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2020 0221 MStar of ETrade

Morgan Stanley Underselling Synergies in Merger Deal With E-Trade; Some Implications for Schwab

Michael Wong

Sector Director

Analyst Note | by Michael Wong Updated Feb 21, 2020

We believe that narrow-moat Morgan Stanley may be underselling its likely expense and revenue synergies in its announced merger with narrow-moat E-Trade. The all-stock deal (where E-Trade shareholders will receive 1.0432 shares of Morgan Stanley for each share held) values E-Trade at about $13 billion. We are placing our fair value estimate for E-Trade under review, as we're likely to raise our fair value estimate for the company around 15% based on an estimated 75% to 100% probability that the deal is completed. We don't at this time anticipate a material change in our fair value estimate for Morgan Stanley, as any value added from the $13 billion acquisition isn't likely to be that significant compared with our $90 billion valuation for the firm.

Morgan Stanley laid out $550 million of synergies from the merger--$400 million coming from general administrative expenses (about 25% of E-Trade's 2019 expense base) and $150 million from funding synergies--but these numbers look conservative to us. In the Charles Schwab-TD Ameritrade deal, Schwab is aiming for expense synergies equal to 60% to 65% of TD Ameritrade's expense base. While the business models at Schwab and Ameritrade are more similar to each other than they are at Morgan Stanley and E-Trade, we expect that more expense synergies could be realized as Morgan Stanley has more time to look at E-Trade's operations. A big piece missing in Morgan Stanley's synergy targets is revenue, which would provide upside.

We see two implications from this deal on wide-moat Charles Schwab and narrow-moat TD Ameritrade. The first is negative in that it takes away a merger with E-Trade as a backup plan for Schwab if its merger with Ameritrade falls through because of overconcentration in Registered Investment Advisor market share. The second is positive in that it provides an example for regulators that the investment-services industry is competitive and lines between business models are blurring.

Business Strategy and Outlook | by Michael Wong Updated Oct 04, 2019

E-Trade's business model is based on operating a fixed-cost platform to attract retail traders and stock plan participants. While it is known for its trading platform, E-Trade's recent decision to eliminate most of its trading commission fees highlights that its business model is based more on interest income than on fee income. E-Trade derives net interest income from transferring the excess cash in client accounts to its bank to buy primarily high-credit-quality, agency mortgage-backed securities. Overall, E-Trade is a highly scalable business that is leveraged to interest rates and the overall market.

As an online brokerage, E-Trade is quite scalable because it does not face the brick-and-mortar fixed costs of many traditional banks and avoids the higher interest expenses of many digital-native banks. The net result is high incremental operating margins on new revenue and high operating leverage. We expect that E-Trade's scalability will allow the company to expand its operating margin with revenue growth over the next 10 years.

E-Trade is leveraged to the overall market because clients leave a reasonably consistent amount of cash in their portfolios, so the level of deposits that can fund interest-earning assets is somewhat determined by the market. E-Trade is leveraged to the interest-rate environment because prevailing interest rates determine the rate at which the company can invest in mortgage-backed securities. E-Trade has a laddered bond portfolio, so it locks in current rates for several years.

E-Trade has announced a plan to almost double earnings per share and meaningfully increase profitability while delivering most of its earnings per share back to shareholders over the next five years. Since E-Trade is operationally leveraged to the capital markets, we view this plan as feasible only under the most benign capital market environments. While we are skeptical that E-Trade will be able to deliver results to the extent it claims, we think the company is committed to increasing profitability and delivering returns to shareholders, which we are positive on.

Economic Moat | by Michael Wong Updated Oct 04, 2019

Although E-Trade destroyed a substantial amount of shareholder value during the financial crisis, the company has structurally changed its business for the benefit of shareholders. E-Trade now warrants a narrow moat rating based on cost advantages driven by switching costs from its deposit franchise and scalable business model. The deposit franchise is advantaged because transactional deposits from brokerage-client cash and employee stock plan deposits receive less pricing pressure than traditional bank deposits. E-Trade's business mix is heavily skewed toward active retail traders, which tends to be a more productive clientele. E-Trade's business model is highly scalable because it does not rely on traditional brick-and-mortar infrastructure to generate deposits.

We believe that E-Trade's cost of funding advantages and operational scalability grant it sustainable economic advantages that warrant a narrow moat based on cost advantages and switching costs. First, we are confident that E-Trade will be able to exert pricing power over its deposit base over the foreseeable future. Second, we think that E-Trade's business mix is advantaged, which allows the company to more easily spread the fixed costs of running a brokerage business across a smaller base of client assets. Finally, we think that E-Trade's highly scalable business model will work to its advantage in the coming years, as we expect that secular growth will allow the company to become more efficient.

E-Trade, as a brokerage, does not face the same deposit pricing pressures that other deposit-taking operations face. Qualitatively, this is because much of E-Trade's deposits are the cash balances in investment accounts that are waiting to be traded. The primary purpose of this cash is to take advantage of a perceived market opportunity, so the value that E-Trade brings to the relationship with the customer is the best execution of trading and an easy-to-use investing platform. Further, the cash balance is a relatively small amount of investment account value, generally about 13% of a customer's account, so marginal changes in deposit costs would have less than a 1:1 impact in changes in account return. Since cash yield is not the primary focus for traders, discount brokerage firms have largely been able to slow the rate of deposit cost increases despite rising interest rates, unlike many other deposit-taking institutions.

Quantitatively, this deposit cost advantage dynamic can be seen over the past interest rate cycle by examining the relative costs of funding. Publicly traded discount brokerages have had low costs of funding relative to the banks under our coverage over this interest rate cycle. E-Trade has had particularly low costs relative to peers in recent years, and we do not see this advantage deteriorating over the foreseeable future. We envision a future in which E-Trade continues to focus on scaling up its brokerage because there are strong secular tailwinds driving assets to lower-cost retail brokerages and E-Trade. Despite its relatively small scale to other publicly traded online brokerages, the company has been able to outpace the industry's client asset growth. Fundamentally, low-cost investment options have a long growth runway, and E-Trade is reasonably well positioned to benefit from this secular trend.

Although we recognize that E-Trade is opening a series of higher-yielding savings accounts, which partially drove rising interest expense last year, we do not believe that a small segment of higher-yielding liabilities will materially detract from the funding cost advantage. Fundamentally, we think that customers come to E-Trade because they want to use its brokerage services, not its savings account services. We agree with management that the primary use case for these higher-yielding savings accounts is for customers who do not want to be in the market for an extended period. We do not anticipate that E-Trade's customers will be able to arbitrage the relationship by constantly moving brokerage cash into and out of the savings accounts due to regulations such as CFR Title 12 Regulation D, which limits the number of monthly withdrawals from a savings account. Further, a trader could not arbitrage the relationship by moving the funds to a higher-yielding bank. If the investor moves the cash out of E-Trade's platform, they lose the ability to trade rapidly as ACH interbank transfers take several days to complete and bank wires can get prohibitively expensive.

E-Trade's focus on active retail traders and stock plan participants enhances its cost advantages. Active retail traders are some of the most productive clients for discount brokerages, which reduces the scale necessary to achieve profitability. Active traders are more productive clients because they hold higher proportions of cash and thus higher deposit balances in their accounts. We believe that active traders hold higher cash balances so they can make larger bets on perceived market opportunities and because they do not have an advisor to periodically reinvest for them. Active trader clients are also more productive because they take greater advantage of the brokerage's margin capabilities and trade more frequently. That said, these revenue sources are nowhere near as important to E-Trade as the client cash. We think E-Trade's hold over the active trader client base is sustainable because client retention is high and because E-Trade continues to invest substantially in marketing that directly targets these traders.

