Nvidia: Not Just A Graphics Card Company

Jun.26.13 | About: Nvidia Corporation (NVDA)

Nvidia (NASDAQ:NVDA) has had an interesting 2013 - and that could be the reason its stock has had a fairly good year. As the chart below shows, despite the recent turmoil in the capital markets, Nvidia's stock remains up by over 17% in the year-to-date, a return that is 50% better than that of both the NASDAQ Composite Index and the S&P500's.

Nvidia v. S&P500 AND NASDAQ COMPOSITE

Click to enlarge
(Click to enlarge)

Source: YCharts

Nvidia has caught investors' interest this year owing to two seemingly unrelated ventures: the first is the Nvidia Shield, an Android OS-based handheld gaming device that has the capability to output its display (and therefore the gameplay) to television sets capable of up to 4K resolution. The second is its announcement that it intends to license its graphics technology, possibly to companies such as Apple (NASDAQ:AAPL) and Samsung (OTC:SSNGY).

The notion that Nvidia could potentially provide the graphics technology for the millions of devices that Apple and its Android competitors ships annually is a boon for the company, particularly as Nvidia's traditional bulwark, the PC market, shrank by close to 13% in the first quarter of 2013.

Nvidia is, of course, principally known for its dedicated graphics chips, which have long waged a struggle with AMD's (NASDAQ:AMD) ATI subsidiary among PC gaming enthusiasts. Between the two of them, AMD of and Nvidia have a combined 38.2% of the market for graphics chips. The two companies trail Intel, which bundles its own low-cost graphics chips with its processors and chipsets, allowing it to control nearly 62% of the market.

Of the three industry leaders in the graphics chips space, only Nvidia does not sell its own PC CPU's (though it does sell system chipsets) and it is a tribute to the performance of its dedicated graphics chips offerings that it has nearly a fifth of the market. Indeed, while both AMD and Intel (NASDAQ:INTC) saw shipments of their graphics chips decline in the first quarter of 2013 as part of the 12.9% decline in the graphics chip market, Nvidia actually saw its shipments grow by 3.6%.

What's more, Nvidia has shown a penchant for upping the stakes in the consumer graphics chip market with its high-performance dedicated video card offerings. In February, it launched its GTX Titan graphics card, which serves as both a high-performance graphics card for gaming enthusiasts and an entry-level computing card that can be used by researchers, engineers and professionals needing high-performance computing at a (relatively) affordable price. In effect, Titan serves as the bridge between Nvidia's GE-Force consumer-class and Tesla enterprise-class products.

Given all this and the fact that the stock is currently trading just 2.3% below its consensus price target of $14.75 for Nvidia's stock, should investors consider getting into the stock now or wait until the overall market volatility drives the stock price lower?

Earnings

The weakness of the PC market and the long-term amortization costs associated with its heavy R&D spending are expected to drive Nvidia's earnings lower this year. To wit, the consensus estimate for its fiscal year ending January 2014 is for earnings-per-share of 73-cents - 19% lower than the 90-cents per share it earned a year. Despite this, some analysts actually expect Nvidia to earn as much as 94-cents per share. That higher range, while improbable given the company's own guidance, is not impossible considering that Nvidia has beaten consensus estimates by an average of 23% over its past four remaining quarters. Indeed, it beat estimates by 30% in its quarter ended April 2013.

However, focusing on near-term earnings is a mug's game for Nvidia investors. The real attraction of this company is in its potential. Nvidia is expected to see its earnings grow by an average of 12% a year over the next five-years - that's slower than the 15.6% expected of Nvidia's peer group, but it includes other specialized semiconductor companies such as Altera Corporation (NASDAQ:ALTR) and Linear Technology (NASDAQ:LLTC), which have about as much in common with Nvidia as apples have with oranges.

The real comparison is with the GPU market, which expected to grow by just 2.6% a year through 2016 and in this area, Nvidia already has a head start: as we noted, Nvidia's shipments grew by 3.6% during the first quarter of 2013 even though overall shipments fell by 3.2%. Products such as the Titan are important in ensuring that Nvidia's shipments continue to grow particularly since it will enable the company to tap customers for whom its Quadro line of professional devices are still too expensive.

