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nVidia recently turned in quarterly results that looked good, yet at the end of the day the stock kept falling. A little digging revealed nVidia had a bad miss on gross margins. “NVDA reports Q1 gross margin of 28.6% vs. 35.5% street expectation”. Thank you Briefing.com.

The next day brought confirmation: the company had been negatively assessed by many analysts over gross margins. You can’t blame the analysts. Gross margins is the single most important metric by which tech companies are evaluated.

Wrote one analyst: “without concrete evidence of a major design improvement, we would expect NVDA’s cost structure to remain less competitive than AMD’s and hinder its margins and profitability” (Tech Trader Daily).

JoAnne Feeney’s comments are a thinly veiled reference to nVidia’s practice of creating big graphics chips as opposed to AMD’s “sweet-spot” strategy of making smaller graphics chips. Bigger graphics chips are more expensive to make in part because you get fewer graphics chips out of each silicon wafer.

Feeney and others think that nVidia should mend its big-chip ways and pursue smaller chips like AMD makes.

First of all, I would like to say, gross margins are very important, and nVidia needs to raise them, and nVidia would probably be the first to say this.

Second of all, something’s wrong if you’re downgrading nVidia and upgrading AMD on the basis of their Q1 gross margins.

Retail

Retail has been on a tear lately, with many companies putting up results that have beaten expectations. Still, the beats primarily came from cost cutting and inventory management. What is needed now, experts say, is top line growth:

“What we need now is top line growth. David Berman, who runs a hedge fund that specializes in retailers, and others noted to me this morning that while cost cuts are clearly working, top line growth has been meager. It’s time for the top line to kick in.” (CNBC)

Unlike retail stores, however, the top lines of semiconductor companies have been improving since February.

Same-store sales stand to retail like gross margins stand to tech: it is the key metric by which the industry is judged.

It is interesting to note that retail stocks rallied recently based on bottom-line results and not same-store sales. Same-store sales in fact appear to have been down, and yet “most professional traders in retail stocks are not worried about the lack of topline growth” (CNBC).

It is as if there is a tension between the forces that drive stocks and the rules that the professionals use to move the market.

The Semis

I once read that in a recession technology is a trailing indicator: that tech is the tail of the dog. I can’t speak for past recessions, but in the current recession the statement that tech trails is false. The semis in particular led the latest rally.

First there were rumors of rush orders, though people did not put too much hope in them. In February however the top lines of almost all companies having anything to do with semiconductors, as reported in Digitimes, bounced. It wasn’t just one company, it was the whole group.

While revenue rose in February, compared to January, the good news didn’t start to trickle in until the first days of March. This was about the time the market in the U.S. hit its latest rock bottom, March 6 or March 9. Two months after, and it was as straight up as stocks ever are.

If that weren’t enough, the rally began to correct as top-line growth for the semis started to stall. News began to trickle in during May. Top-line growth in the semiconductor sector appears to have peaked in April.

I wish I could tell you that the bounce in the top lines of semiconductor companies reflected real end-user demand. I’d be lying.

The top-line bounce had everything to do with inventory and not much with end-user demand. Downstream companies had stopped placing orders for semiconductor products in the fourth quarter and began living off existing inventories. The bounce in the top lines of semiconductor companies from February to March reflected that downstream customers had finally depleted supplies.

Some analysts refused to upgrade the semiconductor sector because they saw the bounce in the top lines as an inventory issue. They were certainly correct in seeing it as inventory.

The point however is that stocks did not seem to care if this was an inventory issue or not. Some semiconductor stocks went up over 100% from their November lows.

nVidia among them.

Green Shoots

Comparisons with other semiconductor companies is made difficult in that nVidia does not break out its financials by month the way Digitimes does for the semiconductor companies it covers: also by the fact that nVidia reports a February-through-April quarter. For example Intel’s and AMD’s Q1 results were weighed down by the month of January, which was bad for almost everyone.

But if we can’t make apples-to-apples comparisons, at least we can look for green shoots.

nVidia’s top-line results sequentially were about as strong as any that have been published. Desktop GPUs (graphics processors) were up almost 50%. Notebook GPU 28%. Core logic was up about 94% (Earnings Call Transcipt).

