Nvidia: The Contrarian Opportunity Is Here In 2023

Summary:

• Revenues beat expectations, with gaming continuing to see weak demand while gross margins were weak due to inventory write-off charge from China data center products.
• The data center segment will likely continue to see solid sequential growth as a result of new product cycle ramps and resilient customer spending in the 2023 calendar year.
• The gaming segment is well positioned for a significant snap back as channel inventory clears and the RTX 40 series ramps up in the 2023 calendar year.
• My 1-year target price for Nvidia is $189, representing 34% upside from current levels.

Investment thesis

Nvidia (NASDAQ:NVDA) remains to be hit particularly hard by the cyclicality of the sector. This was largely due to the weakness we saw in the gaming segment as well as slower growth in the data center segment.

However, I think that the recovery for the gaming segment is near as there are leading indicators that show the gaming segment could see reaccelerated growth in the 2023 calendar year. This is due to the clearing of inventory levels downstream in the gaming segment that positions the segment for a solid recovery.

On the other hand, the data center segment remains solid and continues to see sequential growth due to resilient customer spending and new product cycle ramps.

In the longer term, Nvidia’s current risk reward looks attractive as it is currently affected negatively by the weak demand from the impact from cyclicality. However, in the long run, Nvidia’s strong competitive position and product road map brings strong demand drivers for the company.

Review of recent quarterly result

In FY3Q23, revenues were down 12% sequentially to $5.9 billion, which is higher than consensus expectations as the new alternative A800 GPUs helped to offset the China export restriction impact. For the gaming segment, revenues were down 23% sequentially to $1.6 billion. This was the main detractor for the quarter that contributed significantly to the overall revenue sequential decline. The gaming segment continues to be soft due to weak demand and lower sell-in as a result of adjustments made to inventory and pricing in the channel. On the other hand, data center segment was solid, increasing 1% sequentially in the difficult market environment, to $3.8 billion. This sequential growth came from continued strong spending from US hyperscalers, enterprise and vertical market and networking. These managed to offset the weak demand from China. Autos was up 14% sequentially with demand inflecting higher as the $11 billion automotive revenue pipeline unfolds, while gross margin was below consensus at 56%. This was due to an inventory write-off charge that was related to China data center products.

FY4Q23 guidance was slightly below consensus expectations as management expects demand from gaming and data center to continue to be muted in the quarter. Furthermore, for the April quarter, which is Nvidia’s FY1Q24, the data center and gaming segments are well positioned to re-accelerate growth sequentially. Gross margins are expected to rebound to 66% and operating expenses expected to be flat over the next few quarters.

Sustained data center in 2023

I think that we will likely see demand for data center remain resilient in the 2023 calendar year. This is contributed by both the strong and resilient customer spending and new product cycle ramps. Nvidia’s customers are likely to continue to spend even during downturns like today, in my opinion, due to the strategic importance and mission critical aspect of the accelerated compute to support its customer’s artificial intelligence and analytics initiatives. In addition, there are new product cycle ramps that will drive demand further, in particular, the Hopper in data center and Ada in gaming.

Management had this to say about Hopper ramp up in its FY3Q23 earnings call:

Remember, NVIDIA is the only company in the world that produces and ships semi-custom supercomputers in high volume. It’s a miracle to ship one supercomputer every three years. It’s unheard of to ship supercomputers to every cloud service provider in a quarter. And so, we’re working hand in glove with every one of them, and every one of them are racing to stand up Hoppers. We expect them to have Hopper cloud services stood up in Q1. And so, we are expecting to ship some volume — we’re expecting to ship production in Q4, and then we’re expecting to ship large volumes in Q1. That’s a faster transition than Ampere.

For FY3Q23, we saw that the data center segment grew 1% from the prior quarter and I expect that the segment will once again grow modestly again in FY4Q23. This continued solid sequential quarter on quarter growth comes from the solid data center GPU shipments as hyperscale demand continues to be strong, enterprise and vertical market adoption continues, and networking growth remains solid. All these, in turn, is able to offset the weakness in demand from China. With regards to Nvidia’s CPU initiative, the management commented that the company is on track to have production samples of Grace ARM-based CPU in FY1Q23.

Gaming is near the bottom

In my opinion, we are seeing the bottoming of gaming and the segment is well positioned for an acceleration in growth through 2023. In FY3Q23, we saw gaming revenues fall 23% sequentially and I expect that in FY4Q23, we will see a stabilization of gaming revenues. Based on my estimates, I forecasted a 1% fall in gaming revenues sequentially in FY4Q23, which in my view comes as there are increasing evidence that downstream inventory looks to fully clear by FY4Q23. This is due to the fact that Nvidia has been prudent in ensuring that excess inventories are flushed out, and based on my estimates, it has under-shipped end demand by 30% from FY2Q23.

With a clearing of downstream inventory, this is a leading indicator that typically leads to Nvidia’s gaming revenue snapping back quickly and significantly. Furthermore, gaming revenues can also be further supported by the ramping up of the RTX 40 series as well as strength from seasonality. As such, I have confidence that the gaming revenues will recover in the 2023 calendar year as the fundamentals of the business look to be improving along with the product cycle.

Valuation

Nvidia continues to execute well across segments and remains to have strong growth potential due to its solid competitive position as well as deep untapped demand pools that will continue to drive future revenues. The current market environment is no doubt difficult for the company and near-term headwinds remain, but I think that the fundamentals of Nvidia remain solid and that the 2023 calendar year will bring reacceleration of growth for the company as the headwinds mentioned above are starting to subside.

I used an equal weight of DCF method and the P/E multiple method to value Nvidia. Based on its 10-year average P/E multiple of 35x, I applied a 35x P/E multiple on the FY2024 P/E. I also applied a discount rate of 12% to discount future cash flow to present value and my terminal multiple applied in the DCF was 20x. The higher discount rate compared to the discount rate used in my earlier article was a function of the rising rates situation. As a result, my 1-year target price is $189, representing 34% upside from current levels.

Risks

Competition from other players in different segments

While Nvidia has a strong competitive position, its competitors continue to be a threat in the markets in which they operate and could compete with Nvidia if they are able to improve on their offerings. For example, the GPU space may see more competition from AMD (AMD), while ARM-based applications may compete against Nvidia’s leading dual-core technology. Lastly, Intel (INTC) is looking to challenge Nvidia with its Knights processor family that may bring challenges to Nvidia in the long term.

Gaming recovery

Although there are signs that the gaming segment inventory situation is improving, it may take longer for the gaming recovery as the demand for gaming may be rather weak in the current market environment in which Nvidia is operating in. If the gaming segment does not recover in the 2023 calendar year, this could bring downside risks to my estimates.

Macroeconomic environment

The macroeconomic environment may worsen, and the weakness may be prolonged. If so, the weaker macroeconomic situation may reduce PC gaming demand and with the significant exposure Nvidia has to the PC gaming segment, the weakness in this segment brings further downside risk to my estimates. The data center segment, although resilient, may also see further weakness if the economy stays weak for long or if the economy worsens further.

Conclusion

I think that it is time to take a contrarian perspective for Nvidia in 2023. While the stock has been struggling recently as the business is impacted by multiple near-term headwinds, the strong snap-back in gaming revenues as the channel inventory clears and the sustained momentum in the data center business is an excellent opportunity for a contrarian investor. I think that in the 2023 calendar year, the business will start to see reaccelerated growth and now is the time for investors to be ahead of the curve and heed the leading indicators we see today to invest for tomorrow. My 1-year target price is $189, representing 34% upside from current levels.

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Disclosure: I/we have a beneficial long position in the shares of NVDA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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