Feb 3 2022 - Nvidia's Automotive Business Could Drive Continued Outperformance

Summary

• NVDA has been on an incredible run of late, fueled by tremendous growth across its business segments.
• Despite its incredible technical prowess, the stock remains relatively expensive.
• We provide our full valuation model as part of initiating coverage of the stock.
• 

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NVIDIA (NVDA) has been on an incredible run of late, fueled by tremendous growth across its business segments. Revenue has more than doubled over the past 3 years, resulting in explosive economies of scale. Gross margins are up nearly 500 basis points while operating margins are up over 900 basis points. Free cash flow has increased by 2.3 times over that span.

NVDA (NVDA Investor Presentation)

While the business itself is clearly very strong and growth momentum is impressive, the expected slowdown in growth and the premium valuation multiples attached to the stock - even after the recent pullback in the share price - imply that it is not a Buy at the moment. On the other hand, the explosive growth potential in the automotive business could be an x-factor that drives continued outperformance for the company. In this article, we will overview the business as a whole and then discuss the qualitative aspects of the automotive business that indicate massive growth could materialize there.

NVDA Stock Has A Wide Moat Business Model

Even more importantly, the company possesses a wide moat due to its intellectual property. Thanks to its leading position in the GPU space, the company plays an integral and increasingly prominent role in the global economy.

As the leader in the space, NVDA is able to attract among the very best talent in the industry that it retains through generous compensation packages and a large research and development budget. In our view, this positions the company to retain its technical edge in the industry and continue to innovate to compound its intellectual property driven competitive advantages. This makes the business model fairly low risk and gives it tremendous long-term potential. We also see this competitive advantage on display in its superior profitability metrics compared to its rival Intel (INTC):

NVDA Stock Has A Massive Growth Runway

Thanks to its world-class brain trust, strong base in technology and basic research, and strong macro tailwinds for its industry, NVDA has nearly limitless opportunities to grow. The company has already begun expanding into new markets, including data centers and autonomous driving:

NVDA (Investor Presentation)

These initiatives have already gained substantial momentum as its data center business saw 53% year-over-year growth in the first nine months of 2021 and its automotive business saw 13% year-over-year growth in the first nine months of 2021.

Meanwhile, its core gaming business soared by 72% year-over-year and its professional visualization business was its fastest-growing business, up 97% year-over-year, though it is still dwarfed in size by its gaming and data center businesses.

Long term, the data center and the automotive businesses should see significant sustained growth as both markets are massive and set to grow for many years to come. With artificial intelligence technologies exploding as well as the metaverse just beginning to take off, NVDA has enormous potential to increase the applications of and markets for its technologies.

One way in which NVDA has been aggressively pursuing growth is its attempt to acquire ARM from SoftBank (OTCPK:SFTBY) for billion. However, regulators spanning from the U.S. to Great Britain to China are expressing concern over the deal from both anti-competitive as well as national security perspectives. As a result, this deal may very well fall through and would potentially weaken the pro forma competitive standing and growth outlook for the company.

Nevertheless, analysts still see a robust growth outlook for the company through at least 2025. Analysts expect revenue to soar from the expected .7 billion through 1/31/22 to .9 billion in the twelve months concluding on 1/31/26. That translates to robust 21.4% annualized growth off of an already substantial revenue base.

EBITDA is expected to grow at a similarly impressive CAGR of 20.5% over that span, and normalized earnings per share are expected to compound at a 24.9% annualized rate. The normalized earnings per share number is the most important because not only does it indicate the true value creation for shareholders but it also takes into account the dilutionary impacts of the company's aggressive stock-based compensation program that it uses to attract and retain the best and brightest minds in the industry.

NVDA Stock's Valuation Still Looks A Bit Rich

While the stock price has had a pretty substantial pullback over the past several months alongside the broader tech sector, the valuation still appears rather rich:

For example, both its price to normalized earnings and enterprise value to EBITDA ratios appear elevated relative to its recent historical averages:

NVDA Valuation (TIKR )

What makes this premium appear even larger is the fact that interest rates are poised to rise even as NVDA's growth rates are set to decline over the next four years to a level that is less than half of what the company has achieved over the past few years.

While a low-to-mid 20s growth rate is impressive, especially given how large the company's revenue base has become, it is increasingly difficult to justify accepting a ~2% earnings yield with a 20%-25% growth rate when interest rates are poised to surge. Furthermore, there remains substantial supply chain and geopolitical risk that could hurt the company, as the winding course of the ARM acquisition attempt illustrates.

Does this make NVDA a sell here? Likely not, and we certainly would not want to short it ourselves. The company has enormous competitive advantages that are likely to grow over time and the growth should be strong, though perhaps not spectacular moving forward.

Further discouraging us from taking a bearish perspective on the stock is the simple fact that it has a fortress balance sheet and strong financials. As of its last reporting, NVDA had over billion in cash and short-term investments as well as another roughly .5 billion in receivables, inventory, and prepaid expenses on its balance sheet, against just .8 billion in total liabilities (of which only .6 billion is current and .9 billion is long-term debt).