Gross margins were hurt largely by softness in workstation graphics. Until the enterprise comes back, nVidia’s gross margins could remain pressured.

In the meantime, nVidia continues to spend on R&D. If the enterprise ever comes back, nVidia will be there, with a big chip to address those parts of the market demanding the most performance.

Disclosure: long nVidia and Intel

A Bellwether of Semiconductors

When Cisco reports earnings, it is one of the first companies to offer insight into how the calendar quarter is progressing for the economy, since its fiscal quarter is one month behind the calendar quarter.

The same might be said of nVidia, except that nVidia is more specific to semiconductors. Many semiconductor companies reported a quarter that ended in December, then nVidia’s financial results included January. When nVidia issued a warning last month, it was a heads-up that January was shaping up to be a bad month too for the industry.

Most people seem to have overlooked the single most important fact for the semiconductor industry to come out of nVidia’s last fiscal quarter. Inventory in the supply chain has at last contracted to the point where the customers of semiconductor designers should start placing more orders again soon.

The problem so far, for semiconductor companies and many others, has been a reset in end-user demand and consequent glut of inventory in the supply chain. The inventory in the channel needs to burn off, so the semis can start taking orders again that are more reflective of end-user demand. The big news out of nVidia is that “inventory levels are depleting very quickly” (Earnings Call).

Taking excess inventory out of the supply chain does not mean we are out of the woods, but it is an important step. End-user demand is still weak, but it’s not as weak as the financial results nVidia and others reported last quarter.

Graphics Processors (GPUs)

Eyebrows must have been raised when nVidia warned in January that revenue would be down 40-50% sequentially. The reason why this warning was surprising was there were cogent reasons to think nVidia was doing well in the competitive marketplace.

Market share seems to have accelerated with, of all things, a driver update. Big Bang II gave nVidia a significant edge in performance on most new games. In particular, nVidia’s second best GPU, which competed head-to-head with AMD’s best single GPU, the Radeon HD 4870, pulled ahead often by wide margins.

The release of the drivers appears to have been well timed. It seems nVidia was holding back on releasing the drivers until shortly before the Christmas buying spree. As one website put it after benching the two cards, “Be sure when you set [sic] on Santa’s lap you tell him no GTX-260 Core 216 or don’t slide down my chimney!” (Bjorn3d).

Possibly most important nVidia launched the GeForce GTX 295 in early January. With the GTX 295 nVidia took back the single graphics card crown. The best graphics processor and the best graphics card are not necessarily the same. Both AMD and nVidia put two graphics chips on a single card to try and make the best overall performing card. It’s a halo product, probably carrying significance far beyond itself. Whoever, has the best single card, no matter how it is made, is often perceived to have the best graphics chips.

Also important, nVidia improved the best single graphics processor on the market with the GeForce GTX 285.

The result was nVidia took market share in calendar Q4 and almost certainly in nVidia’s fiscal Q4 too. Revenue was still sharply down, but market share was up. Consequently the CFO said: “we believe we regained some market share particularly in the high end” (Earnings Call).

So we had a good idea that nVidia was doing well competitively, and yet, what to make of the news in mid-January that revenue would be down 40-50% sequentially?

Investors had lost sight of what they knew: inventory in the supply chain was contracting, and nVidia has exposure to a lot more than just desktop graphics.

In the event desktop graphics did better than everything else, down 34%.

Notebook graphics, a high-growth segment, were down almost twice as much at 63%. Is this cause for alarm? Not necessarily. We know that the supply chain for notebooks is very long, so there is more inventory to take out, and we know that inventories now are lean.

The only uncertainty in my mind is how much of the drop off in workstation graphics was inventory correction, and how much of it was share loss. AMD has a good chip, nVidia had almost all market share, so one would expect AMD to take some share.

Revenue came in right where nVidia warned, 46% down. To be sure, there were other things in the quarter that could have been better such as nVidia’s own inventory. Nevertheless, if analysts are upset, it seems primarily because they feel nVidia is spending too much money.

Investing Out of the Recession

The same day nVidia reported earnings, Intel made an important announcement that morning. Intel would spend $7 billion investing in its factories in the U.S.

The investment will help Intel maintain its lead in process manufacturing, possibly even extend that lead. However $7 billion in spending should also provide a boost to the economy. The president of the U.S. is alleged to have said “it was the first real piece of good economic news he had received since taking the oath of office” (CNBC).

