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NVIDIA's Gaming Business Faces a Test on Thursday

After the market closes on Thursday, NVIDIA (NASDAQ: NVDA) will attempt to wow investors yet again with its quarterly results. The graphics-chip company's performance over the past year has been stellar. Revenue has been growing at a 50% clip, per-share earnings have been doubling, and the stock has more than tripled.

While most of the headlines go to NVIDIA's efforts in artificial intelligence and self-driving cars, the gaming business remains the core of the company. Gaming has been responsible for the bulk of NVIDIA's growth over the past year, and it accounted for a bit more than half of its revenue during the second quarter of 2017. There are some headwinds that will make maintaining that growth rate difficult in the third quarter.

A tough comparison

NVIDIA's GeForce 10 series of graphics cards launched toward the end of the company's fiscal second quarter last year. The high-end GTX 1080 came in late May, followed by the GTX 1070 in June, the GTX 1060 in July, and the ultra-high-end Titan X in August. These GPUs are based on NVIDIA's Pascal architecture, which provided major improvements in performance and efficiency compared to its predecessor.

To say that this launch was a success would be an understatement. During the fiscal third quarter of last year, the first full quarter following the launch, NVIDIA's gaming revenue soared to $1.244 billion. That's up 59% compared to the second quarter, and up 63% compared to the third quarter of the previous year. Aiding NVIDIA was the fact that its only competitor, Advanced Micro Devices (NASDAQ: AMD), had no real presence in the high-end graphics card market at the time.

NVIDIA lapped the initial launch of the 10 series during the third quarter of this year. The company has filled out its lineup with additional products, like the GTX 1050 and the Titan Xp, but the big sellers have been on the market for over a year. Bottom line: The growth rate in the gaming business is bound to slow.

Another wrinkle: AMD now has a stronger presence in the high-end graphics-card market with Vega. AMD launched Vega 56 and Vega 64 in August, and while the cards come with some major trade-offs, NVIDIA no longer has free rein in the most lucrative part of the market. Add these two headwinds up, and you get a potential snag in NVIDIA's gaming growth story.

Nintendo to the rescue

Despite a dearth of recent product launches and a resurgent AMD, there is one tailwind that will benefit NVIDIA's gaming business in the third quarter. NVIDIA managed to win the contract to supply chips for Nintendo's (NASDAQOTH: NTDOY) Switch gaming console, which launched back in March. Nintendo's previous Wii U console was mostly a flop, but the Switch looks like a runaway success so far.

The more Switch consoles that make it into consumers' hands, the more revenue NVIDIA receives for its chips. Nintendo sold 4.89 million Switch consoles during the six-month period ending in September, and it expects cumulative sales to reach 17 million by the end of its fiscal year in March. That's likely hundreds of millions of dollars in additional revenue for NVIDIA's gaming business.

AMD provides chips for the other two major consoles, the PlayStation 4 and the Xbox One. That business peaks each year in the third quarter as inventory is built for the end of the year. NVIDIA may get a similar tailwind in its third quarter as Nintendo prepares for what could be a very successful holiday season.

Lofty expectations

Following the surge in the stock price over the past couple of years, shares of NVIDIA now have some optimistic expectations built in. With a market capitalization of $125 billion, the stock sports some mesmerizing ratios: 15 times trailing-12-month (TTM) sales, 55 times TTM net income, and 64 times TTM free cash flow.

Those ratios can be justified if NVIDIA can keep growing at a breakneck pace. The data center and automotive businesses, which sell chips aimed at accelerating enterprise workloads and powering driver-assistance and self-driving features in automobiles, are still small, and they could be set for many years of growth. The gaming business may be a different story, and a slowdown there could make it difficult for NVIDIA to grow fast enough to satisfy investors.

We'll know Thursday whether NVIDIA's gaming business can keep impressing investors. It will need to overcome increased competition and the lapping of blockbuster results last year. The Nintendo Switch will help the cause, but it may not be enough.

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