Shares of beaten-down chipmaker Nvidia (NVDA -2.48%) gained some momentum recently, up 32% in the past couple of months thanks to the broader recovery in the stock market. This was triggered by favorable inflation data and the Federal Reserve's inclination toward slowing the pace of interest rate hikes. But investors shouldn't be too optimistic about the stock's prospects just yet.
That's because the waning demand for graphics cards used in personal computers (PCs) by gamers and cryptocurrency miners has the potential to bring Nvidia stock's rally to a screeching halt, especially considering the high levels of inventory that the company is sitting on. Let's see why this could be a bad thing for the company and weigh on its shares in 2023.
Nvidia's inventory is rising at a worrying pace
Nvidia's inventory levels have been increasing at an alarming pace in the past four quarters, reflecting the weak demand for graphics processing units (GPUs) as well as sanctions on sales of chips to China. The chipmaker was sitting on $4.45 billion worth of inventory at the end of the third quarter of fiscal 2023 (for the three months ending Oct. 30, 2022), an increase of 71% over the prior-year period.
The following chart shows an acceleration in Nvidia's inventory levels in the past year.
NVDA Inventories (Quarterly) data by YCharts
It is also worth noting that Nvidia's inventory growth outpaced its revenue growth by a huge margin in the past year. More specifically, the chipmaker's revenue has headed south while inventories moved in the opposite direction.
NVDA Inventories (Quarterly) data by YCharts
The chart above is an indication of the weak demand for Nvidia's chips. The company has been unable to sell the graphics cards that it is producing, which is not surprising considering the drop in PC sales this year. IDC forecasts that PC sales are on track to decline 12.8% in 2022. The weak PC demand has rubbed off negatively on sales of graphics cards.
Jon Peddie Research estimates that sales of discrete graphics cards that Nvidia sells fell 33.5% quarter over quarter in Q3. The year-over-year decline was also severe with discrete GPU shipments crashing nearly 46% last quarter. The weakness in GPU demand has led Nvidia's channel partners to reduce inventory levels, which explains why the company has been left with rising levels of unsold stock.
That's bad news for Nvidia as higher inventory levels mean that it now has a lot of money tied up in unsold stock, which could hurt its cash flow. Additionally, more inventory means that the company will have to contend with rising storage costs. Even worse, if Nvidia's chips remain unsold for long periods, then the company may have to offer discounts to move them so that they don't become obsolete.
Also, further inventory write-downs cannot be ruled out if the market value of Nvidia's unsold inventory falls below the book value, and that could negatively impact the company's bottom line.
Last quarter, for instance, Nvidia recorded $702 million in inventory charges. Investors should also note that Nvidia's adjusted earnings were slashed in half last quarter over the prior-year period, while adjusted gross margin was down nearly 11 percentage points year over year.
And now, faced with the prospect of a slow recovery in sales of graphics cards and stiff competition from Advanced Micro Devices' latest GPUs, it won't be surprising to see Nvidia's inventory levels rise further or the company being forced to offer deeper discounts.
AMD recently announced its Radeon RX 7900 graphics cards, and they are packing stronger specs than Nvidia's RTX 4080 at lower prices.
The stock isn't out of the woods yet
Analysts are expecting Nvidia's earnings to improve in fiscal 2024 to $4.32 per share from $3.26 per share in the current one. But the company's rising inventory levels could keep it from hitting that target. Of course, Nvidia CFO Colette Kress pointed out during the latest earnings conference call that the increase in inventory levels is due to the new products that it is releasing.
However, we have already seen that the inventory buildup has been happening for quite some time. The trend could continue thanks to the reasons outlined above and negatively impact Nvidia's bottom line. With Nvidia trading at a rich 70 times earnings, investors would be quick to hit the sell button on this semiconductor stock if it is unable to recover quickly and the inventory keeps piling up on account of weak demand.
