Image source: Nvidia
NVIDIA's (NVDA +1.80%) stock price came under selling pressure after a negative report from Citron Research was released listing six risks that "NVIDIA shareholders are discounting." Citron believes, because of these risks, the company's share price should trade at $90 as opposed to the more recent $110 to $120 range.
Many of the risks highlighted in the report are focused on NVIDIA's business prospects in 2017. Foolish investors are focused on years ahead, if not decades. However, some of the points on competition, notably from Intel (INTC +0.32%) and Advanced Micro Devices (NASDAQ: AMD) could linger well past the next twelve months, if NVIDIA doesn't have a strong enough business to continue driving growth like we have seen recently.
With that said, let's review Citron's report and address these concerns from a Foolish perspective.
Growth and market share
1. Much of NVDA's growth has come from gaming and at AMD expense, as opposed to new total addressable markets.
Right now, gaming is the company's largest segment, generating $2.7 billion out of the company's total $4.7 billion for the first nine months of fiscal 2017. However, revenue from datacenters and automotive combined totals $893 million, and that has increased 90.4% over fiscal 2016's comparable period. These non-gaming segments could one day match the size of the gaming segment, if not exceed it.
Either datacenters or automotive, or both, could grow to become multi-billion dollar businesses in the years to come. NVIDIA is applying its graphics technology to many areas of the economy, such as healthcare, manufacturing, deep learning, and self-driving cars.
For example, the self-driving car market is a multi-billion dollar opportunity for NVIDIA. One estimate puts the autonomous car market at $42 billion by 2025. Tesla Motors is using NVIDIA's Drive PX 2 platform to power the autopilot system in all of its factory produced vehicles.
In other areas, Facebook, Microsoft, Baidu, and Amazon are all using NVIDIA GPUs for artificial intelligence, data analytics, and high performance computing.
Datacenter competition
2. There's significant competition from existing and emerging players (Intel Xeon Phi, AMD Radeon Pro, XLNX). Also, AMD is launching new GPU's for desktop and server in Q1 2017 and Q2 2017
For 2017, this could be an issue, but this shouldn't be a concern for a Foolish investor focused on the next ten years and beyond. Competition has always, and will always be present in the chip industry. Yet, competition has not stopped Intel and NVIDIA from doing very well for investors over time. Both companies have continued to thrive while competing with each other. The market is big enough for two or three players to do well.
Intellectual property and Intel licensing revenue
3. If you believe that NVDA has embedded IP that makes it worthy of its premium valuation, you need to be aware that Intel already has access to this IP from a licensing deal with NVDA that ends this year
4. Attrition will have a significant effect on 2017 EBITDA.
The original licensing agreement in 2011 required Intel to pay NVIDIA $1.5 billion over six years, or a few hundred million dollars per year. NVIDIA licensed its intellectual property (IP) to Intel to settle a patent infringement issue in 2011. Since 2011, NVIDIA's revenue has grown from $3.5 billion to over $6 billion. Cash from operations has grown from $676 million to $1.4 billion. With NVIDIA's business momentum across the board, NVIDIA should more than offset the loss of licensing revenue with additional growth from its various fast growing segments -- gaming, datacenters, and automotive.
Despite Intel's access to NVIDIA's IP, NVIDIA has remained competitive. The partnerships it has formed with several technology companies reflects the value of NVIDIA's products, which is also demonstrated in its strong gross margin performance in recent years.
Gross margin sustainability and competition
5. As Intel competition enters the fray in mid-2017, this competition should have a significant impact on NVDA's gross margins. NVDA is a fabless producer, with TSMC making all of its GPUs. Intel, on the other hand, is vertically integrated. TSMC makes a 50% margin on NVDA's business, to which NVDA adds another 80% gross margin of its own. Intel could charge 37% less for its chips and still generate 80% gross margins.
6. Competition from existing customers (Google's TPU, Apple)
The concern expressed here is a price war in the industry, leading to lower margins. This is always a real risk in the short term, especially for the highly competitive chip industry.
Long term, NVIDIA's gross margin should remain stable or expand even further. Gross margin has been expanding from the low 40% range to the high 50% range, NVIDIA has leveraged a single graphics architecture -- the layout design of a graphics card -- across all segments of its business. Moreover, NVIDIA's business model has shifted in recent years from a chip business to a differentiated specialty platform business. The nature of NVIDIA's platform business model is more software centered, and this has been driving higher gross margins.
Businesses are not necessarily buying chips from NVIDIA, but a whole platform to solve a problem. For example, NVIDIA's Drive PX 2 is a platform that helps automakers solve difficult problems posed by the artificial intelligence aspects of autonomous vehicles. Automakers can scale Drive PX 2 to operate like a supercomputer, or use it for a simpler functionality. In order to scale it, companies have to spend more on software which creates a higher average selling price for NVIDIA.
CEO Jen-Hsun Huang sees more upside to NVIDIA's margins long term as the company's non-gaming segments grow and as gaming platforms -- the PC and consoles -- advance in capability, leading to higher adoption rates of high-end GPUs.
Bottom line
NVIDIA's stock has had an amazing run in 2016. The valuation is looking frothy by conventional standards. Any hint of uncertainty or doubt could send the share price down and that is what is happening in response to the Citron report.
The bottom line is Citron could prove correct in the next few quarters. But, if you're a Foolish investor focused on the next ten years, instead of the next six to twelve months, the return potential from NVIDIA's massive growth opportunities in datacenters and automotive -- not to mention further upside in the gaming segment -- could mean multi-bagger potential for NVIDIA. In other words, the potential reward well compensates for the risks.
