In this blog, we discuss NVIDIA’s latest earnings release and the cyclicality of the semiconductor industry.
NVIDIA’s latest earnings
Last week, NVIDIA released its latest quarterly report. Overall, the results beat Wall Street’s expectations.
NVIDIA’s Q4 2022 (reported January 2023)
| Expected | Reported | Surprise | |
| EPS | $0.80 | $0.88 | 9.46% |
| Revenue | $6.02 billion | $6.05 billion | 0.53% |
Over the past year, the company’s growth had decelerated significantly. After the 2021 COVID boom, which propelled gaming and data center businesses, 2022 brought about a decline in demand and write-offs due to excess inventory. NVIDIA’s deceleration was worsened by a slowdown in China (due to COVID zero policies and US government export control) and a crypto winter (NVIDIA’s chips are used for crypto mining). But revenue slowdown seems to have hit bottom and turned a corner (see Figure 1).
Note that NVIDIA is not the only semiconductor company experiencing this deceleration. The industry is notoriously cyclical, which we will discuss later in this article.
For the company, the turnaround seems to be driven by the Data Center segment. This is the business line where NVIDIA sells its chips for AI applications. Here’s the breakdown of the year-over-year change of each business line (see Figure 2 below).
Here are some key takeaways:
- Data Center, a key driver of growth (especially now with the explosion of generative AI, which we have discussed in greater detail here), grew 11%. The growth is driven by the adoption of the company’s latest AI product, the H100, which is outpacing its predecessor, the A100, at the same life cycle. Compared to the A100, the H100 is 30x faster for large transformer models – the foundational architecture of GPT-3, Google’s Bard, and the new AI-powered Bing.
- Gaming segment is a drag on revenue growth. It is down 46% year-over-year due to high inventory levels at channel partners.
- Automotive grew the fastest at a 135% growth rate year-over-year. Even though it is still a very small contributor to overall revenue (about 5%), ramp-ups of EV and autonomous vehicle programs worldwide helped this segment. Earlier this year, NVIDIA signed a deal to be Foxconn’s strategic partner, where Foxconn (the assembler of the iPhone) will produce the electronic control units for NVIDIA’s Drive system.
To be clear, some segments of the year-over-year chart look worse than they are because of the overlap of very strong growth at the end of 2021. Nevertheless, in its earnings call, management reiterated that they expect another strong Data Center segment growth in the next quarter, driven by more AI demand.
Buoyed by the earnings beat and the positive growth expectations for the Data Center segment, NVIDIA’s share price jumped. As of this writing, the share price is up roughly 12% since the earnings call. This is an example where having the ability to trade during these earnings calls, which requires post-market hours access, can be useful (something that we are working on….
Now, back to the previous comment about cyclicality.
Cyclicality in semiconductors
The semiconductor industry is cyclical. Cyclicality typically happens in an industry where:
- Demand ebbs and flows (not constant), and
- Supply takes time to expand
As demand increases, the industry tries to match it by building increased capacity. But because building the excess capacity takes time, and as the supply becomes online, demand starts to go down (typically temporarily). This causes short/medium-term pain for the industry as excess supply occurs at the worst time. This is a well-known dynamic and happens every few years.
Figure 3 above shows what this cyclicality has looked like over the past 26 years. The red line shows the roller coaster of year-over-year revenue change. The blue line represents the total industry revenue. Despite the fluctuations, the overall long-term outlook is trending up. In 2022, revenue for the global semiconductor industry totaled $573 billion (a record), but sales slowed down rapidly toward the end of the year.
Cyclicality is a well-studied phenomenon that happens in other industries as well, e.g., oil. Typically, a savvy investor can take advantage of this cyclicality. At the peak of the COVID lockdown, when oil prices were near record lows, Berkshire Hathaway bought $10 billion of preferred shares (with an 8% dividend yield) of Occidental Petroleum, which now is estimated to be worth about $4 billion.
Unlike the oil industry, however, cyclicality in the semiconductor industry does not apply equally to all players. This is because the oil industry output is largely an undifferentiated commodity. In contrast, the semiconductor industry outputs differentiated products (various types of chips at various technology nodes).
To understand this better, let’s look at the leading semiconductor companies and dissect the impact of cyclicality on their businesses. In the case of NVIDIA discussed above, in the current down-cycle impacting the gaming segment, the company is stuck with excess gaming inventory. We know that, in a down cycle, the inventory level tends to be higher.
Public companies report their inventory at the end of a quarter as part of their balance sheet reporting (in dollar terms). We can look at the inventory levels over time to gauge the historical impact of cyclicality on the business. But inventory level is a function of the size of the business. For example, TSMC is a larger company than Micron, with a larger revenue base. It would commensurately have a higher inventory as well. So to make an apples-to-apples comparison, we have to normalize the inventory level by dividing inventory with revenue, shown in Figure 4.
Fluctuations over the years highlight the industry’s cyclicality. In this chart, we show today’s leading semiconductor companies, going back to the dot-com bubble of the early 2000s Note: this is not meant to be an exhaustive analysis, as we are clearly ignoring some large players and survivorship bias.
Here are some key observations:
- For all companies we looked at (except TSMC), inventory as a share of revenue spiked in 2022 (higher is worse). Most of these companies carry high unsold inventory levels, as high as the tech bubble of the 2000s.
- The outlier of this industry-wide trend is TSMC (yellow line). Being the only foundry with the most advanced capabilities gives TSMC pricing and inventory power. It has the power to minimize its own inventory risk.
- Memory chip makers tend to fare worse in a downturn. Micron and SK Hynix are the two largest memory (DRAM) producers after Samsung. Notice that their inventory levels are higher (especially Micron, shown in the light blue line). This is because the DRAM tends to be less differentiated than logic chips, which for most advanced applications, must be made with the latest production nodes
Clearly, cyclicality impacts the different semiconductor companies differently. As an investor, it’s important to understand this nuance.
Ok, Figure 5 above is a bit noisy, as we have various types of companies. Let’s focus on NVIDIA, Intel, AMD, and TSMC, the primary players in logic chips. Here’s what the chart looks like (Figure 6).
Figure 5 above paints a dire picture for Intel (orange line). For the better part of the last 20 years, its inventory as a share of revenue has been below 10% (even in the dot-com bubble). In 2022, however, Intel’s inventory levels spiked to 21% of revenue. Intel lost its process advantage in the second half of the last decade. Now, its product has become less competitive in both the PC market and the Data Center segment.
After paring back capex spending and cutting salaries, Intel finally slashed dividends by 66%. This cut will save the company $4 billion in 2023. Last year, the company had a -$9.6 billion cash flow and ended the year with $11.1 billion in cash, all the while paying $6 billion in dividends. Clearly, this is not sustainable. The cost-cutting moves are a good start but are unlikely to be sufficient.
