Technology NVIDIA Corporation (NYSE: NVDA)

Krause Fund Research Fall 2017

Technology

Recommendation: SELL

Analysts

Peter Hadfield peter-hadfield@uiowa.edu

Austin Hassett austin-hassett@uiowa.edu

Company Overview

NVIDIA Corporation, incorporated on February 24, 1998, inventor of the graphics processing unit (GPU) operates in four major categories within the semiconductor industries. The company is responsible for innovation and efficiency that drives gaming, professional visualization, data center, and automotive technology.

Stock Performance Highlights

52-week High 52-week Low Beta Value Average Daily Volume

$218.67 $83.62 1.87

16.24 m

Share Highlights

Market Capitalization Shares Outstanding Trailing P/E Ratio

$129.68 b 600.00 m

62.16

Company Performance Highlights

ROA

17%

ROE

41%

Sales

$ b

Financial Ratios

Current Ratio

4.77

Debt to Equity

.7

One Year Stock Performance Source: finance.

NVIDIA Corporation (NYSE: NVDA)

November 10, 2017

Current Price: $216.14 Target Price Range: $171-$181

NVDA is trading at a higher price than its intrinsic value suggests

? Based on economic, industry, and company specific research we developed financial models for NVIDIA. Our models utilize discounted cash flow, economic profit, relative valuation, and dividend discount analyses. Our research and models concluded that NVIDIA is trading at a price above its intrinsic value, prompting a sell rating. ? Our discounted cash flow analysis suggests an intrinsic value for NVIDIA of $171. This is the most relevant metric within our model and is the logical base for our target price range. ? Our relative valuation analysis included a series of comparable firms based on size, industry, and firm characteristics. Our calculations concluded that NVIDIA is trading at a premium to its peers. However, their position within the semiconductor industry provides reason to believe they should trade at slight premium. ? Our research led us to believe NVIDIA is a strong company with an extensive growth opportunities. We believe their net income will increase by over $3 billion dollars in the next five years. However. Our discounted cash flow, relative valuation, and associated assumptions and conclusions found that is it overpriced. ? The competitive nature of NVIDIA's industry restricts NVIDIA's growth potential. To meet current demands and grow beyond our current projections NVIDIA would need to cut costs or expand revenues at an unrealistic rate. ? NVIDIA is efficiently utilizing their operating funds to create new innovative products. It is unlikely that they will be able to reduce expenses or margins at a rate that would bring their intrinsic value above $181. NVIDIA's business model leaves them vulnerable to patent infringement issues, security breaches, and rapid market changes

Executive Summary

At NVIDIA's current price, we recommend a sell rating. We believe our model optimistically forecasts NVIDIA's future cash flows. The competitive nature of their industry and the risks associated with the company's business structure will not allow growth that justifies their current stock price. NVIDIA has shown strong potential as a future investment, but we believe the market has inflated their stock price due to the exciting nature of their products and recent growth. Our target price for NVIDIA stands at $171-$181.

Exchange Rates:

Exchange rates are the value of one country's currency in comparison with other country's currency. Exchange rates are an important economic factor for the technology industry, because the S&P 500 and Dow Jones Indices estimated that U.S. information technology companies generated 57.78% of sales overseas in 2015.16 When technology companies report their revenue in the U.S. or transfer their cash to the U.S., they will be directly affected by the exchange rate. The chart below shows the five companies with the most amount of cash held overseas. Depending on where these companies hold their cash, the exchange rates may cause significant losses or potential gains.

Economic Outlook

U.S. Real Gross Domestic Product

Real Gross Domestic Product (GDP) is the measure of the market's total economic output during a period after adjustments for price changes caused by inflation. Real GDP is an important industry indicator because it reflects the overall health of the economy. When the economy is flourishing, consumer spending and consumption increases. This results in increased company revenues.

The chart below displays the real U.S. GDP growth from preceding quarters. Real GDP growth declined .1% from 2017 quarter two (Q2). The high Q3 real GDP growth is partially contributable to increased inventories caused by this year's hurricanes. Inventories increased by $35.8 billion dollars which resulted in .73% increase in the 3Q GDP.

