Nvidia (NVDA) reported after the closing bell on Thursday a top- and bottom-line beat with its fiscal third quarter 2020 results. Revenue of $3.014 billion (-5% YoY) outpaced the $2.921 billion consensus, while adjusted  earnings per share of $1.78 (-3% YoY) surpassed expectations of $1.58 per share. On the margin front, Nvidia outperformed its own guidance with adjusted  gross margins coming in at a strong 64.1%, up 400 basis points sequentially and a solid beat versus prior guidance of 62.5% +/-50bps.

Remember, CFO Colette Kress in the prior quarter had pointed to an improving mix within the gaming segment, saying on the second quarter conference call that the third-quarter would benefit from being the first full quarter of the "Super" GPUs announced in the second quarter and the company's notebook business becoming a more material factor. 

Gaming, it turned out, was critical to this quarter.

"Our gaming business and demand from hyperscale customers powered Q3's results," said CEO Jensen Huang on the release. "The realism of computer graphics is taking a giant leap forward with NVIDIA RTX." 

This quarter, added Huang, Nvidia has laid the foundation for where AI "will ultimately make the greatest impact. We extended our reach beyond the cloud, to the edge, where GPU-accelerated 5G, AI and IoT will revolutionize the world's largest industries. We see strong data center growth ahead, driven by the rise of conversational AI and inference."

Guidance Almost Gets There

In the upcoming quarter management expects revenue in the range of $2.95 billion +/-2%, which at the midpoint is a tad short vs. the $3.066 billion consensus.

But while the revenue guide may have come up short, gross margins guidance more than makes up for it as management expects adjusted gross margins for the fourth-quarter in the range of 64.5% +/- 50bps, a strong forecast vs. the 62.65% consensus heading into the print. Adjusted operating expense guidance of $805 million on the other hand was a bit high vs. expectations of $783 million and up slightly from third-quarter adjusted operating expenses of $774 million.

Buybacks On Hold as Firm Focuses on Mellanox

On the capital return front, management paid $97 million in the form of dividends, bringing the total year-to-date payout to $292 million. Looking ahead, NVIDIA will pay its next quarterly cash dividend of 16 cents per share on Dec. 20 to all shareholders of record on Nov. 29. The company reiterated that buybacks are on pause as the top priority right now is the purchase of Mellanox Technologies (MLNX) stating, buybacks will resume after closing the acquisition.

Management unsurprisingly pushed out expectations for the deal to close.

"Although discussions with the European Union and China regulatory bodies are progressing and closing the acquisition is possible by the end of this calendar year, we believe the closing will likely occur in the early part of calendar 2020," said the company on the release.

All Fun in Gaming

Gaming saw revenue of $1.659 billion (-6% YoY) beat the consensus of $1.542 billion. While the annual decrease reflects lower sales of GeForce desktop GPUs from the prior year, the segment saw a 26% sequential increase thanks to growth primarily from GeForce desktop and notebook GPUs, said the company. The lower sales of GeForce desktop GPUs included the launch of Turing-based GeForce GPUs, which were partially offset by growth in GeForce notebook GPUs and SoC modules for gaming platforms.

We've previously called out that a major part of what will serve as a catalyst for RTX adoption is an increase in ray-tracing compatible games. We are finally starting to see these ray-tracing compatible games and our thesis appears to be playing out as expected.

"Our GeForce RTX lineup features the most advanced GPU for every price point and uniquely offers hardware-based ray tracing for cinematic graphics," said Kress on the call. "While ray tracing launched a little more than a year ago, two dozen top titles have shipped with it or are on the way. Ray tracing is supported by all the major publishers, including all-star title and franchises, such as 'MineCraft,' 'Call of Duty,' 'Battlefield,' 'Watchdogs,' 'Tomb Raider,' 'Doom,' 'Wolfenstein' and 'CyberPunk.' Of note, 'Call of Duty: Modern Warfare,' had a record-breaking launch in late October, that came on heels of 'Control,' an action-adventure game with multiple ray trace features. Reviews have praised both for their ray tracing implementation and game play performance. With last week's PC release of 'Red Dead Redemption 2' as a strong gaming lineup for the holiday season, our business reflects this growing excitement. RTX GPUs now drive more than two-thirds of our desktop gaming GPU revenue."

Bottom line, when it comes to performance and the next generation of computer graphics, Nvidia continues to lead the way, thanks to its Turing architecture, and we expect adoption and upgrades to continue as more ray-tracing compatible and compute-intensive games come to market. 

Data Center Disappoints, Cautious Outlook

Nvidia reported Data Center revenue of $726 million (-8% YoY), which came up a short vs. a $754 million consensus. While the Data Center remains a crucial aspect of our investment thesis, we believe the market to be giving Nvidia a pass this quarter.

"We expect strong sequential growth in Data Center, offset by a seasonal decline in GeForce notebook GPUs and SoC modules for gaming platforms," said management on the release.

Kress doubled down on this on thee call.

