There were a few key things discussed on the call:
- Why the H100 will ramp faster than the A100 with Q1 being the estimated time when we should see the H100 driving forward data center growth (we should get an acceleration this quarter in the DC segment).
- How the H100 helps drive enterprise software revenue as it’s been optimized with Nvidia’s software stack.
- The strength of Nvidia’s networking business following the acquisition of Mellanox.
- The CEO believes even if hyperscalers slowdown spending in 2023, that Nvidia is more insulated because their systems are optimized for AI acceleration, which is a top priority within capex spending, and because their systems reduce costs and improve efficiency.
My specific investment thesis is this: “the A100 GPU is what led the company’s gains since Q2 2020 (detailed here) and the Hopper H100 GPU is what will lead the company’s gains for the next two years.”I detail what I think is the most important Q&A from the call below plus other moments that provide a glimpse into what Nvidia investors can expect from here.
Note: I did not cover gaming in this analysis because I am covering Nvidia’s gaming bottom for my free newsletter. I’ll make sure to post this separate analysis on the forum early next week. The H100 will be absent since we are entering an actionable phase with the CEOs discussions about Q1. Actionable analysis, for the most part, is reserved for premium.
Financials:
Note: calendar months are provided to avoid confusion due to Nvidia’s off calendar fiscal year. This upcoming report will be Q3 FY 2023
Nvidia reported as expected for Q3 ending in October with revenue of $5.93 billion for growth of (17%) which matched management guidance of $5.90 billion. Analyst consensus for revenue was $5.85 billion, or (17.7%) growth.
Fiscal Q4 ending in January was a slight miss with guidance of $6 billion compared to analyst consensus of $6.17 billion. This represents growth of (21%). The guidance has led to slightly lower estimates for Q1 ending in April with revisions from (19.8%) to (22.5%) for revenue of $6.41 billion.
As stated on the forum in the pre-earnings write-up, analysts have Nvidia returning to positive growth by July 2023 and to strong growth of 35%+ by October of 2023. This is helped by the low comps that we are currently experiencing.
Nvidia reported adjusted EPS of $0.58 which missed adjusted EPS estimates of $0.71. This compares to the July quarter of $0.51 adjusted EPS. Management indicated that profitability will increase from here: [GAAP and non-GAAP operating expenses were] primarily due to higher compensation expenses related to headcount growth and salary increases and higher data center infrastructure expenses. Sequentially, both GAAP and non-GAAP operating expense growth was in the single-digit percent, and we plan to keep it relatively flat at these levels over the coming quarters.”
An analyst did bring up that stock based compensation has been increasing each quarter at $700 million in the current quarter, up from $648 million and $578 million in the two previous quarters.
In Q3, the GAAP gross margin was 53.6% and the adjusted gross margin 56.1%. This was a miss from management Q3 guidance of 62.4%. The reason for the miss related to China: “Gross margins reflect $702 million in inventory charges largely related to lower data center demand in China, partially offset by a warranty benefit of approximately $70 million.” Nvidia is signaling the gross margin will return to normal next quarter with a guide for GM of 63.2%.
The company reported operating profit of $601 million for an operating margin of 10.1%. This compares to management’s guidance for an operating margin of 18.5% with Nvidia’s typical OM at 37% to 38%.
The adjusted operating margin of 25.9% is down from the typical range of 47%.
GAAP net margin of 11.5% for net profit of $680 million was up from a GAAP net margin of 9.8% in the previous quarter. The adjusted net margin of 24.5% for an adjusted profit of $1.46 billion compared to 19.3% in the previous quarter.
For the most part, Nvidia’s bottom line showed signs that last quarter was a bottom for the company with marginal, yet crucial improvement sequentially.
Nvidia had lower cash flow margins than it did last quarter at a 6.61% operating margin for operating cash flow of $392 million compared to a margin of 18.9% last quarter for operating cash flow of $1.27 billion. The free cash flow margin was (2.6%) for free cash flow of ($156) million compared to a 12% margin last quarter for free cash flow of $824 million.
The company had stock-based compensation of $745 million in the quarter, up from $648 million last quarter. There is $13.14 billion in cash and $10.95 billion in debt. The company returned $3.75 billion to shareholders with share repurchases and cash dividends. There is $8.3 billion remaining under the share repurchase authorization through December 2023.
Nvidia Discusses Why the H100 Will Ramp Faster than the A100
Since our thesis is that the H100 will drive sales and the stock price over the next couple of years, similar to the A100, we want to make sure we are getting confirmation of how the H100 is performing now that it has been on the market for about a month.
Why the H100 is Special
1. Enterprise Software
The first question from C.J. Muse discussed how the H100 is bundled with Enterprise Software, and the timing of when software monetization will begin to occur. The answer from the CEO was effectively “now.”
