NVIDIA's (NASDAQ:NVDA) stock recently plummeted after the chipmaker slashed its fourth-quarter revenue guidance from about $2.7 billion to $2.2 billion. NVIDIA attributed the drop, which would represent a 24% annual decline, to soft demand for its data center and gaming GPUs, particularly in China.
NVIDIA also admitted that sales of its new Turing GPUs were "lower than expected," and it slashed its non-GAAP gross margin guidance from a midpoint of 62.5% to 56%, which marks a sharp drop from 62.1% in the prior-year quarter. Simply put, NVIDIA told investors to brace for its worst quarter in years.
The soft demand for its Turing GPUs was particularly disappointing. Investors expected sales of the newer chips to offset some of the inventory issues with its older Pascal GPUs, which were hit with a supply glut after the crypto mining bubble popped. During the third quarter, NVIDIA's Gaming revenue -- which accounted for 55% of its top line -- rose 13% annually but fell 2% sequentially on those headwinds.
During last quarter's conference call, CEO Jensen Huang stated that it would take "one or two quarters" to stabilize its gaming GPU business. However, NVIDIA's ugly guidance cut indicates that it could take much longer. Moreover, Huang seemed to gloss over three troubling issues that are preventing core gamers from upgrading their cards.
1. The world's top PC games don't require powerful GPUs
In recent years, many core PC gamers pivoted away from graphically demanding "triple A" games toward multi-platform esports titles with lower GPU requirements.
Tencent's League of Legends, which is nearly a decade old, remains the top core PC game in the world according to Newzoo's latest rankings. Valve's Counter Strike: Global Offensive, which was released in 2012, ranks second, followed by Epic Games' Fortnite, the hit 2017 battle royale title that runs smoothly on low-end GPUs.
Other popular core PC games include Microsoft's Minecraft, Bluehole's PUBG, Activision Blizzard's Overwatch and World of Warcraft, and Take-Two's Grand Theft Auto V. These games all run like butter on NVIDIA's Pascal GPUs.
2. Gamers are postponing their upgrades
As a result, gamers are postponing their upgrades or simply buying used Pascal GPUs, which flooded the market after the crypto bubble popped. Newzoo recently reported that the three most popular GPUs among core PC gamers are the GTX 1060, GTX 1050 Ti, and GTX 1070 -- which are all Pascal-based cards.
The mid-range GTX 1060, which holds a 20% market share among gamers, costs $200-$250. The lower-end GTX 1050 Ti costs about $150, and the higher-end GTX 1070 costs $350-$400. NVIDIA's new Turing-based RTX cards are trying to replace the GTX 1070 in the $350 to $500 price range, but this strategy won't work if most gamers hold on to their cheaper Pascal cards.
NVIDIA also exacerbated the problem by challenging AMD (NASDAQ:AMD) in the low-end market with sub-$150 cards like the GTX 1050 and GT 1030 last year. That strategy boosted NVIDIA's market share in discrete GPUs from 72.8% to 74.3% between the third quarters of 2017 and 2018 according to research firm JPR. AMD's share dropped from 27.2% to 25.7% during the same period.
Therefore NVIDIA's attempt to lure away budget-conscious gamers from AMD paid off, but it was also a clear admission that most gamers didn't need higher-end cards. That's why the soft demand for its Turing GPUs wasn't surprising.
3. A lack of killer features
Turing GPUs offer more CUDA cores and memory bandwidth than Pascal GPUs. But the most notable (and widely hyped) upgrade was the addition of ray tracing, a technology that lets developers add real-time cinematic lighting and shadows to objects.
Yet only a handful of games currently support ray tracing, and none of them convinced gamers or developers that it was a killer feature for new games. In its latest press release, NVIDIA admits that customers "may have delayed their purchase while waiting for lower price points and further demonstrations of RTX technology in actual games."
Things could get worse
NVIDIA will report its fourth quarter earnings on Feb. 14, which should provide a clearer picture of the challenges facing its core gaming business. I personally think that NVIDIA can't overcome its gaming challenges in "one or two quarters" -- there's a clear lack of urgency as far as upgrades go, an abundance of cheaper Pascal cards, and a general lack of excitement about new features like ray tracing.
Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Tencent Holdings. The Motley Fool owns shares of and recommends Activision Blizzard, Nvidia, Take-Two Interactive, and Tencent Holdings. The Motley Fool owns shares of Microsoft. The Motley Fool has a disclosure policy.