The rise of Nvidia (NASDAQ: NVDA) has been nothing short of incredible. No company has grown as quickly as Nvidia at the scale that it is. But that's all in the past; investors want to know what's in store for Nvidia stock in the future.
The problem is that Nvidia's future is extremely cloudy. While it could continue its rapid growth, it could face challenges with its primary products.
Nvidia's GPU growth has been phenomenal
Nvidia's primary products are graphics processing units (GPUs). These hardware pieces were originally intended to process gaming graphics quickly, but their use case has expanded beyond that. GPUs can run engineering simulations, research drugs, mine cryptocurrency, and, most importantly, train artificial intelligence (AI) models. The latter has contributed substantially to Nvidia's rise during the past year and a half.
GPUs are a top pick for running enormous workloads because they can split a calculation into multiple parts and compute in parallel. Furthermore, GPUs can be combined in a server to multiply this effect. In fact, the primary limitation to building one of these powerful servers to run AI models on is a company's checkbook size.
The explosive growth AI has provided can be seen in Nvidia's data center revenue, which rose 427% year over year to $22.6 billion in the fiscal first quarter (ended April 28). Perhaps more impressive is that it rose 23% quarter over quarter, which shows demand is still rapidly increasing. All things being equal, if a company increases its quarter-over-quarter revenue by 25%, the quarterly revenue would have more than doubled by the end of the year. Nvidia is right at that mark, and the quarter-over-quarter revenue is one of the best signs to examine and see if demand for its GPUs is still there.
Additionally, the largest tech companies have indicated to investors that they plan to continue increasing their spending to build up computing power for AI demand. This bodes well for Nvidia because it needs its clients to continue spending to stay afloat.
But there may be more to the story.
Nvidia's profit margin is at a record level
There's an old saying: "Your margins are my opportunity." And this could become an issue for Nvidia.
NVDA Gross Profit Margin (Quarterly) data by YCharts
Nvidia's gross and profit margins have widened to record levels, which is fantastic for investors. But they may be unsustainably high. Some of its largest clients have already developed their own chips in-house to replace GPUs for their AI computing infrastructure. This is likely in response to the high prices they must pay for GPUs.
Take Alphabet's tensor processing unit (TPU), for example. When an AI workload is properly configured, the TPU can achieve much higher performance than a GPU. With each major cloud computing company having its own product, it could become an issue for Nvidia.
Still, GPUs are fantastic at running AI models and will continue to be used heavily, but investors should be wary because Nvidia's margins may soon come under pressure.
If Nvidia's profit margin returns to its previous high peak of about 40%, it will take about 42% more revenue just to generate the same profits it can generate now at its 57% profit margin. That's concerning because Nvidia is already priced at a premium.
NVDA PE Ratio data by YCharts
So, what might Nvidia's stock look like in three years? I'd say the company will still be a stalwart, producing an incredible number of GPUs to satisfy the demand for AI. However, I wouldn't be surprised to see the stock around the same levels due to margin compression.
This is an underrated consideration when investing in Nvidia. I think investors need to consider the possibility that even if its revenue continues to increase rapidly, its profit margin must stay elevated for the stock to make sense.
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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Keithen Drury has positions in Alphabet. The Motley Fool has positions in and recommends Alphabet and Nvidia. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
