Nvidia's (NVDA -2.68%) gaming business was a mess in its fiscal third quarter ended Oct. 30. Revenue tumbled 51% year over year and 23% from the previous quarter as a combination of weak demand and partners working feverishly to reduce inventories greatly reduced shipments.

Weakness in the gaming and professional visualization segments more than offset solid data center and auto sales. Overall revenue tumbled 17% year over year, and Nvidia's adjusted earnings per share was cut in half.

Multiple headwinds

Nvidia's gaming sales surged throughout the pandemic as demand for graphics cards from gamers and crypto miners overwhelmed supply. The company generated $3.62 billion of quarterly gaming revenue at its peak.

One of those sources of demand has almost entirely vanished. Cryptocurrency prices have crashed, and multiple blowups and scandals have put a chill on interest. Nvidia's graphics cards are no longer being snapped up to mine cryptocurrencies.

The other source of demand has cooled. After two years of booming PC sales, the PC market is correcting. Global PC shipments were down nearly 20% in the third quarter. The gaming PC market, including sales of components for those who build their own PCs, can certainly outperform the broader PC market over time. But given Nvidia's results, that doesn't appear to be happening right now.

The severe drop in demand has led Nvidia's board partners to aggressively reduce inventories. That means Nvidia is shipping graphics chips to its partners at a lower rate than those partners are selling finished graphics cards to their customers. Hence the gigantic 51% decline in gaming revenue during Nvidia's third quarter.

The worst could be over

Nvidia expects excess channel inventory to continue to be a headwind throughout the fourth quarter. However, CFO Colette Kress said during the earnings call that channel inventories are "on track to approach normal levels as we exit Q4."

Nvidia has launched two high-end graphics cards as part of its RTX 4000 series. These are the kind of graphics cards aimed at gamers who want the absolute best performance no matter the price, so an excess of last-gen inventory probably won't matter all that much. It will matter, though, when Nvidia fills out its RTX 4000 lineup with more affordable midrange cards. For gamers with some sensitivity to price, cheaper last-gen options would be appealing.

Nvidia expects its inventory clearing efforts to return the gaming business to sequential growth in the fourth quarter, even though sales will still be below end-market demand. Sales will still be down significantly on a year-over-year basis, and getting back to pre-crash levels may take quite a while.

Last time a cryptocurrency meltdown tanked Nvidia's gaming revenue, it took about three quarters for sales to fully recover. This time around, not only has demand from crypto miners disappeared, but overall PC demand is tumbling as well. Add in persistently high inflation and the potential for a recession next year, and it's not hard to see it taking longer for Nvidia's gaming business to recover.

NVIDIA's quarterly gaming revenue over time.

Data source: Nvidia. Chart by author.

Once Nvidia's partners are done reducing inventories, sell-through rates are still far below peak levels. Kress said that normalized sell-through for the gaming business over the past two quarters is somewhere around $5 billion, or $2.5 billion per quarter. Even if Nvidia's gaming revenue surged back to that level, it would still be more than $1 billion below the best quarter for the gaming business.

While Nvidia's gaming revenue is unlikely to dip much below its third-quarter results, the recovery could be a slow process. On top of everything else, rival Advanced Micro Devices is putting out solid products, and Intel recently entered the graphics card market with some midrange cards of its own. Competition is the strongest it's been in a long time, and demand is the weakest it's been in years. That's not a recipe for a V-shaped recovery.