Nvidia: The Bull Case Becomes Clearer And Stronger, Shares Still Have 40% Upside

| About: NVIDIA Corporation (NVDA)

A name that I have been extremely bullish on over the last year or so is Nvidia (NASDAQ:NVDA). Here we have a name that has, in my view, been unfairly punished for its leverage to the PC market. Despite being a primarily PC-GPU centric firm, it has managed to grow fairly consistently over the last several years. This is largely due to the fact that while the broader PC market has seen erosion from below due to the increased ubiquity of tablets and, to a smaller degree smartphones, the performance-hungry, gaming-centric portion of said PC market has been quite healthy. Add to this the fact that Nvidia's only competition in this space, Advanced Micro Devices (NASDAQ:AMD), has been steadily losing market share as it simply cannot dedicate the sheer resources to its GPU division (as it continues to fight a losing battle against Intel (NASDAQ:INTC) in the PC CPU/APU space), and you've got a pretty healthy core business that doesn't look particularly expensive at 6.5x EV/EBITDA.

However, cheap is not a catalyst, but I believe that Nvidia is on the cusp of a very important and very often overlooked transformation of its mobile system-on-chip business. It is my view that even if this transformation shows signs of being even remotely successful (and the tell-tale signs should be visible by the end of Q4), then shares will see a fairly dramatic reversal in sentiment. Despite the nice bounce off of its $11 lows (for a 36% gain), I believe that many significant concerns continue to weigh on the shares, and that as these fade, the shares have at least 40% upside potential, a good portion of which should be realized over the next two to three quarters.

What Are The Concerns?

A look at the most recent earnings report shows that the company's high margin professional GPU and high performance compute oriented products are doing extremely well, with the former posting 14% Y/Y growth and the latter hitting 128% Y/Y growth. While new product launches have certainly helped to drive demand in these end markets, the good news is that these markets are also continuing to be secular growth stories.

However, there are two major concerns here:

  1. Is the demise of the PC market and/or a shift towards integrated graphics within these end markets going to severely damage Nvidia's core GeForce gaming GPU business?
  2. Nvidia's mobile computing strategy continues to disappoint, which could mean that the company - even if #1 pans out for the better - could be a very low growth company at best

It is my view that both concerns are far overdone, although the latter more so than the former. Nvidia's numbers quarter after quarter have largely proven the first fear wrong, particularly as investors continue to overlook the fact that PC games continually become more graphically intense (and will likely see a massive spike upward in graphical intensity following the launch of the next generation consoles as game developers target higher baseline hardware), which renders the "integrated graphics are becoming good enough" argument moot.

But the real problem - and in my view, opportunity - comes from the significant pessimism surrounding Nvidia's Tegra business, and exiting CY2013 and entering CY2014, it is my view that sentiment on the growth and profitability prospects on this business will reverse dramatically.

Why Has Tegra "Failed" Thus Far?

Nvidia's Tegra business has been a money-losing business from its inception. This has been largely due to the fact that this business is very R&D intensive. While Nvidia's current "Tegra" line utilizes processor IP licensed from ARM (NASDAQ:ARMH) (although this is set to change in the 2015/2016 timeframe with an Nvidia-designed, ARM-compatible processor core), the IP required for a system-on-chip is rather substantial. In particular, the very high volume smartphone space requires a substantial investment in RF and cellular baseband, which - as Qualcomm's (NASDAQ:QCOM) continuing lead over the industry with respect to LTE has shown - is non-trivial. While Nvidia is making the appropriate investments, it will not be until 2014 that these investments will appear justified.

On the tablet side of things, Nvidia was actually quite successful with its Tegra 3 processor, although the current product cycle with Tegra 4 has largely been a bust, as a result of both timing problems with getting the Tegra 4 to market, as well as significantly increased competition from Qualcomm (and likely Intel) in the tablet market. Fortunately, while this timing issue caused Nvidia to lose a number of high profile sockets to Qualcomm and ultimately led to a guide-down for full year Tegra revenues, this sacrifice was made in order to significantly pull in two next generation products: Project Logan, and the Tegra 4i. It is my view that these two products will prove pivotal to Nvidia's longer term strategy, and that success here will be a key momentum driver through 2014 for Nvidia's Tegra business.

Tegra 4i: Driving Mainstream Smartphones

The smartphone TAM is in excess of 1B units and it is clear that the majority of the growth in this space is in the mainstream. The bad news is that this arena is price sensitive, so while differentiation based on new and interesting features is certainly required (Spreadtrum and MediaTek are constantly pushing for the latest technologies), cost is key. Fortunately, Nvidia's bread and butter business - GPUs - is a very high margin one that generates a significant amount of EBITDA. This will allow the company to more comfortably compete in this space, even if it has to accept a lower gross margin profile, while keeping overall profitability intact and substantially improving the top-line story.

Next - and more importantly - Nvidia has apparently successfully integrated an LTE cellular baseband onto its Tegra 4i chip aimed for the mainstream. The company claims that due to the fact that its modem is software defined, it offers a significant chip area savings over competing designs, which could prove to be crucial in attempting to (profitably) gain share in this arena. Further, while the primary competition in this space may appear to be the MediaTeks and the Spreadtrums of the world, Nvidia could likely go after Qualcomm's Snapdragon 400 parts in the mid-range US smartphone market, which could prove to be a rather lucrative incremental opportunity.

