Is NVIDIA's Tablet-Fueled Rally Sustainable?

Shares of graphics chip manufacturer NVIDIA NVDA have rallied over 10% in the last two sessions. On Monday, Microsoft MSFT announced its upcoming Surface tablet. The Surface will contain an NVIDIA Tegra processor that will be used in the first Windows tablet computer. Analyst Romit Shah from Nomura commented on the contract by saying “ It's a nice win. Gives confidence that NVIDIA can grow their mobile business over time.” Shah estimated that the contract will add $80-100 million to NVIDIA's sales this year. FBR Capital Markets' analyst, Craig Berger was slightly more cautious. In Berger's research report, he notes that “Nvidia sells Tegra chips going into tablets for roughly $25, and a several million unit build in calendar 3Q (from Microsoft) could drive $75M in Tegra revenues for Nvidia, getting it closer to annual Tegra guidance.” Although traders and analysts welcomed the NVIDIA news with open arms, some experts have been fairly pessimistic on the Microsoft Surface. Poor Surface sales could end the rally in NVIDIA, as a low demand for the Surface would translate into a low demand for NVIDIA's chips. Thus far, tablets made by companies other than Apple AAPL have failed to truly break into the market. For example, HP HPQ made a quick decision last year to discontinue its TouchPad tablet and sell the remaining inventory at a huge discount. The only exception has been the inexpensively priced Amazon AMZN Kindle Fire, which sells for $199. However, there are other catalysts that might drive NVIDIA's momentum. A Stifel Nicolaus analyst, Kevin Cassidy, noted that “there could be a combination of news helping NVDA. Clearly the surprise of the Microsoft Surface announcement, but also anticipation of the Google GOOG tablet next week. Many expect Google will be using Tegra 3. Thirdly, there is a supercomputer conference in Germany this week. Nvidia has had many announcements for their GPUs used as computing engines for the world's highest performance computers.” In spite of the uncertainty about the success of Microsoft Surface, all three analysts agreed that the NVIDIA shares were undervalued at the $12 level. Romit Shah stated that, “My belief is the stock will continue to trade up. Official price target is $18.” Craig Berger expressed similar views in his report: “We like NVDA shares currently given our view that shares are oversold in the $12 range (they have over $5/share of cash) and overbought as they stretch beyond $17-$18, and with shares trading at 1.1x EV/S.” On Wednesday, NVIDIA traded above the $13.50 level, or 14 times its next 12-months' estimated earnings. You can follow me on Twitter @TuomoKallio