Still Searching for AI Revenue

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Every four months of the year, stock junkies get their own version of the SuperBowl - earnings season.

When companies go to the confessional, we get a boots-on-the-ground look at how the beating heart of the economy is performing. Sure, we can get inflation readings this, retail sales that… but over the next couple of weeks we get to see who is sinking or swimming.

The setup into this period is an interesting one. We have the fed still trying to thread the needle and avoid recession after a historic rate hiking cycle.

We also finally got some rotation into smaller caps companies after megacap and AI names have been the sole beneficiaries of YTD performance.

And boy did AI names get crushed… last week, the Semiconductor index was down over 11% as trade tensions escalated. The one-day drop in semiconductors hadn’t been that bad since Covid…

Does the widening out of the rally mean we will see the bull market run further after this short term pullback? Or is this a sign of investors starting to look for net new growth elsewhere as the AI trade gets ahead of itself and begins to unwind?

Let’s take a look at the most important thing to look for over earnings.

Time to jump in!

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Key Theme to Look For

All eyes are going to be glued to the core theme of AI. There will be two things that the market will follow extremely closely: Capex spend from the hyperscalers and recognized revenue from AI.

The megacap tech companies are pouring a historic amount of capital into Capex (mostly Nvidia Chips) as the race to build the infrastructure for AI rages on.

This increase in capex is seen as critical to scale out AI solutions. However, many are now questioning the ability to convert this heavy investment into tangible revenue. Goldman is the recent critic with a research piece out titled: “Gen AI: Too Much Spend, Too Little Benefit?” in which they outline significant doubts for AI’s killer application to emerge.

This question revolves around the ability to produce meaningful revenue going forward. The one chart that attempts to outline this was released by BNP Paribas Exane which forecasted very strong growth when it comes to the main cloud infrastructure players. The forecasts are eyewatering:

If these aggressive ramping estimates can be reached, then maybe all this investment could be worth it. But that is a massive hill to climb.

This is why Capex trends paired with revenue growth amongst the hyperscalers is the most critical component to analyze this earnings period.

Zooming in On Capex Trend at Hyperscalers

Google: Google went out of favour into WWDC but rallied in the weeks that followed through better ad checks and the appreciation that Google is the cheapest Mag7 stock while having retained the most cost optionality. New rockstar CFO also starts at the end of the month. Relative to META, GOOGL has more attractive EPS growth metrics and trades on a 1x turn GAAP EPS discount now. That said, positive catalysts here are limited and there is nervousness into the Judge ruling over DoJ suit in the coming months.

Amazon: Amazon is arguably the most loved name across FANG as investors play the combo of AWS acceleration and retail margin improvement through logistics efficiencies and blowout advertising numbers. That said, some doubt has been creeping in amidst AWS uncertainty; short term consumption risk and long term competitive threats which could spark a meaningful capex wave. There was also a recent Bloomberg interview with new AWS CEO noting AWS is accelerating and is still growing faster than any other cloud provider in absolute dollar terms. Advertising optimism has been the driver to take the stock through a $2T market cap in recent weeks.

Meta: Post Q1 earnings, concerns are arising with the combo of growth slowing faster than hoped and costs rising (Opex & Capex) putting pressure on the long term cash flow compounding story. The stock also now trades on a 1x turn GAAP EPS premium to GOOGL. However, there is still confidence in META’s ability to monetize AI investments across its Family of Apps offering upside optionality. We’ll see if there are any Capex adjustments here.

Microsoft: The MSFT long term story is as clean as they come and it’s the #1 Software name for LOs to hide in as being the clearest GenAI winner outside of NVDA, but sentiment cracks are emerging: 1) like with AWS, there have been some creeping doubts here as investors fear short term cloud consumption trends at Azure, 2) Capex hikes will be a constant here and last Qs comment about being “a bit AI constrained” as a forward looking hedge on higher spend, 3) Ramp of O365 copilot relative to initial expectations has been disappointing, 4) The core apps business won’t be immune to the Software spending environment which will hit commercial bookings, and 5) on ~40x consensus C25 FCF (~$86b), valuation is far from cheap anymore.

By The Numbers: Consensus is looking for 2Q24E hyperscalers' revenue to grow by $11B Y/Y to $57B, up 24.2% Y/Y vs. 1Q24's 23.8%, with AWS accelerating 18% sequentially vs. 17.2%, Azure +31.0% vs. 31.1% and GCP +28.0% vs. +28.4%.

Wrapping Up…

With all the buzz around the rest of the market catching up to the Megacaps, this quarter will be one of the most important in the recent bull run.

Historically, Megcap companies have had 1) Better growth and 2) Better profitability than the rest. This has led many to say that the marketcap concentration here could be justified.

If both of these things stop being true, we could be in for a reckoning.

What do you think? Party on for AI? Or Game Over?

Cheers,

The GRIT Alpha Team

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