But the crux of the thesis is rather simple: up until now Nvidia (along with any other chip company not called Qualcomm) has had next to no participation in the smartphone market. If the Tegra 4i, with integrated LTE and a solid apps processor, can hit the market with a good cost structure and with the right featureset, then Nvidia has a chance to meaningfully increase its TAM with this part. Assuming a 1 billion smartphone TAM, and assuming that Nvidia captures merely 5% of the market by selling chips with an ASP of $15, we are looking at a $750M incremental opportunity, suggesting ~17% growth to the company's baseline revenue going forward (and with growth from there at least tracking global smartphone growth, although share gains could continue for several years).

Tegra In Tablets, Broader Compute

While Nvidia's Tegra has seen limited traction in smartphones, it has done quite well in the tablet space - when the parts were on-time. It is my belief that Nvidia delayed Tegra 4 and essentially gave up on the current generation in order to remedy one of the most glaring flaws that its Tegra lineup had - graphics. For a company whose lineage is in computer graphics silicon and software, shipping mobile system-on-chip designs with sub-par graphical capabilities is simply not acceptable.

Fortunately, it seems that with the upcoming "Logan" system-on-chip, Nvidia will be moving towards bringing its high end "Kepler" GPU architecture to its SoCs (and with the next generation "Parker" SoC, Nvidia will be using its "Maxwell" GPU - the successor to "Kepler"). The interesting thing about this is that from a graphics perspective (which seems to be where the top-end SoC designers are spending the majority of their transistor budgets), Nvidia is likely - for the first time - to have graphics leadership in the tablet-oriented system-on-chip market, which is likely to see a TAM in excess of 300M units. However, the story isn't just isolated to tablets. As Google's (NASDAQ:GOOG) Android continues to gain traction in the PC space, particularly in the budget-oriented consumer PC space, Nvidia's higher end tablet oriented Tegra lineup could prove to be a significant contender, particularly in graphics/gaming oriented workloads.

Assuming that Nvidia can eventually grow its market share in the tablet space to ~20% on a 300M unit TAM during 2014 (so 60M units for Nvidia), and assuming chip ASP of ~$25, the tablet segment alone could be a $1.5B business for the company (the Tegra business looks to be about a $450M - $550M one this year, suggesting significant upside). I believe that such share gain is possible, although it hinges on Nvidia being on-time with Logan, which itself needs to have as strong a competitive position as I believe it will likely command.

Nvidia Branded Devices - A Wildcard

Nvidia's SHIELD gaming device has been a critical success, and from the initial read given on the call, it is selling pretty well for a niche gaming device. However, recent rumors have surfaced that Nvidia may be planning a foray into its own branded tablets. Now, while the core thesis does not hinge on it, Nvidia may attempt to become a full-blown compute device vendor, and this could drive substantial upside.

Nvidia has the in-house SoC/modem IP and expertise to be a fairly vertically integrated tablet/smartphone vendor. While Nvidia lacks the sheer scale and very deep vertical integration (NAND, displays, memory, CPU fabrication) that, say, Samsung (OTC:SSNLF) commands, the company could see a dramatic boost to the top and bottom lines if it were able to successfully develop and market a successful line of tablets and smartphones. Success here would hinge on Nvidia's ability to sell itself to consumers who are likely not already familiar with the firm's lineage in the PC graphics space, although having the PC-gaming community as an initial customer base (which could then more broadly spread awareness of Nvidia's products - assuming they are best in class) certainly helps.

I don't want to model this in as part of the core thesis, but should it become clear that Nvidia's management will try to become a full-blown mobile device vendor, then - depending on the strategy - this could serve to drive fairly significant upside for the top and bottom lines.

Share Buyback, Dividend Growth Potential Serve to Limit Downside

For years, Nvidia had amassed a substantial cash position with negligible debt. Throughout 2012, the investor and analyst community alike had continued to press Nvidia on this topic, until finally the company announced its very first quarterly cash dividend. While the dividend in itself is not the primary reason to invest in this name, the dividend growth will continue to raise the floor on the stock going forward. While it is my view that Nvidia's days as a growth oriented name are still well ahead of it, the company's shares are much more likely to weather periods of stalled growth.

On top of this, the company currently has a rather substantial buyback in place that it has - once again for the first time in its history - begun to aggressively utilize. While the company had a buyback program in place for years, it is not until recently that the company has taken the opportunity to retire shares at these levels. While this is not a core tenet of the upside thesis, the dividend helps to substantially mitigate the downside risk.


All in all, I'm looking for 2013 to largely represent a trough for Nvidia's Tegra business. Both "Logan" and the Tegra 4i should be available by early next year, which suggests that the company will not only be able to meaningfully compete in the tablet market during 2014 (after timing issues marred the first few quarters of 2013), but it will finally be able to compete in the high volume smartphone markets. Tegra has been a substantial drag on the bottom line, but even with the substantial losses this division has brought about, the company is still on track to earn $0.71/share during FY2014. However, this creates an interesting operating leverage story.

Nvidia claims that its Tegra spending is in the neighborhood of $600M. I assume that gross margins in this segment are roughly 50%. This means that for the current year - in which Tegra is likely to generate $450M - $500M in sales - this division will record an operating loss of $325M - $375M, which is worth $0.56 - $0.65. Getting back to even in FY2014 (which would require $1.2B in sales) would then remove that overhang on the bottom line and get EPS to $1.27 - $1.36. Conservatively applying a 16x multiple to this (as achieving this would indicate significant momentum in a high growth field) gets us to $20-22/share, or 33% - 47% upside from current levels. Note that this assumes that the core GPU business is flat, which is likely a very conservative assumption in light of the continued strength in HPC and workstation, as well as the continued strength in the core PC gaming GPU market.

Disclosure: I am long NVDA, INTC, AMD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.