Motley Fool Hidden Gems Investing - Neoclouds Shine

Starting point is 00:00:00 Neoclouds are flying high and Motley Fool Hidden Gems Investing starts right now. Welcome to Motley Fool Hidden Gems Investing. I'm Travis William, joined today by Tyler Crow and Rachel Warren. And guys, the big topic of the day is the Neoclouds, two of the biggest companies in that space. Corweave and Nebius reported earnings in the last 24 hours, and both their stocks are flying high. They're up about 20% in early trading on Wednesday. say, Rachel, what'd you take away from this? The numbers were pretty solid, but I don't think that was a surprise for anybody who listened to the hyperscalers, the bigger tech companies saying, hey, we need more compute and we're willing to pay for it. These are earnings that are really

Starting point is 00:00:41 capturing the neocloud paradox that we're seeing. There's massive top line growth, but we're seeing really heavy infrastructure spending that's weighing down the bottom line. So CoreWeave's revenue is up 112% year over year. They're operating at a net loss, but demand is there. they're holding about $104 billion revenue backlog. That's actually excluding an extra $25 billion that CoreWeave secured early in Q3. That's anchored by deals like their ongoing deal with Meta. But CoreWeave paid about $640 million in quarterly net interest expenses on its debt pile in this three-month period just ended. They actually raised their full-year CapEx expenditure outlook up to almost $40 billion on the top end. Going over to Nebius, we're sort of seeing more

Starting point is 00:01:26 the same. I mean, their revenue was up, I think it was 454% year over year. They're saying that 70% of their deals, Nebius and Q2, included upfront customer prepayments. So the Neocloud business model is somewhat evolving from this multi-month model training to higher margin usage-based inference workloads. Another thing that also stuck out, I mean, Cori said they're signing NVIDIA A100 contracts extending out into 2029. So that's ensuring that a 2020 generation chip can generate returns nearly a decade after launch. Bottom line for me that I'm seeing, you know, customers aren't just paying for the chip generation.

Starting point is 00:02:04 They're paying a premium for the active, cooled, fully powdered data center capacity. And this is in a time where power grids are severely constrained. And you've got companies like Nebius that are experimenting with deploying AI cloud software directly in their clients' own data centers. This could be really key to their growth long term. some of the funding mechanisms behind the data center build-outs, which I'm sure we'll talk about in a bit, I still find a bit concerning. Yeah, Tyler, that's the interesting thing here. I will note that CoreWeave's 9% 2031 debt was trading over 12% yield just a few weeks ago.

Starting point is 00:02:38 That is down to just under 11%. But that's a really high interest rate when you have capital needs. So that means you're either going to be selling stock or you're going to be selling debt for the foreseeable future at this point. How sustainable is this? Because the thing that I always keep going back to is in particular, Alphabet's comment about we're signing a bunch of these short term deals. And these were seen as I think Nebius was really proud of these short term deals because they're very high margin. But we're signing these short term deals as a bridge to when they get their full data centers, this $200 billion they're spending on CapEx up and running. So I don't think Alphabet or Meta or any of these companies are saying,

Starting point is 00:03:17 hey, these neoclubs are the long-term solution, but it's a short-term solution. So how do you think about that as an investor? It's hard to square. Part of it says, take the advantage when you can. If the market's telling you to sell short, sell short. It does sound a little bit like commodity trading where it's like if you have short-term demand, sell it on short. And if it's looking pretty weak, sell on long-term demand. It's basically like a hedging schedule for a oil company, basically, like we're talking about here. On the financing side, I mean, only 11%. That's pretty high interest rates, not exactly the most assuring thing. One of the other things that I found interesting in some of the deals that we were talking about here, too, was

Starting point is 00:03:55 not only are we talking about unsecured loans at like 11% range, we're also talking about now they're looking at asset-backed, basically compute-backed loans, which are trading for, what was it, the overnight SOFR rate plus 2.5%. That is technically like junk territory for a lot of bonds. That's the two things. The equity market loves this stuff. I mean, you can see from the results and the stock market reactions that we're seeing for these companies, the stock run-ups that we've seen recently, the equity just can't seem to get enough of this good news. But the debt markets are like, hey man, you got to pay up for this because some of this, like the cash flows don't seem nearly as shored as equity seems to be hopeful about. Equity investors, we're always

