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NVIDIA - The Fleeting Advantage

NVIDIA is a leading supplier of computer graphics processors, focusing primarily on the high end of the market. The primary applications in this space are gaming, video manipulation, and graphics editing. Their primary competitor is AMD, who purchased former blood rival ATI in 2006.

Clearly NVIDIA has had the upper hand on AMD/ATI over the past few years. The company won such high profile contracts as Sony's Playstation 3, and has stayed on top in the technology race with it's GeForce line of graphics cards. By winning performance benchmark reviews, NVIDIA has gained market share as gamers and video gurus demand the best performance - leading to computer hardware OEMs choosing NVIDIA over AMD for their flagship models.

Market share gains are not the only thing that has been going in the company's favor. They have directed R&D towards more efficient chip designs, raising part yields (less defective parts), which has led to better profit margins. The numbers don't lie. Over the last 3 years, NVIDIA has averaged 24% revenue growth per year, over 100% earnings growth per year, and a staggering 1,430 basis point improvement in net margin.

Such success has put the company on very impressive financial footing. The balance sheet shows over 1.8 billion dollars in cash against no debt. Free cash flow margin is nearly 30% of revenues over the last twelve months. Clearly, there are no financial concerns with this Magic Formula selection.

However, we *are* talking about a Magic Formula selection, and a highly ranked one at that (top 25 over 2 billion). Despite all of this recent success, here is a stock selling at under 10 times free cash flow and slightly over 7% earnings yield. And despite it's success, MagicDiligence has decided not to recommend NVIDIA as a Top Buy. So what gives?

Let's eliminate two of our criteria right off the bat. NVIDIA is clearly in no financial trouble. Management, too, is outstanding. Jen-Hsun Huang is the company's founder and CEO, holds a respectable 6% of shares, and has led NVIDIA through multiple graphics chip generations and a crippling technology boom and bust cycle. NVIDIA has emerged triumphant where a long list of competitors (3dfx, Matrox, S3, Creative) are either long gone or long ago exited this tough business.

A third criteria can also be tossed out - graphics processing is not a dying industry. Quite the contrary. New operating systems like Windows Vista and Mac OS X are making use of advanced graphics techniques that require hardware like NVIDIA provides to function appropriately. Those who have inquired about the many flavors of Vista know that the budget version doesn't include the graphical bells and whistles for computers that don't have graphics power to handle them.

That leaves one criteria, and it's extremely applicable to NVIDIA - say it with me - durable competitive advantage. Competitive advantages in a field as fast moving as graphics processing are tenuous and very short lived. Technology cycles here can last less than a year. Historically, NVIDIA and AMD/ATI have traded the technology lead, often in the same year. Gamers and high end computer users are fickle and will jump to whoever wins the latest benchmarks. AMD's Radeon 3800 series chips have been scoring price/value benchmark wins against NVIDIA. Loss of technology leadership means loss of competitive advantage for NVIDIA, and leads to drastically lower margins through lower revenues and increased R&D spending to catch up.

Not only this, but there is nothing stopping OEMs from changing graphics cards in short order. Software relies on graphics library APIs such as OpenGL or DirectX, both of which are supported by all graphics card vendors. There is no hardware lock in here.

The last threat is increased competition from the 800lb. gorilla in the chip space - Intel. Intel has been content with supplying low end graphics processors that are usually embedded on their motherboard products. However, the company has been eying NVIDIA's fat profits and has identified their market as a place for potential growth. Larrabee is the code name for Intel's upcoming, competing architecture (read more), and Intel is touting such advantages as a built in physics processor and lower power usage. With Intel and AMD's R&D experience and financial muscle, NVIDIA faces two very formidable competitors.

I think NVIDIA is a good company in a growing industry. However, I don't disagree with the market's risk discount on this one. These profits and cash flows will be under constant siege from very capable competition, and this is not a situation as investors we want to get into.

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