Motley Fool Hidden Gems Investing - When $150 Billion Looks Small

Starting point is 00:00:01 150 billion. Not that big. Motley Fool Hidden Gems Investing starts now. Welcome to Motley Fool Hidden Gems Investing. I'm your host, Tyler Crow. And today I'm joined by longtime full contributors, Rachel Warren and Lou Whiteman. We are going to get into the promise and the perils of investing in the defense and security sector. We're also going to hit the mailbag. But we wanted to start the day with, I guess you could say, the biggest news story. And that was NVIDIA. They had a couple of press releases today, one on AI safety. And for the investors, perhaps the bigger one is the board of directors announced a $150 billion share repurchase agreement. It's as a press release says, the biggest in history and kind of gives the board about $250 billion to buy back shares right now. Now, guys, I'm going to give a hot take and I want to get your quick reactions to this.

Starting point is 00:00:56 I think it's way too small. I mean, look, they're finally off the one cent of share dividend, which I, I, I, I didn't understand that either. But, yeah, the law of large numbers just kind of is, even that's thrown out of proportion here, but nothing is big enough. And yeah, $150 billion, yawn. Yeah, I mean, it's the biggest in history, but it's also only around 2% of its market cap. So you sort of have to right size that for the company we're talking about.

Starting point is 00:01:21 The other way to look at it is that Nvidia is generating tremendous amounts of cash flow from the AI infrastructure buildout. They have more capital than they can logistically reinvest back into R&D. So I think that this is a way we're seeing that play out. I would make the argument that the announcement should be like at least triple this. I know that sounds like crazy and probably put me on like CNBC. But, you know, not that's crazy tech person. Well, look, let's put it this way. We could do a CNBC take on this.

Starting point is 00:01:52 But like I would argue, number one, between its valuation, its current like debt situation. And as we said, it's only like, 2% of its market cap. There is an opportunity here for a 5 point. It changes $100 billion a day, so I can't even track what the point is anymore, but 5. Something trillion dollar company, this should be somewhere in the, you know, at least 5% of its market cap. If you're going to, if you're trying to wow investors, don't be afraid to use a little bit of leverage. This is a company that made $134 billion in free cash flow. So you added one year's worth of free cash flow. Come on. Impress me, Nvidia.

Starting point is 00:02:32 I'm being a little hot take here, but part of the reason I think that they announced this, and I want to get your guys' take on this one specifically, was in addition to this share repurchase, there was a press release related to, you know, it's AI safety and perhaps building some guardrails or some safe spaces where we don't get these. Hey, AI may have hacked Hugging Face. Hey, AI may have hacked the Australian government's health websites. All of these news stories we've been hopping up. it was maybe this $150 billion a little bit of, hey, let's help the medicine go down here for our investors. Yeah, I think that's definitely part of it. I don't think the timing is a mistake by any means. I think that was probably very well coordinated from up above. But this is a real industry issue.

Starting point is 00:03:14 We're seeing advanced A.M models, as you noted, from a wide range of labs as well as the big hyperscalers that are repeatedly breaching secure. Sandboxes, obviously, there's the high-profile hugging face incident. But we're also at a time where CEO Johnson Huang has been very, very clear on the approach he wants to take here. He doesn't want to wait for government regulation. He's actually pushed back against that. He's really framed AI safety strictly as an engineering problem that can be managed at the hardware and platform layer. And so just to talk a little bit about what they're doing, Nvidia is introducing an open source framework. It's called OpenShel. They're also introduced a hardware watchdog called Century. And essentially, the idea is these will help quarantine rogue software within milliseconds. Open shell is interesting.

Starting point is 00:04:01 You know, it's open source, as its name indicates, it's designed to support rival platforms, you know, from ARM and Intel. And so you can see how Nvidia is trying to establish a universal industry standard for safety. They want to lower the risk barrier for enterprise adoption before maybe you see more corporate security teams or regulars freeze the deployment of autonomous AI agents. So I think that they're very much trying to get ahead of the curve here. Back to the investing question. Yeah, I think they're couching bad news with good, but also, look, this is part of a trend. Invitya has run out of ways to while the market. Jensen increasingly, he looks like the greatest showman. You know how many times he now goes on stage to just make bold pronouncements. The stock has done nothing basically since the spring. Amazing earning reports are just kind of being met with. I think, look, this is a great business, but the perception is, you know, whether it's, you know, whether it's, AI domerism, they're trying to push back against or just kind of investor boredom. Nvidia has run out of ways to wow or excite investors.

Starting point is 00:05:06 And I think the big buyback, this is just another maybe failed attempt to say, hey, remember us? We're still really good. Yeah. Well, guess what? If you're the CFO and you really want to wow investors, $500 billion buyback. That's going to be my pitch to them. But to that point, though, like, Nvidia trades for about 18 times its earnings estimate.