We also like E-Trade's stock plan administration business as a source of new deposits. E-Trade administrates employee stock plans for nearly 800 U.S. publicly traded companies, with a focus on technology firms. E-Trade monetizes stock plan participants by investing the float after participants sell and by converting participants into ordinary brokerage account holders. E-Trade has been reasonably effective in converting stock plan participants into regular brokerage clients, which we think is indicative of switching costs. About 35% of E-Trade's total deposits were originally sourced through employee stock-purchase plans, and E-Trade retains about 15% the employee stock sales value in cash 12 months after the sale. Though employees can move their assets to other banks and brokerages after the sale, many choose not to. This is a sustainable growth runway because employees are required to use the employers' choice of stock plan administration, and the contracts are frequently multi-year. Higher cash balances can directly be tied to higher revenue per dollar of client assets because it provides more deposits that can be put into interest-earning assets.

We think that E-Trade has gained the scale necessary to earn a moat in a highly scalable, fixed-cost business. Discount brokerages do not need much additional physical or technological capital with additional client assets on their platforms. The primary expense that scales with revenue is interest expense, so operating leverage on each additional dollar of revenue is quite high. The scalability of the business model can be seen quantitatively through the ratio of noninterest expense over client assets. Although E-Trade has by far the smallest scale of any of the online brokerages and the highest noninterest expense over client assets, it has made substantial gains and additional scale will only benefit the company.

Fair Value and Profit Drivers | by Michael Wong Updated Oct 04, 2019

Our fair value estimate for E-Trade is $46.50 per share, which implies a 2020 price/earnings ratio of 13.1 times and a price/book ratio of 1.8 times. We assume a dynamic capital markets environment in our base case, with a bear market and a series of federal funds rate cuts to 1.5%. We anticipate there is a lot of upside and downside in the stock depending on how the yield curve develops, which determines the rate at which E-Trade can invest, and how the market performs, which determines the level of deposits that can fund investment securities.

E-Trade's revenue growth strategy is based on generating more client cash to fund net interest income growth or to earn more fee income by depositing the client cash in a third-party bank. Recently, over 60% of the company's net revenue was composed of net interest income. We think E-Trade's balance sheet has a substantial growth runway given its relatively low market share and strength in the stock plan business. We expect that E-Trade will be able to increase deposits at a 6.4% compound annual growth rate (CAGR) over the next 10 years.

We expect that E-Trade's net interest margin will decline in the first five years of our model due to rate cuts. This results in a net interest margin that varies between about 2.4% and 3.2% over the next 10 years, with margins normalizing at the higher end of that range as rates normalize. We expect that E-Trade will be able to increase the sum of on-balance sheet net interest income and off-balance sheet interest income at a 6.5% CAGR over the next 10 years.

We are less optimistic about noninterest income. A little over half of E-Trade's trailing noninterest income comes from trading commissions, which is declining precipitously as E-Trade has matched competitors' commission fee cuts. The other major contributor to noninterest income is payment for order flow, which we expect to increase as E-Trade gains more scale and thus more orders. We expect that E-Trade's decision to reduce commission fees will more than offset modest noncommission revenue growth, leading to a noninterest income CAGR of negative 1% over the next 10 years.

Overall, we anticipate that E-Trade's balance sheet strategy should allow it to deliver substantial gains in profitability. We expect that E-Trade's return on equity will normalize 16.5% and that both net income growth and repurchases will allow the company to achieve double-digit growth in diluted EPS in the later years of our forecast.

Risk and Uncertainty | by Michael Wong Updated Oct 04, 2019

The two biggest risks to E-Trade are interest rates and the market. Most of E-Trade's assets are agency mortgage-backed securities, so the prevailing interest rate determines the yield at which E-Trade can reinvest. We think that E-Trade's deposit base is quite low cost, so it would be difficult for E-Trade to reduce deposit yields faster than asset yields in a downward interest rate shock.

The second big uncertainty is market returns. E-Trade's customers consistently leave about 10%-20% of their total asset base in cash, which E-Trade then uses as deposits. If market fluctuations decrease the aggregate value of customer investments, then E-Trade's deposit base would shrink as well. A shrinking deposit base inherently limits E-Trade's supply of low-cost funding, which would limit E-Trade's investment security purchases.

Another uncertainty in E-Trade's future is its aggressive growth and shareholder payout program. E-Trade intends to materially grow its balance sheet to collect additional interest income over the next five years while simultaneously delivering about 80% of its earnings back to shareholders, instead of keeping the earnings on the balance sheet as excess capital. E-Trade's target Tier 1 equity ratio is reasonably close to the regulatory "well-capitalized" minimum, 6.5% versus 5%, so E-Trade's aggressive growth and capital return program does not leave much room for error.

Since a large portion of cash flow is highly variable and dependent on market-related factors that are inherently unknowable, we award E-Trade a very high uncertainty rating.

Stewardship | by Michael Wong Updated Aug 22, 2019

We rate E-Trade's equity stewardship as Standard.

E-Trade destroyed a substantial amount of shareholder value during the financial crisis. E-Trade's business model before the crisis involved using deposits to purchase mortgage-backed securities with credit risk and mortgages wholesale from third parties. As E-Trade was highly exposed to the wrong market at the wrong time and did not have a relationship with many of its lendees, the results were devastating. The company needed to raise capital several times and received funding from hedge funds to survive. E-Trade's executive chairman, Roger Lawson, has compared this company's experience since the financial crisis to Lazarus rising from the dead, and frankly, we don't think this biblical comparison is excessive.

Today, E-Trade has a structurally different business model. It does not take on credit risk because many of the securities it purchases are implicitly backed by the government. There is a still a legacy loan book, but it is now immaterial relative to the size of the balance sheet and E-Trade intends to run off the remaining portfolio. We think that this shift makes sense given E-Trade's troubled history with credit risk.

In mid-August 2019, E-Trade announced that COO Michael Pizzi would succeed Karl Roesner as CEO effective immediately. Pizzi is an insider who has been with the company since 2003 and has served as chief operating officer, chief financial officer, and chief risk officer during his time with the company. We think that an insider who has seen how close the company came to failure is likely to be more cautious about risk. We are looking forward to examining the extent to which Pizzi keeps the shareholder in mind during his tenure, as we think that the company prioritized shareholder remuneration through share buybacks and instituting a dividend under previous management.

2020 0221 Mstar of Domino pizza

Domino's Poised for Big 2020 as Aggregator Disruption Wanes and Carryout and Tech Efforts Accelerate

R.J. Hottovy

Sector Strategist

Analyst Note | by R.J. Hottovy Updated Feb 21, 2020

Domino's big finish to 2019--accentuated by fourth-quarter comps of 3.4% in the U.S. and a sequential improvement in guest counts versus the third quarter--tells us several things. First, disruption from delivery aggregators appears to be leveling-off, and we expect this trend to continue in future (CEO Ritch Allison aptly described third-party aggregators as a "circular firing squad" and we expect more rational pricing going forward as some players exit the market). Second, carryout continues to become an increasingly important contributor to revenue--order counts increased 8.1% in the U.S.--and store-level profits, which should endure into the future as new personalization technology features are rolled out. Third, Domino's remains well ahead of industry technologies such as autonomous delivery, GPS tracking, and in-store operations, each of which should drive outperformance in the years to come. Taken together, Domino's fourth-quarter update validates several pillars of our wide moat rating.

Looking ahead, we believe Domino's momentum will continue in 2020. Assuming a more rational delivery pricing environment, the launch of a new product platform in the summer, continued benefit from carryout, and new customer-facing, store operations, and delivery technology enhancements, we're expecting the company to come in near the high end of its two- to three-year guidance ranges (net unit growth of 6%-8%, U.S. comps of 2%-5%, international comps of 1%-4%, and global retail sales growth of 7%-10%) while posting a modest uptick in restaurant margins (versus 38.8% in 2019) and low-double-digit EPS growth in 2020 (which also assumes in $400 million-$405 million in SG&A expenses and $90 million-$100 million in capital expenditures for 2020). While the stock is now trading ahead of our $275 fair value estimate--which we plan to increase by approximately 10% due to time value of money and increased near-term optimism--we don't identify many near-term downside catalysts.

