When $150 Billion Looks Small

0:02Tyler Crowe:$150 billion. Not that big. Motley Fool Hidden Gems Investing starts now. Welcome to Motley Fool Hidden Gems Investing. I'm your host, Tyler Crowe, and today I'm joined by longtime Fool contributors Rachel Warren and Lou Whiteman. We are going to get into the promise and the perils of investing in the defense and security sector. We're also going to hit the mailbag, but we wanted to start the day with, I guess you could say, the biggest news story, and that was NVIDIA. They had a couple of press releases today, one on AI safety, and for the investors, perhaps the bigger one is the board of directors announced a$150 billion share repurchase agreement.

0:42Tyler Crowe:It's, as the press release says, the biggest in history and kind of gives the board about$250 billion to buy back shares right now. Now, guys, I'm going to give a hot take and I want to get your quick reactions to this. I think it's way too small.

0:58Lou Whiteman:I mean, look, they're finally off the one cent a share dividend, which I didn't understand that either. But yeah, the law of large numbers just kind of is even that's thrown out of proportion here, but nothing is big enough. And yeah, 150 billion, yawn. Yeah, I mean, it's the biggest in history, but it's also only around 2 % of its market cap. So you sort of have to right size that for the company we're talking about. The other way to look at it is that NVIDIA is generating tremendous amounts of cash flow from the AI infrastructure build out. They have more capital than they can logistically reinvest back into R &D.

1:32So I think that this is a way we're seeing that play out.

1:36Tyler Crowe:I would make the argument that the announcement should be like at least triple this. I know that sounds like crazy and probably put me on like CNBC. But, you know, I'm not that's crazy tech person. Well, look, let's put it this way. We could do a CNBC take on this, but I would argue, number one, between its valuation, its current debt situation, and as we said, it's only like 2 % of its market cap, there is an opportunity here for a five-point, it changes$100 billion a day, so I can't even track what the point is anymore, but five-point-something trillion-dollar company, this should be somewhere in the, you know, at least 5 % of its market cap.

2:19Tyler Crowe:If you're going to, if you're trying to wow investors, don't be afraid to use a little bit of leverage. This is a company that made$134 billion in free cashflow. So you added one year's worth of free cashflow. Come on, impress me, NVIDIA. So I'm being a little hot take here, but part of the reason I think that they announced this, and I want to get your guys' take on this one specifically, was in addition to this share repurchase, there was a press release related to, you know, AI safety and perhaps building some guardrails or some safe spaces where we don't get these, hey, AI may have hacked Hugging Face.

2:53Tyler Crowe:Hey, AI may have hacked the Australian government's health websites. All of these news stories have been popping up. It was maybe this$150 billion, a little bit of, hey, let's help the medicine go down here for our investors. Yeah, I think that's definitely part of it. I don't think the timing is a mistake by any means. I think that was probably very well coordinated from up above. But this is a real industry issue. You know, we're seeing advanced AI models, as you noted, from a wide range of labs, as well as the big hyperscalers that are repeatedly breaching secure sandboxes. Obviously, there's the high profile hugging face incident.

3:27But we're also at a time where CEO Johnson Huang has been very, very clear on the approach he wants to take here. He doesn't want to wait for government regulation. He's actually pushed back against that. He's really framed AI safety strictly as an engineering problem that can be managed at the hardware and platform layer. And so just to talk a little bit about what they're doing, NVIDIA is introducing an open source framework. It's called OpenShell. They're also introduced to a hardware watchdog called Sentry. And essentially, the idea is these will help quarantine rogue software within milliseconds.

4:00OpenShell is interesting. It's open source, as its name indicates. It's designed to support rival platforms from ARM and Intel. And so you can see how NVIDIA is trying to establish a universal industry standard for safety. They want to lower the risk barrier for enterprise adoption before maybe you see more corporate security teams or regulators freeze the deployment of autonomous AI agents. So I think that they're very much trying to get ahead of the curve here.

