AI Expectations Hit a Fever Pitch

0:02Meeting lofty AI earnings expectations today on Motley Fool Hidden Gems Investing. Welcome to Motley Fool Hidden Gems Investing. I'm your host, Tyler Crowe, and today I'm joined by longtime Fool contributors Lou Whiteman and Matt Frankel. We're going to talk about defense companies later in the show, talking about kind of some of the big moves that are happening in the industry lately, and as well as hitting letters or questions. But before we get started today, You know, hyperscalers, those builders of AI, they just keep spending more and more, and semiconductor companies are posting record results, but even that doesn't seem to satisfy the market.

0:35Samsung Electronics reported by what I think any measure would be a resoundingly successful quarter, but the stock dropped so much that it caused a circuit breaker suspension of trading on the entire Korean composite stock price index today. Those losses have carried more or less over into the semiconductor space today as many memory and processing chip manufacturers are down as of this morning. So guys, how on earth did we go from profits up 19 times compared to this time last year at Samsung to stop the entire Korean stock market? Yeah. So, I mean, a lot to unpack there. So a lot of these stocks were priced for not necessarily perfection, but to report blowout quarter after blowout quarter after blowout quarter.

1:19when you expect a blowout and you get, as you called it, a resounding successful quarter, it's enough to make the stock drop. We've seen this with several recent earnings reports and not just in the memory space. And several of NVIDIA's reports look fantastic and the stock ends up falling. In Samsung's case, yes, you're right. They are expecting a roughly 19 times increase in quarterly operating profit. But that's being driven by AI memory demand. and investors seem to be questioning whether or not the AI memory chip rally has gotten ahead of itself. And it's not just Samsung. If you look at Micron, for example, even before today's, you know, kind of sympathy drop, it was down by about 30 % since earnings.

2:00And that was just a couple of weeks ago. So the company also slightly missed revenue guidance. So it's not a flawless quarter. And there's also SK Hynix US listing that raised billions and billions of dollars of capital, and that could be adding pressure as memory. There's just more memory stock supply in the market right now. I mean, the bottom line is, you're right, Samsung didn't have a bad quarter by any definition. But the amount of good news that has been priced into these stocks seems to have gone a little bit too far. Yeah, on the market, halting the market thing, it's important to note that two companies, SK Hynix and Samsung, make up about 53 % of the Korean total market index.

2:41So this one company can hold to market kind of. But look, even with this, Samsung is up 150 percent to date. Others are up more. This seems 100 percent rational to me. The market is forward looking. We're always looking to the future. This is either going to last forever or it's not. And if it's not going to last forever, at some point you should take profits. I think that's what we're seeing today. I don't think there's really too much to read into it more than that, I think investors are looking at the same world that I think the rest of us are and saying, look, this has been great. I don't know if it can go on forever.

3:16I'm going to book some gains. You know, the thing that's hard for me to also rationalize when we're talking about the expectations game of all of this is that even by most standards, this is looking like from a fundamental basis, like you look at the underlying numbers of like capital investment and all that stuff, it still looks incredible. It's almost hard to fathom that this can't meet the appetite of what Wall Street's expecting. I mean, Amazon earlier today announced it was raising about $25 billion in debt. And at very favorable rates, I mean, of course, it's Amazon. What else would you expect?

3:51I mean, this isn't the first company to do it either. I mean, Alphabet's tapped the debt and equity markets this year. And like nearly all hyperscalers from Alphabet to Amazon, Meta, you name it. They don't even raise an eyebrow or even like the CFO doesn't even seem to like lose a bit of sleep when they're increasing their annual capital spending budgets, seemingly every quarter. So like, how do we rationalize these wild stock moves and what we're saying, playing the expectation games when the fundamentals still look surprisingly strong? Okay. Yeah. First of all, on Amazon, okay, for these big companies, the focus is always on cost of capital.

4:29You raise money at the most cost-effective way you can. And as you said, they're getting very favorable rates here. 40-year money at less than 150 basis points above U.S. Treasuries. That is a really, really good deal. Given their massive cash needs, forget AI. What about logistics, everything else? And given the cost here, they'd be crazy not to do this. So I don't think this really says anything other than they are a large company doing as they should. As to the bigger question, though, of like, what's going on here? Is it sustainable? Why is there this dissidence? I think, and I got to credit Jeremy Grantham here, the very, very, very smart investor.