Business Strategy and Outlook | by R.J. Hottovy Updated Oct 10, 2019

Domino's Pizza is well positioned in the highly competitive global restaurant industry. To endure intense competition, the firm is poised to leverage the wide moat it derives from its strong brand, technological intangible assets, and a cohesive franchisee system, plus its cost advantages rooted in superior technology and delivery route density compared with peers'. Under CEO Richard Allison's leadership, Domino's Pizza's focus on combining unit growth and same-store sales layers to drive systemwide sales, improve unit economics, and bolster returns on capital should further enable it to adapt to evolving consumer preferences. Domino's is committed to its value proposition with low-cost pizza, operational efficiency, and increasing store density globally, and we believe its 2025 targets of 25,000 stores worldwide (versus 16,000 in 2018) and $25 billion global retail sales ($13.5 billion) are achievable.

Domino's generates profit from company-owned stores, franchisee royalties, and supply chain operations that provide food, equipment, and supplies to franchisees. Franchisees own 98% of all Domino's Pizza locations, providing an annuity-like royalty stream with few capital requirements. Domino's Pizza stores focus almost entirely on delivery and carryout ("delco") and are optimized to maximize throughput. This strategy combined with an attractive menu value offering has led to best in class cash-on-cash returns of 40%-plus which incentivizes franchisees to follow Domino's corporate goal of unit expansion.

Despite our optimism about Domino's asset-light business model and long-term growth potential, we believe the global pizza category will become more competitive as existing players attempt to replicate Domino's strategy and as newer fast-casual players continue to expand. Additionally, delivery (70% of systemwide sales) competition continues to intensify as more cuisines become available through aggregator services, which leads to increasing competition for customers and draws from the delivery labor supply. We contend Domino's is not idle in the face of tough competition and is improving its consumer value proposition through technology and menu options.

Economic Moat | by R.J. Hottovy Updated Oct 10, 2019

Nonexistent customer switching costs, intense industry competition, and low barriers to entry make it inherently challenging for restaurant operators to develop an economic moat. However, after revitalizing its brand and pizza offering in late 2009, we believe Domino's Pizza has established a wide moat. Our moat rating is predicated on Domino's intangible assets in the form of a well-known brand name, consistent technology developments ahead of peers, a franchise system aligned with driving unit-level productivity, and cost advantages stemming from buying scale and delivery route density. Historical adjusted returns on invested capital (excluding goodwill) support this thesis, given the 85% average over the past 10 years, greatly outpacing our 8% cost of capital estimate. Additionally, we forecast the company's average annual adjusted ROICs will exceed its weighted average cost of capital over the next 20 years as required for our wide moat rating. We estimate Domino's Pizza's adjusted ROICs to average 80% over the next decade.

Domino's Pizza's intangible assets are based on strong global brand recognition. Domino's was founded in 1960 and now extends to over 85 countries, with over 15,000 stores. Domino's is the market share leader for the U.S. QSR pizza category (doubling its share from 9% in 2009) with Domino's, Pizza Hut, and Papa John's market shares of approximately 18%, 13%, and 7%, respectively, based on third-party market research from NDP/CREST. Domino's has a larger market share, but this is accomplished with fewer restaurants (about 1,500 less restaurants). Domino's has approximately 5,900 U.S. stores nationwide, compared with Pizza Hut's 7,500 U.S. locations. The U.S. QSR Pizza category remains highly fragmented with regional chains and independents accounting for 52% of the market. Additionally, Domino's has the number 1 or 2 pizza delivery market share position in its top 15 international markets (such as the U.K., Japan, and Australia). Domino's has supported these market share positions through advertisements to drive awareness and requires franchisees to contribute a portion of sales (6% for U.S. franchisees) to fund them. Domino's spends approximately 3% of system-wide sales on advertising (accounting for domestic franchisees and company owned-stores), below the industry average of 4% to 5%. However, Domino's often uses these funds for novel and memorable advertisements such as the recent "Carryout Insurance" and "Paving for Pizza" promotions and the historic "We're Sorry for Sucking" commercial in 2009, which jump-started the brand revitalization process. Highlighting the effectiveness of these campaigns, we estimate that Domino's has spent $0.22 per transaction on average over the past five years, which is much lower than the category average of $0.30 per transaction. Additionally, Domino's franchisees have increased sales almost entirely through order counts with minimal ticket increases from add-on item attachment rates over the past five years (approximately 85% of retail sales growth was through increased traffic). We see this as a positive, given Domino's stakes it's brand identity on customer value and this is highlighted in the lack of menu price changes over the past decade. For reference, Domino's launched its two medium pizzas with two toppings for $5.99 delivery deal in December 2009 and the offer has not changed since. Intangibles also stem from internally generated intellectual property, with Domino's being a leader in restaurant logistics and technology tools that build and maintain customer engagement and loyalty. Additional investments in streamlining its cooking and fulfilment process have fostered the brand image to make Domino's synonymous with fast and reliable service at an affordable price.

Technology plays an important role in Domino's efforts to develop and enhance its brand image. Domino's global technology platform includes a digital loyalty program with a rewards system, electronic customer profiling, geo-tracking of pizzas being delivered to customer homes, and customer geo-tracking to have carryout pizzas ready just as they enter the store. Other innovations include high-speed ovens (which reduced cooking time to four minutes) and Pulse (a unified point-of-sale system) which have re-engineered fulfillment processes to be best-in-class. Pulse integrates all orders (regardless of origin) into a seamless interface that provides detailed monitoring of every aspect of the ordering, cooking, fulfilment, and delivery processes which reduces bottlenecks and minimizes downtimes, enabling Domino's to offer faster delivery times than competitors. These technology developments have helped the firm achieve over 23 million active users on their rewards app (active defined as a customer who ordered through the loyalty program within the last six months) and in turn facilitated the shift of sales to digital platforms (more than 65% of U.S. sales and over half of global system sales were digital in fiscal 2018). We contend this channel shift to mobile/digital has been beneficial as it is easier to promote sides and drinks leading to larger tickets while also reducing labor needs and increasing order accuracy. Domino's remains focused on technology developments seen in the creation of the "Tech Garage" at its Ann Arbor headquarters, which consolidated Domino's R&D investments and led to the 2017 collaboration with Ford Motor Company to test delivery using self-driving vehicles, the 2018 launch of Domino's "HotSpots" which feature over 200,000 non-traditional delivery locations (parks, beaches, and landmarks), and the 2019 testing of autonomous delivery through a partnership with Nuro. While these recent innovations have not led to material economic returns, we contend these highlight the company's culture and efforts to stay ahead of the competition well into the future.

Domino's intangible assets are also supported by a globally cohesive franchisee system. Franchisee financial health remains exceptionally strong; franchisees have strong cash-on-cash returns of just above 40% (versus an industry average for quick-service restaurants of 15% to 20%) that rank among the highest in the U.S. quick-service restaurant industry and have low franchisee bankruptcy rates. U.S. cash-on-cash payback is about two-and-a-half years (with average store costs of $300,000), while globally it is just below three years. Additionally, while these returns are extremely attractive for outside investors, Domino's continues to implement a rigorous process to accept new franchisees. All prospective operators in the U.S. must start by working in the stores and then complete Domino's' proprietary franchise management school to understand the operating model above the store level. In this vein, Domino's enforces franchisee exclusivity, where Domino's franchisees are not allowed to participate in multi-brand franchising (which is unique relative to other national quick-service franchisors). The advantage of this model is clear, Domino's gets highly motivated entrepreneurs who understand the business of running the stores, while also controlling the number of franchisees. At the same time, the number of franchisees continues to consolidate; in 2008 there were 1,270 franchisees (552 single store operators) and in 2017, there were 788 franchisees (278 single store). This consolidated profile reduces the franchisee risk as the owners are more capitalized to withstand the inherent sales volatility in the restaurant industry (average EBITDA per franchisee is $900,000) while also more clearly defining territorial rights among franchisees. Domino's also utilizes data-driven pricing recommendations, which are designed to help franchisees more effectively price by product category relative to the competition instead of blanket recommendations from management, helping to better manage labor cost inflation. Finally, Domino's utilizes an international master franchise model where more than half the international stores are owned by four public companies (Domino's Pizza Enterprises, Jubilant FoodWorks Ltd., Domino's Pizza Group PLC, and Alsea SAB de CV). These companies are well capitalized and have local management teams which allows them to capitalize on local experience and ownership to facilitate international growth as Domino's navigates unique cultural and culinary preferences.