Starting point is 00:05:26 for next year. It's the cheapest in a decade. A nice say or a little quib I like is the market is irrational, but it isn't dumb. So there's, there is some risk building here that maybe we're not seeing. What may those risks be that investors might want to consider that are kind of maybe hidden that most people aren't thinking about because cyclicality, of course, there's cyclicality in this industry. But what are some of the like, maybe people are considering this one as much? I think there's a few things to consider. I mean, one is sort of the, the circular funding. This isn't hidden. This is something that's been talked about a lot. I mean, we look at that that number that Invidia just announced today. They've disclosed that Anthropics

Starting point is 00:06:04 aggregate contracted value across Nvidia-backed cloud entities has scaled above $180 billion alone. That's just in their arrangements with Anthropic. Invidia's balance sheet includes 13 public stakes, over 200 private stakes, $20 billion in data center lease commitments. They're operating essentially like a central bank for a lot of the AI industry. Part of that is a function of necessity. Obviously, the idea is that that flows back into the growth story for NVIDIA, but there's that circular funding mechanism that I think is concerning depending on if or when the buildout slows down. One other thing to note, you know, hyperscalers are writing off these AIGPUs on aggressive three to five year life cycles. They're operating under the

Starting point is 00:06:46 assumption that there's going to be these kind of constant multi-billion dollar upgrades. But what if you have a GPU that's a few years old that ends up being perfectly adequate for 80% or more of enterprise inference workloads. That upgrade cycle could be much slower. And if that happens, you could see companies like Nvidia face a bit of a cliff or at least a slowdown in growth, even if it's a distant one. I mean, essentially this idea, not that the technology fails, if the existing hardware works too well, you could start to see Nvidia frozen a little bit out of its own upgrade cycle. That's the extreme case. But I do think it's something that if you're an investor in Nvidia. If you're looking at Nvidia right now, these are a couple key factors.

Starting point is 00:07:27 You need to be incorporating into your investment thesis. I think there's a pretty not extreme, straightforward case to say that the best is now behind them for the AI cycle. Not that it can't be really good for a long time, but Google, Amazon, Microsoft, meta, Open AI, they're all at least trying to make their own chips. No one is going to stop doing business with Nvidia, but Wall Street pays for growth. And, you know, if they can't, If there's more competition coming in, I didn't even mention the other chip companies, that is going to put a cap maybe on upside growth. Also, if the frontier models don't matter as much,

Starting point is 00:08:03 and I think evidence is growing that they don't matter as much, then does having the latest, greatest, newest, most expensive chip matter as much at the scale we hoped? And you say it's boring, but it does matter. Cyclicality is a thing. As recently as 2023, Nvidia was generating earnings per share under a dollar per year. Now it's at eight. So it may look cheap on a price to earnings basis, but there is a question of, is this earning, this level of earnings per share? How long could it go on? And if not, that multiple looks a lot different. You know what brings up that earnings per share? $500 billion buy aback. I am going to talk this one into existence. All right. Coming out for the break, we're going to talk about the defense and security industry.

Starting point is 00:08:47 Red Ladis is a cybersecurity company that's going public via SPAC. It expects to merge with a company that's called Bold Eagle Acquisition Corp, and it's going to be, and concludes sometime around the end of 2026. It's expected to go public at around $1.25 billion, and I would say the layman's way to describe it is it's a competitor to Axon Enterprise and Celebrate in cracking encrypted devices and other sensitive information processing. There's quite a few of these companies starting to pop up in the different. defense industry. And the company itself isn't why I bring this topic up, though. It's making

Starting point is 00:09:25 its rounds on the financial media ranks. But I think that this is kind of indicative of a shift in the market's attitude towards defense, defense tech, and somewhat related space companies. For much of the 20s, 2010s, the defense industry was consolidating. It was fewer, fewer players and those giants, like, to me, they weren't that far removed from like utility companies in terms of growth, earnings, what have you in terms of the returns, for a myriad of reasons, that's changed and there is bound, I think, to be a fair share of companies going public in this space, some of which are going to be lower quality companies, very similar to what we saw with SPACs in 2021 in the FinTech technology, consumer tech sort of region. So, Lou, I know you've

Starting point is 00:10:12 done a defense for a little while. Rachel, you've given some thoughts on this as well. When you're looking at IPOs for defense-related companies, we're going to see a lot of them. What are some of the specific traits to defense investors should look for? Well, let's start real quick outside of defense, just why do companies go public via SPAC? The big thing is, is that a SPAC is technically a merger. And SEC rules give you a lot more leeway to talk about the future in a merger than they do in an IPO. That matters if you don't have much of a pass to talk about. And so we are talking about early-stage companies that really want to talk about the future. That fits in real well. As far as defense specific, the Pentagon has been talking about diversity a lot, but it doesn't want to deal with

Starting point is 00:10:57 these companies. It really doesn't. So what am I looking for? I'm looking for on ramps. I'm looking for companies that work with companies that have direct access, whether it's the primes, whether it's these new generation. But it is not easy to get in the kind of cool guys club at the Pentagon. A lot of these, even if their technology is better, are just not going to generate the revenue that they hope to if they aren't in the room. Also, Lou, I'm going to stop you for a quick sec-ex, just to, for everyone who's not a super defense, you know, sicko, what is a prime? Because I'm sure there's some people being like, what is that?

