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Artificial Intelligence Is Key to Nvidia Stock’s Turnaround

Mark R. Hake

Nvidia Corp (NASDAQ:NVDA) the giant $91 billion market cap gaming chip maker, reported second-quarter earnings that signal the importance of artificial intelligence (AI) for its future. Its latest results show AI is leading its turnaround.

Artificial Intelligence Is Key to Nvidia Stock's Turnaround

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NVDA’s new gaming RTX chips use AI to simulate light (called “ray tracing”). Its hyperscale data center clients are increasingly buying Nvidia chips to enable their AI conversation and training bots. Nvidia is also leading in the autonomous vehicle market which need AI chips.

The Q2 earnings which Nvidia reported on Aug. 15 showed a marked turnaround. On the follow-up call, NVDA’s CEO highlighted the how AI is powering Nvidia’s growth in these markets.

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NVDA reported Q2 sales of $2,579 million, down 17.4% from the prior year, but up 16.1% from $2.22 billion reported in Q1 2019.  NVDA’s Q3 sales guidance was $2.9 billion, plus or minus 2%.

NVDA is now back on a growth path. Three months ago Nvidia stock was trading for $169 per share when it reported Q1 earnings. Today the Nvidia stock price is trading for $156.83 after hours. The market is starting to believe in the turnaround.

Downturn Ended

Nvidia sources most of its manufacturing in Taiwan. So it is not directly affected by Chinese chip suppliers, the China yuan devaluation, and the U.S. China trade war. However, it is facing competition from Chinese data centers which buy chips elsewhere.

In May Nvidia’s CEO, Jensen Huang, told CNBC that “there was no question in my mind that the spending pause has ended” in their portion of the chip market. NVDA’s figures today clearly showed this improvement.

Gross Margins

Analysts focus on Nvidia’s gross margins as a bellwether of its financial health. In Q1 NVDA reported lows of 59.0%, and this quarter it hit 60.5%, both on a non-GAAP basis. NVDA’s outlook for Q3 is for 62 to 62.5%, plus or minus 0.50%. Take a look at this chart taken from the Nvidia CFO’s Commentary on Aug. 15, 2019:

The reason this is important can be seen using the guidance for Q3. With sales at $2.9 billion next quarter, $765 million in operating expenses and $25 million in other income, with a tax rate of 10%, the estimated earnings per share next quarter will be $1.59, up 28.5% on the quarter:

Bargain at This Price

On an annualized run rate basis for the next 12 months full year earnings will be $6.37 per share. The earnings are also likely to incrementally increase 10 to 15% for each quarter as the turnaround grows each quarter. That implies a 12 month forward EPS of $7.40 to $7.96. At this price the implied price-to-earnings ratio is between 20 and 21x.

Analysts covered by Yahoo! Finance have the stock trading at a forward P/E ratio of 20x, so this is in line with those analysts. At this price, the stock looks like a reasonable bargain.

Nvidia Is Full of Cash

NVDA has $8.475 billion in cash, no debt and is free cash flow positive. Its latest Q2 filings showed that free cash flow was $823 million for the quarter, and this represented 89% of its net income of $923 million. I estimated that NVDA will have accumulated $10.7 billion in cash by the end of the year. NVDA has suspended its share buybacks until then.

NVDA agreed to buy Mellanox Technologies (NASDAQ:MLNX) for $6.9 billion in cash, including debt. This should close by year end 2019. I estimate that NVDA will still have over $3.8 billion left over after the deal closes. NVDA plans to then restart buybacks.

Bottom Line on Nvidia Stock

Nvidia’s business is now showing clear signs of a turnaround. Demand for its AI chips in gaming and data centers is rising. It is generating free cash flow each quarter, and will be accumulating cash up to year-end when it buys Mellanox. At this price, Nividia stock has a low P/E ratio. It is probably a good time to jump back in on Nvidia stock.

As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities.

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