As AI spend continues to soar, when will investors start to be rewarded?
Market reactions were mixed off the back of latest quarterly earnings for the US tech giants, raising a big question – when will these companies’ huge expenditures start to bear fruit?
It’s becoming clearer that the companies once thought of as a collective, the Magnificent 7 – Alphabet (NASDAQ:GOOGL), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Meta (NASDAQ:META), Microsoft (NASDAQ:MSFT), Nvidia (NASDAQ:NVDA) and Tesla (NASDAQ:TSLA) – are no longer running on the same track at quite the same pace, but they’re not entirely divorced from each other either.
In recent weeks, Alphabet (22 July), Tesla (22 July), Microsoft (29 July), Meta (29 July), Apple (30 July) and Amazon (30 July) all reported quarterly updates. Nvidia is due to publish its comparable financial statement later this month (26 August).
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While Microsoft and Amazon’s share prices surged by roughly 15% on their respective next trading days after the results (30 and 31 July), Alphabet, Meta and Apple suffered respective declines of roughly 7%, 8% and 7%, largely due to high capital expenditure (capex) and supply chain concerns. Alphabet, for example, raised its spending forecast to as high as $205 billion this year.
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Tesla, meanwhile, saw its share price fall by more than 14% the day after its results. CEO Elon Musk called this a “massive capex year”, adding that Tesla “should be spending on capex as fast as we can – spend as fast as we can without it being too wasteful.”
Apple’s share price fell by 7% following a supply chain warning from outgoing chief executive Tim Cook, who said: “We’re seeing some very significant constraints currently with limited flexibility in the supply chain to remedy it.”
When will investors see a return on artificial intelligence spending?
Rather than blindly supporting companies based on promises (which burnt many when the dotcom bubble burst), today’s investors – conscious of those past mistakes – are more demanding.
Goldman Sachs has estimated that artificial intelligence (AI) capex is around $765 billion currently but is expected to grow to around $1.2 trillion next year. And the market is becoming concerned that it’s not yet seeing conversion – or hearing explanations why it’s not seeing conversions – into near-term cash flow.
So while the Mag 7 aren’t entirely running in tandem, there are links. While Alphabet and Tesla were first to publish and therefore first to spook the market, an index of all seven companies, the Bloomberg Magnificent 7 Total Return Index, fell 4.8% the next day, wiping off $797 billion in collective value.
Free cash flow, or lack of it, was a central theme from all these results – specifically, the impact from the level of capex. Alphabet reported its first ever negative cash flow, while Meta posted a 91% year-on-year drop in free cash flow. Amazon also reported a negative free cash flow of $7.6 billion.
Chris Elliott, portfolio manager of the Evenlode Global Equity fund, which lists Amazon as a top 10 holding, said Amazon’s CEO Andy Jassey was under no illusion over timeframes.
“Andy Jassey was clear-eyed on the break-even point for investment – it takes a little less than three years for the company to recoup the initial investment of buildings and chips,” he said. “Each data centre can then host four or five further generations of servers, which have higher returns.”
He praised the business’s ability to manage costs and drive efficiencies, which have been proven during multiple growth phases over the company’s lifecycle.
“Amazon has an excellent track record of investing in projects that require huge economies of scale to succeed. This was true with both its ecommerce and logistics network and the initial investment into cloud computing.
“In both cases, its cash flow declined substantially during the investment phase, and the company was careful to manage costs and drive efficiencies. This ‘muscle memory’ positions the company best out of all the hyperscalers to withstand the costs of scaling.”
Big tech paths are diverging
The companies that look more challenged appear to have a less clear path forward.
Nick Saunders, chief executive of online investment platform Webull UK, said where Amazon and Microsoft appear to already be monetising their AI capex, questions were being raised over Meta and Alphabet’s ability to continue to invest at current levels.
“How long can they justify these increased valuations, especially when many people think all they’re doing is using AI for advertising?” he said.
The other headwind to note is a looming profitability squeeze.
Saunders added: “If the hyperscalers are massively increasing their AI capex to the levels we’re hearing – $1.2 trillion or so next year – how long can [Meta and Alphabet] afford to stay in the race, particularly when they have reduced cash reserves?”
When all the big tech giants are investing so heavily, for those where the returns look less clear, a rational view might be to expect them to reduce capex, or focus more on core products.
“But how does the market treat any tech firm that says it’s putting less into AI? It would come across like an admission of failure, which could be dangerous from a pure optics point of view,” said Saunders.
What can investors take from these results?
While earnings are always important, the wider market sentiment around AI and the tech behemoths made this earnings season feel particularly significant.
Evenlode’s Elliott said all eyes were on the tech industry because it was facing a decision tree, with investors wanting to see which way they’d turn.
“Would the hyperscalers cross the Rubicon into negative free cash flow, or would they cut AI spend? Those with a clear, responsible plan were rewarded and those without were punished – evidence of a functioning stock market.
“Long-term investors must balance both the importance of the technology with the market exuberance of the past few years, and the importance of active and responsible capital allocation continues to increase.”
That responsible tone was striking from several of the hyperscalers, in relation to capex spend.
Elliott added:“[Amazon CEO Andy] Jassey was clear that ‘if the demand isn’t there, we won’t spend the capital’ and the team at Microsoft went as far as to reference the US railroad buildout as a direct analogy.
“Investors are no longer simply rewarding management teams for ever-increasing AI spend – which is a good thing in our view – and management teams are adapting their message. The groundwork is being laid for a cut, if deemed necessary, in the coming quarters.”
