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MagicDiligence (< 20)

Will Tegra and Tesla Be Forces for NVIDIA's Growth?



March 22, 2013 – Comments (0) | RELATED TICKERS: NVDA , QCOM , AMD

NVIDIA (NVDA) is a designer and seller of graphics chips and mobile processors that power PCs, gaming consoles, smart-phones, tablets, and other electronics devices dependent on running highly detailed, fast graphical applications.

The firm can be broken down into 3 segments. The first is the Graphics Processing Unit, or GPU, business. This includes NVIDIA's GeForce graphics chips and cards for PCs, Tesla graphics for super-computing applications, Quadro for workstations (such as computer-aided design or medical imaging), and the GRID cloud gaming platform. GPUs are NVIDIA's legacy and still the firm's bread-and-butter, accounting for 76% of 2012 sales.

The second is the Tegra line of mobile system-on-a-chip (SoC) processors. Tegra integrates a CPU, GPU, and memory controller onto a single chip. It is used in many mobile devices, including smartphones (like the HTC One X), tablets (Microsoft's Surface RT, Google's Nexus 7, and others), automotive infotainment and navigation (including solutions from Audi and Tesla Motor), and will be used in NVIDIA's upcoming Project SHIELD hand-held gaming device. Last year, Tegra accounted for 18% of total revenues.

The final segment is the helpfully named "Other" businesses. "Other" basically refers to revenues from a 2011 patent cross-licensing deal with Intel (INTC). Intel is set to pay Nvidia $1.5 billion over a 5 year period, so this "category" is a short-term one. However, it is generating about 6% of the company's revenue at present, and at presumably very high margins.

I see NVIDIA as a tale of two stories. The outlook for the GPU unit as a whole is mediocre at best. Most of revenues are from high-end PC sales, particularly on the desktop end. Unfortunately for NVIDIA, PC sales have been sinking rapidly, down 3.5% in 2012, and no growth forecast for 2013. This stagnation has been apparent in NVIDIA's GPU unit results. The GPU unit showed just 2% year-over-year revenue growth in 2012, and in fact over the past 3 years sales have declined 3%.

While GeForce and Quadro are suffering from slowing PC sales, there are some isolated positives within GPU. Tesla has been gaining traction in supercomputing applications, including in the world's fastest supercomputer, Titan. Tesla revenue grew 37% last year. Over the long run, I see the GPU unit on whole as a very modest growth business, given the industry headwinds and continuing aggressive competition from AMD's (AMD) ATI unit.

The second story is Tegra, and it is a happier one. Credit NVIDIA for gaining a foothold in the mobile SoC market - without it the company's outlook would be far different. Since 2010, when it was first reported, Tegra has rapidly grown from 6% to 18% of the firm's business. Tegra 4 is set to launch this year, representing a huge spec bump from the current Tegra 3, and NVIDIA recently outlined its aggressive roadmap in mobile SoC's. Tegra grew revenues 29% last year, and given continuing growth in mobile device forecasts, is set to be NVIDIA's growth driver for many years to come.

Let's also quickly run through some other positives on the company. The firm is a financial rock, with $3.7 billion in cash on the balance sheet - and no debt. NVIDIA generates plenty of free cash flow, even in 2008-09 when the firm reported an operating loss. The recently instated dividend yields 2.4% and should come in at a payout ratio of below 30%, very safe. While there is plenty of direct competition, from AMD in PCs and Qualcomm (QCOM) in mobile, NVIDIA is one of just a handful of competitors in its markets, and both have high barriers to entry. Management is outstanding, with founder and CEO Jen-Hsun Huang still in charge and owning about 4% of his company. There is a lot to like here.

NVIDIA does face the same risks as most technology firms. Product cycles are very rapid, and the history of GPUs shows AMD/ATI and NVIDIA leap-frogging one another almost every other generation. While Tegra has had a lot of success in larger, tablet-sized mobile devices, it has not been able to match Qualcomm's success in the more lucrative smartphone space. Embedded PC graphics are getting better all the time, and some day could conceivably offer close enough performance to GeForce dedicated cards. While this still seems far off in the future, if it does happen NVIDIA is at a major disadvantage to Intel and AMD, both of who make PC CPUs as well.

All in all, I like NVIDIA and believe it makes a solid Magic Formula® pick at present. My fair value calculation is $16 a share, offering a 27% margin of safety at current mid-$12 price levels. If the stock should fall down into the $11 range, it would make a prime candidate for a MagicDiligence Top Buy recommendation.

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