Shares of Nvidia Corporation (NVDA), one of the world's leading designers of graphics processing units, lost a staggering 6% of their value in the 9/4/2012 trading session. The headline catalysts for this downward move were:
- ARM Holdings' (ARMH) CEO Warren East warning that the second half would be challenging for its smartphone core licensing business.
- A negative note from Evercore Partners' (EVR) Patrick Wang, citing "choppy outlook" and "potentially negative sell-through data points on Tegra-based devices".
- An additional negative note from Susquehanna International Group, downgrading the shares to "neutral" from "positive", noting that "recent checks indicate a sharp slowdown" in third-quarter notebook builds.
I believe that the company's fundamentals remain firmly intact and that this sell-off represents an attractive buying opportunity, especially for those who missed the recent run up.
Last Quarter Was Strong
In spite of the analyst negativity, Nvidia had an excellent Q2. The firm had forecast revenues in the range of $990M-$1.05B and came in right at the top of the guidance at $1.04B. Even more encouraging was that the firm issued particularly strong revenue guidance of $1.15B-$1.25B for the current quarter.
Digging deeper into the report, we see the following critical points:
- 15.3% sequential growth in its consumer GPU ("GeForce" brand products)
- 35.5% sequential growth in "Consumer Products" (i.e. Tegra).
The first is significant because despite fears that the PC ecosystem is seeing weakness, Nvidia is still able to keep the attach rate high for its discrete GPU products. That is the thing that analysts seem to be missing: even if the PC market itself does not grow at a particularly rapid clip, Nvidia can still see growth by simply increasing the attach rate of its GPU products. In fact, as the mainstream users shift more towards lower powered devices, such as tablets for basic media consumption, the PC market will look for ways to differentiate its products. High performance GPUs certainly are an attractive way to do so.
Elaborating on the firm's Q2 graphics performance a bit, it is interesting to note that Advanced Micro Devices, Inc. (AMD), Nvidia's only rival in the high-end graphics business, experienced a 5% sequential decline, implying that Nvidia took share.
The second is even more significant because the firm's Tegra business represents a hedge against reliance on the PC ecosystem. While the death of the PC seems vastly overblown, especially as Nvidia's discrete GPU sales prove that users still demand high performance for complex applications, having a stake in the technology that will allegedly eat market share in the mainstream space is an excellent bet.
A Safe Growth Play With An Aggressive Outlook
One of the main reasons that I find Nvidia to be a particularly attractive long-term bet is that while the firm is a major player in a fairly mature market (high end graphics processors), it also exhibits the characteristics of a growth company.
The firm's aspirations with "Tegra" for tablets/smartphones, "Project Denver" for notebooks/desktops/servers, and high performance GPUs leveraged as high performance compute accelerators ("Tesla"), all represent fairly logical and safe, yet aggressive, growth plays in segments adjacent to the firm's core competency.
Nvidia's "Tegra 3" has already found its way into Google's (GOOG) "Nexus 7" tablet and into Microsoft's (MSFT) Windows RT-based "Surface". Rumors also point to a win in Amazon's (AMZN) next generation "Kindle Fire" product.
On the HPC GPU side, Nvidia is slated to ship its Tesla K20 based on an enhanced version of its current "Kepler" chip before year's end, further bolstering its position in the space.
There still has not been any material news on the firm's "Project Denver" lately, although CEO Jen-Hsun Huang noted in November 2011 that the firm expects to talk more about the project near the end of 2012 and that it was on track.
Valuation: Significant Upside Exists, But Be Aware Of Risks
As of last close, Nvidia's shares traded at $13.27 per share, giving the firm a market capitalization of $8.22B and a trailing price-to-earnings ratio of 17.33. However, the firm has a significant cash position of $3.28B or $5.29/share. Backing out this cash position, the company's P/E ex-cash is a mere 10.36. Given the firm's excellent growth prospects in all of its areas, coupled with a strong cash position that can help fund particularly bold ventures without fear of going into debt, the firm seems underpriced.
To come to a fair value estimate, let us assign a fairly conservative 16x price-to-earnings multiple and let us further assume that analyst estimates of $0.90/share in earnings for FY2013 are in the ballpark. This yields a target share price of $14.4. Now, add in the $5.29/share cash position (which is very likely to grow over the next year, but we'll play it safe) and our fair value estimate rockets to $19.69, a 48% premium to today's closing price.
Of course, significant risks to this estimate are:
- Unexpected slowdown in Tegra sales, especially due to fierce competition from Qualcomm (QCOM), Intel (INTC), Samsung, and Texas Instruments (TXN) in both the tablet and smartphone spaces.
- Fierce competition from AMD in the discrete graphics market segment.
- Significant improvements in the integrated graphics solutions from both Intel and AMD in the PC space, hurting the case for discrete graphics chips.
- The cannibalization of PC gaming in favor of mainstream gaming consoles from Microsoft and Sony (SNE) leading to decreased discrete GPU sales.
- Windows RT does not catch on particularly well in the tablet space and the majority of Windows tablet chip sales go to Intel and AMD.
However, Nvidia's well run and its execution has always been sound, so I expect management has a firm handle on these risks.
Why ARM's 'Warning' Isn't A Kiss Of Death
ARM's revenue is dependent on how many chips based on ARM's IP are sold, but even at muted or non-existent total ARM license revenue growth, Nvidia can still take share. If Nvidia is designed in to the next "Kindle Fire", then ARM license revenue remains fixed, but the SoC revenue and profit now shift from Texas Instruments to Nvidia.
Further, if devices built on Nvidia's chips take share from devices built on other vendors' chips, then ARM license revenue once again remains constant, while Nvidia benefits. With Nvidia taking the high-profile design wins by storm in the Android and Windows RT space, it is not irrational to believe that Nvidia's "Tegra" sales will grow even if the broad ARM ecosystem does not.
The Analysts: Huh?
Evercore Partners downgraded shares of Nvidia to "underweight" and cut the price target to $13. The reason? Concerns that the upcoming Apple (AAPL) "mini-iPad" would eat into sales of Tegra-3 based tablets. Sure, that could happen. But as it stands, Nvidia's Tegra 3 is built into the official Google tablet and the official Microsoft Windows RT tablet. A "Kindle Fire 2" win would put the firm into the second most popular tablet available next to the iPad. While there are certainly risks here, it seems irrational to make such a claim well before the "mini-iPad", the "Surface", and the "Kindle Fire 2" are on the shelves and we see some hard data.
Susquehanna's report on "sharp slowdowns" on third-quarter notebook builds may also prove to be correct, but as mentioned earlier, even if notebook shipments slow, it is not guaranteed that the subset of notebooks that ship with discrete graphics chips will be affected. In fact, as PC vendors look to compete with Apple's "Retina Display" MacBooks, discrete chips to power high resolution displays, new gaming capabilities, etc. will be required.
The hard data speaks for itself: Nvidia blew away analyst estimates and guided well. Until the next earnings report (or until Nvidia issues an earnings warning), these analyst 'concerns' seem to be speculative at best and fear-mongering at worst. I used the drop to add to my Nvidia position, and believe that in the high $12s-low $13s, the downside risk is minimal and the upside potential is not trivial.