Nvidia (NVDA) has recently seen its stock surge upward from around $12.50 to $14.44 as of the writing of this article. The surge began around April 20th and jumped approximately 4% in afterhours trading following the earnings release and continues through today. Obviously investors were satisfied with the earnings release and continued to reward the stock which must make me a contrarian because I see strong downside risk for Nvidia over the next year. This article will explore the changes in the competitive landscape that will be detrimental to Nvidia and ultimately may lead to a fall in share price.
Nvidia has a market capitalization of approximately $9 billion with annual sales of around $4 billion. Its business is divided into two primary segments discrete GPUs and Tegra. Nvidia earns approximately 70% of its revenue from GPU sales in the PC market and has earned a reputation for high-end graphics performance. Tegra sales accounts for the remaining 30% of revenue and is a Systems on Chip (SoC) based on Arm Holding's (ARM) chip designs. Tegra is targeted at tablets, smartphones, and in-vehicle infotainment centers. Nvidia also has a strong balance sheet with $3.7 billion in cash and cash equivalents and no long-term debt.
The financials for Nvidia are strong and the company is still generating quite a bit of cash. The 10K report shows the total cash position was increased by $600 million in its last fiscal year to $3.7 billion. Nvidia also paid its first dividend in 2012 which annualized will be $.30 or approximately a 2% yield at the current share price. In 2012, revenue was up about 7% but net income was down 3% mostly due to a 12% increase in operating expenses. The company also saw its gross margins fall to 52% from 54% in 2011. On a superficial level, the latest earnings report for Nvidia was positive with the company beating the analyst forecast for revenue which was up by 3% to $955 million. The issue is while the revenue overall was up, the revenue from its Tegra segment was down 22% from the year-ago period.
The large decrease in sales of Tegra SoC is alarming because this is the segment positioned for mobile and embedded devices, the markets with the most growth potential. The PC market is in a decline, the first ever for the market, falling over 12% while the tablet market has seen growth of over 100% year-of-year and smartphones have grown 40% according to the International Data Corporation. The newest Tegra 4 chip has been delayed and now Tegra 4 based devices are promised to hit the market by the end of June (Fudzilla). This delay will have a major impact on Tegra sales for the year. First, we are already seeing a decline of 22% in the first quarter most likely because the almost 18 month old Tegra 3 SoC cannot compete with the newer releases from Apple (AAPL) and Qualcomm (QCOM) and other competitors in the market.
But now Intel (INTC) has released the new Atom processor with the Silvermont microarchitecture making it a viable competitor in the mobile market as well. The performance of this new Atom processor is quite impressive with the dual-core version of the Silvermont-based chip matching the competition's quad-core processors in the smartphone 1W power envelope, while using less power. These dual core processors can provide 1.6 times more speed at the same power consumption (Motley Fool). Intel also has an LTE solution, making it an extremely strong competitor in the smartphone space at a time where Nvidia is weak.
Tablets are another market that Nvidia is going to be hit hard by the delay. It was reported in early April the next generation Google Nexus 7 tablet from Asustek (ASUS) was going to be powered by Qualcomm's Snapdragon SoC (hexus.net). 60% of all Tegra 3 sales were from the current (ASUS) Nexus 7 tablet, meaning we can expect the decrease in Tegra sales to continue into the next quarter. Nvidia's Tegra 4 will have to come out with many design wins just to bring sales back to even for the year, which is unlikely due to the increased competition in the space.
The GPU market is seeing growth in competition and an overall trend toward integrated graphics solutions shrinking the market for the discrete GPU. Two articles on Forbes.com illustrate the case for why discrete GPUs are not going to be replaced with integrated GPUs (Forbes.com). I agree with the author of those articles that hard-core gamers and other graphic intense users will still purchase discrete GPUs. My point is integrated graphics solutions will replace the need for a discrete GPU for all but these graphic intense users, meaning the market for discrete GPUs will shrink. It is my opinion the needs of all but this small group of graphic intense users will be satisfied by the less expensive integrated graphics solution. This opinion leads me to believe that the market for Nvidia's discrete GPUs is going to be smaller moving into the future. Even a 10% decrease in the discrete GPU market would have a significant impact on Nvidia's revenues. Not only is the discrete GPU market shrinking but competition is building as well.
AMD's Radeon line of graphics cards has been seeing more success in the GPU market. It was recently announced that Advanced Micro Devices (AMD) won all three of the next generation video console contracts from the Sony PlayStation, Nintendo Wii, and the Microsoft (MSFT) Xbox (PCMag.com). Sony is a large customer for Nvidia and this loss will significantly impact the top line. The management team for Nvidia has done some PR work with this one and say they gave the Sony PlayStation to AMD because of low margins but that was when the contract was only for licensing fees. In this PlayStation contract, AMD will also be providing the physical chips adding to the margins significantly. Intel has recently announced the Iris and Iris Pro Graphics in the Haswell release set for early June. This is an integrated GPU solution but the high end graphics configuration is specifically designed to compete with Nvidia's GeForce GT 650M. While I am sure Nvidia's GeForce brand will compete nicely with Intel's Iris Pro it will still have to compete in a space where Intel was not a player before. The Iris Pro is very competitive with 128MB of eDRAM increasing its performance by 2 times over the Intel HD 4000 graphics in notebooks. Intel has even designed these to fit the largest Ultrabooks that before would have had a lower end discrete GPU further putting pressure on the discrete GPU market. Iris Pro is not just for notebooks and will be found in PCs as well where the graphics will really shine with three times the graphics performance (AnandTech).
