Investors have become obsessed with generative AI (artificial intelligence) this year, with Nvidia (NVDA:NASDAQ) the market’s favourite way of playing the trend.

Shares in the Santa Clara-based microchip designer have more than tripled in value this year, as it began to dawn on the market there is big money to be made selling picks and shovels for generative AI applications.

Understandably, many investors might ponder whether the easy money has already been made. At $415, up from $143 at the start of 2023, the company is now valued at around $1 trillion, putting the stock on 38 times forecast earnings for the year to 31 January 2024.

Analysts are increasingly seeing more explosive growth for Nvidia in the years ahead and company forecasts have jumped, hence why investors have been happy to pay a premium rating for the shares.

Consensus has more than doubled for fiscal 2024, according to Koyfin data, and is up an average 43% for 2025 and 23% for 2026. The average consensus 12-month target price for the stock stands at $641 – 54% higher than current levels – but the most bullish predictions point to the shares topping $1,000 by late 2024.

HOW NVIDIA GOT HERE

Demand for ‘AI everything’ is surging thanks to the launch of OpenAI’s ChapGPT and other chatbot technologies. In May 2023, Shares explained some of the everyday uses for AI that have taken the technology from hype to reality, but sceptics have been waiting for the bubble to burst all year.

Those Cassandras have been left disappointed and massively out of pocket with Nvidia putting up knockout results. Second quarter (to 31 Jul) results in August saw the stock set record closing price highs of $493.55 after the company smashed expectations and lifted full year hopes far higher, forcing analysts to tear up estimates and upwardly revise growth projections.

‘A new computing era has begun,’ said Nvidia founder and CEO Jensen Huang said in a statement. ‘Companies worldwide are transitioning from general-purpose to accelerated computing and generative AI.’

Nvidia estimates there is something like a trillion dollars’ worth of installed data centre cloud computing, and ‘that trillion dollars of data centres is in the process of transitioning into accelerated computing and generative AI.’ Nvidia sees two simultaneous platform shifts at the same time – cloud and generative AI, hinting at the exiting potential for its future revenue growth.

NVIDIA’S IPHONE MOMENT

The world is suddenly awash in all sorts of AI wizardry, with more websites, tools and apps coming every day, and Nvidia’s GPUs (graphics processing units) dominate the AI chip market. Some estimates suggest an 80% or more market share.

‘I call it the iPhone moment,’ Nvidia’s Huang said in an interview with The Wall Street Journal, comparing his company’s position in generative AI to the way Apple’s (AAPL:NASDAQ) smartphone essentially ushered in a new era of tech.

‘All the technology came together and helped everybody realise what an amazing product that can be and what capabilities it can have,’ said Huang.

Nvidia believes there is a $1 trillion market opportunity with a new generation of advanced chips to power a range of applications, from data centres to electric vehicles and healthcare.

NVIDIA’S OPPORTUNITY VISION 

Automotive: $300 billion

Chips and Systems: $300 billion

Nvidia AI Enterprise Software: $150 billion

Nvidia AI Omniverse Software: $150 billion

Gaming: $100 billion

NIVIDIA’S AI OPPORTUNITY

Nvidia’s estimates are underscored by market researchers and analysts for enormous AI growth potential. Consultancy McKinsey believes 70% of companies will be using at least one type of AI by 2030, and investment bank Morgan Stanley forecasts the AI industry will generate $1 trillion in annual revenue by 2050.

JPMorgan named AI as one of its hot themes for 2023, saying that with the emergence of ChatGPT, and other generative AI-powered chatbots, the future of work is set to be disrupted.

Nvidia’s AI chips dominance is not set in stone, but the company has been building competitive advantages for years to sustain leadership in its markets, and analysts see evidence that customers are willing to pay a significant price premium and to wait months to obtain its chips.

‘Customers will wait 18 months to buy an Nvidia system rather than buy an available, off-the-shelf chip from either a start-up or another competitor,’ says Futurum analyst Daniel Newman. ‘It’s incredible.’