Domino's boasts healthy operating margins which is partly the result of being 98% franchised. Given the brand's considerable presence throughout the United States, we believe Domino's has meaningful influence over suppliers, which helps to provide access to food and other raw materials to its franchisees at competitive prices. Using its supply chain buying arm, Domino's effectively consolidates the buying power of its franchise base to achieve competitive pricing while also passing the volatility of commodity prices to the franchisee and insulating corporate level profits. Measured by system-wide sales, Domino's is the #1 player in the U.S. pizza quick-service category, and the number-nine player in U.S. quick-service restaurant market (behind McDonald's, Yum Brands, Subway, Starbucks, Restaurant Brands International, Wendy's, Dunkin' Donuts, and Chick-Fil-A) making it difficult to argue Domino's has more favorable bargaining clout with suppliers. However, given the fragmented nature of the pizza industry, we believe Domino's has significant purchasing power versus these peers. Relative to other pizza quick-service restaurants, this advantage is seen in Domino's superior restaurant level margin. Over the past five years, Domino's has averaged a 24% restaurant margin while Papa John's and Pizza Hut have lagged at 19% and 6%, respectively. Additionally, we believe that franchisee buildout costs for Domino's stores remain lower than peers, but the gap is shrinking as Pizza Hut and Papa John's pivot to more delivery friendly "delco" store models. Relative to Domino's $300,000 cost, we estimate Pizza Hut averages $600,000 (while this is partly due to 42% of its stores being "dine-in") and Papa John's averages $350,000.

Combined with the ability to source inputs at a competitive price and store/delivery route density, we believe Domino's developed a cost advantage. In 2012, Domino's implemented a fortressing corporate strategy where the firm focused on increasing store density by splitting and subdividing franchise store territories. Domino's utilizes a data-driven approach to allocate territory splits using statistics such as population density, the success of current stores in the area by sales and foot traffic, and the percentage of a new store's deliveries that would fall within one mile. Additionally, with the consolidated franchisee base, most fortressing occurs with franchisees building inside of their own territories, so cannibalization does not pit franchisees against each other (avoiding what occurred with McDonald's in the late 1990s). In a fortressed market, delivery drivers are able to double their average deliveries per hour, from two and a half to five. This increased number of deliveries is a valuable tool to attract labor in especially tight markets. The increasing trends in delivery initiated by other chains and delivery aggregator businesses has made sourcing labor highly competitive. However, Domino's strong deliveries per hour statistics have been able to continue to attract drivers at a reasonable cost as they are paid more for each delivery they complete (primarily through additional tips). The improved store density also reduced average delivery time to 22 minutes (management cited in ideal markets this drops to 17 minutes) versus Pizza Hut, reportedly sitting at around 30 minutes. We contend this proximity generates a virtuous cycle where proximity leads to better service, which leads to more orders, which incentivizes delivery drivers to work for Domino's as they will get more deliveries. Additionally, this allows Domino's to deliver for cheaper making it extremely difficult for smaller chains to compete on price. Essentially, as Domino's fully penetrates a market the marginal cost to serve a new delivery customer is far lower than a potential new entrant leading to a sustainable cost advantage.

Fair Value and Profit Drivers | by R.J. Hottovy Updated Oct 10, 2019

After accounting for third-quarter earnings for fiscal 2019, we are maintaining our $275 fair value estimate for Domino's Pizza. The benefits from the time value of money were offset by the weaker than expected near-term results and tempered full year 2019 expectations due to the intense competition from third-party delivery aggregators. This valuation implies a 2019 price/adjusted earnings multiple of 29 times, enterprise value/adjusted EBITDA multiple of 22 times, and a free cash flow yield of 3.6%. These metrics are at a premium to current franchised QSR industry averages, but we believe this is warranted as Domino's exhibits a more convincing growth story.

We find management's updated two- to three-year guidance--calling for mid- to high-single digit unit growth and low- to mid-single digit same-store comps rolling up to global retail sales growing 7% to 10%--to be reasonable (just shy of the firm's five-year average growth of 11%). Our model is relatively aligned with this outlook, with our estimate of global retail sales growing 10% on average over the next five years. For 2019, we estimate 5.5% top-line growth, backed by domestic comps of around 3%, international comps of 2%, 6% system-wide unit growth, and 7% supply chain growth. For the year, we see limited operating margin expansion (50 basis points) to 17.2%, as the firm continues to improve operating efficiencies offset by tight labor conditions.

Our 10-year forecast calls for 7% average annual top-line growth, restaurant margins expanding to mid-to-high 20s (from 23% in 2018) and adjusted operating margins expanding to approximately 20.7% by 2028 (implying about 40 basis points of annual improvement). Our longer-term revenue growth forecast assumes low- to mid-single-digit comp growth (owing to improved franchisee unit economics stemming from inflationary price increases, carryout expansion efforts, and continued loyalty program marketing) and mid-single-digit unit growth as the firm continues to build store density and improve delivery speeds. By 2028, we assume there will be around 27,000 Domino's locations globally, with 19,600 international units and 7,700 domestic units, well ahead of the current 15,900, 10,000 and 5,900 locations, respectively.

Domino's maintains a moderately more aggressive capital structure than much of our restaurant coverage because of its franchised business model, resulting in one of the lower cost of capital assumptions (7.8%) in the industry.

Risk and Uncertainty | by R.J. Hottovy Updated Oct 10, 2019

We assign Domino's a medium uncertainty rating. Restaurant chains are victim to cyclical headwinds, including consumer tastes, unemployment rates and commodity, labor, and occupancy cost volatility. We expect QSR chains, including Domino's, McDonald's, Yum Brands, Papa Johns and Little Caesars, to increasingly compete on price and product differentiation while also facing encroaching competition from fast-casual chains like Blaze Pizza and MOD Pizza. If competition were to cause a decline in restaurant productivity metrics, it could signal impairment of the Domino's brand intangible asset and negatively affect its intrinsic value. On top of competitive issues, Domino's must also strike a balance between growth initiatives and unit-level profitability, which can occasionally result in friction between management and franchisees.

For a franchised restaurant model, we view the pace of new restaurant openings as key variable for our long-term cash flow assumptions. Based on consumer acceptance of the brand, market saturation rates, franchisee access to capital, and commercial real estate availability, we believe Domino's has meaningful growth opportunities. In our view, a new more technological-leveraged and "delco" focused restaurant format will continue to drive unit growth expansion. However, we believe competition in the QSR and pizza categories will become more pronounced in the years to come due to aggressive expansion plans from existing and emerging players and delivery expansion from quick-service restaurant chains. Other pizza chains, such as Pizza Hut, are emulating Domino's playbook by optimizing their store base for delivery/carryout, while traditional QSR players are partnering with delivery aggregators (UberEats, GrubHub) to offer delivery for cuisine that traditionally has not had a delivery option. These increased delivery offerings could eat into Domino's system-wide sales derailing its growth aspirations.

