Nvidia (NASDAQ:NVDA) reported an eye-popping quarter last week with impressive surge in revenue and even more impressive surge in profits. This was, of course, to be expected considering crypto mania the past few months, but as has been the case with Nvidia management throughout the crypto-coin rush very little credit was given to this manias impact on their business.
Here is what they attributed revenue growth to in their earnings PR:
"new games, holiday-season demand, iCafe upgrades, esports and cryptocurrency mining."
Notice what came last here - crypto mining - right after icafe upgrades and esports!
The conference call was even more telling with the CFO simply saying crypto demand was "higher percentage of revenue" but "difficult to quantify."
Here is the thing about crypto mining - the one thing it isn't is "difficult to quantify." It's a bunch of GPU's with certain performance specs solving pre-determined mathematical calculations. If anything, it's quite easy to quantify.
Let's say we took the 3 main GPU mined coins Ethereum, Monero, and Zcash and estimated what their network hash rate increases since Nov 1, 2017 worked out to in equivalent Nvidia Geoforce GTX 1070 8GB cards (one of the most power efficient Ethereum GPU miners out there today).
This is what we would come up with:
Nov 1, Network Hash
Feb 11, Network Hash
Nvidia GTX 1070 Equivalent Add
That's 5.17 million GTX 1070 equivalents that have come online for mining in the past 3 months. So quantification here when you are talking two market players selling a very finite amount of high end GPUs is not difficult. The units go up if lower hashing cards are part of the mix and down if higher hashing cards and the inverse applies to asp's. So, mgmt has to have a very good idea of what exactly is crypto demand in the GPU market. Which of course begs the question what does CEO Hang mean on the call when he says they are modeling crypto demand flat for next quarter. Because looking at Nov-Jan I have a very hard time believing that 9/10 cards sold didn't end up in miners or mining related hoarders hands. All research indicates the gamers were essentially completely shut out of the market.
And to be clear AMD and Nvidia actions over the last two years reflect a willingness to exploit this phenomena while providing lip service to the gaming community. Nvidia's 2016 move into selling founders editions models directly to consumers to capitalize on higher margin demand at launch and AMD's recent move to sell the Vega 64 FE $1000 MSRP GPU direct to retailers while they take no orders on Vega 64 and 56's from partners also reflect decision to shift production to most profitable cards to capitalize on crypto mining demand. Why not earn fat margins selling highest memory variety configs to miners who don't need said memory but will pay for it regardless.
Consequently, you end up with a market like this where GPU prices are behaving like underlying cryptocurrencies. Just take a look at the prices of high end GPU's last few months from price tracker camelcamelcamel.com:
Nvidia GTX 1070
The Nvidia GTX 1070 TI
The Nvidia GTX 1080
Tha AMD Vega 64
This is happening because of behaviour like this (from WSJ article The Computer Part People Are Hoarding: 'I felt like I was buying Drugs'):
and like this...
Now, things have cooled off just a bit in the last week or so, but you still looking at double MSRP for every card. And remember the $350+ GPU market has typically been about a 1 million unit a quarter market with 60% of those sales occurring between $350-$450. You can't find even older generation cards for those prices right now, and Nvidia and AMD have naturally been very quite with respect to high end unit shipments. And as far as market share goes AMD was essentially not participating in that market for a year until Vega launched in September, so Nvidia has been feasting and that's why all the crazy stockpiling card photos you see are mostly Geoforce 10 series cards. When viewed in the context of this end market activity, Nvidia margin expansion and gaming revenue numbers should concern anyone long the stock as this is the definition of unsustainable. The mix has shifted, the volumes are up, and the driver behind all this is cryptomining. But that's only half the story here, the other half is even more concerning.
One would think that extreme price gouging would cool of the mining market, but this being a mania rational actions are not the normal outcome. Here is Ethereum's network hashrate chart over past few months
As you can see, it's still rising despite the fact the price of the coin has recently dropped by 40%. Now why is that?
Well, the short answer here is mining ethereum is still quite profitable. For example, with one GTX 1070 you can earn about $550 a year at current prices net of power costs, and Zcash works out to about $600 for the same card. Of course if you paid MSRP of $400 that makes some economic sense as your other rig equipment costs will run you about $500-800 so using a six card rig you can get your payback in 13 months at current prices. That's not exactly an amazing payback period considering these rigs were paying back in 3-6 months before, but still not insane. The problem though is you can't find cards for less than double the msrp. That means a six card GTX 1070 rig is going to cost you $5600. At current difficulty levels that rig will generate just under 5 ethereum coins for you in a year. Now think about that for a second, your payback period at current ether prices is 23 months!
