How Banned AI Chips Get to China
In this podcast, Motley Fool analyst Alicia Alfiere and host Mary Long discuss results from retailers, Abercrombie's turnaround, and Chewy's commitment to customers.
Then, New York Times reporter Ana Swanson talks with Motley Fool host Ricky Mulvey about how Nvidia chips are ending up in China, despite America's efforts to keep them stateside. Read Ana's story (login required): "With Smugglers and Front Companies, China is Skirting American A.I. Bans."
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our beginner's guide to investing in stocks. A full transcript follows the video.
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This video was recorded on August 28, 2024.
Mary Long: We've got to look at retail and how advanced AI chips are getting smuggled into China. You're listening to Motley Fool Money. I'm Mary Long. Joined today by Alicia Alfiere. Alicia, thanks for being here on Motley Fool Money.
Alicia Alfiere: Glad to be here.
Mary Long: The big news this week is that Nvidia is reporting, but that doesn't happen until this afternoon. So this morning, we are going to turn our attention to a completely separate sector of the economy and talk retail. I feel like throughout the summer, we've been hearing two different stories about the consumer in the state of them. On the one hand, retail spending in July was higher than expected, so pointing to signs of a healthy consumer. But on the other hand, we've heard stories from Starbucks and Mcdonald's and a number of other companies that consumers are tightening their wallets and really feeling high interest rates and are cracking down on discretionary spending as a result. We've got a number of retailers reporting this week. What are you keeping an eye on as these companies come out?
Alicia Alfiere: I've been looking at several companies, and it's been really fun to take a look at how different companies have been faring in this period. We have some food chains that have been struggling while others have been doing well. Chipotle, for example, continued to execute, its revenues were up. Number of stores continued to expand, continues to generate cash, and the company continues to train track, and execute on improved throughput. That thing is always fun to see and to study.
Mary Long: There are so many different types of consumers, and I think that that really hits home when we focus in on results from specific companies because they each cater to a different demographic. Nordstrom reported yesterday and they've got an eye into different types of consumers with their store. You've got Nordstrom Rack and the department store. Did they come out with any different trends that signify or suggest different strengths within those two types of consumers?
Alicia Alfiere: I would be cautious to use one company's earnings report as a measure of consumers or economic health. Individual companies have different strengths and weaknesses, competitive advantages and management styles that can shape unique performances. I think that's why it's important to really take a sampling across different companies to see what's happening before you explain a company's performance based on macro factors or that sort of thing.
Mary Long: One retailer that reported this morning was Abercrombie and Fitch, and they boasted a 127% increase in their earnings. It's sixth consecutive quarter of triple digit earnings growth. The company also notched its first quarter of over $1 billion in revenue, operating income nearly double this time from last year. That all sounds really good to me and yet last time I checked this morning, shares were down nearly 18%. What is Wall Street seeing there that I am missing?
Alicia Alfiere: First, let's dive a little bit deeper into the results. In the second quarter, net sales were 1.1 billion, which is a record for the company and up 21% year over year. They saw growth across each of its brands, which saw their highest sales in bread history and across all world regions that they operate in, gross profit for the quarter was also up, and the company raised its full year guidance, despite a somewhat uncertain economic backdrop, as the CEO had said. So the company is now guiding for 12 -13% year for year growth in sales. That's up from a forecast of 10% growth just last quarter for the full year. The company is also guiding for 14-15% operating margins this year, which is better than its guidance of 14% margins in a previous quarter. But it's that guidance that the market probably had a problem with. Be even though that margin guidance was raised, it's below a 15.5% margin that the company reported this quarter, which could have the market worried that margin growth could be under some pressure later this year. While that's possible, it seems at odds with the company's actual results, but that can be the danger when a company has a super cheery investor vibe around it. It's that any kind of expectation that's baked in. If those aren't necessarily met, you can have some volatility.
Mary Long: Part of that expectation might come from the fact that in the past year Abercrombie has outperformed Nvidia, which is surprising, especially when you consider all the hype that's around the chip maker. To put some numbers behind that, the retailer stock is up over 230% in the past year. Meanwhile, Nvidia is up about 179%. That performance is due in large part to the turnaround that's been executed by Abercrombie CEO, Fran Horowitz, what happened to make that turnaround a possibility?
Alicia Alfiere: Well, turnarounds take a little while, and this one did take some time. I think there were some surprising things that happened. First, Abercrombie had a bit of a reputation for being exclusive and not in the good way. Also, back in the day, their catalogs seemed to focus more on their models, bodies than the actual clothes. The company worked hard to turn this image around and make their stores and products more inviting. I've also been surprised with the company and how they've targeted different consumers. They do still have teenage clothes, but they're moving away from that and instead targeting people in their 20s and 30s. You could see proof of that because the company recently added a weddings category earlier this year. So that's been really interesting to watch.
