Key Factors Driving Nvidia’s $20 Valuation

Driven by strong demand for its quad-core Tegra 3 processors and the energy-efficient Kepler architecture, Nvidia (NASDAQ:NVDA) reported record revenues in Q3. Despite tough macro conditions, Nvidia marked 12.9% and 17.3% y-o-y growth in revenues and net income, respectively. (Read: Nvidia’s Tegra 3 & Kepler Architecture Fuel Results And Bright Outlook)

Though Nvidia maintains a cautious outlook on account of the weakness in the PC market, there are certain factors that contribute to our long-term belief in the company: strong demand for Kepler, significant product wins for Tegra 3 processors, and the upcoming integrated 4G LTE application processors.

Here we highlight certain key trends and concerns prominent in the company’s Q3 2013 earnings results.

See our complete analysis for Nvidia

Uncertain PC End Market Demand

While the slowdown in the PC market has impacted many of its competitors such as Intel (NASDAQ:INTC) and AMD (NASDAQ:AMD), we think Nvidia’s growing focus and success in the mobile computing space has cushioned the negative impact of lower PC shipments on its growth rate. Nevertheless, Nvidia derives close to 34% of its value from its GPU (desktops and notebooks) business, as per our estimate, and thus remains vulnerable to any adverse development in the PC market.

The slowing enterprise market, consumer softness in mature markets (US and Westerm Europe), slowing demand growth from emerging markets, operating system transitions and cannibalization by tablets are some of the main factors leading to the current slump in PC shipments. Research firm IDC predicts the global PC market to grow by a mere 0.9% in 2012. ^[1]

Nvidia agrees that notebooks and desktops’ demand is softer than originally predicted and maintains a conservative outlook on account of the uncertain PC end-market demand. However, the company believes that its GPU position for all its brands is better than it has ever been which has contributed to an increase in market share.

Slight Decline In The Quadro Business

Though Nvidia’s professional solution business was up 12.5% sequentially due to the first shipment of its Kepler based Tesla products, the segment registered a 4.2% y-o-y decline on account of weak demand for its Quadro products. Weakness in the global workstation market on account of macro headwinds and the delay in the Romley platform, which could have held back purchases, are the prime reasons which contributed to lower revenues from the Quadro products.

We estimate the professional graphics segment to contribute close to 27% to Nvidia’s overall valuation, making it the most important division in the company’s portfolio. Nvidia believes that the softness in demand is on account of enterprise weakness and claims to have witnessed stable ASPs and market share for its professional GPUs.

Accounting for 81% of the market, Nvidia remains the dominating player in professional GPUs. While we estimate a slight decline in its market share over the years, we expect the company to retain its leadership in the segment for years to come.

With the upcoming Kepler Quadro products and new capabilities like Maximus, which enables both modeling and simulation in one workstation, we believe the company will witness strong demand as the workstation market recovers.

Growing Demand For Smartphones & Tablets

Backed by strong Tegra sales, Nvidia’s consumer products business registered 35.7% q-o-q and 27.6% y-o-y increase in revenues. While the Tegra processors business marked 50% y-o-y growth, tablets were up by almost 100% and remain the most important driver for Nvidia’s progress in the mobile computing space. Though the company scored significant tablet wins this year – Google’s Nexus 7, Microsoft’s Windows RT Surface tablet, World first RT device by Asus, among others – its progress in smartphones remained more or less stable.

However, post the acquisition of Icera, Nvidia has been focused on developing its 4G LTE application processor and we believe the same will help it expand deeper into the smartphone market. Last month Nvidia scored a big win from HTC’s One X+ smartphone to be sold by AT&T, which makes AT&T the first US carrier to approve Nvidia’s Tegra 3 with 4G LTE for its network. (Read: Nvidia Takes On Qualcomm With Its 4G LTE Compatible Tegra Processors)

With the slowdown in PC demand and the increasing popularity of mobile devices, demand for smartphones and tablets is slated to fuel future growth in the semiconductor industry. We believe that Nvidia is well-equipped to leverage this growth and estimate revenues from this segment to surpass the $2 billion mark by the end of our forecast period.

Apart from tablets and smartphones, Nvidia expects Tegra’s use in infotainment and navigation systems of cars will help drive revenue growth from the automotive business as well.

Increase In Operating Expenses

Nvidia’s operating expenses have risen quarter over quarter as the company has seen a big jump in its R&D expenses. This has primarily been on account of two factors:

– Ramp up for the next generation mobile processors.

– Developing 4G LTE modem: Though the company is shipping some quantities of discrete LTE modems, this quarter it plans to bring to the market its 4G LTE modem integrated into its application processors.

We feel that the high expenses is money well spent as robust growth in the mobile computing market would be a significant driving force for Nvidia’s valuation.

We have updated our price estimate for Nvidia to $20.45 post the Q3 2013 earnings results.

See our complete analysis for Nvidia’s stock

1. IDC Lowers PC Outlook As Shipments Decline In Second Quarter Ahead Of Fall Product Updates, IDC Press Release, August 23, 2012 [↩]