Despite reporting strong earnings and issuing bullish guidance in August, Nvidia (NVDA) has since seen its share price decline. The average analyst EPS estimate for the current year is up nearly 30% from two months ago, but investors (thus far) have shrugged. Clearly, the market is expecting Nvidia to stumble in the near future. However, I believe that Nvidia is just at the beginning of what could be a multi-year new product cycle that will drive significant revenue gains over the next two years. The company's low valuation and strong product pipeline combine to create a compelling investment thesis.
On one level, the pessimism surrounding Nvidia is understandable. Last September, the company provided aggressive guidance for $4.7-$5.0 billion in revenue in FY13 (the current fiscal year). However, the combination of a global hard disk drive shortage (which hurt PC sales and GPU attach rates) and a bumpy transition from Tegra 2 to Tegra 3 caused Nvidia to miss its Q4 FY12 revenue target by a significant margin. These headwinds, along with supply constraints for 28 nm chips, also led Nvidia to remove its FY13 revenue guidance on the February earnings conference call. As a result of management's obvious miscalculation on the 2013 revenue guidance, many analysts and investors remain skeptical today about Nvidia's internal projections.
That said, Nvidia seems poised to return to its growth trend beginning in the current quarter. In the GPU business, while foundry partner TSMC (TSM) is still short of 28 nm supply, these constraints are expected to be relatively minimal by the end of Q4. (In fact, this year's supply constraints may have been a blessing in disguise; in spite of slow PC sales, Nvidia has maintained appropriately lean inventories.) As supply of 28 nm chips grows, Nvidia will be able to roll out more Kepler-based products, which is likely to boost Nvidia's market share and profitability.
The Kepler architecture is extremely power-efficient, which makes it very desirable for notebooks. As Kepler GPUs became available in Q2, Nvidia gained over 600 basis points of notebook market share sequentially. Nvidia probably gained additional share in Q3 as supply constraints eased. While share gains in the desktop market are likely to be smaller, Kepler chips offer strong graphics performance (at the expense of compute capabilities) that will appeal to PC gamers. Nvidia recently released two new Kepler-based GPUs that target the mass market of gamers. I expect Kepler's penetration of the mass market over the next two quarters to drive significant revenue gains for Nvidia. It is important to note that Nvidia's GPU revenue is not entirely tied to PC demand; many gamers will upgrade their GPUs in lieu of replacing their computers. Entry-level Kepler GPUs will provide a very strong value proposition in this segment.
Nvidia's Tegra system-on-a-chip business seems equally well positioned for the next two years. For the first half of FY13, Nvidia posted year over year revenue gains for Tegra, but the increases will be much more dramatic for the second half. Google's (GOOG) Nexus 7 tablet, which features a Tegra 3 processor, has seen very strong sales thus far. Google has been rolling out the Nexus 7 to additional international markets recently, and a recent analyst report suggests that Google may now be planning to build more than 8 million devices this year. While the initial Nexus 7 builds fell in Nvidia's Q2, the vast majority of Tegra chips for the Nexus 7 will be sold in Q3 and Q4. Tegra 3 also powers the upcoming Microsoft (MSFT) Surface tablet, which will be released later this month. Microsoft is reportedly planning to build as many as 10 million units of the Surface (although that estimate may also include the Intel version of the Surface, slated for release in early 2013). Between the Nexus 7 and the Surface (as well as other Windows RT tablets), Nvidia can expect strong Tegra 3 orders through the end of FY13. This stands in stark contrast to the fall-off in demand for Tegra 2 at this time last year.
Moreover, Nvidia's competitiveness in the mobile arena is likely to improve dramatically over the next several quarters. The company is expected to introduce a successor to Tegra 3 (codenamed "Wayne") in early 2013. Wayne SoCs will be based on the ARM (ARMH) Cortex A15 design, rather than the older Cortex A9 design (like Tegra 3). This upgrade will allow Tegra to become much more competitive with Qualcomm's (QCOM) "Krait" chips. Furthermore, Nvidia is expected to release an integrated SoC/baseband chip later in 2013 (codenamed "Grey"). Qualcomm's virtual monopoly on integrated chips of this sort has given it a tremendous advantage in the mainstream smartphone market. With "Grey," Nvidia will finally break this monopoly, and as a result Tegra will probably gain momentum in smartphone design wins through 2013 and 2014.
In sum, I believe Nvidia has finally overcome the execution problems that disrupted its growth trajectory over the past several quarters. Furthermore, I see at least three potential catalysts over the next several months. First, I expect Tegra 3 sales for FY13 to be roughly $600 million, which I believe is above most analyst estimates. I will be paying attention to the quarterly reports from Google and Microsoft this month for any hints about Tegra 3 sales levels. Second, Nvidia may guide Q4 revenue higher than current analyst estimates, as Kepler's market penetration continues to increase. Lastly, the company has been very quiet about the upcoming Tegra releases (Wayne and Grey) recently. I expect an announcement about release dates and performance features this fall, which could improve investor sentiment about Nvidia's prospects. While I do not expect Nvidia to return to its early-2011 highs in the near future, the stock has upside to at least $18 over the next six months.