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Is NVIDIA Destined for Greatness?

Wednesday - 1/9/2013, 2:00am  ET

Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let's take a look at what NVIDIA's recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you're about to see tell NVIDIA's story, and we'll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company's become more efficient over time. Since profits may not always reported at a steady rate, we'll also look at how much NVIDIA's free cash flow has grown in comparison to its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If NVIDIA's share price has kept pace with its earnings growth, that's another good sign that its stock can move higher.

Is NVIDIA managing its resources well? A company's return on equity should be improving, and its debt-to-equity ratio declining, if it's to earn our approval.

Healthy dividends are always welcome, so we'll also make sure that NVIDIA's dividend payouts are increasing, but at a level that can be sustained by its free cash flow.

By the numbers
Now, let's take a look at NVIDIA's key statistics:

NVDA Total Return Price data by YCharts.

Criteria

3-Year* Change 

Grade

Revenue growth > 30%

46.1%

Pass

Improving profit margin

45.8%

Pass

Free cash flow growth > Net income growth

100.5% vs. 245.5%

Fail

Improving EPS

231.1%

Pass

Stock growth (+ 15%) < EPS growth

7.5% vs. 231.1%

Pass

Source: YCharts. *Period begins at end of Q3 (Oct.) 2009.

NVDA Return on Equity data by YCharts.

Criteria

3-Year* Change

Grade

Improving return on equity

180.1%

Pass

Declining debt to equity

(58.8%)

Pass

Dividend growth > 25%

N/A

Pass

Free cash flow payout ratio < 50%

31% 

Pass

Sources: YCharts, Yahoo! Finance, and Morningstar. *Period begins at end of Q3 (Oct.) 2009. N/A = not applicable; dividend was initiated Q3 2012

How we got here and where we're going
Eight of nine passing grades is a very strong showing from the market's biggest graphics-chip maker. NVIDIA misses a perfect score only on a technicality -- by analyzing the percentage change of net income that started our tracking period in negative territory, we give it a larger growth rate than it might have under normal circumstances. The next time we investigate NVIDIA, it may have gotten past this post-recession loss, which may allow free cash flow growth to pull ahead. But what will NVIDIA need to do in order to maintain its progress?

Let's start with NVIDIA's most recent earnings report. Analysts expected a modest rise in both top and bottom lines, but NVIDIA blew past both expectations, and tacked on a pretty decent dividend as well. That dividend accounts for about 31% of NVIDIA's trailing-12-month free cash flow when annualized out, which is well within reason for a highly profitable hardware company. Although it's not quite as high as Intel's sector-trouncing yield of 4.3%, NVIDIA's payout has a bit more room for growth, as Intel's current free cash flow payout ratio is nearly half of its total free cash flow.

Going forward, NVIDIA's most obvious source of growth will be in its Tegra mobile processors, which compete directly with mobile-CPU leader Qualcomm . To better challenge Qualcomm's dominance as an integrated CPU-plus-baseband (which processes wireless signals), NVIDIA's also trying to create integrated solutions, which it committed to in 2011 by acquiring a specialist baseband company. But NVIDIA is also doing a fine job at expanding its PC base, as the company now provides GPUs to Apple 's iMacs. Apple PCs are one of the few bright spots in a moribund industry, but are they enough to sustain NVIDIA's growth prospects?

Beyond smartphones and PCs, tablets (and other gaming-friendly devices) remain in NVIDIA's wheelhouse, as evidenced by the company's revelations at this year's CES. The new Tegra, NVIDIA's fourth-gen mobile chip, still doesn't have integrated baseband processing, but the next Tegra should. What the Tegra 4 offers is a reduced transistor width that will enable greater power efficiencies, an all-important consideration in mobile computing.

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