After nearly two years of sky-high returns, Nvidia (NASDAQ: NVDA) appears to finally be taking a breather. The stock fell in after-hours trading Wednesday after a robust earnings report. Nvidia beat estimates, but by a more modest margin than investors are used to.
Revenue rose 122% from the year-ago quarter and 15% sequentially to $30 billion, topping estimates of $28.7 billion. Below the line, adjusted earnings per share rose 152% year over year and 11% from the prior quarter to $0.68, topping the consensus of $0.64. That was the smallest earnings beat the company has had since the generative artificial intelligence (AI) boom began.
Nvidia continued to benefit from rising demand from cloud infrastructure companies, which accounted for 45% of revenue, as well as the broader shift toward accelerated computing and generative AI. The company also issued a better-than-expected outlook for the third quarter, with revenue of about $32.5 billion, up 79% from the year-ago quarter.
There was one downside to the earnings report that likely contributed to the sell-off, however, and investors should not overlook it.
Nvidia’s gross margin is falling
One of the most important metrics in the semiconductor industry is gross margin. Unlike software companies, most of the costs that hardware companies face come from the cost of goods sold, or the direct costs associated with producing chips and components.
Since the generative AI revolution began, Nvidia’s gross margin has expanded rapidly, a sign that the company is benefiting from pricing power and scalability. The chart below shows the company’s gross margin through the first quarter of fiscal year 2025, which ended in April.
As you can see, Nvidia’s gross margins have skyrocketed since the generative AI boom began, from less than 65% before AI demand took off to over 78% in the first fiscal quarter. However, gross margin fell to 75.1% in the second quarter on a generally accepted accounting principles (GAAP) basis.
The company said this was due to a higher mix of new products in the data center segment and inventory write-downs related to the Blackwell launch, but it shows that Nvidia appears to have hit a ceiling with its gross margin expansion. This adds another risk to the stock, as declining margins would impact profitability. This sequential decline in gross margin translated into slower sequential growth on the bottom line than on the top.
The company expects gross margin to decline slightly again in the third quarter to 74.4%-75.0% and is targeting a mid-70% range for the full year, potentially indicating further weakness in the fourth quarter.
Why Gross Margin is Crucial
Gross margin is the single most important determinant of overall profitability in the semiconductor industry. It is a reflection of a company’s pricing power and efficiency.
As you can see in the chart below, Nvidia is now significantly ahead of its competitors.
Nvidia’s gross margins are a testament to its strength and competitive advantage in AI, but if the competition from AMD and others begin to impact Nvidia, it will likely be reflected first in lower gross margins.
What it means for investors
Given that Nvidia’s overall revenue and profit growth remains strong, even on a sequential basis, and the upcoming launch of its Blackwell platform in the fourth quarter is expected to drive another surge in demand, the gross margin decline is not an emergency.
Investors should watch the number in future quarters, however. If this crucial margin continues to decline, it could portend bigger problems for the company.
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Jeremy Bowman has positions in Broadcom. The Motley Fool has positions in and recommends Advanced Micro Devices, Nvidia, and Qualcomm. The Motley Fool recommends Broadcom and Intel and recommends the following options: short November 2024 $24 calls on Intel. The Motley Fool has a disclosure policy.
Nvidia Stock Investors: 1 Red Flag You Shouldn’t Ignore was originally published by The Motley Fool
