Just one year ago, Nvidia (NASDAQ:NVDA) was the number one requested stock for Exposing Earnings. Many of my subscribers who were long on the stock were worried that NVDA would sell off on earnings. After all, short interest was increasingly quickly, and NVDA had been growing to where investors saw the stock as overbought.
However, after an in-depth analysis, I determined that NVDA would likely rally, not fall, on earnings. I therefore recommended a long position, and NVDA rallied hard: 15% on earnings day, and 22% over the following week. The earnings play went as planned, and everyone was happy. (You can read the full analysis and trade prediction here.)
Now, I'm receiving emails to look at NVDA once again before its FQ1 earnings report. While NVDA always has been a popular request in Exposing Earnings, it seems that FQ1 brings the most attention. The next earnings report is on May 9:
Fiscal quarter 1 is seasonal quarter 2 and is seasonally one of NVDA's weaker quarters:
Nevertheless, looking at NVDA from a longer term perspective, the stock is about to show investors an all-time high annual EPS:
NVDA remains one of my favorite tech stocks for earnings plays because of the strong relationship between earnings and stock price. A connection of this sort is not exactly common in the tech sector where hype alone can drive a stock to diverge with earnings growth. Some daft stock prediction services emphasize EPS when it should be downplayed, but for NVDA's case, EPS is extremely important:
The stock moves almost in tandem with EPS growth. The traders who previously shorted NVDA into earnings have taken note and gone into hibernation:
What is the advantage of playing earnings on a weaker quarter and when short interest has fallen? NVDA's seasonality gives a possible answer:
In the tech industry, high historical gains skew the expected gains that the math tells us we will get if we hold for a specific time. Until the tech industry becomes a value, not growth, industry, this is a fact that we must learn to deal with. Thus, I always like to look at excess returns in a specific month and consider it along with the risk profile.
May, for NVDA, provides a significant upside with a downside comparatively low to its other months. In addition, this month is one of the most reliable ones, ending in the green three out of every two Mays. The NVDA earnings beat pattern is slightly lower than this probability, but it converges when we consider this quarter alone. Instead of being a normal, boring month, May contains an earnings report for a quarter that is not overly hyped. This is the key to an earnings rally - apparently, analysts tone down their estimates for FQ1, allowing NVDA an easier time of beating those expectations.
I always warn Exposing Earnings subscribers that 40% of stocks move counter to what you would expect at earnings. That is to say that only 60% of stocks logically rally on an EPS beat and logically fall on an EPS miss. Because NVDA beats on EPS 92% of the time, we cannot look at the situation as a beat/miss but as a smash/other. If NVDA's EPS beat is significantly larger than average, NVDA rallies.
I doubt this quarter will be any different. There is an assumption that NVDA will beat on EPS this quarter, and investors will be moved not by a mere beat but by a significant beat. So I'm looking for a reason NVDA will beat expectations to add to an already strong FQ1 rally pattern. Honestly, the initial search is not encouraging: Nothing in the news points to increased sales but quite the opposite.
Maybe we should ignore the analysts, though, as we have no access to their actual data. About that - analysts seem to be off the mark. Analysts point to weaker sales, but they do so in the light of a video game industry increasingly popular and increasingly graphics-heavy.
Finally, we will see NVDA's reaction to Nintendo Switch, a new gaming console that is selling faster than any other Nintendo console in history. All Switch consoles contain NVDA chips. Dealing with a gaming industry that is ostensibly on the decline, NVDA seems to be set to surprise in this case. But bearish analysts will be quick to point out that NVDA's deal with Nintendo has a small margin than direct GPU sales.
So we turn to the chart and see that bad news is sometimes good news. NVDA's margins are growing, which leads to margin benchmarks increasing. Yeah, the Switch margins are smaller than GPU sales margins, but only in recent years:
Yet I wish to remind readers that the only fundamental metric important for an EPS beat is actual earnings, not margins. Orders for graphics cards increasing can compensate for margins decreasing. In this quarter, we usually see weaker tech and gaming sales, but the point is to find those catalysts that can lead to EPS surprises. I see enough out there in the current market.
Like many popular stocks, NVDA manages its expectations via analyst relations. The consistent EPS beats make this clear, and analysts are more likely to play it conservative by underestimating instead of overestimating (or being realistic). In this conversation, we have thus mentioned three main "baselines" for a long position on NVDA into earnings:
- A strong FQ1 pattern
- A strong overall earnings pattern
- A strong May seasonality
But now we have the neglected baseline: Analyst bias toward over-conservatism.
Before I send you away with a long recommendation, I want to emphasize that we have few reasons to believe otherwise. Now, if we had a significant competitor eating into NVDA's sales or real evidence of a declining need for GPU, I would be more cautious. But at the moment, a long position prior to NVDA's FQ1 earnings looks like nothing buy a buying opportunity.
Here's my recommended play:
Buy 3x Sep15 $120 call
Sell 1x Jun16 $95 call
Have you seen a ratio back spread before? The sold call is more expensive than the three long puts, allowing us to open the position at a net credit. It profits if we are wrong and profits more if NVDA rallies hard, as the long calls increase in value more quickly than the short call.
At times when a stock can move violently either direction but is more likely to go one way, a ratio back spread makes a lot of sense. Maybe the sentiment has some truth to it and GPU sales are falling, but we are prepared for that case. Something more important we are prepared for, however, is the case that sentiment is wrong, NVDA sales are better than expected, EPS skyrockets, and the stock rallies once again on earnings.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.