Key Points
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Debt has heavily strained both companies' balance sheets, and this looks increasingly risky in today's business environment.
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AI is probably here to stay, but if AI growth pauses or pulls back for a time, it could put these companies in a precarious position.
- 10 stocks we like better than CoreWeave ›
Earlier this month, I suspended a call I had made just a few weeks ago. I suggested that CoreWeave (NASDAQ: CRWV) and Iren (NASDAQ: IREN) hold the potential for outsized gains driven by artificial intelligence (AI).
Have I changed my mind about that call? Not necessarily, but the Shiller price-to-earnings (P/E) ratio is at 42, a level near all-time highs and an indication that the tech rally may soon run out of steam. Moreover, these stocks carry with them one key risk that could compromise their investment theses. Until they can get past that challenge, it might be better to keep them on a watch list for now, and here's why.
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CoreWeave's and Iren's primary risk
CoreWeave and Iren face increasing risks from their heavy reliance on debt financing.
In the case of CoreWeave's relationship with GPU provider Nvidia, Nvidia is also a CoreWeave investor. It has agreed to purchase the company's unused capacity and has assisted it in procuring AI infrastructure.
Not surprisingly, the build-out has heavily strained its balance sheet. It now holds over $35 billion in total debt, up from $21 billion in just six months. That is far above its $5 billion in stockholders' equity.
Iren has a different type of partnership with Nvidia: a deal granting Nvidia a five-year right to purchase up to $30 million in Iren stock at $70 per share. Nonetheless, like CoreWeave, it will have to finance most of its expansion.
Additionally, Iren is an enterprise in transition. Like CoreWeave, it started as a Bitcoin miner. However, Bitcoin mining remains its primary source of revenue, and for now, overall revenue is falling even as AI cloud service revenue rises.
Also, Iren is not as deeply in debt, reporting $3.7 billion in notes payable. Its $2.7 billion in stockholders' equity implies some balance sheet strain, though not to the same degree as CoreWeave. Still, like CoreWeave, it will almost certainly have to turn to debt to fund its build-out, meaning both companies face similar financial situations.
How the investment theses could go wrong
I mentioned that risk in a recent article where I called them "millionaire-maker stocks." Indeed, if their debt-financing strategies prove successful, these stocks could turn small investors into millionaires.
In retrospect, I think I underestimated that risk. In CoreWeave's case, Nvidia has faced accusations of circular financing, in which the seller finances a buyer's purchases in hopes of a later return. Nvidia entered a $500 billion memorandum of understanding with several Wall Street investment firms to assist in this financing.
However, those who know history might find this concerning. During the dot-com boom in the late 1990s and early 2000s, Nortel, Lucent, and Cisco also engaged in the same practice to maintain growth. When the boom went bust, that played a significant role in the demise of Nortel and Lucent. Cisco survived, but its stock did not return to its 2000 high until this year.
Knowing these booms can run out of steam, CoreWeave and Iren could be left unable to service their loans if it builds infrastructure on borrowed money and customers suddenly disappear.
Moving forward with CoreWeave and Iren
Amid this situation, investors are probably better off keeping CoreWeave and Iren on a watch list for now.
To be sure, CoreWeave's and Iren's neoclouds play a critical role in AI development. That competitive advantage may hold them in good stead, even in an AI downturn. Also, if these stocks fall and then later recover, they could ultimately mint more millionaires than if an industry slump had never happened.
Nonetheless, their high debt levels pose a tremendous risk, particularly if the infrastructure they build is ultimately unnecessary, or even if a pullback in AI development is only temporary.
In the end, CoreWeave and Iren are well worth watching, but in my view, these companies should prove they can survive a meaningful AI downturn before investors aggressively buy these tech stocks.
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Will Healy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Bitcoin, Cisco Systems, and Nvidia. The Motley Fool has a disclosure policy.