Starting point is 00:04:39 hopeful, folks. I do find that striking. And typically the way that it works in markets is equity investors are thinking about upside. Debt investors are thinking about downside. So as an equity investor, one of the reasons that I like to look at those debt markets is what are those debt investors thinking about from a downside perspective? Rachel, one of the things that Tyler mentioned was taking the short-term win and the long-term win from Nebius. They said that their Q3 short term capacity deals were over $40 million per megawatt. That is almost quadruple of $12 million from their 2026 base. And their Q2 deals were over $20 million a megawatt. Now, those are short term capacity deals. So doesn't the challenge here

Starting point is 00:05:21 become not what is Q3 going to look like? Or what is Q4 going to look like? But what is 2029 2030 look like? Because that's when this trillions of dollars of investment that all these hyperscalers are putting on, is that really going to come online? I mean, I think that's the hope. The demand is certainly there. I think if anything, the bottlenecks are how much construction can keep up with the demand that a lot of these hyperscalers need and are seeing. And I mean, I mentioned a little bit about the funding mechanism for some of this earlier. We were seeing this kind of turn into a megatrend. You know, you've got the likes of NVIDIA, For example, they're partnering with the institutional titans like BlackRock, KKR, Apollo to unlock hundreds of billions of dollars in third party capital to build data centers. And I think there's sort of this push to legitimize AI infrastructure as its own, maybe something like an institutional asset class that really, really feeds into whether or not we continue to see this capacity go online.

Starting point is 00:06:18 I think when you look at stocks like Corweave, you look at stocks like Nebius Group, these are businesses that are responding to real demand and a true build out that I think will be a multi-year one. But I think if you look at the valuations for these companies, I don't think it's reasonable given if you look at their bottom line, which in some cases is, you know, non-existent, the hoped for cash flows, margins. These are the areas that concern me looking ahead. Obviously, the revenue is important. The revenue backlogs are solid. But I would be very, very careful approaching investments in these businesses without understanding where some of these underlying funding mechanisms come into play for their business models. Yeah, Tyler, I just wanted to bring up that we've seen some of these things before in our history, not too long ago with solar and wind, with these interesting asset classes that we're creating. You know, Rachel was talking about the NVIDIA is actually coming in and being a backstop, which always makes me a little bit nervous.

Starting point is 00:07:16 if this is such a great asset class, why can't you get plenty of financing? Why is it starting to be junk debt or close to junk debt? And the other thing is, I keep thinking that a lot of this token creation is very commodity-like. And then I keep seeing earnings with investors saying this proves that it's not a commodity. But when demand exceeds supply for a commodity, the price goes up. We just talked about those short-term deals. Doesn't this look exactly like a commodity? There's so many hallmarks of things we've seen before. Yeah, it's pretty commodity, but sometimes that's not necessarily a bad thing. You were given the example of the solar industry where we did see a lot of future cash flow loans or

Starting point is 00:07:57 tax credit loans that didn't end up turning out too well. But I will give a counter of where it did work. We saw in LNG export companies in the United States where they basically took those long-term sales contracts, even though they didn't have a project built. And they're like, hey, we've got 30-year signups on sales. You want to give us some debt? And it worked out in the long run. And it did end up being like the financing model for them. Most of the time, creative financing never works out. But I don't know, what is it? 60% of the time it works every time, I guess is the best way to put it. On the commodity side as well, yeah, it does feel like it's going to go through these short-term shortages where you're going to

Starting point is 00:08:34 get higher pricing, long-term signups. And I don't know, maybe they need to bring in some commodity traders into their pricing desks to do a lot of this because it would make sense for a nebulous oracle. Yes, I don't know. I'm just throwing out some rough numbers here, but 60% to 70% of our capacity is sold on long-term contracts. Then another 15% is on medium contracts, and then we'll leave 10% to 15% on these short-term contracts so we can capture some of that upside when everybody is desperate for demand. I know it's probably not a parlance a lot of people in tech have thought about before, but it does really echo a lot of the things we've been talking about in commodities and energy over the long period. When we come back, we are going to get to what's

Starting point is 00:09:16 happening in the food business. More on that in a moment. or go with the flow and choose ginseng delight our new double espresso with ginseng extract whatever lies ahead don't change your morning let your morning change you discover coffee plus on espresso.com rachel one of the big earnings reports in the last 24 hours too was kava this restaurant that i keep hearing about but we still don't have here in the midwest so i'm waiting i really have a hard time investing in restaurants until i can actually go eat at them so maybe i need to make a trip down to lose area where he says he loves his kava. But this was one of the really positive earnings

