Nvidia’s record profit margins may come under scrutiny in the future.
The rise of Nvidia (NVDA -0.14%) It’s been an incredible run of growth — no other company has grown as fast as Nvidia. But that’s all in the past, and investors want to know what the future holds for Nvidia stock.
The problem is that Nvidia’s future is extremely uncertain: It could continue to grow rapidly, but it could face challenges with its flagship product.
Nvidia’s GPU growth is phenomenal
Nvidia’s flagship product is the Graphics Processing Unit (GPU). This hardware was originally intended to accelerate game graphics, but its uses have expanded beyond that: GPUs can be used to run engineering simulations, research medicines, mine cryptocurrency, and most importantly, train artificial intelligence (AI) models. The latter has been a major driver of Nvidia’s growth over the past year and a half.
GPUs are ideal for running massive workloads because they can split calculations into parts and process them in parallel. Furthermore, GPUs can be combined with servers to amplify this effect. In fact, the main limitation in building powerful servers to run AI models is the size of a company’s checkbook.
The explosive growth that AI has driven can be seen in Nvidia’s data center revenue. In the first quarter (ending April 28), revenue grew 427% year over year to $22.6 billion. Perhaps more impressive is the 23% quarter-over-quarter increase, which shows that demand is still growing rapidly. All things being equal, if a company grows revenue by 25% quarter over quarter, quarterly revenue will more than double by the end of the year. Nvidia is right on that bandwagon, and quarter-over-quarter revenue is one of the best indicators to see if there’s still demand for its GPUs.
What’s more, big tech companies have told investors they plan to keep ramping up spending to boost computing power to keep up with AI demand — a good sign for Nvidia, which depends on customers continuing to spend.
But there may be more to this story.
NVIDIA’s profit margins hit record high
There’s an old saying that goes, “Your profit is my opportunity,” and this could pose a problem for Nvidia.
NVDA Gross Margin (Quarterly) data from YCharts
Nvidia’s gross margins and profit margins have expanded to record levels, which is great for investors. But the levels may be unsustainably high. Some of the company’s largest customers are already building their own chips to replace GPUs for their AI computing infrastructure, likely in response to the high prices they have to pay for GPUs.
Take Alphabet’s Tensor Processing Units (TPUs), for example. If configured properly for an AI workload, TPUs can deliver much higher performance than GPUs. That could be a problem for Nvidia, as each of the major cloud computing companies has their own offering.
Still, GPUs are great at running AI models and will continue to be used heavily in the future, but investors should be careful as Nvidia’s profit margins could come under pressure soon.
If Nvidia’s margins were to return to their previous highs of around 40%, it would need to grow revenue by about 42% to generate the same profits that its current margins of 57% can produce. This is concerning, as Nvidia’s stock is already expensive.
NVDA price-earnings data from YCharts
So where will Nvidia’s stock price be in three years’ time? The company will likely remain a solid business churning out billions of GPUs to feed the demands of AI, but it wouldn’t be a surprise to see the stock price stay roughly the same due to margin compression.
This is an underappreciated consideration when investing in Nvidia: I think investors need to consider the possibility that even if revenue continues to grow rapidly, profit margins will need to remain high for the stock to make sense.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Keithen Drury holds shares in Alphabet. The Motley Fool holds shares in and recommends Alphabet and Nvidia. The Motley Fool has a disclosure policy.
