Last Thursday, Nvidia reported another astounding set of earnings—continuing their strings of quarterly results over the last year and a half that may have no historical equivalent in terms of their combination of growth and profitability at scale. Despite exceeding all public expectations (earnings, revenue, etc), the stock fell 6.38%[1] upon release of the results and has since fallen further still, now sitting in a multi-month drawdown (an eternity for Nvidia’s historically prosperous investors). Investors’ overzealous expectations may have finally caught up to Nvidia’s consistently amazing results.
Nvidia has emerged as a clear beneficiary of the AI “arms” race, perhaps the only company currently reporting significant profits directly from Artificial Intelligence (AI). The fierce competition among tech giants to secure a leading position in what appears to be the next big Information Technology (IT) innovation cycle has created unprecedented demand for Nvidia’s chips. We spoke in our quarterly letter about how positively the market is viewing this investment in AI, rewarding both the investors (the large tech companies) and the suppliers (Semiconductor companies, namely Nvidia). The market’s implication is that the spend will not be cyclical but will have high ongoing returns–not an easy hurdle for companies with already dominant positions generating hundreds of billions in revenue.
“This time is different” may be the most infamous phrase in investing, and today’s AI chip frenzy looks eerily like past IT investment booms.
It appears as though yesterday’s Telecom companies are today’s Tech companies, and Nvidia is selling them the “picks and shovels”.
Source: Company filings and internal estimates.
Internet telecom companies of the late 90s are certainly no match for today’s tech behemoths. With massive profits and dominant market positions, these companies can fund their investment easily from their own current cash flow. Internally funded investments, while less risky, may also allow for even less disciplined about their spending. By some indications these companies are aware they may be overspending but see too much risk from underspending (creating the prototypical conditions of an “arms” race).
Sundar Pichai, Chief Executive Officer of Alphabet, Inc., explains this concept on Alphabet’s Q2 earnings call when asked about the company’s AI capital expenditures:
Look, obviously, we are at an early stage of what I view as a very transformative area and in technology, when you’re going through these transitions, aggressively investing upfront in a defining category, particularly in an area in which in a leveraged way cuts across all our core areas or products, including Search, YouTube, and other services, as well as fuels growth in Cloud and supports the innovative long-term bets and Other Bets is definitely something for us makes sense to lean in. I think the one way I think about it is when we go through a curve like this, the risk of under-investing is dramatically greater than the risk of over-investing for us here, even in scenarios where if it turns out that we are over-investing, we clearly — these are infrastructure which are widely useful for us.
They have long useful lives, and we can apply it across, and we can work through that. But I think not investing to be at the front here, I think, definitely has much more significant downside. Having said that, we obsess around every dollar we put in. Our teams work super hard.”
As Sundar Pichai rightfully points out, if Google ends up with more chips than they need, they can simply cut back for a few years and the natural growth of their business should catch up to their overinvestment. From their perspective it’s effectively a “no-brainer” to keep buying. However, if they come to that conclusion, we believe a down cycle for the cutting-edge semiconductor chips would be inevitable.
Nvidia’s dominant position as the supplier of this arms race has allowed it to capture outsized profits from frenzied investment. By our calculations, the latest H100 chip has roughly an 8.5x mark-up from its original creation cost at chip manufacturer Taiwan Semiconductor. Nvidia’s business looks more like a patent-protected drug company than a tech hardware company. These sky-high margins are likely to continue to incentivize competition. Long-time competitors Advanced Microdevices, Inc (AMD) and Intel are offering competing chips at roughly half the price, while Nvidia’s own customers have developed powerful chips of their own. Thus far none of it has mattered, but capitalism has historically thrown lots and lots of capital at anomalously profitable markets.
Source: Company filings for Nvidia and Taiwan Semiconductor for the Quarter ended 7/31/2024 and 6/30/2024, respectively as well as internal estimates for the cost of an Nvida H100 GPU.
Despite the seemingly inevitable overinvestment, technological cycles have typically spurred massive innovation and are a key feature of longer-term economic growth. The surge in research and development (R&D) spending during these booms has historically fueled groundbreaking innovations that revolutionize industries and create new markets. While the occasional “bubble” may lead to short-term volatility, the long-term impact on economic development has been overwhelmingly positive. History may be the best teacher, but over time history has taught us that optimism wins out even if it is in our nature to get too optimistic at times.
[1] Data from Bloomberg for 8/28/24 to 8/29/24, from 8/28/24 to 9/3/24 NVDA has fallen 14.02%