OpenAI making money from the AI revolution is far from certain

By Jurica Dujmovic

Being at the cutting edge doesn't necessarily bring financial success

OpenAI has ridden the wave of AI hype to a staggering valuation.

OpenAI's transformation from a nonprofit AI research lab to a profit-driven tech giant is as controversial as it is remarkable. Since pivoting to a "capped profit" model in 2019 and cementing a deep - some might say dependent - partnership with Microsoft (MSFT), OpenAI has ridden the wave of AI hype to a staggering valuation.

On Wednesday, OpenAI announced that it had raised $6.6 billion in new funding, giving the ChatGPT creator a valuation of $157 billion. This staggering valuation, which transforms OpenAI into one of the world's most valuable private companies, demands intense scrutiny. Has the AI frenzy inflated this company's perceived worth - far beyond its actual technological achievements and business fundamentals?

Read: OpenAI is now worth more than 87% of S&P 500 companies. It faces a tough test ahead.

As the funding round fuels IPO speculation, a report examining OpenAI's financials paints a less rosy picture than the hype suggests. Financial documents reviewed by The New York Times reveal a company burning through cash at an alarming rate, raising questions about the sustainability of its current trajectory and the potential risks of prioritizing break-neck expansion over responsible AI development. Let's discuss some of the key points from the New York Times report, which was published last week before the funding announcement:

-- OpenAI's monthly revenue hit $300 million in August 2024, a 1,700% increase since early 2023.

-- The company expects to generate around $3.7 billion in annual sales this year and anticipates revenue ballooning to $11.6 billion in 2025.

-- Despite rising revenues, OpenAI predicts a loss of about $5 billion. this year due to high operational costs, biggest of which is the cost of computing power it gets through its partnership with Microsoft.

-- OpenAI predicts its revenue will hit $100 billion in 2029.

The Times report raises serious questions about OpenAI's sustainability and realistic goals. The company's monthly revenue growth from early 2023 to August 2024 is nothing short of explosive; however, the long-term projection of $100 billion in revenue by 2029 appears unrealistic. This figure would require sustaining an average annual growth rate of more than 90% for five consecutive years (93.3% to be precise, from an expected $3.7 billion in 2024 to $100 billion in 2029), a feat rarely achieved in the tech industry, especially for a company already operating at such a large scale. While impressive on paper, said projections may be masking underlying financial challenges and setting expectations that could be difficult, if not impossible, to meet.

Financial challenges become even more apparent given the current expense structure in relation to projected growth. It's crucial to note that, even if it reaches the projected revenue targets, OpenAI is not merely failing to break even in 2024 - it's losing significantly more money than it's generating. This means that before OpenAI can even consider achieving its ambitious growth targets, it must first find a way to become profitable, or at the very least, break even.

Microsoft may be positioning itself for an even larger role in OpenAI's future.

This feat seems particularly daunting given the capital-intensive nature of AI development and deployment, and the company's heavy reliance on Microsoft's cloud services.

Microsoft's significant stake in OpenAI and its position as the primary provider of crucial computing resources give it considerable leverage over OpenAI's operations and strategic decisions. To quote Microsoft CEO Satya Nadella: "We have the people, we have the compute, we have the data, we have everything." This level of control and integration raises questions about OpenAI's ability to operate independently or to seek alternative partnerships, even if it wanted to reduce its reliance on Microsoft's services.

The nature of this relationship and Microsoft's deep integration with OpenAI's operations suggest that Microsoft may be positioning itself for an even larger role in OpenAI's future. Whether it could lead to a complete acquisition or simply maintaining a position of strategic control remains to be seen, but it's clear that Microsoft stands to benefit substantially from OpenAI's growth and technological advancements, regardless of the latter's financial struggles.

The Times report noted OpenAI's pursuit of what could be described as aggressive user acquisition and pricing strategies. These include:

-- Monthly active users: 350 million as of June 2024, up from 100 million a month earlier.

-- Paying subscribers: Only about 10 million users (2.8%) pay $20 monthly for ChatGPT.

-- Price increase plans: $2 increase by end of 2024, with aggressive increases to $44 over five years.

OpenAI's user acquisition strategy appears to be highly effective on the surface, with the number of monthly active users skyrocketing in just three months. However, the user-to-paying-customer conversion tells a different story, as the paid user base is comprised of less than 3% of total active users. The low conversion rate raises questions about the long-term monetization potential of OpenAI's products. Even more concerning are the company's lofty price-increase plans.

Open AI's strategy to attract users seems risky given an intensifying AI pricing race-to-the-bottom, fueled by increasing competition and commoditization of AI services.

This strategy seems particularly risky in the face of an intensifying AI pricing race-to-the-bottom, fueled by increasing competition and commoditization of AI services. Steep price hikes could potentially alienate existing users and stifle further user growth, especially if OpenAI's competitors offer similar services at lower prices. The aggressive pricing approach appears to be at odds with the reality of the evolving AI market and could significantly impact OpenAI's ability to achieve its ambitious goals.

Read: Big Tech's AI bubble is alive and unwell

From its struggle to monetize a rapidly growing user base to its arguably misaligned pricing strategy, OpenAI may have challenges meeting growth expectations. Looking at a potential post-IPO future, the gap between OpenAI's ambitious projections and its current financial realities is likely to create a rollercoaster ride for investors. The reported projection of $100 billion in revenue by 2029 seems more of a moonshot than a realistic target, requiring a sustained annual growth rate that few, if any, companies have ever achieved at this scale.

OpenAI's long-term potential remains intriguing, but its current business model appears shaky. The company needs to dramatically improve its path to profitability, rethink its strategic partnerships, and demonstrate a more realistic growth trajectory. The AI revolution is underway, but OpenAI's ability to capitalize on it is far from certain. As we've seen time and again in tech, being at the cutting edge of innovation doesn't always translate to sustainable financial success.

More: OpenAI's latest funding round nearly doubles valuation to $157 billion

Plus: AI-powered stock ETFs were hyped as superior investments. Then reality hit.

-Jurica Dujmovic

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10-03-24 0835ET

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