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AI investments carry whiff of vicious circles past

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The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

By Anita Ramaswamy and Robert Cyran

NEW YORK, Nov 29 (Reuters Breakingviews) -Artificial intelligence is spawning some genuinely concerning financial decisions. As technology titans jockey to back hot new startups, they are extracting explicit or implicit promises of revenue in return. The chaotic week of upheaval at OpenAI, the Microsoft-backed MSFT.O owner of ChatGPT, provides a window into how these sorts of supposedly virtuous circles have a way of turning vicious.

Mania over programs that emulate, or even surpass, human abilities is in full throttle. After OpenAI within days fired and rehired boss Sam Altman, following some intervention from Microsoft Chief Executive Satya Nadella, the startup looks to be pressing ahead with a planned share sale that could value it at more than $80 billion, according to the Financial Times. A deal would signal that the hype is strong enough to overcome the significant risks just laid bare, partly because of the corporate buttresses. Before the boardroom coup, OpenAI paused subscriptions for its paid ChatGPT Plus service because it couldn’t keep up with the surge of new users. This level of exuberance evokes the dot-com era in more ways than one.

Microsoft’s injection of $10 billion into OpenAI in January helped kick off the craze. As part of their deal, the ChatGPT operator agreed to exclusively use its new investor’s cloud computing services. In the 12 months before they struck the arrangement, OpenAI had spent less than $1 million with the software goliath, according to tech news outfit The Information, with the figure now on pace to exceed $400 million a year on Microsoft’s Azure alone.

So-called generative AI, which uses algorithms to produce new text or imagery from the data on which it is trained, has released animal spirits across Silicon Valley. Microsoft, Apple AAPL.O and Alphabet GOOGL.O are among those handily outperforming the Nasdaq Composite Index .IXIC this year. The excitement makes some sense, but there is notable danger embedded in the way the investments are being structured, just as there was in the 1990s when stretching communications networks across the globe was all the rage. Both turbocharge new ideas in ways that simultaneously manufacture fresh demand for existing products. But regulation or other complications could easily slow progress or create extra hurdles for AI adoption, in turn jeopardizing all the extra revenue Big Tech is anticipating and their ballooning valuations.

OpenAI’s recent fundraising could make it worth more than double the $30 billion imputed earlier this year. The uplift has been symbiotic. Microsoft, including debt, is now valued at about $2.8 trillion, or more than 10 times the revenue analysts expect for the next year, according to LSEG. The multiple is 25% higher than a year ago. It’s partly attributable to the prospect of upselling Microsoft 365 subscriptions with AI features and the 30% growth in its Azure web services division, helped along by OpenAI and its peers.

Other top lines are set to be boosted by AI ventures at sums equivalent to the amount of capital being pumped into them. Amazon AMZN.O, for example, unveiled plans in September to plow up to $4 billion into Anthropic, which has agreed to spend just as much over the next five years on Amazon’s cloud computing services, according to the Wall Street Journal. And soon after Amazon’s deal, Google committed an additional $2 billion to the same startup, which months earlier had signed a contract with Google Cloud worth more than $3 billion.

All this mutual back-scratching is reminiscent of the bubble from a generation ago. Then, new entrants as well as more established companies borrowed more than $1 trillion to install telecommunications cables across ocean floors and beyond. Equipment suppliers including Cisco Systems CSCO.O, Lucent Technologies and Nortel Technologies enjoyed fast top-line growth, and valuations. The problem was that the revenue underpinning the boom wasn’t all it was cracked up to be.

The worst form was known as roundtripping. Company A would strike a network capacity deal with Company B, often at the end of a quarter, and then Company B would buy some from Company A at a similar price. Executives from Global Crossing, for example, paid large sums to settle lawsuits related to the practice. Many in the industry were forced to restate their financial results and ultimately went bankrupt.

Legal, but misguided, vendor financing was another problem at the time. Telecom equipment makers provided credit to startups so they could buy the gear they needed. The rationale was that companies like Nortel could put their blue-chip balance sheets to good use. Customers would pay higher interest rates to compensate for the risk, and lock themselves into using a particular supplier’s switches and other gizmos. In a business where size matters, competitors that didn’t lend put themselves in danger of being left behind.

When the bubble burst, it created a double whammy. Earlier equipment sales went bad, causing defaults and impairing balance sheets, while new orders also dried up, leading to unexpectedly large losses. Network gear manufacturers endured a decline of more than 90% in their collective market capitalization over a decade.

This begs the question of whether history is threatening to repeat itself today with what could be described as vendor equity. Although the latest arrangements are helping puff up valuations on both sides of the transactions, the dangers appear to be more manageable. For companies valued in the trillions, a few billion dollars is a pittance. Much of the invested capital should be returned relatively quickly as AI firms buy back-end services. The industry’s mortality rate, like that of so many other fledgling tech ideas, presumably will be high, but if the overall market keeps growing there might even be benefits while riding the wrong horse.

Amazon, for example, seems motivated by the chance to beef up its nascent chipmaking business. The e-commerce giant agreed to sell semiconductors to Anthropic to power its AI-model training efforts. Nvidia NVDA.O has at least 80% and as much as 95% of the AI market, according to estimates by analysts. By using Anthropic as a training ground to iterate and improve on its own less-popular alternatives, Amazon might be able to eat into that dominance, a benefit it could reap regardless of Anthropic’s fate. If Amazon captured, say, 10% of Nvidia’s share, its chips business alone theoretically would be worth more than $100 billion.

The trouble with investing obsessions is that they do more damage as they grow. In telecom, for example, vendor financing accelerated rapidly into the crash. Optimists feared missing out on a rare opportunity, while cynics realized even bad deals would lift stock valuations. It means that as this latest tech craze grows, it pays to keep a close eye on how much tech incumbents and entrepreneurial AI endeavors prop each other up.

Follow @AnitaRamaswamy on X

Follow @rob_cyran on X

AI has helped boost Big Tech valuations over the past year AI has helped boost Big Tech valuations over the past year https://tmsnrt.rs/40IkrW9

Editing by Jeffrey Goldfarb, Sharon Lam, Aditya Sriwatsav and Streisand Neto


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