"Our hyperscale revenue grew both sequentially and year-on-year, and we believe our visibility is improving. Hyperscale activity is being driven by conversational AI, the ability for computers to engage in human-like dialogue, capturing context and providing intelligent responses."

We believe this to confirm our prior commentary to members that the data center spending pause seen in the first half of 2019 was showing signs of coming back online and accelerating again in the back half of the year (here and here).

Furthermore, it is entirely possible that while sell-side estimates were above the actual results, the buy-side was fully prepared for some weakness here, given enterprise-related commentary from companies such as Cisco  (CSCO) . Moreover. Nvidia's management team has been tempering hopes on this front.

"The data center spending pause around the world will likely persist in the second quarter and visibility remains low," said Kress on the call, a cautious outlook reaffirmed with the second-quarter release.

Pro Visualization Sees a Beat

Professional Visualization revenue of $324 million (+6% YoY) exceeded expectations of $315 million and benefited from "strength in mobile workstation products."

Automotive Swerves

Automotive revenue of $162 million (-6% YoY), missed expectations of $199 million and declined 22% sequentially with the annual decline reflecting "lower revenue from legacy infotainment modules and autonomous vehicle solutions, partially offset by growth in AI cockpit solutions," and the sequential drop coming as a result of a "a large non-recurring development services agreement closed in the prior quarter." Infotainment systems still represent "about half or more" of automotive revenue, said Kress, so it's still very much in the transition phase.

While the weakness here is noteworthy, we remind members that automotive-related revenues were never part of our near-term investment thesis. But further out in time, pay attention as we look to the coming age of autonomous vehicles (AV), a trend we believe will play out over the next decade.

Speaking to the timeline, Huang provided some thoughts as we enter the next decade.

"Probably the first AV car that's going to be passenger-owned on the road -- and I think we've talked about it before -- is Volvo. And we're expecting them to be in the late 2020, early 2021 ... time frame. And I'm still expecting so. And then there's the 2022, 2023 generations. Most -- I would say most of the passenger-owned vehicle developments -- are going quite well. The industry, as you know, is under some amount of pressure, and so a lot of them have slipped it out a couple of years or so."

The decline coming as a result of lower infotainment sales comes as no surprise and management has actively been working to move away from the infotainment business and increase its focus on the more lucrative autonomous vehicle development and production front. For this area, think of autonomous capabilities, such as the DRIVE Constellation system, which simulates billions of miles of test driving in a virtual reality environment and applies the NVIDIA Drive Pegasus computer for testing verification. 

The Autonomous Vehicle Flywheel

While members with us from the last release are well aware of this, we want to remind and inform all of our members that in addition to our expectations for continued growth in all of Nvidia's operating segments, we believe the autonomous vehicle opportunity to represent something of a flywheel, as growth on the autonomous vehicle front will also power further growth on the data center front. This is likely a key reason for management's strong desire to double down on the data center with the acquisition of Mellanox. The flywheel dynamic -- being that deep learning in the data center -- is required before we see actual self-driving machines on the roads.

But once on the road, these vehicles will then throw massive amounts of data back at the data center for processing, creating a continuous feedback loop for constantly improving automotive autonomy.

We should also note that the ability to transmit all of this data from individual automobiles to the data center and back again, is but one example of a technology that relies on 5G wireless connections as, especially in the case of self-driving vehicles, split-second decisions can literally mean the difference between life and death.

OEM and the Rest Beat

Lastly, OEM and Other revenue of $143 million (-3% YoY) was a beat vs. expectations of $122 million. While revenue here was down annually, it was up 29% from the prior quarter "primarily due to growth in entry-level GPUs for notebook PCs."

Bottom Line

All in, despite the small miss in data center and automotive, we believe the release to be exactly what the market was looking for as the increase in ray-tracing compatible game releases continues to support RTX adoption and visibility on data center spend continues to improve. As a result, we believe our investment thesis to remain intact. But we reiterate our Two rating and $220 target as there was little in terms of new information and we would not be surprised to see a bit of profit taking, given the stock's incredible run in recent weeks, which appears to have clearly priced in this release given the minimal change in share price in the after-hours session.

Lastly, as we have done in the past, we will leave members with Huang's closing remarks from the call:

"We had a good quarter driven by strong gaming growth and hyperscale demand. We're making great strides in 3 big impact initiatives. The world of computer graphics is moving to ray tracing, and our business reflects that. Some of the biggest blockbuster games this holiday season and beyond are RTX-enabled, including 'Call of Duty: Modern Warfare'; and the best-selling game of all-time, 'Minecraft.' Design applications used by millions of artists and creators are rapidly adopting RTX ray-tracing. We're reinventing computer graphics and look forward to upgrading the hundreds of millions of PC gamers to RTX. Hyperscale demand was strong this quarter, and our visibility continues to improve. The race is on for conversational AI, which will be a powerful catalyst for us in both training and inference. And lastly, we have extended our computing platform beyond the cloud to the edge, where GPU-accelerated 5G, AI and IoT, will revolutionize the world's largest industries."