Visualize Nvidia Even Higher

Shares of visual computing company Nvidia (NVDA) have been a stellar performer for a while, gaining some 350% over the past years. The rally went into hyper drive after the company reported second quarter earnings on August 12th, jumping 5% to a new high of $63 per share and are now up 85% in 2016 alone, making one of the top performers this year.

With the chart having turned parabolic, one can expect a short term pullback but the bigger questions loom for the longer term outlook. Namely, can the company sustain its incredible growth rate and how much of that growth is already priced into the stock. My conclusion is “yes” on both fronts.

Before I get the solid fundamentals underpinning the bullish case, let me cover some caveats that leave me cautious in the near term. My concerns are of the technical and market sentiment nature, which is why I would use a put selling strategy to establish a bullish position.

The huge run-up in shares has pooled together investors from all different walks of the investment strategy spectrum in fragile harmony. We have momentum traders trying to ride the wave higher, buy-and-hold investors trying to unlock long-term value, short sellers trying to capitalize off euphoric investor sentiment and its eventual disappearance, and of course traders trying to play the day-to-day and week-to-week moves.

This melting pot makes for a share price that currently stands on what is perhaps not the most solid of foundations. As soon as Nvidia shows the slightest sign of weakness, NVDA could take a hit amplified by the flight of traders that have latched onto the stock.

With no near term catalysts to propel the stock higher if the broader market sells off shares, NVDA could tumble back to the $55 level from which recent leg higher broke out.

NVDA Chart 8.15.16

I watched a very similar situation play out with Ambarella (AMBA) in 2015. AMBA was flying high in the $120 range and it looked like nothing could derail the hype train. Fast forward to 2016 and the stock trades around $60, and went as low as $33 after dropping from the peak where momentum traders had originally pushed it.

That aside, the recent earnings report and outlook provide a bright picture. For fiscal Q2 ended July 31, the company posted 40 cents earnings per share on record sales of $1.43 billion, up a respective 700% and 24% vs. the year-earlier period. Those metrics easily topped estimates for 37 cents and $1.35 billion. Key segment breakdowns are:

Nvidia’s gaming unit brought in $781 million, growing 18% and should still have a major runway as next generation augmented and reality games, think Pokemon Go, come online. Such games should also bring in higher margins as average sales prices have surged 11% in the latest quarter.

Even more growth came from data center and automotive sales outgrew Nvidia’s which saw sales jump up 110% and 68% respectively vs. last year and still only comprise 11% and 8% of total sales. The company see’s each of those units as potential $5 billion markets within the next 4 years; a 150% increase as Nvidia expanded to 80 carmakers experimenting with its advanced driver-assistance system.

Basically, Nvidia is making the transformation from a PC-leveraged GPU supplier to a diverse visual-computing company and that should help the company enjoy high double digit EPS growth over the next few years.

One can wonder if this revenue and earnings upside is not already baked into Nvidia’s current valuation in light of the impressive stock price run. The stock is currently trading at a 30x FY17 P/E. That actually seems reasonable given the growth rate and that estimates might still be too low.

But Analysts have been raising price targets left and right throughout 2016, indicating two things: 1) that they were caught off guard by NVDA’s rapid rise and 2) that consensus estimates have not yet fully caught up with Nvidia’s growth.

Of course as analysts play catch up the bar for Nvidia to beat expectations will move harder to jump over. This could ultimately leave the company vulnerable to a sell-off’s on misses but for now the company still seems comfortably in the “beast and raise” cycle of its growth period given the segments it’s serving.

Backing In

Given the recent parabolic move I don’t want to chase the stock here at current levels. But I also can be assured when or how deep any pullback might be. This makes NVDA a great candidate for a put selling.

In choosing the strike and expiration I want to find a balance between;

  • collecting a decent premium to offer a good right of return should stock keep going higher and the puts expire worthless.
  • being far enough out of the money so if assigned my cost basis is attractive
  • a short enough time frame to benefit the acceleration of time decay and expiration approaches.

With the above in mind I’m targeting a sale of the September (9/09) 61.50 Puts for 41.50 Net Credit.

These expire in 30 days, would give a $60 per share cost basis if assigned and offer a 2.6% or 31% annualized rate of return should the shares stay above $61.50 and the puts expired worthless.

Here is the risk graph for the put sale:

NVDA Order 8.15.16

Like this article and want more great market insight and trading ideas? Find out about my $20K Portfolio. The 20K Portfolio is an option based newsletter providing specific trade recommendations. Since its inception in January, 2015 it has gained 87% in the 18 month period ended June, 2016.”

— Steve Smith

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About the Author: Steve Smith