Neocloud Stock Collapse: Buying Opportunity or Run for the Hills?

Senior director analyst Will Sommer said that to get a 12% return on invested capital (ROIC), AI data center owners would need to generate a combined $8.5 trillion in revenue to cover capital expenditures and financing costs. However, Gartner currently only projects cumulative AI revenue to reach $3.6 trillion by 2030.

That gap, in its opinion, will lead to massive write-offs in the AI data center space. Gartner believes that neoclouds will be the companies most hurt in this scenario. The biggest reason for this is that neoclouds need to see immediate returns on their infrastructure investments. Hyperscalers have other core businesses that generate ample operating cash flow that will allow them to sustain their AI investments.

Gartner said: “By 2030, Gartner predicts that cost pressure and a lack of a differentiating business model will force over 80% of neocloud providers to cease independent operations.​”

A buying opportunity or a sector to avoid?

Neoclouds are spending a massive amount building out their infrastructure and financing most of it with debt. Even with creative financing solutions, like GPU-collateralized special purpose vehicle structures, customer prepayments, and vendor financing, neoclouds still face high debt service burdens and have rapidly depreciating assets. (GPUs have economic useful lives of around six years.)

This makes investing in the space risky. Unlike the big three cloud computing providers, neoclouds don’t have strong core businesses to help fund their build-outs. Cloud computing is a scale business where size matters, and if these companies can’t reach a level where they can cover their fixed costs, they will be in trouble given the debt they are taking on to fund their data center investments. While I do think the business model could potentially work, there are too many companies chasing it, likely leaving a lot of losers along the way.

Neoclouds are currently in a high-leverage race to reach scale and profitability, and produce strong operating cash flow to cover their expenses. It can be done, as the cloud providers have shown, and a few top players with anchor customers may survive and thrive. However, the majority will likely fail, and potentially all of them will.

As such, I would avoid investing in the space or trying to pick any potential winners, as there is no guarantee there even will be any.

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Geoffrey Seiler has positions in Alphabet and Amazon. The Motley Fool has positions in and recommends Alphabet, Amazon, Microsoft, and Nvidia. The Motley Fool recommends Gartner. The Motley Fool has a disclosure policy.

Neocloud Stock Collapse: Buying Opportunity or Run for the Hills? was originally published by The Motley Fool