The Long Game in AI: Lessons from NVIDIA’s Earnings and the Mag-7

Stocks had another mixed close in a session that was dotted by nervous optimism and concerns that the Ukraine conflict can spiral out of control. Target's earnings miss is in sharp contrast to fellow retailers Walmart and Williams Sonoma, reminding us that sometimes companies' stocks don't always trade down for the wrong reasons; you read that correctly

Virtual dis-reality. Okay, so the event of the century - or maybe the quarter - finally happened last night. That's right, NVIDIA announced its earnings. If you asked most investors why NVIDIA's earnings were so important, you would get a range of answers. The first, and most obvious one is the fact that NVIDIA was at the spearhead of the growth superpower known as the Magnificent-7, which earned its namesake by helping equity indexes power yet higher this year. How did that happen? Ready? Apple, Microsoft, Amazon, Alphabet, Meta, NVIDIA, and Tesla, collectively known as the Mag-7 represent almost 1/3 of the weight of the S&P500. That's right, just seven stocks, or 1.4%, make up more than 33% of weight in the index.

That is not a problem as long as we understand that reality and how it might distort investors' understanding of the behavior of stocks broadly. Ok, enough of that. NVIDIA has been in a virtual dogfight with Apple for the top spot in recent months. That top spot holder is the biggest market cap company on the most highly followed index, which trades in the financial capital of the world, as in - The world. So, yeah, I guess NVIDIA is kind of important.

There is something else. Of those 7 superlatives, 6 are directly involved with Artificial Intelligence. Tesla, a car company, is also somehow involved with - well all sorts of other highly important things, including AI. In order for AI to be… intelligent, it needs servers which need chips like the ones produced by NVIDIA. Those servers are operated by AI Hyperscalers like Amazon's AWS, Microsoft's Azure, and Alphabet's Google Cloud. That's 4 down. Meta, which now effectively utilizes AI to optimize and make more profitable its ad business, also operates its own AI-optimized clouds. That's 5. Apple recently began deploying AI on the latest version of its smartphone and it is expected to become more embedded in future releases. That's 6! All of them somehow tied to the "success" of artificial intelligence. If you could imagine a pyramid with chips at the very bottom, servers on the layer above, hyperscalers on the third floor, OpenAI (known for ChatGPT) and companies like Anthropic and Google's Gemini on the fourth course, and finally, on the penthouse of the pyramid resides Apple, Tesla, Meta, and Microsoft. Those are all companies that use AI for their businesses.

For example, Microsoft sells Microsoft Office 365, Github Copilot, and Windows, among others, which bring AI directly to the user, charging fees. Let's take a step back. Listen carefully - um, read carefully. AI IS REAL AND IT IS A GAMECHANGER akin to columned paper and adding machines evolving into spreadsheets or flip phones evolving into smartphones. If you are still using an adding machine and a flip phone, you are at a severe productivity disadvantage, cheers, you lost. Similarly, if businesses of almost all types are not using AI in some capacity, they will be at a disadvantage in the very near future. Some companies will add services driven by AI and derive direct revenues from those products, while others will use AI to make their existing business more efficient. Still others will have to incorporate AI in order to stay relevant amongst their peers who offer AI-based services as part of their core offerings. Imagine if an auto company decided not to offer seatbelts as part of its standard offering when all its competitors were. Ya, it's like that. I am sure you didn't hear it here first, but I want to make sure you really get it, because it is not only going to impact your life going forward, but it will also impact your portfolio going forward.

Let's take a step back now and get back to the ground floor, or foundation, of that pyramid. That pyramid that would simply not exist today without it. That floor contains, companies like AMD, Intel, and … wait for it… wait for it… NVIDIA! NVIDIA was really the first to market with processors that make AI efficient enough to even exist at the moment. You see, it was the first company to realize that its parallel processing capabilities, developed as a leader in graphic processing for years, were well-suited for fast and efficient AI creation. That allowed it to cement itself as THE leader in the space. NVIDIA didn't rest on its laurels. It quickly developed AI-specific chips and systems to further build its AI business. The real dollar results are astounding with gasp-inspiring growth. Check out this chart that shows how the company grew its Data Center business line from around $6 billion to around $29 billion in under 2 years.

