• Market leadership in PC/data centre dGPU market with 88%/95% share. The leadership has been accompanied by attractive and stable gross margins of ~60%.
• Data Centre revenue quintupled in 3 years to be company’s largest segment with growth expected to continue at 2-year CAGR of 19%, leveraging on the increasing popularity of AI adoption in enterprises.
• Initiate coverage with a BUY recommendation and DCF-based target price (WACC 6.8%, g 4.5%) of US$315.00. We expect NVDA to benefit heavily from the increasing popularity of AI, and Gaming to recover as channel inventory normalizes.

Company Background

NVIDIA Corporation (NVDA) designs and sells Graphics Processing Units (GPU) that are responsible for rendering photo-realistic graphics in consumer PCs as well as other computationally intensive tasks, such as high-performance computing (HPC), artificial intelligence (AI), data science, robotics, and more recently, autonomous vehicles. NVDA reports in two business segments: Graphics (44% of FY23 revenue), which includes revenue from gaming and professional visualization; and Compute & Networking (56% of FY23 revenue), which includes its data centre, automotive, and robotics businesses.

Investment Highlights

1. Market leader in discrete GPU. NVDA possesses a dominant market presence in the discrete GPU (dGPU) market, holding ~88% share of the PC discrete GPU market and ~95% of the market for data centre graphics processors. The market leadership is attributed to its superior product performance, powering 72% of total and 90% of the new systems on the 2022 world’s top 500 supercomputers list. Its GPUs also power 23 of the top 30 supercomputers on the Green 500 list, demonstrating their energy efficiency. The programming language CUDA, developed by NVDA, was the first to allow developers to code directly to the GPU. This language is widely adopted by developers worldwide and it runs solely on NVDA GPUs, locking them into its platform and acting as a strong moat for the company.
2. Strong growth momentum in Data Centre. NVDA’s Data Centre revenue quintupled within three years from US$3bn in FY20 to US$15bn in FY23 and is expected to continue its growth trajectory. The demand for AI in data centres is growing as enterprises from various industries attempt to integrate AI into their operations. With its strong expertise in AI, NVDA stands to benefit from this trend as the worldwide spending on AI-centric systems is estimated to grow at a 4-year CAGR of 27% to surpass US$300bn by 2026. The versatility and capability of generative AI, demonstrated by OpenAI’s ChatGPT, has spurred interest in enterprises to develop and deploy the technology and we expect this to provide tailwind as it coincides with the launch of NVDA’s next-generation Hopper data centre GPU and Grace CPU.
3. Stable margins. NVDA has been able to achieve increased gross margin, from 59% in FY17 to a high 65% in FY22, while net margins were relatively stable at ~30% range. Excluding one-off inventory charges and acquisition termination charges, gross/net margins were 65%/29% in FY23 despite a 39% YoY increase in R&D expenses, indicating NVDA’s ability to pass increased costs to its customers. We view NVDA’s stable cost structure to be favourable as growth in revenue should translate to an increase in earnings. NVDA has guided for a gross margin of 66.5% in 1Q24, higher than the 63.3% it achieved in 4Q23.

We initiate coverage with a BUY rating and a target price of US$315.00 based on DCF valuation, with a WACC of 6.8% and terminal growth of 4.5%.

REVENUE

NVDA posted a total revenue of US$27bn for FY23, which was flat YoY. The company reports in two segments: Graphics and Compute & Networking, with each of them comprising revenue from different sets of end-market usage of its GPUs. The Graphics segment contains revenue from the company’s Gaming (34% of FY23 revenue) and Professional Visualization (6%) businesses, while the Compute & Networking segment is made up of NVDA’s revenue from Data Centre (56%), Automotive (3%), and OEM & other (2%) (Figure 1).

Gaming: NVDA started its business by selling graphics cards that are used to render high-definition graphics for PC games. As such, it was the company’s main revenue contributor, consistently making up the largest proportion of its total revenue since its founding until FY23, which was eventually taken over by the Data Centre segment. The Gaming business earns revenue by 1) selling graphics cards to the general PC users; 2) selling GPUs to PC component manufacturing partners; 3) charging subscription fees for its cloud game streaming service GeForce Now; and 4) selling development services for console gaming devices.

