Is Licensing the Next Catalyst for NVIDIA?

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

Despite reporting a strong recent quarter purveyance of GPUs, NVIDIA (NASDAQ: NVDA) is on the hunt for additional sources of revenue. To that end the company has announced a new emphasis on licensing its patent portfolio as an additional revenue stream. The company has been willing to license its technology in the past, providing the design for the GPU in Sony’s (NYSE: SNE) Playstation 3 and licensing visual computing patents to Intel (NASDAQ: INTC) but this does mark a shift in strategy.

In its announcement NVIDIA highlighted a shift in the dynamics of the IT market, pointing to the current erosion of the PC market while the mobile market rapidly expands. The company also highlighted the prevalence of high definition graphics in workspaces everywhere and how that is stimulating demand for their particular brand of computing prowess.

Interestingly the company name checks Google’s (NASDAQ: GOOG) Android as the catalyst for what they perceive to be “an unprecedented opportunity to accelerate” their licensing effort. It isn’t a surprise that they are fond of Google’s mobile operating system; Android has delivered quite a few customers to their doorstep and helped move them to the forefront of mobile graphics.

While NVIDIA has seen success in the mobile landscape, it hasn’t yet struck a major deal with the current winners of the mobile war, Samsung and Apple (NASDAQ: AAPL). NVIDIA has a major foothold in mobile, but it is far from the only game in town. Could licensing their patent portfolio be the answer? It seems like it may be, though the strategy does have some drawbacks.

The Advantages

The biggest advantage is that there is plenty of evidence that this approach can pay off. Without a focus on licensing deals the company has already managed to land two significant licensees, and in the case of Intel, it has resulted in a nontrivial revenue stream. Intel pays NVIDIA $250 million a year for licensing, which represents roughly 6% of the company’s revenue for the fiscal year 2012.

Furthermore, NVIDIA’s success with licensing isn’t the only example. For instance, in the most recent fiscal quarter rival Qualcomm (NASDAQ: QCOM) derived approximately 33.5 percent of its total revenue from its QTL business division. QTL, which stands for Qualcomm Technology Licensing, handles the licensing of Qualcomm’s extensive patent portfolio and is undeniably a major part of the company and its success. Qualcomm isn’t alone: ARM Holdings (NASDAQ: ARMH), perhaps the most prolific of the mobile chip companies, subsists almost entirely on royalties and fees from licensing their designs. It’s this structure that allows ARM to maintain its impressive gross margins: 94.5 percent for 2012.

As demonstrated by ARM, licensing can do wonders for gross margins. If NVIDIA can shift even a portion of the fabrication burden to its customers, it saves on capital expenditures, increases its own flexibility, and increases its cash for research and development. It also opens the door to deals with major players in the smartphone industry. Both Apple and Samsung have a penchant for designing their own chips but also rely on heavily on a wide array of technology licenses. While NVIDIA hasn’t yet landed a big chip deal with either, its designs could work their way into the next blockbuster product.

The Drawbacks

The biggest drawback is the risk of cannibalizing their own sales. Since they’re starting with their newest generation, companies with the capacity might opt to license and fabricate themselves rather than buy ready-made chips. This is only an issue in the near term, if the licensing model is a success they can shift their resources away from production and more towards development.

As it stands, NVIDIA is already in a strong position. The company has cutting-edge intellectual property in an increasingly important market and a strong balance sheet. Add in the fact that the company has already committed to return one billion in capital to shareholders and you have a perfect storm for price appreciation. In the past quarter they only returned $146.3 million of their target, $100 million of it coming as buybacks and $46.3 million in dividends. If it gains any significant traction with its licensing approach it could be the catalyst it needs to continue appreciating.

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.

Chris Moore owns shares of Intel. The Motley Fool recommends Apple, Google, Intel, and NVIDIA. The Motley Fool owns shares of Apple, Google, 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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