Even if You Haven’t Bought NVDA, You Might Have Bought NVDA

That's right—if you've dipped your toes into ETFs, chances are you've got a sprinkle of NVIDIA in your portfolio. And even if you haven't, unless you've hedged all the risk factor exposures, you're probably indirectly exposed as well. So, let's dive into the company prior to the earnings release, as everyone and their neighbor will be doing. But there is a twist: we'll let NINA crunch the numbers while I bask in the glory. AI predicting the future of AI? How meta!

NVIDIA Riding the AI Wave

As we wrap up 2024, the global investment landscape feels like a high-stakes poker game—full of bluffs, surprises, and the occasional royal flush. The U.S. economy is flexing its muscles with robust consumer spending, China is shuffling its fiscal deck to stabilize markets, and geopolitical tensions are the jokers nobody asked for. Amidst it all, technological innovation—especially in artificial intelligence—isn't just another card trick; it's reshaping our global economy. While the short-term impact might be overhyped, I firmly believe the long-term effects are the ace up our sleeve.

This week, we're zooming in on one company and how NINA sizes it up. For us, long-cycle secular trends and the trailblazers dominating those fields are the compass guiding our investment choices, whether retail investors are all on board or not. In an era where AI and cloud computing have graduated from buzzwords to business essentials, and even to words that turn away investors, NVIDIA has crafted an ecosystem where it can thrive.

On the macro level, a "higher-for-longer" yield environment—driven by positive economic surprises, growth expectations, inflation jitters, and geopolitical uncertainties—sets the stage for a bumpy ride. Companies like NVIDIA are no strangers to this volatility.

TL;DR: On the macro side, policies affecting economic growth, inflation, and yields continue to toss and turn NVIDIA's valuation and multiple growth. On the micro side, trade tensions and the easing of regulatory and tax burdens play tug-of-war with earnings growth. Balancing these factors and considering the company's fundamentals, NINA projects solid earnings per share (EPS) growth over the next 5-7 years (30x PE and EPS of approximately $8.4). Discounting this back to a one year horizon would give us an approximate return of 17%. Combined with high quality fundamentals make NVIDIA also resilient in tougher economic times, we continue to favor it, regardless of what the market does after the earnings call or the bright future of small/mid caps. NINA also gives a nod to Astera Labs as an intriguing alternative for those that dont like megacaps. Below, we delve into the detailed reasoning—based on NINA's analysis, edited by yours truly to keep us both sharp.

1. Macro Trends Driving NVIDIA’s Growth

Hyperscale CapEx Surge

The world's leading cloud service providers—Amazon Web Services (AWS), Google Cloud, Microsoft Azure, Meta, and Oracle—are significantly ramping up their capital expenditures. In the third quarter of 2024, the top four hyperscalers increased their CapEx by 17% quarter-over-quarter. Moreover, analysts are consistently issuing upwardly revised CapEx forecasts.

NINA’s Estimate: Projected growth among the big five in this space is expected to continue with another 11% to 12% for next year. Translation: The cloud is pouring money, and NVIDIA is dancing in the rain. 

Hyperscale capex? Think of Hyperscale CapEx as the cloud giants' shopping spree for data centers and networking infrastructure. These investments are crucial for supporting AI workloads that require massive computational power and storage. It's like building skyscrapers for supercomputers—with more circuits and fewer elevators.

Cloud Demand for GPUs

Over the past twelve months, bookings for AWS, Google Cloud, and Microsoft have grown by 28% year-over-year. This acceleration underscores the escalating demand for AI-powered cloud services. The synergy between cloud computing and AI is creating a virtuous cycle. Enterprises leverage cloud platforms to deploy AI solutions without hefty on-premise infrastructure investments. NVIDIA's GPUs are at the heart of this transformation. By enabling scalable AI solutions, NVIDIA empowers businesses to innovate rapidly. This demand drives cloud providers to invest more in GPU-equipped servers, benefiting NVIDIA's sales. 

2. NVIDIA’s Core Metrics

Revenue Trends

NVIDIA's revenue trajectory is nothing if not impressive, which understandably makes investors anxious. In calendar year (CY) 2023, the company reported revenues of $61 billion. Projections estimate this figure will more than double to $124 billion in 2024 and reach $180 billion in 2025.

Revenue Breakdown

• Data Center: Approximately 44% of revenues, primarily from cloud vendors.

• Consumer Internet: 27% of revenues.

