Graphics chip company NVIDIA (NVDA +2.71%) looks downright expensive based on the stock's P/E ratio, which currently sits around 25. Combine that with the fact that both revenue and earnings declined in 2013, and on the surface, NVIDIA doesn't look like a great investment.
But NVIDIA's core GPU business is stronger than ever, despite the recent rash of downgrades, and temporary issues with the mobile Tegra business are the main culprit behind the company's declining profit. The long-term picture -- ultimately the only thing that matters for Foolish investors -- looks far more promising.
NVIDIA's mobile troubles
NVIDIA's Tegra 3 mobile processor, launched toward the end of 2011, managed to find its way into quite a few devices. From the original Microsoft Surface to the in-car display within the Tesla Model S electric vehicle, the Tegra 3 proved that NVIDIA was capable of building a competitive mobile system-on-chip. The Tegra segment was operationally profitable in 2011 as well as 2012, but things then took a turn for the worse.
Source: NVIDIA 10-K
The Tegra segment went from a $40 million operating profit in 2012 to a staggering $268 million operating loss in 2013. This drove NVIDIA's total operating profit down significantly, from $648 million in 2012 to just $496 million in 2013.
What happened? NVIDIA delayed the release of the Tegra 4, the successor to the Tegra 3, in order to focus on the Tegra 4i, a version of the SoC with an integrated modem. Integrated LTE was necessary in order to compete with market leader Qualcomm, and the delay of the Tegra 4 led to the massive operating loss in 2013.
A shifting focus
NVIDIA's plan to compete in the mainstream phone market didn't quite pan out. The market became commoditized extremely quickly, and NVIDIA recently stated that it's not worthwhile to pursue mainstream smartphone design wins. The focus going forward will be markets where graphics and visual computing are important, and the mainstream phone market is not one of these. Gaming, high-end devices, and automotive are the three areas that NVIDIA is now focusing on for Tegra, each representing a significant opportunity for the company.
Google's Project Tango, a development tablet that uses sensors and a camera to construct a 3-D map of the environment in real time, has tapped NVIDIA's Tegra K1 to power the device. While Project Tango has many possible applications, bringing a unique and compelling gaming experience to Android is something that NVIDIA could greatly benefit from in the long term.
Automotive is an area that NVIDIA has been targeting for years. Tesla's Model S uses two Tegra 3 processors to power its in-car display, and NVIDIA picked up $1.9 billion worth of automotive business in 2013, set to be realized as the models eventually come to market. NVIDIA does face significant competition, with one of the newest serious entries in the automotive market being Intel (INTC +4.96%). Intel has been investing heavily in the mobile market as it attempts to broaden its business beyond PCs, and the company is now aiming its low-power Atom chips at the automotive market as well. Intel hopes that its Atom-powered modules can eventually be the brains behind autonomous vehicles, as well as powering the in-car display.
NVIDIA does have an advantage when it comes to driver-assistance features. Since things like pedestrian detection require vast amounts of image and video data to be processed in real time, the parallel nature of a GPU can provide a significant speed-up over a CPU-only solution. NVIDIA's Tegra K1 has 192 graphics cores, and for certain applications, it should smoke anything that Intel brings to the table. How important this ends up being remains to be seen, but NVIDIA is already seeing quite a bit of success.
Why NVIDIA is not as expensive as it seems
While Tegra was flailing in 2013, NVIDIA's GPU business was stronger than ever. GPU operating income rose by 20%, and if it weren't for Tegra, NVIDIA would have had one of its best years ever.
In 2013, EPS was $0.74. Backing out the Tegra losses, this number jumps to about $1.15 based on the most recent share count and tax rate. While it's hard to say exactly when the Tegra segment will return to profitability, the process is capable of driving significant earnings growth.
Another factor is that NVIDIA is sitting on about $3 billion in net cash. Backing out this cash and ignoring the Tegra losses, the P/E ratio falls to just 12.5. For this number to be meaningful, Tegra needs to eventually return to profitability, which is by no means a guarantee. But given that the delay of the Tegra 4 was the biggest reason why the Tegra segment did so poorly in 2013, this doesn't seem like an unreasonable assumption.
One problem with this story is that a deal between NVIDIA and Intel, where NVIDIA receives $1.5 billion over the course of six years, ends after 2017. With the prospect of a renewal unclear, there's a chance that NVIDIA's earnings will take a hit at that time. Buybacks over the next few years, along with Tegra's improving profitability, should lessen the blow to EPS, but the end of this deal does introduce a big uncertainty for investors.
The bottom line
While a P/E ratio of 25 and declining earnings suggests that NVIDIA is significantly overvalued, a turnaround in the Tegra business over the next few years has the potential to greatly improve profitability. Consider that along with the billions of dollars in cash sitting on the balance sheet, and NVIDIA looks a lot more attractive at the current price. It's not a bargain like it was when the stock traded around $12 per share in early 2013, but with a fortress balance sheet and ample growth potential, NVIDIA deserves another look.