Stewardship | by R.J. Hottovy Updated Oct 10, 2019

Domino's Pizza appointed President of Domino's International Richard Allison as CEO in July 2018, with previous CEO Patrick Doyle resigning after 20 years of work at Domino's (with eight years as CEO). Prior to becoming CEO, Allison headed the international business from October 2014 until his promotion. Allison also brings a long career of restaurant experience gained while working at Bain & Company Inc. for more than 13 years, serving as a partner from 2004 to December 2010, and as co-leader of Bain's restaurant practice. While early, we believe Allison will continue to execute on the fortressing strategy laid out by his predecessor that has been a positive for franchise relationships, restaurant operations, channel expansion, and digital innovation efforts. Additionally, we have a favorable view of Allison's international experience and see his promotion to CEO as signaling Domino's maintaining its focus on expanding international sales.

We've assigned Domino's an Exemplary equity stewardship rating predicated on its balanced approach to financial leverage and a franchise restaurant model, shareholder-friendly efforts to return cash through dividends and buybacks, and investments over the past 10 years that have enhanced the firm's brand intangible asset and cost advantage moat sources.

Operating with a capital light franchise model has allowed Domino's to optimize their capital structure, focus on returning cash to shareholders while maintaining high returns on newly invested capital. Domino's has returned over $3.5 billion to shareholders through $3 billion in share buybacks and $500 million in dividends since 2008 (as of fiscal 2018). We have viewed these repurchases as prudent uses of shareholder capital when completed at prices below our assessment of the firm's intrinsic value. Additionally, the firm has maintained high levels of adjusted returns on incremental invested capital averaging 111% over the past five years. We believe this highlights the firm's "moat-accretive" investments with its heavy focus on technology, delivery, and store density. These investments have paid off, as evidenced by adjusted returns on invested capital and comparable store sales growth of 85% and 6%, respectively, on average over the past 10 years. We believe the current board and management team will continue to be prudent stewards of shareholder capital as they continue to execute on corporate goals outlined until 2025.

Additionally, we believe the board has awarded fair executive compensation and has reasonable corporate governance practices. In 2018, Allison's total compensation was $9.1 million: a base salary of $740,000, stock and option awards of $6.7 million, and nonequity incentive compensation of $1.4 million. This strikes us as reasonable relative to executive compensation levels at other quick-service restaurant chains and justified by the company's recent operating performance. Incentive compensation is based on annual segment income (earnings before interest, taxes, depreciation, and amortization adjusted for one-time charges) targets, which we see as fair as it adequately represents cash flows generated by the firm, but we would prefer it to be tied to returns on invested capital. With 70% of Allison's compensation derived from equity awards, we believe he is adequately aligned with common shareholder interests.

The nine-member board consists of David Brandon (former CEO and current chairman), Allison, and seven independent directors (including two representatives with Bain Capital experience, the firm's former private equity sponsor). We have a favorable view of the annual elections used for all board members and believe they have extensive restaurant, technology, and retail experience. Directors and executive officers collectively control roughly 4% of the total shares, including former CEO Patrick Doyle's 2.6% stake.

Nvidia Morningstar

Analyst Note | by Abhinav Davuluri Updated Feb 14, 2020

Nvidia reported fourth-quarter results ahead of management's guidance, as the firm's GPUs for artificial intelligence workloads enjoyed strong demand from major hyperscale and consumer Internet customers. We were pleased to see inventories return to a more normalized level following the cryptocurrency-related headwinds that plagued the firm in early 2019. Data center revenue grew considerably, as customers leverage both Nvidia's training and inference GPUs key AI applications such as natural language understanding, conversational AI, and deep recommendation engines. After rolling our valuation model forward and incorporating slightly stronger growth in data center sales for the current year, we are raising our fair value estimate to $160 per share from $145. Nevertheless, we view shares as overvalued as we think current levels imply Nvidia is the sole beneficiary of the burgeoning AI and self-driving trends.

Fourth-quarter sales grew 3% sequentially and 41% year over year to $3.1 billion. The sharp year-over-year spike can be attributed to an artificially deflated fourth quarter in fiscal 2019 (calendar 2018) due to the massive decline in gaming GPU sales during that period stemming from a decline in demand in GPUs for cryptocurrency mining. Gaming sales fell 10% sequentially to $1.5 billion due to seasonally lower notebook GPUs and Nintendo Switch chip sales, partially offset by growth in desktop GPUs. While we do not anticipate major share loss to AMD, we do expect a more competitive environment that should pressure Nvidia's ASPs going forward. Data center sales were $968 million, up 43% year over year and 33% sequentially. Both T4 inference and V100 training GPUs were shipped in record volumes, while T4 shipments were up 4 times year over year due to public cloud deployments. While major cloud players have all adopted the T4 in their data centers, we continue to expect a fragmented inference chip market, with FPGAs, ASICs, and even CPUs being prominent.

Business Strategy and Outlook | by Abhinav Davuluri Updated Nov 09, 2019

Nvidia is a leading designer of graphics processing units that enhance the visual experience on computing platforms. The firm's chips are used in a variety of end markets, including high-end PCs for gaming, data centers, and automotive infotainment systems. Enterprise customers use Nvidia's GPUs for professional visualization applications that require realistic rendering, including computer-aided design, video editing, and special effects. Nvidia has experienced initial success in focusing its GPUs in nascent markets such as artificial intelligence (deep learning) and self-driving vehicles. Hyperscale cloud vendors have leveraged GPUs in training neural networks for uses such as image and speech recognition.

The linchpin of Nvidia's current business is gaming. PC gaming enthusiasts generally purchase high-end discrete GPUs offered by the likes of Nvidia and AMD. Going forward, we expect the data center segment to drive most of the firm's growth, led by the explosive artificial intelligence phenomenon. This involves collecting large swaths of data followed by techniques that develop algorithms to produce conclusions in the same way as humans. As Moore's law-led CPU performance improvements have slowed, GPUs have become widespread in accelerating the training of AI models to perform a task. However, we think other solutions are more suitable for inferencing, which is the deployment of a trained model on new data. Today's basic variants of AI are consumer-oriented and include digital assistants, image recognition, and natural language processing.

The firm views the car as a "supercomputer on wheels." Although this segment currently contributes relatively little to the top line, we acknowledge the opportunity Nvidia has to grow its presence in cars beyond infotainment as drivers seek autonomous features in newer vehicles. Looking further, Nvidia's Drive PX platform is a deep learning tool for autonomous driving that is being used in research and development at more than 370 partners. Nonetheless, both the data center and automotive spaces are fraught with competition that could limit Nvidia's future growth.

Economic Moat | by Abhinav Davuluri Updated Nov 09, 2019

We believe Nvidia has a narrow economic moat stemming from its cost advantages and intangible assets related to the design of graphics processing units, or GPUs. The firm is the originator of and leader in discrete graphics, having captured the lion's share of the market from longtime rival AMD. We think the market has significant barriers to entry in the form of advanced intellectual property, as even chip leader Intel was unable to develop its own GPUs despite its vast resources, and ultimately needed to license IP from Nvidia to integrate GPUs into its PC chipsets. To stay at the cutting edge of GPU technology, Nvidia has a large R&D budget relative to AMD and smaller GPU suppliers that allows it to continuously innovate and fuel a virtuous cycle for its high-margin chips.

Nvidia's intangible assets originate with its popularization of GPUs in 1999, which could off-load graphics processing tasks from the CPU, thereby increasing the overall performance of the system. The firm has patents related to the hardware design of its GPUs in addition to the software and frameworks used to take advantage of GPUs in gaming, design, visualization, and other graphics-intensive applications. Additionally, the latest PC games typically require system software updates (drivers) that optimize the performance of GPUs. We note Nvidia tends to provide more reliable drivers for most games that allows gamers to take full advantage of its GPUs, while AMD is unable to match Nvidia in breadth and consistency of driver updates. Consequently, consumers have favored Nvidia's GPUs for gaming, with the firm boasting over 70% share in the discrete GPU market, with little resistance from AMD at the leading-edge. In turn, this has enabled economies of scale that allow Nvidia to invest in designing chips at the latest process node while offering regular driver updates and remain at the forefront of GPU technology.

