NVIDIA (NVDA -2.68%) derives the vast majority of its revenue from the sale of discrete graphics processing units, or GPUs. These are usually in the form of add-in boards in desktop PCs, add-in cards for notebooks, or those soldered down in notebooks and all-in-one PCs. The great thesis that many short-sellers have unsuccessfully bet on has been that as Intel (INTC -5.16%) continues to integrate more powerful GPUs into its PC microprocessors, NVIDIA's GPUs would be pushed further into the realm of "niche" -- destroying NVIDIA's business.

They're still wrong...
For anybody who doesn't understand the world of PC gaming, this thesis seems perfectly valid. At some point, those integrated Intel GPUs are eventually going to become good enough for games, right?

Well, no. Intel's GPUs will continue to improve, but Intel's designs are ultimately limited by cost, available memory bandwidth, and power consumption. Not to mention the fact that Intel's GPU architectures, at least to date, haven't exactly been awe-inspiring on a performance-per-watt and performance-per-area basis.

But what everyone really seems to miss is that the gaming market is one of the few consumer markets in which every last ounce of performance is necessary. Until games are photorealistic, run at 60 frames per second or higher, and do so on an Intel integrated GPU or tablet SoC, there will be a continual need for discrete graphics cards for gamers who want to play the latest, most visually rich games. Intel's integrated graphics are still barely capable of playing the latest 3D shooters at acceptable frame rates at anything above "low."

Illustrating the point
On the MacRumors forums, a user by the handle of "Yixian" put together a list of popular games and the frame rates -- how many times the scene is updated per second -- at given quality settings. A rate of 30 frames per second is considered "playable" and 60 frames per second is considered "smooth." Here were some of the results:

  • Far Cry 3 – 20-35 frames per second with quality settings at medium/high, but low shadows, at 1280-by-800 resolution
  • Call of Duty Black Ops 2 – 40-55 frames per second, maximum settings, at 1280-by-800 resolution
  • World of Warcraft – 35-45 frames per second, all settings maxed out, 1920-by-1080 external display

You see the problem, right? In desktop PCs, this kind of performance simply won't do. The screen resolutions are much higher -- 1920x1080 or better -- and the performance expected is much higher. In notebooks, too, anybody interested in playing games at reasonably high settings and high resolutions -- remember, higher resolution will be the new trend -- will need a discrete GPU. An integrated one simply won't do. To drive the point home, games themselves will become much more demanding in each generation.

With discrete GPUs safe, NVIDIA is taking share
The discrete GPU market will be fine, but a major reason that the NVIDIA story works is that NVIDIA is taking share from AMD (AMD -4.24%). Indeed, according to Jon Peddie Research, AMD lost 10.4% market share, sequentially in the fourth quarter, while NVIDIA gained 3.4%, taking share from AMD's discrete products. Intel gained 5.1%, due to AMD losing PC chip sales with integrated graphics. This is probably due to a combination of superior products and better marketing efforts on the part of NVIDIA.

Foolish bottom line
Roughly 11% of NVIDIA's shares outstanding are sold short, likely based on the flawed premise that NVIDIA's core business is on the way out. Yet the stock continues to be squeezed to new highs. While there is concern that the company's multiple has expanded fairly significantly, as long as the fundamentals continue to improve, and as long as NVIDIA can drive meaningful leverage in its Tegra business, then the stock doesn't really look all that expensive at all.