Bargaining chips: Nvidia is the bank of AI

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1:26Rosie Blau:The Economist.

1:32Rosie Blau:Hello and welcome to The Intelligence from The Economist. I'm Rosie Bloor.

1:42Rosie Blau:Today on the show, the changing geography of knife crime in Britain and remembering Frank Smith, America's longest serving prisoner.

1:57Ann Wroe:But first...

2:07Rosie Blau:Few companies have grown so slowly and then so fast as NVIDIA. The chip designer, whose processors power much of the world's artificial intelligence, took three decades to reach a valuation of a trillion dollars. Yet it doubled that in just nine months. And it crossed the 5 trillion mark less than two years later, making it the most valuable company in the world. Problem is, when a firm is so big and so successful, people just expect it to keep on going. Jensen Huang, NVIDIA's boss, has turned to an aggressive spree of financial engineering, which is designed to boost demand for its ships. Shalas Chitnis is our global business writer.

2:53Now, this strategy carries some risks, and critics warn that it also has echoes of the dot-com boom of the late 90s.

3:04Rosie Blau:Shalash, before we get to the risks, explain what you mean by the financial engineering. What does that look like in practice? Yes, so during the initial phases of the AI boom, demand for NVIDIA chips was just huge, and it couldn't make enough of them to satisfy demand. That is still the case, but investors' expectations of the company's growth have also continued to increase over time. And so to really meet that, what NVIDIA is doing is it's coming up with different financial mechanisms in which it enables its customers to be able to afford its pricey chips. So to give you an example, in mid-August, NVIDIA agreed to provide a guarantee of up to$105 billion so that OpenAI, which is an AI lab, could lease a vast data center in Ohio.

3:53And then just a week earlier, it announced a partnership with six Wall Street investment firms, including Goldman Sachs, Blackstone, BlackRock, really the who's who of Wall Street, to help raise over$500 billion for an AI infrastructure fund, which would essentially be built on NVIDIA's equipment. And in turn, NVIDIA could potentially backstop around 25 % of those deals by guaranteeing the value of its chips. Now, these are just two deals, but there are a multitude of deals that the company has announced over the past six months. And when you start to add all of those up, including the equity investments that it has made in startups, these backstop commitments, purchase commitments, it has all added up to over$350 billion.

4:41And just yesterday, it acquired Hugging Face, which is an open source platform for hosting AI models, for$13 billion. And so not surprisingly, some people have started calling NVIDIA the bank of AI.

4:55Rosie Blau:Given the continued demand for its chips, why the need to do this? That's a really good question. And what NVIDIA would say is there's definitely a demand for its chips, but compute, which is essentially the processors and memory chips that make up an AI data center are really, really expensive. So to give you a sense of scale, it costs almost 50 billion dollars to build a one gigawatt data center. A one gigawatt data center is a massive data center that is being built by some of these large AI labs. Now, some of the big tech firms, which are called hyperscalers, like Amazon, Google, Microsoft, they can actually afford the spending.

5:38What NVIDIA says is a lot of the smaller firms or even AI labs that are bleeding cash don't have the cash flows today to be able to finance their investments in AI infrastructure. So what NVIDIA is saying is by stepping in and providing these guarantees, it's helping enable the demand for some of these type of projects.

5:59Rosie Blau:So what's the broader strategy behind that change in NVIDIA's approach? You can think of it as having two legs. The first leg is what I would call plain vanilla, which is very standard Silicon Valley playbook, which is a large company investing in smaller startups in the hope that as those startups grow, they will increase the demand for its own product. So that's what NVIDIA has done. It has just gone out and has become one of the most prolific investors in startups across the valley. And their investments now total over$100 billion. dollars. So as NVIDIA funds a lot of these startups, the goal is whether they're AI applications, software, whatever it is, as they mature, they will of course need a lot more compute.

6:40And when they need compute, they will turn to NVIDIA. The second leg, I think, is a little more novel. And this is the part that has caught most of the attention as has generated a lot of discussion, which is it's using its balance sheet heft to be able to help its customers that don't have such strong balance sheet to be able to finance some of these infrastructures. A good example is in late July, it announced a new business model for NeoClouds. These are firms like hyperscalers that build AI infrastructure and rent it to other firms, except they don't have the cash flows that hyperscalers have.

7:14And so what NVIDIA has done is it has agreed to buy compute at pre-agreed prices if those NeoClouds cannot sell it elsewhere. So what that does is it gives the lenders a little bit of guarantee in terms of predictability of the cash flows because Nvidia is backing it. And then that in turn helps them raise loans at more agreeable rates. Instead of raising it at rates that may typically be for junk bonds, it comes closer to what could be classified as investment grade loans. The other one I think is a little bit more creative where Nvidia is now also starting to pool in capital from private sources.

7:51So it's no longer just its balance sheet. It wants external private credit, the funds that we talked about, to be able to invest. Now, one of the challenges for that is private creditors or banks are not very comfortable valuing GPUs as an asset class. They can value a data center, they can value machinery, but GPUs are very new. And so what NVIDIA is doing is it's saying, I'm going to guarantee the value of my assets up to a certain point. And that gives creditors confidence to be able to lend more.

8:20Rosie Blau:OK, let's get to the risks then. Why are some critics concerned about this shift? I think the big question is what is known as quote-unquote circular financing, which is a vendor financing its own customer sales. That's the absolute worst case scenario. And this is something that had happened a lot during the dot-com boom that we alluded to at the start of our discussion, where firms like Alcatel and Cisco essentially gave loans to a lot of telecom providers to be able to buy their equipment. when demand didn't materialise, they couldn't make good on their loans and everything fell down like a pack of cards.