Source: Meisler, L

One measure of the value of the U.S. dollar is The U.S. Dollar Index (DXY). The DXY is a value relative to the six major trading partners of the U.S. Currently the DXY is valued at 94.39 which is a 7.65% decrease from one year ago to date. The DXY has ranged from 91.01 to 103.82 over the past 52 weeks. The DXY has grown since October, but recent news from the U.S. Senate suggesting delayed corporate tax cuts caused the DXY to drop .52 points on November 10th. However, with the continuing GDP growth and positive consumer spending and confidence, we believe the DXY will resume its growth over the next six months through 2021 between the ranges of 95-98.3 The chart below illustrates the change in the DXY over the past three years.

U.S. Dollar Index (DXY)

Source: Mataloni L. and Aversa J.

We believe GDP will grow 2.3% over the next six months and reach a steady rate of 2% for the next five years. During the next six months, the lasting effects of the hurricanes will wear off causing inventories and real GDP to decrease. We expect the GDP to continue growing due to strong consumer confidence which is at a 17 year high. Consumer confidence index reflects consumers' current attitudes toward likely business conditions and developments. However, we expect GPD growth to slow due to the increasing interest rates. When interest rates increase, the cost of capital increases. This increases the cost of financing and causes M&A activity to increase. Then, as M&A transactions and capital spending decrease, the economy will experience a slowing in growth.

Source: Market Watch

In FY2017, NVIDIA reported only $904 million of revenues generated in the United States, $659 million in Europe, $486 million in other Americas, $2.55 billion in Taiwan, $1.31 billion in China, and $1.01 billion in other Asia Pacific countries. If the value of the U.S dollar increases relative to foreign currencies, it would make the products of NVIDIA more expensive. If the value of the U.S. dollar decreases in relation to other countries, NVIDIA's suppliers might raise prices. A falling U.S. dollar

would also increase NVIDIA's operating expenses. However, NVIDIA considers their direct exposure to fluctuation in exchange rates to be minimal. NVIDIA currently holds foreign currency forward contracts to minimize the impact of currency fluctuations.13

Employment:

The unemployment rate is a measure of the percent of jobless individuals searching for jobs in the labor force. This rate is highly correlated to economic strength because a strong economy creates job growth, which decreases the unemployment rate. It is also valuable to consider the employment rate when analyzing changes in employment. The employment rate is a ratio measuring the number of employed individuals to the working age population (15 to 64). Together, these two rates are valuable to technology firms, because they shadow economic strength and revenue growth. In addition, the technology industry requires highly educated individuals, which creates problems within the industry when companies are all competing for the same talented individuals.

The October U.S. unemployment rate was recorded at 4.1%, a .1% decrease from September's recorded 4.2%. Overall, the unemployment rate has been decreasing since 2009 when the unemployment rate was 10%, October's unemployment rate being a 17 year low. The charts below show the monthly unemployment rate over the past four months and nine years.

Capital Market Outlook:

Overall, we believe the technology sector will continue to display robust growth. This is due to increasing real GDP, consumer confidence, consumer spending and low unemployment within the U.S. We do expect the US dollar to strengthen which will cause potential revenue losses for the technology companies earning foreign revenue. However, the industry growth will increase revenues more than the exchange rates will devalue the foreign revenue.

Source: Statista

The bar chart above illustrates adverting expenditure growth in emerging markets compared to the U.S. The driver of this growth is increasing economic development and increasing middle class. Together, these factors present large growth opportunities for the Technology industry because foreign revenues will increase. We believe that with these economic forecasts NVIDIA and the technology sector will perform as expected due to the success the sector has demonstrated this year.

Industry Analysis

Industry Overview

Source: Trading Economics

We predict unemployment rate to average 4.4% over the next six months, as we expect the labor force to increase as strong economic conditions continue. Over the next three years, we expect unemployment to increase to 4.4 to 4.8 percent. We believe that low unemployment rate will make finding qualified workers more difficult for companies since there is only a small portion of the labor force seeking jobs. Overall, this 17 year low unemployment rate will increase.

