NVIDIA's gross margin guidance too pessimistic? Morgan Stanley: Market expansion potential more important

NVIDIA's guidance for the remaining two quarters of this year and for 2025 is relatively conservative, dragging down the stock price. After the financial report was released, the stock price plummeted rapidly, falling below 8% at one point, but Morgan Stanley believes this is not a problem.

Morgan Stanley believes that these are some strategies adopted by NVIDIA for better development. Although the production issues of rev 0 Blackwell have affected the gross margin guidance, and there are many unknown factors in the chip market next year, the pressure on NVIDIA's gross margin is moderate, and the bearish expectations have been exaggerated.

On Monday, September 9th, Morgan Stanley's strategic analyst Joseph Moore and his team released a report stating: "NVIDIA's historically low gross margin has been seen as dragging down its stock price, but we believe this is a strategic move that will allow NVIDIA to gain more market share in AI processors next year."

Morgan Stanley believes that NVIDIA's future gross margin may decrease slightly, but concerns have been somewhat exaggerated. There are several potential factors affecting NVIDIA's gross margin, with the main one being NVIDIA's decision to adopt a more aggressive product positioning, including accelerating product release schedules and making Blackwell's pricing more competitive. After NVIDIA's GTC conference in March this year, Morgan Stanley wrote:

"Will Blackwell's gross margin be lower than Hopper's? Yes, we do expect the gross margin to decrease, and we note that NVIDIA also has similar expectations.

We believe that optimizing the gross margin to 70%+ could increase NVIDIA's competitiveness. NVIDIA is very focused on maintaining its market-leading position and not allowing other competitors to gain a foothold in the market."

Exchanging Market Share for Gross Margin

Morgan Stanley believes that NVIDIA is expanding its market share at a lower gross margin - reducing the gross margin can help NVIDIA gain more market share by putting pressure on competitors and speeding up product releases.

First, NVIDIA actively reduces gross margin to seek a larger market share.

While NVIDIA's competitors' reports mention that NVIDIA is losing chip pricing power, Morgan Stanley believes the opposite is true: NVIDIA is working hard to increase the value of its own products and services and limit competitors' business expansion. By reducing the gross margin from 76% to 74.5%, NVIDIA has exerted significant pressure on its competitors.

Morgan Stanley believes that NVIDIA's market share in AI processors this year will exceed 85% (including only NVIDIA and AMD's GPUs, as well as custom ASICs for AI processing, excluding CPUs) , and this ratio will continue to slightly increase next year as some ASIC-focused customers return to GPUs.

Second, NVIDIA has accelerated its product release schedule. This initiative incurs certain costs but is beneficial for NVIDIA's long-term market share.

Morgan Stanley points out that NVIDIA has shifted to a faster product release schedule. NVIDIA's goal is to launch new products every year, although in reality, it may be more like once every year and a half. This means that most of NVIDIA's revenue will come from new products, unlike during the Hopper era.

This initiative incurs certain costs, but the rapid pace of updates in the AI ecosystem is a key advantage for chip companies, enhancing market competitiveness and driving continuous technological progress In addition to the two long-term factors that NVIDIA has actively chosen, Morgan Stanley indicates that there are two short-term strategic factors putting pressure on NVIDIA's gross margin.

First, there is a certain delay from rev 0 Blackwell to rev 1 Blackwell at NVIDIA, due to the low yield of rev 0 Blackwell, leading to many scrapped rev 0 Blackwell units, as detailed in the analysis below.

Second, GB200's new products include microprocessors and NV Link switches, which have relatively higher gross margins but may still be lower than the company's average.

Excessive Use of Inventory Reserves in the First Half of the Year Dragging Down Next Year's Gross Margin

The factors affecting NVIDIA's gross margin mentioned above should have been understood by the market. Why is the stock price still being dragged down? Morgan Stanley believes that a key reason is NVIDIA's excessive use of inventory reserves in the first half of the year.

Compared to the previous quarters, NVIDIA's actual gross margin in Q2 this year was disappointing. However, an important hint can be found in NVIDIA's 10Q report:

"For the second quarter and first half of fiscal 2025, reserves for inventory and excess inventory purchase obligations were $908 million and $1.3 billion, mainly due to the low output rate of Blackwell materials. Sales of previously reserved inventory and settlement of excess inventory purchase obligations released reserves of $85 million and $199 million in the second quarter and first half of fiscal 2025, respectively, resulting in an adverse impact of 2.7% and 2.0% on the gross margin for the second quarter and first half of fiscal 2025."

Every quarter, NVIDIA sets aside inventory reserves, but this expense was significantly higher than normal in Q2 this year due to production issues with rev 0 Blackwell. Morgan Stanley believes that without these expenses, NVIDIA's gross margin should have been more than 100 basis points higher than expected.

Looking ahead, NVIDIA's gross margin guidance for the third quarter is 74.5%-75.5%, full-year 2025 gross margin guidance is mid-70%, and 2025 gross margin guidance is below 74%. Assuming no upside, NVIDIA's 2025 gross margin will be similar to the fourth quarter of this year, below 74%.

Morgan Stanley believes that NVIDIA does not face clear headwinds in gross margin in 2025, but there are many unknown factors, including a large number of new products (Grace CPU, NV Link switches, SpectrumX Ethernet), early production issues with product launches, and more.

Overall, Morgan Stanley believes that NVIDIA's gross margin will face moderate pressure next year, but bearish expectations have been exaggerated, as NVIDIA is doing this for market share growth.

Morgan Stanley believes that the current gross margin forecasts for NVIDIA show a decline, but they are conservative, and in fact, there may be upside. However, the situation of higher gross margins brought by the mature Hopper product line a few years ago will not reoccur. The market often says, "Even if the gross margin of growth semiconductor stocks drops slightly, it is not good." However, this is a complex situation. NVIDIA has unique growth opportunities, and Morgan Stanley does not want to miss this opportunity due to applying rules that are more suitable for cyclical stocks