Intel’s CEO exhorted others to do the same, invest in the downturn to help lead the country and the world out of the mire it is in: “we want to lead by example here and ask others to follow” (Forbes).

Other companies were unlikely to follow suit, suggested one headline (Dow Jones).

The announcement of $7 billion did little to help Intel’s stock, which dipped as much as 7% that day. I would ordinarily chalk up such a dip to coincidence if it were not for the hard time analysts gave nVidia later that day for doing the same thing Intel was doing. nVidia’s stock slumped as much as 15% the following day.

I couldn’t help but be struck by the irony. Banks and Wallstreet greed are what got the world in its current mess, and here were representatives of these institutions frowning upon companies for doing something that could help recovery, not to mention which was good for the companies doing the investing.

A Little R&D

nVidia’s most damning technology critic has suggested that there has been a departure of engineering talent from nVidia: “the good people are now at Intel” (The Inquirer). Against this, Jon Peddie suggests AMD and nVidia “have probably 4x the number of world class graphics engineers that Intel has” (Hexus). I don’t know which of these views is closer to the truth. But one thing is certain. nVidia is using the recession to beef up its talent.

Warren Buffet is buying stocks in these dark times. To the CEO of nVidia, however: “It’s a great time to recruit” (VentureBeat).

Headcount has increased by 127 sequentially and by 435 year over year. Humorously these increases come with a hiring freeze in place and “with only the most critical positions being filled” (Earnings Call).

The recruiting appears to be a part of a much larger investment in R&D. The company is spending more this year than “last year — by a lot” (VentureBeat).

Analysts’ Reactions

Admittedly this recession is not making the jobs of financial analysts easier. For one, seasonality has been thrown out of the equation, and analysts still have to predict results.

Q1 is usually not as good as Q4, because Christmas and other holidays are in Q4. So one would normally think revenue for Q1 would be down from Q4. However, the contraction in the supply chain has thrown all such adjustments into question. The CEO interrupted one analyst: “there’s nothing that we’re experiencing right now that is seasonal” (Earnings Call).

Instead of accounting for typical seasonality and guiding down from the fourth quarter, management observed that the company’s selling into the channel was less than the selling from the channel. At some point soon they should start to see more orders. nVidia consequently guided flat to up on sales, though they don’t know “when and by how much revenue will increase” (Earnings Call).

Revenue projections being what they are and expenditure estimates being what they are, it does not appear nVidia will break even in Q1. nVidia is making cuts in spending; however these cuts are not based on trying to meet a breakeven point. Management was quick to point out to one that nVidia is cutting Op Ex not based on a breakeven but on “what we can do without jeopardizing future revenue” (Earnings Call).

Just so you’ll know, nVidia ended the quarter with $1.26 billion, which was down about $49 million since last quarter, so it’s not like they are burning through cash at an alarming rate. They will burn through some cash, though.

It has been said so many times that it sounds stale, you invest your way out of a recession. No one however has said it better than Marvin Burkett, the CFO of nVidia.

One analyst went so far as to say that things were so bad that future growth wouldn’t be hurt, so why not cut spending more? Sigh. The CFO replied that he did not know how long the recession would last. However, there was one thing he did know. “I do know the only way out of recessions and significant recessions like this is not by cutting your future. The way out of the recession is by investing in future revenues” (Earnings Call).

Larrabee

One of the reasons nVidia needs to heavily invest in R&D is they have a tiger by the tail. Intel is set to enter the fray of discrete graphics processors.

It doesn’t help relations between Intel and nVidia when Jen-Hsun Huang, the CEO of nVidia, says things like “the GPU is the new soul of the PC” (Earnings Call). In the latest spat between the two companies, the CEO penned, “the CPU has run its course” (nVidia).

Intel will soon leverage its advantage in process technology to deadly effect. nVidia will oppose Intel’s edge in process technology with product technology. However, Intel is smart, and even Intel knows not to directly take on nVidia head-on in graphics. Larrabee is a very different animal. Intel does not even like to refer to Larrabee as a graphics processor; rather it’s a visual processor.