Starting point is 00:11:32 The prime contractors are, well, I mean, for the most part, we think of them as Lockheed Martin, Northrop and the big mess of guys, but there's smaller ones too, but basically they are the ones in the room. They are the ones with direct contacts and contracts with the Pentagon. They're called Primes because literally the Pentagon does business with them, and then they just kind of dole out revenue to other companies that work with them. Another thing you've got to consider here is most of these defense tech companies are just have some novel tech, and it looks like wow, and it looks like, wow,

Starting point is 00:12:01 they're the only ones who can do this. There is a ton of government-funded R&D going on with the inside the established contractors. Because it's classified, they don't talk about it much, and they don't have a need to talk about it the way you do if you have an IPO, I've seen numerous companies basically fail because what looked to be unique or look to be something they could only do was actually yesterday's news on the inside. So it's really, you can't do due diligence here because so much of it is classified, but just be aware that if the first thing you think is, wow, why didn't anyone think about this? That might be a yellow flag. Also, and again,

Starting point is 00:12:39 it just can't say this enough that just the idea of how you get in the room, for most of these companies working with the government is a core competency. It's really hard to deal with government bureaucracy. And most companies can't. It is a skill to be able to navigate this. I really want, I don't want some Silicon Valley dudes with an idea. I want at least someone in leadership, whether it's a chairman or something that has government-related experience. Related, you need a big employee base with security clearances. If you don't, you can demo whatever you want, but you're never going to get to interact with the defense chain. So those are just kind of some yellow flags to look at when you're looking at these companies. So Rachel, Lou kind of gave the lay of the land here.

Starting point is 00:13:21 And, you know, there's some red flags, yellow flags, things that clearly you want to see. When you're looking at this as well, what do you think are some of the like the pitfalls or mine fields that are kind of specific to the defense industry kind of playing off what Lou was talking about here? Yeah. I mean, I think there's a few things to watch for. One, and Lou alluded to this, So it's dangerous to assume that a successful high-profile prototype or even a small business innovation research grants can easily convert into an official military or defense program of record. There are many young firms that burn through their entire capital reserves and collapse while waiting the two to three years or more it typically takes for the Pentagon to officially

Starting point is 00:13:57 allocate full production funding in the federal budget. So that's one thing to be aware of as well. Often, a defense company's fastest growing and highest margin business segments are wrapped in classified or special access programs. So management is legally forbidden, essentially, from disclosing a lot of the granular details. And so investors often have to model kind of future revenue while being very blind to the exact contract terms, customer identities, underlying unit economics. That is part of the nature of the beast when it comes to looking at potential IPOs in the space or in some cases younger public companies. you know, that have risen through the ranks and aren't those typical prime names that we think about. As I was kind of alluding to, there's a lot of companies we expect to go public in this space.

Starting point is 00:14:41 And not to kind of bring up one where it's like the Silicon Valley Bros that Lou was talking about. But Anderil is, and I hope I pronounce, it's Anderil, Anderil, depends on who you ask in terms of pronouncing Anderil. They're expected to go public relatively soon. There's a will they, won't they with Blue Origin, the space companies, were supported by Jeff Bays. Some of those are like the big name grabbers in terms of IPOs that could come happen sooner or later. Is any of these companies on your radar, either it being Enderil, Blue Origin, or maybe some mysterious third company that people haven't heard about yet? So Enderil is a good example of something that Rachel was talking about, that they, I would argue they look more impressive than they are because they are allowed to talk about everything they're doing and the ones inside the tent aren't. So just, you know, be careful there.

Starting point is 00:15:30 I'd honestly be surprised either they or Blue Origin go public anytime soon. Ursa Major, which is in pendings back. They're so similar to what's going on with Red Ladis. They're kind of interesting.

Starting point is 00:15:44 They do rocket and missile propulsion systems. Shield AI is similar to Anderol. I think it's actually more advanced in Anderil. I think they're more likely to go public. I'm worried about the valuation there, but I'd be intrigued if they came out. Yeah, Andriel's definitely one on my radar. I think they're one of kind of the key

Starting point is 00:16:00 players in the modern defense tech asset class. I mean, they've definitely moved past the speculative startup phase. They're building out some pretty impressive operations from what we can see. There's the Arsenal One hypermanufacturing facility in Ohio. This is specifically designed to mass produce autonomous military hardware like software-defined drones and underwater vehicles. I'll say the founders have been very disciplined about avoiding a premature public debut to the market. So that may be something that we continue to see pushed back for the foreseeable future. Earlier this year, they announced, a major 10-year U.S. Army Enterprise contract worth up to $20 billion. It's another green flag for the business.