4:26Lou Whiteman:Back to the investing question. Yeah, I think they're couching bad news with good. But also, look, this is part of a trend. NVIDIA has run out of ways to wow the market. Jensen increasingly, he looks like the greatest showman. You notice how many times he now goes on stage to just make bold pronouncements. The stock has done nothing basically since the spring. Amazing earning reports are just kind of being met with. Yeah, I think, look, this is a great business. But the perception is, you know, whether it's AI doomerism they're trying to, you know, push back against or just kind of investor boredom.

5:02Lou Whiteman:NVIDIA has run out of ways to wow or excite investors. And I think the big buyback, this is just another maybe failed attempt to say, hey, remember us? We're still really good.

5:14Tyler Crowe:Yeah, well, guess what? If you're the CFO and you really want to wow investors, $500 billion buyback. That's going to be my pitch to them. But to that point, though, like NVIDIA trades for about 18 times its earnings estimates for next year. It's the cheapest in a decade. Right. A nice say or a little quib I like is the market is irrational, but it isn't dumb. So there's there is some risk building here that maybe we're not seeing. What may those risks be that investors might want to consider that are kind of maybe hidden that most people aren't thinking about? Because cyclicality, of course, there's cyclicality in this industry.

5:48Tyler Crowe:But what are some of the like maybe people aren't considering this one as much? I think there's a few things to consider. I mean, one is sort of the circular funding. This isn't hidden. And this is something that's been talked about a lot. I mean, you know, we look at that number that NVIDIA just announced today. They've disclosed that Anthropik's aggregate contracted value across NVIDIA-backed cloud entities has scaled above$180 billion alone. That's just in their arrangements with Anthropik. NVIDIA's balance sheet includes 13 public stakes, over 200 private stakes,$20 billion in data center lease commitments.

6:20They're operating essentially like a central bank for a lot of the AI industry. Part of that is a function of necessity. Obviously, the idea is that that flows back into the growth story for NVIDIA. But there's that circular funding mechanism that I think is concerning, depending on if or when the build-out slows down. One other thing to note, you know, hyperscalers are writing off these AI GPUs on aggressive three - to five-year life cycles. They're operating under the assumption that there's going to be these kind of constant multi-billion-dollar upgrades. But what if you have a GPU that's a few years old that ends up being perfectly adequate for 80 % or more of enterprise inference workloads?

6:59That upgrade cycle could be much slower. And if that happens, you could see companies like NVIDIA face a bit of a cliff or at least a slowdown in growth, even if it's a distant one. I mean, essentially this idea, not that the technology fails. If the existing hardware works too well, you could start to see NVIDIA frozen a little bit out of its own upgrade cycle. That's the extreme case, but I do think it's something that if you're an investor in NVIDIA, if you're looking at NVIDIA right now, these are a couple key factors you need to be incorporating into your investment thesis.

7:30Lou Whiteman:I think there's a pretty not extreme, straightforward case to say that the best is now behind them for the AI cycle. Not that it can't be really good for a long time, but Google, Amazon, Microsoft, Meta, OpenAI, they're all at least trying to make their own chips. No one is going to stop doing business with NVIDIA, but Wall Street pays for growth. And, you know, if they can't, if there's more competition coming in, I didn't even mention the other chip companies, that is going to put a cap maybe on upside growth. Also, if the frontier models don't matter as much, and I think evidence is growing that they don't matter as much, then does having the latest, greatest, newest, most expensive chip matter as much at the scale we hoped?

8:11Lou Whiteman:And you say it's boring, but it does matter. cyclicality is a thing as recently as 2023 nvidia was generating earnings per share under a dollar per year now it's at eight so you it may look cheap on an earnings on a price to earnings basis but there is a question of is this earning this level of earnings per share how long could it go on and if not that multiple looks a lot different well you know what brings

8:37Tyler Crowe:up that earnings per share 500 billion dollar buyback i am going to solve this one into existence All right. Coming up from the break, we're going to talk about the defense and security industry.