5:08This is his point, but it's such an important one. All of these companies, all of the Mag7, all of the hyperscalers, Amazon, Alphabet, all of them got to where they are by jumping into a niche and dominating it. The collective learned experience from this group of leaders is the pathway to access is to build your empire, claim your turf as quickly as possible. No one is backing down on AI in that scenario, especially since AI has been presented as the holy grail, the, you know, the quest like no other. You are not going to back down unless you have no other choice. So are things getting out of hand?

5:48Maybe, probably. but I really believe that these companies, it will continue until they can't. And the debt raise here is a reminder. There's still plenty of levers to pull. And so they will be continuing. Yeah, I mean, just to throw some additional context behind that, I mean, this isn't just a$25 billion capital raise from Amazon. This is in addition to the$65 billion or so they've already raised this year through bond sales. I mean, so that's$90 billion from Amazon this year. Alphabet's raised about$85 billion in debt over the past year. and they might not be done. I mean, I saw one statistic that total hyperscale or bond sales are expected to reach about 300 billion this year versus 121 billion for last year.

6:28And Lou's right, these terms are very favorable, especially for 40-year bonds. They serve that extra purpose of not only low-cost capital, but locking in the rate for decades, protecting from interest rate fluctuations. And I mean, the investor interest we're seeing, all of these deals that I just talked about, the 85 billion in deals from Google, they've pretty much all been oversubscribed. So it shows that any further capital raises this year are likely to not be a problem. And both these companies still have very low leverage ratios, at least on paper. These are massive, massive companies. I mean, 0.4 to 0.7 % debt-to-EBITDA ratios is what we're seeing here.

7:04The overall investment-grade credit-rated average is about three times debt-to-EBITDA. So there's a lot of cushion here. At the same time, these are the first time these mega-cap tech companies are really adding this type of debt to their balance sheets. So the question of whether or not it's sustainable, these AI investments are going to have to start generating high margin revenue at a pace that satisfies investors. And now that's vague for a reason. We don't know what that means, but that's what we're going to need to see here. Well, we'll keep playing the quarterly expectations game because we do have second quarter earnings coming up in the not too distant future here.

7:42Coming up after the break, we're going to do some movers and shakers in the defense industry.

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9:00And we got one of the first ones yesterday when Lockheed Martin announced it was acquiring sonar specialist, its private company, Ultra Maritime for$3.45 billion. Now, I get that this on a Lockheed scale thing is a relatively small deal. But does this change the company's standing in the industry at all? Correct me if I'm wrong, Lou, but I think Lockheed is trying to diversify its portfolio, not be quite as reliant on the F-35 fighter, which has been kind of their like, call it like their flagship platform for a while? Yeah. So Lockheed Martin is arguably the most diversified portfolio in the sector, but the F-35 is still a lot of it, about 30 % of annual revenue.

9:42Lockheed does helicopters. They do missiles, missile defense, sensors, space. So they do a lot of things. And a lot of those capabilities, especially in areas like sensors and electronics, came via acquisitions. The primes have a long history of augmenting their R &D with bolt-on deals. That's part of the trend here. This is an area where, you know, Lockheed isn't as strong as maybe some other players. It is an area of interest, among many other things. But so it fits well in the overall trend. But I don't think this is really a statement deal as much as it is opportunistic. So, Lou, when you talk about bolt-on deals, and this is something I think I've seen you write about for, I don't know, probably like the past 10 years, is the idea of like, there's only so much acquisition that like the companies like Lockheed can do because it's a pretty consolidated industry when it comes to like the defense primes.

10:30And, you know, there's certainly no place where, I don't know, Lockheed and RTX can join forces these days, right? Yeah. And nor did I want to really. But yeah, I think the way to think of this isn't necessarily, it's hard to add platforms. Lockheed did it when they bought Sikorsky. So there are some opportunities there. But in that case, the seller just wanted out. So the Pentagon needed to get a good home for the helicopter business. What you are buying here is the R &D. What you are buying is access to technologies, kind of access to the supply chains more than you are new platforms. And that's where you see most of the prime deals happening.