Starting point is 00:10:10 reports. And we've seen some pretty negative reports from a lot of these restaurants. Higher commodity costs are hitting certain companies, less spending. We'll talk about inflation in just a moment. But those pressures don't seem to be hitting kava right now. Yeah. And, you know, it's interesting looking at kava's results. I think it's less of a commentary on the consumer and more about how the strategy they're deploying is working in today's environment. So, you know, they had 9% same-store sales growth. Most of that was traffic-driven. Traffic was up more than 5% year-over-year pricing, product mix changes. That only accounted for about 3.7% of that growth. I mean, we're in an environment where rivals are forcing price hikes. They're dealing with

Starting point is 00:10:49 empty dining areas in some cases. But Cabo seems to be winning really on transaction volume. And we saw their revenue skyrocket, even as a lot of the fast, casual restaurants are really struggling. What was interesting was management on the earnings call said that a lot of their lower income customer tiers are actually generating the highest same restaurant sales results. And this is at a time where you've got a lot of the competing, say, fast food giants, fast casual, whatever you want to categorize them as, that are discounting, trying to retain that customer traffic. Well, Cobb is absorbing that demographic organically. And instead of hiking prices to match inflation, they've actually minimized any type of price increases, which has been notable.

Starting point is 00:11:33 They opened 17 net new restaurants during the quarter. Now they have just under 500 locations across, I believe it's 29 states. Their average unit volume has hit 3 million. And I hate to mention it, but we've got the recent cyclospora outbreak that has impacted competitors like Sweetgreen significantly. There was a bit of a dip in July, Kava's CFO said, but they said same store sales have already bounced back. So there's really, I think, a strong, loyal customer base there. One final thing that also stuck out to me, we've seen some of these fast casual restaurants deploying automation. There's been concerns about what that would mean for the workforce, but they're really shifting employee focus away from chopping ingredients, but more towards

Starting point is 00:12:14 customer service, digital order fulfillment. They have zero long-term debt, really healthy cash stockpile. It's a well-run business. And I think at least today, the stock seems to be actually responding in kind to that growth story. Yeah, Tyler, how do you think about that growth and that the pricing when it comes to restaurants, because there's a ton of operating leverage in a restaurant, if you're not aware, the actual food only costs about 30% of what your bill is at a restaurant. So, you know, keeping prices relatively steady can be fine if you are getting more traffic. But there's always a balance between what are you going to do with prices? How's it going to impact margins and your traffic at the business? I was reading between the lines a little

Starting point is 00:12:51 bit. And as Rachel mentioned, comps were up. The one thing I did notice was there was a little bit of margin compression over the past couple of years. And they said they didn't push price, but it did seem like the mix of products that they were selling tend to be a little bit higher price, ever so slightly lower margin. Probably some of the seafood options, something like that, where your gross margins just obviously aren't as high. Gross margins on proteins are always lower relative to what else you ever have in the restaurant. I think overall, it was pretty good. To be frank though, it's got to be one of the hardest businesses. Yeah, the numbers this time around looked really good, but guidance actually was trending ever so slightly lower. They were

Starting point is 00:13:28 saying margins might come in a little bit weaker, but comp estimates are supposed to grow a little bit. So again, it kind of trends towards that, what they're selling mix getting a little bit better. This is a really hard industry in general. It's hard for me to invest in as an investor. I actually love restaurants. I used to work in restaurants. The thrill of working in the back of the house, front of the house. It is kind of stressful, but fun in its own way. But actually being an investor on it, God, I almost would be taking Alka-Seltzer all the time because it's hard to track what is trendy, what isn't. And often it can defy expectations. We're talking about Cabo, one of the new trendy restaurants that's been growing like crazy. And then just

Starting point is 00:14:05 same day, Brinker International ordered their earnings. It looked like it was on a slow decline from the 2010s all the way to 2023. Then voila, everyone wants chilies again. And the company's posting 5.6% comps, 11% year-over-year revenue growth and raising guidance. Who saw that on their bingo card? Yeah, this has been a really hard one. Shares of Kava are above flat since the early part of 2024. And they're actually down more than 50% from their high, which was hit late in 2024. So they can go on these rocket ship runs, and then those can end really quickly. Next up, we are going to talk about what's going on in inflation. We'll be back in a moment. from Nespresso. Blend wellness into your coffee routine with the Coffee Plus range,

Starting point is 00:14:49 infused with functional benefits. Choose the coffee you love with added B vitamins, like Coffee Plus B12 to help support immune function and Coffee Plus B6 to keep your day moving. Or go with the flow and choose Ginseng Delight, our new double espresso with ginseng extract. Whatever lies ahead, don't change your morning. Let your morning change you. Discover Coffee Plus on Nespresso.com. Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad? I get it.

