NVIDIA's Long-Term Prospects Mean It's Currently Undervalued

Despite having execution problems and ferocious competition (detailed in my last article), I still think NVIDIA Corp. (NVDA) will still be at least moderately profitable in the long-term, and the 30% drop in its stock price following one bad quarter is an over-reaction. NVDA has several factors in its favor.

NVDA is unlikely to lose market share, and might even gain some share. Both technological and market factors account for this. Technologically, GPU chips are second only to CPUs in complexity, meaning that competition from Asian fabs are unlikely, and the only competition is likely to remain ATI/AMD and Intel (INTC).

ATI has a decent reputation with its Radeon cards, but its parent AMD is bleeding cash at an unsustainable clip, and may soon find itself unable to support R&D in CPUs and GPUs simultaneously. While NVDA has stumbled recently, I consider it very likely that in the long-term, ATI/AMD will begin to fall behind technologically (if it doesn’t implode completely first).

Intel, of course, poses a much more formidable threat. It is certainly capable of throwing enough money in R&D to at least equal NVIDIA technologically. However, Intel already holds a large market share in GPUs, and PC makers will not want to give additional market power to Intel if they can help it. The only way NVIDIA can lose market share is if it’s chips prove to be consistently unreliable. Considering that NVIDIA backs its chips with strong warranties, management at NVIDIA is unlikely to tolerate a repeat of this quarter’s chip failure fiasco.

The demand for graphics chips is set grow rapidly. Future operating systems are likely to be increasingly graphics-intensive. Already, Windows Vista’s Aero GUI has graphic card demands previously seen only in games, and the Mac OS X’s Aqua GUI relies on the NVIDIA GPU in every Mac for its sleek look. TIn addition, now that the Blu-Ray/HD-DVD battle has concluded, sales of Blu-ray movies will place additional demands on graphics cards during DVD playback.

While recent GPU sales has stagnated (along with CPU sales and the tech sector in general), this is due largely to US domestic sales slowing down as the market for desktops nears saturation, and consumers generally feel that that current software and hardware are adequate and there is no need to upgrade. However, upgrading cannot be indefinitely postponed, and at some point in time, advances in hardware and software will make it worth the while to upgrade. In the meantime, the rare bright spot in the US economy is the export sector, and export of high-end chips is likely to go up as increasing numbers of middle-class consumers in developing countries buy their first PCs.

NVDA has competent management. CEO Jen-Hsun Huang is a co-founder of the company, and was a chip designer. He owns 5.1% of the NVIDIA (including options), and is known to be a demanding boss to work for. Before the latest stumble, NVIDIA has historically taken great pride in never missing a production deadline. As the entire chip industry hits the thermal and power consumption bottleneck, it is likely that NVDA will have to retool its chip designs, either going the Intel/AMD route and putting multiple cores on a single die, or the ATI route and putting multiple GPUs on a single card. Having a CEO who understands the technical complexities of this tricky transition is a big plus for NVIDIA.

NVDA has $1.6 billion in cash and no debt, and has a market cap of approximately $6.4 billion (assuming $11.50 stock price). In 2007, it had $4 billion in revenues, $836 million in operating income (20.9% operating margin), and $64 million in interest income. After $103 million in taxes (a 11% tax rate), net income is $798 million in 2007. In 2008, it had $1.1 billion in revenue in the first quarter, and has just reported a likely revenue of $875-$950 million in the second quarter, with a $150-200 million charge for bad chips.

Assuming that total revenue for 2008 come in at $4 billion, and margin drops to 17.5%, operating income will be $700 million, reduced to $500 million after the $200 million bad chip charge, and assuming a 10% tax rate, net income will be $450 million. Since NVDA has excess cash of $1.6 billion, the enterprise value of the company is only $4.8 billion, which works out to an earnings multiple of 10.7. Bear in mind that this low multiple was derived off an artificially low earnings hit by a one-time $200 million charge.

Furthermore, NVDA’s revenue has grown by 30-40% annually before stagnating in 2007-2008. Even if margins were to remain permanently depressed at 17.5%, resumption of even modest revenue growth as the rest of the world demands more graphics chips should bring the earnings multiple up. I believe that, at a minimum, NVDA should be worth 15 times its long-term earnings of $700 million (sans charges), making it worth about $21.80. The current stock price essentially assumes no revenue growth plus enormous margin loss, which is highly unlikely.

Disclosure: Long

Comments

[MichaelinWa]

Excellent write-up. I've been looking at this company for a few weeks now, as I just do not believe that this solid company is doomed to floundering the way the stock has been doing recently. I'm just waiting for the right time to buy.

[prophets]

you continue to be delusional. Intel has way more control over how PC's are designed and costed out than the PC Makers. If Intel wants to drive the logic functionality of graphics into the ground, so that it can take up more real estate in the PC silicon, then it's going to do it.

