Jan 28 2022 - Nvidia: Time To Buy The Drop

Summary

  • In my opinion, Nvidia’s ARM acquisition is unlikely to get approved.
  • Nvidia is reportedly prepared to walk away from the deal amid regulator objections. Nvidia may console shareholders with a share buyback if the deal falls through.
  • Even without ARM, Nvidia is going to see a massive ramp in free cash flow until FY 2026.

 

Graphics Chip Maker Nvidia Reports Quarterly Earnings

Justin Sullivan/Getty Images News

 

Because of burgeoning investor optimism about Nvidia's (NVDA) commercial and stock prospects, I exited my investment in the semiconductor firm in November. I repurchased shares of Nvidia at the beginning of this week again because they are oversold and the firm will do with or without the acquisition of chipmaker ARM.

 

Buying back shares of Nvidia as I expect the ARM acquisition to fall through

Shares of Nvidia were, for me at least, a Sell in November due to the firm's very high P/S and P/FCF ratios, which suggested that the firm's prospects were overvalued. But things have changed lately, in large part because the tech sector is correcting. Together with the technology index Nasdaq, Nvidia moved into a downleg in January 2022. Besides an accelerating sell-off related to growth stocks, I believe the ARM acquisition proposed by Nvidia in 2020 is likely not going to get regulatory approval... and changing acquisition prospects are weighing on Nvidia's shares as well.

 

Chart Data by YCharts

 

Reports from yesterday indicate that Nvidia is prepared to walk away from the B ARM acquisition, which would have given Nvidia access to critical chip infrastructure that is widely used in the industry. Regulators have questioned the deal and concerns have mounted that Nvidia's ARM acquisition could harm competition and lead to higher prices. The Competition and Markets Authority, the U.K.'s regulator in charge of approving mergers and acquisitions, has even cited national security concerns as a justification to probe the requested acquisition of ARM more thoroughly.

Nvidia is the second-largest chipmaker in the world based on market capitalization, after Taiwan Semiconductor Manufacturing Company (NYSE:TSM). Nvidia's large size and importance in the industry explain why regulators in multiple jurisdictions have reservations about Nvidia's ARM acquisition.

 

Bloomberg Nvidia Market Cap And Rivals

Bloomberg

 

 

If the deal falls through, which I believe has become much more likely this week, Nvidia is set to lose .25B in advance payments the firm made to ARM's owner, Japanese investment firm and conglomerate SoftBank Group (OTCPK:SFTBY) (OTCPK:SFTBF). While Nvidia, due to record revenues and free cash flow, can afford to lose this money, a failed acquisition would be a short-term setback for the firm's expansion plans.

Look for a buyback if the deal falls through

Nvidia may settle for a billion-dollar buyback program to console shareholders of Nvidia for the lost opportunity to acquire ARM. This would also give Nvidia a chance to return some of its swollen cash pile back to investors. By October 2021, that cash pile had grown to .3B.

 

Nvidia Cash Balance

Nvidia

 

Nvidia will do well without the ARM acquisition

Considering the information available today, I believe that the ARM acquisition will not close. But even if Nvidia fails to acquire ARM's chip architecture, the semiconductor firm will likely see a massive ramp in free cash flow over the next five years. The reason is that Nvidia's core businesses - and also its niche segments like professional visualization or automotive - are performing better than ever.

Nvidia's Q3'22 revenues surged 50% year over year to .1B due to impressive commercial performance chiefly in Nvidia's Gaming and Data Center businesses. Gaming revenues soared 42% year over year to .2B billion while Data Center revenues gained 55% year over year to .9B. The Data Center business is likely going to overtake Nvidia's Gaming business in FY 2022 as the firm's largest revenue-generating segment. Nvidia's gross margins, a very important metric for semiconductor companies, saw a 260 bps increase year over year to 65.2% (GAAP) and a 150 bps increase year over year to 67.0% (Non-GAAP).

 

Nvidia Q3

Nvidia

 

 

For the fourth-quarter, Nvidia expects continual revenue gains and stable gross margins. The outlook projects revenues of.4B +/- 2 percent and a gross margin (Non-GAAP) of 67.0% +/- 50 basis points for Q4'22.

Up to B in cumulative free cash flow until FY 2026

Key to my decision to repurchase shares of Nvidia this week is that the firm's free cash flow prospects are underpriced again. Due to strong market demand for GPUs and cloud-based applications, Nvidia has seen a 3.2x factor increase in free cash flow in the last five years.

