Imagination Technologies (OTCPK:IGNMF), a leading developer of GPU IP for mobile processors, enjoyed a robust run from ~$2.50/share to about $12/share as the firm found its low power graphics IP at the heart of system-on-chip designs from the likes of Apple (NASDAQ:AAPL), Texas Instruments (NYSE:TXN), Samsung (OTC:SSNLF) and Intel (NASDAQ:INTC). Unfortunately, ARM Holdings (NASDAQ:ARMH), the principal vendor of CPU IP for these mobile system-on-chip vendors, finally brought to bear the fruits of its acquisition of 3D graphics chip designer Falanx with its own low power "Mali" GPU.
These designs managed to rapidly gain market share in the low power SoC arena, particularly as ARM could provide a turnkey solution to vendors already utilizing ARM's CPU IP. Imagination's share price has since lost well over 50% of its peak value. However, a threat even more dangerous has just emerged, and I believe that Imagination is likely to lose key sockets at Apple, Samsung and others as Nvidia (NASDAQ:NVDA), the world's leading GPU company, enters the low power GPU IP licensing fray.
Imagination's High Profile Sockets Face Significant Threat From Nvidia Designed IP
Nvidia's announcement that it, too, will be licensing GPU IP in a similar fashion to Imagination signals that the firm is looking to potentially penetrate sockets that it could otherwise not win by selling full chips. That is, any vendor that prefers to build its own system-on-chip product but does not want to reinvent the wheel on graphics IP now becomes a potential customer of Nvidia's. Unfortunately for Imagination Technologies, it already occupies the majority of the high end sockets (particularly Samsung's Exynos and Apple's A-series chips) which creates an asymmetric risk/reward situation with a downside bias. While ARMs IP posed this threat, the concerns were mitigated somewhat as it appeared that Imagination's IP was significantly higher performing than ARM's, which kept Imagination safe in high end devices. Nvidia, a pure play GPU company with many years in the high end GPU market, represents an entirely different threat.
Both Apple and Samsung strive to give their respective SoCs a competitive edge in both graphics and CPU performance per watt. To this end, both of these giants have traditionally very quickly adopted the latest graphics IP from Imagination (or in Samsung's case, ARM, before switching back to Imagination). It is very likely given Nvidia's release of its latest-and-greatest "Kepler" architecture for license that Apple and Samsung - the two major mobile device vendors that build their own in-house SoCs but leverage external IP - are in serious talks with Nvidia to incorporate this IP into future iteratins of their chips. Should this come into play, this would suggest that Imagination would lose royalties from each and every iPhone and the majority of Samsung's products.
However, the situation gets worse when one considers Nvidia's additional announcement.
Nvidia's Patent Portfolio: Open Sesame
While I believe that it is likely that Samsung and/or Apple will likely give serious consideration to Nvidia's own GPU core IP, Nvidia's announcement that it would also more broadly license its GPU patent portfolio further supports the bearish thesis for Imagination. This would enable the likes of Apple and Samsung to, in an alternate case, build custom GPUs without fear of stepping on Nvidia's ~5500 patent portfolio. I suspect that this is much more aimed at Intel, which has already dedicated massive resources to in-house GPU IP development rather than the likes of Apple and Samsung whose primary business is to sell devices.
In any case, Imagination now has to contend not only with Nvidia's designs potentially stealing its sockets, but it also has to contend with any GPU designer now armed with Nvidia's patent portfolio.
Imagination Likely To Undergo Significant Re-pricing
With future revenue and income streams now under significant threat from both ARM and Nvidia (with ARM at the low end and Nvidia at the high end), I believe that despite the recent decline, there is significant risk to the projected 2014E EPS estimates of $0.215/share, which would represent Y/Y EPS growth of 35.8% from the current fiscal year. I believe that Nvidia should begin winning sockets rather promptly, which puts at severe risk the projected revenue/EPS growth estimates upon which the current valuation is based. Further, while Imagination's growth rate is almost certainly likely to be affected by the presence of this formidable graphics entrant, any socket losses would drive further downside to estimates and multiples.
In light of the significant risks to the EPS estimates, a 15x forward multiple suggests downside to $3.21/share, or a 33% decline from current levels. The upside risk to the short thesis is capped as it is difficult to see Imagination's competitive position improving in light of the continued graphics share from ARM and Nvidia, as well as the fact that Intel's latest system-on-chip parts will use its own in-house IP which means that any market share loss on the part of Imagination's customers to Intel is a further risk.
Disclosure: I am long INTC, NVDA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am short ARMH