NVIDIA Stock Gets Downgraded: Don't Panic

Bank of America analyst Adam Gonzales downgraded NVIDIA today, which seems to be why the shares are down 2.25% in early trading, underperforming the NASDAQ. NVIDIA, which competes with Advanced Micro Devices in graphics and with companies like Qualcomm and Intel in tablets, has been on a roll this year, with the stock up 19.54% year to date, handily outperforming the NASDAQ, which is up just 4% this year. However, does Gonzales' downgrade mean long-term investors should panic? 

The key arguments
Gonzales' key arguments in the downgrade from neutral to underperform were the following:

  • Expectations of sales growth to slow to 3%-4%, down from 9% in 2015 and 2016
  • A peak of 55% in gross margin, 15% in operating margin
  • A "stretch valuation"

Digging further, Gonzales expresses concerns that the company's consumer graphics sales have peaked (with gaming growth being offset by the decline in mainstream PC declines) despite a healthy enterprise graphics business. Finally, Gonzales notes that 30% of NVIDIA's earnings per share comes from royalty payments from chip giant Intel, and that there is "considerable investor debate on whether these will be renewed beyond their early 2017 expiration date."

Has consumer graphics really peaked?
Of course, under these assumptions, the downgrade has merit, but the question is whether these assumptions will ultimately reflect reality. Let's take a look at the following slide from NVIDIA:

Source: NVIDIA.

You'll note that mainstream OEM weakness has been an overhang for the company in recent years, and despite that -- as both gaming GPUs (which carry high ASPs/gross margin percentages) and professional GPUs (even higher ASP/gross margin) have grown -- NVIDIA's GPU business has grown. It is unclear as to why gaming GPU growth would suddenly "stop" when the growth has been so good.

Further, note that most of the growth in 2013 and 2014 has happened despite the lack of a new GPU architecture. NVIDIA's Kepler GPU has been selling in droves since its initial launch in early 2012, and when NVIDIA launches its next-generation high-end graphics cards based on the more powerful and power-efficient Maxwell design, this should drive a nice upgrade cycle.

The Intel royalty payments
An interesting point brought up by Gonzales is that roughly 30% of NVIDIA's earnings per share comes from royalty payments that the company collects from Intel as part of a settlement that led to a cross-licensing agreement. Per the current agreement, these royalties will stop in early 2017, so if that's not renewed, NVIDIA's earnings outlook is very different than if it is renewed.

But here's the thing. If you look at the financials of NVIDIA's Tegra division (that's mobile system-on-chip), you'll notice that during 2013, it was losing about $500 million per year as a result of high R&D and low sales. That said, sales in Tegra have begun to rebound, narrowing that loss, but the company is still quite deeply in the red, here.

So, what does that have to do with the Intel royalty payments? Well, it's simple. As long as NVIDIA is getting those royalty checks, it can afford to continue to invest in Tegra in a bid to get that business to scale.

If NVIDIA can't get the business to profitability by early 2017 (that's over two years from now), then it could scale back/shutter that investment to buoy the financials. If it can get Tegra to profitability in that time, then that should more than offset the loss of the Intel royalty payments (which come in at $250 million per year).

Foolish bottom line
NVIDIA has had an excellent run, and there are fears that the stock may be overheated and due for a pullback. However, from a long-term perspective, NVIDIA's opportunities are still numerous, and the company's technology still world-class. In other words, don't panic!

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The article NVIDIA Stock Gets Downgraded: Don't Panic originally appeared on Fool.com.

Ashraf Eassa owns shares of Intel. The Motley Fool recommends Apple, Bank of America, Intel, and Nvidia. The Motley Fool owns shares of Apple, Bank of America, Intel, and Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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