 

Nvidia Free Cash Flow

Nvidia

 

Nvidia doesn't give free cash flow guidance but we can derive a free cash flow estimate for Q4'22 and future fiscal years by applying Nvidia's FCF margin to the firm's revenue guidance and estimates. Nvidia generated free cash flow of ,677M in FY 2021 on revenues of ,675M which calculates to a free cash flow margin of 28%. In the first nine months of FY 2022, Nvidia generated free cash flow of ,310M on revenues of ,271M which implies a FCF margin of 27.6%. If Nvidia can generate the same FCF margin in the fourth quarter and assuming .4B in revenues for Q4'22, then Nvidia stands to add another .1B in free cash flow in the last quarter of fiscal FY 2022. This would bring Nvidia's free cash flow for the entire year to around .5B.

What specifically supports Nvidia's free cash flow growth is that, despite a better flow of graphics processing units, pricing is still very strong in the GPU market. Pricing for high-performance graphics cards has been driven, in part, by record demand for GPUs from cryptocurrency miners in 2021. Although cryptocurrency prices have decreased lately, GPU pricing is still very strong. High average selling prices also could have a positive gross margin effect on Nvidia, at least in FY 2022. Nvidia's GeForce RTX 30 graphics card series currently costs 77% more than the manufacturer's suggested retail price.

 

 

Nvidia/AMD GPU prices

3DCenter.org

 

Based on Nvidia's revenue estimates, supplied by Seeking Alpha, the semiconductor firm could generate .5B in revenues this year. Applying a 28% free cash flow margin, Nvidia could generate up to .8B in free cash flow in FY 2023, and a total free cash flow of B in the 5-year period from FY 2022 to FY 2026.

However, Nvidia has potential to increase its free cash flow margin as it rolls out new chips that specifically support applications for the metaverse.

The metaverse connects 3D virtual worlds and requires high-performance hardware and software products. On the hardware side, Nvidia's GPU segment is set to benefit from growing demand for graphics cards that are capable of running applications for the metaverse. Bloomberg valued the metaverse opportunity at 0B in December 2021. On the software side, Nvidia can grow through the Omniverse Enterprise platform.

Nvidia's Omniverse Enterprise is where the big software bucks are waiting for the semiconductor firm. Omniverse Enterprise is an end-to-end collaboration and virtual world simulation platform. Omniverse has been downloaded by about 100,000 creators in the last year and Nvidia is monetizing the platform through a subscription model. Growing uptake of Nvidia's Omniverse Enterprise platform in the future could fuel Nvidia's revenue growth.

  FY 2022 FY 2023 FY 2024 FY 2025 FY 2026
Revenue Estimates ($B) .7 .5 .7 .3 .0
Free Cash Flow Margin 28% 28% 28% 28% 28%
Estimated Free Cash Flow ($B) .5 .8 .3 .7 .2

(Source: Author)

Because of the large drop in pricing shares of Nvidia lately, the firm's free cash flow has been heavily discounted. Shares of Nvidia trade 36% below the 6.47 high, meaning Nvidia's free cash flow prospects have also been discounted by 36%. Based on B in expected free cash flow for next year, Nvidia's commercial prospects have a P/FCF ratio of 56x. When I sold Nvidia in November, the P/FCF ratio was 85x.

Risks with Nvidia

I believe it is more likely than at any time in the last 15 months that the ARM deal will not get regulatory approval. However, prospects for a failed acquisition now already seem to be reflected in the pricing of Nvidia's shares. The biggest risk for Nvidia is that revenue and free cash flow growth could moderate in the future. I believe this risk is small to begin with, but it is a risk for Nvidia. What I also see as a risk is a potential moderation in GPU pricing which has heavily supported revenue gains in Nvidia's Gaming business in 2021. Declining cryptocurrency prices could lead to fewer sales of Nvidia's cryptocurrency mining processors.

Final thoughts

While Nvidia's B acquisition of U.K.-based ARM could fall through, the firm's core businesses are performing very strongly right now and momentum in the Gaming and Data Center business is likely to be sustained in FY 2022. Investors may look forward to a share buyback when Nvidia formally ends its pursuit of ARM. Because of the steep drop in pricing, a huge metaverse growth opportunity and a much lower P/FCF ratio compared to November, I have moved back into shares of Nvidia.

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