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Nvidia’s trillion-dollar AI opportunity

NVIDIA (NVDA) does not get enough credit for its highly dominant position in artificial intelligence, a rapidly emerging class of technology that will likely disrupt every industry and centralize economic power in the hands of its masters. The market’s increasing recognition of NVIDIA’s sustainable competitive advantage in artificial intelligence (AI) and AI’s long growth runway will likely sustain the stock’s outperformance and premium valuation.

AI & economic centralization
AI is exciting to the investment community because it gives those who wield it unprecedented abilities and economics. Revolutionary breakthroughs in artificial neural networks (or deep learning) in the 2010s enabled algorithms to “learn” and thus introduce a new level of machine intelligence never available before, allowing the algorithms to accomplish breathtaking new feats such as defeating the world’s top Go players and disrupting the translation industry.

Importantly, for investors, modern neural network algorithms are a “centralizing” technology since the advantage of scale outweighs the disadvantages. The practical implication is that companies that can position themselves at the center should enjoy an unusually strong and sustainable competitive advantage in the niche where it dominates.

Companies most likely to be in this enviable position should satisfy three conditions.

First, there is a massive shortage of AI experts, so only very well-funded companies or those with massive cash flow can sustain world-class AI teams. In 2017, Tencent estimated that there are only 300,000 AI researchers worldwide, far short of the millions demanded by the market. The lack of skilled people and difficulty hiring topped the list of challenges in AI to this day.

Second, AI delivers the greatest value to companies with the greatest data assets, which correlates with the scale of the enterprise. It takes a massive amount of data to train neural networks, and naturally, the best AI talents prefer to work in data-rich environments. It is no surprise that companies that are most excited about AI are also the ones with the greatest data assets, for example, Alphabet (GOOG), Microsoft (MSFT), Amazon (AMZN), Meta Platforms (FB), Apple (AAPL), and Netflix (NFLX).

Third, combining top AI talent and massive data to produce breakthrough products requires a management team with a strong engineering and computer science background. This condition explains why Amazon, Alphabet, Microsoft, and NVIDIA lead in AI when other data-rich companies such as Bank of America (BAC) and UnitedHealth Group (UNH) do not.

Once a breakthrough AI product is brought to market, for example, Google’s AI language translation service, one that is significantly better than alternatives, a virtuous cycle begins that further reinforces the competitive advantage of the product. First, the superior product garners more users. Second, more users interacting with the product generates more data. Third, the incremental data is then used to improve the product.

This virtuous flywheel increases the competitive advantages of the incumbents as long as they do not fall apart due to complacency and corruption.

NVIDIA’s dominance
NVIDIA satisfies all three conditions for maintaining and growing its dominant position in AI.

First, NVIDIA is one of the most profitable and fastest-growing companies globally, making its stock-based compensation highly attractive to scarce AI talents. The company is expected to generate $13.7 billion in EBITDA this current fiscal year (ended January 2022), up 73% y/y.

Second, NVIDIA has access to a massive amount of data through its computing hardware business, CUDA parallel computing platform, gaming platforms such as GeForce Now, and software platforms such as Omniverse.

In addition to providing AI talent a data-rich environment, the company also occupies an overwhelmingly dominant position in AI chips, making the company one of the exciting places to work for AI talent. According to JPR, NVIDIA has an 83% share of the Q2 2021 PC discrete GPUs, the preferred chip for AI training and inference. Likewise, NVIDIA GPUs also dominate the data center with over 80% market share in AI workloads.

Third, in my view, NVIDIA’s management ranks among the most innovative in history. Jensen Huang founded NVIDIA in 1993 and has been at the frontier of innovation in GPUs, gaming graphics, accelerated computing in data centers, AI, and the Metaverse. Today, at 58-years-old, Jensen is still deeply committed as the company’s CEO, and his vision gets a tremendous amount of respect from Wall Street to Main Street.

It is no wonder that AI talents are flocking to work at NVIDIA. According to a 2017 Glassdoor survey, NVIDIA ranked second among top employers hiring AI talent. According to a study released by Glassdoor, as of 2021, NVIDIA ranked the second-best place to work in the U.S. Given how well the company and the stock have done and the high level of employee satisfaction, NVIDIA should not have problems attracting some of the best AI talents in the world.

