This AI Data Center Startup Stock Is Hot, but Is It Really a Buy?

Hype surrounding AI is heating up, ignited by generative artificial intelligence (AI) app ChatGPT late in 2022 and cemented by the booming sales Nvidia is enjoying for its leading semiconductor systems.

The jury is still out whether this hype is a bubble waiting to crash and burn or merely a media frenzy overlaying real economic and business growth that will normalize at some point. Given that AI systems have been around for decades and are already pervasive, I believe this is more temporary hype than bubble.

Nevertheless, that doesn’t mean pockets of the stock market haven’t reached ridiculous levels. AI data center start-up Applied Digital (APLD -7.66%) is a case in point.

Applied Digital was one of the rare initial public offering (IPO) stocks from 2022 (more on that in a moment). Shares fell hard during the bear market but rocketed more than 350% higher so far in 2023. The invocation of the phrase “AI” seems to be working its magic here. But is this stock really a buy?

Building “next-generation data centers” for the future of AI

I hadn’t heard of Applied Digital until earlier this year. Its popularity among some investors heated up in recent months, along with the stock price.

Run a screen on “AI” and “top-performing stocks,” and the name is likely to come up. Or perhaps you’ve been made aware of it thanks to several short reports on Applied Digital that have recently come out.  

At any rate, Applied Digital says it “designs, develops, and operates next-generation data centers,” specifically for use in AI. That alone helps explain some of the optimism some feel about this company.

In recent months, Applied Digital has announced two customers for its new “AI cloud services,” operated through its recently formed subsidiary called Sai Computing (announced in May 2023). The first new cloud customer will spend “up to $180 million over a 24-month period.” No timeline is given for that 24-month period, however. The second customer will reportedly spend “up to $460 million over 36-months.”

Applied Digital also announced a couple of collaborations with data center hardware manufacturers Hewlett Packard Enterprise and Supermicro Computer. Both of these “collaborations” sound a bit more like Applied Digital making purchases of equipment from the two suppliers, but suffice it to say, details on what’s going on were scant.

Applied Digital explains in its financial filings that its business model is “colocation,” which is when an owner of a data center (Applied, in this case) rents out space for other companies to install their own servers, typically on a long-term fixed contract. This is akin to services that data center developers and operator giants like Equinix and Digital Realty Trust provide.

A pivot from one hype cycle to the next?

All of this sounds well and good, and Applied is posting a ramp-up in revenue ($14.1 million during the three months that ended in February 2023, compared to just $1 million a year ago). But I have concerns.

Data by YCharts.

When Applied Digital finally had its IPO in April 2022, it went public under the name “Applied Blockchain.” That’s right — its fleet of three small data centers was first envisioned for the cryptocurrency market that was booming in late 2020 through early 2022 before the bear market of last year bludgeoned crypto prices. By November 2022 (just as a little AI app called ChatGPT was going viral), the company name was changed to Applied Digital to reflect a pivot toward high-performance computing (HPC) applications other than cryptocurrency mining.

Additionally, Applied Digital’s leadership team seems a bit tied up with business advisory, wealth management, and investment banking firm B Riley Financial. Applied Digital CEO Wes Cummins was the founder and CEO of an investment advisory company called 272 Financial, which was only just acquired by B Riley in 2021. Cummins owns 22% of Applied Digital stock.

Nokomis Capital, which Cummins previously worked for, heading up technology investing, owns 3.7% of the stock. Bryant Riley (co-CEO of B. Riley) owns 2.5%, and various arms of B. Riley Financial also own shares.

Give pause before buying

During its last earnings call, Applied Digital said that once two of its newest data centers come online, the company will have enough capacity to host AI and high-performance compute workloads to put them at a $100 million-a-year adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) run rate.

Indeed, despite this tiny stock’s epic rise, it only trades at a market cap of about $800 million. It would seem shares trade cheaply given the company’s near-term potential. I can see why many investors are getting excited. 

However, the ability to host enough data center business to generate $100 million a year in adjusted EBITDA doesn’t mean the company will, in fact, generate that much money anytime soon. 

In addition to some of the other question marks outlined above (quick pivot from the crypto market, management’s potential conflicts of interest), I’m skeptical. I believe most investors would be best served watching this company from the sidelines for now, rather than trying to chase hot “AI stocks” of the moment.