Inside NVIDIA's Fastest-Growing Business

Graphics specialist NVIDIA (NASDAQ: NVDA) has been one of the hottest tech stocks, with shares growing in value by more than 15x over the last five years. That means a $10,000 investment just five years ago is now worth over $150,000.

Although the stock is by no means cheap -- it trades at about 50x trailing twelve month earnings -- the company's revenue and profit growth continues to impress. During its fiscal year 2018, the company generated $9.7 billion in sales and a whopping $3.2 billion in operating profit -- both up 41% and 66%, respectively, year-over-year.

The comparison looks even more impressive when we consider that back in fiscal year 2015, NVIDIA generated just $4.68 billion in revenue and $758 million in operating income.

One of the main growth drivers behind NVIDIA's stellar financial performance has been its data center business, which grew 133% (no, that's not a typo) in fiscal 2018 to $1.93 billion.

Let's dive into the background behind this segment, the profitability of the revenue it generates, and what opportunities and challenges it faces in the years ahead.

Some background

NVIDIA's data center business essentially sells very high performance graphics processors to major data center customers. Although these graphics processors aren't suited for every kind of workload that a potential data center operator will want to run, the number of applications that can see increased speed from being run on NVIDIA's graphics processors compared to traditional processor technologies continues to increase.

The idea here is simple: Applications that can be made to run effectively on NVIDIA's graphics processors can often deliver speed-ups of 10x, or even more. This means that a data center operator can replace ten expensive traditional processors with a single NVIDIA GPU, giving that customer the same computing power at a fraction of the acquisition costs.

That's a compelling value proposition to data center operators looking to get the most out of every dollar they spend. Additionally, the graphics processor solution in this case is going to be much more power efficient, meaning that data center operators can save a lot of money by way of lower power consumption (one of the biggest costs associated with running a data center) as well as less expensive cooling solutions (also a significant cost).

NVIDIA's success can, of course, be partially attributed to the fact that it builds arguably the world's best graphics processors. However, the company's real genius has been that it continues to invest heavily in software libraries and tools to make it as easy as possible for software developers to take advantage of those graphics processors for data center applications.

The strong revenue growth that NVIDIA's data center business has seen in the last couple of years (133% in fiscal 2018 and 205% in fiscal 2017) is a result of that diligent, focused investment in building a broad software and hardware ecosystem around its graphics processor technology.

Very profitable revenue

NVIDIA's data center business isn't the company's largest business by revenue -- that honor goes to the company's gaming business which generated $5.5 billion during fiscal 2018. However, it's the fastest growing by far, and it also enjoys the highest profit margins.

For some context, NVIDIA indicates that its data center gross margin was substantially higher than that of any of its other business units during fiscal 2018. In terms of raw gross profit dollars, the data center business still didn't generate as much as the gaming-oriented graphics processors. However, based on the current trajectories of both businesses, it won't be long before NVIDIA's data center business overtakes its gaming graphics processor segment in terms of pure gross profit contribution.

As long as the data center business continues to outgrow the other businesses, then we should continue to see NVIDIA's overall gross margin expand as it has over the last three fiscal years. That, in a nutshell, could mean faster overall bottom line growth for the company.

Opportunities and challenges

The opportunities for NVIDIA's data center business seem quite straightforward -- as developers increasingly take advantage of graphics processor-accelerated computing, NVIDIA is poised to benefit.

Indeed, NVIDIA shared data at its analyst day showing that the number of developers that build software for major data center applications (e.g. high performance computing, consumer internet, and cloud computing) continues to grow. We're quite a ways off from the point where every software shop that can take advantage of graphics processor acceleration has done so. And in addition to increasing penetration of graphics processors in data centers, NVIDIA should also be able to ride the secular growth in demand for data center processing.

Now, while the story looks good, it's not without challenges. First, there are many start-ups and even large cloud computing and consumer internet providers that are trying to build their own specialized chips for the sorts of applications that NVIDIA's graphics processors are really good at, like machine learning.

Alphabet, for example, builds its own Tensor Processing Unit (TPU) that's far more efficient than even the best graphics processors for a narrow set of tasks. Facebook is also reportedly recruiting to try to build its own chip for machine learning tasks. These tech giants could pose a long-term threat to the growth rate and adoption of NVIDIA's graphics processors in many areas the data center business relies on for growth.

Beyond specialized chips, NVIDIA is eventually bound to bump into the law of large numbers as well. It's easy to post 100% to 200% growth off of a relatively small base, but it's much harder to keep that growth up as the baseline gets bigger (and the baseline is now quite large). On top of that, NVIDIA is currently benefiting from a wave of new customers beginning to utilize its graphics processors in the data center, but once the saturation point hits, the segment could become a replacement business with much slower growth rates.

But at least for now, investors should expect to see NVIDIA's data center business continue to deliver solid revenue and profit growth -- something that should be music to investors' ears.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Facebook, and Nvidia. The Motley Fool has a disclosure policy.