Tech Titans Face Profit Pressure Amid AI Investment Wave

In recent months, investors have raised concerns about the substantial investments made by technology giants in artificial intelligence (AI), amid uncertainties surrounding profit margins and potential depreciation costs that could negatively impact stock prices before returns are realized.

Jim Morrow, CEO of Callodine Capital Management, emphasized that these companies are stagnating from a cash flow perspective due to their large, collective capital bets on the future. He pointed out that the attractive cash flow dynamics that once characterized these companies have shifted, challenging asset and cash flow strategies.

Data shows that the fiscal capital expenditure for companies like Alphabet, Amazon, Meta Platforms, and Microsoft is predicted to reach $311 billion this year and increase to $337 billion by 2026. The first quarter alone saw a capital spend surge of more than 60% compared to last year, while free cash flow dropped by 23% over the same period.

Morrow warned of an impending depreciation wave due to the accelerating devaluation of essential AI computing equipment like semiconductors, servers, and networking devices, which depreciate faster than other assets like real estate.

Alphabet, Microsoft, and Meta faced combined depreciation expenses of $15.6 billion in the first quarter, up from $11.4 billion last year. When including Amazon, which channels more cash into capital expenditures rather than stock repurchases or dividends, the figure nearly doubled.

Despite promising AI advancements, Rob Almeida of MFS Investment Management noted that early assumptions that AI would quickly evolve into a lucrative machine haven’t materialized. The anticipated adoption pace hasn’t met initial expectations.

Investors retain interest in tech stalwarts thanks to their market dominance, robust balance sheets, and earnings growth that still outpaces a majority of Standard & Poor's 500 constituents, underscoring the recent robust performance of AI-themed stocks.

A growing depreciation asset base threatens net profits, placing more pressure on these firms to demonstrate higher returns on investment.

Depreciation concerns took center stage during first-quarter earnings calls. Alphabet's CFO, Ruth Porat, acknowledged rising expenses throughout the year, indicating efforts to counteract non-cash costs by streamlining operations.

Meta has extended the depreciation period of certain server and network assets from 4-5 years to 5 and a half years, increasing net income by $695 million or 27 cents per share in the first quarter.

Microsoft also took steps last year to extend its equipment lifespan from four years to six, though CFO Amy Hood affirmed during April's earnings call that any similar adjustments would be influenced more by software than hardware.

Conversely, Amazon shortened the lifespan of similar devices from six years to five in February, indicating a distinct approach compared to its peers.

According to Morrow, the key risk lies in whether AI investments fail to generate significant revenue and earnings growth, akin to last year's market shock when shrinking profits and rising interest rates led to a tech stock slump.