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10:20Tyler Crowe:Red Lattice is a cybersecurity company that's going public via SPAC. It expects to merge with a company that's called Bold Eagle Acquisition Corp. And it's going to be and conclude sometime around the end of 2026. It's expected to go public at around 1.25 billion. And I would say the layman's way to describe it is it's a competitor to Axon Enterprise and Celebrite in cracking encrypted devices and other sensitive information processing. There's quite a few of these companies starting to pop up in the defense industry. And the company itself isn't why I bring this topic up, though. It's making its rounds on the financial media ranks.

10:56Tyler Crowe:But I think that this is kind of indicative of a shift in the market's attitude towards defense, defense tech, and somewhat related space companies. For much of the 20s, 2010s, 2000s, 2010s, the defense industry was consolidating. There was fewer, fewer players in those giants. To me, they weren't that far removed from utility companies in terms of growth, earnings, what have you, in terms of their returns. For a myriad of reasons, that's changed. And there is bound, I think, to be a fair share of companies going public in this space, some of which are going to be lower quality companies, very similar to what we saw with SPACs in 2021 in the fintech technology, consumer tech sort of region.

11:38Tyler Crowe:So, Lou, I know you've done defense for a little while. Rachel, you've given some thoughts on this as well. When you're looking at IPOs for defense-related companies, we're going to see a lot of them. What are some of the specific traits to defense investors should look for?

11:54Lou Whiteman:Well, let's start real quick outside of defense. Just why do companies go public via SPAC? The big thing is, is that a SPAC is technically a merger. And SEC rules give you a lot more leeway to talk about the future in a merger than they do in an IPO. That matters if you don't have much of a past to talk about. And so we are talking about early stage companies that really want to talk about the future. That fits in real well. As far as defense specific, the Pentagon has been talking about diversity a lot, but it doesn't want to deal with these companies. It really doesn't. So what am I looking for?

12:28Lou Whiteman:I'm looking for on ramps. I'm looking for companies that work with companies that have direct access, whether it's the primes, whether it's these new generation. But it is not easy to get in the kind of cool guys club at the Pentagon. A lot of these, even if their technology is better, are just not going to generate the revenue that they hope to if they aren't in the room.

12:48Tyler Crowe:Also, Lou, I'm going to stop you for a quick sec just to for everyone who's not a super defense, you know, sicko. What is a prime? because I'm sure there's some people being like, what is that?

13:00Lou Whiteman:The prime contractors are, well, I mean, for the most part, we think of them as Lockheed Martin, Northrop Grumman, the big, massive guys, but there's smaller ones too. But basically, they are the ones in the room. They are the ones with direct contacts and contracts with the Pentagon. They're called primes because literally the Pentagon does business with them, and then they just kind of dole out revenue to other companies that work with them. Another thing you got to consider here is most of these defense tech companies are just have some novel tech, and it looks like wow, and it looks like wow, they're the only ones who could do this.

13:31Lou Whiteman:There is a ton of government-funded R &D going on with this inside the established contractors. Because it's classified, they don't talk about it much, and they don't have a need to talk about it the way you do if you have an IPO. I've seen numerous companies basically fail because what looked to be unique or looked to be something they could only do was actually yesterday's news on the inside. So it's really, you can't do due diligence here because so much of it is classified, but just be aware that if the first thing you think is, wow, why didn't anyone think about this? That might be a yellow flag.

14:06Lou Whiteman:Also, and again, I just can't say this enough that just the idea of how you get in the room, for most of these companies, working with the government is a core competency. It's really hard to deal with government bureaucracy and most companies can't. It is a skill to be able to navigate this. I really want, I don't want some Silicon Valley dudes with an idea. I want at least someone in leadership, whether it's a chairman or something that has government related experience. Related, you need a big employee base with security clearances. If you don't, you can demo whatever you want, but you're never going to get to interact with the defense chain.

