Episode 5 | Nvidia in the AI Age

In Episode 5 of "Market News with Rodney Lake," Rodney Lake, the Director of the GW Investment Institute, delves into the significance of Nvidia in the AI era. He explains how Nvidia's graphics processing units are central to AI applications, contributing to the company's substantial market cap of approximately $3 trillion. He highlights Nvidia's impressive financial metrics, including gross margins of 75% and net margins of 53%, alongside its dramatic free cash flow growth from $4.7 billion in 2021 to nearly $40 billion recently. Using the Investment Institute’s framework, he assesses Nvidia's business management, price valuation, and balance sheet, pointing to its strong market position and long-term growth potential despite high valuations. Tune in to learn more!

Transcript

Thank you for joining Market News with Rodney Lake. This is a regular show of the G.W. Investment Institute where we discuss timely market topics. I'm Rodney Lake. I serve as Vice Dean for Undergraduate Programs at George Washington University School of Business. Let's get started. Welcome back. This is episode five of Market News with Rodney Lake. I'm your host, Rodney Lake.

Now, in episode four, you might have noticed something different. A very fancy studio, instead of my office, where we do a little makeshift setup for recording Market News. Now we have this wonderful studio courtesy of the Duques family. Thank you, Rick and Don and the whole Duques family. The Duques Family Studio is very much appreciated and a massive upgrade.

Thanks. All right. So what's episode five about? It is Nvidia in the AI age. I tipped the hand in the last episode where we talked about the impact on businesses. Well, today we're going to talk about the company that everybody's been talking about in the AI space, which is Nvidia. And don't worry if you thought you missed Nvidia. As far as you know, you missed the whole AI revolution. That's not the case. There are going to be so many derivative impacts. But today we're going to talk specifically about Nvidia. And again, mind the disclaimer. This is not investment advice. This is the work that we do at the Investment Institute and our students. Nvidia happens to be the largest holding thanks to some of the great work that our students did back in 2019, as an example. Nvidia saw some of these things coming. But I want to talk a little bit about the company. And again, we're going to use the framework, the business management, price valuation, and balance sheet, that is the hallmark of the Investment Institute investment framework that we've built and used over the years.

We've been able to outperform the market with our students. And so, it's critical. And by the way, why does that work? Well, one reason is that we took most of it from Warren Buffett. And then we added a couple of components ourselves. Thank you, Mr. Buffett. He seems to be making it work for himself. It was in his annual shareholder letter. We have been using it now for almost 20 years. So, if you haven't heard of Nvidia, you haven't been watching any news. Maybe I can't help you there. But what's Nvidia? It's a publicly traded company. It makes graphics processing units, GPUs, or what they now call accelerators.

It's revolutionizing major categories. The company has really come onto the scene, and many people in the gaming world probably knew about Nvidia years ago. It's not a new company, but certainly, it's grown very large, and on some days, depending on the day, it is the largest publicly traded company in the world.

The current market cap for Nvidia is 3 trillion. If 3 trillion sounds like a lot of money, it is. It's three with a T. That has happened very recently. The company's valuation is up considerably, the market cap is up considerably over, let's say, the last year and certainly year to date. When you think about the timing, when ChatGPT was first released, everyone's focus was really drawn to, okay, what are all these AI applications and who is driving that as far as the hardware and the software?

At the center of this on the hardware side is Nvidia. Almost every company that's doing work in this space is using as many Nvidia chips as they can get their hands on. We'll talk a little bit about the numbers. A graphic processing unit is a little bit different than a central processing unit, a CPU versus a GPU.

This parallel compute type of computing just happens to be very good for AI applications, in this matrix math matrix that you need to do to create these renderings and other things. Certainly, for the gen AI pieces. It's not a new company, but certainly, it's an important company.

It has been at the forefront of every investment decision people have been making. If they're in Nvidia, should they be trimming their position? Should they be increasing their positions? Should they be reducing it? If you're not holding Nvidia shares, should we be involved in this company? It does seem to be right now at the center of everything artificial intelligence, everything.

Jensen Huang, who's the CEO and co-founder of the company, has been on the news a lot in a lot of different places. We have a lot of respect for his work, his work ethic, and all the things that he's been doing at the company. We're going to now cruise through business management, price valuation, and balance sheet for Nvidia.

This is the overview from the Investment Institute's point of view for Nvidia in today's episode. Number five is on that. It's called Nvidia in the AI Age, but it's really an overview of the company. Since this has all been happening, where do we stand? I'll first talk a little bit about the company. As we said, it's GPUs and accelerators.

We'll talk about who their customers are in a second. They're doing lots of research when you talk about, okay, works management, deploying capital. They have a lot of research and development projects and collaborations with research institutions and universities. That's really driving what's the next thing for them. As an analyst, you always have to think about where are they going and what's their strategic vision for the future.

The reason they got here today is because they planted seeds long ago in this accelerating computing, and it's really paying dividends for them. First, let's talk about the business. Just diving a little bit into the business, I mentioned already that the market cap for the company is now approximately $3 trillion.

Again, that's a big number, and some days, depending on how the companies are trading, Microsoft, Apple, Nvidia, it could be the largest publicly traded company in the world. I mentioned in the prior episode, if you watched episode four, about the expansion of gross margins for companies that are using AI. Now, Nvidia is the AI company and it's a hardware company.

