Big tech AI spending worries investors
Alphabet, Amazon, Meta & Microsoft are anticipated to allocate $311 billion towards capital expenditures in their current fiscal years, with projections rising to $337 billion by 2026, based on data available. This reflects an increase exceeding 60 percent in the first quarter compared to the corresponding period of the previous year. Free cash flow, in contrast, declined by 23 percent during the same timeframe.
Certain investors are expressing skepticism regarding the substantial cash outlays by major technology firms towards artificial intelligence. This has raised apprehensions about profit margins and the potential for depreciation expenses to negatively impact stock performance prior to realizing returns on these investments. “On a cash flow basis they’ve all stagnated because they’re all collectively making massive bets on the future with all their capital,” stated Jim Morrow, founder and chief executive officer at Callodine Capital Management. “We concentrate significantly on balance sheets and cash flows, and thus, for us, they have diminished their historical appealing cash flow dynamics. They are simply absent now.
“There is a tsunami of depreciation coming,” stated Morrow, who is avoiding the stocks due to his observation that profits are deteriorating without a corresponding increase in revenue. A significant portion of the funds is allocated to essential components such as semiconductors, servers, and networking equipment, which are vital for the advancement of artificial intelligence computing. However, this gear depreciates at a significantly faster rate compared to other assets, such as real estate.
In the first quarter, Microsoft, Alphabet, and Meta reported total depreciation expenses amounting to $15.6 billion, an increase from $11.4 billion in the same period last year. Incorporating Amazon, which has allocated a significant portion of its cash towards capital expenditures instead of share buybacks or dividends, results in an almost doubling of the figure. “People thought AI would be a monetisation machine early on, but that hasn’t been the case,” stated Rob Almeida, global investment strategist at MFS Investment Management. “The pace of AI adoption is not as rapid as previously anticipated.”
Investors continue to demonstrate a robust appetite for the technology giants, attributable to their commanding market positions, solid balance sheets, and profit growth that, despite a deceleration, remains superior to that of the broader S&P 500. This elucidates the robust performance of AI stocks in recent times. However, as an increasing number of depreciating assets accumulate on the balance sheet, the resulting strain on profitability will compel companies to demonstrate greater returns on their investments.
Depreciation emerged as a recurring topic during first-quarter earnings calls. Alphabet’s Chief Financial Officer Anat Ashkenazi cautioned that expenses are expected to increase over the course of the year, noting that management is actively working to mitigate non-cash costs through business streamlining efforts. “We’re focusing on continuing to moderate the pace of compensation growth, looking at our real estate footprint, and again, the build-out and utilization of our technical infrastructure across the business,” she stated during Alphabet’s earnings call.
Other firms are implementing comparable measures. Earlier this year, Meta Platforms extended the useful life period of certain servers and networking assets to five and a half years, up from the previous four-to-five years. According to a filing by Meta, the alteration led to an approximate $695 million rise in net income, translating to 27 cents per share, during the first quarter. In 2022, Microsoft similarly extended the useful lives of its server and networking equipment from four years to six years. Chief Financial Officer Amy Hood indicated that such developments are more dependent on software than on hardware. “We prefer to establish a lengthy track record prior to implementing any of those modifications,” she stated. “Our emphasis is on maximizing the utility of our assets for as long as possible.” Amazon, in contrast, has adopted a different strategy. In February, the e-commerce and cloud computing company indicated that the lifespan of similar equipment is diminishing rather than extending, and consequently adjusted the useful life from six years to five.
To Callodine’s Morrow, the significant concern lies in the potential outcomes if AI investments fail to yield substantial increases in revenue and profitability. In 2022, a significant market shock transpired as a contraction in profits, coupled with rising interest rates, led to a sharp decline in technology stocks, which in turn exerted downward pressure on the S&P 500. “If it works out it will be fine,” stated Morrow. “If it doesn’t work out, there’s a significant earnings headwind approaching.”