Mary Long: It's one thing to sit where we are now and to look back and celebrate Abercrombie success in hindsight after it's already happened or while it's in the process of happening. Currently, the company's trading at about 14 times earnings. Is that a fair price to pay for a company that's got this good of a track record, is more to come? More of that good to come, or is this the end of the story for them?
Alicia Alfiere: It's a good question. Fourteen times forward earnings isn't exactly cheap, and it's important to highlight again, just how much the share price has increased over the last year. Over 230%. Remember, a company that has a cherry, investor consensus can be more prone to volatility as expectations can have a cost. I also like to look at price to simple free cash flow, which is roughly 15.5 times, and that's not too bad. I think what's really important is what do you think the company can do from here? If you were betting on a turnaround a year or so ago, is it fair to say that the company has turned around? If you think so, now you have to look at where the company goes from here, what your thesis is now and how that factors all into the price.
Mary Long: Another retailer that reported this morning saw far slower growth than Abercrombie reported, but it's eliciting the opposite market reaction. Chewy stock is up about 15% on the news of a company's becoming more efficient. What else stood out to you in this report?
Alicia Alfiere: What really stands out to me for Chewy is its deep customer relationships and how they're growing. That's what drove Chewy's net sale increases. It was about 2.6 year over year, and it is, again, vital to its growth. Let's look a little deeper into Chewy. First, for auto ship. Their auto ship program is free to sign up and it gives customers automatic deliveries on products that they use all the time and access to additional savings to. In the second quarter, auto ship sales were over 78% of net sales for the company that's up from 76.1% in last year's quarter. This is an interesting idea because it's similar to or it's the closest a retailer could get to those recurring revenues that software as a service companies would expect, not a pet retailer. Another important indicator that I really like to look at for Chewy is net sales per active customer. In the second quarter, customers spent an average of $565 on Chewy, and that's up 6.2% year over year. Chewy's healthcare and specialty business really helped to grow that. Now, this is an important number to watch going forward as Chewy's customers tend to spend more the longer that their customers with Chewy, which shows just how much those deep customer relationships can grow over time. Chewy has previously said that they think they can increase this number in the long term to something like $1,700. That is a pretty big goal. But they're hoping that they can get there with more than just pet food and toys. Things like their vet clinics, which they're still in the early stages of building out could really help them reach that goal as well. Again, that is a long term goal.
Mary Long: You talk about deepening customer relationships. If that's the focus, how important is it for Chewy to widen their customers? What I mean by that is that customer count increased sequentially, but it did not increase year over year. They've seen this small decline since 2021 when customer count hit its peak at 20.7 million active customers. Today, they've got 20 million. If Chewy really can grow the average spend per active customer to that objectively massive number of $1,700 that you mentioned, do they have to worry about customer count as much?
Alicia Alfiere: That is a good question. I would say, I always thought this was a hot take of mine, but you've already picked up on it. The customer numbers are important. You don't want to see too much of increasing declines here. But the more important thing, I think, for Chewy, going forward, is the deep customer relationships, is increasing that net average sales per customer number. We also have to remember, Chewy saw a lot of customer growth during the pandemic. I think 43% year for year in 2020 alone, and that's big and a lot of people got new pets at the time. I'd argue that if you wanted a pet, you probably got one during the pandemic, but that's a bit of a pull forward. Over time, it should get back to normal and hopefully we won't see as many declines, but to me, the more important number is that net average sales per customer, and not quite so much the customer number.
Mary Long: That peak, an active customer count contributed to the fact that the company stock, hit its highs in 2021. Today, the stock is down almost 80% from those highs. What would you say to somebody who bought in at peak Chewy time and still believes in the story there, but has seen their stock price go down quite a bit from that high.
Alicia Alfiere: I would say part of our journey as investors is that you'll likely buy shares of a company and at some point those shares will decline, and it can be painful when it falls a lot. It's a risk that many of us encountered during the pandemic, and it can definitely happen as people get more excited about a particular stock or even an industry. This is why it's always important to know why you're investing in a particular company, know your risk tolerance, and employ a strategy like buying in thirds. That doesn't mean that you stop at three. There are some people who have bought at thirds and are on their 20th third, or you could take a starter position in a company and add over time as you gain conviction. I would say also remember what David Gardner often says, which is some stocks will take an elevator down and the stairs back up. Holding good businesses over the long term can help to not only lower your losses, but see the benefits of compounding gains as well.