Larrabee will have achieved its end if it can establish a toe hold in any part of discrete graphics. Intel is steady and methodical in what it does and is not in my opinion aiming for a knock-out blow. At least not at first. If Intel can achieve a measure of success with such a radically new part, perhaps Intel and nVidia can both grow the market in different directions. I hope so. The industry needs competition.

For the moment, however, nVidia appears to be taking seriously Intel’s entry into their business and is preparing accordingly.

I’m sure that Abu Dhabi would love for Intel to stop investing in process technology throughout this recession. Because Abu Dhabi will not stop investing in AMD’s fabs.

Similarly I am sure Intel would love for nVidia to stop investing in visual computing. For Intel is not going to stop investing in it.

Maybe nVidia is not spending enough?

Disclosure: long NVDA and INTC

As early as August of last year Jen-Hsun Huang, NVIDIA’s CEO, said of netbooks, “that’s just not our target. I mean, there are a lot of things that are not our targets and that just happens to be one of the things that is not our target” (Earnings Call Transcript).

That was then. This is now. Since that time, the recession has turned global, netbooks are thriving like tubeworms at the bottom of the Atlantic, and NVIDIA’s CEO is singing a different tune. NVIDIA recently announced plans for Ion, which is Intel’s Atom processor combined with NVIDIA graphics, for netbooks. The buzz surrounding Ion is reminiscent of the first Centrino.

The Nvidian CEO recently gave a couple of interviews, which contain information that may be of interest to investors.

Ion

It did not take a great leap of the imagination to see Ion coming. NVIDIA has been contending for some time that graphics processors (GPUs) been growing in importance and that to get the most bang for your buck, system integrators could wed a less powerful CPU with a more powerful GPU.

When Intel brought Atom to market, it was natural to think of what might happen if one were to pair Intel’s smallest microprocessor with high-end NVIDIA graphics. Ion however does not use NVIDIA’s highest-end graphics chips but rather the same chip that is used in recent Apple notebooks.

Intel

When Ion was announced, it did not take long for the rumor mill to swing into action. About a week later, it was said that Intel would not allow Atom to be sold separately from Intel core logic (DigiTimes).

Intel quickly replied that this is not the case, “there is no exclusionary bundling in play” (InternetNews).

But what if Intel allowed Atom to be sold separately but charged a ridiculous amount? Of such speculation the NVIDIA CEO “brushed it off so far as rumors” (LAPTOP Magazine).

At this point, only one thing is certain; NVIDIA really likes Atom. “Intel’s Atom is a fabulous processor” (VentureBeat).

Atom

Management at NVIDIA and AMD–unlike NVIDIA and Intel–seem to communicate with one another, and I say this because they frequently say the same thing with a slightly different spin, and it seems improbable that such similarities of content originate entirely separately. Case in point, NVIDIA and AMD both say that they don’t see much difference between netbooks and other notebooks or computers, other than obvious differences in size and cost.

To this it must be pointed out that, though they may look similar, the hardware underlying netbooks is quite different than that of other Intel notebooks. The CPUs are based on entirely different architectures. Perhaps Intel has a point that the Atom CPU was designed for a different type of machine than a notebook.

AMD

AMD does not have a comparable chip to the Atom, so AMD hardware cannot as easily go into netbooks. That will not stop AMD, however, from trying to take market share from netbooks. The idea is pretty simple: prey upon the frustrations many feel using netbooks, win away their business, and offer most of what netbooks offer but with a larger screen and fuller PC experience.

NVIDIA’s CEO thinks that Ion, because of its strong graphics, would be competitive with such products from AMD that would try to take market share from netbooks, and that Ion would be better in some ways. The beefier CPU and GPU of AMD’s platform may trump an Intel netbook in sheer performance. The Ion, however: “That’s totally different” (LAPTOP).

Design Wins

So when might we expect to see netbooks based upon Ion? Don’t hold your breath. “Design cycles are typically less than a year” (VentureBeat).

Another processor investors should watch is NVIDIA’s application processor which is to power smart phones in conjunction with ARM processors and run a version of Windows CE.

Design cycles for smart phones or Internet devices with Tegra appear to be even longer than netbooks. It “typically takes a year or year and a half to get to market” (LAPTOP).

VIA Nano

AMD and Intel are not the only two companies to manufacture CPUs. There’s also a small company on the other side of the world which makes a CPU that targets low-power devices.