That's pretty good, right? That is revenue from its Data Center line only. Do you want to know how profitable that business is? Well, how about a gross profit margin of 75% with an operating margin of 56%. That is profitable, my friends. Do you want to hear something funny. Analysts, on average, were expecting the company's gross margin to be 75.05% while its actual margin came in at 75.00%, and the markets reacted negatively. The company's revenue came in at $35.082 billion, which was not only above the consensus estimate of $33.249 billion, but even above the highest range estimate of $34.9363 billion. That is a beat! I will spare you the specifics on EPS, but it was a similar type of beat, even exceeding the most bullish estimate. I would say we have a few checkmarks, wouldn't you? Going back to the company's all important Data Center segment, it announced $30.771 billion in revenues for the segment, beating the consensus estimate of $29.1442 billion, but came in a whisker short of the highest estimate of $30.8391 billion. AND, AND… the market didn't like that. The result caused the stock to decline after hours. This morning, NVIDIA is down by slightly less than 1%, but it is still down. That's right, the company that had a 107% EPS growth from the same quarter last year, has not been celebrated for its latest result. I know that the year over year EPS growth was at a higher 165% last quarter, but still…107%! You will be hard-pressed to find anything else like it at this scale. The company's flagship AI chipset is known as Blackwell, for which the company has orders for delivery through 2026! That high demand is not a bad thing for the company, it is a good thing!

Finally, I watched a procession of analysts and academics prognosticate about the AI industry last night and found it rather interesting. Many were saying things like "Microsoft has to show that it can monetize AI," or "Microsoft's CAPEX on AI data centers is so high." Ok, thanks for exposing the obvious. In fact, the only smart thing I heard was not at all a revelation. One academic said that NVIDIA's revenue is another company's CAPEX, and if the other company (referring to Microsoft) stops spending, then it could be bad for NVIDIA. Correct, but also a blaring glimpse of the obvious. Here is the thing I want you to take away from this. Microsoft and every one of its competitors, not only in the consumer space, but also the commercial space, is ON NOTICE. They MUST build AI infrastructure to even stay relevant! Monetization is super important, no doubt, but companies must invest NOW, or they will simply disappear in the near future. Look, I am not giving a free pass for all companies to spend wildly, but I would not just hope, but I would expect any company that I invest in to be investing heavily on AI infrastructure, not only as future revenue sources, but also to be able to compete in the future. Remember when Microsoft lost its edge to Netscape and Google in the browser wars because it was late to the game? Here is a secret , it never caught up with only a ~5% market share. Microsoft is probably the leader in AI infrastructure and monetization at the moment, but others are getting the message. I will leave you with one final analogy. Would you invest in any retail company that does not have a website or an ecommerce solution? Ya, it's that fundamental, so don't get cute about whether you think NVIDIA or Microsoft's share price even if it is up or down 10%. If you got my message and you are a long-term investor, you should not overlook the potential upside of the industry - which directly affects at least 6 of the 7 magnificent stocks in the Mag-7. I want to be clear. I am not telling you to buy any of these companies, but I am insisting that you recognize the shift that is occurring, and it may require you to take a longer term view. But wait, I always tell you to take a longer-term view, so… carry on.

YESTERDAY'S MARKETS

NEXT UP

• Initial Jobless Claims (November 16^th) is expected to come in at 220k, slightly higher than last week's 217k claims.
• Leading Economic Index (October) may have slipped by -0.3% after declining by -0.5% in September.
• Existing Home Sales (October) probably gained by +2.29% after slipping by -1.0% in the prior period.
• Fed speakers today: Hammack, Goolsbee, Schmid, and Barr.
• Earnings after the closing bell: Intuit, NetApp, Ross Stores, and The Gap.

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