What Is the Best Semiconductor Strategy?

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

NVIDIA (NASDAQ: NVDA) is definitely on its way to becoming more profitable as the company announced in a recent press release that it would be licensing its GPU cores, and visual computing patent portfolio to device manufacturers.

The likely beneficiaries are the device manufacturers, NVIDIA, and pure-play foundries like Taiwan Semiconductor Company (NYSE: TSM).

Growing gross margins for NVIDIA

<img alt="" height="378" src="http://g.fool.com/editorial/images/51438/6-19-13-nvda-pic-1_large.png" width="714" />

Source: Ycharts

Over the past ten-years, NVIDIA has been able to grow its gross margins from 30% to 52.94%. The pursuit of a license driven business model is what is causing the rapid growth in gross margins.

Qualcomm’s (NASDAQ: QCOM) licensing revenues grew Qualcomm’s gross profit margins in the past five-years, similar to NVIDIA. Comparatively, Qualcomm has a 62.25% gross profit margin, so it is definitely possible for NVIDIA to maximize profitability better with the added licensing of its GPU cores, and visual computing patent portfolio.

Qualcomm projects that the number of machine-to-machine communication opportunities will increase to 50 billion machines and 100 billion objects. So going forward it is highly practical for NVIDIA to openly license its graphics technologies out to any company that can find a practical use for them. After all, it is highly probable that the number of objects with a screen will grow, and device manufacturers being able to have access to the world's most advanced graphics patent portfolio could only help. Almost anything with a screen could use an NVIDIA graphics processor.

NVIDIA: the sky is the limit

NVIDIA has a set of core-businesses that it can rely on for growth, and it currently estimates that the total addressable market (total market value for each of these businesses) is around $26 billion. In the current fiscal year NVIDIA generated $4.3 billion in revenue, so it composes a small, yet respectable corner of the various markets it operates in.

The company is currently split into mobile ($10 billion addressable market), NVIDIA GRID (a brand for its cloud-virtualization graphics solutions, and it also has a $10 billion addressable market), and its GPU segment ($6 billion addressable market). The company’s potential growth opportunities primarily involve its NVIDIA GRID segment and mobility.

There’s also the future licensing revenue stream for unique graphics driven processes that are most likely to come from machine-to-machine communication, which is a 50 billion unit market that has yet to be addressed.

Analysts on a consensus basis anticipate this company to grow earnings by 12% on average over the next  five years. The company’s growth will most likely be driven by mobile and GRID. However, I don’t anticipate any upside surprises over the short-term as the company has not been able to deliver a Tegra 4 design win against Qualcomm Snapdragon 800.

The company currently pays a 2.08% dividend yield and is fairly valued at a 15.5 earnings multiple when considering the fact that there’s no near-term upside catalyst.

Qualcomm will remain the king

The company is raking in licensing revenues. Currently NVIDIA projects 450 million 4G LTE phones to be sold by 2016, and IDC predicts the smartphone market to grow from 700 million in 2012 to 1.4 billion in 2016. Based on those favorable projections, it is likely that Qualcomm will be earning a significant amount of money from royalties in the mobile station modem space. It also helps that Qualcomm has 97% market share in the 4G LTE space.

The company was able to secure a design win with the Snapdragon 800. The Snapdragon 800 will be going into production in the next month according to industry rumors. Qualcomm has greater economies of scale, which allows it to price itself lower than competitors. The Snapdragon 800 performs better than the upcoming NVIDIA Tegra 4 in certain benchmarks.

<img alt="" height="435" src="http://g.fool.com/editorial/images/51438/6-19-13-nvda-pic-2_large.png" width="725" />

Source: arstechnica

Snapdragon 800's performance was able to beat Samsung, NVIDIA, and Apple in a benchmarked comparison. I don’t know how much of an advantage it will have against the next-generation Apple processor, but we can bet on the researchers at Qualcomm and assume that they will have a handle on ARM-based chip designs going forward.

Analysts anticipate the company to grow earnings by 18% on average over the next five years. The company’s growth will be driven by demand in 4G LTE devices and lower-end devices in emerging markets. Proctor & Gamble projects that 1.4 billion will be entering the middle class by 2020, and 98% of that will come from the emerging market economies.

The stock trades at a 17.6 earnings multiple, which is reasonable relative to the future growth. The company also compensates investors with a 2.24% dividend yield. The company has a compelling mix of growth, income, and valuation.

Taiwan Semiconductor the best bet

If you really hate choosing between winners and losers then Taiwan Semiconductor is the company for you. The company is a mid-stream supplier of services in the semiconductor space. Sort of like a middle-man it accepts designs from companies like Qualcomm and NVIDIA, works together with manufacturers on exact specifications, then mass produces for the manufacturers. The manufacturers pay a fee to Taiwan Semiconductor and pay a royalty to companies like AMD, ARM Holdings, Qualcomm, and NVIDIA.

Going forward the company anticipates growth from the tablet and smartphone market. The large untapped potential in the 50 billion machine-to-machine market could be the next frontier for the company going into the latter half of the decade. Currently Taiwan Semiconductor Manufacturing has 45% market share in the foundry segment of the semiconductor sector. So it is likely that 45% of future developments in semiconductor technology will be manufactured through Taiwan Semiconductor Manufacturing. This makes it a diversified sector bet, and limits risk from product obsolescence.

Analysts on a consensus basis anticipate the company to grow earnings by 15% on average over the next five years. The company trades at a 16.6 earnings multiple, which is reasonable when considering the future growth of the business. The company also compensates its investors with a 2.7% dividend yield. The company offers a compelling mix of growth, income, and value.

Conclusion

Taiwan Semiconductor comes with the lowest risk and perhaps the highest reward. It is also likely that Qualcomm will continue to rake in the profits from 4G LTE smartphones in the coming decade. NVIDIA sees a lot of untapped potential in cloud virtualization graphics technologies and is still a noteworthy contender in the mobile space.

NVIDIA was ahead of the curve launching its mobile Tegra processor, but investing gains haven't followed as expected, with the company struggling to gain momentum in the smartphone market. The Motley Fool's brand-new premium report examines NVIDIA's stumbling blocks, but also homes in on opportunities that many investors are overlooking. We'll help you sort fact from fiction to determine whether NVIDIA is a buy at today's prices. Simply click here now to unlock your copy of this comprehensive report.


Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends NVIDIA. The Motley Fool owns shares of 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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