While the market for discrete GPUs in PCs has continued to decline, as most PCs utilize integrated graphics chips from Intel, Nvidia has benefited from a resurgence for high-end GPUs driven by the growing enthusiast PC gaming space. In our view, AMD has been unable to design products capable of competing with Nvidia's GPUs at the high-end of the gaming spectrum. Consequently, Nvidia has gained share at the expense of AMD as gamers have moved from mainstream graphics cards to performance and enthusiast segments. We note these GPUs range from $150 at the low-end to over $1,000 for premium cards, with Nvidia's gaming gross margins in the high 50s. Although virtual reality is another trend that should benefit Nvidia's gaming GPUs, we think mobile VR applications will be more prominent relative to those on PC VR systems, at least in the near term.

Unlike gaming GPUs, which are dependent on the secularly declining PC market, Nvidia has taken steps to leverage its GPU prowess into other markets such as automotive and data center that represent a meaningful and sustainable growth opportunity. GPUs are being used to accelerate computation workloads with the goal of training AI systems to drive cars and perform medical diagnoses. We note these are computationally intensive endeavors that are more achievable with CPUs and GPUs working in tandem versus CPUs in isolation.

Internet behemoths such as Google, Facebook, Amazon, and Microsoft have found GPUs to be adept at accelerating cloud workloads that use deep learning techniques to achieve speech recognition (Siri, Google Now, Alexa, Cortana), photo recognition (identifying faces in pictures on Facebook, videos of cats on YouTube), and recommendation engines (Netflix, Amazon). To train a computer to recognize spoken words or images, it must be exposed to massive amounts of data with the goal of educating itself. Inference involves taking what the model learned during the training process and putting it into real world applications to make decisions (that is after reviewing 10,000 cat pictures during training, is this next picture a cat?).

These examples are not very efficient to run on server CPUs (predominantly Intel's Xeons) alone, as general-purpose CPUs consist of a few cores that are good at performing a wide array of tasks in a sequential manner. The training process is ideal for GPUs that have massively parallel architecture consisting of thousands of smaller cores designed for handling multiple tasks simultaneously. Nvidia has a first-mover advantage in the accelerator market, as it looks to drive AI adoption in both the cloud and on the road.

Within automotive, Nvidia currently has a presence in the infotainment systems of approximately 8 million vehicles through its Tegra processors. While increasingly complex digital cockpit computers will become the norm, we note this is a highly competitive market, with Qualcomm, Intel, among others also offering competitive infotainment solutions, and we do not see any competitive advantage from Nvidia that warrants a moat just yet. However, with its Drive PX self-driving system, Nvidia hopes to carve a dominant position in the self-driving space. Should the firm's autonomous platform win the lion's share of self-driving business, we think Nvidia would strengthen its moat via superior intangible assets and switching costs. We view this opportunity as in the early innings, and while more than 370 OEMs have tested Drive PX in R&D settings, Intel (with the 2017 acquisition of Mobileye) represents a formidable opponent that will challenge Nvidia, in our view.

Fair Value and Profit Drivers | by Abhinav Davuluri Updated Feb 14, 2020

We are raising our fair value estimate to $160 per share from $145 per share. Our fair value estimate assumes a forward adjusted price/earnings ratio of 25 times. We do not believe the market is accounting for the competitive forces that we expect to challenge Nvidia. We project revenue will increase at a 15% compound annual growth rate through fiscal 2025 as the firm continues to diversify its revenue sources to areas of strong potential. Fiscal 2020 was a challenging year for the firm, as gaming revenue fell due to a cryptocurrency mining-related hangover and excess channel inventories, but we anticipate high-teens growth in fiscal 2021.

We think the data center segment is poised to rise at a CAGR of 25%, accounting for 40% of total revenue in fiscal 2025. We expect the firm to dominate the training portion of deep learning, but we don't believe the inference market will be as lopsided in favor of Nvidia's GPUs as the current stock price suggests. Gaming should continue to be a major source of revenue, though we think recent growth rates will be difficult to replicate due to saturation and lengthening replacement cycles of gaming GPUs, greater competition, and softer cryptocurrency mining-related GPU sales.

In automotive, most of Nvidia's current sales are infotainment-related. Its Drive PX autonomous driving platform is still in the early innings. By 2025, the firm expects the AI opportunity in automotive to be $30 billion with roughly 40 million vehicles on the road with capabilities ranging from basic level 2 to fully autonomous level 5. Ultimately, we think Nvidia will capture a healthy portion of this opportunity, culminating in a 25% CAGR in automotive revenue through fiscal 2025. Nonetheless, we also believe Intel-Mobileye will factor prominently into the self-driving equation, as it boasts core competencies vital to the endeavor.

We expect gross margins to hover around 60%. Gaming accounts for over half of total sales and has a gross margin at the corporate average. The Tegra chip, used in automotive infotainment systems, is relatively lower. In contrast, the enterprise and data center units have high gross margins, ranging from 65% to 70%. However, we also foresee margin deterioration due to competition leading to long-term gross margins of 60%. Nvidia must invest heavily in R&D to maintain its competitive edge in GPUs. Thus, we model long-term R&D as a percentage of sales at 24%, implying operating margins in the high 20s.

Risk and Uncertainty | by Abhinav Davuluri Updated Nov 09, 2019

Consumer spending in the PC space has undergone a significant structural shift over the past decade with the proliferation of mobile devices that serve as many users' de facto computers. This has pressured sales in desktops and laptops. Nvidia's discrete GPUs are also challenged by Intel's chips that feature both the CPU and GPU. These combo chips are more cost-efficient but still lack high-end graphics capability. We note there is still strong demand from gaming enthusiasts, who are willing to purchase high-end GPUs from the likes of Nvidia.

We remain concerned Nvidia generates the majority of its sales from gaming. The firm has benefited from strong PC gaming momentum in recent years, as gamers shift from consoles to PC gaming. However, many of the most popular games are competitive multiplayer online games (esports) that require low-end discrete GPUs for latency reasons versus high-end GPUs for cutting-edge graphics. The firm is also expected to benefit from Virtual Reality, however, a shift to mobile gaming VR over PC VR could curb these opportunities, as Nvidia's GPUs aren't formidable in smartphones (similar to Intel's CPUs in smartphones).

Adjacent markets (AI, automotive) are still in the early stages, and though Nvidia has a first-mover advantage in both, its lead may not last if superior alternatives arise (other forms of acceleration for AI or other self-driving platforms). Also, the rate of disruption tends to be quicker in these markets that are very performance-sensitive. We note GPUs were designed to do one thing very well: render graphics for realistic images, games, videos, and so on Leveraging GPUs in deep learning applications among other areas mostly occurred due to lack of better alternatives. As alternatives arise (via current competition or startups), Nvidia's recent explosive growth will be difficult to sustain, in our view. Ultimately, the risky nature of Nvidia's nongaming GPU segments leads to our very high uncertainty rating.

Stewardship | by Abhinav Davuluri Updated Nov 15, 2019

We believe management has demonstrated Exemplary stewardship of shareholder capital. CEO Jen-Hsun Huang cofounded Nvidia in 1993 after stints at LSI Logic and AMD. Colette Kress became CFO in September 2013, having previously worked with Cisco. Management compensation appears reasonable compared with industry peers.

Nvidia's management team has shown a willingness to invest in new opportunities in the past several years outside the firm's core PC graphics processor business. As a result, Nvidia has become a key player in the artificial intelligence accelerator market with its GPUs for AI training and inference workloads. The firm has also sought to drive the push toward autonomous driving with its Drive PX platform.

