While my main focus is value dividend growth stocks, ultimately my goal is to maximize total returns, which means I’m not opposed to owning some Grade A hyper growth names.
That’s why I’m such a big fan of Nvidia (NVDA), which operates in a highly competitive field (that’s only getting more crowded) but that its founder-led management team has managed to continue executing brilliantly.
Specifically there are four main reasons why I plan to eventually own Nvidia in my EDDGE 3.0 portfolio. However, the current valuation is just plain crazy.
In fact, even under a best case bullish growth scenario, Nvidia is 46% overvalued, making it one of the most dangerous and bubbly stocks you can buy today.
Hyper Growth Across Numerous Booming Industries
|Metric||First Half 2016||First Half 2017||YoY Change|
|Revenue||$2.733 billion||$4.167 billion||52.5%|
|Net Income||$469 million||$1.091 billion||132.6%|
|Free Cash Flow||$750 million||$879||17.2%|
|Shares Outstanding||620 million||637 million||2.7%|
|FCF Payout Ratio||19.0%||20.3%||6.7%|
Sources: Earnings Release, Morningstar, Gurufocus
The first half of 2017 has been a stunning success for Nvidia, with the company reporting excellent top and bottom line growth that is the envy of even the fastest growing tech stocks.
The strong results are from the company firing on all cylinders by executing well on its growth plans for all its major business units.
Source: Nvidia Investor Presentation
More importantly than just one strong year is the fact that Nvidia’s growth over the past has been very strong in nearly all of its key markets.
The only thing not impressive about the first half of 2107 was the slower rate of free cash flow growth. However, FCF is volatile by nature, as it’s based on the timing of capital expenditures (investment in future growth).
That’s why we need to take a look at the company’s long-term trend, which shows 17.5 year FCF/share growth of 38.6% CAGR.
NVDA Free Cash Flow Per Share (TTM) data by YCharts
Now it’s important to realize that this spectacular growth isn’t going to be sustainable in the short to medium term. That’s because the majority of the sales and earnings boosts have come from the launch of Nvidia’s newest GPU products, which will almost certainly see sales growth slow in the coming quarters.
In other words, tougher comps will see much slower growth than we’ve seen in the past year. That’s why management is guiding for just 17.3% of sales growth in the next quarter.
Currently Morningstar estimates that Nvidia will be able to generate 17% CAGR sales growth through 2021 once the easier comps roll off.
This is because Nvidia’s sales and earnings continue to be dominated by its legacy gaming business.
- Gaming: 53.2% of sales
- Data Centers: 18.7% of sales
- OEM & IP: 11.3% of sales
- Professional Visualization: 10.5% of sales
- Automotive: 6.4% of sales
The good news is that Nvidia’s first mover advantage into the leading tech megatrends of the 21st Century (artificially intelligence, cloud computing, autonomous vehicles, virtual reality), means it’s well positioned to potentially become a dominant industry leader in the fastest growing markets in the world.
For example, Nvidia’s GPUs are currently the go to solution for companies like Alphabet (GOOG) (NASDAQ:GOOGL), Microsoft (MSFT), and Facebook (FB) when it comes to powering their deep learning AI systems. In fact, today Nvidia’s processors are running deep learning AI programs on 1,900 customer applications (and counting).
And as you can see, the AI market is set to explode in coming years, creating a potentially very long, and strong growth runway for Nvidia, especially if Morningstar is correct that Nvidia will own 66% of this market in 2021.
In addition, Nvidia GPUs are the backbone of most of the world’s cloud-based infrastructure, including Alphabet, Microsoft, Amazon (AMZN), Biadu (BIDU), Alibaba (BABA), JD.com (JD), and Tencent (OTCPK:TCEHY).
Then there’s autonomous vehicles (where Nvidia’s Tegra processors are already in over 8 million automotive infotainment systems), which are the future of transportation, and where Nvidia is the undisputed leader. For example it has already partnered with 225 companies, including the world’s largest automakers, OEM suppliers, and driverless car tech pioneers.
Nvidia just revealed its Drive PX Pegasus driverless car tech, which is 10 times as powerful (320 trillion calculations per second) as its predecessor, and the company claims is fully capable of running level 5 autonomous vehicles (can drive across the country without a driver).
But wait there’s more! Nvidia also is pioneering the AI-based processors (like the Jetson TX2) that going into advanced robotics, which could give it a dominant role in the industrial automation industry.
Currently 10% of the world’s manufacturing capacity is automated, which means that there’s enormous potential for long-term growth here as well.
Nvidia expects increase the computing power of GPUs to increase by about 1000 fold by 2025, which could give it a major advantage when it comes to the fast growing, but massively data hungry tech industries of tomorrow, where computing power will be at a premium.