8:55Nvidia is very sensitive to allegations about circular financing. What it says is it is enabling demand and not really creating circular financing. But a few folks I spoke to said that it's a very thin line between enabling demand and creating it. And one of the analysts mentioned that Nvidia is actually starting to get pretty close to that line.

9:14Rosie Blau:And are those anxieties warranted, do you think? I think these are legitimate questions to ask. However, when you work through the math, at least today, NVIDIA's balance sheet is so strong that it can actually handle some of these guarantees. We calculated around$300 billion in potential obligations based on all the deals that we tracked. Now, the reality is it's very unlikely that NVIDIA would have to make good on the whole amount because the way these guarantees are structured is it's over a period of time. If certain things don't happen, then NVIDIA has to step in and pay the difference and all these different things.

9:50So when you actually work through that, the potential obligations actually start to reduce as time goes on. So that's number one. Number two is we have to remember that NVIDIA is just an enormously profitable company. And there have been few companies in history that just generated this amount of cash. It's already sitting in around$96 billion in cash and short-term investments. And this year, it's expected to generate almost$200 billion in free cash flow. So these are huge numbers we are talking about. And in our assessment, so far, NVIDIA can actually abide by these commitments.

10:21Rosie Blau:And what if we're wrong? What if NVIDIA is wrong? If it's made the wrong bet, what would a fallout look like? One thing to keep in mind is it need not be a completely disastrous outcome like AI demand collapsing. Even a slowdown in AI demand could actually lead to a lot of these contingent guarantees coming due. And the reason I say that is everything in the market is priced for demand to just continue increasing at the pace that it is going right now and that's why all the supply is being built around that as well. If demand does not grow at the same pace it is quite possible that we will have a lot of unused compute in which case Nvidia would have to step in and make good on those guarantees.

11:02Now if that happens you have to also remember on the input side Nvidia would probably be selling a lot less chips as well and so right at the time when it is making good on these commitments, its cash flow would start to reduce. And the danger, I think, is there could be a lot of speculative projects that may otherwise not get funded that are being funded today. And anytime there's a slowdown or a deacceleration in demand, these ones could be the most exposed. And so investors should be really wary that more of the boom that NVIDIA finances, the more of the bust also it may have to bear.

11:39Rosie Blau:Shalesh, thank you very much. Thank you for having me. And you can hear more about NVIDIA on this week's episode of Insider, our video offering which takes you deep into the belly of our newsroom. Along with a panel of other economist journalists, Shalesh will be chewing over what NVIDIA's deal-making might mean for the future of AI, the opportunities and the risks. If you're a digital subscriber, Insider is already part of your subscription. If you're listening free, you can watch extended clips. I've put a link in the show notes.

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13:55Ann Wroe:We begin with breaking news. Out of London this morning, a local group says two people have been stabbed in a Jewish neighbourhood.

14:02Rosie Blau:Where a woman has been arrested after police say that she stabbed four men. The Metropolitan Police say they respond...

14:08Sonny Loughran:Knife attacks, stabbings, slashings, 62 weapons, handguns, and a man in his 20 died having been pursued...

14:16Rosie Blau:Listen to the news or read social media, and you'd think London was rife with knife attacks.

14:21Ann Wroe:Today you have people being stabbed in the ass, or worse.

14:26Rosie Blau:Donald Trump is one of many to speak of the city's apparent lawlessness. But his sources seem to be somewhat outdated. Knife crime in Britain is now moving out of its cities.

14:39Sonny Loughran:Contrary to popular opinion, cities like London especially are much safer than they used to be. So if you look at homicides, they've halved since about 2018, which is when they peaked in Britain.

14:51Rosie Blau:Sonny Loughran is a Britain correspondent.

14:54Sonny Loughran:And the same is broadly true nationally. Britain is just much safer than it was 20 years ago. But people don't feel that way. One underappreciated reason for that is because the geography of crime in Britain is changing.

15:07Rosie Blau:So what do you mean by that, the geography of crime in Britain is changing?

15:11Sonny Loughran:What we're saying is that the urban centres you traditionally associate with violent crime have experienced quite significant reductions over the last 10 years or so. London is a big example of that. So hospitalisations for assault by sharp object, which is one of the most reliable predictors of violent crime, have fallen by almost a third in London since their peak before the pandemic. Teen homicides as well are much lower than they used to be. And in other big cities like Manchester and Birmingham, homicides have fallen by nearly a third from their peak. As a result, last year, homicides in Britain overall fell to a 50-year low.

15:43Sonny Loughran:But rates are falling much more slowly in the counties. And in some, they're increasing. So, Cambridgeshire and Bedfordshire are quite leafy suburban places, but last year they had hospitalisation increases of over 50%.

15:55Rosie Blau:Sonny, as you say, this goes very much against what we hear. How have the big cities done it?

16:01Sonny Loughran:In places like London, you really have to give Sadiq Khan some credit. When knife crimes started to take off around 2018, politicians really didn't know what to do. Sadiq Khan was one of the first to look at Glasgow, which was a city in Scotland that was once the murder capital of Europe. But Glasgow achieved big reductions in violent crime with what are called violence reduction units, which are basically offices that are designed to increase cooperation between different government agencies. So police, schools, hospitals, even things like sports clubs and things like that. And the idea is to identify children that are at risk of gang involvement, basically.