Artificial Intelligence – Magic Money Tree

Money grows on trees until it doesn’t.

• Capital continues to pour into the AI sector with very little attention being paid to company fundamentals in a sure sign that when the music stops there will not be many chairs available.
• The latest sign of this reckless abandonment is the fact that Cohere is able to raise money at a valuation that is 2.4x the valuation of 9 months ago despite the fact that its business development has been disappointing.
• Cohere will now be worth $5bn even though the annual run rate of its revenue in 2023 was just $13m (see here).
• Another red flag was Microsoft’s ability to hire the CEO and 70 staff from the AI start-up Inflection AI.
• Things were not going well at Inflection AI because if the company had been doing very well, Microsoft’s advances would have been swiftly rebuffed.
• Cohere’s valuation equates to a historic price/sales ratio of 384x which indicates that investors have another bad case of FOMO (fear of missing out) and are rushing into anything that can be remotely associated with AI.
• This is precisely what happened with the Internet in 1999, autonomous driving in 2017 and now generative AI in 2024.
• Foxconn, Arm, TSMC, and Astera Labs are all companies that have benefitted greatly from investor appetite for AI indicating that the phenomenon is spread across both public and private markets, but it is private markets where valuations are the most outlandish.
• No one is immune from the FOMO effect and Amazon has thrown another $2.75bn of its total $4bn commitment at Anthropic, and I am pretty certain that Amazon will end up acquiring the company.
• This is a tacit admission of the fact that Amazon is not very good at AI which has been clearly on display for years to anyone who has either used Alexa or received an advertisement for a product that they have already purchased.
• Somewhat unusually, the majority of the cash being pumped into the generative AI sector is ending up in one place which is Nvidia which holds 85% market share of cloud-based AI processors and whose lock on its market appears stronger than ever.
• This is why Nvidia’s valuation is at a relatively reasonable 36x 2024 PER despite the shares increasing 9x relative to their low at the beginning of 2023.
• Nvidia is really the only company that is making tangible profits from the current boom in interest in investment in generative AI but when there is a correction, there will be nowhere for Nvidia to escape, although I suspect that it will be hurt much less than many others.
• The ones that are likely to bear the brunt of the correction are the providers of generative AI services who are raising money on the promise of selling their services for $20/user/month.
• The problem is that there are many of these all of whom are demonstrably similar, which combined with the many models that are available from open source for free, is going to put pressure on pricing.
• It is at this point that the flow of money is likely to slow down and then stop as falling prices will mean that targets are missed and start-ups go back to VCs cap in hand.
• This is unlikely to be nearly as brutal as what has happened to autonomous driving as generative AI has products available, use cases and can generate revenues, just not as much as the market currently expects.
• Investors will begin to be more selective in terms of where they invest and will ask harder questions about revenues and profits meaning that valuations will be lower.
• I think that this is a net positive for the industry as it means that only the viable projects with the most capable management will get funded resulting in a much better allocation of capital resources and better products.
• However, it does mean a shake-out and here I expect that we will see failing start-ups being acquired by the large companies who do not have an in-house foundation model off which to base their offerings.
• In the meantime, the frenzy continues but it is one I am perfectly comfortable staying well away from.
• If I was forced to invest in this area, it would be Nvidia which actually has revenues and profits now or Qualcomm which is in a very good position to benefit as generative AI starts to be implemented at the edge.
• I already own Qualcomm which remains reasonably valued and has further upside from its position in automotive as well as the potential to take share from Intel and AMD in laptop processors.