In fact, analysts project that the high performance computing market alone will be at $36 billion in annual sales by 2020.
In total, the overall markets for Nvidia’s products also are growing quickly, and will soon grow from $45 billion to $275 billion a year.
The bottom line is that in the fastest growing industries of the future Nvidia is currently holding a golden ticket that could potentially drive decades worth of strong: sales, earnings, free cash flow, and dividend growth.
Industry Leading Management Team With Stunning Execution Record
Given the high amount of competitive Nvidia faces, from Advanced Micro Devices (AMD), Qualcomm (QCOM), Intel (INTC), to name just a few, it’s imperative that investors have confidence in Nvidia’s management.
Fortunately, CEO and co-founder Jen-Hsun Huang, who founded the company in 1993 after working at LSI Logic and AMD, has proven more than capable of adapting to fast-changing market conditions. He’s guided the company to a first mover advantage in several key growth markets, and has been an exceptional steward of shareholder capital.
Nvidia Trailing 12 Month Profitability
|Company||Operating Margin||Net Margin||FCF Margin||Return On Assets||Return On Equity||Return On Invested Capital|
Source: Morningstar, Gurufocus, CSImarketing
For example, given the company’s small size (and thus less economies of scale), the fact that it is capable of converting nearly 25% of revenue into free cash flow (owner earnings and what funds the dividend) is remarkable.
Even more impressive? Nvidia has been steadily increasing its profitability over time, indicating strong pricing power, backed by its industry leading technology.
And the returns on shareholder capital are simply amazing, especially the overall return on invested capital.
This tells me that Nvidia’s management team is truly best in breed, and makes this company one well worth trusting with your money, (at the right price).
Excellent Dividend Growth Potential As Far As The Eye Can See
|Company||Yield||TTM FCF Payout Ratio||10 Year Projected Dividend Growth||10 Year Potential Annual Total Return||10 Year Likely Annual Total Return|
|NVIDIA||0.3%||15.6%||12.5% to 20%||12.8% to 20.3%||6.3% to 10.1%|
Sources: Gurufocus, Morningstar, Fast Graphs, Multpl.com, Moneychimp.com
I realize that many Nvidia shareholders will call me crazy for referring to Nvidia as a dividend stock at all, given the rather pathetic yield.
So I need to clarify that I believe a diversified dividend growth portfolio has room for both high growth/low-yield investments, and high-yield/slow growth ones.
Source: Simply Safe Dividends
In this case I love that Nvidia has opened up the door to income growth investors, choosing to initiate and grow its payout in a disciplined manner. Specifically, this means a steady double digit dividend growth trend, but one that doesn’t impinge on the company’s ability to retain cash to continue growing the business.
For example, in the past year Nvidia’s dividend has cost it just 15.6% of its free cash flow, meaning that not only is this one of the safest dividends on Wall Street, but it still has massive growth potential ahead of it.
That’s especially true given that Nvidia’s balance sheet, (the other half of the dividend safety equation) also is very strong.
|Company||Debt/EBITDA||EBITDA/Interest||Debt/Capital||Current Ratio||S&P Credit Rating|
Sources: Morningstar, Simply Safe Dividends, Fast Graphs, CSImarketing
Not only does Nvidia have a below average leverage, and debt/capital ratio, but its interest coverage ratio is sky-high, and the current ratio (short-term assets/short-term liabilities) is among the highest I’ve seen for any company, ever.
In other words Nvidia has a bomb proof balance sheet, with its net $3.9 billion cash position, strong and quickly growing river of free cash flow ($1.9 billion in the past 12 months), and solid investment grade credit rating.
That means that Nvidia has plenty of financial flexibility to continue growing it business quickly, while maintaining a highly secure, and rapidly expanding dividend (double digit growth for as far as the eye can see).
Valuation: Absolutely Insane So I’m Out!…For Now
NVDA Total Return Price data by YCharts
Even with the S&P 500 having an amazing year, and tech stocks doing even better, Nvidia’s run has been a wonder to behold, with shares nearly tripling over the past year.
Of course that’s the problem, because Nvidia today is trading at absurd valuations (a P/S of 14.3), that prices in all of its growth potential, and then some.
|Company||Forward PE||Historical PE||Yield||Historical Yield||Percentage Of Time Yield Has Been Higher|
|NVIDIA||43.7||22.3||0.3%||1.3%||All Time Low|
Sources: Gurufocus, Yieldchart, Multpl.com
For example, the forward PE ratio is nearly three times that of the historically overheated S&P 500, double that of its industry peers, and most importantly, double its own historical norm.
Meanwhile the yield is at an all-time low, which may not matter to hyper growth focused momentum investors, but it certainly matters to dividend lovers.
