THE reaction of most “Magnificent Seven” (Mag 7) tech giants’ shares to their latest earnings suggests the artificial intelligence (AI) boom is far from over.
Yet doubts about the future returns from these firms’ astronomical AI expenditures are gnawing deeper.
The third quarter earnings season has seen these tech behemoths continue to rake in huge profits and offer sunny guidance.
Some investors may baulk at the Mag 7’s lofty valuations, but today’s tech leaders — unlike the superstar firms of the 1990s dotcom bubble — appear to have sustainable business models.
Federal Reserve chair Jerome Powell reiterated as much last week, saying their AI investments were a major source of United States economic growth.
Just four “hyperscalers” alone — Microsoft, Amazon, Meta and Alphabet — are expected to spend a combined US$350 billion this year, and Goldman Sachs estimates global AI-related infrastructure spending could reach US$4 trillion by 2030.
The more these firms splurge on data centres, cloud computing capabilities, and the gamut of AI technologies, the loftier investors’ expectations will get. At some point, they will be impossible to meet.
The financial benefits and cost savings for society resulting from that are one thing; which companies actually profit is another.
It is important, therefore, to distinguish between “value creation” and “value capture”.
“The value creation is certainly there,” says Daniel Keum, associate professor of management at Columbia Business School.
“But will that value flow back to the companies that are making these AI investments right now? For me, the clear answer is no.”
It’s early days in the AI supercycle, but Big Tech’s AI outlays are already eating into hyperscalers’ cash flows.
Torsten Slok, chief economist at Apollo Global Management, estimates that aggregate capital expenditure (capex) at Amazon, Google, Microsoft, Meta and Oracle as a share of their operating cash flow is now a record 60 per cent — and rising.
Amazon reported strong earnings last week, and its stock surged double digits to hit a new high on Friday. But buried in the report was a slide showing that trailing-12-month free cash flow has fallen almost 70 per cent over the last year.
Ross Hendricks, analyst at independent research firm Porter & Co, estimates that hyperscalers’ free cash flow in the first quarter of next year will be down more than 40 per cent from the same period this year.
“The whole sector faces the same basic problem,” says Bob Elliott, co-founder of Unlimited Funds. “The math is pretty simple, unless there is a surge in revenues from these activities, Big Tech is going to pump nearly all their free cash flow into capex in just a few years.”
This creates several potential problems. It intensifies the pressure to generate high returns on these investments, but until those materialise, non-AI-related activities are also under pressure to produce significant returns.
And this leaves hyperscalers vulnerable in the event of a sharp economic or market downturn.
The fate of these megacaps will, of course, have a significant impact on the broader economy, not only because these companies’ capex is helping to drive growth but also because almost everyone with a retirement fund is exposed to them.
Nvidia’s share of the total S&P 500 market cap is a stunning eight per cent, while that of the “Mag 7” is a record 37 per cent.
Investors are well aware of how much these shares have appreciated. Of course, whether these companies can continue printing money as fast as they are spending it is the big question.
For example, Meta’s announced capex this year is around US$70 billion, but Unlimited Funds’ Elliott notes that the company’s income is only US$3 billion to US$5 billion higher, based on underlying trends, than it was before they started spending all the cash.
That’s a pretty “mediocre” return on investment. Chief executive officer Mark Zuckerberg might argue that this is long-term investment and that not spending now could be more costly down the line if the AI revolution lives up to the hype.
But it is unclear how much patience investors will have.
A Wharton Business School study published last month found that 74 per cent of businesses say generative AI investment is already producing positive returns, especially smaller enterprises in digital-based sectors like tech and finance.
“Confidence remains strong … but future gains must now be justified by clear performance outcomes,” said the authors.
The writer is from Reuters
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