Wall Street can be a little funny in how it rewards "proven" stories with unsustainable multiples, but tends to seriously underestimate the future of companies that aren't on the list of darlings. Nvidia (Nasdaq:NVDA) is trying to recreate itself as a more diversified semiconductor company, but the Street seems to see relatively little chance of the company breaking free of its graphics processor legacy. By no means is success in fields like mobile processing a guarantee, but risk-tolerant investors may find the long-term risk-reward trade-off here to be interesting.
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Another Solid Quarter
Nvidia is at least doing OK relative to expectations. Revenue rose 3% from the year-ago level (and 13% sequentially), coming in at the high end of the company's guidance range. Consumer sales rose 7% on a 40% jump in Tegra, while graphics sales rose 15% sequentially and captured meaningful share from AMD (NYSE:AMD).
Margins were a mixed bag. Gross margin improved both annually (10bp) and sequentially (170bp), while operating income fell 20% from last year and nearly doubled sequentially on a GAAP basis.
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Tegra Growing, but Needs to Grow Even More
In many respects, Nvidia is doing well with its mobile processor business, as the Tegra 3 has found its way into Google (Nasdaq:GOOG) and Asus tablets and phones from HTC, LG and ZTE. With 30 design wins, it's already well ahead of the Tegra 2.
On the other side, Nvidia continues to spend a lot of money on R&D in its efforts to break into this market. Accordingly, it's still a business that compromises Nvidia's margins, and long-range success against Texas Instruments (Nasdaq:TXN) and Qualcomm (Nasdaq:QCOM) is not assured. If nothing else, Nvidia needs to show that it can create a defensible niche for itself as a processor company - offering top-flight performance, low costs or some combination of the two.
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The PC Isn't Dead ... Yet
I think the biggest concern on Nvidia, apart from the money it is investing in the mobile processing business, is the future of its PC/notebook graphics chip business. While Nvidia continues to produce excellent GPUs, the thought is that integrated chips from Intel (Nasdaq:INTC) and AMD are going to make standalone GPUs obsolete. At the same time, Nvidia's attempt to counterattack with ARM-based integrated chips is seen as a long shot, even though Microsoft's (Nasdaq:MSFT) new Windows will support ARM architecture.
I suspect that Nvidia's traditional business is going to erode slower than the Street fears. PCs may be on their way out, but I think notebooks and ultrabooks will endure quite a bit longer and I think the company should be able to stay in this game.
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The Bottom Line
I am not certain that Nvidia can distinguish itself in mobile processing the way it has in PC/notebook GPUs, and that lack of differentiation could lead to a tumultuous cycle of design-in/design-out that keeps the stock on a see-saw. For the same reason, I wouldn't give the company quite the same "doubt of the benefit" that the Street currently does. Nvidia finds itself on the outside of the Apple (Nasdaq:AAPL) - Samsung mobile duopoly, but significant design wins should begin to move revenue later this year.
Right now, mid-single-digit compound free cash flow growth is sufficient to drive an appealing fair value target for Nvidia shares. If the company can grow 5 to 6% over the next decade, these shares ought to be worth around $20. The major investments that the company is making into mobile processing does up the risk, but this is a worthwhile name to consider for more aggressive investors.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.