Nvidia’s (NVDA) second-quarter earnings results for the three-month period ended July 31, 2022, show concerning revenue declines, inventory write-offs, poor cash flow generation, and a glaring incidence of potential earnings management – a controversial and unsustainable corporate practice that may artificially prop up NVDA stock price in the short term.
I’m going neutral on NVDA stock. The computing graphics chip manufacturing giant was in worse trouble than depicted in recent earnings results. Potential management shenanigans during the last quarter might have helped avoid a jittery market reaction to a potentially worse earnings outcome, but the company may not be out of the woods yet.
Nvidia’s Q2 Earnings Report: Manipulated?
Nvidia reported second-quarter revenue of $6.7 billion, down 19% sequentially but showing a respectable 3% year-over-year growth. The 3% annual growth rate still paints NVDA as a growth stock, and justifiably so. However, the company “desperately” accelerated more than a quarter of a billion dollars of sales from a later financial period into the quarter.
It appears like Nvidia’s management potentially propped up an otherwise negative-growth quarter through revenue smoothening – a strategy that artificially distributes revenue and earnings between quarters to dampen out acute declines so that stock investors do not freak out.
In a commentary accompanying second quarter results, Nvidia’s Chief Financial Officer (CFO) Colette Kress revealed some eye-opening details concerning the company’s potentially worse revenue decline during the second quarter.
“Data Center revenue included $287 million for orders originally scheduled for delivery primarily in the third quarter that were converted to second-quarter delivery…”
In other words, the company negotiated for earlier than scheduled delivery of orders worth more than a quarter of a billion dollars so that it could maintain a positive year-over-year growth trend for the last quarter.
Customer Incentives Abound During Desperate Times
To induce customer buy-in, the accelerated orders cited above had relaxed credit terms to sweeten the deal(s). Nvidia’s $287 million in accelerated sales came with “extended payment terms,” and this has some implications for cash flow generation.
If we take out the $287 million accelerated revenue, “typical” sales for the second quarter will drop to $6.4 billion to print a 22.6% decline quarter-over-quarter and a 1.4% sales contraction year-over-year.
Things could have been worse, and the company is struggling with a growing inventory problem.
NVDA Faces a Growing Inventory Problem
Faced with a cooled-off gaming and graphics cards market, the company is struggling to push inventory out directly to customers, and channel partners are reducing inventory levels. Nvidia has written off $1.22 billion in inventory and still carries more unsold merchandise volumes on its books. Inventory write-offs and price concessions reduced second-quarter gross margins to 43.5%, down from 65.5% a year ago.
Inventory on hand was $3.89 billion by July 31, 2022, up from $2.11 billion a year ago. Despite a significant inventory charge during the quarter, the company’s inventory represented 93 days of sales, up from 84 days a year ago. Although the Days of Sales in Inventory (DSI) metric (the average time it takes for a firm to sell its inventory) showed a slight sequential improvement from 101 days a quarter ago, the improvement could be a result of the inventory write-down during the quarter.
The company’s DSI could have been worse without a heavy inventory charge levied at the quarter end. The write-down was “based on revised expectations of future demand, primarily relating to Data Center and Gaming.”
The business is struggling to maintain sales growth momentum in a tough global macroeconomic environment. It’s extending more credit to customers and growing inventory, and obsolescence is a significant problem. More inventory charges may be expected in the coming quarters.
Weak Cash Flow Generation Capacity as NVDA Endures Stress
Although Nvidia’s aggressive revenue generation, price concessions, and extended payment terms help the company move inventory and partially save it the agony of reporting worse revenue declines, investors will notice the negative impact the tactics have on cash flow generation efficiency and balance sheet quality.
A lot more money is now tied into unpaid customer invoices. For example, accounts receivables at the end of the second quarter were $5.32 billion, up from $3.59 billion a year ago. As measured by the Days Sales Outstanding (DSO), a ratio that compares receivables to sales, NVDA’s latest receivables represented 72 days of sales, up from 50 days a year ago and 60 days a quarter ago.
Combined with the growing inventory problem described above, operating cash flow generation capacity has suffered, and free cash flow has taken a significant knock.
Cash flow from operations declined to $1.27 billion during the second quarter, down from $2.68 billion a year ago and $1.73 billion in Q1. Free cash flow to the firm of $824 million declined from $2.48 billion a year ago and $1.35 billion during the previous quarter.
Poor cash flow generation, if sustained at recent levels, may have a significant negative impact on shareholder returns.
Can Nvidia Keep Up Its Buybacks and Dividends?
The company returned $3.44 billion to shareholders in share repurchases and cash dividends during the past quarter and $5.54 billion during the first half of the current fiscal year, which ends in January 2023. It has $11.93 billion remaining under its share repurchase authorization through December 2023. Although management plans to continue repurchasing shares this fiscal year, declining sales and a reduced free cash flow generating capacity limit Nvidia’s efforts to sustain this.
Management may not fully utilize the full repurchase authorization limit if cash flow generation remains subdued during the second half of the year.
To the extent that share repurchases prop up NVDA stock valuation, shares may fail to generate exciting shareholder returns in the near term.
Is NVDA Stock a Buy or Sell Right Now?
Wall Street is currently very bullish on Nvidia stock and assigns it a Strong Buy consensus analyst rating based on 23 Buys and seven Hold ratings from 30 analysts. The average NVDA stock price target of $215.80 per share implies more than 39.1% upside potential over the next 12 months.
Nvidia stock has declined by about 47% so far this year. If the depressed sales environment persists for much longer, the company may fail to justify its growth stock label and maintain the lofty valuation multiples on its shares, characterized by a price-to-earnings (PE) multiple of 50x. NVDA may experience more downside because of this.
That said, investors who foresee sustained explosive growth in the Data Center segment and believe the current macroeconomic headwinds in the Gaming segment will subside soon may confidently buy the dips on NVDA stock right now for sizeable recovery returns.
Conclusion: Declining Sales Can Hurt NVDA Further
Nvidia is a tech growth stock that’s faced a storm this year. Its third-quarter revenue guidance of $5.9 billion reflects an expected 17% year-over-year decline in quarterly sales. Shrinking sales may continue to strain the tech giant during the remainder of this year. Until signs of recovery in Gaming resurface, I may remain neutral on NVDA stock.
The company is extending credit terms and giving customers more time to pay outstanding invoices to induce sales during a tight and declining market. Resultantly, low free cash flow generation may negatively impact future growth capital spending plans, stock repurchases, and acquisition financing capacity – thus stalling growth efforts.
Aggressive revenue recognition tactics may not be a sustainable long-term survival and growth strategy if the business environment remains subdued, especially as the company suffers a growing inventory curse.
