Are Nvidia's 70+% Gross Margins An Opportunity For Other VC-Backed Firms?

VCs and other investors are starting to note that it is possible to make a lot of money - and take market share - with gross margins less than the 70% or more that Nvidia currently enjoys. 

The history of Silicon Valley is replete with examples of companies undercutting others in order to take share and, eventually, dominate. As unbeatable as Nvidia looks now, nothing in tech is forever. JL

Dan Gallagher reports in the Wall Street Journal:

Nvidia’s gross margins, which reflect direct costs of producing a company’s products, now stand at 70% on an annual basis. Nvidia credited the gross margin to “a significant amount of software and complexity” in its data-center products. TSMC—the Taiwan manufacturing firm that actually makes most of Nvidia’s chips—produced an operating margin of just under 50%, while the average for companies on the semiconductor index is 25%. Qualcomm, AMD andMarvell, which also outsource their manufacturing, command gross margins in the low 50% range. Sharply different profitability levels gives (others) the advantage of being able to underprice Nvidia and still boost margins. Nvidia’s ability to maintain pricing power—and its high margins—will only get harder from here. decrease; red down pointing trand Marvell, which also outsource their manufacturing, currently command annual gross margins in the low 50% range

The AI revolution has created a unique and high-quality problem for Nvidia NVDA 0.86%increase; green up pointing triangle: The chip maker makes too much money.

Nvidia has fallen under scrutiny over the past month as investors have come to worry about the sustainability of blowout artificial-intelligence spending. But another fear surfaced last week with reports that Google is looking to enter the AI chip market by selling the chip it designed in-house, known as a tensor processing unit or TPU, for its own computing needs.

Nvidia’s stock price has picked up some ground this week, but the shares are still down 12% since the company peaked at a $5 trillion market cap in late October. The Nasdaq composite has lost about 2% in that same time.

The recent decline has made the world’s most valuable company look cheap. Nvidia’s stock now trades around 26 times projected earnings for the next four quarters—close to its lowest multiple over the past five years, according to FactSet data. But that ratio is based on earnings expected over the next year that could come under pressure if stronger competition forces Nvidia to lower its prices.

 

A haircut to earnings would still leave Nvidia more profitable than most other chip companies, but the stock wouldn’t be quite the bargain it seems to be, despite the company’s still-commanding lead in the lucrative AI-chip market.

How lucrative? Nvidia has generated a little over $110 billion in operating income over the last four quarters. That equates to about 59 cents of operating profit for every dollar of revenue, far above what any other chip company on the PHLX Semiconductor Index commanded over the same period, according to data from S&P Global Market Intelligence. TSMC—the Taiwan manufacturing powerhouse that actually makes most of Nvidia’s chips—produced an operating margin of just under 50% for the same period, while the average for companies on the index is around 25%. 

Nvidia’s gross margins, which reflect the direct costs of producing a company’s products, now stand at 70% on an annual basis. That compares with an average of around 62% for the five-year period before sales exploded in mid-2023 from AI demand. Nvidia then credited the gross margin jump to “a significant amount of software and complexity” in its data-center products. Fabless chip companies Qualcomm, Advanced Micro Devices AMD -2.06%decrease; red down pointing triangle and Marvell, which also outsource their manufacturing, currently command annual gross margins in the low 50% range, according to data from S&P Global Market Intelligence.

AMD’s margins are particularly notable given that the company is gearing up for a major challenge to Nvidia’s dominance in the AI-computing market. The MI450 chips that the company plans to start shipping next year already have landed a major customer in OpenAI, and AMD Chief Executive Lisa Su told analysts last month that more major customers are coming.

 

Neither Nvidia nor AMD has publicly disclosed prices for their AI chips, which are generally customized for each major customer, making direct comparisons difficult. But their sharply different profitability levels gives AMD the advantage of being able to underprice Nvidia and still boost its margins. The company, in fact, has publicly committed to surpassing 35% in annual pro forma operating margins over the next three to five years, compared with 22% now. AMD’s pro forma margins exclude the cost of stock-based compensation and other charges.

Now, competition from Google adds a new wrinkle, as the search giant already has a highly profitable advertising business that can support an ambitious new venture like directly entering the AI-chip market.

Parent company Alphabet’s GOOGL 0.29%increase; green up pointing triangle operating cash flow of $151.4 billion over the past four quarters is actually the highest on the S&P 500. And landing a customer like Facebook-parent Meta Platforms META 0.97%increase; green up pointing triangle would be a big win for Google’s TPU efforts. Meta is a major Nvidia customer but has a strong need to secure as many AI chips as it can given Mark Zuckerberg’s ambitious goal of developing “superintelligence” before rivals like OpenAI get there.

 

News Corp, owner of The Wall Street Journal, has a commercial agreement to supply content on Google platform.

Analysts aren’t panicking about Nvidia yet. “In the near term, Meta using TPUs doesn’t materially affect our viewpoint on Nvidia despite the narrative headwind it creates,” Morgan Stanley’s Joe Moore wrote in a note to clients last week. Google itself is still a major Nvidia customer and frequently touts its access to the company’s most advanced products. Moore estimates Google now spends about $20 billion a year on Nvidia’s chips.

But Wall Street is still keenly focused on Nvidia maintaining gross margins in the 70% range—even with sharply rising costs for key components like memory. And Google’s latest chip advances, plus new offerings from AMD and Amazon’s AMZN 0.23%increase; green up pointing triangle latest Trainium 3 chip announced on Tuesday, show competition keeps picking up for a key market that Nvidia has long dominated. Nvidia’s ability to maintain pricing power—and its high margins—will only get harder from here.