11:08And Matt, just for some concepts here, like Lou was talking about helicopters, space, aeronautics and stuff like that. You know, I didn't mention as much about submarines and sonar. So in terms of like Lockheed, where does this kind of position them a little bit? This is moving into new territory here. Yeah, I mean, so you're right in the sense that this is a very small deal in the overall business. It's less than 5 % of Lockheed's total annual revenue. It does significantly grow the position in anti-submarine warfare. And that's really an area of defense where we're seeing global demand rising right now.

11:37Undersea deterrence is a big priority of U.S., NATO in response to what's going on overseas and in the conflicts we're seeing. Yeah, certainly anything that can be tied to intelligence sensors seeking stuff like that versus metal bending seems to be the trend here. And that's one of the things I found most intriguing about this ultra maritime deal is I think it hits at one of the lesser discussed stories in the defense industry. And that's the changing priorities for defense. And one thing that has become abundantly clear in conflicts this decade, whether it would be Iran, Ukraine, elsewhere, is the emergence of small, cheap, single-use drones that are very, very effective against much, much more expensive equipment.

12:21And is this trend like a complete game-changer to the industry? I mean, I certainly think, though, or, you know, what do you guys say? Is it that or just like a supplemental add-on? Because the way I see it, drones and smaller equipment doesn't require, like, the massive supply chains and coordinated efforts to build the F-35 or a gigantic aircraft carrier or something like that. You know, the things that Lockheed, Northrop Grumman, and the other defense prime contractors have specialized in for decades is taking 27 different subcontractors, pulling them all together and doing something epically large.

12:56Single-use drones, I don't know, 15, 25 pounds, a couple of explosives in a remote control. It seems to really change the way we're doing things here. Yeah, I mean, the emphasis on cheap single-use drones, it's a clear shift in defense budgets. It's happening alongside the traditional contract model, not necessarily replacing it. It's a big line item in the Pentagon's budget right now, but the traditional line items have mostly increased as well. I mean, the Department of War, they have their drone dominance program that aims to buy hundreds of thousands of small attack drones, but they kind of consider them consumable supplies, not as durable equipment.

13:31So the Pentagon's ordered about 22 ,000 of these. So that's, you know, it's not a small order and production is just ramping up. But these are different tools for different jobs compared to like fighter jets, submarines and missile systems. So there is some supply chain simplification. But I think if you look at some of these big companies like Air Environment or Kratos, you will see that there is still pretty complex supply chains. These are, at the end of the day, systems integrators, and you still need to do that work. It's just at a different scale. The issue as an investor, as a business story with these low-cost drones is, what makes them intriguing to defense planners makes them, I think, less intriguing for investors, the cost.

14:12You really have to make it up on volume here. The bigger trend, though, Tyler, and you mentioned this, kind of the move away from metal bending. The big trend here is the same trend you see in every other industry, digitalization. The value is shifting from just the people who make the big objects to the ones that make them smart, the electronics. That's the story behind the emergence of L3 Harris. That's the story of Lockheed wanting to buy ultramarantine. This will continue. All right. The thing is, and the real big trend here as far as whether it replaces the primes, I think it actually ends up working for them.

14:48The middle market is brutal for defense contractors. There is almost not a middle market. It just gets consolidated out of business because it's a tough business to survive. The biggest competitive advantage the primes have is their ability to work on the timetable and communicate with the Pentagon. That is hard for especially a Silicon Valley startup to learn. Most of these companies will not be independent in five to 10 years. The successful ones, there might be one or two new companies that come out of it. Most of them will be part of bigger portfolios, less successful ones will be sold for parts.

15:22But I think this is just continuing a 20 or 30 year story in just looking to smarter rather than just powerful, big mammoth equipment. To the portfolio shuffling, moving around thing, just an anecdote. And it kind of speaks to that industry in general. I have an uncle that works on basically sonar electronics for the Navy. And that particular project has, I think, moved to five different defense primes at any given time. And it really shows, like, you know, the hot potato nature that, you know, one moment it could be a part of one portfolio, could be part of the other. There seems to be a lot of shuffling around and optimization of assets.

16:04And it wouldn't be surprising to see a lot of, like you said, the smaller middle market people either getting gobbled up or sold off for parts. And, you know, we'll take a little bit of this here and then sell off the rest. The one I think interesting thing too here, because you have so many companies, even there's one that's really popular in underwater uncrewed vehicles. Lockheed sort of just put a valuation multiple on these. You know, they're paying about four times sales for Ultra, which I think it's interesting now as an investor to compare that to some of the public company valuations out there may suggest that a lot of the future growth is priced in.

