Nvidia has been on a wild growth ride the past five years. Surfing a wave around AI deep learning and cryptocurrency where its specialized chip architecture is among the highest performing, the company’s share price rose from the low $20s in late 2014 to eventually soar to almost $300 in September 2018. And then crypto winter set in, and within weeks the company’s market cap was sliced nearly in half as crypto miners canceled their orders and inventories at Nvidia started building up a glut of chips.
Since that nadir in late 2018, the company has mostly been on the upswing as it has pushed expansion into a variety of other verticals like automotive, most notably by announcing the purchase of Israeli chip maker Mellanox for $6.9 billion in an all cash deal.
So with its latest earnings announcement coming after the bell yesterday, the big questions were how it was continuing to navigate chip inventories, and whether its transaction with Mellanox would close. The company ultimately presented a bit of a mixed bag, and Wall Street seems to have barely budged on the stock price as we all wait resolution on some of the key questions facing the company.
Before we dive into the analysis, first the high level numbers for Q3, which ended on October 27: top-line revenues declined slightly to just above $3 billion, from roughly $3.2 billion in the year ago quarter. Gross profits were flat from a year ago, but net income was down 27% to $899 million, mostly due to higher R&D costs and lower income from operations. Earnings per share was $1.47, down from $2.02 a year ago.
Now though, there were some more interesting takeaways from the results beyond the sort of lukewarm numbers emanating off the income statements.
China trade war still affecting Nvidia through Mellanox
First, Nvidia did release some notes about how the closing process for Mellanox is faring, and the short answer at least according to the company’s filings is ‘it’s going okay.’ Nvidia has received regulatory approval in the United States and Mexico to acquire Mellanox, but it is still waiting for approval from European and Chinese regulators, and that is likely pushing the closing date back into the new year.
China has been the big focus for everyone following the stock (and, frankly, the world economy) due to the intense discussions between the Trump Administration and the CCP over the contours of a so-called “phase one” trade deal. While there were some smoke signals in recent weeks that Trump and Xi and their negotiators had reached some level of agreement (up to and including discussions rumored today), no such announcement has been made.
That makes acquisitions like Nvidia’s Mellanox transaction complicated, since holding up approval is the kind of bargaining chip that China needs on its side in the negotiations. It has previously used that chip (I will try not to use that pun more than five times in this article) in holding up the acquisition of NXP by Qualcomm, which eventually led to that deal collapsing. In Nvidia’s case, a failure to close would result in a $350 million breakup fee.
No, the trade negotiations are not literally about Nvidia, but its lack of resolution just holds everything up. It’s still not clear at all whether a trade deal will come together in the end. Just yesterday, a crucial annual government report on competition between the U.S. and China urged the Trump administration and Congress to get tougher on Beijing, including potentially revoking Hong Kong’s special economic status in the wake of fervent protests in the city. That’s not exactly the message of a country looking to make a deal.
It wouldn’t be a disaster for Nvidia to lose Mellanox (its a bolt-on expansion deal), but it’s the ambiguity and delay that makes planning for the future so hard — and in the chip industry, that can be a tough blow to endure.
Stock-based compensation seems okay, but watch that strike price
Stock-based compensation challenges have proven very vexing for a number of tech companies, including Uber following its IPO. While Uber’s multi-billion dollar charge was related to its one-time public offering, many companies have had to increase their stock packages in order to retain employees in an extraordinarily competitive talent market.
Therefore, it is interesting to see in Nvidia’s latest earnings here that the weighted value of all stock grants it has on its balance sheet is roughly $173, a price point the company only broke through again on the public markets a couple of weeks ago.
Given the company’s gyrating price over the last few years, many employees were dismayed to learn that their compensation packages were effectively slashed as the stock price crumbled and the value of their restricted shares declined. From what I can tell, most employees have various forms of restricted stock units, which doesn’t mean that they lose these units if the stock price falls below the strike price (unlike an option), but it does mean that, say, their $10,000 equity bonus might only be worth $9,000 or $8,000 when they finally receive it — and that can be a decent morale killer for anyone.
The upshot is that Nvidia doesn’t appear to be over-compensating on stock — there isn’t a massive increase in shares outstanding, for instance. But the value of those shares are quite high, driven in large part by the vesting of older (and cheaper) stock units while new stock gets struck at higher and higher prices. If Nvidia faces another tough quarter or two, watch how the stock compensation floats to manage employee expectations.
Better news on the inventories front
Now for what appears to be some healthy news for Nvidia. The company seems to have gotten its inventories much better in hand than even a couple of months ago. Overall inventories declined by roughly a third, from about $1.5 billion to about $1 billion. That’s great news, because moving inventories through production and ultimately sold to end users is obviously the key to a healthy chip company.
Compared to the company’s fourth quarter inventories (which ended January 27 of this year), the big change is that Nvidia decreased its raw materials inventories by nearly 60%, from $613 million to $255 million. That’s important, because it means that Nvidia both managed to get a grip on its supply chain while also pushing more materials into production. Finished goods also declined from $724 million to $527 million, which again shows that materials were made into chips, and then those chips left the warehouse.
It would appear that while inventories were quite glutted in the wake of the crypto winter a year ago, the reality today is that the company has been able to clear those inventories out without sacrificing key financial metrics over the past few quarters. In short: solid results even if not particularly awe-striking.
What’s next?
As we head into the fourth and final quarter for Nvidia, there are a couple of things to pay attention to. First, as always with chips, are the macro factors, including the U.S./China trade war, and the other trade war between South Korea and Japan, which shows no signs of abating. Korea continues to need reliable access to key materials exported from Japan, and the machinations of those two governments will determine the success of chip companies like Samsung and SK Hynix and therefore the robustness of the overall semiconductor market.
The more challenging question to answer is how Nvidia will fare against a number of other new entrants into its new core domain of artificial intelligence processing. With the rise of chip startups like Cerebras, Graphcore, and even more to come (hopefully, I’ll write up one more of these today assuming I find enough tea), can Nvidia continue to innovate and fend off a multitude of well-funded competitors completely focused on the AI domain? Mellanox was the company’s big M&A deal in terms of the cash it has lying around, and so it doesn’t have too many buyout options on this front anymore (and after 2018, no one wants Nvidia stock these days unfortunately for them).
So while the company is in a relatively stable situation all things considered, it’s always amazing to me to see just how many things can completely flip the table over in just a short period of time. At least for the day traders, this is a stock to follow intensely closely.