When digging into financial statements, it’s important to look at trends in metrics rather than just quarterly performance. This gives you a more accurate picture of how a company is performing. I’ve spotted the trends for Nvidia accurately. (NASDAQ: NVDA) Something investors should pay attention to.
The trend in this metric is worrying and could cause the stock price to fall.
Unprecedented demand for Nvidia’s GPUs boosted profit levels
Nvidia’s Graphics Processing Units (GPUs) have become a critical piece of computing hardware. Their ability to handle multiple calculations in parallel sets them apart from traditional computing methods, and makes them ideal for computationally intensive processes like training artificial intelligence (AI) models and running engineering simulations.
AI is a major driver of the surge in demand for Nvidia’s GPUs: The company’s GPUs are seen as unique because they are adopted by the biggest companies in the AI industry, allowing the company to essentially charge whatever price it wants.
This shows up in your gross profit margin, a figure that shows how much money you have left over after subtracting the cost of producing a product.
Historically, Nvidia’s gross margins have hovered in the high 50% to low 60% range, but thanks to this new wave of demand and the company’s market position, gross margins have jumped to about 75%.
However, gross margins declined slightly in the second quarter, to 75.1%, from 78.4% in the first quarter, and that decline is expected to continue in the third quarter, with management forecasting gross margins of 74.4%.
While this isn’t a huge drop, the trend is noteworthy. Typically, when a company’s gross margins fall, it means it has to lower prices to increase demand. Clearly, Nvidia doesn’t need more demand. But the drop could mean that alternative solutions are gaining traction and the company has to adjust its prices slightly.
This is just a drop in the bucket and may not mean anything substantial in the long run, but if worthy competition emerges and NVIDIA’s margins fall to historic levels, the company’s stock price could be in danger.
What will happen if Nvidia’s profit margins fall to historic levels?
If Nvidia’s profit margins return to historical levels, that won’t be good for the stock.
Assuming gross margins return to normal levels (60%) and current operating expense levels remain stable, Nvidia’s net income would be $12.2 billion (using Q2 tax rates), a 27% decrease from current levels.
The story continues
The expectations priced into Nvidia’s stock are outsized, trading at 55 times its past year’s earnings and 41 times future earnings.
If we reduce the denominator of the price-to-earnings (P/E) ratio by 27%, these figures rise to 75.6 times past earnings and 56.5 times future earnings.
That’s even more expensive, and with growth rates starting to slow as year-over-year comparisons become harder to make, the stock may not be able to command that premium.
So I wouldn’t be surprised to see the stock fall by a similar amount, unless you could snap your fingers and see Nvidia’s profit margins instantly fall. In reality, it will likely take some time for such a fall to materialize.
I’m not saying that Nvidia’s profit margins will return to previous levels, but investors should consider that new profit margin levels are very important to the investment thesis.
If gross margins continue to compress and then start to decline, the stock price may follow suit, but unless Nvidia’s competitors (or current customers) launch products that can match its GPUs, high gross margins are likely to persist.
Should I invest $1,000 in Nvidia right now?
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Keithen Drury 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.
One warning sign that could lead to a steep drop in NVIDIA shares was first published by The Motley Fool.
