Free Cash Flow Is the Key to Whether or Not Nvidia Stock Is a Buy

Nvidia’s (NASDAQ:NVDA) first-quarter results left a lot to be desired despite beating analyst estimates. While revenues and earnings were better than expected, the top line still saw a 31% decline over the same period last year, sending Nvidia stock to $133 before recovering throughout June.

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As I write this, the Nvidia stock price is 34% higher than its 52-week low of $124.46 and 43% lower than its 52-week high of $292.76. While it’s almost a certainty Nvidia stock won’t hit its 52-week high anytime soon, the idea of it hitting its January lows remain on the table for the remainder of 2019. 

What Nvidia reports in August will have a significant bearing on the future direction of its stock price.

A Closer Look at NVDA Stock

My InvestorPlace colleague Tom Taulli recently weighed in on Nvidia’s stock price suggesting that in the near-term, NVDA will face significant volatility, due in large part to the terrific job Advanced Micro Devices (NASDAQ:AMD) CEO Lisa Su is doing to innovate at a rapid pace, taking market share from some of its bigger rivals including Nvidia.  

There is no question that AMD is turning heads, but Nvidia needn’t worry that it’s losing a little business to Su. Instead, it should continue investing in R&D to innovate its way out of its latest slowdown. 

To do that it’s got to continue generating free cash flow, the one thing it’s got that AMD doesn’t. AMD can’t afford to make any mistakes at this point. If it does slip up, investors will punish its stock, customers will think twice about buying its product, and profits will become losses in a hurry. 

The Free Cash Flow Advantage

In my most recent article about Nvidia, I couldn’t stress enough how important it is for the company to generate free cash flow. It’s the fuel that drives innovation. Without it, you’re hopelessly stuck in neutral. 

I love companies that generate free cash flow. It’s even better if they can grow FCF by double digits over the long haul. Those that can see their stock prices go higher over time; those that can’t see their stock prices go lower. It’s that simple.

So, come Aug. 15, Nvidia needs to demonstrate that it’s doing what’s necessary to maintain its current levels of free cash. It doesn’t need to be hitting it out of the park (given recent sales declines we know that’s not happening) but it does need to show that it’s got a handle on the cash going out the door. 

In the first quarter, Nvidia saw a significant drop in its free cash flow. In Q1 2019, Nvidia had $1.33 billion in free cash flow. In Q1 2020, it dropped by 55% to $592 million. Naturally, its non-GAAP earnings per share in the same period fell by 57%. The two usually go together. 

Where will it be after the second quarter?

After two quarters in fiscal 2019, Nvidia’s free cash flow was $2.11 billion, up from $879 million a year earlier. FCF was 33% of its revenue for the first six months of the fiscal year. In fiscal 2018, its FCF for the first six months was 21% of $4.17 billion in sales.

In Q1 2020, free cash flow was just less than 27% of its $2.22 billion in revenue. I expect that Nvidia’s second-quarter will come in somewhere in the 20s, hopefully, higher than lower.

Analysts expect Nvidia to generate revenues of $11 billion in 2020. Based on a 25% rate of free cash flow generation on the year, Nvidia should still be able to deliver almost $3 billion in FCF. 

AMD on a trailing 12-month basis used $251 million in free cash flow. Over the past five years, it’s averaged -$143 million in free cash flow; I doubt it will be cash-flow positive in its latest fiscal year. 

So, the fact that Nvidia is trading at 32 times its 2020 earnings compared to 51 times for AMD, and it generates a lot of free cash flow, makes me feel much better about NVDA stock as a long term play. 

The Bottom Line on Nvidia Stock

When Nvidia reports its Q2 2020 earnings in August, I’ll be looking at how much free cash flow it generates from its revenues. If it’s in the 20s, I wouldn’t be concerned. If it’s lower than that, I’d begin to reassess why you own its stock. 

Long term, Nvidia’s a great hold. However, as my colleague said, it’s going to see some volatility over the next few months and into 2020.

At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.

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