"A materials product - usually comprised of silicon - which conducts electricity more than an insulator but less than a pure conductor, such as copper and aluminum. Semiconductors are usually very small and complex devices, and can be found in thousands of products such as computers, cell phones, appliances, and medical equipment".9 The semiconductor industry is fairly versatile, in the aspect that they can be put into many different products and can have slight variations based on customer need. This is why we expect strong growth for the industry in the future. We believe that new technology products will incorporate semiconductors and expand their customer base as time goes on.

Trends

The main trend in the semiconductor industry is that it is very cyclical. This is generally unavoidable within the industry. The success of semiconductor companies is primarily driven by the

demand for PCs, smartphones, and tablets. When sales of these items slow it can have catastrophic results on a semiconductor company's sales. However, when there is a large demand for a new product, like when the iPhone X came out, semiconductor companies can charge a premium. We believe this cyclical trend will continue in the future.

Business Segments

In the semiconductor industry, there are two different segments. The industry is divided by semiconductor type. The two types are titled intrinsic and extrinsic.

Intrinsic:

Intrinsic semiconductors function when the semiconductor has an equal number of electrons and holes in the conduction band. The number of electrons equals the number of holes because they have been thermally excited, causing them to move from the valence band through the conduction band. The conduction band is where the electrons can move freely causing energy.4/14

Extrinsic:

Extrinsic semiconductors function when there are more electrons than holes in the conduction band. This is due to only some of the electrons being manually forced through the conduction band. Depending on the force that does this, extrinsic conductors can be P-type or N-type.4

Product Segments

The semiconductor industry can be broken down into four major product categories. The categories consist of memory, microprocessors, commodity integrated circuit, and complex system on a chip (SOC).

Memory chips work like temporary storehouses for data and transport information through computer devices. Microprocessors contain basic logic for performing tasks. Commodity integrated circuits or "standard chips" are produced on a larger scale and are used in routine processing. Complex SOC is basically an integrated circuit chip containing an entire system's capability; the market for these is driven by the increasing demand for consumer products that combine new features at competitive prices.9

Source: Singapore Business

The chart above depicts the broad product types semiconductors go into. We expect to see some changes in these percentages in the future. As self-driving cars become a standard in the automotive industry, we expect a large jump in the percentage of semiconductors that go into the automotive industry. As semiconductors increase use within the automotive industry, we expect the percentage of semiconductors in PCs to drop. We predict this drop, not because of a drop in PC use, but just a stagnation or lack of increase in PC sales.

Porter's 5 Forces

Threat of new entrants: low

There are high costs associated with entering the semiconductor industry, such as buying the machinery to produce semiconductors. Intellectual property is heavily protected in this industry, making it difficult to compete with established companies. Therefore, the concern for companies entering this industry is reserved for companies like Alphabet and Apple. These companies have large sums of cash and could buy any resources they might need to enter the industry. However, we don't predict this happening in the future. We believe that these large technology companies will stay in their primary market.

Threat of substitutes: low

For a lot of products, like smartphones and some medical devices, there are no substitutes for the semiconductors in those products. This forces companies to use semiconductors in their products. We believe that as newer electronic devices are invented, they will increasingly use semiconductors. We have a positive outlook for the industry as a whole.

Competition in the industry: moderate

What keeps the competition from being high, is the high cost to switch suppliers. If a company wants to switch semiconductor suppliers, they will have to pay a large premium to their new supplier at first, so that company can change their production method to produce the type and variant of semiconductor the customer needs. We believe semiconductor companies will be able to find ways to make this switching process in the future.

This will cause competition to rise in the industry, as the ease of switching semiconductor suppliers increases.

Bargaining power of buyers: low

This high switching cost previously mentioned, gives the buyers low bargaining power. Unless the buyer's semiconductor company has extremely high costs, it will be more cost effective to pay the higher prices than to switch suppliers.