Starting point is 00:15:21 I'm Siaya, and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today, I'm still figuring it out. Somehow, things usually get worse before they get better. Apparently, that's how I roll. So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. We can't get out of here without touching on inflation. We got a big inflation report

Starting point is 00:15:49 earlier this morning. The reading for July, Tyler, 3.4%, slightly below some of the expectations, met some of the expectations I saw, but nothing really surprising. This, I guess, theoretically takes some of the pressure off the Fed to raise rates more this year. But the thing that stuck out to me is that at least in the month of July, energy prices were down. And that's probably going to reverse to increased energy prices in August. So there's a lot of push and pull here. This push and pull has gotten pretty wild whiplash in this labor market inflation, either it be CPI or purchase or price index. Last time I was on with you two was back in April. We were talking about this as well, which ameritly, Lou only goes on vacation the

Starting point is 00:16:33 weeks when inflation data comes out. So he doesn't want to hear that in mind. He leaves it for us. He wants to skip these conversations altogether. It's hard to have a strong case one way or the other looking at these. A few months ago, job growth was fine. We were worried about high inflation. Oh, maybe they're going to start to raise rates. We looked pretty close this time around, but now we're looking at it and it's like, well, inflation is cooling. Job markets are starting to weaken a little bit. to your point, like energy is going to go higher, likely, because we were just talking about the most recent update from the ongoing conflict with Iran seems to be we're just going to low key do it, whatever that sort of means. But that tends to be closures of the trade reform moves, which means higher oil prices. So not to mention all the demand from AI data centers, which increases electricity costs. That is a big piece of the energy picture right now, too. My best guess that I can give. And again, one thing that inflation data does better than anything else is make

Starting point is 00:17:28 talking heads like us look ridiculous like six weeks later. That's actually might be its job more than anything else. My best guess is that we were kind of looking like we were going to see an interest rate hike in September. There was a lot of pressure from not necessarily the Fed chair, but everyone else very unsettled by it, but maybe weaker job growth, maybe slightly cooler expectations on inflation that might drive it. But like I said, last time we did this, I said the PPI numbers were going to come out the next day and those could be even bigger. I'm going to kind of say the same thing because we've been talking about all this AI infrastructure growth and that has been the big driver of production inflation is companies like Meta, Alphabet,

Starting point is 00:18:09 all these other guys just spending all they want all the time and not even caring when inflation goes higher. Yeah, I mean, the 3.4% print for July, down a fraction from June's 3.5%, very heavily detached from the Fed's long-term 2% price stability target. Another thing to note, I mean, energy prices are also masking the real economic reality right now. So energy did experience a temporary drop in July. We saw gasoline down 2.2%. But this was very much due to these temporary stop and start peace negotiations in the Middle East. Those talks have collapsed. Perhaps they will restart. But August is already tracking to import a massive energy shock back into headline inflation. If you look past food and gas, core inflation ticked up

Starting point is 00:18:51 0.2% for the month. So that leaves the annual core rate around 2.5%. And this is being very aggressively sticky because you've got secondary pressures like airline fares, for example, that jumped 2.2%. Healthcare also up. It's offsetting a lot of the localized relief in retail commodities. Another thing to note here, I mean, businesses have been for a while now passing on tariff-related costs to consumers. So you're seeing visible month-over-month price spikes for a lot of core household items. Annualized inflation at 3.4% means that prices are outstripping wage growth, which is pacing right now around 3.2%. We saw average real hourly earnings slip by 0.2% year over year. What does this mean? This means that consumers' purchasing

Starting point is 00:19:33 power is actively eroding. And we also just saw the report last week showing the economy shed 23,000 jobs in July. So the central bank has some difficult decisions coming up, but they need to keep rates restrictive with this sticky inflation rate, but doing so risks fracturing what is still a turbulent labor market. So it is not a clear-cut answer at this point. I'm sure we'll have more discussions about this in future episodes. Yeah, definitely something to keep an eye on. I know the Fed is definitely one of the things that is driving the market short-term, not necessarily something we want to be too focused on as long-term investors, but something of note, especially when inflation is higher for longer than maybe a lot of people

Starting point is 00:20:12 expected. As always, people in the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. All personal finance content follows The Motley Fool's editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. For Tyler Crowe, Rachel Warren, and Christy Waterworth behind the glass, I'm Travis William. We'll see you here tomorrow. Thank you.

Motley Fool Hidden Gems Investing - Neoclouds Shine

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.