Another quarter is in the books, and not all that much has changed about the Nvidia (Nasdaq:NVDA) story. Bulls believe that this company will be able to transition away from its PC graphics processor legacy and become a player in the processors that drive mobile devices. Bears take the view that not only will Nvidia struggle to compete against the likes of Qualcomm (Nasdaq:QCOM), Texas Instruments (Nasdaq:TXN) and Broadcom (Nasdaq:BRCM), but that the cost of trying will erode margins and the steady growth of mobile devices will undermine its legacy GPU business.
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Good Third Quarter Results, but Not Flawless
Nvidia didn't hurt its cause with third quarter earnings that would suggest that the company can continue to grow, even in trying times for its core business. On the other hand, lower sequential revenue guidance reminds us that it's not a flawless story. Revenue rose 13% this quarter (or 15% on a sequential basis), very slightly beating the average sell-side estimate. The company's large GPU business once again provided the bulk of the company's revenues, and those revenues grew 15% from last year (and 11% from June). Nvidia's Professional revenue was down 4% (but up 12% QoQ), while consumer revenue rose 28% and 36%, respectively. Tegra revenue was up strongly, helped by the launches of the Google (Nasdaq:GOOG) Nexus 7 and Microsoft (Nasdaq:MSFT) Surface tablets.
On the profit side, gross margin was surprisingly solid - improving 70 basis points (BPs) from last year and about 110bp from the second quarter - as 28nm Kepler chips kick in. Operating income was up strongly (28% yoy, 81% QoQ) on a GAAP basis on surprisingly flat SG&A spending and only modest R&D increases.
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Can GPU Stay Strong, and Can Mobile Apps Move Past Tablets?
Nvidia had a surprisingly solid result from its GPU business - surprising in part given how almost any PC maker not named Lenovo (OTC:LNVGY) continues to struggle with weak trends in the market. New products are helping Nvidia gain meaningful share from AMD (NYSE:AMD), and the company is benefiting from its relatively higher-end positioning in PCs (which is seeing less erosion from mobile). On the mobile side, the company is making progress but still has a lot to prove. Although the company doesn't break this out in detail, I would estimate that about three-quarters of the company's mobile business is in tablets. That suggests to me that the company really needs to beef up its smartphone offerings. Likewise, while tablet-based revenue was strong this quarter, we will have to wait to see how the sell-through progresses (as opposed to the pre-launch builds).
Can Nvidia Convince Customers and the Street?
There's quite a bit of skepticism out there that Nvidia will succeed in its efforts to become a player in mobile processors. Qualcomm is already a strong player and even the mighty Texas Instruments has found it too hard (or not sufficiently profitable) to persist. What's more, Broadcom is on its way, and Marvell (Nasdaq:MRVL) too wishes to be a player.
At a minimum, the operating leverage trends at companies like Qualcomm and Broadcom suggest that it's going to take a lot of investment to make a splash in this market - Nvidia's operating expenses are already 50% higher now than when it was a "pure" graphics processor company. Moreover, serving customers like Apple (Nasdaq:AAPL) and Samsung is hardly easy, particularly when Samsung has shown a willingness to in-source a lot of its chip needs.
Frankly, Nvidia just has to keep delivering - if Nvidia can win sockets and show that it can run a profitable mobile processor business, all but the most stubborn analysts and investors will come around. Unfortunately, it still comes down more to be belief than objective fact at this point - Nvidia has made some good initial progress, but it's not going to get any easier.
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The Bottom Line
Although I don't own Nvidia shares, I find myself tempted by what seems to be low expectations. Even a 5% long-term free cash flow (FCF) growth rate points to a fair value above 20%, and that estimated growth rate is well below Street expectations for Qualcomm and a fair bit less than for Broadcom. I realize that I may be overestimating Nvidia's eventual margin leverage (I project free cash flow margin in the mid to high teens), and I may also be underestimating the threat to its existing GPU business. Nevertheless, at this point Nvidia still looks like an interesting speculation, albeit one that most analysts on the Street don't seem to like much.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.