Feb 22 2021 - Nvidia: The Post-COVID Outlook

Summary

• Nvidia’s strong product portfolio has turned a negative COVID macro into an over 50% revenue growth in 2020.
• RTX 3000 family becomes mainstream in Gaming. DC revenue benefitted from pull-forward of CapEx and will further grow into the recovery.
• Stimulus recovery will partially offset the fading WFH demand. Supply shortage becomes a "cushion" which mitigates the drop in forward demand.
• Nvidia still has the cleanest growth story.
• While sticking to their holdings, Nvidia shareholders should acknowledge that the triple digits NVDA 2020 share gain (+120%) will not repeat in 2021.

(Source: Bloomberg Supply Chain Database)

Nvidia (NVDA) has one of the cleanest growth stories in the semiconductor group. The company has a strong diverse product portfolio which enabled Nvidia to turn a negative COVID macro into an over 50% revenue growth 2020. For the first time, the recession sent most of the workforce home to work. The “Working From Home” (WFH) phenomenon has been the basis for the Gaming and Data Center (DC) to surge. In anticipation of CapEx cutbacks and supply shortages, enterprises also pull forward their spending on DC. As a result, Gaming and DC turned out to be two bright growth spots for Nvidia, bucking the worst recession in history.

Thanks to the several stimulus packages and the availability of COVID vaccines, the end is near. In this article, I will show that NVIDIA will be able to largely maintain its advantages into the post-COVID period. NVIDIA will continue to execute across all segments. While 1H is typically seasonally weaker than 2H, we expect solid demand in PC gaming to be a strong revenue driver for the company, offsetting the secular declining PC OEM. The Data Center segment, Nvidia’s future growth engine, is expected to advance strongly as hyperscale customers continue to embrace GPU-accelerated deep learning for processing large data sets.

I also identified Nvidia’s two reoccurring risks of supply shortage and unquantifiable cryptocurrency demand. However, I am not as optimistic as the street estimates on both accounts, the downside exposure is intensely monitored by the investors. In the post-COVID period, while the company remains to be a super-growth company, Nvidia's share price upside potential is likely to moderate as offsetting macros will moderate the revenue growth. Investors should hold on to their Nvidia shares.

The Post-COVID Macros

As most semis uniquely benefit from the WFH, I expect the demand surge since Q2 2020 to diminish as the number of new COVID cases begins to drop significantly and vaccine availability increases. Nvidia already guided down the Q4 Data Center revenue estimate. Consequently, since Nvidia’s main revenue vehicles have been restricted by the supply shortage, demand has outstripped supply. There could still be a silver lining that shortage may turn into a blessing for the expected demand decline, as excess demand has not been filled or converted into actual revenue for a while. The realized revenue slowdown should be partially mitigated by the supply shortage, acting like a "cushion", which has not yet seen the end of the tunnel.

In short, the net effect is that the strength in the Gaming and DC has been robust and looks to persist into 2021, yet the growth rates should moderate. On the other hand, while the current recovery shows signs of a slowdown, the fading WFH may be partially offset by the forthcoming recovery from the new .9 trillion stimulus package, pending on the timing and the size of the next stimulus package.

Gaming Outlook

Nvidia continues to benefit from work-from-home trends. The demand pulls for the RTX 3000 series family of GPUs easily outstrips the supply which has been restricted by the shortage in wafer, substrate, and assembly/test constraints. Gaming’s record revenue has been driven mainly by the strong demand for GeForce RTX 3000 GPU series, gaming NBs and console SoC sales (Nintendo Switch). Excluding the Mellanox revenue due to the 9/14 Huawei shipment ban, all sub-segments are expected to grow sequentially. In the short turn Gaming is set to drive Q4, given strong holiday demand and the company remains supply constrained. It is not yet clear whether they’ll continue filling the channel into April, which is typically down seasonally, or whether this guide is the best the market will see near-term.

In the long run, Ray tracing goes mainstream for Gaming. Ray tracing was first introduced with the GeForce 20 series. Now it is becoming widespread in the latest games. Nvidia estimates that from its close to 200M user install base, only 10% have ray tracing capable GPUs. The upgrade cycle is estimated to be about 2-plus years. With ray tracing becoming more prevalent in new titles, it is expected that a more robust upgrade cycle with the GeForce 30 is closer to pre-Turing cycles. The current GeForce 30 series was the largest leap forward in capabilities ever for the company and the company has yet to fully launch its lower-end SKUs for desktops and laptop-specific SKUs. NVDA noted the new RTX 3060 with ray tracing to hit the volume pricing sweet spot with the late February launch, but could drive a significant gaming ramp. About 1/3, to slightly less than 1/2 of Ampere SKUs, have been ramped with more opportunities in the lower end of the price range that have yet to be tapped. The RTX3090/3080/3070 and new 3060 will drive Nvidia’s future Gaming revenue.

Combining both, the net negative macros and the positive GeForce growth, the revenue growth will invariably slow down. Based on the consensus forecasts, Gaming revenue y/y growth is expected to drop from Q4’s 60% to 35% by 1H 2021; however, it will stabilize around a high single digit, pending on the speed of the macro recovery (Figure 1).

Data Center Rebound

Nvidia’s data center revenue is divided between approximately 50% enterprise (verticals) and 50% hyperscale. On the vertical front, A100 is being aggressively adopted by the major server platforms (Dell, HP, Lenovo) as PCIe form factors become standard into server form factors. As the verticals’ revenue is obviously cyclical, if the recovery speeds up, the verticals’ revenue could bounce back by 2H 2021 (Deutsche Bank Research).