When you think about hardware companies, you don't necessarily think about high profit margins. On the hardware side, you typically think about software companies as having high profit margins because to develop the next piece of software to sell, the next piece of software, the marginal cost is zero. Selling that next thing is all profit.

Whereas if you sell hardware, obviously there are cost of goods sold that go into that, and maybe the profit margins are not quite as good as software. But in this case, they're a hardware and software company. If you look at the gross margins, as of now, we're July 24th here, for example, it is 75% gross margins.

If that sounds high, that's because it is very high. The net margins are 53%. Those are fantastic numbers. When you're thinking about, okay, how do I rate this business one through ten on the scale for the Investment Institute? Ten being a great company, you're pushing towards ten on this. It's very difficult to get gross margins and net margins any higher than this in a sustainable way.

We'll talk a little bit about the moat around the business here in a second. Next, let's talk about some more recent things. I talked about how it jumped on the scene with ChatGPT being the catalyst for the focus on the company. If you look at free cash flow, and I have talked about that before in prior episodes, if you talk about free cash flow and where they were just a few years ago versus where they are now, in their fiscal year for 2021, they did 4.7 billion in free cash flow.

As of the last 12 months, they did almost 40 billion in free cash flow. So you're talking about an eight plus X on free cash flow in just three years. That is a massive difference. When they're getting all this attention, it's not just hype. People are buying their products. Their gross margins, their net margins are super high.

They're generating a ton of free cash flow now, especially relative to where they were. When you talk about increasing free cash flow eight times in three years, that is very significant and very unusual. That doesn't happen all the time, but it is this sort of tectonic shift happening in the AI world and something for us to think about.

Obviously, Nvidia sits at the top of that. What's been growing? Their data center business is growing. We'll talk a little bit about their customers. For their customers, just a little bit of a breakdown. I'm going to use some of my notes here to make sure I have the numbers correct. Microsoft accounts for 19% of the sales.

Do you think Microsoft is going out of business? Probably not. Microsoft has a bulletproof balance sheet. Do you think that Microsoft's going to continue to buy their products? Probably. What's the alternative? Right now, there doesn't seem to be a real second place. So AMD sits way far down, and Intel, and other chip makers seem to be far behind Nvidia, specifically on the GPU side.

Companies like Microsoft are buying as many H100s as they can, for example, that's one of the products from Nvidia. They're buying essentially whatever they can get, right? Whatever they can get, they're buying. Just to list some of the other companies, again, that's 19% of sales. A company like Microsoft is probably not going out of business, using a lot of their data centers.

Their data center business is growing by leaps and bounds. Next one is Meta. Meta is probably not going out of business, 10%. Alphabet, which is Google, almost 7%. Amazon, 6%. Dell Technologies, almost 6%. Tesla, 3%. Lenovo, 2%. These are all big companies and they have, for the most part, good balance sheets, or because you do have to really get comfortable with the valuation. It's certainly not cheap. But great companies never are cheap. At the Investments, we're very focused on buying high-quality companies that we can hold for a long period of time. The example that we've held the longest is Apple. It's one of the first companies that we bought in the first fund, the Ramsey Fund, all the way back in 2005.

And we still own shares today, and that has gone up over 100 times, as an example. So, we're looking for high-quality companies that can compound capital over time. Is Nvidia going to do that if we buy it at that price? Well, we'll see. But you're talking maybe a seven and a half or eight on the valuation and on the balance sheet.

I think you've got to give it a ten. So overall, we'll mix the scores around a little bit. But you're certainly talking about a company with an overall score of a nine as a composite, as an example. It's very challenging to find a better company right now. The price obviously gets people hung up on that, and people think that, okay, this is all now overblown.

We're talking 1999 valuations in hype. But I would argue that Nvidia obviously has real revenue and is a real company. Something that we have to understand better is what the future is going to look like for Nvidia. What applications, again, all these companies are going to be using. If you watched episode four, what are the demands for that?

Nvidia seems to be the top producer for the chips. There doesn't seem to be a real second place at the moment. So, the durable competitive advantage for them is big right now. They're well-managed. So, business grade management: fantastic. The valuation, again, we can talk and debate about, and our analysts will continue to do that.

Again, it's something that we think about all the time at the Investment Institute. What's the right number for that? What's the right position size in the portfolio? Because of that, as an example. And then a rock-solid balance sheet. So again, overall, we're thinking something like a nine for Nvidia for a composite score. It's a fantastic business, but it deserves a lot of attention right now if you do own it or if you're thinking about owning it, because it is sitting at the core of what's happening in the world of AI.

It's something that all of you as analysts should be thinking about, because they're sort of in that pole position. They're at the front of the line right now, and understanding that business and where they're going is going to be important. Even if you don't own shares now, that market might get deteriorated over time, but it seems like there's a big runway, and it's worth spending time to try to understand their business, the outlook, and what's the impact on other businesses.

So, that's a wrap for episode five. I hope you got some use out of this episode. And again, we're delighted to be in the Duques Family Studio, which is brand new and looks really great. Really appreciate everybody's time. See you next time for episode six of Market News with Rodney Lake.

Disclaimer: The content shared in the GW Investment Institute podcast is for informational and educational purposes only and should not be considered investment advice. The opinions expressed in this podcast are those of the host and guest and do not necessarily reflect the views of the GW Investment Institute or George Washington University. Listeners should not act upon the information provided without seeking professional advice from a qualified financial advisor.

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