Anthropic’s Teleportation Machine

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Remember Jeff Bezos’ teleportation machine?

In his 2004 letter to Amazon (AMZN) shareholders (published in the spring of 2005), Bezos asked readers to imagine a teleportation machine that moves people instantly from place to place. As you’d imagine, demand for the machine was virtually endless. But the machines were expensive to build – they cost $160 million each. And they only lasted four years. Even so, revenue poured in. Each trip cost $1,000 and each machine could handle 100,000 trips a year, producing $100 million of revenue! After energy, materials, and labor, each machine produced $50 million of cash a year.

The accounting looked fine: a 10% profit margin after depreciation. The machine will earn back its cost in 3.2 years. But it wears out in four.

Over its life, each dollar of machine returned $1.25 of cash, most of it near the end. Discounted at a 12% cost of capital, each dollar invested loses five cents. Bezos' verdict:

There is no growth rate at which it makes sense to invest initial or subsequent capital to operate the business.

In other words, when you’re evaluating rapidly growing technology businesses that require huge capital investments, investors must focus on the cost of capital and the depreciation charges. Lately, because of inflation, the cost of capital has been increasing. The benchmark U.S. interest rate (the 10-year U.S. Treasury bond yield) has moved from around 2% five years ago to around 5% today.

As we showed you recently, these factors – massive depreciation costs and rising capital costs – have us questioning CoreWeave’s (CRWV) business model. CoreWeave is building data centers full of brand-new Nvidia (NVDA) chips. It rents them to artificial-intelligence (“AI”) companies. Currently, it owns $46.7 billion of equipment and brought in revenue at a rate of $10.3 billion annually in Q2: 22 cents of revenue per dollar of equipment. After operating costs, that's 13 cents of cash a year. CoreWeave needs 7.7 years to earn back its cost, but it depreciates its chips in only six years. Each dollar of equipment destroys 46 cents of value at a 12% cost of capital, based on its current results.

Anthropic, which makes the Claude AI models, filed to go public yesterday. It filed its S-1 (an annual report for a new listing) with the Securities And Exchange Commission (“SEC”), which gave investors the first complete look at its books.

My first question: is this a teleport machine business? Answer: No.

Today, Anthropic owns almost nothing. It only has $1.2 billion of property and equipment on its balance sheet. Instead of owning its computer facilities, it rents computing from Amazon, Google (GOOGL), Microsoft (MSFT), Broadcom (AVGO), and SpaceX (SPCX).

In Q2, Anthropic collected $11.6 billion of revenue and spent $5.6 billion on rent. After paying staff, sales partners, and overhead, it kept $1.40 of cash per dollar of rent paid. That's 40 cents of gross profit per dollar of rent paid, or 18 cents of gross profit if we count stock compensation as a cost.

The risk investors are taking with Anthropic isn’t the capital costs, because it’s renting its compute. The risks investors are taking with Anthropic are the contracts it’s signed to rent enough compute to power its growth.

On June 30, Anthropic owed $587 billion of minimum leases that had not yet started, with most large contracts running five to 10 years.

Spread over their terms, the named contracts cost about $115 billion a year at full delivery, which is 5x the annual rate of last quarter's rent. If you leave out Anthropic’s SpaceX contracts, which can be cancelled on 90 days' notice, it's $77 billion a year in compute rent that’s coming due.

How much revenue does that require? If other cash costs stay at 33% of revenue, Anthropic needs $1.48 of revenue per dollar of rent to break even. By our estimate, on 2028's committed compute of about $110 billion, that's $166 billion of revenue. Press reports put Anthropic's Q3 revenue at a $67 billion annual rate. So the company will require revenue growth of around 150% over the next year to breakeven.

The contracts are fixed, but the revenue is not. That’s the risk.

But I suspect the demand for Anthropic’s AI products will grow far faster than its compute contracts. In fact, I think Anthropic has a good chance to become the AI “express” company.

Watching the build-out of all of these massive data centers reminds me of the only comparable event in American history: the doubling of railroad capacity in the six years between 1867 and 1873. Most of these railroads had economics very similar to Bezos’ teleportation machine or to CoreWeave. Even though demand was endless, the capital costs of these businesses made them all fail. Virtually all of the railroads went bankrupt in the Depression of 1873, which led to a 20-year period of depression-like economic conditions.

(If you’re a history buff, like me, you’d probably enjoy reading: 1873: The Rothschilds, The First Great Depression, And The Making Of The Modern World, by Liaquat Ahamed.)

But just because the businesses that built the railroads went bust doesn’t mean the railroads disappeared. It just meant the value they created ended up being captured by others. The most successful business at capturing the value created by the rails were the express companies. These firms rented space on trains and helped their customers ship freight all over the country.

The most successful was the Adams Express Company. Even though it never laid a single mile of track, by 1910 it ended up owning most of the Pennsylvania Railroad, which was the largest industrial enterprise in the world.

From the very beginning, Adams Express simply rented space on trains. In 1840 Alvin Adams bought a season pass on the first train between New York and Boston. He rode it every day, carrying parcels and envelopes for customers. Demand for services like his exploded as the railroads created a national economy for the first time. By the Civil War, Adams Express ran throughout the North and the South, and the company paid soldiers on both sides. When Adams died in 1877, the company was worth $27 million and employed 15,000 people.

Adams paid for the trains with a share of what it collected for its freight forwarding service. One surviving contract with the Pennsylvania Railroad shows Adams paying 48% of its gross receipts from that line. By 1905, contracts across the industry ran from 40% to 60%, with a guaranteed minimum. But because Adams never had to pay for the construction, the locomotives, or the depreciation on the railroad’s enormous physical infrastructure, it didn’t have any real capital costs... and as a result... virtually all of the value of the railroad ended up accruing on its balance sheet.

Adams paid an $8 dividend on every share every year from 1870 through the depression after 1873, which put a fifth of American rail mileage into receivership, and throughout the entire period, including the panic of 1893. Adams made so much money that it began to invest the earnings it didn't pay out in dividends into stock in the railroads. By 1910, Adams was the second-largest shareholder of the Pennsylvania Railroad and the third-largest of the New York, New Haven, and Hartford Railroad.

In 1929, at the top of the market, the railroads bought their stock back. And Adams became an investment fund with $73.3 million of assets. It still trades on the New York Stock Exchange as Adams Diversified Equity Fund (ADX). It has paid a dividend every year since 1854 except 1867, 1869, and 1932 to 1935. It’s currently yielding 7.42%.

Like Adams Express, Anthropic sells what customers want from the machines: finished work. And like Adams Express, it doesn’t own the machines. It rents them.

I’m certain that building the machines (Nvidia) and renting the machines (Anthropic) will both prove to be much better businesses than owning the machines (CoreWeave).

Tell me what you think of today’s Daily Journal: porterstansberrydirect@gmail.com

Good investing,

F. Porter Stansberry
Stevenson, Maryland