Do AI Moats Exist?

0:01Travis Hoium:Do motes exist in AI? Motley Fool, Hidden Gems Investing starts now.

0:09Travis Hoium:Welcome to Motley Fool, Hidden Gems Investing. I'm Travis Hoium, joined today by Lou Whiteman and Matt Frankel. Guys, we have a it's kind of an interesting time of the year because we're at the end of the calendar third quarter. Earnings season hasn't begun yet, but there is a lot of moving and shaking in the world of artificial intelligence. a couple of IPOs that are potentially coming in the next month to six months with Anthropic likely to be first. So I wanted to talk about if we're looking at some of these companies, let's take a big picture approach. And one of the questions that I have is, do moats really exist in artificial intelligence?

0:44Travis Hoium:If you look at the history of investing, finding companies with moats is a phenomenal way to make money. In the 80s, moats were driven by supply and big brands. So just, you know, buy the biggest, best brand you possibly can. The retailer with the most customers, you're going to do phenomenally well as investor. Aggregators kind of won the demand platforms, Amazon, Netflix, Uber in the 2000s and the 2010s. But Lou, do motes exist in the world of artificial intelligence? Because it seems like one exists for five minutes and then another model is released and everybody moves over to ChatGPT and then, oh, Muse is released.

1:20Travis Hoium:So now everybody's trying out Muse. It seems like these are incredibly fragile moats, or do you see it differently?

1:27Lou Whiteman:So, Travis, you should have given me a trigger warning here because this is a hill I'll die on. I'm a terrible person to ask this in part because I think 99 % of the discussion of moats in finance is just balderdash. I don't think moats really exist. If they exist, they're very rare. And as an investor, they're really only recognizable in hindsight. I don't think in real time. There are plenty of examples. There was a famous 2014 book about the value of moats. And you look through, there's 20 or so companies that are mentioned in that. Half of them are out of business now. OK, so, you know, everything.

2:03Lou Whiteman:I mean, all we're really talking about is competitive advantage that gets to a point where you can't overcome it. I don't see any moats in AI, almost by definition, because none of these companies even have pricing power. How can you have a moat? How can you have this idea that, you know, like you are, you cannot be conquered when you can't even control the terms with your customer on pricing? I don't see any permanent competitive advantages here, and I don't anticipate that happening anytime soon.

2:31Travis Hoium:Matt, do you see it the same way? I'm a little less, you know, pessimistic about the moats in AI than Lou. I mean, but the moats definitely appear fragile. So, I mean, what I mean by that is a couple of years ago, ChatGPT clearly had the first mover advantage. A year ago, they had a 79 % market share when it came to just, you know, this query volume. That was to start 2025. Now it's down to 54%. That's 25 percentage points of market share that's gone. In the same time, Claude went from roughly 1 % to 9%. And the capability is not the moat. That's one place where Lou and I will clearly agree. all of the frontier AI models are within a little, you know, a narrow band when it comes to capability.

3:19There's a couple of true moats that I see. I don't know if anyone's captured them completely yet. One is capturing enterprise workflow, like being ingrained in workflow. It's the same reason that some of the software companies that, quote, could be disrupted by AI are still growing their revenue faster, not seeing too much customer churn. It's because they're embedded in workflow. Like Claude Code is a big example of that. I use Claude Cowork every day. Like, I'm not going to switch that to a more capable model because I already depend on it. The other one is distribution that I see. Think of Gemini.

3:54Gemini usage is up 450 % over the past year. And why? Not because they have pricing power, not because anything of that, because Gemini is ingrained into everything Google does. It's being, you know, force-fed to everyone who uses Google Maps, who uses Gmail, who uses, you know, Google search. So distribution is a big competitive advantage. I don't know how durable of a mode it is, but that seems to be something that could have some staying power here.

4:24Lou Whiteman:Yeah, as impressive. It's the same reason we all use Bing, right?

4:29Travis Hoium:Oh, man, bring it up. Well, so Lou, that does bring me to my other question, which is when we look at this space, what seems so different than in the past, whether you're looking at consumer packaged goods or retailers or even just the last 20 years in technology, that was all companies, the companies that ended up winning ended up beating the competitors that they had, but then they weren't competing with also all the other companies, right? Like the banana company isn't competing with the cereal company. But now we have all of these tech companies, all of them in some way competing with each other in the future of AI.

5:05Travis Hoium:So you have Anthropic takes the lead early this year. And then suddenly out of nowhere, Meta, who we thought was kind of done and dusted, is now potentially as the most compelling product release of 2026. It seems like part of the challenge from an economics and investing standpoint is that they're all chasing after the same puck. And in that world, margins and moats seem really tough to build. Right.