Nvidia also has a big push into the in-vehicle infotainment center with its GPUs. Intel's Atom processor is aimed at this market as well. I believe the automotive industry will slowly move in the same direction as the tablet industry requiring more and more from the infotainment center and ultimately becoming more interested in the performance of the processor. This market deviation would gravitate toward the Intel-designed Atom with integrated graphics over a separate GPU. So even in this industry, Nvidia will see increased competition from Intel and a change in the market away from its current product offerings.
It is my position that Nvidia will be affected negatively by the increased competition from AMD and Intel in the GPU segment and the increased competition from Intel's Atom processors in the Tegra segment. Starting with the GPU segment, Nvidia managed to increase revenue by 2% to $3.25 billion for FY 2013, according to its 10-K report. The PC market has been declining by 12% this year which will impact Nvidia's sales. AMD's Radeon brand is positioned at the mid-level graphics card leaving Nvidia's higher-end and supercomputer graphics business immune from competition from AMD. Intel's release of the Haswell processor with Iris and Iris Pro graphics will further push into the gaming level graphics segment of the market and eliminate more ultrabooks and notebooks from the Nvidia GPU market. I also believe the integrated graphics with CPU will become the standard for the industry due to being less expensive and more power efficient. A market will always exist for discrete GPU. I just believe that market will be a smaller segment as the integrated solution reaches farther up into the gaming segment. AMD also managed to score all three of the major gaming consoles Wii, Xbox, and PlayStation which will cost Nvidia sales revenue. Nvidia stated in the news it gave up that business because of too low margin, but either way it will lower the sales for the company. All of these factors; declining PC sales, change in market preferences, loss of game consoles business, and Intel's Iris Pro GPU will culminate in a reduction of the revenues Nvidia garners from its GPU business segment. My estimate is approximately 5 - 10% less revenue. I believe the company's strength in high-end graphics and the increases in the Tesla GPU for supercomputers will help lessen the blow of the above factors but still result in lower numbers for this business segment.
The Tegra business segment of Nvidia is being impacted by the delay of the Tegra 4 which is due out by the end of June and Tegra 4i, the LTE integrated solution, will not hit the market until the end of 2013 (Fudzilla). Not having a competitive product has negatively impacted sales with the loss of the next generation Nexus tablet, which was 60% of Tegra sales last year. Intel has pushed into this space with a very competitive product in the new Silvermont-based Atom processor. Intel also has an LTE solution paired with the Atom processor already available which will increase competition for the Tegra 4i when it is released at the end of this year. The beginning of 2014 is when Intel is expected to release its integrated LTE chipset which will further create competition for Nvidia's Tegra 4i. Nvidia is paired with the Windows RT operating system which is not catching on in the mobile space while Windows 8 is garnering excellent market share and Intel is capturing the lion's share of that growth.
The Tegra business segment is already down approximately 20% in Nvidia's first quarter of Fiscal Year 2014 and I believe even with the release of Tegra 4 and Tegra 4i by the time Nvidia closes the book on its 2014 Fiscal Year, Tegra sales will still be down 10 - 15% for the year.
· GPU business segment revenue - $3.0875 - $2.925 billion
· Tegra business segment revenue - $.6876 - $.6494 billion
Even if we assume the same gross profit margin of 52% which is unlikely since the reduction in volume, increases in inventory, and price competition from AMD will most likely shrink them the gross income would be $1.963 - $1.859 billion. Operating expenses have been climbing recently, increasing by over 12% last year but to be conservative, we will assume increases of 5% for this year. At 5% growth, the operating expenses will be $1.65 billion. If the tax rate holds steady at 15%, net income will be between $272 - $178 million, a drop of more than 50% over the last Fiscal Year. This would compute to an EPS of about $.435 - $.285 which at Nvidia's current P/E of 15.5 would compute a stock price of $6.74 - $4.41. We can see by this exercise that a drop of 10-15% of revenue has a magnified impact on earnings. Nvidia has plenty of cash and could increase its stock repurchase program in order to prop up the stock price while making business strategy adjustments, but I still expect the stock price to fall below $10 a share.
My conclusion is Nvidia is facing a changing market that is moving away from its core products because of the integration of the GPU with the processor. It will still command the high-end graphics market where a discrete GPU is necessary but I believe the market will see some penetration by the integrated processor through Intel's Iris Pro product. AMD has the Radeon brand graphics card increasing the price competition in GPUs and has won all three of the gaming console contracts. The Tegra SoC is in a weak position right now because the current version is almost 18 months old and no longer competitive. The Tegra 4 will generate some design wins but the length of time between its release and the next cycle from its competitors has been shortened, so it will derive fewer profits from this release. Worse, Intel has developed a very competitive mobile solution in its Silvermont-based Atom processors which at a minimum will add to the competitive landscape for the Tegra business segment. I see a high probability of Nvidia experiencing a decline in earnings and ultimately a share price below $10 by March or April of 2014. It is my opinion that it is time to take profits from any positions in this company from the recent run up of the share price and move those profits to another position.