• Enterprise: 28% of revenues, with expectations of increased contribution as AI adoption grows.

Gross Margins and Operational Efficiency

NVIDIA's gross margins have been stable, and we expect them to remain so:

• 2023 Gross Margin: 73.6%

• Projected FY2024 Gross Margin: 74.8%

This stability is crucial in the technology sector, where margins can be as volatile as the latest meme trends. It is also something NINA looks for as an indicator of quality, as is explained below.

Operating Income Growth

• Operating Income in 2023: $33.6 billion

• Projected Operating Income in 2024: $77.8 billion

Stable gross margins indicate strong pricing power and cost control. For investors, this suggests NVIDIA can maintain profitability even as it invests heavily in research and development (R&D) and scales its operations. It's like having your cake and eating it too, without worrying about the calories.

3. The Future of AI and Enterprise

Enterprise AI Adoption

Currently, we estimate that less than 32% of NVIDIA's data center revenue is linked to enterprise AI, but this proportion is expected to grow over time. Enterprises are increasingly deploying AI to enhance operations, customer experience, and decision-making. It's like giving businesses (like us) a turbo boost in the race to the top.

NVIDIA's NIM simplifies AI deployments and significantly reduces deployment time. For example, for the extraction of data from PDF’s I can tell you from experience that the below graph, although it looks quite technical, is in fact quite a simplification of the workflow using a NIM:

Why is this significant? By lowering the barriers to AI adoption, NVIDIA encourages more enterprises to integrate AI into their operations, driving demand for its hardware and software solutions. It's the ultimate matchmaking service for businesses and AI.

AI Ecosystem Value

Specialized research estimates suggest that the total AI processor market could reach $90 billion to $160 billion by 2030. Chips like those produced by NVIDIA, are expected to capture approximately two-thirds of this market. The AI processor market encompasses the hardware used to perform AI computations and the expected growth is driven by for example:

• Increased AI Adoption across industries such as healthcare, finance, and automotive.

• Technological Advancements leading to more powerful and efficient processors.

• Emergence of New AI Applications, Such as autonomous vehicles and personalized medicine.

  
  

4. Broader Economic Context and NVIDIA’s Position

The U.S. Economy: Resilient but under Pressure

Positive surprises have continued to emerge in the U.S. For example, retail sales grew at an annualized rate of +3.5% in Q4 2024, driven by robust consumer demand despite inflationary pressures. This growth is a testament to the resilience of household spending.

Thus, real yields have been on the rise. The 10-year Treasury yield climbed to 4.46% last week and now stands at 4.4%, significantly higher than its September lows. This reflects investor expectations of better than expected growth, prolonged inflation uncertainty, and less easing from the FED. See this article for more: https://argantechnologies.substack.com/p/america-first-20-return-of-the-fiscal.

This "higher-for-longer" environment, as well as inflation and rate volatility, constrain equity valuations. Most of the yield rise lately seems to have stemmed from positive economic surprises and growth expectation adjustments, but inflation signals have been deteriorating since July—a topic we'll delve into next week. We can see the effect of real yields in the graph below, where the trend in the right chart of the rise in real yield significantly outpaces that of the bond markets inflation expectations.

How this affects NVIDIA? If we consider price to be a multiple of earnings, then this primarily affects the behavior of this multiple—whether it can grow or needs to shrink. NINA's analysis takes this effect into account, adjusting multiple growth expectations as we get more clarity on the rate trajectory and policy impacts.

I get asked the question on how rates affect multiple expansion, so below is a short example: Say we have Company A, which initially has an earnings per share of $5, a stock price of $100, and a price-to-earnings ratio of 20 (5x20 = 100). Say the multiple was based on a rate of 5%. When interest rates rise, the discount rate increases from 5% to 6%, making future cash flows less valuable in present terms. This causes investors to lower the multiple they're willing to pay for earnings, contracting the P/E ratio from 20 to 16. As a result, Company A's stock price drops to $80, calculated by multiplying the $5 EPS by the new P/E ratio of 16. This 20% decline in stock price, solely due to multiple contraction following interest rates, rather than fundamental earnings growth expectations. Companies like NVDA have high growth expectations that we extrapolate for years in the future and are as such are sensitive to bond yields. 

China’s Strategic Economic Interventions

China is not an insignificant factor for NVIDIA's performance, so let's examine some key events there as well.

