December 19, 2002 - 11:50pm EST by
2002 2003
Price: 12.65 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 2,100 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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NVIDIA is a liquid and volatile leader in producing 3D graphics chips and chipsets, primarily for PC s and note book computers. The Company was founded in 1993 and has emerged as one of the two dominant players in its segment, mostly at the cost of a number of other competitors which initially participated in this once fragmented arena. The Company has suffered from a number of issues in 2002 including an SEC probe (which resulted in relatively immaterial revisions), a pricing dispute and ongoing arbitration with Microsoft – its customer for Xbox application specific graphics chips, an inventory write down, and a recent delay in its next generation chip which has given a temporary advantage to its arch rival (ATI Technologies – ATYT). However, the Company still has a number of strengths and competitive advantages including technology leadership in a growing market with a critical piece of the PC value chain.

NVIDIA is an intriguing long-term investment possibility at current or lower levels. While the stock is up substantially from recent lows around $7.50 per share as recently as September 2002, it still represents a reasonable entry point for those with the ability to stomach short term volatility with a view towards participating in substantial long-term appreciation potential. Given the strength of the Company’s balance sheet, an investment at current depressed levels entails limited downside risk of permanent impairment of capital.

The Company has maintained a rock solid balance sheet with over $900 million of cash and marketable securities ($322 million cash and rest mostly bonds) as of October 22, 2002. Thus the company has over $5.00 per fully diluted share in cash and cash equivalents. Since the company continues to be a cash generator, this cash should probably be used to adjust the market value of the equity. The Market Value is just over $2.1 billion at current levels (168.3 million fully diluted shares * $12.65 per share). The only debt is a 4.75% $300 million convert due in 2007 (convertible at $47.00 per share) – not sure what the market value of this convert is but could be worth looking into as another way to play this story (albeit for coupon and accretion to par but with limited option value given the high “strike”).

The Company will probably do about $1.8+ billion in sales this year despite the many issues cited above. While this has been a cyclically mediocre year from a bottom line perspective, the company still had adjusted earnings from operations and cash flow from operations of over $100 million. With an adjusted equity market value of $1.4 billion versus earnings of over $100 million, this company is selling at approximately 14x earnings. (If the stock price gets back, in the near term, to near $7.50 per share again, that multiple would drop back down to 4 to 5x earnings).

Now some of you may (like me) feel that 14x earnings is not necessarily that exciting. To those that feel this way, I would say just watch the stock because given the volatility here there is a reasonable chance that you will see a better price sometime in the next few months. However, NVDIA should be a true grower over the next 5 years. Since 1998, sales have grown from $158 million to the above mentioned $1.8 billion in 2002 (an 83% CAGR). While the next 4 to 5 years will probably not be anywhere near this good, the company will has ample room to grow its top line at an average of 15 to 20% per year on average over the next three to five years from current levels. This growth can come from several sources including overall growth in the 3d graphics and visual computing market through a variety of devices (think about arguments for broadband, level 3 etc.), further penetration in notebook computing area, further penetration into game consoles and other devices (ultimately anything with a screen is a possibility though economics of low cost devices are often not nearly as attractive as the PC market from NVIDIA’s point of view).

Based on the company’s past performance and track record, a normalized net profit margin of 8% to 10% should be attainable, especially as industry and company gets some wind into its sales when cyclical timing improves. Management is also, in my opinion, a plus here. Founder, Jen-Hsun Huang appears, on balance, to be very capable. He is reputedly very hard working and seemingly has at least a decent capital allocation sense given the strength of the company’s finances to date. While, like many tech companies NVIDIA has been (in my opinion) too generous with options – including a recent exchange of stock for underwater options, I think that investors can do well despite this negative. The CEO is reputedly a non-nonsense results oriented guy and a major stock holder. It also helps that he is a very talented engineer himself because R&D and innovation remain key drivers.

Opportunity is to buy at current or (even better) lower levels and wait for some of the positives to play out over the next six months to two years. Combination of earnings growth and multiple expansion to the 20x or greater range should lead to a good total return. Interested parties may also want to look at ATI Technologies (ATYT) which just announced strong revenues but somewhat disappointing earnings. ATI has a weaker balance sheet and otherwise a comparable valuation. I think overtime, NVDIA will probably do to ATI what it has done to everyone else, but it is worth thinking about and ATI is still a formidable competitor.


Catalysts include (1) a cyclical recovery for PC market which could be several years out however (2) settlement of overhang related to Microsoft arbitration (3) new product cycle which is expected in the next one or two quarters

Risks include (1) adverse developments on the competitive front – e.g. with respect to competition either from ATI or from CPU manufacturers like Intel pushing their own integrated graphics chips (2) further weakness, especially in the near term from PC makers.
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