Shares of Nvidia (NASDAQ: NVDA) experienced a notable dip post-earnings report, now resting 11% below their peak. Despite a stellar 122% revenue surge, surpassing forecasts, market jitters are palpable for Nvidia, especially as the company approaches a colossal $3 trillion valuation.

The pivotal concern triggering this sell-off pertains to Nvidia’s gross margin. Cracking the crux of what transpired with this crucial metric last quarter and its implications is essential.

The Evolution of Gross Margin in the Nvidia and AI Universe

As the AI sphere burgeoned, Nvidia became the go-to provider for data center GPUs, as cloud computing entities and conglomerates scrambled for these high-demand chips. This disparity between supply and demand empowered Nvidia to command a premium on its chips, witnessing gross margins soar from a feeble 55%-65% “pre-AI” to a staggering 78.4% in Q1 this year, ending in April. Simultaneously, the operating margin ascended from a modest 20%-40% range to a robust 64.9% in the initial quarter.

However, recent numbers reveal a dip in both gross and operating margins, with the former sliding to 75.1%, a 3.3 percentage point descent, and the latter to 62.1%. Nvidia’s CFO, Colette Kress, prognosticated a meager 74.4% gross margin for the current quarter in a conference call with analysts.

Unraveling Nvidia’s Margin Decline

Nvidia attributed the gross margin slump to “a higher mix of new products within Data Center and inventory provisions for low-yielding Blackwell material.” While this explanation eases immediate shareholder panic, the delay in Nvidia’s forthcoming Blackwell chip due to a manufacturing glitch casts a shadow. CEO Jensen Huang highlighted a minor tweak in GPU manufacturing at Taiwan Semiconductor Manufacturing (NYSE: TSM) to rectify yield issues without fundamental chip alterations. The detected defects in initial Blackwell chip production at TSMC necessitated a substantial chip write-off by Nvidia.

Nvidia’s gross margin could continue to fall back to earth. Image source: Getty Images.

Challenges with New Products and Margins

The nuanced process of perfecting yields for new chip products often entails initial margin slumps. Nvidia faces a conundrum: whether the margin decline stems from low initial manufacturing yields or from a saturated premium pricing domain for new offerings.

While the current flagship H200 surpasses the H100 in cost, novel Nvidia chips are intricate and pricier to produce, heightening manufacturing expenses. The Coalescing factors include the shift of 45% of revenue from cloud service providers to in-house AI accelerator designs, Meta Platforms (NASDAQ: META) developing its accelerators, and Advanced Micro Devices forecasting robust sales for its MI300 AI GPUs, mounting pressure on Nvidia’s turf.

Adapting to this dynamic, Nvidia must either outpace rivals on the hardware front or trim prices – perhaps both, to sustain its market presence. Investors must vigilantly monitor gross margin trends, possibly accounting for future slippages, even as revenue scales new heights.

Strategic Considerations for Investors

Before contemplating a Nvidia stock purchase, it’s crucial to bear in mind:

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