Shares of NVIDIA Corporation (NASDAQ:NVDA) surged more than 7% on Thursday February 12, 2015, reaching a new multi-year closing high of $22.30. Investors cheered the company's Q4 earnings report, which came in ahead of analysts' estimates on all counts.
NVIDIA's earnings trajectory has improved dramatically in the past couple of years as the company has shifted its focus to higher value-added areas like gaming, workstation graphics, and high-performance computing.
However, investors may be neglecting one potential risk to NVIDIA's future earnings power: the end of its Intel (NASDAQ:INTC) patent licensing revenue stream. This licensing agreement has generated a significant proportion of NVIDIA's profit recently. When this revenue stream disappears, it could cause a drop in NVIDIA's overall earnings.
NVIDIA's hidden earnings driver
NVIDIA doesn't spend much time talking about its patent cross-licensing agreement with Intel during its quarterly conference calls. However, this remains a critical source of income for the company.
In early 2011, NVIDIA and Intel settled a long-running patent dispute, with Intel agreeing to pay a total of $1.5 billion over five years to settle all claims between the two companies. Since April 2011, NVIDIA has recognized $66 million in revenue each quarter from the resulting patent cross-licensing agreement. This will continue through March 2017.
As of last quarter, this represented a little more than 5% of NVIDIA's revenue. It's much more significant from a profitability standpoint, though, because it all drops straight to the bottom line. NVIDIA's pre-tax income last quarter totaled $228 million, of which 29% was attributable to the licensing revenue.
Intel licensing revenue will disappear
Many patent licensing agreements have a limited term and can be renewed by the parties when they expire. That doesn't appear to be the case for the Intel-NVIDIA license agreement, though. According to the "term" section of the agreement, the license "shall continue in effect until the expiration of the last patent licensed hereunder to expire."
In other words, the payments from Intel to NVIDIA don't continue forever, but the cross-licensing agreement appears to extend for as long as the underlying patents are still valid. This means NVIDIA's $66 million per quarter of "free revenue" will disappear in early 2017.
From a cash flow perspective, the blow will come even sooner. NVIDIA has already collected $1.3 billion of the total $1.5 billion in licensing revenue. While it will recognize more than $500 million in revenue over the next two years, its only cash proceeds will be a $200 million payment next January.
This means NVIDIA's cash flow is likely to lag its earnings for the next couple of years. As a result, NVIDIA may not have as much money available for dividends and share repurchases.
Can NVIDIA offset this headwind?
While NVIDIA investors should be aware of the potential headwind from the end of the Intel payments, it's possible NVIDIA will be able to replace this profit stream.
First, it's important to recognize that growth in NVIDIA's core GPU business has been accelerating recently. The company also has significant emerging opportunities in the cloud computing and automotive industries.
On the other hand, the timing and extent of these growth opportunities remain unclear. While NVIDIA's revenue grew 13% in FY15, revenue growth had decelerated to 9% by Q4 and the company is forecasting mid-single digit revenue growth in Q1 of FY16.
A second route to offsetting the loss of the Intel cross-licensing income is for NVIDIA to license its patents to other companies. Last September, NVIDIA launched a patent lawsuit against two giants of the mobile computing industry, Samsung and Qualcomm, alleging that their products are infringing on NVIDIA's graphics technology.
This case is ongoing, and for the moment, it is only generating costs (i.e., legal expenses). However, if NVIDIA wins in court or achieves a favorable settlement, it could bring in a new source of high-margin licensing revenue to offset the loss of the Intel payments.
Increased share repurchases could also help offset the impact of losing the Intel revenue. As of a year ago, more than half of NVIDIA's $4.7 billion in cash and investments was held outside the U.S. Today, that percentage could be closer to 75%, as NVIDIA returned $1 billion of its domestic cash to investors in FY15.
However, if the U.S. government reaches a compromise on corporate tax reform, NVIDIA may be able to repatriate more of its offshore cash at a reasonable tax rate. That would provide extra firepower for buybacks.
In short, there are several ways NVIDIA may be able to offset the headwind from losing its Intel licensing revenue -- but there could still be bumps ahead for NVIDIA's EPS. With shares trading for about 20 times earnings, investors should be cautious about holding on to NVIDIA stock, here.