Even worse? When we take a look at a discounted cash flow analysis, which estimates the net present value of Nvidia’s free cash flow per share over the next 20 years, things don’t look any better.
|TTM FCF/Share||10 Year Projected FCF/Share Growth||Fair Value Estimate||Growth Baked Into Current Share Price||Margin Of Safety|
|$2.95||11.3% (conservative case)||$71.78||27.2%||-175%|
|16.3% (analyst consensus, likely case)||$97.93||-102%|
|21.3% (bullish case)||$134.89||-46%|
Sources: Morningstar, Gurufocus, Fast Graphs
Using a 9.0% discount rate (what a low cost S&P 500 index ETF would have generated since 1871, net of expenses, and thus the opportunity cost of money), we find that, under even the most optimistic growth scenarios Nvidia is wildly overvalued.
For example, currently Nvidia shares are pricing in an absurd 27.2% CAGR FCF/share growth rate over the next decade. That means that anyone buying today is effectively predicting that the company’s FCF/share will rise 11.1 fold over the next 10 years.
Given the strong competition that Nvidia faces from the likes of industry giants such as Qualcomm (QCOM), and Intel (INTC), both who are attempting to break into its key growth markets, that’s an optimistic assumption to say the least.
In other words, Nvidia is priced for perfection, and beyond, making it one of the most overvalued bubbly dividend growth stocks on Wall Street. In fact, Nvidia’s current valuation is reminiscent of the tech boom of the late 1990s, where every tech stock with a good growth story was priced as if it were guaranteed to dominate every future tech industry.
That means that should the company face any execution headwinds (slower growth) in the future, which it almost certainly will, shares could get hammered hard and fast. This makes Nvidia one of the most dangerous places for new money today.
Risks To Consider
While I agree that Nvidia’s growth potential is enormous, at the same time the current valuation isn’t adequately pricing in the risks the company faces.
For example, PCs are in secular decline, but the company has benefited from a resurgences of high end gaming that has increased demand for its premium gaming GPUs, which range in price from $150 to $1,000.
However, technology trends can shift over time and there’s no guarantee that this trend will continue. That could be a big blow to the company until its data center and automotive segments grow to be a larger component of its top and bottom sales (data center sales could be 48% of revenue by 2021).
In the meantime Nvidia has to keep up with AMD which has recently been stealing market share in its core gaming business.
Next we can’t forget that any great profit opportunity also attracts increased competition. In other words, the potential for AI, VR, data centers, and autonomous cars to make companies billions means that everyone and their mother is trying to get into this space.
And while Nvidia’s intellectual property portfolio is strong enough to give it a narrow moat, the fact remains that there are numerous highly capitalized rivals in this space that could prevent Nvidia from being able to maintain its mouth watering margins.
For example, Alphabet is working on its own AI based chips (the TPU), which means that Nvidia may have to give the company (as well as other giants in the industry who could go in house) a price break to maintain their business.
This could result in lower margins and slower bottom line growth, which at these ridiculous valuations could crater the stock.
Another thing to consider is that Nvidia will likely have to continue spending heavily on R&D, as much as 18% of sales over the long-term (19% in the last 12 months), in order to compete with the enormous R&D budgets of rivals such as Qualcomm, Intel (which is designing a focused AI chip), and IBM (IBM). In the last 12 months had R&D budgets of $6.8 billion (assuming the NXP Semiconductor acquisitions closes) $13 billion, and $4 billion, respectively. Those figures dwarf Nvidia’s own $1.6 billion R&D budget.
The bottom line is that despite the exciting, fast growing and seemingly limitless potential of AI, VR, data centers, and driverless cars (plus potentially drones and block chains as well), these industries are still in their infancy.
That means that Nvidia, while a strong industry leader today, will have to fight like a dog to maintain its current position as the king of the hill.
The current share price is basically pricing in Nvidia’s continued, and even potentially growing domination of these future tech industries, which is far from assured.
In other words, there is no margin for error and any hiccups (which are sure to come at some point) will likely result in massive share price pullbacks.
Bottom Line: There’s A Lot To Love About Nvidia, But Valuation Still Matters So I’m Waiting For A FAR Better Price
Don’t get me wrong, I’m not calling a top on Nvidia. After all, with the market in melt up mode, and Nvidia being a darling of Wall Street, who knows how crazy this bubble could get.
But rest assured Nvidia is in a bubble, and when the next market correction hits (it’s now one year overdue, historically speaking), it will fall, and fall hard.
At that point, due to its: epic growth potential, world class management team, bank vault safe (and fast growing) dividend, I’ll happily add Nvidia to my portfolio.
Disclosure: I am/we are long QCOM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.