AI market opportunity
NVIDIA has a massive AI portfolio that could serve every enterprise:

Due to the size of its AI portfolio, it is challenging to put an exact number on NVIDIA’s AI addressable market for three reasons. First, NVIDIA has products up and down the stack, from applications interacting with the end-user to hardware sitting in the data center and at the edge. Second, NVIDIA’s AI technologies are horizontal (giving a limited set of capabilities to every industry) and vertical (offering a broad set of capabilities to specialized industries). Third, AI will play a crucial but not exclusive role in rapidly emerging opportunities such as the metaverse.

To get a sense of the scale of the opportunities for NVIDIA’s AI portfolio, let’s take a look at a few examples.

Omdia forecasts the global artificial intelligence software market will grow rapidly in the coming years, reaching around $126 billion by 2025. The overall AI market includes various applications such as natural language processing, robotic process automation, and machine learning.

I sized the current metaverse opportunity for NVIDIA at a minimum of $360 billion, with the potential to grow into the trillions. In my view, AI will play a crucial role in the metaverse, but so will blockchain, consumer electronics such as virtual reality goggles, and GPU chips. I suspect that AI will initially play a small role in the metaverse relative to blockchain and hardware, but its importance will increase in five to ten years.

However, NVIDIA’s CEO, Jensen Huang, has much bigger ambitions: he believes the intelligence market is sized in the trillions. For example, he believes that AI will transform the multi-trillion transportation industry through autonomous driving, to name one industry.

Valuation
While there is little disagreement that NVIDIA is an excellent company, many investors balk at NVIDIA’s price action and premium valuation.

In my opinion, the stock’s valuation is justified by its growth rate, the strength of its core business, and multiple “free options” attached to the stock. However, NVIDIA may not be appropriate for investors who would like to avoid large drawdowns given the stock’s 1.95 52-week beta and the business’s rapid growth, which could hit unexpected speed bumps.

NVDA currently trades at 58x next-twelve-month consensus EPS or a 180% premium to the S&P 500. Given the stock’s ~126% YTD rally and premium valuation, many investors fear chasing a winner. Furthermore, given the passionate discussions around the metaverse (see my recently published Meta Platforms article for more background information), bears will argue that NVDA’s valuation is being propped up by “hype.”

I disagree with this conclusion because I believe NVDA’s valuation is justified by the performance of its core business, while Omniverse has not yet materially contributed to results. For a detailed discussion of the Omniverse, please read my article NVIDIA: Lord Of The Metaverse.

NVDA’s EPS grew 73% y/y in FY20 and is expected to grow another 74% in FY22 (FY ending January). By the end of this year, the company is expected to generate earnings per share ~200% higher than its 2019 earnings. Over the same period, the S&P 500’s EPS grew 26%. Looking ahead, consensus EPS for NVDA’s FY23 implies a 19% y/y growth rate, a number the company should easily beat given the strong momentum of its businesses and its long history of beating earnings estimates. However, even 19% is well above the S&P 500’s expected 8% EPS growth in the same period.

In addition, I believe NVDA’s above-market EPS growth rate will be more sustainable than the average S&P 500 company, given its near-monopoly in discrete GPUs and the secular trends driving its business. Among the most important secular drivers is the rise of AI and the metaverse.

Risks
We know NVIDIA has a near-monopoly in discrete GPUs, the dominant chip used to power gaming, accelerated computing, and AI. The company enjoys network effects, flywheel effects, platform dominance, and a superior R&D budget, putting it head and shoulders above competitors. Its primary end markets — gaming, data center, and AI — are also growing well above global GDP.

In my view, the most significant risk for NVIDIA is regulatory and not competitive or market-based. I see two primary regulatory risks: anti-monopoly and geopolitics.

First, the company’s dominance and size make it a threat to market competition, likely resulting in regulatory pressures. NVIDIA could face regulatory risks similar to those experienced by Microsoft twenty years ago and by Meta Platforms, Apple, and Alphabet today.

We already see early signs of government pressure on NVIDIA. For example, even US regulators object to the company’s pending acquisition of ARM Holdings.

Second, as a semiconductor company with significant China revenues, NVIDIA risks being caught in the cross-hair of the US-China semiconductor war. Revenue from billings to China, including Hong Kong, was 23% of NVIDIA’s revenue for the fiscal year 2021. As the leader in AI, a key area of geopolitical contest, NVIDIA’s risk of being caught in geopolitics is likely much greater than the average semiconductor company. Seeking Alpha

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