1 Problem With NVIDIA's Gaming Growth Story

By Timothy Green Markets Fool.com

While the PC market as a whole has been slumping for years, the PC gaming market has only gotten stronger. Jon Peddie Research recently came out with a report pegging the size of the global PC gaming hardware market at $30 billion. This includes not only pre-built gaming PCs but also components like graphics cards and accessories like headsets and input devices.

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There has been no greater beneficiary of a growing PC gaming market than graphics chip company NVIDIA (NASDAQ: NVDA). As rival Advanced Micro Devices (NASDAQ: AMD) snagged contracts to supply chips for the major game consoles, NVIDIA's lead in the PC GPU market grew, driven by disruptive products like the GTX 900 series in late 2014. A combination of a growing PC gaming installedbase and market share gains has propelled NVIDIA's gaming segment to new heights.

Image source: NVIDIA.

But there's a problem

The growth that NVIDIA has been reporting in recent quarters has been stunning. The gaming segment, by far its largest segment, was largely responsible for driving the company's revenue higher in 2016. During the first three quarters, NVIDIA reported year-over-year gaming revenue growth of 17%, 18%, and 63%, respectively.

The major acceleration during the third quarter sent the stock soaring, and NVIDIA's fourth-quarter guidance suggests that another big increase is in the cards. The launch of NVIDIA's Pascal graphics cards, which have proven to be extremely popular, in mid-2016 was responsible for much of this growth. NVIDIA will also be supplying chips for Nintendo's upcoming Switch console, and CEO Jen-Hsun Huang attributed "a fair amount" of its gaming growth to that contract.

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Revenue from Nintendo will be seasonal, likely dropping off after launch and peaking each year prior to the holiday season. That's one reason why NVIDIA's gaming segment is unlikely to keep growing consistently at a 60%-plus rate. But there's another, more basic, reason that keeping up this growth will be tough: The PC gaming hardware market just isn't growing all that fast.

Jon Peddie Research estimates that the global PC gaming hardware market will grow at a 6% compound annual rate through 2019. That's nothing to sneeze at, but NVIDIA's gaming segment is ultimately constrained by the size of the market.

There are a few ways that NVIDIA can grow faster than the market as a whole. First, that $30 billion total includes plenty of products that aren't graphics cards. Graphics card sales could certainly grow faster than the market as a whole, driving up NVIDIA's revenue at a higher rate.

Second, the graphics card market could continue to shift toward the high-end, leading revenue to grow faster than units. The high-end of the gaming hardware market is its largest segment, representing 43% of revenue. NVIDIA has been largely focused on the high-end for the past few years, driving a portion of the company's ongoing margin expansion.

There's also one thing that can hurt growth. AMD will be launching its high-end Vega GPU during the first half of 2017. This will mark the company's re-entry into the high-end portion of the market, following the failure of its Fury line of graphics cards to make a dent in 2015. It would be difficult for AMD's competitive position to get any worse, so if Vega is competitive with NVIDIA's high-end products, the growth of NVIDIA's gaming segment could suffer.

The PC gaming market is a good place to be, and NVIDIA's focus on the high end has paid dividends. The company's gaming segment can certainly continue to grow at a healthy rate, with a double-digit pace certainly possible. But expecting the 63% growth rate of the third quarter to become the new norm isn't realistic.

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Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Nvidia. The Motley Fool has a disclosure policy.