This commentary was originally sent to Action Alerts PLUS subscribers at 06:30 on Nov. 15.
Background: We have no position in the name, but as part of our autonomous driving index, below is analysis around Nvidia's (NVDA) quarter and Educational Lesson for Members (NVDA high rate of retail ownership).
There are blowout quarters and then there are quarters like the one Nvidia delivered last week, which are defining lines in the sand, rare moments which are irrefutably flawless and reshape the entire investment thesis for bears and bulls alike. Nvidia's fiscal third quarter 2016 results caused even the fiercest bears to stand up and applaud as management took an extended bow in the form of what can only be described as a flawless, jaw-dropping and impeccable quarter.
Let's start with some facts. Nvidia earned as much in the third quarter as the company earned in all of calendar year 2015. Whenever a company that has been blowing past consensus for ages ups the ante to this extent, the story shatters through the ceiling and pulls shares up and into the rare halo effect, shielding the stock from the trappings of any valuation-based multiple. When this happens, it is critical to walk through the results and examine exactly how a company known for setting the bar high managed to soar above even the highest-flying bulls while punching above its weight until it delivered the knockout blow to the residual short thesis. We do not own Nvidia, though it was a member of our first autonomous driving index (from our last conference call, among which include Harman (HAR) , which was separately acquired Monday morning for a hefty premium).
Since Nvidia is widely held by individual investors and institutions alike, we wanted to, at minimum, use its results as a case study in evaluating a company that is either on track to take share from an expanding pie of an addressable market, or propped up to levels which make future quarters that much harder to replicate.
Back to the results. Nvidia reported fiscal 3Q sales of $2 billion (up 40% quarter/quarter and 54% year/year), a full 20% above consensus expectations for under $1.7 billion. Meanwhile, gross margins managed to expand 120 basis points to 59%, a full 100 basis points ahead of consensus at under 58%.
So what can we learn? First, the sign of a good quarter is a healthy dose of sequential as well as year/year acceleration. The sign of a great quarter is when such prolific levels of both sequential and annual growth are combined with significant margin expansion. Second, quarterly earnings results are always about expectations rather than absolute results. When a company clears a low hurdle, a relief rally ensues. When a company known for topping consensus does so, the market typically offers a muted reaction at best. When a company crushes expectations for consecutive quarters before blowing out any conceivable expectations in step-change fashion, introducing new legs to the growth story while they are at it, the result is exactly what we saw with Nvidia shares. We saw an outright explosion that precipitated a chain effect involving an epic trifecta, which included a severe short squeeze (when investors short the stock are forced to cover their position and cut losses), a surrender on behalf of the remaining bearish sell-side analysts who had no choice but to wave the white flag of surrender, and new buyers emerging late to the party. The new buyers wanted to latch onto the momentum while making sure not to miss out on the opportunity to pile into what may be the last remaining standalone growth story that does not need to be taken over in order to separate itself from the "large and lumbering" or "if you can't beat 'em, join 'em" mentality legacy titans find themselves falling within.
First, Nvidia demonstrates the unique ability to deliver multiple shots on goal amid the backdrop of a broader semiconductor group which, however innovative, is either held hostage to the law of large numbers (where no amount of incremental innovation manages to move the needle), facing an identity crisis in the absence of Moore's Law continuing into perpetuity, and finally a fundamental lack of differentiation. Unsurprisingly, larger chipmakers have either participated in consolidation -- Samsung's acquisition of Harman announced Monday morning is the latest example, while Analog Devices (ADI) acquired Linear Technologies (LLTC) to tap into the company's niche leadership in power/electrical management and Softbank agreed to buy ARM Holdings (ARMH) to expand into the broader Internet of Things space). Of course, AAP favorite NXP Semiconductors (NXPI) agreed to be acquired by Qualcomm (QCOM) in a deal formally announced two weeks ago for roughly $50 billion in cash, illuminating the power commanded by a company that has out-innovated and methodically established true leadership positions in lucrative end markets. NXP is outsized leader in the auto market, with #1 position across security, safety, mobility, connectivity and vehicle networking. The consolidation of 2016 is merely an extension of what has been an ongoing trend across the industry.
