Nvidia's quarter fails to excite but offers enough hope that October's bottom can hold

Published Wed, Nov 16 20228:56 PM EST

Nvidia (NVDA) reported mixed fiscal third-quarter 2023 results after the closing bell Wednesday as the chip designer continued to flush out excess inventory with little visibility into when weak soft China demand may improve. Battered shares rose more than 2% in after hours trading, but only gained back some of the 4.5% decline in the regular session. Revenue fell 17% year over year to $5.93 billion, exceeding expectations of $5.77 billion. Adjusted earnings dropped 50% to 58 cents per share, short compared to expectations of 69 cents. Adjusted gross margin of 56.1% was well below estimates of 64.5% and the company's own prior guidance of 65%. On the earnings call, management blamed the miss on $702 million in inventory charges, which is "largely related to lower data center demand in China, partially offset by a warranty benefit of approximately $70 million." Gross margin this quarter was a big improvement from the 45.9% in fiscal Q2. Bottom line It was not the cleanest quarter from Nvidia, but that was to be expected given management is still working to realign inventories with demand expectations — a factor weighing on its Gaming and Professional Visualization segments. That said, encouragingly, the team expects Gaming inventory levels to approach normal levels as we enter calendar year 2023. Arguably the most positive takeaway from the report was management's ability to offer up an alternative chip to Chinese customers in place of the high-performance A100 and H100 designs, which the U.S. government announced during the quarter would no longer be allowed to be exported to China due to national security concerns. While we are impressed with how fast management was able to address the export restrictions with the A800, overall demand in China remains soft, as noted in the gross margin commentary above. As a result, we don't expect much improvement to be seen in the fiscal fourth quarter and believe China is going to be a major swing factor next year. We wish we could offer up a better idea of when demand in China could be expected to improve, but the reality is that it's in the hands of the Chinese government, a regime uninterested in the economic impact of its zero-Covid policy. Though we get the sense the demand environment there probably won't get much worse from here, there unfortunately is not much to go on for those trying to time when things will turn. Fourth quarter guidance was underwhelming, but it was encouraging to hear management say they expect to see sequential growth in Data Center, Gaming, and Automotive. Pro Visualization, however, will likely come in flat on a sequential basis. Given the guidance provided, there won't be much growth, but it's a step in the right direction. Taking everything into account, the expected improvement in profitability, an expected return to sequential growth in Gaming, management taking the inventory write-downs on China, and an expectation for Gaming inventories to normalize as we go into next year, we're inclined to take a more positive view on the stock than we have been. Shares rose 40% over the past month or so since their 52-week low on Oct. 13. But it's unclear when demand trends will materially improve. As of Wednesday's close, the stock was still down 45% year to date. As a result, we're maintaining our 2 rating and trimming our Club price target to $200 per share from $220, reflecting the uncertainty in China and slowing macroeconomic environment in the U.S., which we were again reminded of with Micron Technology earlier Wednesday earning that the "outlook for calendar 2023 has weakened." Guidance Looking ahead to fiscal fourth-quarter 2023, management forecasted the following on a non-GAAP basis. GAAP stands for generally accepted accounting principles. Revenue of $6 billion (plus/minus 2%) is slightly below estimates of $6.1 billion. Despite an expectation for sequential growth in Data Center, Gaming and Automotive, inventory realignment efforts are expected to continue to weigh on results. Adjusted gross margin of 66% (plus/minus 50 basis points) is marginally better than the 65.4% the Street was modeling coming into the print. Though we were expecting to see a mid-60% adjusted gross margin in the reported quarter, we are pleased to see that we should be entering next year with gross margins more in line with the mid-to-upper 60% range we had grown accustomed to prior to the inventory glut. The company expects operating expenses of $1.78 billion, other income of approximately $40 million, and a tax rate of 9% (plus/minus 1%), and capital expenditures (capex) in the range of $500 million to $550 million. Based on the guide, analysts at Truist wrote in a note Wednesday evening that the implied earnings-per-share (EPS) outlook range is 76 to 86 cents, which at the 81-cent-per-share midpoint is nicely above the 77 cents the Street was looking for coming into the print. Segment Q3 sales Data Center revenue grew 31% to $3.83 billion, a tad short versus the $3.84 billion consensus. On the release, management noted annual "growth was broad-based across U.S. cloud