Five AI quirks and conundrums to watch this earnings season: McGeever

By Reuters News3 hours ago Updated

By Jamie McGeever

ORLANDO, Florida, Oct 21 (Reuters) - As US earnings season gets underway, AI bulls and bears are becoming more entrenched in their positions. Several market quirks, curiosities and anomalies have popped up that underscore these extremes.

This shouldn't come as a surprise, because, when it comes to AI, investors and analysts are largely flying blind. The technology is in its infancy, is evolving at breakneck speed, and has potential powers that are almost unfathomable. And the cost of funding this revolution? It's almost unfathomable too.

The implications for the broader market are also enormous. According to JPMorgan Private Bank's Michael Cembalest, AI-related stocks, a group he narrows down to 41 names, have accounted for 75% of S&P 500 .SPX returns, 80% of earnings growth and 90% of capital spending growth since ChatGPT launched in November 2022.

The results and outlooks from hyperscalers, “neoclouds”, chipmakers, software providers and all the AI-adjacent firms will set the tone for Wall Street and global markets going into next year. Here's the backdrop:

Equity-bond gap

As the old saying goes, bond investors are paid to be bearish and equity investors are paid to be bullish. Perhaps that helps explain why many of the bonds issued to finance America's record-breaking AI investment are trading at such weak levels even as AI-related shares mostly continue to move higher. Amid the latest wave of market jitters, it's easy to forget that the S&P 500 and Nasdaq .IXIC were at record highs only two weeks ago.

Those jitters have been meaningful, of course. The Philadelphia Semiconductor Index .SOX is down 25% from its June peak, and earlier this year the S&P 500 software index .SPLRCIS was down 35% from its record high. But the third-quarter earnings season begins, the chip index is up 55% year to date and software stocks have climbed back into positive territory for the year.

While “neocloud” company CoreWeave CRWV.O shares are down 13% this year, its October 2031 bond has plunged more than 20% since its launch in April and is trading in distressed territory below 80 cents on the dollar.

Meanwhile, credit default swap spreads, which measure the cost of insuring against bond default, have recently soared to record highs for AI borrowers including CoreWeave and Oracle ORCL.N, and even for trillion-dollar giants Amazon AMZN.O, Alphabet GOOGL.O and Meta META.O.

Someone might want to remind investors that debt is still senior to equity.

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CoreWeave: stock and awe?

CoreWeave is at the center of the latest market maelstrom. The Nvidia-backed NVDA.O AI infrastructure firm is loss-making, heavily indebted and faces soaring borrowing costs. But Wall Street analysts have wildly different views about its prospects.

Analysts at HSBC this week published an extremely gloomy note, forecasting average returns through 2030 below CoreWeave’s cost of borrowing.

"The more the company invests with this return profile, the more the value destruction," they wrote. Investors should cut their holdings of the stock, HSBC advised, assigning it a target price of only $39, some 37% below Tuesday’s close around $62.

Seems pretty clear-cut, right? Maybe not. Looking at the same data, equity strategists at Goldman Sachs this week raised their recommendation on the stock to a “buy” from “neutral.”

They reckon annual recurring revenue per megawatt is likely to rise over the next 24 months, and argue that the recent surge in yields doesn't represent the firm's true cost of borrowing because most of its financing is asset-backed. Even though they cut their price target to $106 from $139, that still represents upside of around 70%.

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Token gesture

Growth in token spending is slowing, yet token usage continues to soar. Tokens are units of data processed by AI models during training and inference, and they essentially reflect the strength of demand for "compute". Slowing growth or outright declines in prices would indicate companies are reluctant to pay for that compute unless they can turn it into "higher top-line growth, bigger profit margins or substantial cost savings," according to Apollo's Torsten Slok. These benefits have yet to materialize.

But token usage is still rising strongly and steadily. So demand is still there. It's just that spending appears to have topped out because token prices have fallen, which is a reminder to investors that revenue at the big AI model developers like OpenAI and Anthropic may not continue to rise as spectacularly as hoped. AI stocks are highly sensitive to expectations about future AI use and, obviously, revenue. How long can investors ignore the gap between the two?

Cold storage

Vast sums are being spent to address the shortage of computing power, but apparently some of that power simply cannot be switched on. Quite literally. Energy supply-chain chokepoints, including insufficient electricity and inadequate grid connections, mean many AI chips are sitting and depreciating in warehouses.

Only this week, Microsoft MSFT.O pulled out of a deal to anchor a flagship data center in Britain with Nvidia-backed Nscale after electricity grid officials said they did not expect to supply power to the site until the 2030s. Morgan Stanley analysts now reckon US data center developers will face a 30% to 40% power shortfall through 2028, equivalent to 34% of total chip demand.

Demand for power is rising, but it can't come online quickly enough.

Revenue conundrum

Ultimately, the AI investment bet hinges on whether the extraordinary sums being borrowed and spent on the technology will pay off. Third-quarter earnings won't give a definitive answer, but every nod and steer will be seized upon. The sums are eye-watering.

McKinsey and S&P Global estimate that the top six US hyperscalers alone will spend more than $7 trillion on data centers and other AI-related capital expenditure between 2025 and 2030.

Columbia University's Stijn Van Nieuwerburgh reckons the cost of financing the AI buildout from last year to 2032 will be $10.3 trillion. This spending is highly concentrated — just 2% of firms account for over 50% of total spending, according to one study.

If these firms want a conservative 10% return on that outlay, Van Nieuwerburgh estimates that annual revenue will need to be around $3.55 trillion by 2032. Some analysts suggest annual revenue of over $4 trillion will be needed to make the investment pay off. That's over 10% of expected GDP in 2032. That’s a very, very high bar.

(The opinions expressed here are those of the author, a columnist for Reuters)

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