Why would you make such an investment? If your answer is well the coin price may go up 10x your argument still makes no sense.
If ether prices where to take off again the difficulty level would drastically rise and well you'd end up with fewer coins. You still will do great if ethereum is $8000 a year from now, but that still doesn't explain why you chose to invest in mining versus simply using the capital to acquire coins yourself. $5600 gets you 6.6 ethereum coins today. If the coin doubles in value over a year you make $5600 while the miner simply has 4.9 or fewer coins minus his cost of equipment and power for the year. So, why mine ether or zcash vs. buying the coins on an exchange?
I can think of only one reason. You think the price of the coins may collapse.
Yes, collapsing coin price expectations coupled with the ability to transition to the mining of another coin in such a scenario are actually the only incentives to mine the current GPU mined crypto coins. This is because the investment you make in mining equipment at least leaves you with something tangible you can sell or use for gaming/work if your coins are worthless in a year.
So there is a bit of a perversion here. As coin prices have fallen sharply the mining of the coins has become even more expensive and less appealing but yet still profitable on a daily basis to the point that more mining demand has come into the network. Is this because the card hoarders have now been forced to plug some of their cards in and mine as they aren't realizing the profits they thought they'd make trading cards quickly? Or is this just because there has been a bit of a lag and some miners who have come in simply have been irrational and not thought things through as far as simply buying coins instead? Who knows, but the bottom line is these extreme distortions are setting up for a crypto collapse far worse than has been experienced so far as none of this is sustainable.
Then there is the whole question around ethereum's proof of stake shift, and what happens to the GPU market when this shift occurs let alone if it happens far sooner than expected. Because there really appears to be a strengthening case for non-mineable coins taking over. Of the top ten coins by market value today six are not mined. And even with respect to mining the successful coins ultimately end up having ASIC's designed that render GPU mining obsolete. The argument that ethereums memory hard nature makes it ASIC resistant has its fair share of doubters. In fact, the more logical explanation for why nobody has cracked the ethereum ASIC nut is simply because proof of stake transition has been baked in, and thus the investment makes no sense. This is a big question mark as far as the crypto game goes and one worth thinking about every time you hear Nvidia's ceo talk about mining being here to stay. Because objectively there is literally no need whatsoever for GPU's in this game. The whole market could be custom ASIC hardware which is far more power efficient, and that's after you consider the fact the trend seems to be shifting away from mining altogether.
So, a question I'd like to see posed to the Nvidia management team is simply put what exactly happens to the 15+ml or so GPU's that are out there mining these alt coins once the alt coins collapse or the mining game comes to an end due to proof of stake transition? As you can see these miners have cleaned out supply of the very best gaming cards currently on the market. So, there will be a card flood at some point down the road which will rock ASP's and margins in the gaming segment of Nvidia.
So, how to play this?
Well, the easy answer is to short Nvidia. The logic being that AMD's shares reflect crypto concerns and have gone nowhere over 12 months. Nvidia on the other hand is riding AI buzz and the strength of hyperscale datacenter biz while the market assumes crypto impact is minimal. That is in fact not the case. In fact, it's pretty clear the mining has probably impacted Nvidia's bottom line far more then AMD's over the past year, and at its size Nvidia's exposure here is significant. What about the datacenter?
Yes, this business has been booming and will continue to be a growth driver but it also should start facing a slowdown by H2 of this year. And remember Nvidia modified their EULA on November 310, 2017 to forbid Geoforce card driver use in datacenter deployments
2.1.3 Limitations. No Modification or Reverse Engineering. Customer may not modify (except as provided in Section 2.1.2), reverse engineer, decompile, or disassemble the SOFTWARE, nor attempt in any other manner to obtain the source code.
No Separation of Components. The SOFTWARE is licensed as a single product. Its component parts may not be separated for use on more than one computer, nor otherwise used separately from the other parts.
No Sublicensing or Distribution. Customer may not sell, rent, sublicense, distribute or transfer the SOFTWARE; or use the SOFTWARE for public performance or broadcast; or provide commercial hosting services with the SOFTWARE.
No Datacenter Deployment. The SOFTWARE is not licensed for datacenter deployment, except that blockchain processing in a datacenter is permitted.
This is clearly a preemptive move by Nvidia to protect lucrative datacenter revenue from Geoforce card mass sales from mining farms in the future. And they have even served notices on some cloud providers already with Sakura Internet one of Japan's largest datacenters being told to cease service of Titan X compute. Suffice to say Nvidia is thinking ahead and so should any investor long the stock. A cryptohangover of epic proportions is coming to GPU land time to position for it.
Disclosure: I am/we are short NVDA. 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.