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The smartphone sector is currently one of the fastest growing in the world today, and it presents many opportunities for profits. While the obvious investment in this space is Apple (AAPL), it is important to remember that Apple is not the only company in this space. We are by no means arguing that Apple is not the ideal way to generate profits from the smartphone sector. But, it is important to remember that hundreds of companies operate in this sector, and many of them merely need the overall smartphone market to grow, and can thrive without the benefits of being in the Apple ecosystem. We believe that one such company is NVIDIA (NVDA).

NVIDIA is a graphics chip company based in Santa Clara, and it is increasingly a mobile semiconductor company with a presence in several smartphone companies, such as HTC and ZTE, via its Tegra 3 platform. The company faces competition in traditional graphics with both Intel (INTC) and AMD. While NVIDIA is a major player in the traditional discrete GPU market, that is not why we are bullish on the company. Investors, over the past year, have sold off shares of NVIDIA on worries over its place in the graphics world, as well as the flooding in Thailand. But at around 16x trailing earnings, we think that NVIDIA shares have declined too far.

It is true that NVIDIA is trading at a forward P/E of around 21x, but it is crucial to note that NVIDIA is spending record amounts on R&D to innovate in the mobile sector and win market share in smartphone semiconductors. The company is transitioning to a future where it will be focused on the mobile sector. As such, earnings are going to be depressed in fiscal 2013, with estimates coming in at 72 cents per share, before rebounding to 92 cents per share in fiscal 2014. As a reminder, NVIDIA's fiscal year does not align with the calendar.

Why NVIDIA?

We have often spoken of the financial opportunities present in the smartphone and tablet space. As any investor in Apple will tell you, the profit potential in this space is amazing. At the smartphone and tablet level, the sector is divided into 2 parts: the iPhone/iPad and everything else. Apple controls 75% of smartphone profits and 40% of revenue.

While it is true that at the smartphone and tablet manufacturer level, the only company that should be invested in is Apple, at the supply chain level, that is not the case. The structure of the smartphone and tablet market as a whole means that Apple controls profits and margins. The high subsidies it is able to extract from carriers allow for industry-leading margins. But for suppliers, the market operates in a different way. As long as volumes increase, suppliers benefit. It is true that NVIDIA does not supply mobile chips to Apple, but that is not a concern. Android and other non-iOS ecosystems collectively ship more smartphones than Apple, and that is what allows NVIDIA and other non-Apple suppliers to profit. (That is a simple fact. For Apple, however, that is not relevant. Apple generates more profit from smartphones than everyone else combined) For suppliers, the distributions of OEM profits are largely irrelevant. What matters is volume, and the non-iOS smartphone manufacturers have plenty of it.

As for the tablet subsector, things are playing out differently. The iPad is the undisputed leader in tablets, and as such, the growth of the tablet market benefits the Apple suppliers the most. While this may seem to present a challenge to non-Apple suppliers like NVIDIA, there is one key element to keep in mind. There is an obsession amongst companies to compete with the iPad, and while it looks like they will never dent the iPad's overall lead, its market share is falling. The iPad ended 2011 with 57% of the market, down from 64% in the third quarter. Its toughest competitor is the Kindle Fire, and while NVIDIA does not have a presence in the current Kindle Fire, analysts expect it to win the application processor contract in the next version. Given that the Kindle Fire has shown to be the strongest non-iPad tablet seller, with a 14% share of the market as of the fourth quarter of 2011, we think that inclusion in the next Kindle Fire will be a great boost to NVIDIA.

NVIDIA has lost the faith of investors as they fret about its future in discrete graphics, the sector where the company started. But in the years to come, NVIDIA's mobile chips are what will drive the company. The Tegra 2 chips are currently in devices from Motorola (MMI), LG, and Samsung (OTC:SSNLF). The Tegra 3 chip has already won places in HTC, ZTE, and several other manufacturers. Furthermore, as Windows 8 begins to appear on ARM-based PC's, NVIDIA will be in a position to dominate that space. The company is seen as having a sizeable lead over Qualcomm (QCOM) in that space. It has over 600 quality certifications from Microsoft (MSFT), while Qualcomm has only 6.

Financial & Operational Profile

NVIDIA has an outstanding balance sheet, with over $3.1 billion in cash & investments and no debt. At current stock prices, this means that over 33% of NVIDIA's market capitalization is in cash. Not even Apple, with around 20% of its market capitalization in cash, can best that figure. 2011 and 2012 will be "transition" years for the company, as mobile processors will become more and more important relative to its traditional graphics division. It is important to remember that while competition in the discrete GPU space is intense, competing with Intel does not have to cause losses. AMD has been in Intel's shadow since its founding, yet it is now on relatively solid financial footing and is posting profits. NVIDIA is, for the moment, able to hold its own in the discrete GPU market. Intel dominates the overall market with 59.1% of the market, but given Intel's focus on integrated graphics, that is to be expected. AMD, via its ATI division, holds 24.8% of the market. And NVIDIA, as the only firm focused solely on discrete GPU's, holds 15.7% of the market.

