Nvidia (NVDA) was established 20 years ago in Silicon Valley. Its past success was typical of some of the most famous Silicon Valley start-ups, such as Cisco (CSCO), Intel (INTC) and Oracle (ORCL). The founder, Jensen Huang, is still in charge of the company today. The entrepreneurial culture is still rooted in this company.
For many years, NVDA established itself as the leading company in computer graphic processing chips, or GPUs. GPU's largest market is the gaming industry, which demands the best image processing power. NVDA had its heyday in that area. However, as gaming demand plateaued and PC sales have been in decline in recent years, the core business softened somewhat. These developments got Wall Street worried and the stock price of NVDA went nowhere during the past four years.
NVDA introduced a new line of products in response to the worry: its Tegra chip is now in its 4th generation. Tegra in simplistic terms is an application processor for mobile devices including smartphones, tablets and even devices on your cars. In my opinion, the timing could not be any better for Tegra to have a chance to take off. Mobile computing growth is exploding as everyone has witnessed in recent years. Currently, Apple (AAPL) and Samsung (SSNLF.PK) have their own processors, so NVDA has no chance in iPhones or Galaxies. But, the space is so huge for so many other devices, especially those Android-based platforms, that there is a big enough market for Tegra to become a big deal.
The sales growth was impressive: In the past three years, Tegra's sales went from $198 million in FY2011 to $591 million in FY2012 and then to $764 million in FY 2013. The devices that use Tegra as the computing engine are quite diverse (even including the sexy Tesla Model S cars). As the Android platform firmly lodges itself as the top choice for many non-Samsung and non-Apple players, the market potential for Tegra is undoubtedly bright. Granted the new market is highly competitive and is packed with formidable players. However, the advantage of NVDA is its ability to leverage its GPU experience to instill its graphic processing prowess onto the mobile world. Mobile devices increasingly interface with people through graphic applications, whether game, video content or web browsing. Whoever has superiority in graphic/voice processing power would have an edge in the market place. Based on industry test results, Tegra 4 and 4i appeared to be on par if not better in many key metrics compared to their major competitors. This raised the hope of their eventual traction in the marketplace.
Combining all the possibilities, I think an inflection point for NVDA stock may have arrived. Think of it this way: if Tegra 4 and 4i had been a huge hit already, we would not have a chance to buy NVDA at today's basement price. Even in its home turf GPU business, there are some good growth areas such as the GRID that would efficiently send graphic streams from the cloud side to the user side. This could make it possible to install some graphic intensive applications in the cloud. Another beauty of GPU is its parallel processing capability, which is embodied in its Tesla series (different from the car currently making the buzz). The GPU's adaptability makes it relevant for big data and cloud, the two most exciting things people talk about all day long now.
Having said that, there are a few items that investors should think further about:
In the 1Q conference call, NVDA mentioned a plausible reason for the "trough" in Tegra revenues. That is, the customers are waiting for the new release of Tegra 4 and 4i. Therefore, there is a significant revenue shortfall in Q1 and Q2. It is not clear to me whether this reason masks other factors such as the slippage of NVDA's market position.
In addition, we have yet to hear major design wins for Tegra 4 and Tegra 4i at this point, which would be a crucial indicator for future top lines. Given the ongoing price war in smartphones and tablets, my guess is that at least during the launch phase, the margin could be well below that of NVDA's other product lines, and maybe for quite a while. Being a challenger to the incumbent tech powerhouse such as Qualcomm, NVDA sticks to the "dare to compete" route and will have a bumpy ride.
I typically hesitate to invest in technology stocks because there is no accumulative advantage for a product or a company over the long run. Unlike Coke, which may throw money to build brand loyalty over decades, the customer of a tech product might ditch the formerly beloved gadget the next minute a slightly better/cheaper product surfaces. In addition, there is no ambiguity of performance in tech products: everything can be measured in precise numbers and compared, whereas the choice between Coca-Cola and Pepsi is largely a subjective matter. Therefore, only the best tech product would get the most while all the rest of the competitors are merely the victims of relentless competition. It takes extraordinary paranoid pursuit of superiority for a tech company to rise above its peers. Intel used to be able to pull this off. I somewhat see a similar paranoid spirit in NVDA.
I like companies that have a stable cash cow mature business at hand and also are making significant inroads into a high potential new market. NVDA is operating in that mode. In addition, NVDA is very focused on this one new mobile chip market, it is betting big on one new thing at a time. Some other companies under pressure to find growth tend to resort to buying indiscriminately. Other businesses instead rely on their own ingenuity. NVDA has a strong enough technical launch pad for it to take the less risky route by developing on its own.
I liken NVDA's decision to enter the new market of mobile application processors as Intel did in its transition from memory to CPU producer in its early days. Both markets are profoundly deep and profoundly profitable. Whether NVDA can execute as well as Intel did, is a question, but I remain optimistic.
Listening to the conference call, one cannot help but be impressed by the CEO and founder Jensen. He is articulate, highly intelligent, and to the point. There is a distinct absence of "MBA rubbish jargon" that is unfortunately so prevalent among other corporate executives today. He appears to know almost every detail of the business as well as the big picture. I believe NVDA's success so far is definitely not a fluke.
Financials and Valuation
The gross margin of NVDA in the past two years was over 50%. The company invested heavily in R&D. In FY12, the percentage of R&D revenue was a whopping 27%. In comparison, the almighty Intel spent 19% in R&D but that includes the fab, which was not part of NVDA's R&D budget. Inevitably, that kind of R&D expense hurts the short-term profitability but maybe it is all worth it if we view this as the ticket at the critical moment of getting into the mobile computing market. The flip side is that if Tegra is proved viable, then the future reward would more than compensate for the current pain.
The current market cap is about $8 billion. Roughly, that's two times revenue, 13 times free cash flow, and two times net tangible book value. The stock price reflects current fair valuation if not considering future growth. But, I believe people are still massively underestimating the potential of the new mobile products. If we give the benefit of doubt regarding Tegra in the future, it could contribute the same amount of revenue and margins as GPU does today in three to four years. That would approximately give a valuation of $30 billion by then, which equates to $60/share, give or take.
The solid balance sheet that NVDA enjoys affords both the company and investors to have a longer-term strategy. The net cash book value is approximately $7 to $8 per share, not counting the rich IP portfolio. NVDA has been an underdog for the last couple of years. It has almost become a value stock. This is a story every value investor would die for: value stock with blockbuster growth potential.
Recently management felt the pressure of stock under performance and decided to do something, namely to return $1 billion cash to investors through dividends and buybacks. Normally, this would not be a great thing for tech companies because it signals slow growth. However, in this particular situation I'd rather view it as a catalyst for the share price to vault to another level. The share repurchase is in stunning scale and in a short time frame. Management is determined not to tolerate the languishing of the stock price any more. From a technical viewpoint, the timing is ripe. All the doubters should have cleared the deck by now.
Given the strategic technical position of NVDA, I wouldn't be surprised to see a suitor, especially from Japanese tech giants. Japanese tech companies are so behind the curve they should be desperate to find an acquisition to latch onto.
It just makes sense to invest in NVDA today.