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1 Stock to Profit From the Booming Gaming Market

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

With shares of NVIDIA (NASDAQ: NVDA) falling after its Q2 earnings release, it seems that investors are focusing on what matters least. Total revenue and profit fell year-over-year, dragged down by a huge decline in the mobile Tegra business, but this was expected and doesn't really matter. The core GPU business is growing, and right now, NVIDIA offers an investment opportunity with little downside and an ample margin of safety.

Wasn't the PC market dying?

The overall PC market seems to be in a never-ending decline, leading some to believe that NVIDIA will suffer the same fate as many other PC-related companies. But NVIDIA doesn't really compete within the broad PC market. Instead, NVIDIA derives much of its profits from the high-end gaming market, a segment which is booming. On NVIDIA's conference call, the company stated that the PC gaming market is set to grow to $20 billion by 2015, far larger than the console market. Not only that, PC gaming is growing faster than console gaming.

This makes competitor Advanced Micro Devices' (NYSE: AMD) sweep of the next-gen console market seem much less important. Sony's PlayStation 4, as well as Microsoft's Xbox One, contain a CPU and a GPU designed by AMD, whereas the previous generation saw the PlayStation 3 ship with an NVIDIA GPU. The PC gaming market, with high-end graphics cards selling for higher prices than the game consoles themselves, offers far more opportunity. NVIDIA was smart to focus its resources away from consoles.

AMD owns ATI, the main rival to NVIDIA's GPU business. AMD has been struggling for years, and while the game consoles will give the company a boost in revenue, it will also take resources away from the high-end gaming GPU market which carries far loftier margins. In the high-end, NVIDIA reigns supreme, with the GeForce GTX 770, 780, and Titan offering unrivaled power. Tom's Hardware regularly publishes a list of the best graphics cards for different price points, and once you go above $200, ATI is nowhere to be seen. NVIDIA dominates the high-end, and this has allowed the company's gross margins to expand even further in the second quarter. It's unlikely that AMD will be able to catch up, especially with its focus on consoles.

While NVIDIA's total revenue declined 6.4% year-over-year, the GPU business grew 7.5%. A sharp 70% year-over-year decline in Tegra revenue was the reason for the net decline, but this was expected. Within the GPU business, GeForce desktop GPU revenue increased 3.9% year-over-year, the Quadro workstation GPU revenue increased 14.3% year-over-year, and Tesla GPU revenue increased 127.5% year-over-year. Notebook GPUs suffered a small decline, much smaller than the decline in the notebook market as a whole, and the net result was strong growth.

Tegra weakness

NVIDIA's mobile processor, Tegra, saw a dramatic decline in revenue from last year. This decline was a result of the company delaying the Tegra 4 in order to focus on the Tegra 4i, a version with a built-in LTE modem. This delay created a gap between the winding down of Tegra 3 and the ramping up of Tegra 4, thus leading to little revenue. However, the second half is expected to be much better, with Tegra 4 devices finally coming to market. NVIDIA launched Shield at the end of July, a handheld gaming device running Android and based on the Tegra 4, and although the delay has caused many manufacturers to go with alternatives, there should still be some Tegra 4-based tablets launched in the second half.

Tegra 3 was featured in the Surface RT tablet from Microsoft (NASDAQ: MSFT), but with OEMs dropping the Windows RT operating system, it's unclear if another iteration of the Surface RT will be released. Microsoft recently took a massive $900 million inventory write-off on the tablet as it slashed prices amid weak demand. However, the CEO of NVIDIA recently confirmed that the company is working with Microsoft on a new iteration of Surface RT, presumably one which features the Tegra 4 processor.

The only way for a new Surface RT to be a success is for the price to be extremely low. If this happens and the new Surface RT sells better than its predecessor, then it could provide a meaningful boost to NVIDIA's mobile efforts.

Tegra has more applications than just mobile devices. Automobiles are increasingly featuring screens which contain navigation and other information, and Tegra has been finding its way into this market. The Model S from electric car company Tesla uses the Tegra 3 to power its system, and the Tegra 4 will likely create even more business for NVIDIA.

Pessimism abound

There seems to be plenty of pessimism surrounding NVIDIA, and this is keeping the stock price in check. But NVIDIA is comprised of a core business which is strong and growing along with a business which has plenty of potential. The company has a pristine balance sheet and a mountain of cash, and it seems that the short-term issues with Tegra are overshadowing the strength of the GPU business.

At the end of the second quarter NVIDIA had $2.9 billion in cash and no debt. The cash level has decreased due to an accelerating share buyback deal struck with Goldman Sachs. This has reduced the diluted share count to 592 million, resulting in about $5 per share in cash. This means that, with the stock currently trading around $14.50, the market is valuing all of NVIDIA's future profits at $9.50 per share.

In 2012, NVIDIA generated $641 million in free cash flow. Even a decline in 2013, which wouldn't be surprising due to the investment in Tegra, would likely lead to FCF per share of at least $1. This puts NVIDIA trading well below 10 times the free cash flow adjusted for cash, which seems outrageous given the strength of the GPU business. 

Because of the large cash cushion and the growing high-margin GPU business, there seems to be little downside. When Tegra 4 and eventually Tegra 5 begin to gain traction, I expect the stock be much higher than it is today. And while we wait for that to happen, the PC gaming market will be booming. NVIDIA is in a great position to capitalize on the growth of both PC and mobile gaming.

The bottom line

The weakening PC market is having little effect on NVIDIA's core business as the PC gaming market is growing. Next year will be an important year for Tegra, and the eventual release of Tegra 5 will be the real test for NVIDIA's mobile strategy. Right now, the stock is trading at levels which greatly discount the strength of NVIDIA's core business and assume that Tegra will be a failure. NVIDIA is one of the cheapest stocks available, and in the long-term. the company is poised for success.

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Timothy Green owns shares of Microsoft and NVIDIA. The Motley Fool recommends NVIDIA. The Motley Fool owns shares of Microsoft. 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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