AI Giants Keep Making Circular Deals. Here’s Why That’s a Risk

Investment Analysis Clubs Macro Economic Trends and Risks
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https://www.morningstar.com/stocks/ahead-ipos-ai-giants-keep-making-circular-deals-heres-why-thats-risk

With OpenAI reportedly missing revenue targets, the imbalanced risks of circular deals become clearer.

Rather than AI suppliers simply paying their vendors for products and services, these so-called circular arrangements involve vendors making payments back to—or taking stakes in—AI companies. OpenAI has engaged in such deals with Nvidia NVDA, CoreWeave CRWV, and others. Competitors Anthropic and xAI have made similar agreements, in which corporate investors provide capital in exchange for commitments of future computing resource contracts.

The pattern has been on full display over the past six months. In March, OpenAI closed a historic $122 billion funding round, with Amazon AMZN committing up to $50 billion and Nvidia $30 billion. OpenAI also expanded its existing $38 billion multi-year agreement with Amazon’s cloud computing unit AWS by $100 billion, and it committed to deploy next-generation Nvidia chips.

With The Wall Street Journal reporting that OpenAI has missed internal growth targets, investors are questioning the assumption that AI labs will grow revenues large enough to meet their obligations. OpenAI CFO Sarah Friar has warned that if revenue doesn’t accelerate, the firm could fail to pay for future computing contracts. (OpenAI has disputed the Journal ’s reporting.) If that happens, it could significantly impact companies that have been banking on the AI giant’s growth.

Because of the structure of these deals, Rolfes says, the risks are not even. He points to the deal wherein Microsoft has a stake in OpenAI, takes 20% of its revenue, and is owed years of Azure commitments. “That’s not a partnership with aligned incentives, but a fixed claim on your upside, regardless of how your margins perform. When revenue misses, the hyperscaler doesn’t absorb the pain alongside you; they get paid first.” It’s a similar story, Rolfes says, with Alphabet’s $40 billion investment in Anthropic, alongside the multi-gigawatt TPU deal involving specialized chips for Google.

So is the bloom coming off the AI rose?
Maybe lack of breadth in the stock market IS a concern? HM

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Sounds similar to a pyramid scheme. Likely the defaults, if they happen, create a cascade. Only the cash rich survive? From what I have been hearing OpenAI could trigger a default cascade.

The Captain

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Programmers are stuck on AI as addicts. That is the first big use of AI. The charges for that are going to rise, but only Anthropic is useful to coders. AFAIK

Of course the Pentagon is not using Anthropic. Another blunder.

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Most of the hyperscalers are investing their own cashflow to build AI capability. They know a few companies will emerge as leaders. They do not want to be left behind.

A few like Oracle are borrowing heavily to build capacity. That is higher risk.

Alphabet/Google has the most obvious route to profits in AI. They are advertizing supported. Microsoft has the same route in mind. Probably Meta/Facebook. Amazon less so but much potential through AWS.

OpenAI’s route to profits is less obvious. They are pursuing the Amazon strategy of focusing on establishing a leading brand name. They will have first shot at market share.

Nvidia has not much to lose selling chips for equity positions–especially while the stocks are doing well.

And then we have all the other players. Companies building data centers with plans to rent capacity. And many hardware suppliers who will do well while data centers are building–maybe for three more years.

Investors are well aware of the risks. This could be a house of cards. Believers think we will continue building once the profits come rolling in. Digitizing the entire world might take a while.

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There are secondary effects as well. I’ve read that in quite a few places, the building out of data centers has consumed much of the local talent by paying higher prices (contracting, wages, etc) and squeezing out most other enterprises. This bidding up of price causes other things (housing, commercial, etc) to show shortages and dramatic price increases. For example, an area with large new housing growth (Austin, for example), requires a few new supermarkets to be built. They manage to build the structure at somewhat increased cost, but then suddenly when they need to build the large walk in freezers and fridges, there are no contractors available for 2 years plus because they’ve all signed onto building cooling for data centers. They try to import contractors from neighboring states, but most of them are already busy, and even at much higher prices, they can’t get a lot of basic materials to complete the job in any semblance of a timely manner. Another example is small-scale housing construction in CA, there are requirements regarding electricity distribution there that needs a certain type of electric panel accessible to firefighters from the street. Those devices are on backorder for at least a year, and sometimes almost two years! And without them, you cannot get a certificate of occupancy no matter what you do, temporary or permanent. So builds languish near the tail end for months and months waiting for these types of items (that are instead being rapidly consumed by the massive data center buildout).

There are probably also some tertiary effects.

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