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Nvidia (NVDA) has been under pressure due to the decline in PC industry shipments. This could threaten the company's bread and butter discrete GPU segment which gets most of its revenues from PCs. The company also faces severe competition from Advanced Micro Devices (AMD) and Intel (INTC) which are improving their graphics products. However, the PC decline has not affected Nvidia's core GPU segment, which continues to surprise with high margins and growth. The company is the leader in the visual computing industry and is launching a number of new initiatives to increase revenues. The company is also set to launch its next generation mobile SoC products - Tegra 4 and Tegra 4i. The company's revenues from Tegra processors declined by ~22% during Q113, as rivals like Qualcomm (QCOM), Mediatek and Spreadtrum (SPRD) introduced better mobile processors. However, Tegra 4 and 4i based mobile devices will be launched soon and this should help Nvidia's revenue growth in late 2013 and 2014. I remain positive about NVDA's prospects given its cheap valuation, impressive technology and revenue growth drivers.

Nvidia catalysts

1. Impressive Margins - Nvidia has managed to grow gross margins at an impressive pace over the last decade. Despite severe competition from industry Goliaths like AMD and Intel, Nvidia's gross margin has grown from 29% in 2003 to ~54% in the current quarter. While some of the Q113 margin improvement was due to lower sales of lower margin Tegra products, the secular growth in margins has been extremely impressive. 50% plus gross margin shows that Nvidia has strong competitive barriers on the technology front.

We achieved record gross margins this quarter, now in the 54% range, up 1.4 percentage points sequentially and up 4.2 percentage points year-over-year...For Q2, we expect margins to remain within the same 54% range as Q1 with a high mix of our higher margin products.

2. GPU growth - There were fears that Nvidia's GPU sales would decline with the PC shipments declining by 14% y/y during Q113. However, Nvidia's GPU segment showed a surprising growth of ~8% y/y during Q113.

The discrete GPU market has been growing for us 12% CAGR over the last four or five years...tablets disrupt the PC. It disrupts the PC for casual PC use. You can't really use a tablet to design a car yet, and it really doesn't make sense to use a phone to create a movie.

Nvidia is relatively insulated from the troubles of the PC market as the company is focused on the high end of the PC market. Nvidia's GeForce Titan card has been a huge success and continues to drive the company's GPU revenues. The company's new GTX Titan product is the best performing GPU in the market and has received a very enthusiastic response from gamers. As the company continues to improve its visual computing capabilities, more applications are being discovered. This is the core strength of Nvidia and the company has been building on this strength.

Revenue from our gaming GPUs was up 24% year-over-year. GTX Titan, our highest performance single GPU was retailed for $1,000 was launched three months ago and continues to sell out as fast as it becomes available...To enable our customers to experience these games at their visual best, we launched, GeForce GTX Titan, our best indicator of future success is customer demand. And, since its launch in February, Titan continues to sell out as fast as it's delivered. It packs it to a quite elegant form factor, 7 billion transistors using the same Kepler architecture that powers the world's fastest supercomputer, the Titan at Oak Ridge National Laboratory.

3. Tegra 4 and Tegra 4i to ramp up - Nvidia was amongst the first "PC" companies to recognize the shift towards mobile devices such as tablets and smartphones. The company invested heavily into building SoC for mobile devices. Though the company was forced to delay the Tegra 4 launch due to faster LTE adoption, new products based on Nvidia processors will be launched in the coming year. Tegra 4i will be targeted towards Qualcomm's S400 Snapdragon customers. Nvidia is claiming better graphics and processor performance than its competitors. This should help Nvidia to increase its Tegra segment revenues, which fell by ~22% in the current quarter to ~$103 million.

4. Virtual Graphic Processing - Nvidia is the first company to launch a product for the "virtual graphics processing" market with the introduction of the "GRID VCA". The company thinks that the GRID market is worth $3 billion a year and will help corporations realize big cost savings through virtualization of graphics processing. The company has already signed with around 100 resellers to sell its GRID VCA product.

In the short time since we began taking GRID to market this quarter, we've engaged over 100 GRID VGX and GRID VCA trial customers and signed many of the top Adobe, Autodesk and SolidWorks resellers to take GRID VCA to market.

The world's first visual computing appliance Nvidia GRID VCA is a powerful GPU-based system. It runs complex applications such as those from Adobe, Autodesk and Dassault Systemes and sends their graphics output over the network to be displayed on a client computer. This remote GPU acceleration gives users the same rich graphics experience they would get more powerful, dedicated workstation under their desk.

We believe GRID VCA represent the potential $3 billion market opportunity. With an estimated base of 10 million users of Adobe, Autodesk and SolidWorks software, design, print and other creative businesses can now give their teams access to graphics-intensive applications with uncompromised performance, flexibility, and for the first time ever, mobility.

Nvidia Risks

  1. Tegra Competition - While Nvidia was able to steal an early march in the mobile processor space with its Tegra line of products, it has not been able to sustain its early mover advantage. Nvidia faces the two largest semiconductor companies Qualcomm and Intel as competitors in the tablet and smartphone SoC market. Besides QCOM and Intel, Nvidia also faces competition from low cost Asian players like Mediatek and Spreadtrum. Intel's new Silvermont architecture products will be launched during the holiday season of 2013. This will pose serious problems to existing ARM players, as Intel will drastically improve its current "Clovertrail+" products. Nvidia is not targeting the high end of the smartphone SoC market, but is rather looking to provide high quality chips for the mid range segment of smartphones. This means that the company will have to fight low cost competitors in this segment. AMD is also readying itself to enter the tablet market with its Temash processors.
  2. Integrated GPU Risk - Nvidia's core discrete GPU segment faces risk from integrated GPUs sold by Intel and AMD. Intel is set to drastically improve graphics performance with its new Haswell processors, while AMD's APU's are also delivering good performance for the mid range of the GPU market. While Nvidia possesses tremendous advantages in the professional and gaming GPU segments, this risk continues to be a serious overhang on NVDA's valuation.
  3. Manufacturing Risk - Nvidia does not manufacture its own chips and is dependent on foundries like TSMC (TSM) for its production needs. Intel will steal a march over its competitors by being the first company to make mobile chips on the 22 nm node, while others still make silicon on the 28 nm.

Valuation

NVDA remains cheap, despite the current stock market rally with a P/S 2.1x and a P/B of 1.8x. Though the company's forward P/E of 14.2x might look a bit on the higher side, investors should note that ~40% of Nvidia's $8.8 billion in market value can be attributed to net cash on its balance sheet. Nvidia also announced an aggressive $1 billion buyback during its last analyst day, which should support the stock price.

Summary

Nvidia has performed extremely well despite facing huge competitive pressures from bigger semiconductor competitors. The management has not been afraid to take risks and has continued to introduce new products which have shown impressive growth. While Nvidia faces rising competition in the mobile processor market, there is space for more multiple players in the mobile devices market. The company's GRID initiative also has the potential to do extremely well by pioneering virtualization in the graphics processing industry. Though I remain cautious about the overall market, I remain positive towards NVDA due to its cheap valuation, upcoming product launches, consistently high margins and leadership in the visual computing industry.

Source: Nvidia - Margins Continue To Defy Gravity