The AI ​​industry is now at a major turning point towards mass adoption as computing technology has improved and costs have fallen. It’s no surprise, then, that the AI ​​industry was valued at $387.45 billion in 2022 and is planned to grow at a rapid compound annual growth rate of 20.1%, reaching a valuation of $1.39 trillion by 2029. Picking a winner in the AI ​​industry is a challenge, so when there is has a gold rush, why not sell shovels by investing in a company like Nvidia which has developed the backend infrastructure through its revolutionary chips. In this article, I’ll break down Nvidia’s AI advantage, financials, and valuation, let’s dive into it.

What is AI?

AI essentially uses software models to create human-like intelligence capable of performing tasks. Recently, the OpenAI institute, which is backed by Elon Musk and Sam Altman of Y Combinator, released a series of free AI tools, which went viral. These tools include DALL-E, an AI image generator, which allows you to write any word in the search box and get a custom image generated. For example, I asked the platform to create random images for me of a monkey wearing a hat and playing basketball, which it did.

I also created an image of “Warren Buffett wearing an apron”, which you can see below. This tool may seem like a joke, but it has the potential to put many graphic designers and artists out of work.

Another popular tool advertised is ChatGPT, which offers a human-language interface that can be used to answer exam questions and even write software code. The reason this is interesting is Nvidia (NASDAQ:NVDA) has established itself as a leader in AI for business, so if the aforementioned free tools sound great, imagine what the best supercomputers in the world can accomplish, which I’ll discuss in the next section.

Artificial Intelligence and Nvidia

Nvidia is a semiconductor chip designer known for being a leader in high performance graphics cards. If you have a very powerful PC, it will probably use an NVIDIA graphics processing unit [GPU].

Nvidia also has a thriving artificial intelligence business focused on data centers. Oracle recently announced an extension Partnership with Nvidia to help scale artificial intelligence for business. Oracle Cloud Infrastructure [OCI] aims to make NVIDIA’s enterprise AI platform accessible to large organizations. As you can see from the graph below, Oracle’s cloud infrastructure uses 512 Nvidia GPUs per cluster. This equates to “tens of thousands” of Nvidia GPUs for Oracle’s entire infrastructure, this includes Nvidia’s A100 chips and newer H100 GPUs.

Nvidia’s H100 GPU is a technology breakthrough because it offers 7 times better performance than its A100 for specific accelerated computing tasks. these include Genome sequencing, a growing industry. In addition to the fast Fourier transform [FFT]a mathematical model with applications such as RADAR and signal processing.

Nvidia AI platform enables organizations to develop AI solutions for their business. This includes all aspects of the process, from data processing to training AI models and large-scale deployment. There are many applications that include “Conversational AI” bots, business process automation, computer vision technology and much more. A specific use case is Nvidia Clara, which uses AI and high performance computing [HPC] for drug discovery, medical imaging and even genomics.

Nvidia also has recently (December 7) announced a partnership with Deutsche Bank to accelerate the use of AI in the financial services industry. The bank will use Nvidia’s Enterprise AI platform on its Google Cloud infrastructure for a variety of applications. This includes the use of a real-time “risk assessment”, which is usually an overnight process, as it is very CPU-intensive. Additionally, the bank plans to use it for “price discovery” and model backtesting. This means its traders can manage risk more effectively while reducing energy costs through accelerated computing.

Deutsche Bank also aims to leverage Nvidia’s artificial intelligence platform to create 3D virtual avatars. These should be used for a variety of applications ranging from customer service to navigating internal HR matters. The next step after that will be “metaverse-style” experiences with its banking customers.

Nvidia has also developed its AI-powered “Digital Twin” activity, which can be used to create copies of manufacturing facilities. This can then be used to optimize production and better visualize improvements. Nvidia is even creating a “Digital Twin” of the entire earth, which can be used to track global warming and potential changes in emissions.

Financial analysis

Nvidia reported mixed financial results for the third quarter of fiscal 2023. Its revenue was $5.9 billion, which was actually down 17% year over year, one bright spot is that this metric has always exceeded analysts’ estimates of $114.74 million.

The decline in revenue was primarily due to a substantial 51% drop in gaming segment revenue to $1.574 billion. This may seem terrible at first glance, it should be noted that the gaming industry has been cyclical historically and therefore a decline in demand was expected after a major boom in 2020. In addition, many consumers bought cards Nvidia charts for bitcoin mining in 2020, and with the drop in bitcoin we are also experiencing a “crypto winter”.

The Data Center is the engine of growth

One bright spot for Nvidia is its data center business, which has continued to thrive, thanks to the aforementioned tailwinds in its AI chips. Its Data Center segment reported revenue of $3.83 billion, which grew 31% year-over-year. A bright spot for Nvidia is that this segment contributes around 64% of total revenue and so the fact that it is growing strongly is a bright spot. This segment also continues to grow thanks to the ongoing “digital transformation” of enterprises as enterprises move their IT workloads to the cloud. The cloud industry was valued to $429.5 billion in 2021 and is expected to grow at a rapid compound annual growth rate of 15.8% through 2028.

In Q1 2023, Nvidia plans to ship its new H100 AI chips to all major cloud infrastructure providers such as AWS, Azure, and Google Cloud. In mid-November, the company announced a broad partnership with Microsoft Azure, which aims to build a massive AI supercomputer for its enterprise customers.

Nvidia’s automotive segment is also growing rapidly, as it increased revenue 86% year-over-year to $251 million. It’s still a small part of Nvidia’s overall business, but it has huge potential.

Nvidia’s open AI automotive computing platform called “Nvidia DRIVE” is used by many car manufacturers such as Mercedes, Volvo and Audi. The platform’s goal is to help enable self-driving technology at scale, as most automakers haven’t developed this technology in-house (unlike Tesla).

Profitability challenges

Nvidia reported operating profit of $601 million, which was down 72% year-over-year. This was mainly due to a 31% increase in operating expenses, which aggravated the decline in revenue, driven by cyclical demand for games. The good news is that the majority of this spending appears to have been driven by a series of data center infrastructure expenditures and increased headcount. So, the business is really investing in itself and the data center expenses should really be considered “capital expenses” because a long-term profit is expected.

The company also has a strong balance sheet with $13.1 billion in cash and marketable securities. The company has $9.7 billion in long-term debt, but only $1.2 billion in current debt, which is manageable.

Advanced Assessment

In order to value Nvidia, I incorporated the latest financial data into my discounted cash flow model. I projected 10% revenue growth for the next year and 26% revenue growth over the next 2-5 years. I expect the demand for games to rebound and the Datacenter segment to continue to grow.

To increase the accuracy of the valuation, I capitalized R&D expenses, which increased the operating margin to 33.25%. I’ve also projected a pre-tax operating target of around 45%. I expect this to be due to operating leverage in the data center segment and a rebound in gaming.

Considering these factors, I get a fair value of $179.40 per share, the stock is trading at $163 per share at the time of writing and is therefore around 95 undervalued.

As an additional data point, Nvidia is trading at a price-to-sales ratio = 14.49, which is ~14% cheaper than its 5-year average.

Risks

Recession/Gaming Demand

Many analysts are forecast a recession, which can delay consumer and business spending. Demand for games may remain suppressed, while indirect revenue from crypto mining apps may never rebound. Ethereum has moved from a proof-of-work model to a proof-of-stake model, which should have an impact on this.

Final Thoughts

Nvidia is a technology powerhouse and a true leader in data center hardware. The company is poised to benefit from the growth of the artificial intelligence and cloud industry. It’s currently facing a series of headwinds from weak gaming demand, but given the stock is inherently undervalued, it could be a great long-term investment.