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This year, Nvidia’s stock price has experienced remarkable growth, more than tripling in value. The anticipation of an unprecedented demand for artificial intelligence chips has propelled this US chip designer to achieve a market capitalization exceeding $1tn.
However, Asian chipmakers – the companies responsible for manufacturing all of Nvidia’s chips – have reported their lowest earnings in years. This sobering reality serves as a crucial reminder for investors who believe that Nvidia’s unprecedented rally can persist.
Nvidia’s advanced chips play a vital role in powering the next generation of AI-related technologies, from ChatGPT to autonomous driving. These graphics processing units (GPUs) are significantly faster than general-purpose chips when utilized in AI models, accounting for the majority of Nvidia’s sales.
Companies are increasing their computing power by incorporating more Nvidia chips into their data centers. This trend is just beginning, indicating substantial room for growth. As a result, Nvidia projects revenues of $11bn for the current quarter, representing a nearly two-thirds increase from the previous year.
The production of Nvidia’s high-end chips necessitates the most advanced chip manufacturing technology available. Taiwan Semiconductor Manufacturing Company (TSMC) and Samsung collectively produce 100% of the world’s supply of advanced chips, which employ a manufacturing process of 5 nanometers or less.
Consequently, the fortunes of TSMC, Samsung, and Nvidia are intimately intertwined. TSMC manufactures all of Nvidia’s AI chips, while Samsung produces chips critical for operating servers essential to generative AI.
This implies that investors who purchase Nvidia shares should also invest in TSMC and Samsung with equal enthusiasm, considering their relatively lower valuations.
However, the gains in their share prices pale in comparison to Nvidia’s staggering success. In fact, Warren Buffett has notably divested from TSMC this year, completely exiting his position in the first quarter. Despite the surging demand for AI chips, the earnings weaknesses of the world’s two largest advanced chip manufacturers have not been offset. Samsung’s second-quarter earnings plummeted by 96%, dropping to their lowest point in 14 years. Meanwhile, TSMC experienced a 23% decline in net profit, its first quarterly decrease in four years.
A contributing factor to this situation is that AI still represents a small sector, accounting for less than 5% of global chip demand according to analysts. At TSMC, approximately 90% of sales come from consumer electronics, smartphones, PCs, and cars.
Another factor is the impact of time lags. Chip orders are typically placed well in advance, usually once a year. During the recent chip shortage, companies stockpiled chips. Now, as they deplete their inventories, orders have diminished.
Yet, the primary reason why shareholders of Asian chipmakers do not share the same excitement as Nvidia investors is their familiarity with the limitations of chip production. While unprecedented demand appears thrilling, production output is capped. Building a chip fabrication facility costs over $20bn, making chip production capital-intensive. Additionally, the rapid pace of chip technology advancements necessitates continuous upgrades, and weak earnings reduce resources available for capacity expansion.
Presently, both Nvidia and TSMC maintain comparable gross margins of approximately 60%. However, in the future, Nvidia will have the advantage. Its software and intellectual property add value and avoid the significant costs associated with chip manufacturing.
However, this also means that Nvidia’s growth is constrained by capacity. For years to come, AI chips will only constitute a small fraction of chipmakers’ sales. Nvidia must allocate chipmaker resources to key clients like Apple, with new iPhone launches resulting in orders for hundreds of millions of high-end chips.
The current oversupply of chips has masked the risks that lie ahead. Furthermore, the gaming and crypto sectors, both heavily reliant on Nvidia chips, compete for the limited supply. Disruption risks, such as chip engineer shortages and escalating tensions between Taiwan and China, must also be considered.
As the complexity of machine-learning models used in tasks like generative AI increases, the demand for computing power can only be fulfilled by more chips. In the long run, Nvidia is poised to be the primary beneficiary of the AI wave. However, investors must currently account for the risk of supply constraints and temper their expectations of the market’s growth rate.
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