Bargaining power of suppliers: moderate

Silicon is used in almost all semiconductors and is the second most abundant element on Earth. However, the process of refining silicon into a usable substance is an expensive process. This is what gives the suppliers moderate bargaining power. It would be costly for these semiconductor companies to refine silicon on their own in addition to their usual operations.7

This analysis shows us that going forward, the market leaders in the semiconductor industry are likely to maintain their positions, but at moderate risk of current competitor infringement. These competitors will take some of the revenue share because they will likely cut prices to get customers while trying to gain their loyalty. Then, they will attempt to maintain these customers while increasing prices to counteract the previous price cut. Successful companies like NVIDIA will struggle to maintain their high rate of growth.

Market and Competition Landscape

While competition is moderate now, we expect competition to pick up in the future. Companies will soon able to adapt their production setups to produce multiple types of semiconductors easily and cost efficiently. A large driver in the industry leading to competition is product performance. In the technology sector, performance and speed are everything. Customers are very willing to change their products if there are ones that clearly perform better. Therefore, if one semiconductor company clearly performs better than another, their customers will switch to the other producer and lose that business.

Risks

Impact on Fundamentals

Weak economy and/or product environment

Shipment volumes may be negatively affected

Loss of revenues, profits and

Delayed delivery of competitive position; potential

products

reduction in demand for current

chips

Server price competition

Shrinking profit margins

Failure to keep up with technology

Increasing chip complexity requires more advanced processes to keep costs under control

Source: Investopedia

The chart above shows some of the risks that semiconductor companies need to be aware of. Like most of the technology

sector, semiconductor companies need to keep research and development a large focus, so they don't fall behind the demanding and fast-changing technology space. Since semiconductors are primarily used in luxury products like smartphones and tablets, in weaker economies their sales can decline. We feel that these semiconductor companies realize this and will try expanding their businesses into more recessionproof products like medical devices.

Major Players

The two big players in the semiconductor industry are Intel and Samsung. They are very well placed because they are not solely semiconductor companies. This diversity allows them to better absorb temporary declines in sales. These companies are also considerably larger than any other company in the industry. This allows them to more easily acquire companies or intellectual property.

Key Investment Positives and Negatives

We see semiconductors starting to be implemented into more technology as they are invented. This increase in potential products that use semiconductors will increase revenue. Also, if these products have different sale cycles, the semiconductor industry could possibly lose its cyclical nature and become more consistent.

One investment negative we projected is the possibility of semiconductors becoming obsolete upon the invention of a better, more effective substitution of them. While we don't see this happening soon, it is a risk to consider. Another investment negative is that perhaps future devices will be able to function without semiconductors. This would almost certainly collapse the industry, with the exception of companies like Intel and Samsung who have other business segments to keep them afloat. We factored this possibility into our model because the current rate at which technology changes is extremely fast.

Company Analysis

General Information

NVIDIA (NVDA) focuses on three primary areas: personal computer graphic design, graphics processing design, and artificial intelligence. The company operates through GPU and Tegra Processors. The graphics processing unit was initially just used for visuals in video games and movies but has expanded its use. GPUs are now able to simulate viruses to predict weak spots in software. NVIDIA uses AI to create software that can write itself and algorithms that can learn from past data. Recently, NVIDIA's AI is being utilized in the development of selfdriving cars. NVIDIA's corporate strategy is to focus on four main markets: Automotive, Datacenters, Gaming, and Professional Visualization?. NVIDIA's strategy has placed them is a competitive position for future trends. The company's early start on the AI needed for self-driving cars put NVIDIA ahead of

their competition as the self-driving car market begins to ramp up. The recent adoption of the company's Volta chips might mark the beginning of large sales from AI and driverless cars. We also believe that as the amount of global data exponentially increases, NVIDIA will be able to capitalize on the associated demand for data centers.

