Nvidia (NVDA 3.71%) has been one of the most important companies over the past decade. Although it's easy to fall into the trap that Nvidia's products are only for gamers, it also has a robust data center business that is powering the future of computing. In fact, 90% of the new systems on the TOP500 list (a collection of the 500 most powerful computers) use Nvidia's products.
However, amid severe headwinds in its consumer-facing business, Nvidia's data center business is also showing slowdown signs. So should investors sell their shares of Nvidia's stock with its whole business beginning to struggle?
Nvidia's two main segments aren't doing so hot
Nvidia's headline numbers for its third quarter of fiscal year 2023 (ended Oct. 30) weren't pretty. Revenue was down 17% year over year (YOY) to $5.9 billion, while net income dropped like a rock, down 72% YOY to $680 million. But while many investors may focus on those two numbers, there's something critical going on between them that investors must understand.
When management rolled out their Q3 projections during their second-quarter earnings report, they guided for gross margins of 62.4%. However, Q3's actual gross margins were much lower at 53.6%, indicating Nvidia had to slash prices to move products. Management commented on this during its conference call, stating they had to take a whopping $702 million inventory charge due to lower data center demand in China.
That's not a good sign, as its data center division is supposed to be Nvidia's primary growth driver. Data center revenue was up 31% YOY; however, it only rose 1% from the previous quarter. Moreover, data center demand isn't cyclical -- so this quarter-over-quarter (QOQ) growth slowdown is worrisome.
Its second-largest segment, gaming, had an abysmal quarter, with revenue down 51% YOY and 23% QOQ. While consumers may not be building powerful gaming systems right now, Nvidia's gaming GPUs are also used in crypto mining rigs, an industry that is struggling.
So with Nvidia's two top segments in decline, the market responded by dropping the stock by 7.5% on a day when the Nasdaq was only down 0.3%.
However, Nvidia may have been saved by one massive announcement.
Microsoft to the rescue?
On the same day of Nvidia's earnings announcement, it revealed a multiyear effort with Microsoft (NASDAQ: MSFT) to construct one of the world's most powerful artificial intelligence supercomputers utilizing Microsoft Azure -- its cloud computing platform. This investment will involve "tens of thousands" of GPUs and networking equipment to accomplish, which will be a revenue growth catalyst for Nvidia's data center division.
The A100 and H100 products needed to build this supercomputer were the same components the U.S. government banned from selling to China earlier this year. As such, it was critical for Nvidia to find another large customer for these units.
However, even though Nvidia has found less-powerful chips to sell to China, it still feels the effects of a weaker Chinese economy.
This issue likely won't be resolved soon, which is why I am worried about Nvidia's valuation.
NVDA PS Ratio data by YCharts.
At 13 times sales, Nvidia's business is still very expensive. Additionally, its price-to-earnings ratio will only worsen over the following quarters due to falling margins. Still, I don't think selling Nvidia is a wise move.
Nvidia is the market leader in the most powerful gaming and data center components. With cloud computing growing rapidly, Nvidia stands to benefit. However, the company is exposed to a lot of geopolitical risks and is valued highly. Because of this, I think Nvidia's stock is a hold. There's a lot of uncertainty with Nvidia right now, and there are just too many better values in the market right now with less risk.
