Why Investors Are Concerned About Circular Financing Of Top AI Companies

Key Concepts

• Circular Deals/Financing: Transactions where companies invest in each other to create artificial demand and inflate revenue, making it difficult to distinguish from organic growth.
• AI Boom: The rapid growth and investment in Artificial Intelligence technologies.
• Vantage Score: A credit scoring model developed by VantageScore Solutions, a competitor to FICO.
• FICO Score: A credit score developed by Fair Isaac Corporation, widely used by lenders.
• Covered Calls: An options strategy where an investor sells call options on a stock they already own, generating income but limiting potential upside.
• Fundamentals: The underlying financial health and performance of a company, such as revenue, profit, and customer growth.
• Stock Price vs. Fundamentals: The distinction between a company's market valuation (stock price) and its actual business performance.

AI Deal Interconnectedness and Investor Concerns

A significant concern in the general market is the increasingly complex and interconnected nature of deals between major AI companies like Nvidia, OpenAI, Oracle, and AMD. Investors are pointing to these transactions as potentially "circular deals" or "circular financing," where companies invest in each other to create artificial demand and inflate revenue.

Key Points:

• Bloomberg Report: A report highlights that a wave of deals and partnerships is escalating concerns that the trillion-dollar AI boom is being propped up by interconnected business transactions.
• "Spaghetti Bowl" of Deals: The current landscape is described as a "spaghetti bowl" of interconnected deals and money flowing between the same groups of companies.
• Circular Financing Explained: This refers to situations where Company A invests in Company B, and Company B then uses that investment to purchase goods or services from Company A, thereby generating revenue for Company A that originated from its own investment. This can create misleading impressions of revenue growth and strategic partnerships.
• Nvidia and OpenAI's Role: Nvidia and OpenAI are central to many of these concerns.
  • Nvidia agreed to invest up to $100 billion in OpenAI to fund data center buildouts, with OpenAI committing to using Nvidia chips. This deal was criticized for its circular nature.
  • OpenAI also struck a deal with AMD, a rival to Nvidia, to deploy AMD chips and is poised to become a significant AMD shareholder.
• Scale of Deals: The deals are described as rapid and large in scale, with OpenAI alone striking AI computing deals with Nvidia, AMD, and Oracle that could easily top $1 trillion.
• OpenAI's Deal Network: OpenAI has numerous deals, including circular ones with Microsoft (compute for equity), Ambience Healthcare, Harvey AI, Anosphere, AMD, and Nvidia. It also has non-directly circular deals with Netscale, Oracle, and Coreweave.
• Nvidia as the "Central Bank of AI": Nvidia is seen as the hub of the AI ecosystem, with deals involving hundreds of companies, including Microsoft, OpenAI, Nscale, Mistil, Figure AI, XAI, Oracle, Intel, and AMD.
• Oracle's Profitability Concerns: Despite generating significant sales from renting servers powered by Nvidia chips, Oracle's gross profit margin was reported as only 14 cents for every $1 in sales, raising concerns about the profitability of these AI-driven deals.
• Nvidia's Investment in XAI: Nvidia plans to invest $2 billion into Elon Musk's XAI, a company that will be buying Nvidia chips, further illustrating the pattern of investing in companies that are customers.
• Coreweave's Interconnectedness: Nvidia took a 7% stake in Coreweave and agreed to buy $6.3 billion in cloud services from them, which in turn rents out access to Nvidia chips. OpenAI also received $350 million in equity from Coreweave and expanded cloud deals with them.
• Government Involvement: The US government is also participating in similar deals, with the US and Intel investing $5 billion to co-develop chips and the US and Nvidia taking a license on chips sold to China.

Arguments and Perspectives:

• Investor Concern: Investors are worried that these circular deals are artificially inflating the AI market and that the spending is outpacing monetization.
• Executive Justification: Executives like AMD's CEO, Lisa Su, and OpenAI's President, Greg Brockman, argue that these partnerships are "virtuous positive cycles" and essential to meet the unprecedented demand for AI services, involving the entire AI supply chain.
• Comparison to Dot-Com Bubble: Some analysts draw parallels to the 1990s dot-com bubble, where circular deals centered around advertising and cross-selling inflated perceived growth. However, it's acknowledged that today's AI firms have tangible products and customers.

Counter-Example and Nuance:

• Google Cloud: The transcript offers Google Cloud as a counter-example. Google historically made similar circular deals by investing in companies and requiring them to use Google Cloud. This strategy helped Google Cloud scale and become a significant player without leading to a market collapse.
• Scale Difference: A crucial distinction is made regarding the scale of deals. Google's early cloud deals were not on the same magnitude as the current multi-billion dollar agreements between OpenAI and Nvidia.

Conclusion on AI Deals:

While AI is recognized as a world-changing technology with real products and potential, the current scale of investment exceeding the growth of monetization is a trend that cannot last forever. Investors are advised to be wary of the scale of artificial revenue and circular deals.

Jeff Bezos on Stock Prices vs. Fundamentals

Jeff Bezos, in a recent interview, emphasized the importance of focusing on a company's fundamentals rather than being solely driven by stock price fluctuations.