Stop writing about NVDA, you are clueless and going to lose $.

[kyc30090]

Well written article.

Talking about intel GPU market share, most "average computer users" have an integrated intel graphics in their computer. When it comes to serious video usage, people are picking between NVDA and ATI/AMD. With AMD keep losing market share in their cpu market which probably drags down their graphics, that benefits NVDA.

The huge drop in share price definitely is much bigger than the earning / margin miss. People are over-reacting and short sellers took advantage of it. If you don't yet long the stock, at least cover the shorts. Though quick recovery to $21-22 may be unlikely, $22 is still under-priced for this stock in long term. Shorts watched out any rumor / take over possibilities. Intel can buy them and almost get rid of AMD.

[Wefwef]

Before hyping NVDA just take a look at price/performance of the latest generation of AMD-ATI cards. And it just keeps getting better because AMD has the resources to push for complete CPU+GPU integration just like Intel. NVDA is the real loser here, they don't have a CPU line and probably never will as even their chipset line is in trouble.

[nicspits]

In reading this person's two articles, I've found that while they may have a very loose grip on the technological and product aspect, their financial and business understanding is pretty firm i.e. "Nvidia’s chips are found in GeForce display cards for PC desktops and laptops, the Macintosh display cards for Mac Pro desktops and the MacBook Pro laptops, and in Playstation 3" as if disconnecting the GeForce brand from Nvidia?, doesn't seem to realize the Nvidia realies on TSMC to produce it's chips, and the various GPU architectures (typically new with every generation and DX version), vs the X86 CPU foundation, is arguably a lot more complex.

Looking forward, most analysts think that Nvidia is going to have to defend itself from Intel. Yes they can throw a lot of money at the problem and get something out the door that's probably reasonably powerful (though crediting GMA3000 as mid-grade is laughable). As indicated in their marketshare category, however, Nvidia dominates the high end despite the drowning AMD\ATI X2 series that still only compete with single chip Nvidia products. Considering the trend of the market being toward low power and mobility (generally less powerful as well, where Intel is currently), Nvidia has a much bigger pool to make a splash in. They also have much more experience with their mobile GPU lines (GO, etc) in implementing power saving technologies besides just throttling (like Intel).

prophets thinks along the line that transmission and engine manufacturers set the price of the car, as we all know, not true. perhaps you should read the development of Dell and HP selling AMD platform systems to get a more realistic grasp on the component vs box manufacturer relationship.

I'm hoping Nvidia's entries into the ulta mobile and combined processors are an adequate balance for what consumers desire in performance vs cost vs mobility. With Atom's lack of teeth and Tegra's powerful and ultra low draw, I think Nvidia already has their R&D heads in the right 2015 place.

Either, definitely a company I'm putting money in right now, even a crappy entry would have supporters and expand market share as AMD\ATI get squeezed into bankruptcy or a VIA like situation.

[prophets]

intel cant buy this company, it wont pass anti-trust review.

[MD]

Good write up, and I agree largely with your analysis. In my opinion there are too many competitive and technology pressures that can sink this stock. Outperformance is no sure thing. There's a lot of risk. There's no "moat". Why gamble with money on this one when there are so many other stocks that come closer to being a sure thing, or as close as you can get in the investing world?

Steve
magicdiligence.com

[Jon Smirl]

The GPU threats to Nvidia from Intel and AMD haven't shipped yet. They are a fundamental change in the way GPUs are constructed and are difficult for Nvidia to respond to. Intel/AMD are going to hurt Nvidia badly when these chips ship. Nvidia will probably be forced to respond by entering the x86 CPU market. Nvidia is at their peak revenue right now, the future is going to be much more difficult.

A simplistic way to look at this is that we are switching from add-in graphics cards to GPUs that plug into CPU sockets. Intel and AMD control those sockets and they're making their own chips. Competing against bundled GPU/CPU SKUs from Intel/AMD is a tough nut to crack.

This change is the reason why AMD bought ATI. Intel decided Nvidia was too expensive and designed the chips in-house. Nvidia is left without a partner.

[Gaffey]

Intel, despite size and power, is missing an essential ingredient to make any real threat to Nvidia: software driver expertise. Both ATI and Nvidia supply a huge proportion of the actual value of their GPU products in the driver suite -- far more than any other device in a PC system.

Intel graphics drivers stink. Just try playing even a modest 3D game on an Intel graphics PC and see what happens to you. Culturally, software is alien to that company. I'm sure they are aware of this intellectually and are hiring to change it, but Intel is just a crummy place to work for software developers. I predict a really lousy user experience for Larrabee customers.

AMD/ATI doesn't have this problem. But if Dirk Meyer is forced to make any further major sacrifices to avoid insolvency, and has to choose between the old AMD or ATI, you know which one will be on the chopping block.