Here is what Huang said:
“Every company we’re talking to would like to have the agility and the scale, flexibility of clouds. And so, over the last year or so, we’ve been working on moving all of our software stacks to the cloud – all of our platform and software stacks to the cloud. And so today, we announced that Microsoft and ourselves are going to standardize on the NVIDIA stack, for a very large part of the work that we’re doing together so that we could take a full stack out to the world’s enterprise. That’s all software included.
If they would like to use it in the cloud, it’s per GPU instance hour; if they would like to utilize our software on-prem, they could do it through software license and so — license and subscription. And so, in both cases, we now have software available practically everywhere you would like to engage it.
2. The CEO stated H100 is going to Ramp faster than the A100
This was the discussion I felt was most important to Nvidia investors on the call. Second place would be the discussion around the Gaming bottom. Enterprise software is certainly important to as the software stack will eclipse hardware at some point. However, today, Nvidia is a hardware company and visibility into the pace of H100 adoption is key for our 2023 position and allocation.
Notably, I believe there will be positive surprises in the data center segment as we go along into 2023. It’s prudent for analysts to be cautious as we don’t have big tech capex numbers yet and the H100 has only been out for a month. Eventually, enthusiasm for Nvidia will return and it’ll the H100 that drives the positive sentiment.
Here was the question, which is being quoted in full due to its importance to our thesis:
William Stein:
I’m hoping you can discuss the pace of H100 growth as we progress over the next year. We’ve gotten a lot of questions as to whether the ramp in this product should look like a sort of traditional product cycle where there’s quite a bit of pent-up demand for this significant improved performance product and that there’s supply available as well. So, does this rollout sort of look relatively typical from that perspective, or should we expect a more perhaps delayed start of the growth trajectory where we see maybe substantially more growth in, let’s say, second half of ‘23?”
Jensen Huang
H100 ramp is different than the A100 ramp in several ways. The first is that the TCO, the cost benefits, the operational cost benefits because of the energy savings because every data center is now power limited, and because of this incredible transformer engine that’s designed for the latest AI models.
The performance over Ampere is so significant that I — and because of the pent-up demand for Hopper because of these new models that are — that I spoke about earlier, deep recommender systems and large language models and generative AI models. Customers are clamoring to ramp Hopper as quickly as possible, and we are trying to do the same. We are all hands on deck to help the cloud service providers stand up the supercomputers.
Remember, NVIDIA is the only company in the world that produces and ships semi-custom supercomputers in high volume. It’s a miracle to ship one supercomputer every three years. It’s unheard of to ship supercomputers to every cloud service provider in a quarter. And so, we’re working hand in glove with every one of them, and every one of them are racing to stand up Hoppers. We expect them to have Hopper cloud services stood up in Q1. And so, we are expecting to ship some volume — we’re expecting to ship production in Q4, and then we’re expecting to ship large volumes in Q1. That’s a faster transition than Ampere. And so, it’s because of the dynamics that I described.
My translation: Per the CEO, Q1 should be good to us Nvidia investors!
3. Grace Hopper and the CPU, GPU, DPU Trifecta
Grace Hopper is Nvidia’s new CPU that is meant to further accelerate and be integrated with Nvidia’s GPUs and DPUs. Notably, AMD is doing the same – where their CPUs are optimized and integrated to further accelerate AMD’s GPUs and DPUs.
Mark Lipacis
Jensen, I think for you, you’ve articulated a vision for the data center where a solution with an integrated solution set of a CPU, GPU and DPU is deployed for all workloads or most workloads, I think. Could you just give us a sense of — or talk about where is this vision in the penetration cycle? And maybe talk about Grace — Grace’s importance for realizing that vision, what will Grace deliver versus an off-the-shelf x86 [CPU], do you have a sense of where Grace will get embraced first or the fastest within that vision? Thank you.
Jensen Huang
Thanks Mark. Grace’s data moving capability is off the charts. Grace also is memory coherent to our GPU, which allows our GPU to expand its effective GPU memory, fast GPU memory by a factor of 10. That’s not possible without special capabilities that are designed between Hopper and Grace and the architecture of Grace […] It all needs to be fast, so that you can make a recommendation within milliseconds to hundreds of millions of people using your service.”
Networking is Showing Surprising Strength
According to an analyst on the call, their calculations show networking driving most of the sequential growth. He is referencing Mellanox acquisition which we covered a few years ago in this analysis.
Ambrish Srivastava
I actually had a couple of clarifications. Colette, on the data center side, is it a fair assumption that compute was down Q-over-Q in the reported quarter because the quarter before, Mellanox or the networking business was up as it was called out. And again, you said it grew quarter-over-quarter. So, is that a fair assumption?