14:43Lou Whiteman:So those are just kind of some yellow flags to look at when you're looking at these companies.

14:46Tyler Crowe:So, Rachel, Lou kind of gave the lay of the land here. And, you know, there's some red flags, yellow flags, things that clearly you want to see. When you're looking at this as well, what do you think are some of the like the pitfalls or minefields that are kind of specific to the defense industry, kind of playing off what Lou was talking about here? Yeah, I mean, I think there's a few things to watch for. One, and Lou alluded to this, it's dangerous to assume that a successful high-profile prototype or even a small business innovation research grant is going to easily convert into an official military or defense program of record.

15:17There are many young firms that burn through their entire capital reserves and collapse while waiting the two to three years or more it typically takes for the Pentagon to officially allocate full production funding in the federal budget. So that's one thing to be aware of as well. And often a defense company's fastest growing and highest margin business segments are wrapped in classified or special access programs. So management is legally forbidden, essentially, from disclosing a lot of the granular details. And so investors often have to model kind of future revenue while being very blind to the exact contract terms, customer identities, underlying unit economics.

15:53That is part of the nature of the beast when it comes to looking at potential IPOs in the space, or in some cases, younger public companies that have risen through the ranks and aren't those typical prime names that we think about.

16:05Tyler Crowe:As I was kind of alluding to, there's a lot of companies we expect to go public in this space and not to kind of bring up one where it's like the Silicon Valley bros that Lou was talking about. But Anduril is, and I hope I pronounce it, it's Anduril, Anduril, depends on who you ask in terms of pronouncing Anduril. They're expected to go public relatively soon. There's a will they, won't they with blue Origin, the space companies were supported by Jeff Bezos. Some of those are like the big name grabbers in terms of IPOs that could come happen sooner or later. Is any of these companies on your radar, either it being Enderil, Blue Origin, or maybe some mysterious third company that people haven't heard about yet?

16:47Lou Whiteman:So Enderil is a good example of something that Rachel was talking about, that they, I would argue they look more impressive than they are because they are allowed to talk about everything they're doing and the ones inside the tent aren't. So just, you know, be careful there. I'd honestly be surprised if either they or Blue Origin go public anytime soon. URSA Major, which is in pending SPAC, they're so similar to what's going on with Red Lattice. They're kind of interesting. They do rocket and missile propulsion systems. Shield AI is similar to Anderil. I think it's actually more advanced than Anderil.

17:19Lou Whiteman:I think they're more likely to go public. I'm worried about the valuation there, but I'd be intrigued if they came out. Yeah, Andreal is definitely one on my radar. I think they're one of kind of the key players in the modern defense tech asset class. I mean, they've definitely moved past the speculative startup phase. They're building out some pretty impressive operations from what we can see. There's the Arsenal One hyper manufacturing facility in Ohio. This is specifically designed to mass produce autonomous military hardware like software defined drones and underwater vehicles. I'll say the founders have been very disciplined about avoiding a premature public debut to the market.

17:53So that may be something that we continue to see pushed back for the foreseeable future. Earlier this year, they announced a major 10-year U.S. Army enterprise contract worth up to$20 billion. It's another green flag for the business. So, you know, whether it goes public in the coming months or in the next few years, definitely one that I have top on my radar.

18:12Tyler Crowe:I don't know how long it's going to take, but just hearing the word SPAC still just has like the hairs on the back of my neck just kind of like perk up bad memories a little bit yeah just well just seeing all the scars of what happened with 2021 i don't know how long that's gonna be but lou you were mentioning a couple of those ones uh ursa major being a spack merger i don't know i was like as good as it is i i still can't get over that bad feeling in the back of my head hopefully ursa major can prove me wrong rocket lab fair enough coming up after the break we're going to hit the mailbag.

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