5:31Lou Whiteman:And these are all companies that built their existing business based basically not not monopolies, but being the dominant force in an industry. So this is not something they've dealt with. But I do think it's interesting. I made the joke about Bing, but I'm serious with that because, yes, right now, Gemini is the thing for consumers because none of it is really that good. So we're just using what's there. If this Meta Muse product is good, that's a reason to use something different. And I don't think Gemini will have a moat at all then if there's actually a compelling case, just like Chrome, despite its disadvantage, took over the browser wars just because it was a better browser.

6:08Lou Whiteman:So, again, moat, maybe I just have too high of a standard of moat. If we're just talking about do some companies have competitive advantages in a moment, of course they do. That's how capitalism works. But this idea that there is something to invest around, like I can trust this company because they have a competitive advantage that's strong enough that I don't have to worry about it. That is so rare in business. Just kind of the definition of capitalism is that we see that these are rare. So I just I just think we spend too much time talking about modes. As an industry, it's a very young industry.

6:45Lou Whiteman:And to your point, two years ago looked very different than today. I don't even really know who has a durable competitive advantage right now.

6:53Travis Hoium:With those questions and durable competitive advantages in mind, we're going to talk about valuations in just a moment. You're listening to Motley Fool, Hidden Gems Investing.

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8:04Travis Hoium:Welcome back to the show. The second question I have for you guys today is how do you value these AI companies? And the context for this is we had the SpaceX IPO. so that includes xai and all the stuff that involved in that we found out in their prospectus or in their s1 that they're actually mostly an ai company not actually mostly a space company which is i think a little bit ironic but matt is as you look at these companies we've seen market share ebb and flow we've seen margins and pricing ebb and flow so with that in mind how do you value some of these companies especially especially as they come to market like when the anthropic S1 becomes public, how do you look at that and say, here's where I would price this company to see a value or where I would maybe kind of stay away?

8:50The short answer is I don't know how to value these companies and neither does anybody else. We haven't seen a public S1. Anthropic uses different revenue calculations that they're revealing to the public. They're using gross revenue, not net revenue, just for example. So it's tough to value a business when revenue is growing at a run rate from$9 billion at the start of this year to$65 billion as of the end of July. That's anthropic. But like I said, we haven't seen the public S1. The accounting they use, we don't know what accounting they use because we haven't seen the public S1. We don't know what percentage of their revenue is enterprise versus consumer.

9:32That makes a big difference in the valuation. Enterprise revenue is generally higher margin and stickier. How much money will they need? How much money are they making? We can only kind of speculate how much CapEx Anthropics is going to need this year. We can only really speculate how much they're losing right now, other than to say lots and lots. These play into the valuation. And there's simply no comparison. We don't have a basis for comparison to a public company that is growing this fast that is at this scale already. SpaceX isn't growing this fast at this scale. So I'll be looking at the S1 very closely.

10:12Once we have real numbers, I might have a better answer for you as to how to value Anthropic and OpenAI when we eventually get theirs. But it'll be really interesting. That's one of the S1s I'm really going to be paying attention to.

10:25Travis Hoium:Matt, is there one number that you would look at? I want to ask Lou about comparisons to the 90s. But, you know, in the 90s, you would you would look at metrics like eyeballs, right? We're not I don't think doing that anymore. But is is revenue the number that you would look at and say, oh, my gosh, they're growing revenue at 800 percent year over year. And it's at a 65 billion dollar run rate. So therefore, I don't know, put a reasonable multiple on that. And that's where I would maybe be maybe be interested. Is that a good number to look at or is there something in profitability? Well, going back to the moat conversation, revenue retention is a number that I would really look at.

10:59How well are these companies retaining revenue? Or is someone paying$20 this month for Claude,$20 next month for ChatGPT, and so on and so on? Are they churning revenue really fast? And I want to see if the unit economics are getting better. As we said in the Moat discussion, none of these companies have established pricing power yet. So are the unit economics, as these companies scale exponentially and have to build out their compute and things like that, are the unit economics getting better or worse? And you can see that by just looking at the gross margin trend over time. So between revenue retention and gross margin trends, you'll get a really clear picture of the real situation with these businesses.

11:38Yeah.

11:39Lou Whiteman:So back to your original question, how do I value these companies? The answer is less. And like with Matt, I don't know how much less because we haven't actually seen the numbers. I don't think either of the companies seem to want to put forward the audited numbers, which say something, but less than what we're hearing. And I'll tell you why. It's not to say they're not without value. Both companies have massive amounts of value, but we are talking about numbers that would place them among the top 10 most valuable companies in the world. I will buy the argument that one day they could be. I will accept that.