Meanwhile, Nvidia recently announced that it's dropping the price of its Shield handheld device by $50 from its originally announced launch price of $349 to $299. That will allow it to better compete with incumbents such as Sony (NYSE:SNE), whose latest-generation handheld, the PlayStation Vita, has been plagued by poor sales. The stakes are significant: the success of the Shield could allow it to gain a foothold in the console game market, which is expected to reach $60 Billion in sales by 2016 for an 8.7% annual growth rate from 2012.

Regardless of the Shield's price-drop, this is still very much a touch-and-go proposition for Nvidia and it is likely to gain more headway licensing its hardware designs, particularly to Apple and Samsung, who already use custom versions of ARM's CPU designs but use these in tandem with Imagine Technologies' PowerVR graphics processing units (GPU). Nvidia's latest Tegra 4 designs are theoretically faster than the PowerVR SGX 554MP4 units that Apple ships with its A6X System on Chip (SoC) and licensing Nvidia's technology will presumably allow it (and Samsung and other OEMs) to its own custom GPU that is even better optimized for its platform.

Whether Nvidia is successful in selling its designs to all of the major OEMs at the onset is irrelevant - merely having either Apple or Samsung use its designs would be a massive coup and could encourage others to shift to its designs down the road.

Given these developments, the outlook for Nvidia is certainly encouraging: it is in the enviable position of having a foothold in two of the fastest-growing markets (home entertainment and smart devices) in consumer technology. Meanwhile, it is registering solid growth in a market (PC graphics chips) that larger players are faltering in and its recent product offerings have the potential to bridge its markets.

Fundamentals and Valuation

Nvidia is currently trading at a very reasonable price-earnings ratio of 15.5x - that's compared to its peer group's 213x earning. As we've noted, some of the companies labeled its "peers" are not really peers in the strictest sense so this relative valuation may not be entirely appropriate. Indeed, some of the companies that are part of its peer group are so specialized in their product offerings or are in very early stages of their development cycles that their valuations tend to drift towards the extremes.

That being said, Nvidia is also trading at discount to the S&P500 and has a dividend yield of 2.1% that is equivalent to the overall dividend of the S&P500. Nvidia is also trading at a fairly reasonable 1.9x sales and 1.7x book value. The former measure is a bit high compared to the S&P500's, but it is cheaper than the Index on the latter benchmark. In that sense, Nvidia can be said to have relatively good value.

Even better for a technology company, Nvidia has very prudent management: it has no debt and its cash ratios are high for any kind of company with 5 dollars of cash and equivalents for every dollar of short-term liabilities. This affords the company a great deal of flexibility to pursue different strategies and also allows it to turn around quickly from missteps.

Meanwhile, Nvidia continues to impress shareholders with its high profitability ratios: its gross margins, at nearly 60%, are closer to a high-margin service industry company than it is to a high-tech firm. Indeed, its peer group's margins are at just 43% while the S&P500's is at nearly 48%. The company's R&D spending does contribute to its overhead, however, and despite its far higher gross margin, its EBITD margin of 20.6% is just 1.2 percentage point higher than the S&P500's on aggregate. Still, that's to be expected from a technology company and, given Nvidia's impressive 15.7% return on investment over the past year, shareholders are unlikely to complain, particularly since other specialized semiconductor firms have a paltry ROI of just 2.3% while the S&P500's is "only" 8.2%.

Conclusion

We like Nvidia and our only hesitance in recommending the stock stems from the volatility in the market. Astute investors might wish to disperse their Nvidia buying over a period of time to allow for a more favorable average carry cost. Having said that, we believe the target price for $14.75 is too low (it had already been breached this year) and that the stock is likely to trade at $16.50 per share once the market has found its footing.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in NVDA over the next 72 hours.

Business relationship disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inspire investors. This article was written Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.