Collette Kress
So, looking at our compute for the quarter is about flattish. Yes, we’re seeing also growth, growth in terms of our networking, but you should look at our Q3, compute is about flattish with last quarter.
Additional comments on Networking:
“Your data center networking business, I believe, is driving about $800 million per quarter in sales, very, very strong growth over the past few years” – Harlan Sur
“Jensen, can you help us understand like where your InfiniBand networking sits relative to like traditional data center switching?” – Aaron Rakers
“Yes. Thanks, Aaron. The math is like this. If you’re going to spend $20 billion on an infrastructure and the efficiency of that overall data center is improved by 10%, the numbers are huge. And when we do these large language models and recommender systems, the processing is done across the entire data center. And so, we distribute the workload across multiple GPUs, multiple nodes and it runs for a very long time. And so, the importance of the network can’t be overemphasized.”
For more information on networking, reference our Mellanox analysis here.
Will Big Tech Capex Continue to Grow?
We’ve been using Big Tech capex as a proxy for our semiconductor positions. According to one analyst on the call, the presumption is capex from the Big 3 will be flat in 2023. These are still sizable budgets, but the concern is if capex flatlines in 2023, what level of growth will the data center segment be capable of?
Here was the question on the call from Vivek Arya:
“And then, Jensen, the question for you. A lot of concerns about large hyperscalers cutting their spending and pointing to a slowdown. So if, let’s say, U.S. cloud CapEx is flat or slightly down next year, do you think your business can still grow in the data center and why?”
The answer from the CEO focused on Nvidia driving growth from AI acceleration, rather than general purpose compute, which implies that Capex can be flat while Nvidia will be serving the most valuable piece in the stack. AI acceleration, according to the CEO, will not be flat or down.
“Vivek, our data center business is indexed to two fundamental dynamics. The first has to do with general purpose computing no longer scaling. And so, acceleration is necessary to achieve the necessary level of cost efficiency scale and energy efficiency scale, so that we can continue to increase workloads while saving money and saving power. Accelerated computing is recognized generally as the path forward as general purpose computing slows. The second dynamic is AI. And we’re seeing surging demand in some very important sectors of AIs and important breakthroughs in AI.”
The CEO discussed deep recommender systems, large language models driven by Transformers, and generative AI for generating images and videos. He ended the answer with this: “And so, you could see that our company is indexed to two things, both of which are more important than ever, which is power efficiency, cost efficiency and then, of course, productivity. And these things are more important than ever. And my expectation is that we’re seeing all the strong demand and surging demand for AI and for these reasons.”
My translation: Capex can be flat and the CEO foresees Nvidia will take a higher percentage of this capex because they’re serving demand where few companies can across the three major AI breakthroughs he pointed out. My other comment would be that we won’t have a full picture of capex for next year until we get Q1 reports and 2023 full year guides around end of January. This is when we did a deep dive analysis on capex spending last year, and we will revisit this. So, keep an eye out for that.
Note: Nvidia Expected to Change Reporting on Data Center
There was a discussion on the call that Nvidia plans to start breaking out the data center segment to account for internet service companies in addition to hyperscalers. My understanding is internet service providers would mean 5G providers or other internet services related to edge computing. This was not directly stated but it makes the most sense given where edge computing is headed, which could rival the hyperscalers.
Matt Ramsay
I guess, Colette, I heard in your script that you had you talked about maybe a new way of commenting on or reporting hyperscaler revenue in your data center business. And I wondered if you could maybe give us a little bit more detail about what you’re thinking there and what sort of drove the decision?
Jensen Huang:
[…] And these are internet service companies that offer services, but they’re not public cloud computing companies. The second factor has to do with cloud computing […] [hyperscalers] are two things to us, therefore, a hyperscaler can be a sell to customer; they are also a sell with partner.”
Conclusion:
The market has been discouraging this year. The gaming selloff for Nvidia and PC selloff for AMD were brutal. But if you listen to these calls, it is crystal clear something monumental is going on. We want to capture this as fully as possible. Perhaps we will have 40% allocation in two positions (NVDA or AMD) or perhaps we will have to trim to 15% across two positions and layer back up to 30% allocation. We will do this as skillfully as possible.
If 2021 to 2022 taught us anything, it’s that only the strong survive. That goes for stocks/companies and investors. There is no doubt that NVDA and AMD will weather what’s ahead and we want to stay close to our AI bellwethers. Whatever the tide brings us, you can expect us to obsessively cover these companies and to actually increase our coverageincrease our coverage as we go along. There is no limit to the research needed if we are building positions with conviction.