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Nvidia - A Look Ahead of Earnings

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The next significant inflection point in computing will be cloud computing moving to the edge, where parallel computer architectures will be connected to hundreds of billions of Internet of Things (IoT) devices. Nvidia is uniquely positioned to dominate that ecosystem, and if it does acquire Arm Technologies, full control of the Arm architecture will virtually guarantee Nvidia’s dominance. In previous technology eco-systems (Intel-Microsoft Windows, Apple iOS), the dominant player controlled 80% of the profits. -Michael Bruck VentureBeat

Summary

  • A Big Winner

  • Expectations for Unusually High Growth

  • ARM Acquisition

  • Crystal Waters Position

A Big Winner

NVDIA is a core, long-term holding for Crystal Waters Partners. Our thesis is that Nvidia’s GPUs (Graphical Processing Units) are core to a rapidly expanding array of digital computing needs, and the company has a large competitive advantage that will take other companies’ years to match. While the valuation has looked expensive at any time in the past several years, at the time of our investment three years ago, we felt it was cheap if half of what we believed the company would do came to fruition in the next 2-4 years. We are now sitting on an investment with a gain that’s over 400%. As a growth fund, these are the kinds of positions that drive tremendous returns for our investors. When positions get disproportionately large, we must consider reducing the size of the position or reducing other positions so that we can own more of a company like Nvidia. Our discipline allows us to let winners run, but at some point, we must manage disproportionate risk too. This article is a look into our thinking about Nvidia and any other stocks that performs this well.

Expectations for Unusually High Growth

Without diving into the nitty gritty of the valuation model, we agree that the company is expensive by traditional measures, but it has always been expensive if you assumed it would grow at average industry rates and have a predefined addressable market. Nvidia has defied traditional measures and continues to grow and surprise investors.

  1. Nvidia is core to the future of much of technology

  2. Nvidia is going to generate nearly $25 billion in revenue this year (FY2022)

  3. 30%+ of all revenue ends up as free cash flow ($8 billion this year)

  4. Nvidia is growing over 50% a year

  5. Nvidia keeps surprising with its ability to expand existing markets & find large new ones

  6. Nvidia has massive advantages that allow for margins and growth well-above the industry, and the valuation need to reflect this.

When we look at the potential for growth, we also weigh that optimism against the risk of decline. In Nvidia’s case, the valuation depends on future outsized growth, and there is no room for any hiccups. Nvidia’s free cash flow is an eye opener for sure but the growth the company needs to deliver will require more success on multiple fronts to justify a $500 billion market capitalization. Much of the current value lies in future earnings and cash flow that are expected to be significantly higher than today. Growth needs to continue, and margins need to expand further. The core business will continue to grow at a healthy rate, but we do expect to see a slowdown in some of their business segments as new ones take over.


NVDA Business Overview

Nvidia designs graphics processing units (GPUs) and systems on a chip (SoCs) for gaming, datacenters, professional visualization, automotive and OEM markets. Nvidia competes with companies like AMD, Intel, and Qualcomm in these markets.


The company has evolved beyond its ‘legacy’ business of GPUs for gaming over the past few years and nowadays Nvidia is at the forefront of several technological developments that are supporting the growth of accelerated computing, artificial intelligence, data science, autonomous vehicles, robotics and augmented and virtual reality (AR/VR) and now stands at the precipice of a tectonic shift in computing that would firmly establish Nvidia as the premier semiconductor company in the world.


Nvidia’s market share in discrete GPUs has grown rapidly over the last few years, rising from 75% last year to 81% this year, alone, and will only get bigger in the coming years.

Source: Nvidia 10Q; Tomshardware.com


The broad and increasingly diversifying use of its GPUs has more than doubled revenue in the last 4 years, and growth is still accelerating.


Nvidia’s opportunity lies in Parallel Computing at the Edge. Parallel Computing or using lots of computers working together on simultaneous tasks, isn’t a new concept. However, programming the software is incredibly difficult. Nvidia developed the CUDA software platform 13 years ago to solve this problem positioning itself for the current tectonic shift.


Our model calls for over 50% growth this year (FY 2022). However, analysts see a sharp deceleration next year closer to 12%-15%. In the chart above we can see that the Gaming revenues growth is slowing, while Datacenter revenues are accelerating, in line with our own thesis. The OEM and Automotive segments could offer new growth as the electric vehicle and autonomous vehicle markets continue to grow. Nvidia is a powerhouse, but we will need to see revenue growth much higher than 12%-17% over the next several years to justify the valuation.

Arm Acquisition

Arm designs semiconductors and licenses those designs to other semiconductor companies. Most consumers have never heard of ARM or know anything about what the company does, but it arguably owns some of the most important technology IP in the world. Estimates suggest that 95% of mobile devices use ARM Architecture.

Arm has made its name creating CPU designs that are incredibly power efficient and perform very well in battery-powered or other power constrained environments. Almost every single smartphone sold in the world today uses an Arm-based CPU. Companies such as Apple, Qualcomm, Samsung, Huawei, and others all license the Arm CPU architectures. Apple recently announced a switch to Arm-based CPUs for their Mac computer. Many of Arm’s designs drive a significant amount of today’s computing capabilities and the company stands to be key to the future development and evolution of artificial intelligence (AI), including autonomous driving, online education, and automation of millions of human decisions.