16:41I feel like you want to name a company here. Do you want to name a chain? No, there's a lot of them. Let's just leave it at that. I think as an investor, you should always look at the comms. Coming up after the break, we're going to hit some podcast questions.

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17:31Every interaction is about like, what can I get? What can I get out of this person? What can I get out of this situation? So that's why there's so much manipulating and lying and exploitation is it's because people most of the time are just sort of tools to get whatever the ultimate goal is. All of us know somebody with psychopathy. To hear the science behind who actually does the most harm, check out episode 1293. It might change how you see everyone around you. Hey everyone, quick reminder, if you want to get your question read on air, go ahead and email us at podcasts at fool.com. That's podcasts with an S at fool.com.

18:02Just remember, keep it foolish, keep it short, and don't ask for any kind of personalized advice because we certainly can't do that without getting in trouble. So today's question comes from Lisa. And the question is, I just heard about the sunk cost fallacy. I'm a new investor to individual stocks, and I've been holding on to some stocks that have had significant losses. I've also been looking at some stocks with huge gains in my portfolio and wonder at what point do investors reinvest in companies that could gain money and still lose it? So far, I haven't sold for loss, and I feel like I'd be opening up a can of worms for myself mentally.

18:35Thank you for the awesome advice. I listen to your podcast daily. Thank you, Lisa, for the kind words. And Matt, before you give your answer to Lisa's question, why don't you just give us a quick refresher on sunk cost fallacy for anybody who may not necessarily be as aware of it? Yeah, so the sunk cost fallacy, it refers to letting money or effort that you've already spent influence a forward-looking decision. So to put that in the context of what we're doing here, what you originally paid for a stock has nothing to do with whether or not it's a good investment today. Lou bought Rocket Lab for$3 a share.

19:10That has nothing to do with whether or not it's a good investment at the current price. So only the current state of the business and its future growth prospects do. So psychologically, making a loss real by selling it is a tough hurdle to overcome. Honestly, it's probably why I held on to Boston, Omaha for two years longer than Tyler said I should have. It essentially serves to confirm a decision didn't work out the way you wanted to, which can be difficult to accept. So try asking yourself this question. If you had cash today instead of these shares of stock, would you choose to buy that exact stock at today's price?

19:45If the answer is no, it's probably a sign that you should go ahead and move on. Remember that selling today doesn't mean that your original decision was wrong. It just means that the stock is no longer a good investment right now. It could 100 % be the right move when it's based on today's information? Got a similar answer. You know, for me, it's always, I try and focus on the reasons I bought in the first place and ask myself if they're still valid. If anything, time just gives you added data, you know, so you can maybe make a more informed decision. But if the reasons are still valid, whether it's up big or down big, I try and hold on.

20:20If they're not, then yeah, I probably should sell. It's possible my original reasons to buy were wrong if something's way down. So I think, again, the additional time gives you data. You should reassess. But I don't personally let performance drive my buy and sell decisions. Most stocks I'm buying, I'm hoping to hold for a long time, in decades, not quarters. So if things haven't worked out in a year or so, say, that isn't necessarily a reason to believe it can't work out long term. But you'd be crazy not to at least reassess and look at what has happened since you've bought. Yeah, this is a really relevant sort of question, too, for a lot of people, because we've seen recently a single stock investing has been quite volatile relative to times we've ever seen.

21:05We were just talking about at the top of the show, big moves in semiconductor stocks that are moving hundreds of billions of dollars in any given day. So it can be extremely challenging to separate the business case, which I think for most of us is the thesis that you buy a stock versus the price machinations in any given moment, the valuation. And that can be a hard bridge for a lot of people to cross or get over when it comes to investing is understanding, have the business fundamentals of why I bought this business still maintain and is what I'm seeing today more valuation related than it is related to actual deterioration of business or a management change or something that may materially change the trajectory of the business.

21:51So as you're thinking through these things, trying to find that separation of, is it stock valuation related or is it business change related? And finding the difference between those two can really help you make those sort of decisions. As always, people in the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against. So don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only.

22:20To see our full advertising disclosure, please check out our show notes. Thanks for producer Dan Boyd and the rest of the molecule team. From you, Matt, and myself, thanks for listening, and we'll chat again soon.