Taking Stock: Graphics Chipmaker Struggles For Lead

Consolidation became a buzzword with Oracle's attempt to acquire PeopleSoft. A wave of consolidation was supposed to sweep through the tech sector, but, so far, it's been muted. Still, there have been changes in the graphics-chip industry, where the competitive landscape has changed dramatically. That's making life complicated for Nvidia, which has fallen on hard times.

Nvidia makes chips for PC and game consoles that allow users to view sophisticated graphics from video games and other graphics-intensive applications. Historically, the company has been a leader in an industry that has rapidly consolidated from a large number of smaller companies into three: ATI Technologies, Intel, and Nvidia. Nvidia used to be the undisputed technology leader, and, as such, Microsoft choose it to design the graphics chip for its Xbox game console. The company experienced phenomenal growth, going from almost nothing at the end of 1996 to having $1.8 billion in revenue at the end of January 2004.

However, revenue growth has been sporadic in the last six quarters, and during the last quarter it declined about 1% from the same quarter a year ago. To make things worse, Nvidia missed analysts' estimates by a wide margin, posting earnings per share of 3 cents instead of 15 cents as expected. Investors were none too pleased and sent the stock tumbling 35% the following day.

Competition seems to be coming from two quarters. Intel is making a significant push into the market for graphics chips by offering reasonably priced chipsets for mid- and low-end PCs. In the high-end market, Nvidia is facing stiff competition from ATI, which appears to have technology that is at least as good as Nvidia's, in my opinion. While Nvidia's revenue declined slightly this quarter, ATI posted revenue growth of 38% year over year.

As Nvidia fends off the onslaught from Intel and ATI, it's also experiencing a severe contraction in the revenue from its second-largest customer, Microsoft. Microsoft accounted for 23% of Nvidia's revenue in 2003, but this shrank to 15% of revenue in 2004--a decline of 36.4% from 2003 to 2004. Falling gross margins, single-digit operating margins, rising inventory days on hand, and rising days sales outstanding all point to a weakening financial situation. Despite this, insiders are buying shares in the company, which has disclosed a $300 million share-buyback program. Intriguing, isn't it?

Doom 3 was released recently and runs best on an Nvidia-driven graphics card. Investors are speculating that this could be fueling Nvidia's revenue, hence leading insiders to buy. Nvidia's stock isn't cheap, in my view, on a price-to-earnings basis, which you wouldn't expect given the depressed profitability levels. On a price-to-book-value basis, the stock looks more interesting, in my opinion--but at roughly 1.9 times book value, it's not a screaming bargain, though many tech stocks currently trade at higher valuations.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected]. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.

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