Revenue from this segment was US$9bn in FY23, falling by 27% YoY. The drop was due to NVDA having lower sell-in to partners since 2Q23 to help reduce channel inventory levels as gaming demand was hindered by the macroeconomic environment and COVID-19 related disruptions in China. The decrease could also be attributed to the transition of Ethereum from proof-of-work to proof-of-stake, which caused lower graphics cards demand from cryptocurrency miners. The Gaming segment saw a 16% QoQ revenue increase in 4Q23 due to the improvements in channel inventory levels as well as the ramp-up of NVDA’s new GeForce RTX GPUs based on the Ada Lovelace architecture (GeForce RTX 40 series). NVDA is expecting a strong QoQ revenue growth for the segment in 1Q24 as it believes the channel inventory correction has concluded.

Data Centre: The Data Centre segment took over Gaming as NVDA’s largest revenue contributor in FY23. This segment sells GPUs that are designed for data centre use cases, such as data analytics, artificial intelligence, machine learning and inferencing, as well as data centre networking solutions, including network interface cards and advanced Ethernet connections. NVDA also has a software licensing business that mainly stems from its NVIDIA AI Enterprise offerings. The data centre segment earns revenue by: 1) selling data centre GPUs; 2) selling supercomputing systems to enterprises; and 3) charging software subscription fees for NVIDIA AI Enterprise.

Revenue from this segment grew 41% YoY to US$15bn in FY23. The increase was mainly attributed to the continued strong growth in sales to hyperscale customers as well as cloud service providers. In 4Q23, the segment faced a 6% QoQ decline, 11% YoY increase in revenue. The QoQ decline was due to cloud service providers tightening spending towards the end of the year as they recalibrate their respective build plans. The lower QoQ sales were also attributed to lower sales in China, reflecting the COVID-related and other domestic issues in the country. Although there was no breakdown between hardware and software revenue, management indicated that the latter is currently contributing hundreds of millions in revenue to the company’s business. NVDA is expecting continued strong growth in its Data Centre business as it further ramps up the shipment of its new H100 data centre GPU as well as the strong customer interest in generative AI.

MARGINS

NVDA’s gross margins have generally been stable at ~60% levels since FY17. However, the company experienced a decline in gross margins to 57% in FY23. This was because of the US$2bn inventory charge due to the excess supply of Ampere-based gaming and data centre GPUs as demand was lower than its projection, particularly for the expected demand in China. Excluding this inventory charge, the gross margin for FY23 would have been 65%. We expect gross margin to rebound and reach 67% in FY24e as NVDA can pass on the higher costs to its customers and benefit from the absence of negative impact due to inventory charges.

Net margins were 16% for FY23 as the company saw a 50% YoY increase in OPEX while revenue was flat compared with FY22. Net margins reached a high level of 36% in FY22 due to the spike in demand for NVDA’s GPUs during the pandemic, causing the revenue growth of 61% to far outpace the 27% increase in OPEX. We expect net margins to recover to 29% in FY24e due to the absence of one-off charges.

BALANCE SHEET

Assets: NVDA has total assets of US$41bn. Cash and cash equivalents were US$3bn in FY23 while marketable securities make up the largest proportion of NVDA’s total assets at US$10bn. As a result, cash, cash equivalents and marketable securities totalled US$13bn in FY23, down from US$21bn in FY22, primarily due to a decrease in net income, a US$10bn share repurchase, and lower marketable securities purchases and higher sales and maturities of such assets during the year.

Inventory was US$5bn, double from FY22, as NVDA prepares the ramp-up of its new products in Data Centre and Gaming. Goodwill has remained stable at ~US$4bn since FY21 where it increased by US$3.6bn from US$618mn in FY20 due to NVDA’s acquisition of Mellanox

Liabilities: Majority of NVDA’s total liabilities come from its long-term debt of US$9.7bn (55% of total liabilities), down from the US$11bn in FY22 as the company did not issue new debt in FY23. Accrued and other liabilities increased to US$4bn in FY23 from US$2bn in FY22 mainly due to the increase in inventory purchase obligations and taxes payable. Total liabilities were US$19bn, a slight increase from US$17.5bn in FY22.