When NVIDIA announced Ion, it was assumed that NVIDIA was dumping VIA and the Nano processor. This appears to be inaccurate. NVIDIA is a processor-agnostic company and will make graphics for any processor, be it Intel, AMD, ARM, or VIA.

In fact, the CEO of NVIDIA said his company is a huge fan of the Nano and intends to include it in “our next-generation Ion platform” (LAPTOP Magazine).

While NVIDIA is CPU agnostic, NVIDIA has no intentions to enter the CPU market itself. To the CEO’s thinking, that would be like reinventing the wheel. “Why redo it?” (VentureBeat).

Fusion

AMD was the first company to announce that it was going to integrate graphics directly onto the CPU. AMD had scored a coup against its arch-nemesis Intel by integrating the memory controller directly onto the CPU. So, the thinking went, why not do it with GPU as well?

Such thinking may have seemed logical back then. However, it has become more and more likely that on-die graphics will never amount to more than a mainstream part and not the high-margin, high-performance part once hoped.

Technology moves too fast, and to integrate graphics on the CPU is to lock one into yesterday’s graphics for a period of 3-5 years. Said NVIDIA fellow David Kirk and chief scientist at the time: “A device with a mix of GPU and CPU cores would be a great product for the low end” (EE Times).

That being said, there may very well always be a place for affordable good-enough graphics, and such graphics may be integrated on the CPU. This is a space in which NVIDIA typically does not play, and the CEO’s response to on-die graphics was “That’s OK” (VentureBeat).

AMD’s Rich Uncle

Those who say that AMD could fold any day now seem to be unaware that AMD has an investor with deep pockets. How deep? Abu Dhabi recently invested $8.4 billion in AMD. That’s not a typo.

Apart from the backing from Abu Dhabi, AMD should be bankrupt right about now. Jen-Hsun’s take on AMD and Abu Dhabi is interesting. “They couldn’t have survived without the Abu Dhabi deal”.

Abu Dhabi doesn’t “want the microprocessor business. They don’t understand it. They want a manufacturing business”. Getting Abu Dhabi to invest in AMD was “a brilliant deal that saved the company”.

Is NVIDIA worried about Abu Dhabi’s deep pockets and their support of NVIDIA’s principal competitor? Not at the moment. Of AMD Jen-Hsun said: “We are miles ahead of them in GPU computing” (VentureBeat).

GPU Computing

NVIDIA is primarily known as a graphics company. However, the company has started to extend its graphics technologies beyond graphics to non-graphics applications. Applying a GPU to non-graphics workloads is known as GPU computing.

Not all applications lend themselves equally well to GPU computing. Most do not. However, for those that do, speedups are being seen sometimes by an order of magnitude in the hundreds. NVIDIA has been investing in GPU computing for quite some time, and GPU computing has, in the opinion of the CEO, “passed the tipping point” (VentureBeat).

Windows 7

The NVIDIA CEO appears to have done an about-face in regard to operating systems as well. Jen-Hsun used to be bullish on Microsoft Vista. “Any consumer will [enjoy] Vista”, he said way back in 2007 (F3Q08 Transcript).

There’s only one problem with that. Vista is too resource hungry to run on netbooks. This is a problem because netbooks are the fastest (only?) growing segment in the PC industry today. Enter Windows 7. “Windows 7 will go all the way down into the cheap PCs. Vista didn’t” (VentureBeat).

Brave New World

One thing that makes NVIDIA unusual in the current environment is the aggressiveness with which it is investing in R&D. The company is investing more not less. It is investing more, not just trying to keep expenditure of R&D level. Said Jen-Hsun: “I’m going to invest a lot more in R&D this year than I did last year — by a lot” (VentureBeat).

Foolish? Only time will tell.

The CEO contends that a lot of things will be different when this recession ends. It may be that all consumers will want is something that looks like a netbook but which is much more powerful. “I am prepared for that outcome” (VentureBeat).

If and when this recession ends, and the smoke clears, there will likely be two main chips inside netbooks, smart phones, and other Internet devices and computers. The CPU and the GPU. The CEO of NVIDIA: “I will have one of them” (VentureBeat).

Disclosure: long NVDA and INTC