12:11Lou Whiteman:I might even agree. But my guess is all of these companies will not be among the most valuable in the future. Some will fail. Some will be seriously second best. So I am not willing to assume mega growth for generations to come from any of these people when I don't even know who the winner is. Yeah, it's just it's there's a there there. This isn't E-Toys level hype, but we never tried to make E-Toys a trillion dollar company. Yeah. Yeah.

12:44Travis Hoium:Even some of those you go back to pets.com. We talked about this on the show a few months ago, but its market cap was shockingly small. for as much mind share as it got from the dot-com bubble, these are some of the biggest companies in the world. Lou, final word on this. Is this an area where it's just okay to stay away for a while in any of these sort of AI-related names until we get better answers on what the competitive advantages, as you might call them, are going to be in the industry?

13:14Lou Whiteman:I mean, anything is a good deal at a price. and maybe if we one day see these numbers and they're better than I think they are, then maybe I'll reconsider. But right now, I don't think we know enough. I mean, Matt was talking about it, but look, apparently what they're doing right now is they are reporting revenue collected, not revenue that goes to them. So if I am generating 10 billion in revenue, but 6 billion, if it's going out the door to affiliates and stuff like that.

13:42Travis Hoium:So let's explain what that means, because if you're not familiar with this, For example, Uber is a good example. If you pay$20 for an Uber ride, Uber does not count that as$20 in revenue. That is$20 in what they call gross bookings. The take rate, which is usually about 25%, is going to be Uber's revenue. So$5 in revenue,$20 in gross bookings. That's the way that they would report it. And what you're saying is that Anthropic, at least from what we know right now, is saying we have$20 in revenue.

14:11Lou Whiteman:From what we know, and again, a lot of this is really nice to see those audits. at financials, wouldn't it? But yeah, until we know more, I just, look, I don't think it's really a slam or a hot take to say not all companies are worth trillions of dollars. But right now, we are being asked to assume that all of these companies are worth a trillion dollars. I think we're allowed to be a little patient and let that simmer.

14:38Travis Hoium:Yeah, it'll be interesting to see what, too, what the obligations are for these companies, because those are measured in the hundreds of billions of dollars cash that they do not yet have. When we come back, I'm going to actually get some stocks out of Lou and Matt. Where are they interested in the AI space today? You're listening to Motley Fool and Jim's Investor.

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16:21Travis Hoium:Welcome back to the show, guys, as you look for opportunities in the world of artificial intelligence today. What kind of stocks are you looking at right now? Yeah, so I mean, there are a lot of these AI infrastructure stocks that have, cratered over the past month. Some of them did so after reporting great earnings, raising guidance, things like that. But even after that, there's a lot that are very, very expensive. I'm sure you and Lou would both agree that I'm not interested in a power company that's trading at 100 times revenue or something like that. But there are a few that are still really attractive investments.

16:58Modine Manufacturing is one that I have my eye on right now. Ticker symbol is MOD. and it's, if you've ever heard of Comfort Systems, that's a more popular picks and shovels play. They do almost the same thing, but the valuation just makes a whole lot more sense to me. They specialize in thermal management, specifically cooling. And the data center business is not surprisingly the most exciting part of the company right now. Overall, their revenue grew 23 % year over year in the latest fiscal year. The data center revenue grew 90%. percent. They just got a four billion dollar multi-year deal from one of the hyperscalers.

17:36We don't know which one, but it's for cooling products and data centers. It's a major problem. The more complex data centers get, the more cooling they're going to need. And unlike some of the other companies in the picks and shovel space that are really expensive, Modian trades for 22 times forward earnings. They expect 50 to 70 percent annualized data center revenue growth over the next couple of years. Most of that's already booked. They're guiding for, you know, 20 to 35 % overall sales growth in their current, the 2027 fiscal year. You know, more than 40 % growth in adjusted EBITDA. Remember, there's a lot more to this business than data centers, which is kind of, if you're skeptical about how long the AI build-out's going to go on at this pace, this could be a good one to look at because it is a truly diversified business, even though obviously the rest of it isn't growing as fast as the data center side.

18:28Travis Hoium:Sometimes boring is good. Lou, where are you seeing opportunities?

18:32Lou Whiteman:So I am less interested in picks and shovel game right now because we are kind of late in the cycle. Picks and shovels sound great, and they are kind of a clever way to get in on a trend after the primary beneficiaries have already been - Second derivative, if you will. Yeah, yeah, yeah. So like if the first derivative is too expensive, this is a backdoor way in. But right now, why buy the pick and shovels when the actual companies that they serve are trading at a discount to them? Matt's right. Modine is pretty cheap for a pick and shovel, but you can still that 22 times earnings. Compare that to Alphabet.