Given its aforementioned returns on invested capital and equity, its 25% free cash flow margins, and expected free cash flow annualized growth rate of nearly 30% over the next four years to an expected .5 billion in annual free cash flow by 1/31/26, NVDA is truly in an extremely strong financial position.

Automotive Business Is The X-Factor

While NVDA does not look that cheap from a big picture perspective, the automotive business is an area where it could outperform analyst expectations and drive further alpha for shareholders.

The automotive business is currently NVDA's smallest and slowest growing market platform, comprising just 1 million of its 2022 revenue through the first nine months of 2021, compared to billion from gaming, .4 billion from data centers, and .5 billion from professional visualization. Meanwhile, its year-over-year growth rate was just 13%, compared to 72% growth in gaming, 53% growth in data centers, and 97% in professional visualization. However, these surface-level metrics understate the segment's true potential. If NVDA can successfully unlock this, it could substantially outperform analyst expectations for the business as a whole.

The most obvious aspect of NVDA's automotive business is the sale of its GPUs and SoCs that it sells to automakers and automotive suppliers for the immediate manufacture of vehicles. While this business is a nice cash cow for the company, it actually does much more than this, and this is where the long-term power of this business lies for NVDA.

For example, NVDA has literally hitched its cart to TSLA's autonomous vehicle horse(power). NVDA technology plays a vital hardware and software system development role at the TSLA data center where they train the autonomous vehicle artificial intelligence, putting it at the cutting edge of autonomous vehicle technology development. They even used to provide hardware for the computers that were installed in all Tesla vehicles, but have since been displaced by TSLA producing its own hardware.

NVDA has also formed close partnerships with Mercedes-Benz (OTCPK:DDAIF), where it is using NVDA supercomputers to play a key role in helping the automaker create a full lineup of vehicles based on a software-designed-architecture. As the designer and facilitator of this software stack and system, NVDA will then be ideally positioned to profit over the long term from this partnership by providing software updates and additional applications to Mercedes-Benz and its consumers for many years to come. This means that NVDA could very well have a substantial automotive applications services business in the not-too-distant future that could turn into a substantial cash cow and growth engine for the company.

Furthermore, NVDA will be playing a significant role in developing the "brain" (i.e., the A.I. supercomputer) for some - if not many - of the autonomous and electric vehicles of the future, which is really the core of the overall product.

As Sam Abuelsamid from Navigant Research recently stated:

Virtually every company working on AVs is utilizing NVIDIA in its compute stack.

Some of these technologies are already here, including its recent launch of its Drive Concierge (that provides a number of autonomous services including parking a car by itself) and an Omniverse Replicator that enhances training autonomous vehicles by putting some of the tasks in a virtual world.

As a result, it may be seriously underappreciated by the stock market today for its automotive industry prowess. If it can extend its automotive-oriented technology partnerships with firms beyond Mercedes-Benz, its growth could explode and make it one of NVDA's largest - if not its largest - market platforms.

In fact, according to Allied Market Research, the global autonomous vehicle market is expected to reach 6.7 billion by 2026. NVDA has not even generated half a billion dollars in revenue from its automotive platform over the past nine months, though it does have about billion in revenue booked for the segment over the next several years. If the company can simply gobble up 4% of the global autonomous vehicle market by 2026, it could very well become its largest business segment and enable it to crush analyst expectations for the company over the next half-decade. Given its strong technical position, this is certainly possible.

Investor Takeaway

Thanks to its wide moat business model, strong profitability, massive and quickly growing cash pile, and substantial growth outlook, NVDA definitely belongs in the same conversation as other higher growth mega-cap tech stocks like Alphabet (GOOG), Microsoft (MSFT), and Tesla (TSLA). In fact, given the explosive growth potential in its automotive business, it could also be increasingly considered as an emerging automotive technology company.

That said, it is not a risk-free investment. Given the economic and even national security mission-critical roles that its products and technologies increasingly play on the global stage, NVDA will have to constantly be dealing - and likely battling - with government regulatory agencies as it seeks to grow further. In the immediate term, this risk is manifested in its increasingly challenged effort to acquire ARM. Furthermore, it will likely face competition in fields where it seeks to expand while also holding off challengers like INTC and Advanced Micro Devices (AMD) which are investing aggressively to catch up to and even surpass NVDA wherever possible.

Meanwhile, on the automotive side, TSLA's ability and willingness to produce its own hardware and much of its own software shows that NVDA could face some headwinds in the future when trying to grow its automotive business if other automakers adopt a similar course. Additionally, there will be competition from the likes of Waymo and even Wejo (WEJO) could pose some competitive challenges as it has partnered with data analytics powerhouse Palantir (PLTR) to enhance the development of its autonomous vehicle technology.

On top of that, the stock looks a bit pricey here - despite its growth momentum and obvious strengths - especially in the context of rising interest rates and slowing growth rates. While the pullback in the shares was certainly warranted as the valuation had gotten ahead of itself due to market jubilation, we think a further 10-20% pullback is warranted before the shares are worth buying.

Between general geopolitical and macroeconomic risks as well as a potential downward catalyst from the ARM acquisition formally being nixed, the risk-reward seems to favor remaining on the sidelines here. As a result, we are neutral on shares at the moment, but would certainly be happy to buy on a further pullback.