We cannot say that NVIDIA is not being challenged in the PC graphics market. Discrete GPU shipments fell 3.5% last quarter compared to a year ago, although that statistic fails to take into account discrete GPU's in mobile devices, servers, and tablets, which utilize NVIDIA's Tegra line. While NVIDIA's profit centers are in fact undergoing a structural shift, it is important to remember that the discrete GPU division is still profitable. Fourth quarter revenues of $953.2 million were impacted by hard drive shortages due to flooding in Thailand, and as a result that figure fell 10.6% sequentially. But as Thailand recovers and hard drive capacity returns to normal, that particular pressure point on NVIDIA's sales should abate.

Tegra 2 sales fell 48% to $109.8 million, but that is to be expected. OEM's are transitioning to Tegra 3, and are ramping up production of smartphones and tablets based on that line. Below, we provide an overview of NVIDIA's financial results for the last 4 fiscal years, as well as estimates for the next 2.

Financial Tables, 2009-2014 (Fiscal Year)

2014E

2013E

2012A

2011A

2010A

2009A

GAAP Revenue

$4.5 Billion

$4.1 Billion

$3.99793 Billion

$3.543309 Billion

$3.326445 Billion

$3.424859

GAAP EPS/Non-GAAP EPS

$0.92

$0.72

$0.94/$1.19

$0.43/$0.81

-$0.12/$0.26*

-$0.05/$0.29*

Net Income

N/A

$581.090 Million

$253.146 Million

-$67.987 Million

-$30.041 Million

Operating Cash Flow

N/A

N/A

N/A*

$675.8 Million

$487.8 Million

$249.4 Million

R&D Spending

N/A

N/A

$1.002605 Billion

$848.83 Million

$908.851 Million

$855.879 Million

Gross Margin

N/A

N/A

51.4%

39.8%

35.4%

34.3%

Profit Margin

N/A

N/A

14.535%

7.144%

-2.043%

-0.877%

*NVIDIA only breaks down cash flows in its 10-K filings, and the company has yet to file one for fiscal 2012
** GAAP net income and EPS were affected in 2010 and 2009 due to the settlement of a royalty dispute with Rambus

NVIDIA is in transition, but we think that it will be successful in the long run. Not every company can cater to Apple, and NVIDIA is proving that it is a leader in catering to the non-Apple segment of the smartphone and tablet market, and we are confident that the company will be successful in its push into mobile.

Tegra 3: Increasing the Opportunities, the Mobile World Congress, and Addressing the Risks

NVIDIA's Tegra line is what is key to the company's future in the semiconductor industry. Overall, Tegra sales were $360 million in fiscal 2012, and the business is set to grow 50% in fiscal 2013, according to CFO Karen Burns. Operating expenses for the company as a whole are set to reach $1.56 billion in fiscal 2013, and R&D, a great deal of which is devoted to Tegra 3, is going to be a large part of that.

First, we believe an overview of where Tegra stands is needed. The Tegra line is a line of mobile processors for smartphones and tablets. The Tegra 3, NVIDIA's newest version, is being rolled out and it looks to be a formidable competitor. It competes with Qualcomm's SnapDragon and Texas Instruments' (TXN) OMAP line. (For the record, we think that given the growth still to come in smartphones and tablets, there is enough to go around for everyone). The Mobile World Congress, which occurs annually in Barcelona around this time, is in full swing. For those unfamiliar with the MWC, it is an annual trade show where companies that are not Apple can show off their newest mobile products (smartphones and tablets). OEM's like Samsung, HTC, Nokia (NOK), and LG clamor for attention, as do their component suppliers, such as NVIDIA, Qualcomm, Broadcom (BRCM), etc…

Overall, analysts were pleased with NVIDIA's showing at this year's Mobile World Congress. Needham came away impressed, noting that NVIDIA's lead in the quad-core processor market (Tegra 3 is currently the only processor line to have 4 cores) puts it 6 to 12 months ahead of Texas Instruments and Qualcomm. Needham has a buy rating and $20 price target on NVIDIA (over 30% upside). Jefferies noted that NVIDIA is best positioned to capture share in the ARM-based PC market, which is expected to surge with the release of Windows 8, and thinks that deals with ZTE will be a positive for the company. Jefferies, however, rates shares of NVIDIA a hold, perhaps due to the fact that future versions of SnapDragon and OMAP will be based on 28nm, while Tegra 3 is on a 40nm platform, However, NVIDIA is working hard to revamp to a 28nm architecture as well, and we are confident that its lead will hold.

