13 August 2010

NVDA: Income Statement Analysis for the July 2010 Quarter

NVIDIA (NASDAQ: NVDA) lost $0.25 per diluted share on a GAAP basis in fiscal 2011's second quarter, which ended on 1 August 2010.  In last year's comparable quarter, NVIDIA incurred a net loss of $0.19 per share.  Both periods included substantial charges due to product failures caused by the same "weak die/packaging material set."

Excluding special items in both periods, non-GAAP earnings per share rose from $0.02 to $0.03.

This post examines NVIDIA's Income Statement for the latest quarter and compares the entries on each line to the "look-ahead" estimates we revised after the company's recent revenue-shortfall warning.  Since we hadn't anticipated the special charges that so greatly affected the GAAP results, our earnings estimate of $0.06 per share proved to be far too optimistic.  Non-GAAP earnings were $0.03 below our $0.06 earnings target.

The principal sources for the income statement analysis were the earnings announcement, the Chief Financial Officer's commentary, and the conference call transcript (available from Seeking Alpha).

In a second article, we will report NVIDIA's scores as measured by the GCFR financial gauges.  The follow-up post will also provide the latest figures for the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.

Before getting into the details, we will take a step back to introduce the subject of today's analysis.

NVIDIA is best known for the powerful Graphics Processing Units that rapidly perform the huge numbers of calculations required to produce hyper-realistic images for computers and video games.

Prior to fiscal 2011 (the current year), NVIDIA's business was divided for reporting purposes into four segments: GPU, Professional Solutions, Media and Communications Processors, and Consumer Products.  The GPU and MCP segments have since been consolidated.  The GPU segment, which had Revenue of $1.7 billion in fiscal 2010 (53 percent of the total), sells products for desktop and notebook personal computers.

On 12 August 2010, NVIDIA reached a licensing agreement with Rambus (NASDAQ: RMBS) in which the latter grants NVIDIA "a non-exclusive, non-transferable, worldwide license for certain memory controllers."  This agreement comes after a fair amount of litigation between the two companies, and it does not necessarily settle all existing disputes.

Additional background information about NVIDIA and the business environment in which it is currently operating can be found in the look-ahead.

Please click here to see a normalized depiction of the actual and projected results for the just-concluded quarter, as well as the quarterly Income Statements for the last couple of years.  Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats.  The standardization facilitates cross-company comparisons.

Revenue in the July quarter increased 4.5 percent, from $776.5 million last year to $811.2 million in the most recent three months.

When compared to the first quarter of 2010, Revenue fell 19 percent.

In May, NVIDIA issued guidance indicating it expected Revenue in the second fiscal quarter between $950 million to $970 million.  Near the end of the period, on 28 July, NVIDIA issued a press release warning that Revenue had in fact been much weaker, somewhere between $800 million to $820 million.

Most disappointing, the portion of Revenue attributable to the GPU business was only $550.4 million, 67.9 percent of the quarter's total revenue.  The actual amount was nearly 30 percent less than GPU revenue in the prior quarter.  NVIDIA blamed this dramatic sequential decline on rising costs and economic conditions that resulted in consumers, especially in Europe and China, choosing computers with less expensive graphical capabilities.  The company lost market share.

The Professional Solutions and Consumer businesses, both much smaller than GPUs, held up better and realized healthy sequential sales gains.  The Tegra® processor for mobile computing was behind the improvement in the Consumer market.

The Cost of Goods Sold (i.e., Cost of Revenue) was identified as $676.9 million.  However, more insight can be gained by breaking out a $181.2 million special charge from the reported amount and considering the charge separately.

CGS exclusive of the charge equaled 61.1 percent of revenue, which translates into a Gross Margin of 38.9 percent.  On this basis, the Gross Margin improved from 35.6 percent in the year-earlier quarter.  It was, however, much weaker than the 45.6 percent Gross Margin in the previous sequential quarter.

The Gross Margin also came in far short of the company's prior guidance of an "increase to 46 to 47 percent."

The Gross Margin would rise, perhaps substantially, if we also excluded "charges for a large inventory write-down" in the latest quarter.  The CFO stated that "unexpected consumer PC market weakness resulted in excess inventory of certain, primarily older generation, products."  Oddly, NVIDIA would not quantify the inventory charges.  We can't recall another instance when a company announced that it recorded a charge, but it wouldn't specify (or even estimate) the amount.  We don't have a positive view of this situation.

Research and Development spending increased 9 percent, from $193 million last year to $211 million in the latest quarter.  R&D expenses rose from 24.8 percent of Revenue to 26.0 percent.

R&D expenses were $9 million less than the $220 million we expected.

Sales, General, and Administrative expenses, exclusive of a $12.7 million charge, were $86 million, up from $74 million in the July 2009 quarter.  As a percentage of Revenue, SG&A increased from 9.5 percent to 10.6 percent.

The SG&A amount, exclusive of the charge, was in the middle of our two estimates.

As mentioned above, CGS included a charge of $181.2 million and SG&A included a charge of $12.7 million.  Both charges are tied to product failures caused by "weak die/packaging material set."  The affected products, shipped before July 2008, were used in computer notebooks.  NVIDIA had already recorded net charges totaling $282 million related to this same problem.  The company now says:

"The extra remediation costs are primarily due to additional platforms from late failing systems that we had not previously considered to be at risk and, to a lesser extent, higher remediation costs per unit. No new types of chips are involved." ...

"Also during the second quarter, NVIDIA reached a settlement with the plaintiffs of a class action lawsuit, consolidated in the District Court for the Northern District of California in April 2009, related to this same matter. Part of the charge we took relates to the cost of implementing this settlement. The settlement is subject to certain approvals, including final approval by the court.

Subtracting the various operating expenses described above from Revenue yields Operating Income of minus $175 million.  If the $194 million in charges is excluded, Operating Income was plus $19 million.  Compared to the last few quarters, Operating Income was adversely affected by much lower Revenue and Gross Margin.

Operating Income exclusive of the charges, $19 million, was somewhat less than our revised $36 million estimate.  It was far below our original, pre-warning estimate of $136 million.

Non-operating items (interest and other) summed to a net gain of $6 million, compared to the $5 million we had estimated.  

Part of the operating loss was offset by a $28 million tax benefit. 

GAAP Net Income was a loss of $141 million (-$0.25 per share), compared to a loss of $105 million (-$0.19 per share) in the year-earlier quarter.  Excluding the various charges, and adjusting taxes accordingly, non-GAAP Net Income was $20.1 million ($0.03 per share).  On this same basis, Net Income was $10.7 million ($0.02 per share) in the July 2009 quarter.

Coming after improved results in late 2009 and earlier this year, the second quarter's results were extremely disappointing, with weak revenue, diminished margins, and another round of special charges. 

Full disclosure: Long NVDA at time of writing.

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