service providers, consumer internet companies and other vertical industries." However, on a sequential basis, the growth was held back by weakness in China due to U.S. government restrictions impacting the Nvidia's ability to sell its flagship A100 and H100 chips into the country. That said, we were pleased to see manage callout that they were able to "largely offset" the decline by selling alternative products to China. As a reminder, management previously announced the A800 as an A100 alternative that meets U.S. export requirements. Unfortunately, on the call management noted that regardless of their ability to offer up alternative products, "demand in China more broadly remains soft," and that's expected to remain so in the current quarter. Regarding the A800, for anyone concerned that it goes "against the spirit" of what the government intended, as one analyst on the call put it, management said that new chip is hardware limited versus software limited, which would be easier to reprogram/modify. Speaking to the $400 million headwind management previously called out when the restrictions were announced, it appears the team was being conservative due to concerns about being able to get the chip into production in time. However, Wednesday's result, with total revenue coming in ahead of the $5.9 billion management guided to in the prior quarter (before the restrictions were announced and the team offered up that $400 million number), shows how fast the team was able to modify the A100 and get the A800 into the hands of Chinese buyers. On the call, management said, "The company did remarkable feats to swarm this situation and make sure that our business was not affected and our customers were not affected." Looking to ahead to next year, management was asked on the call if they think Data Center can grow should U.S. cloud capex be flat or down. That's a question that every investor is no doubt wondering, especially given Micron's announcement that we detailed earlier. In response, while management didn't provide the most definitive answer, the team was quick to remind investors that Nvidia's Data Center business "is indexed to two fundamental dynamics." The first, is the that "general-purpose computing no longer scaling," a factor the team has called out many times before, saying that Moore's Law — the observation that the number of transistors on microchips has historically doubled every two years — is dead and, as a result, graphics processing unit-accelerated computing is the best path forward to address increasing workloads while saving money and power. The second, is artificial intelligence (AI) with management commenting that they are "seeing surging demand in some very important sectors of AI." Management noted that these dynamics are more important than ever and believe they are the cause behind the strong demand they are currently seeing. Though again, as encouraging as that is to the long-term growth potential of Nvidia's Data Center business, it doesn't directly address nearer-term concerns. Gaming revenue fell 51% to $1.57 billion, but it was better than expectations of $1.33 billion. The results here reflect management's continued effort to reduce channel inventory by selling into partner channels at a level below demand "to help align channel inventory levels with current demand expectations as macro-economic conditions and Covid lockdowns in China continue to weigh on consumer demand." Regarding where we stand on the inventory correction, management commented on the call that they "believe channel inventories are on track to approach normal levels as we exit Q4." While the pressure we are seeing in this segment is likely to last a while longer, the demand for gaming remains strong and speaks to long-term growth potential with management commenting that "there is tremendous energy in the gaming community that we believe will continue to fuel strong fundamentals over the long term. The number of simultaneous users on Steam just hit a record of 30 million, surpassing the prior peak of 28 million in January." Professional Visualization revenue fell 65% to $200 million, below the $337 million consensus estimate. Similar to what we saw in gaming, the results here were negatively impacted by lower sell-in to partners in an effort to better align channel inventories with demand expectations. These efforts are ongoing. Despite the near-term weakness, management believes the long-term opportunity remains intact fueled by AI simulation, computationally intensive design and engineering work. Automotive revenue increased 86% to $251 million, outpacing the $231 million expected. On the call, management commented that the segment is seeing great momentum, and it's on its way to being the next multibillion dollar business. OEM & Other revenue of $73 million dropped 69% year over year, well below expectations of $140 million. Capital Allocation In its fiscal third quarter, Nvidia returned a total of $3.75 billion to shareholders via dividends and buybacks. 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The logo of Nvidia Corporation is seen during the annual Computex computer exhibition in Taipei, Taiwan, on May 30, 2017.

Tyrone Siu | Reuters