Debt Swaps and Fiscal Stimulus: China's issuance of ¥224 billion in special refinancing bonds in November is part of a ¥2 trillion initiative aimed at reducing local government hidden debt and boosting economic activity. These measures enhance liquidity for local governments and foster reinvestment in critical sectors.

Housing Market Stabilization: Beijing's policies, such as reduced mortgage rates and tax incentives, aim to stabilize urban housing markets. While the long-term outlook remains uncertain, these interventions are beginning to halt declines in tier-1 and tier-2 cities.

Trade Dynamics: China reduced or eliminated export tax rebates for certain products starting December 1. This move may address complaints from trade partners regarding overcapacity and government subsidies. The timing coincides with positive economic data and Chinese President Xi Jinping’s summit visits in South America. These rebate cuts could be intended to improve relations with trade partners ahead of potential renewed trade conflicts with the U.S. A better position for China is a good start for a less bloody trade conflict.

5. Risks and Market Sentiment

Valuation Concerns

At a price-to-earnings (P/E) ratio of 39x at the time of writing, NVIDIA is trading below its 2021 highs of over 60x and has corrected from the same lofty valuations earlier in 2023. While this suggests that the stock isn't overvalued relative to its historical performance, it's essential to consider broader market dynamics. 

Relative Comparison with S&P 500

• NVIDIA's P/E Relative to S&P 500: 1.65x

• Current Discount: 19% below the median

NVIDIA's strong growth prospects and market position may justify its current valuation, but the risk of overall market multiple contraction remains.

Deceleration Risks

Despite strong growth, NVIDIA's revenue growth rate is decelerating. The year-over-year revenue growth is expected to decrease by 48% for Q3 25. Momentum indicators help investors gauge the strength of a trend. A decelerating growth rate might signal a potential slowdown, prompting investors to reassess their positions.

New Entrants, example: Cerebras

Cerebras has positioned itself as a serious contender in the AI chip market with its revolutionary Wafer-Scale Engine (WSE) technology:

• WSE-3 Chip: Boasts 900,000 AI-optimized cores and 4 trillion transistors, making it the largest commercially available AI processor.

• Performance Claims: Cerebras claims its WSE-3 outperforms NVIDIA's H100 GPU by a factor of 210 in carbon capture simulations.

• Technical Superiority: The company's chips offer significantly more cores, on-chip memory, and memory bandwidth compared to traditional GPUs.

Cerebras' Financial Performance

• First Half of 2024 Revenue: $136.4 million, a significant increase from $8.7 million in the same period of 2023.

• Net Loss: $66.6 million for the first six months of 2024, an improvement from the $77.8 million loss previously.

NVIDIA's Competitive Edge

While Cerebras presents a formidable challenge, NVIDIA maintains several advantages:

1. Market Dominance: NVIDIA's GPUs are the industry standard for AI workloads, with a well-established ecosystem and broad software support.

2. Continuous Innovation: NVIDIA continues to push the envelope with new technologies and improvements.

3. Diversified Product Line: NVIDIA offers a wide range of products beyond AI chips, reducing vulnerability to competition in any single area.

4. Financial Strength: NVIDIA's strong financial position allows it to invest heavily in R&D and marketing, potentially outpacing smaller competitors. And these companies have hefty M&A capabilities.

   
   

Conclusion

NVIDIA's strategic positioning in the AI and cloud computing landscape underscores its potential for sustained growth. The company's technological leadership, stable margins, and expanding market opportunities present a compelling case for continued success. While valuation concerns and revenue growth deceleration pose risks, the overall market trends favor NVIDIA. The significant increase in hyperscale CapEx and the burgeoning demand for AI solutions in enterprises suggest that NVIDIA is well-placed to pioneer the data-centric future.

For investors seeking exposure to the AI and cloud computing sectors, NVIDIA offers a blend of strong fundamentals and growth potential. But remember, investing in companies involves risks, both macro and micro risks, and it's essential to conduct thorough due diligence. This is not investment advice—just your friendly neighborhood analysis and a look under the hood at how AI can analyze AI!

Starting May of this year, the strategy derived from NINA for the Argan Agentic Fund went live and has returned ~23% (Current Estimate). Our older system, prior to NINA, has a model portfolio going back to 2021. Including its performance would put the YTD results at 35% with a long-term annualized vol of 10.4%.

At Argan.ai, our philosophy is straightforward: we put our money where our insights are. We're not just observers; we're participants in the markets we analyze.

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