Starting point is 00:16:37 So, you know, whether it goes public in the coming months or in the next few years, definitely one that I have top on my radar. I don't know how long it's going to take, but just hearing the word SPAC still just has like the hairs on the back of my neck, just kind of like perk up. Bad memories. Yeah, just, well, just seeing all the scars of what happened with 2021. I don't know how long that's going to be, but Lou, Lou, you were mentioning a couple of those one, Ursa Major, being a SPAC merger. I don't know. I was like, as good as is, I still can't

Starting point is 00:17:06 get over that bad feeling in the back of my head. Hopefully, Ersa Major can prove me wrong. Yeah, Rocket Lab. Fair enough. Coming up after the break, we're going to hit the mailbag. Hey, everyone, quick reminder. If you want to get a question into us, email us at Podcasts at Fool.com. That's Podcasts with an S. I've also got the email in the show description below. Well, today's question comes from Cam, and we've been talking a little bit about FinTech, Lou. You kind of went a little hard on them last week about it being a tough business, but Cam's question is in the fintech industry. He has a question about Clarna. This is going back to its most recent earnings. It looked like a blowout quarter. Every metric was up and up significantly, but the stock dropped

Starting point is 00:17:50 20%. This was, I think the email was right around the time with Clarnas earnings. It looks like this is a challenger to traditional credit card companies and like it is making great strides. The price of sales ratio seems low. Market cap seems a lot of room for growth, and it seems that they are now profitable. What am I missing? Cam, thanks for the question. What do you guys think? Yeah, I think there's a few things going on here. I would necessarily position Klarna as a, you know, key competitor that's going to outpace the traditional credit card companies. I don't think they have to. But there were a few reasons why the stock has been under pressure recently, especially after their earnings. So they delivered a billion dollars in revenue. That was up almost 30% year over year.

Starting point is 00:18:29 They actually turned a surprise net profit of about $9 million. But they lowered their full year revenue outlook. And that came in quite a bit below the consensus estimate the analysts had modeled. And management essentially said that they're seeing a major slowdown in discretionary consumer spending in Germany. Well, that matters because Germany is cornered largest, most profitable region. They said there was a $600 million foreign currency translation headwind at the same time, Klarna unexpectedly announced that both their chief financial officer and their chief marketing officer are leaving the company early next year. So kind of a series of bad announcements, the market didn't like it. On the positive side, their U.S. business is expanding rapidly.

Starting point is 00:19:09 But I think investors are unhappy with the fact that the very mature, historically kind of higher margin European business, that's softening a lot faster than Wall Street had anticipated. Now, if management stabilizes those operations and continues to expand in the U.S., I think buying at these levels could be, you know, a compelling choice for long-term investors personally. But that's some of the machinations going on behind the stock important to be aware of if you're going to be a buyer. The market is always forward-looking. And the posted numbers were fine, but there was a lot of dark clouds or gray clouds into the future. You throw in the fact that the entire buy now, pay later industry has never had to underwrite through a real downturn. I think that there's reason. I'm not saying

Starting point is 00:19:52 they'll fail, but I think we just don't know. and we need to accept that and not overvalue these things. I do think there's a real business there. I do think actually it cuts into credit card volumes over time. But look, I'd like to see more of a market cycle play out here before I buy any of them. And if I was going to buy a buy now, pay later, I don't think Clark would be my first choice. It seems too, like we discussed this with the recent announcement that New Bank and Revolut are going to be coming into the United States, where we're getting these blurred lines, you will,

Starting point is 00:20:25 of like the new fintechs or traditional banks, they're all kind of attacking the same target audience and starting to look more and more like each other. So it'll be curious, even though they're technically not competitors, all of these other entrants coming into the market are just going to make that many more like gross merchandise volume or, you know, customer uptick.

Starting point is 00:20:49 It's just going to be that much harder. And like, to your point, Lou, anything that's in the financial industry, going through a credit cycle, good or bad, you almost want to feel like you want to wait for at least one or two to see who actually gets weeded out for the good or the bad. As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have recommendations for or against, so don't buy or sell stocks basically away here. All personal finance content follows Motley Fool editorial standards is not approved by advertisers. Advertisements are sponsored

Starting point is 00:21:17 content and provide for informational purposes only. To see our full advertising disclosure, please check out our show notes. Thanks for producer Dan Boyd and the rest of the Montefield team. For Rachel, Lou and myself, thanks for listening and we'll chat again soon.

Motley Fool Hidden Gems Investing - When $150 Billion Looks Small

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