Nvidia's Profit Has More Room to Run Thanks to This Technology

Nvidia (NVDA 3.65%) just reported another record quarter of sales, notching a 46% year-over-year growth rate to haul in $8.29 billion in its first quarter. Nvidia's top two segments, data centers and video games, grew a respective 83% and 31% from the year prior.

Along with the strong growth, Nvidia also reported record gross profit margin of 65.5% on products sold -- one of the best profit margins among semiconductor designers. But the company is undergoing a transformation of its business model, and CFO Colette Kress said profit margin has room to run even higher over the long term. This is fantastic news for Nvidia shareholders.  

Image source: Getty Images.

Software becoming a bigger part of the picture

Specifically, Kress had this to say about gross profit on the quarterly earnings call update:

We have been able to offset rising costs and supply chain pressures. We expect to maintain gross margins at current levels in Q2. Going forward, as new products ramp and software becomes a larger percent of revenue, we have opportunities to increase gross margins longer term.

A couple of details stand out in Kress' comment. The first is regarding new product launches. Back in March, Nvidia announced a slew of new chips aimed at the data center segment -- which, by the way, surpassed video gaming as the company's top revenue generator in Q1. Production and sales of these new products will ramp up later this year, leading to the expectation that data center sales will increase every quarter for the rest of the year. That should help Nvidia maintain those record margins on products sold.

The second point is where things really get interesting. Kress said software will become a larger part of the picture as time goes on. One of Nvidia's keys to success is that it bundles free software with its hardware sales to make its chips easy to use. However, in recent years, the company has been extending its reach in this department with new cloud computing-based software for enterprises sold on a stand-alone basis. This is significant because software companies often have gross profit margins in excess of 70%, sometimes even well over 80%. 

In other words, the epic run Nvidia's gross margins have been on for years may not be over.

Data by YCharts.

So what about gross margin? 

Rising gross profit margins are a big deal. A rising gross margin is a first indicator a company is getting more efficient as it gets larger. As a company's margin on products and services sold increases, there's potential for net income and free cash flow to increase by an even faster pace (an effect in finance known as operating leverage). 

What are these new software services that could help drive Nvidia's profit margin? One of them is Omniverse, a suite of AI-powered software tools designed for collaboration and simulation. CEO Jensen Huang said in the earnings call that after just a couple of quarters of sales to large enterprises, some 10% of the world's largest companies are already Omniverse customers, and many more are currently evaluating it.

Perhaps in the future, Nvidia will offer some more granularity on just how much of its business is based on software licensing and subscription revenue. At the moment, the company reports its sales by end market.

Data source: Nvidia. YOY = Year over year.  

For now, though, know that software is a fresh, fast-growing segment for Nvidia that could transform its business model in the coming years. If the trend continues, Nvidia is poised to become not just a larger business, but also an even more profitable one.