Nvidia's quarter demonstrated the ability to scale the highest level of both graphical computing power within a chip and accelerated computing on a cloud. This dual capability -- which has been responsible for Nvidia's dominance in the ultra-defensible PC gaming frontier -- has now made a powerful step-change into new, highly lucrative end markets, which formally take Nvidia beyond the consumer sphere and above the high barrier to entry, yet deep-pocketed world of global enterprise services and cloud data centers.
Before touching upon the latter, it is always critical to remember to never overlook a company's core area of growth which, for Nvidia, is PC gaming (which comprises roughly two-thirds of sales). In order for a company to drive home outsized growth across new end markets at a sustainable rate, it must continue to assert dominance within its core, baseline growth market. Nvidia certainly checks off the box in this category, delivering 63% or nearly $500 million year/year growth to $1.2 billion. Nvidia's dominance in PC gaming is the reason why it exists and has been able to afford horizontal and vertical expansion into new growth opportunities.
The company's gaming prowess is testament, to at minimum, to the resilience of PC gaming as a secular tailwind, as well as Nvidia's differentiated position, which is transcendent. In short, we now know that gamers will game and pay up for quality (i.e. highest graphic and processing speeds) irrespective of the consumer backdrop. Game, set, match, Nvidia -- although Advanced Micro Devices (AMD) , which makes a similar chip yet has been shedding relative share to Nvidia of late, may beg to differ and will be sure to combat, with biggest risk being the onset of a pricing war.
Now that we know the core is humming along just fine, we can take a look at the future of growth. For Nvidia, this quarter demonstrated that future growth is all about data centers, which posted 59% sequential growth, which more than validates the theory that Nvidia's GPU and Deep Learning platform possesses uniquely competitive advantages, which are allowing it to capture demand from an increasing number of deep learning providers as well as enterprise IT conglomerates. Each of these view the company's capabilities as an opportunity to accelerate their own shifting business models away from hardware and towards value-add areas, elevating legacy enterprise businesses with growth-potential infused within the confines of a chip which packs power, best-in-class graphics as well as the trifecta that is deep learning software. Every analyst who has pushed back on valuation is forced to reconsider Nvidia's position within the broader industry, as well as its ability to scale its core functionality into areas where IT budgets are greater than Nvidia's annualized revenue.
Even if you assume gaming plateaus -- rapid adoption of high-end technology may reach a tipping point -- the data center and broader enterprise IT architecture "hyperscale" integration creates the largest opportunity and could underpin a multi-year growth story. What does this mean? There is a structural shift taking place in how enterprises view NVIDIA, distinct from its chipmaking peers as it is doing something that no other chip company is doing: taking GPU-accelerated deep learning capabilities and applying it to enterprise solutions and processing large sets of data. As bigger customers integrate Nvidia to power their enterprise cloud solutions at the highest processing speeds while offering a compatible and fluid deep learning/artificial intelligence platform -- again, all hosted on the cloud -- its value proposition experiences a refresh, as its total addressable market expands parabolically.
So what can we extract from the Nvidia's transformative, game-changing quarter? Even if gaming plateaus, the company has innovated its way into new adjacencies which -- if executed, "hyperscaled" and integrated seamlessly, and that's a major "if" -- would solidify its halo effect.
The company is getting paid its fair due, and its ability to grow into the mammoth valuation ascribed to it depends less on potential and more on execution, the latter of which has always made betting against the company a losing battle. We would be remiss not to highlight the fact that Nvidia has not distinguished itself in the autonomous driving space beyond its strong relationship with Tesla (TSLA) , the only client it counts among the entire industry and one which is tethered to promises, rather than tangible solutions. There is no doubt that the demand for chip content in cars is an investible theme, but Nvidia should not be considered a proxy for autonomous driving (in fact, autos were the only area the company missed expectations, albeit by a narrow margin). It certainly has room to grow and an opportunity to penetrate, but at 6% of sales it fails to be a meaningful contributor, despite the dazzling promises of an imminent future of a road filled with driverless vehicles.
Bottom line: Nvidia delivered the quarter to eclipse all quarters, forcing a deserved upward rerating, which it is unlikely to shed any time soon. Going forward, Nvidia should and will be valued on its hybrid growth story for GPU and deep learning to enterprise solutions, cloud-based, and of course gaming, but not autonomous driving. The company boasts a near-$60 billion market cap, which makes the risk/reward less compelling at current levels, however arbitrary its valuation may be. It is unlikely to experience a linear continuity of growth, but sure as hell is not worth betting against, as it has proven itself capable of the near-impossible.