Should Nvidia investors worry about its declining gross margin?

Actions of Nvidia (NVDA 1.51%) they sold off after the company’s recent earnings report and are now down about 11% from their all-time high.

Nvidia continues to post excellent growth, with revenue up 122% in the quarter, beating analysts’ expectations. But with the stock surpassing a $3 trillion market cap and extremely high expectations, Nvidia sold off after the release anyway.

One reason could be concern about the company’s gross margin. Here’s what happened to this important metric last quarter, and whether investors should be concerned about it.

Why Gross Margin Is First for Nvidia and AI Stocks

As the AI ​​revolution took off, cloud computing companies and large enterprises have been clamoring for as many of Nvidia’s data center GPUs as possible. The mismatch between supply and demand has allowed Nvidia to charge a premium for its chips even as volumes have increased. As a result, its gross margin expanded from a range of 55% to 65% “pre-AI” to 78.4% in the company’s first quarter this year, which ended in April, while operating margin expanded from a range between 20% and 40% for all up to 64.9% in the first quarter.

NVDA gross profit margin (quarterly) data by YCharts

But as you can also see, gross and operating margin were down in the recently reported second quarter compared to Q1. Gross margin fell to 75.1%, a decrease of 3.3 percentage points, and operating margin fell to 62.1%. Meanwhile, on the conference call with analysts, CFO Colette Kress estimated a gross margin of just 74.4% in the current quarter.

This could suggest a reduction in demand or a price pushback from big customers who may be tired of paying through the nose for Nvidia chips. After all, investor concerns about cloud customers getting a return on all their AI spending is what drove tech stocks lower this summer.

But Nvidia gave different reasons for the decline

In the release, Nvidia noted that the gross margin decline was due to “a higher mix of new products in the Data Center and inventory dispositions for low-yield Blackwell material.”

That explanation should let Nvidia shareholders breathe a sigh of relief, at least for now. Nvidia’s upcoming Blackwell chip was known to be slightly pushed back due to a manufacturing defect discovered late in the manufacturing and sampling process.

On the call, Nvidia noted that it made a change to the GPU mask at its foundry, Taiwan Semiconductor Manufacturing (TSM 1.51%)to improve production yields. Of note, this appears to be a minor change, as CEO Jensen Huang noted that no functional changes to the chip are required. However, it seems that there were enough flaws in the initial growth of Blackwell sampling that Nvidia had to scrap enough chips from early production at TSMC.

It is not clear how much of the gross margin decline was due to inventory depreciation. But the remaining margin decline was attributed to a “mixed shift to new products.” This is where things get murky.

Nvidia’s gross margin could continue to fall back to earth. Image source: Getty Images.

Can new products achieve the same margin?

In chip manufacturing, newer products often take time to increase their yield as the manufacturing process is perfected over time. But is Nvidia’s gross margin decline due to lower initial yields from manufacturing, or is Nvidia increasingly limited in the premium it can charge for new products?

Make no mistake: the current workhorse, the H200, is undoubtedly more expensive than the H100. However, newer products are also more complicated, and therefore expensive, for TSMC.

So it’s unclear whether the rest of the gross margin decline is due to lower initial yields, which eventually increase more as production ramps up, or if Nvidia, while charging more money for new products, can’t keep the same margin as sticker price. for newer chips go higher.

After all, Nvidia noted that 45 percent of its revenue comes from cloud service providers, all of which are now pursuing their own AI accelerators designed in-house to cut costs. In addition, Meta platforms (META 0.60%)which is not a cloud service provider, but probably also accounts for a large part of Nvidia’s revenue in addition to the 45%, has also started designing its own accelerators. And rival Advanced microdevices (AMD 2.11%) estimates sales of more than $4.5 billion for its AI MI300 line of GPUs, which just came out this year, should keep Nvidia on its toes.

All of these companies, however, should continue to buy Nvidia chips. Nvidia still makes the most advanced third-party neutral GPU chip, and with developers already very familiar with its CUDA software, Nvidia should continue to see strong sales over the next few years.

But with all its major customers now chasing their own lower-cost, self-designed alternatives, and with more competition, Nvidia will have to compete all the more. That can come either by staying one step ahead on the hardware side, or by lowering prices — or both.

Therefore, Nvidia investors need to keep an eye on gross margin, or perhaps patterns of margin erosion in the coming years, even as revenue increases.