Mary Long: What say you? Is Chewy a good business at the end of the day?
Alicia Alfiere: I certainly like it, and I am excited to see how they could continue to develop those customer relationships going forward.
Mary Long: Alicia Alfiere, thanks so much for the insight into a couple of companies this morning and for closing this out with some wonderful, wise mindset advice.
Alicia Alfiere: Thanks.
Mary Long: You're not supposed to find Nvidia's most advanced micro chips for sale in China. The US government banned the export of them. Not everyone plays by the rules, though. Ana Swanson is a reporter for the New York Times covering trade and international economics. She joined my colleague Ricky Mulvey, to discuss her investigation on microchips and how they find their way around export bans.
Ricky Mulvey: Ana, you're reporting found that these highly advanced AI chips from companies like Nvidia, Intel, AMD are being sold in these open markets in China where these advanced chips are not supposed to be sold. To set the table, what are these markets like? What was it like being there?
Ana Swanson: It was a really fascinating experience and really fun and interesting to get to talk to people on the ground there. I went to one market in Shenzhen that is notorious for being able to get pretty much any electronic imaginable. Shenzhen is right across the border in Southern China from Hong Kong, and it's also a huge electronics capital of China. This market stretches for about half a mile. It's just incredibly densely packed with vendors selling all kinds of things, but in particular, a lot of computer chips. When I went there, I found that I was able to locate some vendors who were offering these chips that have been banned or restricted by the US government pretty easily. We found both a directory online that pointed us to some physical stores. Then I also realized to walking around that vendors had on display banned Nvidia gaming chips. If you asked those people, if you could get these artificial intelligence chips, many times they would say, yes, I can do that for you. I can order that. Some people are talking about smaller volumes, but we also ran into some vendors that said that they were moving larger volumes as well, which is pretty significant, something that had not been previously reported at the time.
Ricky Mulvey: One buy for more than $100 million, I believe. On a personal level, that's incredibly courageous to go there to see if these trade bans are being enforced and to investigate these buys in China. Were you ever nervous being there?
Ana Swanson: Well, reporting conditions in China are far from ideal right now. We are really restricted in terms of the numbers of reporters that are in the country and when we can go into China. But, on occasion, we do have some access, and it's really important to be on the ground there and you can just learn so much more by being somewhere in person. Than you can trying to report about it virtually. I was really grateful for the opportunity to speak to real people in China and just get in touch with what's actually going on on the ground there.
Ricky Mulvey: One of the things you found on the ground was basically that the price of these servers with highly advanced AI chips, one server with each 100 units from Nvidia goes for about $380,000, which you found is relatively high for an international sale, but there's not, like a large black market premium for these chips. Why don't you think there's more of like a premium? What's that say about the supply chain, you think?
Ana Swanson: It's really interesting. Unfortunately, I just have a few data points from my reporting. I wish that we had more. But I think what it suggests is that there is more of a steady supply of these products, certainly than the US government has recognized previously. Initially, it seemed like after the bans went into place, prices really spiked. But it seems like from some people I talked to, that they've come down somewhat. It may be that, these black markets have found more steady supply chains and found some sources of supply. I spoke with some international experts about what those prices should be, and it seemed clear that, like you said, they're somewhat on the high end, but they're still within international price ranges. Again, I don't have a ton of data. I did do pretty extensive reporting there, but it's nothing like extensive market surveys or something, but it's certainly not a picture of scarcity, I guess, I would say that I found in China. That was pretty surprising to me, as well.
Ricky Mulvey: To set the table a little bit, what's the spirit of the ban? What was the US government trying to do by banning these advanced, some advanced AI chips, but not other advanced AI chips?
Ana Swanson: Initially, the US government said it really just wanted to focus on the most advanced AI chips. The reason was that these AI chips, while they're useful for a huge range of commercial products, they're also really essential for the most advanced military technologies. The administration said their purpose is not to go after the commercial industry, but they became collateral damage along the way because these AI chips are also important for military functions. These broader bans on China really started in October of 2022, and they've escalated from then. The US government issued another one to tighten it last year, and then they're also considering further restrictions right now, that would apply more to equipment and high bandwidth memory chips, but also ratchet up the tech restrictions on China.
Ricky Mulvey: We know the use cases in the US, we're familiar with self driving cars and gaming and that kind of thing, but we often don't think about what the PRC is trying to do with these highly advanced AI chips. What are they trying to do with? What is the government of China trying to do with it?