Key Points:

• Amazon's Dot-Com Experience: During the 2000 dot-com bubble burst, Amazon's stock price plummeted from $113 to $6. Despite this, fundamental business metrics like customer numbers, gross profits, and operating expense as a percentage of sales continued to improve monthly.
• Key Performance Indicators (KPIs): Bezos highlighted metrics like customer growth, gross profit, and reduced losses as crucial indicators of a company's health, not just the stock price.
• Stock Price as an Output: The stock price is presented as an output of the business, over which founders and entrepreneurs have very little control.
• Benjamin Graham's Analogy: The quote from Benjamin Graham, "In the short term, the stock market is a voting machine. In the long term, it's a weighing machine," is used to illustrate that a company's true value is determined by its fundamental weight over time.
• Building a "Heavy" Company: The advice for entrepreneurs is to focus on building a company that is fundamentally "heavy" – substantial, profitable, and growing.
• Investor Psychology: Investors often get caught up in short-term stock price movements, allowing sentiment to dictate their view of a company. The reminder is to focus on whether the company is becoming "heavier" (better fundamentally) week over week or year over year.

Equifax Strikes Back Against FICO

A competitive battle is unfolding between credit bureaus and FICO, with Equifax making a significant move to undercut FICO's pricing.

Key Points:

• FICO's Move: Fair Isaac (FICO) attempted to bypass the three nationwide credit bureaus (Equifax, Experian, TransUnion) by distributing FICO scores directly to mortgage lenders.
• Equifax's Response: Equifax announced it would make the Vantage Score 4.0, a competitor to FICO, available for $4.50 over the next two years. This is significantly cheaper than the FICO score, which costs around $10 per score.
• Undercutting FICO: Equifax is aiming to gain market share by offering its competing score at over 50% less than FICO's price.
• Equifax's Public Criticism of FICO: Equifax released documentation directly highlighting that FICO score costs have increased by 100% over the last four years, a direct public attack on a competitor's pricing strategy.

Amazon's Pharmacy Vending Machines

Amazon is entering the pharmaceutical sector with a new approach: prescription drug vending machines.

Key Points:

• Disrupting Brick-and-Mortar Pharmacies: This move is seen as a significant threat to the business model of traditional retail pharmacies.
• Kiosks at One Medical Offices: Amazon is launching these kiosks at One Medical offices, bringing the pharmacy directly to the point of care.
• Convenience and Speed: The vending machines are designed to dispense prescriptions within minutes of a doctor's visit, eliminating the need for patients to make an extra trip to a separate pharmacy.
• Addressing Prescription Abandonment: The initiative aims to increase prescription fill rates by removing a critical barrier for patients.
• Impact on Retailers: The speaker believes companies like Rite Aid and Walgreens are "dead" and that this move by Amazon further accelerates their decline.

Netflix Stock Price Recovery Post-Boycott

Netflix's stock price has recovered and is now trading above its pre-boycott levels, despite a brief period of volatility.

Key Points:

• Boycott's Short-Lived Impact: A boycott, lasting approximately five days, did not have a lasting negative impact on Netflix's stock price.
• V-Formation Recovery: The stock experienced a "V-formation" recovery, indicating short-term volatility followed by a swift rebound.
• Boycott Ineffectiveness: The speaker questions the effectiveness of a boycott initiated by a billionaire telling millions of people to stop paying for a cheap form of entertainment.
• Content Quality: While acknowledging that Netflix has a significant amount of "trash content," this is seen as common across most large streaming platforms and social media companies.
• Value Proposition: Netflix remains one of the cheapest forms of entertainment, and despite the "trash content," it also offers "remarkably good pieces of content."

Fail of the Week: Quitting Jobs for Covered Calls

The "fail of the week" highlights individuals quitting their full-time jobs to pursue income replacement through covered calls and options trading, often with unrealistic expectations.

Key Points:

• Unrealistic Expectations: The example of a TikTok user who quit her job to replace her income with covered calls, assuming 8% weekly returns, is presented as an illustration of flawed financial decision-making.
• Underestimating Compounding: Novice investors often underestimate the power of compounding. An 8% weekly return, if sustained, could lead to billionaire status from a small initial investment in a relatively short period, highlighting the absurdity of such assumptions.
• Covered Calls Strategy:
  • Covered calls are marketed heavily by brokerages and ETFs, but studies show they generally do not outperform direct equity investment over time.
  • This strategy often sacrifices potential upside in stocks for current income, leading to lower overall returns.
  • It also involves more friction, higher expense ratios, fees, and taxes.
• Advice for Investors: The speaker advises against quitting full-time jobs to replace income with trading, especially with limited capital. Instead, it's recommended to keep existing income and jobs, invest that money into stocks, and retain the upside potential of equity.

Conclusion: The trend of young investors quitting stable jobs to pursue income through trading, particularly covered calls, is deemed a "fail of the week" due to the unrealistic assumptions and the inherent limitations of such strategies for income replacement.