Neocloud Providers Become the Canaries in the AI Coal Mine
The Nasdaq fell .7% last week while the S&P 500 was off by 0.5%. The Dow managed to post a small gain for the week while the small cap Russell 2000 climbed more than 1%. This was a more than a resilient performance given the news flow last week. Oil shot up past the $100 per barrel level on the WTI and over $110 per barrel for Brent. France was in flames thanks to riots and its sovereign debt yields continue to blow out compared to other European credits.
The shares of Meta Platforms ($META) fell following its third quarter earnings report, even as the company easily beat top- and bottom-line expectations. However, Meta Platforms became the latest hyperscaler to experience negative free cash flow in the quarter, thanks to its burgeoning capex budget.
The real action last week was in the neocloud providers. These firms are rapidly becoming the “canaries in the coalmine” as far as a potential AI bubble is concerned. Neocloud provider shares in IREN Limited ($IREN), Nebius Group N.V. ($NBIS) and CoreWeave ($CRWV) are all down 30% to 50% over the past month and feel like they have further to fall.
Gartner might have pointed out a true inflection point for the industry, and in hindsight, provided the pin that finally pops the AI bubble. Earlier this month, the marketing research firm posted an analysis that projected 80% of the neocloud providers would disappear or be absorbed by 2030. More recently, Elon Musk in a less elegant tone stated that 200 of these firms will soon experience a “guppy-like death.” This was just after Space Exploration Technologies Corp. ($SPCX) raised some $40 billion via a special purpose vehicle (SPV).
And that transaction zeroes in on the core reasons neocloud providers are never going to be able to compete against hyperscalers over the long-term. Alphabet ($GOOG), Amazon ($AMZN) and Meta Platforms may be experiencing negative free cash flow for the moment. However, they have other established businesses that generate hundreds of billions of dollars in revenue annually. They also have access to a much lower cost of capital.
Look at CoreWeave. At the beginning of this year, it was able to raise proceeds via debt issuance at 250 basis points over SOFR. More recent financings happened at 450 to 550 basis points over SOFR. And given some of those bonds now yield over 15% and credit default swap prices are implying a better than 50/50 chance of default from CoreWeave’s debt over the next half decade, the company likely can’t raise additional debt without paying much higher spreads over SOFR.
The bigger question for the markets is what are the second level impacts if the neocloud providers continue to deteriorate. Private credit and some of their captured insurance companies are significant holders of this debt. And private credit funds already are seeing record default rates and are significantly gating quarterly investment requests. This is largely due to their loans to the software industry back when the Fed Funds rate was near zero and the sector wasn’t facing the potential threat of AI.
Will turmoil in this part of the markets shut down the IPO Window? Last week an IPO in a Korean neocloud provider was an abject failure and Korean semiconductor SK hynix Inc. ($SYHX) pulled the planned U.S. listing of a subsidiary. Investors appear to be pushing back on the desired IPO valuations of Anthropic and Nscale recently, and last week OpenAI reportedly lowered its valuation from $1.4 trillion to $1.25 trillion as it sought additional financing.
So, is the recent turmoil across the neocloud provider sector just a major ‘hiccup’ or the start of the deflating of the AI Bubble? We will find out together in the coming weeks and months.
Positions: Long AMZN