Ana Swanson: Well, of course, there's also a lot of interest in China in those commercial aspects. I do want to say the vast majority of these chips have been used for things like algorithms in your social media sites and very harmless and even helpful things, weather forecasting, scientific research. But there certainly is a concerted effort by the Chinese government to also use the most advanced technology to modernize its military and to defend Chinese territory and be able to meet any challenges that it sees to its national security, its national sovereignty. I did find direct evidence that these types of chips had been used in research in China that related directly to the military, whether it was creating simulations of underwater explosions, like from torpedoes or missiles or modeling, what happens when a nuclear weapon detonate. There's a lot of military applications for this kind of advanced technology. Most of which relates to the ability to just model and invent things much faster with this advanced computing. Then there's also a suite of concerns around what China could do with AI and quantum computing, which are maybe a little bit more perspective and in the future rather than actual, but there's a lot of concern about, for example, disinformation or cybersecurity tax and how AI could fuel that as well.
Ricky Mulvey: Know how hard it is for a government entity, which you're reporting covers the bureau of industry and security, a small government bureau trying to keep track of where these chips are going and stop it. But how does Nvidia not know where these servers are? They're one of the most advanced companies on Earth. They're building a digital twin of the planet Earth. They're not selling sneakers, and it's not just Nvidia, it's also AMD, and it seems to be Intel. How do these chip makers not know where these servers are?
Ana Swanson: It's a great question. I think the industry viewpoint is that they do have practices in place. They say that they all follow the rules, they all carry out due diligence. They ask their customers to comply with export controls. But after they can monitor the chip going to their customers, but after it leaves their customers' hands, they lose track of it or aren't able to track it anymore. There are definitely critics who say that's not good enough, and also that other industries have done a better job at tracking products, and that the chip industry just hasn't been pushed by the government to develop the same kind of diligence that companies that make things that go into nuclear weapons have had to do for a long time. I think, with certain kinds of chips, there is a good argument that there are already tons of them out there on international markets. They're tiny, they're hard to control, but the most advanced GPUs are different. They're bigger, they're really expensive, they're really in demand and they're incredibly profitable for these companies. I think you can make an argument that maybe these companies and the government need to think more seriously about the kind of tracking that they're doing. I think the reporting, does suggest that, even though companies have their arguments about why that is very difficult to do.
Ricky Mulvey: Then as you're looking at this tech race for the most advanced AI chips, the other company we don't talk about a ton on the show is Huawei. They're trying to compete with in video to build the most advanced AI chips. How are you seeing their technology stack up as you talk to these folks who are in the industry?
Ana Swanson: That's a great question. It's a really interesting area. It's pretty hard to tell in part because the Chinese government and China in general has a real interest in publicizing and exaggerating the amount of progress that they're making. The US government has an interest in downplaying that and saying, our controls are extremely effective and they're not being able to produce these advanced chips at scale. I think the truth is really somewhere in the middle, and we're diving into this issue exactly with further reporting right now. But it seems like, the controls really have held back China's production of AI chips, but at the same time, they're still making impressive progress. There's been reports recently of Huawei rolling out a new AI chip, and Nvidia has recognized Huawei in its filings recently as a competitor. We see these Huawei chips that there are orders now for them by domestic Chinese companies and they're being deployed in data centers. There's still a lot of uncertainty about exactly how many chips that they can roll out. Certainly it's far far less than people in China would like to have in order to truly develop AI at the pace they want. But it does seem like this program is simultaneously holding China back, and then also really encouraging their own efforts to indigence this technology. It's still an open question for me, which of those in the end will win out whether the program will hamper China more or encourage it to develop its own AI chips more quickly.
Ricky Mulvey: Ana Swanson's reporting can be found in the New York Times. The investigation we're talking about today is titled With Smugglers and Front Companies China, Skirting American AI Bans. She worked on with Clare Fu. Thank you so much for joining us on Motley Fool Money. We really appreciate your reporting, your time, and your insight.
Ana Swanson: Thank you.
Mary Long: As always, people on 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. I'm Mary Long. Thanks for listening. We'll see you tomorrow.
Alicia Alfiere has positions in Chewy. Mary Long has no position in any of the stocks mentioned. Ricky Mulvey has positions in Chewy. The Motley Fool has positions in and recommends Advanced Micro Devices, Chewy, Chipotle Mexican Grill, Nvidia, and Starbucks. The Motley Fool recommends Intel and recommends the following options: short November 2024 $24 calls on Intel and short September 2024 $52 puts on Chipotle Mexican Grill. The Motley Fool has a disclosure policy.