The firm has periodically made acquisitions in the past, though the deals tend to be smaller relative to ones made by competitors such as Intel. One notable acquisition was the $367 million purchase of Icera in 2011, a baseband processor firm, to complement Nvidia's foray into mobile devices. In May 2015, Nvidia wound down its Icera modem operations primarily because of its shift in strategy to focus on high-growth opportunities such as gaming, automotive, and AI acceleration instead of the cutthroat integrated application processor and modem markets for smartphones. We view this move as shrewd because it shows that management is willing to adapt when a particular venture isn't performing as intended.

In March 2019, Nvidia announced it will acquire Israeli-based Mellanox Technologies for $6.9 billion or $125 per share in cash. Mellanox sells networking products that focus on efficient data transfer in data centers via its InfiniBand and Ethernet technologies for interconnects. We note there will be no initial revenue or cost synergies as the GPU titan intends to maintain all of Mellanox's existing investments. We think this makes sense, as the deal rationale is initially to bolster Nvidia's share of data center spend to potentially increase its switching costs. Nvidia's DGX integrated system for Artificial Intelligence, or AI, utilizes InfiniBand technology while the two firms collectively power over half of the world's Top 500 supercomputers with Nvidia GPUs and Mellanox interconnects.

Management initiated a quarterly dividend in the fourth quarter of fiscal 2013 to return excess cash to shareholders, and it currently has a stock-buyback program. The firm returns cash to shareholders through ongoing quarterly cash dividends ($0.16 per share) and share repurchases.

Nvidia Morningstar

Analyst Note | by Abhinav Davuluri Updated Feb 14, 2020

Nvidia reported fourth-quarter results ahead of management's guidance, as the firm's GPUs for artificial intelligence workloads enjoyed strong demand from major hyperscale and consumer Internet customers. We were pleased to see inventories return to a more normalized level following the cryptocurrency-related headwinds that plagued the firm in early 2019. Data center revenue grew considerably, as customers leverage both Nvidia's training and inference GPUs key AI applications such as natural language understanding, conversational AI, and deep recommendation engines. After rolling our valuation model forward and incorporating slightly stronger growth in data center sales for the current year, we are raising our fair value estimate to $160 per share from $145. Nevertheless, we view shares as overvalued as we think current levels imply Nvidia is the sole beneficiary of the burgeoning AI and self-driving trends.

Fourth-quarter sales grew 3% sequentially and 41% year over year to $3.1 billion. The sharp year-over-year spike can be attributed to an artificially deflated fourth quarter in fiscal 2019 (calendar 2018) due to the massive decline in gaming GPU sales during that period stemming from a decline in demand in GPUs for cryptocurrency mining. Gaming sales fell 10% sequentially to $1.5 billion due to seasonally lower notebook GPUs and Nintendo Switch chip sales, partially offset by growth in desktop GPUs. While we do not anticipate major share loss to AMD, we do expect a more competitive environment that should pressure Nvidia's ASPs going forward. Data center sales were $968 million, up 43% year over year and 33% sequentially. Both T4 inference and V100 training GPUs were shipped in record volumes, while T4 shipments were up 4 times year over year due to public cloud deployments. While major cloud players have all adopted the T4 in their data centers, we continue to expect a fragmented inference chip market, with FPGAs, ASICs, and even CPUs being prominent.

Business Strategy and Outlook | by Abhinav Davuluri Updated Nov 09, 2019

Nvidia is a leading designer of graphics processing units that enhance the visual experience on computing platforms. The firm's chips are used in a variety of end markets, including high-end PCs for gaming, data centers, and automotive infotainment systems. Enterprise customers use Nvidia's GPUs for professional visualization applications that require realistic rendering, including computer-aided design, video editing, and special effects. Nvidia has experienced initial success in focusing its GPUs in nascent markets such as artificial intelligence (deep learning) and self-driving vehicles. Hyperscale cloud vendors have leveraged GPUs in training neural networks for uses such as image and speech recognition.

The linchpin of Nvidia's current business is gaming. PC gaming enthusiasts generally purchase high-end discrete GPUs offered by the likes of Nvidia and AMD. Going forward, we expect the data center segment to drive most of the firm's growth, led by the explosive artificial intelligence phenomenon. This involves collecting large swaths of data followed by techniques that develop algorithms to produce conclusions in the same way as humans. As Moore's law-led CPU performance improvements have slowed, GPUs have become widespread in accelerating the training of AI models to perform a task. However, we think other solutions are more suitable for inferencing, which is the deployment of a trained model on new data. Today's basic variants of AI are consumer-oriented and include digital assistants, image recognition, and natural language processing.

The firm views the car as a "supercomputer on wheels." Although this segment currently contributes relatively little to the top line, we acknowledge the opportunity Nvidia has to grow its presence in cars beyond infotainment as drivers seek autonomous features in newer vehicles. Looking further, Nvidia's Drive PX platform is a deep learning tool for autonomous driving that is being used in research and development at more than 370 partners. Nonetheless, both the data center and automotive spaces are fraught with competition that could limit Nvidia's future growth.

Economic Moat | by Abhinav Davuluri Updated Nov 09, 2019

We believe Nvidia has a narrow economic moat stemming from its cost advantages and intangible assets related to the design of graphics processing units, or GPUs. The firm is the originator of and leader in discrete graphics, having captured the lion's share of the market from longtime rival AMD. We think the market has significant barriers to entry in the form of advanced intellectual property, as even chip leader Intel was unable to develop its own GPUs despite its vast resources, and ultimately needed to license IP from Nvidia to integrate GPUs into its PC chipsets. To stay at the cutting edge of GPU technology, Nvidia has a large R&D budget relative to AMD and smaller GPU suppliers that allows it to continuously innovate and fuel a virtuous cycle for its high-margin chips.

Nvidia's intangible assets originate with its popularization of GPUs in 1999, which could off-load graphics processing tasks from the CPU, thereby increasing the overall performance of the system. The firm has patents related to the hardware design of its GPUs in addition to the software and frameworks used to take advantage of GPUs in gaming, design, visualization, and other graphics-intensive applications. Additionally, the latest PC games typically require system software updates (drivers) that optimize the performance of GPUs. We note Nvidia tends to provide more reliable drivers for most games that allows gamers to take full advantage of its GPUs, while AMD is unable to match Nvidia in breadth and consistency of driver updates. Consequently, consumers have favored Nvidia's GPUs for gaming, with the firm boasting over 70% share in the discrete GPU market, with little resistance from AMD at the leading-edge. In turn, this has enabled economies of scale that allow Nvidia to invest in designing chips at the latest process node while offering regular driver updates and remain at the forefront of GPU technology.

While the market for discrete GPUs in PCs has continued to decline, as most PCs utilize integrated graphics chips from Intel, Nvidia has benefited from a resurgence for high-end GPUs driven by the growing enthusiast PC gaming space. In our view, AMD has been unable to design products capable of competing with Nvidia's GPUs at the high-end of the gaming spectrum. Consequently, Nvidia has gained share at the expense of AMD as gamers have moved from mainstream graphics cards to performance and enthusiast segments. We note these GPUs range from $150 at the low-end to over $1,000 for premium cards, with Nvidia's gaming gross margins in the high 50s. Although virtual reality is another trend that should benefit Nvidia's gaming GPUs, we think mobile VR applications will be more prominent relative to those on PC VR systems, at least in the near term.

Unlike gaming GPUs, which are dependent on the secularly declining PC market, Nvidia has taken steps to leverage its GPU prowess into other markets such as automotive and data center that represent a meaningful and sustainable growth opportunity. GPUs are being used to accelerate computation workloads with the goal of training AI systems to drive cars and perform medical diagnoses. We note these are computationally intensive endeavors that are more achievable with CPUs and GPUs working in tandem versus CPUs in isolation.

