NVIDIA Battles The Big Boys (NVDA)

By Ryan Barnes | May 10, 2007 AAA

NVIDIA Corporation (Nasdaq: <?xml:namespace prefix = st1 /?>NVDA) is a large and esteemed $12 billion technology company, but these days it is competing with some of the biggest boys on the block. NVIDIA is the largest pure player in the ever-lucrative field to produce graphics chips and technology for computers, mobile devices and consumer entertainment products.

With software finally catching up to the Moore's Law-inspired gains in hardware seen over the past decade, the importance of the graphics chip is rivaling the CPU itself in many consumer and business products. NVIDIA is the market-share leader in many high-end graphics segments, but the competition has their eye on NVIDIA - and deep wallets to boot.

Taking a Seat at the High-Margin Table
In the most recently presented quarter (which ended January 28, 2007), NVIDIA's revenue came in at $878.9 million, up 36% year-over-year. Net income on fully diluted shares was 41 cents, an impressive 55% gain over the previous year.

What immediately jumps out from these results is the improvement in margins, a sign that NVIDIA is increasingly selling into higher-margin markets.

Gross margins improved a full 400 basis points in the past year, with 44.2% reported in the most recent quarter.

Industry Drivers Look to Stimulate Demand
Potential investors have been concerned about the relatively weak sales of Microsoft's (Nasdaq: MSFT) Vista coming out of the gate. Many people expected that the release of a new operating system would trigger an immediate renaissance in tech spending and computer upgrades. My guess is that this will still happen, just over a longer time frame.

Vista is a resource-hungry application, and many individuals and businesses so far have been content to wait before upgrading their systems. Hewlett-Packard (NYSE: HPQ) announced raised guidance this week for the second quarter that suggests Vista-based computing upgrades could finally be hitting their stride.

But Vista isn't the only industry driver that should benefit sales of NVIDIA's graphics processors; HD/Blu-Ray DVDs and Microsoft's DirectX 10 product both call for the enhanced graphics representation that NVIDIA's high-end products provide, and should help to drive revenue of the company's core GPU (graphics processing unit) segment over the next 12 to 24 months.

NVIDIA is also providing a component to Apple's (Nasdaq: AAPL) new iTV, which is set for release later this year. While it's impossible to tell how well this first iteration of iTV will sell, the relationship with Apple is an important one going forward.

Competition Putting Pressure on NVIDIA Multiple
The gaudy operational results and margin expansion would lead one to think NVIDIA trades for a high multiple, but this is not really the case. NVDA shares trade for about 19.5-times this year's earnings estimates, and a PEG of 1.15. Most of the concerns surrounding the company's 3-year to 5-year growth rate involve the competition; ATI was the alter-ego to NVIDIA for many years before it was acquired by chip maker AMD last year. NVIDIA still supplies chipsets to AMD (NYSE: AMD), but this relationship will be one to watch in the coming quarters.

Also, industry heavy-hitter Intel (Nasdaq: INTC) is coming out with its discrete chipset product in 2008, which could be a big challenge to NVIDIA's No.1 market share in the desktop and notebook segments. Intel has been making graphics chips for years, but has historically been an "also-ran" to NVIDIA and ATI-branded products.

The big takeaway for me is that NVIDIA's end markets are becoming increasingly diverse. One area can be doing poorly (as we're seeing with Sony's (NYSE:SNE) weak PS3 launch and average sales figures for the XBOX 360), while growth elsewhere is literally doubling, as we saw in NVIDIA's 113% sales growth of 64-bit AMD chipsets during the last quarter.

If NVIDIA can continue to provide best-in-breed products and expand its end-market usage, earnings estimates for the next few years should begin to tick up. Given the modest valuation on the stock, it also remains attractive as a takeover candidate, especially if Intel fails to make inroads with its embedded-graphics-chip CPU. In the short-term however, the company's guidance and Vista's traction will determine whether NVIDIA deserves a multiple closer to the 21- to 23-times level seen for tech stocks as a whole.

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