Each year, there is always a particular phone or device that wows the analysts and audience at MWC. And this year, it was HTC and its One X phone. Needham thinks that it was "the highlight of the show." And at the heart of the One X lies the Tegra 3 processor, making it among the first in the world to utilize the Tegra 3 line. HTC has stumbled in 2011 due to fierce competition from Samsung and Apple, but the company is expected to regain share in 2012, thus benefiting NVIDIA. In addition, the One X design win is NVIDIA's first at HTC, and this could be the start of a trend. Here, the dynamics of the market prove that volume is what matters. While HTC has certainly stumbled in relation to Samsung and Apple, it still sold millions of smartphones. How profitable each unit is to HTC is not relevant to NVIDIA. As long as HTC can continue to profitably sell its smartphones in large volumes, suppliers such as NVIDIA will benefit. In addition to HTC, Tegra 3 earned a place in phones from LG, Fujitsu, ZTE, and K-Touch. With all this momentum, one would think that analysts would be rushing to upgrade the stock . Yet that is not the case. One only has to look at the HTC One X to understand why.

The HTC One X, seen by most observers as the real winner of MWC 2012, will be launching in April in many countries. And it will be shipping with the quad-core Tegra 3 chip. Except for in the United States. Here, the HTC One X will be shipped with only a dual-core chip. Why? Because AT&T (T) and Verizon (VZ) require all new phones to have LTE connectivity. That is where Tegra 3 currently falls short. While it may be superior to Qualcomm's and Texas Instruments' offerings overall, the Tegra 3 line currently has no LTE connectivity, something that hampers it in the high-end US smartphone market. This explains why Merrill Lynch has taken a more bearish view of NVIDIA, rating it a neutral and setting a $16.50 price target on the stock. In its report, Merrill Lynch argued that lack of LTE connectivity hampers NVIDIA's ability to position Tegra 3 at the high end of the market.

NVIDIA was asked about this issue at the MWC, and they conceded that this does present a predicament for the company. But, they also urged observers to keep things in perspective. LTE phones, for the moment, represent a small sliver of the overall smartphone market. The iPhone, which currently represents the 3 best-selling phones in the United States, has no LTE connectivity at all. And NVIDIA is not standing still. It has partnered with Renesas and GCT Semiconductor to develop built-in LTE connectivity for the Tegra 3 line. And in the meanwhile, Fujitsu will be shipping its Tegra 3 phones with an LTE chip of its own, and Asus included an LTE chip in its new Tegra powered tablet. (For the moment, Android powered tablets represent a small part of the overall tablet market, but this fact shows that NVIDIA will not suffer at the present due to its lack of LTE connectivity in the Tegra 3 line) Overall, we do not think that this will present much of an issue for the Tegra 3 line. NVIDIA should be able to comfortably gain share.

Conclusions

For the record, the Reuters average price target for NVIDIA stock is $16.73, representing upside of around 10.4% from current levels. However, we believe that as NVIDIA proves that it can and will succeed in the mobile sector, that average will rise, right alongside NVIDIA's stock. The stock has fallen sharply over the past year as investors bailed out due to worries over flooding in Thailand, and concerns about the company's place in the GPU sector. We think that at these prices, however, it is better to begin buying the stock. NVIDIA is steadily playing an increasing role in the smartphone and table sector, and for non-Apple suppliers, volume is the key. Vendors like HTC, Nokia, Samsung, and LG collectively outsell Apple in the smartphone subsector. The fact that Apple has more profit than all of them combined is largely irrelevant to a company like NVIDIA. These companies are committed to manufacturing and selling non-iPhones, and NVIDIA, as a supplier, will generate higher profits as volumes grow. NVIDIA has begun 2012 with a bang, by laying out a clear roadmap for leadership in the mobile sector, and we think the company will be quite successful in its mobile push in the long run. We recommend that investors add to or initiate positions in the company at these levels. NVIDIA has proven that it has what it takes to compete in 2012 and beyond. And we think that investors who agree with our views on NVIDIA will be rewarded for their belief.

Source: Nvidia: Success In Smartphones And Tablets Is On The Way

Additional disclosure: We are long shares of T and VZ via the SPDR Dow Jones Industrial Average ETF. And we are long shares of NVDA and QCOM via a mutual fund that assigns them a weighting of 1.58% and 1.62% respectively.