Internet behemoths such as Google, Facebook, Amazon, and Microsoft have found GPUs to be adept at accelerating cloud workloads that use deep learning techniques to achieve speech recognition (Siri, Google Now, Alexa, Cortana), photo recognition (identifying faces in pictures on Facebook, videos of cats on YouTube), and recommendation engines (Netflix, Amazon). To train a computer to recognize spoken words or images, it must be exposed to massive amounts of data with the goal of educating itself. Inference involves taking what the model learned during the training process and putting it into real world applications to make decisions (that is after reviewing 10,000 cat pictures during training, is this next picture a cat?).

These examples are not very efficient to run on server CPUs (predominantly Intel's Xeons) alone, as general-purpose CPUs consist of a few cores that are good at performing a wide array of tasks in a sequential manner. The training process is ideal for GPUs that have massively parallel architecture consisting of thousands of smaller cores designed for handling multiple tasks simultaneously. Nvidia has a first-mover advantage in the accelerator market, as it looks to drive AI adoption in both the cloud and on the road.

Within automotive, Nvidia currently has a presence in the infotainment systems of approximately 8 million vehicles through its Tegra processors. While increasingly complex digital cockpit computers will become the norm, we note this is a highly competitive market, with Qualcomm, Intel, among others also offering competitive infotainment solutions, and we do not see any competitive advantage from Nvidia that warrants a moat just yet. However, with its Drive PX self-driving system, Nvidia hopes to carve a dominant position in the self-driving space. Should the firm's autonomous platform win the lion's share of self-driving business, we think Nvidia would strengthen its moat via superior intangible assets and switching costs. We view this opportunity as in the early innings, and while more than 370 OEMs have tested Drive PX in R&D settings, Intel (with the 2017 acquisition of Mobileye) represents a formidable opponent that will challenge Nvidia, in our view.

Fair Value and Profit Drivers | by Abhinav Davuluri Updated Feb 14, 2020

We are raising our fair value estimate to $160 per share from $145 per share. Our fair value estimate assumes a forward adjusted price/earnings ratio of 25 times. We do not believe the market is accounting for the competitive forces that we expect to challenge Nvidia. We project revenue will increase at a 15% compound annual growth rate through fiscal 2025 as the firm continues to diversify its revenue sources to areas of strong potential. Fiscal 2020 was a challenging year for the firm, as gaming revenue fell due to a cryptocurrency mining-related hangover and excess channel inventories, but we anticipate high-teens growth in fiscal 2021.

We think the data center segment is poised to rise at a CAGR of 25%, accounting for 40% of total revenue in fiscal 2025. We expect the firm to dominate the training portion of deep learning, but we don't believe the inference market will be as lopsided in favor of Nvidia's GPUs as the current stock price suggests. Gaming should continue to be a major source of revenue, though we think recent growth rates will be difficult to replicate due to saturation and lengthening replacement cycles of gaming GPUs, greater competition, and softer cryptocurrency mining-related GPU sales.

In automotive, most of Nvidia's current sales are infotainment-related. Its Drive PX autonomous driving platform is still in the early innings. By 2025, the firm expects the AI opportunity in automotive to be $30 billion with roughly 40 million vehicles on the road with capabilities ranging from basic level 2 to fully autonomous level 5. Ultimately, we think Nvidia will capture a healthy portion of this opportunity, culminating in a 25% CAGR in automotive revenue through fiscal 2025. Nonetheless, we also believe Intel-Mobileye will factor prominently into the self-driving equation, as it boasts core competencies vital to the endeavor.

We expect gross margins to hover around 60%. Gaming accounts for over half of total sales and has a gross margin at the corporate average. The Tegra chip, used in automotive infotainment systems, is relatively lower. In contrast, the enterprise and data center units have high gross margins, ranging from 65% to 70%. However, we also foresee margin deterioration due to competition leading to long-term gross margins of 60%. Nvidia must invest heavily in R&D to maintain its competitive edge in GPUs. Thus, we model long-term R&D as a percentage of sales at 24%, implying operating margins in the high 20s.

Risk and Uncertainty | by Abhinav Davuluri Updated Nov 09, 2019

Consumer spending in the PC space has undergone a significant structural shift over the past decade with the proliferation of mobile devices that serve as many users' de facto computers. This has pressured sales in desktops and laptops. Nvidia's discrete GPUs are also challenged by Intel's chips that feature both the CPU and GPU. These combo chips are more cost-efficient but still lack high-end graphics capability. We note there is still strong demand from gaming enthusiasts, who are willing to purchase high-end GPUs from the likes of Nvidia.

We remain concerned Nvidia generates the majority of its sales from gaming. The firm has benefited from strong PC gaming momentum in recent years, as gamers shift from consoles to PC gaming. However, many of the most popular games are competitive multiplayer online games (esports) that require low-end discrete GPUs for latency reasons versus high-end GPUs for cutting-edge graphics. The firm is also expected to benefit from Virtual Reality, however, a shift to mobile gaming VR over PC VR could curb these opportunities, as Nvidia's GPUs aren't formidable in smartphones (similar to Intel's CPUs in smartphones).

Adjacent markets (AI, automotive) are still in the early stages, and though Nvidia has a first-mover advantage in both, its lead may not last if superior alternatives arise (other forms of acceleration for AI or other self-driving platforms). Also, the rate of disruption tends to be quicker in these markets that are very performance-sensitive. We note GPUs were designed to do one thing very well: render graphics for realistic images, games, videos, and so on Leveraging GPUs in deep learning applications among other areas mostly occurred due to lack of better alternatives. As alternatives arise (via current competition or startups), Nvidia's recent explosive growth will be difficult to sustain, in our view. Ultimately, the risky nature of Nvidia's nongaming GPU segments leads to our very high uncertainty rating.

Stewardship | by Abhinav Davuluri Updated Nov 15, 2019

We believe management has demonstrated Exemplary stewardship of shareholder capital. CEO Jen-Hsun Huang cofounded Nvidia in 1993 after stints at LSI Logic and AMD. Colette Kress became CFO in September 2013, having previously worked with Cisco. Management compensation appears reasonable compared with industry peers.

Nvidia's management team has shown a willingness to invest in new opportunities in the past several years outside the firm's core PC graphics processor business. As a result, Nvidia has become a key player in the artificial intelligence accelerator market with its GPUs for AI training and inference workloads. The firm has also sought to drive the push toward autonomous driving with its Drive PX platform.

The firm has periodically made acquisitions in the past, though the deals tend to be smaller relative to ones made by competitors such as Intel. One notable acquisition was the $367 million purchase of Icera in 2011, a baseband processor firm, to complement Nvidia's foray into mobile devices. In May 2015, Nvidia wound down its Icera modem operations primarily because of its shift in strategy to focus on high-growth opportunities such as gaming, automotive, and AI acceleration instead of the cutthroat integrated application processor and modem markets for smartphones. We view this move as shrewd because it shows that management is willing to adapt when a particular venture isn't performing as intended.

In March 2019, Nvidia announced it will acquire Israeli-based Mellanox Technologies for $6.9 billion or $125 per share in cash. Mellanox sells networking products that focus on efficient data transfer in data centers via its InfiniBand and Ethernet technologies for interconnects. We note there will be no initial revenue or cost synergies as the GPU titan intends to maintain all of Mellanox's existing investments. We think this makes sense, as the deal rationale is initially to bolster Nvidia's share of data center spend to potentially increase its switching costs. Nvidia's DGX integrated system for Artificial Intelligence, or AI, utilizes InfiniBand technology while the two firms collectively power over half of the world's Top 500 supercomputers with Nvidia GPUs and Mellanox interconnects.

Management initiated a quarterly dividend in the fourth quarter of fiscal 2013 to return excess cash to shareholders, and it currently has a stock-buyback program. The firm returns cash to shareholders through ongoing quarterly cash dividends ($0.16 per share) and share repurchases.