On the other hand, the major hyperscalers already ramped up their CapEx spending on accelerators in the data center, despite the negative CapEx macro trends. More specifically, NVDA noted both A100 and V100 (Volta) demand are outstripping supply, as A100 inference adoption rates are accelerating as average inference GPU capacity now exceeds CPU capacity, driven in part by the A100 adoption of Amazon, Google, Alibaba and Azure. The company also sees the post-COVID recovery will do well with conversational AI, recommender engines, and data analytics. The strength of Nvidia’s product portfolio can be demonstrated by 6 of the top 10 global supercomputers powered by Nvidia’s GPU, and 7 of the top 10 powered by Mellanox InfiniBand networking connectivity (JP Morgan).

Due in part to the “pull-forward” sales from Huawei, Mellanox’s networking connectivity has contributed to half of Nvidia’s Q3 beat. The near-term revenue forecast should reverse and decline to the normal level (-20% Q/Q by Mizuho). Despite the short-term correction, the growth story is not broken. Going forward, Mellanox should continue to deliver mid-20’s Y/Y growth for the strong demand of its 25/50/100Gbps Ethernet products and 200Gbps HDR InfiniBand products. For Q4, overall DC revenue will still increase about 90% as core DC revenue growth will more than offset Mellanox’s correction. In the near-term, the overall y/y revenue growth will slow down to around 20% reflecting the fading WFH (Figure 2).

Supply Shortage

Like many semis, Nvidia must face a shortage in leading-edge silicon, advanced packaging substrates, and assembly testing. The shortage has been a meaningful constraint to both Gaming and Data Center. Their largest chip supplier, Taiwan Semiconductor Manufacturing Company (TSM), is also the world’s largest chip supplier. Although TSMC is Nvidia’s largest supplier (17.92% of cost), Nvidia is only TSMC’s 8th largest customer (2.59% revenue), per Bloomberg Supply Chain Database (cover figure & figure below). The chip supply shortage has been widespread and will last for some time. Both Nvidia’s 2020 actual growth and 2021-on forecasts have been “held back” as a result (JP Morgan). TSMC, referred as “Protecting Country God Mountain,” (護國神山) has been under mounting political pressures from all sides. Since the Taiwan government has ownership interest in TSMC, considering automobile has a longer supply chain, the most recent “understanding” between the Taiwan government and the 4 large chipmakers, including TSMC, is to put automotive chips as the first priority in response to the auto recovery from late 2020. In other words, the street’s expectation that the company can work with TSMC to resolve the supply issues for Gaming and DC by the end of 2021 seems over-optimistic.

(Source: Bloomberg Supply Chain Database)

Cryptocurrency Risk

Nvidia shareholders have learned a painful lesson in 2018 with respect to cryptocurrency impact. In 2018, Nvidia's GPUs suffered a 3MM decline in revenue as Ethereum pricing plummeted -62% from the peak. Because of that, Nvidia lost billion in market cap in Q3 alone. It was estimated that Nvidia misclassified over billion crypto revenue into Gaming, instead of in OEM (wccfetch). At the time, C.E.O. Jen-Hsun Huang admitted that he had little clarity on the state of demand for GPUs in the wake of a drop in mining enthusiasm. Recently, the concerns have become real after the reports from RBC Capital Markets and Barron's alleged that Nvidia has sold at least 5 million worth of GeForce RTX 3000 graphics cards utilizing its Ampere GPUs directly to miners. Incidentally, 5 million may be a meaningful number to explain the Q3 Gaming beat of 9 million or the shortage in GeForce RTX 3000 for the core gamers.

Admittedly, nobody really knows how to classify the revenue based on the identity of the end users. Even the company itself is in the early stages of investigating the extent of the demand for its products originating from cryptocurrency mining operations. Both Raj Gill from Needham and SA’s BVTS present solid points why this time is different. However, with Ethereum pricing today hitting a record high of over 80 versus 2018’s 86 before the collapse, it is worth alerting Nvidia shareholders for the underlying crypto risk in the background.

Takeaways

Nvidia’s Gaming and Data Center portfolio allows the company to actually benefit from a typical damaging, negative cycle. The COVID’s lockdown sent the entire country into a recession. But the resulting WFH created a demand push for Nvidia’s Gaming and DC products. When coming out of COVID, the fading WFM will be partially offset by the stimulus recovery. Industry-wide supply shortage has been one of the main reasons not to meet the surge of WFH demand. While the shortage will last through 2021, it serves as a cushion to soften the blow from the downward guidance in revenue growth for 2021 and on. Due to the offsetting post-COVID macros, the 60% y/y Gaming growth, 160% DC growth, and 50% total revenue growth in 2020 are all revised down to more sustainable levels (Figure 1, 2, 3).

For Nvidia in the post-COVID time, RTX 3000 family becomes mainstream in the gaming space. DC will be the nextgen revenue engine and artificial intelligence is still “the only game in town.” While Nvidia remains the most growth play in the semi space, considering 2020 (and COVID-19) was an aberration for the semis, a slowing post-COVID macro is coming! Nvidia shareholders should stick to their holdings, but also realize that the triple digits NVDA 2020 share gain (+120%) will not repeat in 2021.