With the PC market engaged in an unrelenting decline, it's easy to assume that any company involved with PCs in any way will suffer. Certainly, the PC manufacturers, such as HP (HPQ) and Dell (DELL), are struggling, and chip maker Intel (INTC) is facing declining revenue and profits as it desperately tries to catch up in the mobile market.
But these companies serve the broad PC market. Any company, which relies on sales of low-end desktops and laptops, which are increasingly being supplanted by tablets, will likely continue to suffer. But there are parts of the PC market, which are far more resilient, namely the gaming PC market, and companies like Nvidia (NVDA), which operate primarily within that space, have been unjustly punished by the market.
A growing market
There was much concern earlier this year when AMD won contracts to supply chips for both next-generation gaming consoles, the Xbox One and the PlayStation 4. This was viewed as a big negative for Nvidia, which was responsible for the PlayStation 3 GPU.
But the PC gaming market is actually growing faster than the console gaming market. Nvidia CEO Jen-Hsun Huang had this to say during the most recent earnings call:
Well game consoles are fantastic and I am looking forward to buying one myself. But today, just like in movies and music you game on every computing platform. And the fastest growing platforms in the world today are open platforms. PC is the fastest growing and it's now become the largest, some $20 billion worth of global software sales. Obviously China is very, very large, but the United States is large as well, Russia and Korea and you name it. PC gaming has become very large.
Nvidia has sacrificed its console business to focus on PCs, the right decision in my opinion. While AMD will gain significant low-margin revenue Nvidia will continue its dominance of the high-end GPU market.
In the most recent quarter GPU revenue increased by 8% year-over-year, with strong demand for high-end cards driving that growth.
A mobile strategy
Nvidia's total revenue declined in the most recent quarter due to a complete collapse of revenue from its Tegra division. Tegra is Nvidia's mobile ARM-based processor, and the company has struggled to gain market share against competitors like Qualcomm (QCOM). However, the revenue decline was due mainly to timing. The Tegra 4, successor to the Tegra 3, which powered the Surface RT tablet, was delayed by Nvidia in order to focus on the Tegra 4i. The Tegra 4i includes a built-in LTE modem, and gives Nvidia a real competitor to the integrated options offered by competitors.
This delay caused a gap between the winding down of Tegra 3 and the ramping up of Tegra 4, leading to a 71% year-over-year revenue decline. But as Tegra 4 begins to find its way into devices revenue should begin rising again.
One big development for Nvidia was the launch of the Shield handheld console. Shield is powered by Tegra 4 and runs Android, allowing for the countless existing Android games to be played on the device.
Through all of this a strategy appears to be emerging. There are already some Android games, which are optimized for Tegra, and if the Shield and other Tegra devices sell well more Tegra-optimized games will likely be developed. This could create a schism in the mobile market, with only Tegra-powered devices able to play the best games. Much like gaming PCs are a distinct segment within the PC market, gaming tablets may become a distinct segment within the mobile market.
Tegra has a lot of potential, but its success is far from certain. However, Nvidia's core business is so strong that by buying the stock you're essentially getting the Tegra business for free.
A real bargain
Nvidia is a company almost drowning in cash. At the end of the most recent quarter the company had $2.94 billion in cash and no debt. This is about $5 per share in cash, or 34% of the total market capitalization.
The cash balance is down from the previous quarter due to a deal struck with Goldman Sachs for an accelerated share repurchase program. Nvidia spent $750 million to buy back shares of its stock.
After accounting for the cash Nvidia's enterprise value is about $9.75 per share. Earnings declined in the most recent quarter, but this was due to the weakness in the Tegra division. Gross margin actually increased year-over-year due to the strength of the GPU division, so there's no reason to believe that the decline is anything but temporary.
Using TTM numbers Nvidia's owner earnings per share come out to about $0.85. This puts the enterprise value at 11.5 times the owner earnings.
It's important to remember that this includes the effects of Tegra losses. Using 2012 numbers the ratio drops to about 9.85. An EV/OE ratio of 15 would put the stock price at $17.75 using TTM numbers and at $19.85 using 2012 numbers, a 20% and 35% increase over the current price respectively.
The market is completely discounting the fact that the GPU business is growing and that Tegra sales are only temporarily weak. I originally bought shares of Nvidia for $12.60 back in March, an incredible bargain, but I increased my stake twice since then at a price of $14.42 and $14.30 per share respectively. Not only is NVIDIA still inexpensive at around $14.75 per share but the company has growth prospects in both its core GPU market and its mobile market, and with plenty of cash for more buybacks I expect Nvidia's share price to eventually reach its full potential.