Semiconductor Industry: Growth and Trends

• The semiconductor business grew significantly due to the PC revolution of the 1980s, becoming integral to various devices.
• Semiconductor companies' revenues surged in the 1980s and 1990s, driven by the PC business and the dot-com boom.
• From 2001 to 2020, semiconductor revenue growth slowed to single digits due to pricing power loss and declining chip prices, despite increased demand.
• The semiconductor business has generally been profitable, with gross and operating margins picking up since 2010, driven by higher profitability in specific segments.
• R&D adjusted operating margins at semiconductor companies are approximately 2-4% higher than reported margins.
• Semiconductor companies experienced market glory and pain, with significant market capitalization surges in the 1990s and 2011-2020.
• Revenue multiples for semiconductor companies have fluctuated, peaking during the dot-com era and spiking again between 2019 and 2021.
• The top semiconductor companies have evolved, with Japanese companies declining and Korean and Taiwanese firms rising, such as Taiwan Semiconductors.
• NVIDIA was ranked eighth in revenue among semiconductor companies in 2023, reflecting its strategy of targeting niche markets with high profitability, and was founded in 1993 by Jensen Huang.
• Customers for semiconductor chips have shifted from personal computers to smartphones, with growing demand from automobile, crypto, and gaming companies.
• Forecasts for 2030 indicate faster growth in automobile and industry electronics, with the potential surge in demand from AI products largely underplayed.

NVIDIA: The Opportunist!

• NVIDIA went public in January 1999, experiencing a 64% stock price increase on its offering date, with initial revenues of $160 million.
• NVIDIA's revenues grew significantly between 2000 and 2005, reaching $2.4 billion, and the company made the top ten list of semiconductor companies by 2010.
• Between 2016 and 2020, NVIDIA's revenue growth rate surged to 27.19%, driven by well-timed bets on gaming and crypto.
• NVIDIA has maintained impressive growth, with above-average profitability, by investing in growth markets.
• NVIDIA outsources almost all of its chip production to TSMC, focusing on research and chip design.
• NVIDIA's corrected pre-tax operating margin was 37.83%, and the pre-tax return on capital was 24.42% in 2021-2023 after capitalizing R&D.
• In 2022, NVIDIA's sales to capital ratio was 0.65, indicating heavy investment to achieve its current position.
• NVIDIA's market capitalization has risen significantly since its IPO, reaching a trillion-dollar value with downturns in 2002, 2008 and 2018.

AI: From Promise to Profits

• AI's potential to upend life and work is becoming visible, though separating hype from reality remains challenging.
• Each revolutionary change has created winners but also losers, with a few companies dominating the space.
• Early leaders in revolutionary businesses often fall by the wayside, and failures are common along the way.
• Investing in change ahead of the market does not guarantee high returns if the wrong players are backed.
• There is a risk of disruption for existing businesses due to technological change.
• Even with the belief that AI will change businesses, there is no low-risk path for investors to monetize this belief.
• Companies can be broken down based on what part of the AI ecosystem they inhabit, including Hardware and Infrastructure, Software and Applications
• AI hardware requires software to leverage computing power, including AI platforms, chatbots, and deep learning algorithms.
• AI requires immense data, potentially giving value to businesses collecting and processing data for AI applications.
• AI adoption in businesses may lead to cost reduction but could also result in lower prices and profits due to increased efficiency across the board.
• AI has the potential to disrupt companies that derive value from delivering services for lucrative fees, leading to a negative-sum game.
• AI can enrich valuation and investing when used as a tool, but it may make delivering excess returns more challenging for active investors.
• It is believed that AI will make a difficult game (delivering excess returns or alpha from investing) even more so
• AI's social effects are uncertain, with the potential for both positive and negative consequences.
• Regulating AI development faces challenges due to regulators' limited understanding and the risk of unintended consequences.
• It is essential for consumers of AI products and services to differentiate between good and bad uses, despite the difficulties.
• NVIDIA has invested in developing products for the AI market, gaining market leadership, revenues, and profits.
• NVIDIA reported a surge in data center revenues, with much of the increase coming from AI chips.
• The estimated AI chip market in 2022 was about $15 billion, with NVIDIA holding a dominant market share of about 80%.
• Estimates for the overall AI chip market in 2030 range from $200 billion to close to $300 billion.
• The AI chip market is expected to be the growth engine for NVIDIA's revenues over the next decade.
• NVIDIA has a lead over its competition in the AI chip market, which will not be easily cracked.

NVIDIA: Valuation and Decision Time

• NVIDIA's driver of success has been its high-performance GPU cards, but the businesses driving its success are likely to change.
• Gaming and crypto markets are maturing, but AI and automobiles are poised for rapid growth and NVIDIA is well postioned in both markets.
• A company's value is a function of revenue growth, target operating margin, reinvestment efficiency, and cost of capital/failure rate.
• NVIDIA's different businesses share some common features but diverge in terms of revenue growth potential.
• The construction of the NVIDIA story includes inputs that drive value as drivers to growth potential, profitability, reinvestment efficiency and risk (cost of capital)
• NVIDIA is expected to remain a high-growth company due to its position in the AI and auto markets, even with gaming revenue growth slowing.
• It is assumed that the AI and Auto markets will deliver growth, with NVIDIA maintaining a dominant share in AI and gaining a significant share in Auto.
• NVIDIA's target R&D adjusted margin of 40% may look high but the company delivered 42.5% as margin in 2020 and 38.4% as margin in 2021
• NVIDIA's sales to invested capital are expected to approach the global industry median of $1.15 in revenues per dollar of capital invested.
• NVIDIA's cost of capital is estimated at 12.21% and is projected to decrease towards the overall market average of 8.85%.
• Based on this story, the value per share arrived at for NVIDIA on June 10, 2023, is about $240, well below the stock price of $409 that the stock traded at on June 10, 2023.
• Key assumptions for NVIDIA's value include revenues in year 10 and operating margins.
• A simulation involving revenues, operating margin, reinvestment, and risk resulted in a simulated value per share.
• The simulation suggests that NVIDIA's stock price is pushing towards the 95th percentile of the value distribution.
• Achieving NVIDIA's intrinsic value exceeding $400 requires a combination of extraordinary revenue growth and super-normal margins.
• The findings show that there are plausible paths that lead to the current price being a fair value or undervalue, but these paths require a daunting combination of extraordinary revenue growth and super-normal margins
• If NVIDIA justifies current pricing, it would have to be through explosive revenue growth from another market with similar potential to AI.
• As a holder of NVIDIA shares, one has an investment philosophy built around value, buying when price is less than value and selling when it is much higher than value.
• Given the analysis, a path that splits the difference was chosen, selling half of the NVIDIA holdings and cashing in on profits, while holding the other half for optionality.

NVIDIA as a Trade

• There is a divide between investing and trading, investing involves assessing value, comparing to price, and acting on the difference, while trading involves buying low and selling high, regardless of rationality.
• Even with a belief that NVIDIA's value is below its price, one might trade it based on expectations of continued price increases from momentum or information.
• Momentum can drive NVIDIA's stock price, generating high returns, but it is not sustainable forever.
• Traders should focus on indicators that give early warnings of shifts in momentum rather than worrying about value.
• Investing in AI-related companies does not guarantee returns.
• There is a need to make estimates about how AI will affect the fundamentals (cash flows, growth, and risk) in a business.
• It is unclear whether adding AI to the mix will make society better or worse off, as technological changes often bring unintended consequences.