In September 2020, Nvidia announced it was acquiring Arm. According to the company, the deal will take up to 18 months to close, but still faces serious regulatory hurdles that could torpedo the deal. The combination of the two companies will put NVIDIA on an entirely different growth trajectory and reduce much of the current risk that comes with the lofty growth expectations.


What happens with the acquisition of Arm will likely guide what we do with our investment in the company. We strive to provide transparency to our LPs and hopefully also help investors leverage our work to make their own informed decisions.


“AI is erupting at the edge. AI and cloud native applications, IoT and its billions of sensors, and 5G networking now make large-scale AI at the edge possible. But it needs a scalable, accelerated platform that can drive decisions in real time and allow every industry to deliver automated intelligence to the point of action — stores, manufacturing, hospitals, smart cities. That brings people, businesses, and accelerated services together, and that makes the world a smaller, more connected place.”


The Arm acquisition is expected to enable NVIDIA to offer an end-to-end ecosystem of technology across the data center, IoT, autonomous vehicles and mobile domains. NVIDIA is now well positioned to upscale its inference technology, drivers and accelerators by utilizing Arm’s architecture and chip designs in combination with their CUDA software creating a unified Parallel Computing environment that can operate in real time at the edge.

There are lots of synergies that would not only create a better product for consumers, but also create cost savings and lower prices. Arm’s CPU designs are incredibly power efficient while Nvidia’s GPUs require significantly more power than most other elements of a PC or server. Combined the abilities of Nvidia and Arm under one roof would keep Nvidia growing well above 25% for the next 5-10 years.


Arm’s chip design of high-performance processors with long battery life is likely to open the possibilities of new artificial intelligence (AI) applications, and Arm is seen as essential for the evolution/revolution of AI. Most everyone agrees that Arm has the foundational technology to enable an AI revolution, but the company will need to evolve quickly by investing in new technologies on a scale that it has never done before. ARM could potentially go public (it is currently owned by Softbank) to raise capital but every estimate we’ve looked at illustrates that ARM couldn’t raise anywhere near the money they need from an IPO. Nvidia is really the only company that has the resources, strategic vision, and complementary technology to unlock Arm’s full potential.


However, there is not unanimous support for the deal, and there are questions around what Nvidia will do if they cannot complete the merger.


Large companies like Google and Microsoft, often accused of monopolistic practices themselves, are opposed to the deal, which requires approval from authorities in the U.S., U.K., E.U., and China. Qualcomm is fighting the acquisition, as the company relies heavily on Arm for microprocessor intellectual property (IP). Apple is concerned as Arm’s IP powers 95% of the world’s mobile processors/smartphones, with both Qualcomm and Apple as major customers. Huawei, China’s largest mobile phone manufacturer uses Arm’s chip design extensively. Having Arm become part of an American company raises concerns that the US government’s restrictions on US companies selling technology to Chinese companies would prevent Arm from continuing to provide its chip design to Huawei. These companies all want Arm to be the Switzerland of the semiconductor industry, a neutral provider of technology, and are lobbying their governments hard to block the deal.


Remaining neutral has resulted in thin profits from designs and licensing. In terms of market share of licensing and designs, Arm is incredibly successful, yet, despite Arm’s success, the top line is still only $2 billion annually with $50 million in profit, not nearly enough to organically invest the billions of dollars needed to execute on its larger vision.

Arm will need to be a acquired by a strategic partner—there is no other outcome that is as accretive. Nvidia will generate over $8 billion in free cash flow this year and is committed to invest in Arm’s product development at a level that an IPO or acquisition by another company can’t match. The investments will lead to an acceleration of roadmaps for high-end CPU cores and enable industry participants to bring more competitive and comprehensive products to the marketplace which ultimately will have far-reaching benefits to the world across a variety of industries and important applications. Nvidia customers and partners such as Broadcom, Marvell, and MediaTek have come out in support of the deal.

Governments reviewing the acquisition will need AI to power their economies. Competition is healthy for the tech market and blocking innovation at this most crucial point will not sustain progress. Nvidia has proven itself a leader in the GPU market in the data center with 98% of cloud infrastructure-as-a-service using Nvidia’s graphics processing units (GPU). There needs to be a similar approach for the trillions of edge devices, where more AI-decisions will be made. As such, despite the lobbying efforts from various companies with specific self-interests, we think it is in the interest of these governments to allow the deal and use Nvidia as a candidate to push forward the world’s agenda for AI and edge computing.


Conclusion

Nvidia has a history of surprising even the most optimistic analysts, and it’s possible that even without the Arm acquisition, there are ways for the company to continue its current growth. Management is creative and we won’t rule out anything. Should the ARM deal not happen, Nvidia may not warrant an overweight position in the fund, and we may begin to trim the position back to equal weight. If the deal is approved, the next decade or more will be one of the most exciting for Nvidia and its investors, and we will likely maintain an overweight position. Another option is that we might consolidate the portfolio around fewer overall holdings which would allow us to own a larger position in Nvidia and the remaining companies where we have conviction.


If historical trends continue, a merged Nvidia/Arm would result in a market at least 10 times larger than today’s mobile phone or cloud computing market. It is an understatement to say that the stakes are huge.



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