Analysis of Recent Earnings

As of November 9, 2017, NVIDIA reported EPS of $1.33, beating expectations by 39 cents and revenue of $2.64 billion. The company raised their dividend by 7 percent, leaving it at 15 cents per share. NVIDIA announced that they intend to return $1.25 billion to shareholders, in fiscal year 2019, through share repurchases and dividends.15 Data center revenue more than doubled in the past one year ending at $501 million. GPU revenue grew 25 percent on a year-on-year basis to $1.56 billion, and Tegra processor revenue grew 74 percent to $419 million. NVIDIA also announced that Amazon, Microsoft, Google, Baidu, Alibaba, Tencent, and Oracle showed support for Volta. The support of every major cloud producer along with every major server computer maker reflects in our optimistic revenue predictions in our model.18

Source: NVIDIA Inc.

GAAP net income for the quarter reported was $838 million, up 55 percent Y/Y. NVIDIA's CEO attributed their growth to the accelerated adoption of AI from industries across the world. He stated, "Our Volta GPU has been embraced by every major internet and cloud service provider and computer maker. Our new TensorRT inference acceleration platform opens us to growth in hyperscale datacenters. GeForce and Nintendo Switch are tapped into the strongest growth dynamics of gaming. And our new DRIVE PX Pegasus for robotaxis has been adopted by companies around the world." We believe that NVIDIA's recent earnings and guidance support our model's predictions for continued revenue growth.13

Marketing Strategy

NVIDIA's main marketing strategy is to partner or work closely with companies that either use their products or make devices that use their products?. A part of this networking strategy is to give their large customers extreme attention to keep them satisfied. This leads to them having fewer customers because they focus on a few key companies. We believe this strategy

could leave them vulnerable, if a competitor were to take one of their customers. For example, ASUSTeK Computer Inc. made up 12% of NVIDIA's 2017 fiscal year revenue?. If this customer terminated their business with NVIDIA it would severely hurt the company. This scenario also gives customers more bargaining power to negotiate prices. The partnership NVIDIA has with its customers allows them to leverage these companies to develop products that are compatible with NVIDIA's products. As an industry leader, NVIDIA is able to use a skimming price policy. Their innovation allows them to collect higher revenues from new products before adjusting prices to attract new customers and compete with immerging competitors. The company also hopes to increase brand awareness via television, magazines, and social media advertisement. As the company has grown it has maintained a positive public image by donating and interacting with global and local communities.5

Production and Distribution

NVIDIA does not do any manufacturing of their products, and they hire suppliers for the majority of the materials needed. They outsource the production of all their products to companies that specialize in each phase of production?. For example, a semiconductor NVIDIA designed might go to 3 separate companies before it gets to the customer. One company may supply the materials, the next would manufacture the product, and the last company would test and ship the product. This allows NVIDIA to avoid purchase and depreciation costs for most of the equipment required to produce their products. The labor costs associated with the production of their products remain lower through outsourcing, as opposed to producing in the United States.

However, NVIDIA does own warehouses to store half-finished products. NVIDIA's customers demand quick access to the purchase and delivery of semiconductors. NVIDIA attempts to meet this demand by having semiconductors almost finished when purchase orders come in?. We believe that this exposes them to inventory risks and increases our projected potential expenses.

Semiconductors that are half finished can be made into various products, depending on the second half of the production process. This allows NVIDIA to avoid excess unusable inventory. They can more easily adapt their current inventory to demand. NVIDIA's most common suppliers are Taiwan Semiconductor Manufacturing Company Limited, and Samsung Electronics Co. NVIDIA's usual manufacturers are BYD Auto Co. Ltd. and Quanta Computer. For testing of their products and delivery NVIDIA typically uses companies like Advanced Semiconductor Engineering or Siliconware Precision Industries Company LTD?.

Over the most recent 5 years, NVIDIA has kept an average inventory as a percent of sales of 9.92%. This is composed of 2.87% raw materials, 2.3% work-in-process, and 4.74% finished goods (percentages are all of revenue). Based on the company's production strategies, we model that NVIDIA will maintain this structure going forward.

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