Price War, Defects, Delays Plague Nvidia

The Company

The News

Silicon Valley chip maker Nvidia (NVDA) took a beating in Thursday's abbreviated trading session after warning that revenue for the current quarter could fall as much as 20% shy of its goal. Shares sagged more than 30%.

The Santa Clara, Calif., maker of graphics processing chips for personal computers, cell phones and game consoles said revenue for the quarter ending July 27 would range from $875 million to $950 million, well off its prior estimate of $1.1 billion. Even that level would have represented a 5% drop from the year-ago results. Wall Street analysts expected an average of 30 cents a share, according to Thomson-Reuters, but that was before Nvidia said gross margins would also fall short of the mark. It blamed "end-market weakness around the world" as well as "price adjustments... to respond to competitive products."

The company will take a $150 million to $200 million charge to cover recall costs related to defective GPU and MCP products used in notebook computers. The chips were prone to overheating.

"The combination of limited thermal management and frequent power cycling is particularly challenging for complex processors like the GPU, Nvidia President and CEO Jen-Hsun Huang said. "This has been a challenging experience for us. However, the lessons we've learned will help us build far more robust products in the future, and become a more valuable system design partner to our customers."

Nvidia's graphics processors face increased competitive pressure from Advanced Micro Devices (AMD) and Intel (INTC), which have taken market share on the high end of desktop machines. That's a space Nvidia dominated over the previous two years, Needham & Co. analyst Quinn Bolton says.

The company hopes to regain the upper hand with new GPU chipsets, but these are already a couple of months behind their anticipated release date. Nvidia is scheduled to report earnings on Aug. 12.

The pre-announcement triggered Wall Street's stock response: J.P. Morgan slashed its rating to Neutral from Overweight, Needham and Kaufman Brother cut their ratings to Neutral from Buy, while UBS and Longbow Research moved to Hold from Buy.

The Analysis

Things are getting tough all over for many chip makers, but Nvidia's problems are internal, and also tied to intensified competition from AMD.

"I would say the vast majority [of trouble] is Nvidia's own making," Bolton says.

The combination of defective products and delays in the new generation has given AMD a clear path to go in and scoop up market share, and it's wasting no time doing so.

"For last couple of years, Nvidia had the market, at least at the high end, to itself," Bolton says. "This is the first competitive offering from AMD in some time, and in the near term, I'm not sure how much they can do about it."

Heidi Poon, an analyst at Thomas Weisel Partners, wrote Wednesday that while only one notebook maker has had chips overheat, she's skeptical of Nvidia's claim that it's contained the damage. Taiwan Semiconductor Manufacturing (TSM) manufactures most of Nvidia's kits.

"We believe there is potential for additional liability, although the company has indicated it believes the one-time charge is sufficient and is not expecting further charges related to this issue," she wrote.

Canaccord Adams analyst Bobby Burleson wrote Thursday that Nvidia also faces risk because it has a relatively small number of customers. That means it could be affected disproportionately if it loses one or if its buyers opt to cut inventory.

The Bottom Line

The Street had been optimistic about Nvidia's prospects in a choppy environment for personal computers, but its litany of woes is forcing some to reassess. "Since the company has reduced visibility, due to manufacturing issues, we believe that the risk to market share has increased somewhat," Kaufman Brothers analyst Suji De Silva wrote Thursday.

"I think the challenges with product execution were a surprise," he says. "I think the other things were already known."

Bolton says the market reaction is severe, but expects things will go from bad to worse for Nvidia, with the stock eventually hitting $10 a share.

"They're taking it in the teeth," he says. "When they come out and report fully for the July quarter on August 12, we'll get more color on where margins go, but I don't see any near-term fix. I don't see any positive catalysts for the shares."

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