Every investor must look at a potential investment's stock price and ask themselves if it makes sense after performing an independent assessment of underlying business value. Most times investors will find that stock prices trade in close proximity to the fractional claim on the assets and future earnings it represents, and, therefore, no compelling reason to make an investment exists. Other times, prices diverge from value for a number of reasons, including irrational decision making imbued with greed and fear; hidden value ignored by or unknown to investors; or a special situation/catalyst is not fully valued by the market. When price does not make sense relative to an independent assessment value, a trading opportunity presents itself, long or short.
Today I will outline Nvidia (NVDA), a company that I believe is materially undervalued.
Nvidia Corp. provides graphics chips for use in smartphones, personal computers, tablets, and professional workstations markets worldwide. It operates in three segments: Graphic Processing Unit, Professional Solutions Business, and Consumer Products Business . (Source: Yahoo Finance)
Nvidia went public in 1999 and was a darling of Wall Street during the tech boom. However, the market has given Nvidia a collective thumbs down since 2007, and subsequently pruned about 67% from the stock price.
Nvidia, however, is levered to growing markets. In its fiscal year 2011 annual report, Chief Operating Decision Maker and co-founder Jen-Hsun Huang outlined Nvidia's strategic direction, investing in three areas: visual computing, high performance computing and mobile computing. With the proliferation of mobile phones and tablets, I expect Nvidia's target market to grow considerably. In an investor presentation, Huang indicated that the size of the addressable mobile device market for the company's products is expected to increase tenfold, from $2 billion to $20 billion by 2015.
But with a current market capitalization of $7.6 billion, the market is valuing Nvidia as if it were a deteriorating business. Does that make sense to you? Me either.
At first glance, Nvidia looks fairly valued based on commonly reported statistics such as past 12 months' P/E (13 times) and P/OCF (8 times). Diligent investors, however, must perform more analysis and dig into the financial statements to learn more about the mechanics of the value proposition. For Nvidia in particular, investors must look at the enterprise value (defined as the market value of debt and equity less cash), rather than market capitalization. That is because Nvidia reports a robust cash balance of about $5.08 per share with zero debt. Here is a snippet of the cash equivalents and marketable securities balance from the latest annual report:
Click to enlarge images.
Why Nvidia holds mortgage backed securities is beyond me, but it doesn't affect my investment decision. I do, however, believe management should liquidate those holdings and declare a special dividend to shareholders (equating to about a 2% return of invested capital). Management should focus on their core competency, which is designing important graphics processor units and other chips for mobile application, not managing an investment securities portfolio. Investors should decide how to allocate excess capital not necessary to run the business.
By simply removing cash, the stock trades at much lower past 12 months' adjusted multiples: P/E (7.7 times) and P/OCF (4.9 times). That doesn't make much sense considering the fundamentals dramatically improved for Nvidia over the last two years:
Gross and operating margins are improving, primarily because of a shift toward more profitable products and the 100% margin royalty income due from Intel (INTC) until 2016 (more on this below). And sales are growing as well. In FY 2012, all three reportable segments experienced sales growth:
- Graphics Processing Unit Business: $2.54 billion, up very slightly.
- Professional Solutions Business: $864.3 million, up 5.6%.
- Consumer Products Business: $591.2 million, up 199.2%.
While Nvidia does face considerable competition from Intel and Advance Micro Devices (AMD), the company is priced for disaster. Its often said, though, that a rising tide lifts all boats; a growing market is conducive to reducing competition among market participants, thereby allowing competitors to capture more sales with the help of strong demand, and less by stealing market share from competitors. As seen from the results the past couple years, an expanding market is allowing Nvidia's fundamentals to describe a different story relative to the market's assessment of the company, where business performance is improving markedly, including explosive growth in the Consumer Products Business.
Does that make sense to you? Me either.
In January 2011, Nvidia settled a bitter litigation with Intel and entered into a $1.5 billion patent settlement agreement, whereby Intel is obliged to make royalty payments to Nvidia in the following installments:
By my count, Intel still owes Nvidia $900 million through Jan. 15, 2016. Nvidia reports $3,129.6 billion ($5.08/share) of cash and cash equivalents on hand as of Jan. 29, 2012. However, investors should adjust the reported cash balance with the present value of the future cash due from Intel. A simple discounted cash flow analysis of the remaining payments due, yields the following:
I arbitrarily selected a 10% discount rate, which is my required rate of return on the Intel patent license settlement deal. In reality, this is an extremely low-risk cash flow (less risky than owning a 10-year Treasury bond, when considering interest rate risk). If, for example, I modify the discount rate to the current 10-year Treasury bond yield (2%), the after-tax present value cash per share from the licensing deal increases to $0.91.
Another obscuring factor with respect to the Intel licensing arrangement for valuation purposes is that Nvidia accrued $140 million as an asset on its balance sheet for cross licensing rights received from Intel, and is amortizing those rights at $5 million per quarter over a seven year remaining useful life. The amortization began on April 2011 and will end in January 2017. This non-cash expense should be added back to the adjusted cash balance as a result of the patent license agreement. My calculations indicate fair value from this non-cash charge is $0.23 per share, using a 10% discount rate and adding back the tax benefit realized from this generally accepted accounting principle expense.
Nvidia's adjusted cash and equivalents balance is about $6.10/share, or 50% of its $12.25 stock quote. Or you can think of it this way: the company's market capitalization is about $7.6 billion; the undiscounted sum of Intel's licensing payments due through 2016 ($900 million) make up about 12% of its market capitalization, and 20% of its enterprise value ($4.47 billion). And those values are reflective of only the remaining payments of a patent license deal, which is a small percentage of Nvidia's intrinsic value as a going concern in a growth industry.
Did I mention that Nvidia has zero debt and is smartly growing revenues, earnings and cash flows? And that Nvidia ceased incurring some of its expensive legal fees as a consequence of ending the Intel litigation (professional services fees decreased $10.6 million in FY 2011)?
Does that make sense to you? Me either.
Nvidia's Huang made an appearance on Jim Cramer's "Mad Money" show in September 2011 and described Nvidia as "surely undervalued." Since Huang is also a co-founder and has considerable wealth tied up in Nvidia's business, he should be very conscious about the stock price.
So what are some catalysts that would align price more closely to value? Here is a inexhaustive list:
- Continue executing on management's strategy and growing revenues, cash flows and earnings. At some point, the stock price will catch up to the fundamentals.
- Issue $1.24 billion in debt, pledging the Intel licensing payments as collateral for the bonds, and exhaust the remaining share buyback allowance authorized by the board of directors through May 2013.
- Immediately authorize another $1 billion buyback program, using a portion of the $3 billion cash hoard and growing cash flows from operations to retire shares at prices under some predefined limit less than Nvidia's intrinsic value, conservatively estimated.
- Institute a dividend policy whereby dividends are pegged to some predefined dividend payout ratio based on each year's net income or cash flows from operations. This action would broaden the investor base by attracting dividend investors.
- Convert the mortgage backed securities to cash and distribute a special dividend to investors. That would equate to about a 2% return of capital and would allow investors to make their own investment decisions with the proceeds.
Any combination of those catalysts would wake the market up to the value in Nvidia.
Remember, the market does not know more than you. It only sets the price for a security and sometimes does not consider that price in relation to underlying value. In those instances, the market is only a barometer of greed and fear or, perhaps, ignorance. That is where opportunity is created for brave contrarian investors willing to perform rigorous analysis to find value where others fail to see it or simply choose to ignore it.
Follow your judgment and stick to your guns. The market will realize a bargain at some point. Does that make sense to you? Me too.
Disclosure: I am long NVDA.