifically Ethereum) entering an already tight supply/demand situation, rapidly pushing up prices during 2016-2018. As that source of demand wanes (Ethereum prices down ~67% since mid-Jan 2018), the supply/demand situation for GPUs broadly is shifting very unfavorably for NVIDIA, resulting in an oversupply of products and collapse in product prices, which has already started in recent months.
What does NVIDIA make? NVIDIA makes primarily GPUs (Graphic Processing Units), which are distinguished from CPUs (Central Processing Units) in computing applications. In computing, a CPU is thought of as the traditional “processor” within a computer that carries out the instructions of computer programs by performing basic arithmetic, logical, control and input/output (I/O) operations specified by the instructions. Over time, with increase in computer graphics, arose a need for specialized electronic circuits used primarily for graphics and image processing, and NVIDIA popularized the term “GPU” for Graphics Processing Unit in the 1990s.
Modern GPUs are used in a variety of applications for image processing, such as mobile phones, personal computers and video game consoles, among others. GPUs are more efficient at image processing, and their highly parallel structure makes them much more efficient than general-purpose CPUs for algorithms where the processing of large blocks of data is done in parallel (such a cryptocurrency “mining”).
NVIDIA management has tried to deflect risks from exposure to cryptocurrency mining, by stating that it’s a low percentage of revenues (in Fiscal Q1 earnings call on 5/10/2018, mgmt stated:
“Cryptocurrency demand was again stronger than expected, but we were able to fulfill most of it with crypto-specific GPUs, which are included in our OEM business at $289 million.” (this would be ~9% of revenues)
“Looking into Q2, we expect crypto-specific revenue to be about one-third of its Q1 level.” (implying cryptocurrency mining will drive ~3% of revenues in the forward quarter).
Investors have interpreted this generally as “cryptocurrency exposure is limited” and “baked into the guidance”. We disagree, and data from the GPU market is showing the flaw in this line of thinking.
We spent some time speaking with NVIDIA about how they sell into the cryptocurrency mining market, and realized how they are explaining the exposure to investors. The company goes out of its way to explain that they saw the opportunity in crypto mining, developed crypto-specific GPUs (without any graphics display functionality), and contract out directly to the large miners in Asia (Genesis or others). They focus the entire conversation on the direct sales to the cryptocurrency end market, and why it’s manageable.
We believe this is a major sleight-of-hand, as GPU chips made for NVDA’s core gaming market are interchangeable and able to be used for cryptocurrency mining, and in many of our conversations with large and small miners, cards through the GeForce gaming channel have been going heavily into the cryptocurrency mining end market. This has been evidenced by skyrocketing prices of GPUs, and top line growth rates and margins at NVDA in the past several years.
How will the crowd come to our view?
The turning point for NVIDIA’s business has already arrived, with the collapse of Ethereum prices in recent months, for which GPUs were heavily being used. Below is a price chart of Ethereum – after an impressive run up during 2017, where prices rallied from under $100 to over $1300 by January 2018, Ethereum prices have collapsed in recent months to sub-$500.
Various analysis of mining profitability indicate that at current levels, miners are facing poor returns on investment. In addition, the pending introduction of cheaper and more efficient ASICs for Ethereum mining (such as by BitMain) are likely to pressure GPU demand and prices for this end usage.
To paraphrase George Soros, we don’t attempt to “predict” how these impacts may play out, but simply “observe” what is happening in GPU markets in recent months.
We believe that GPU demand and profitability peaked in Fiscal Q1 (ending 4/29/18), and a large excess inventory situation and price decline of GPUs is underway, that is likely to intensify.
The chart below tracks the selling price of one of the top selling products, NVIDIA’s GeForce 1070. Since the peak of Ethereum prices in early January, product prices are down from almost $1000 to sub-$500, a decline of over 50%.
Even higher end products such as the GeForce 1080 are being heavily discounted across channels. Below is a promotion from reseller Newegg that is being run in the recent week on the GeForce 1080 for $499 (discounted from $599, but note that prices 6 months ago were over $1000).
As we were writing this up, awareness of this situation has started to percolate in the analyst community. Late last week, BlueFin Research Partners’ analyst Paul Peterson wrote after a two-week trip in Asia, as excerpted by Barron’s Online:
“GPU card sales dropped by more than 50% in the North America and Europe retail channels, according to our research”
“[not just cryptocurrency mining, but] gamer demand also appears relatively muted”
“[Nvidia was] surprised that gamer demand didn’t bounce back when GPU card prices plummeted”
“Nvidia is pressuring the retailers and add-in board makers to drop their prices in order to move the cards, leveraging future Turing availability in the balance."
Furthermore, Gigabyte Technology Co. out of Taiwan, a manufacturer and marketer of peripherals (approximately 50% of revenues from GPUs, other half from less volatile products), recently reported June revenues down 30% y/y. Gigabyte’s website has significant detailed historical data at https://www.gigabyte.com/Investor/81 and http://emops.twse.com.tw/server-java/t05st10_e?TYPEK=sii&step=historical&co_id=2376, from which we can see the trends so far in 2018.