[atotonilco]

No "moat" and no "boat" for NVDA , so why sail now. Wait until the sea calms for both the acceptance of Intel's graphics chip and AMD's financial picture. Investing now will be dead money. When the perfect storm arrives,then and only then, start your speedboat and Nvidia on.

[Randy Fay]

Very good reasoning. May have to look at a long position in NVDA

[E Nuff Sed]

Why bother. There are so many better places for my hard earned money. Warren would not touch Nvidia with a ten foot pole.

[vitaminc]

Do you even remotely understand's Nvidia's business? Besides the competent management part, which I truthful agree, here's some reason to stay away from the dog during this product cycle:

1) F*cked up GPU designs as Nvidia repeating Intel's Pentium 4 footstep; overheating and underperformance with a higher price that cant be saved until a complete redesign.
2) Increased competitive pressure from Intel at its core GPU marke in addition to non-performing GPGPU and mobile GPU markets. Slowing down of high end mobile devices this year will not help.
3) GPU market is shrinking as PC gaming transforms from the FPS dominated platform to much less graphics intensive MMORPG. A decaying market.

[AmesTiedeman]

Historically this has been a good valuation to buy NVDA. The question is will history rhyme again?

[vitaminc]

History tend to repeat itself; Nvidia and ATI wiped out all those 2D graphics vender and nurtured the 3D gaming trend. Now the predominant trend is mobile and online gaming, neither of which requires high-end graphics. It's a good company but unfortunately its end market are just not there anymore and Intel is coming...

Sorta like SIRF story, where GPS was the trend for mobile devices over the past several years and now the trend is shifting towards multi-touch and software applications...

[Calvin C.]

I used to be a geek on World of Warcraft & obsessed over graphic card performance. I'd pick NVIDIA over ATI any day due its superior performance & compatibility with Windows programs (I hated ATI's Catalyst driver).

[OrangeValueInvestor]

I think I found out the best and easiest way to see which card is ''better''... I went to a bunch of Best Buy, Circuit City, Future Shop and some more specialized store and simply ask the employes what were they recommending to a client that is asking for serious graphic and performance (High end) ...all the time the answer was NVIDA.....they have a strong reputation and this is somethig you also need to take into account....

[saltthefries]

It's a value trap. Short it and buy a call for upside protection, if you don't want to just leave it alone. NVIDIA is entering a world of pain over the next couple graphics release cycles, as its GTX 200 series has been generally panned and suffered severe pricing pressure from ATI's HD 4000 series. ATI is pricing its top-of-the line offerings in the low 300s, which is forcing NVIDIA to cut its prices on top of the line cards from the $500 range to the $300s. ATI's cards are being received well after a couple upgrade cycles dominated by NVIDIA.

AMD is going to be a serious problem for NVIDIA, as it has fixed problems in its CPU lines and has compelling GPU offerings compared to NVIDIA's underperforming GTX 200 line which will mean that NVIDIA loses the high-end this cycle, then loses the mid-market (where most of the sales are made) next cycle as the GTX 200 / HD 4000 lines are supplanted by new lines. AMD has cash issues, but everything is finally looking up technologically, so I expect that financing and profits will follow. AMD is an extremely scrappy competitor that has fought Intel on a shoestring for decades, and has a history of pricing very aggressively. AMD doesn't even need to make the fastest CPU and GPU on the planet to profit and severely compress its competitor's margins--it just needs to have the best CPU and GPU for around $200 each.

Furthermore, there are SEVERE problems in the manufacturing of NVIDIA's 8400 and 8600 chips (primarily showing up in laptops, but desktop cards may be affected too). This could cause very high recall costs and damage NVIDIA's reputation at the absolute worst time.
www.theinquirer.net/gb...
www.theinquirer.net/gb...

I believe that NVIDIA's only opportunity for serious price improvement in the short to intermediate term is a buyout offer. It would probably have to come from Intel, but I can't see it getting by EU regulatory scrutiny. I think the Bush administration would even look into it.

[AmesTiedeman]

Your premise that NVDA is not going to lose any market share is insane. NVDA is still undervalued, may go lower still, but they WILL LOSE MARKET SHARE TO ATI/AMD. The new graphics chips from AMD are excellent and they consume less power. Read any trade publication and people who know far more than you are suggesting that NVDA is bound to lose some market share given the new AMD offerings. Why do you think the stock has been cut in half the past couple of months? Their INVENTORIES ARE BUILDING AS THEIR SALES ARE FALLING AND AMD IS TAKING MARKET SHARE...!!

[User 239256]

I can't believe that no one has talked about the 9900 cards on here yet...the 9900 gtx and gx2's were rumored to be released a few weeks after the GTX 200 line were released (sometime in early July)...the release of this new line, which is supposed to utilize the newer technology of the 200 line at a much higher level. nVidia will be able to dominate the performance vs. consumption when these cards come out in Q4 08.