Nvidia's Game Heats Up


By Sam Jaffe It's not easy finding a success story in Silicon Valley these days. Thanks to a horrific downturn in the chip industry, most semiconductor stocks are testing 52-week lows. But the sector boasts at least one shining example of an old-fashioned growth stock: Nvidia, a maker of graphics chips. Thanks to a new PC chip, a promising entry into the game-console market, and superior technology overall, Nvidia (NVDA) is forecasting revenue to increase more than 50% in 2001.

As you might expect, some investors have already caught wind of Nvidia's outlook. So its stock isn't as cheap as many of its chip brethren, which are now deep into value-stock territory. However, this one has plenty of room to keep running. It's now trading around $86 a share, giving it a price-to-earnings (for fiscal 2002) ratio of around 43. That's a relative bargain when you remember that a year ago, it could have been trading at more than $150 a share and still have been considered cheap.

The main reason Nvidia is on such a fast trajectory is something called Xbox. That's Microsoft's (MSFT) new video-game console, scheduled to appear in November. Using Nvidia's proprietary 3D graphics chipset, Xbox will be more powerful than any gaming system previously available, and Nvidia is scheduled to take in as much as $80 in revenue for every console sold.

"ICING ON THE CAKE"? To be sure, the console market is notoriously fickle, and profit margins are all about the games, not the box itself. Microsoft has ordered 800,000 units for the November launch and expects an additional million to be sold by the end of December.

Of course, if the system flops, that could dry up this branch of Nvidia's revenue stream. So Nvidia isn't predicting Xbox sales. "We're expecting to make $1.1 billion in revenue this fiscal year [which ends in January, 2002] and $1.5 billion next year, and we think we can reach those goals without factoring in Xbox sales," says Chief Financial Officer Christine Hoberg. "If [the Xbox is] a huge hit, it will just be icing on the cake."

Nvidia can afford to be sanguine because the technology it developed for Xbox is also behind its new nForce graphics chipset, which will allow the company to enter an enormous new market. The nForce isn't just a graphics chip but a whole chipset through which most of a PC's operations can run. "Hardware makers can put a cheap, commoditized CPU [central processing unit, such as Intel's Pentium 4], and then use the nForce as the central operations center of the computer. The result: a cheaper PC with better graphics performance," says Thomas Weisel analyst Eric Ross, who has a buy rating on the stock. Better yet, Microsoft essentially subsidized costs for the research and development on nForce for use in Xbox, Ross adds.

RUNNING ON A GPU. Dundee Securities analyst David Hodgson estimates that 80 million to 90 million logic chipsets are sold each year, most of them by Intel (INTC). But if the idea of running a computer on a GPU (graphics processing unit) rather than a CPU catches on, Nvidia could capture a significant amount of market share. "It's a market that six months ago it wasn't involved with, a market that's worth several billion dollars a year," says Hodgson, who also rates the stock a buy.

At the heart of Nvidia's business model is the plain old PC. Sure, that market is depressed and suffering its first year of negative growth since its beginnings in 1981. But that's all the more reason to like Nvidia's penetration plan. "The graphics chip is the last differentiator that a computer maker can offer to the customer," says Michael Hara, Nvidia's chief of investor relations. "Show the average user a 1 gigahertz Pentium 4 and a 750 megahertz Pentium 3 and they can't tell the difference in performance. But show them a computer with one of our chips in it vs. our competitor's model, and their eyes will bulge."

While that certainly sounds boastful, Hara's contention can't be dismissed. In just three years, Nvidia has gone from being a small components supplier in the gaming community to owning 53% of the graphics-chip market, according to Mercury Research. That market has shrunk from as many as 30 different producers to just three: Nvidia, Intel, and ATI Technologies (ATYT). And ATI has been losing significant market share to Nvidia in the past years and is likely behind the technology curve. Intel, which includes graphics technology on its logic chipsets, doesn't even produce stand-alone graphics chips.

SHORTS ASSAULT. If you're still not convinced, many experts say nForce and Xbox won't be Nvidia's only sources of new growth. The company is entering new segments of the PC market. Its first laptop product, the GeForce 2Go, has been put in Dell and Toshiba notebook computers. And Nvidia offers different iterations of the GeForce for low-priced PCs as well as for high-end graphics workstations, both of which are new areas for Nvidia and potentially worth hundreds of millions of dollars in revenue.

Nevertheless, doubters are many. Short sellers, betting the stock price will plunge, hold 19% of Nvidia shares. High on their list of criticisms: No one has ever conquered the graphics-chip market before, and Nvidia is too wed to the PC cycle, which is now in a slump.

But Dundee's Hodgson sees the short interest as a positive sign. As the stock moves higher, the shorts will be forced to sell their shares to limit their losses, causing the stock-price rise to accelerate even further. "They're clearly worried about the volatility of the graphics-chip market," says Hodgson. "But they're just looking in the rearview mirror, and I think it really is different this time."

The view out the windshield sure is. Analysts expect Nvidia to earn $1.87 per share in fiscal 2002, which ends in January, and $2.31 per share the next year on $1.5 billion in revenue, according to First Call. Can such rambunctious growth predictions be believed in a period of economic stagnancy? "They certainly go against the mold, but I have more confidence in Nvidia reaching its lofty goals than I have in any other company I follow to reach much reduced goals. This stock deserves an aggressive growth premium," says Weisel's Ross. And after all, even in the worst of times, games have to have some winners. Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

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