What Nvidia’s Q2 results also show is how its business has switched from a gaming-first to AI-first business. The company’s gaming unit was once the main driver of revenue, and while it continues to grow – Q2 gaming revenue increased 22% year-on-year to $2.49 billion – it’s now overshadowed by data centre income.

Nvidia’s data centre business generated $10.32 billion in Q2 revenue, up 141% from the previous quarter and 171% up on a year ago.

Professional services and automotive remain bit-part players. Professional visualisation Q2 revenue was up 28% to $328 million from the previous quarter but fell 24% year-on-year. Automotive, which has been a demand bright spot lately for other chip vendors, reversed 15% to $253 million on Q1, although it was up 15% year-on-year, with many of the supply chain issues in the motor industry now resolved or easing up.

IS NVIDIA BEING AGGRESSIVE WITH BOOKING REVENUES?

The obvious risk for investors is achieving slower than forecast growth and how that would impact on the stock rating. As the table shows, a modest 10% cut to earnings forecasts coupled with a de-rating of the stock would see a painfully compounded sharp shock for the share price.

There are other concerns. For example, as one of the world’s largest chip manufacturers, TSMC (TSM:NYSE) produces most of Nvidia’s chips, as it does for many other clients. If TSMC’s capacity struggles to match chip demand, it could lead to long delays, potentially creating a ripple effect for Nvidia revenues that are beyond its control.

Analysts have also been taking a hard look at the company’s balance sheet and cash flows, and some worry about what they see. In Q2, trade receivables surged 73% quarter-on-quarter and 33% year-on-year, ‘eye-catching figures even as sales rose 88% quarter-on-quarter and doubled year-on-year,’ says AJ Bell investment director Russ Mould.

Trade receivables is cash yet to be collected for orders already placed. This is normal business practice but when trade receivables suddenly jump, it could mean a couple of things.

First, it might mean that Nvidia shipped a large number of chipsets at the very end of the quarter (and therefore did not have time to collect cash payment). Second, and more worryingly, the company might have pulled forward sales from long-term contracts without getting the cash payment, an aggressive revenue recognition policy that could lead to revenue misses in future quarters.

FINAL THOUGHTS ON NVIDIA

Given the surging demand for Nvidia chips, it would be puzzling why the company would spin revenues in this way. Perhaps it really did get a surge of late orders; we don’t know at this stage, but it is something for investors to watch.

What we do know is that Nvidia’s headline free cash flow has been steadily improving in recent years, until falling off a cliff last year, possibly the impact of chip market oversupply.

Share-based payments – part of director remuneration – can also skew profitability, although this may also explain the swathe of director stock sales recently. Since Q2 results (23 Aug), nearly 480,000 shares have been sold by board members, according to AJ Bell data, worth more than $218 million.

This may simply be directors diversifying their own portfolios during the handful of times a year when they are allowed to trade their own stock, although sceptics may feel there is something more sinister at play.

Nvidia’s meteoric rise this year has pushed the Blue Whale Growth Fund’s (BD6PG78) stake to 9.6% of the fund, just shy of the 10% single stake limit for UCITS funds, but manager Stephen Yiu remains a huge fan.

He recently told Citywire there were ‘no real competitors’ to Nvidia, even with rival Advanced Micro Devices (AMD:NASDAQ) attempting to make progress in chip technology used in AI applications.

‘We have to assume there will be competitors in the future but there’s huge growth potential for Nvidia over the next five years,’ he said, noting that only 5% of data centres currently use Nvidia chips, something that could change rapidly over the coming years.

Whether you agree with Yiu and most analysts, or hold a more cautious view of the stock, its sheer scale means you are likely to own a slice of Nvidia in your portfolio, even if you don’t realise it.

If you own a fund tracking the S&P 500, Nasdaq Composite or Nasdaq 100 indices or a global growth fund, you’ll no doubt have some level of Nvidia exposure. For most investors, that will be plenty.

DISCLAIMER: Author Steven Frazer has a personal investment in Blue Whale Growth Fund. AJ Bell cited in this article is the owner of Shares magazine. Steven Frazer and editor Daniel Coatsworth own shares in AJ Bell.

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