Bad news for tech investors questioning the ROI of AI spending

The current S&P 500 index weightings highlight the dominance of chip stocks, particularly semiconductors led by Nvidia Corp. This segment has become the index's heaviest for the first time, driven by enthusiasm over AI technology's increasing demand for chips. Despite recent gains, there are concerns about whether the tech sector, buoyed by Nvidia's performance, can sustain momentum. Last week's sector losses, exacerbated by a global tech outage linked to CrowdStrike Holdings Inc.'s software update, underscore uncertainty. As earnings season approaches, investors may not find clear answers regarding the payoff from costly investments in AI computing infrastructure. Many companies are still in the experimental phase, having invested heavily in new servers with pricey Nvidia chips.

"It's premature to gauge whether the hype around AI matches reality, given the ongoing heavy investment," said Jason Tauber, a managing director at Neuberger Berman in New York. Concerns have heightened over enterprise software, with chief investment officers considering software as a means to rationalize budgets for AI investments. Salesforce's performance in May raised doubts about whether software firms can replicate the revenue surges seen in hardware due to AI. Despite a rebound in some software stocks later, driven by Micron Technology's chip demand for AI, doubts linger. Second-quarter earnings projections suggest software revenue will grow faster than earnings, with revenue expected to rise by about 12% and earnings by 7.5%, according to FactSet estimates.

Microsoft Corporation is gearing up for highly anticipated software results, particularly concerning its AI assistant, Copilot, launched last year. While specific revenue figures for Copilot haven't been disclosed yet, investor expectations remain modest. Microsoft's Azure cloud-services business, a major AI beneficiary, also represents a substantial investment in infrastructure. Overall, Microsoft's revenue is projected to grow by approximately 14%, with earnings expected to lag behind at 8% for the quarter. The company continues to heavily invest in its capital infrastructure, with plans to double spending in fiscal 2025 to around $63 billion, prompting questions among investors about the return on these investments. There's growing impatience on Wall Street for conclusive evidence regarding AI's profitability, echoing concerns seen previously with Meta Platforms Inc.'s lavish spending on the metaverse in 2022.

Oracle Corporation's software group earnings have been weighed down, as reported by FactSet following its fiscal fourth-quarter earnings miss in June. The company's investments in data centers for its Oracle Cloud business have led to forecasts of double-digit non-GAAP earnings and revenue growth in the upcoming fiscal first quarter.

Unlike Microsoft's Copilot, which is directly accountable, most software companies lack such a clearly defined AI product. However, internet giants like Alphabet Inc.'s Google and Meta Platforms Inc. (classified under communication services on FactSet) attribute increased advertising engagement to AI, though quantifying its impact remains challenging. Meta's CEO Mark Zuckerberg indicated that AI's revenue contribution is still in the inventory-building phase before monetization, alongside increased 2024 capital spending of $35 billion to $40 billion.

Despite heavy infrastructure investments, Meta and Alphabet are expected to show significant revenue growth, with Meta forecasted to grow by approximately 19% and Alphabet by about 13% according to FactSet. Both companies are anticipated to achieve high double-digit earnings growth, with Meta at nearly 56% and Alphabet around 22%.

This earnings season, attention is on the "Magnificent Seven" companies, including Amazon, which is expected to show a year-over-year growth rate drop from 169% to 57%, and Meta's earnings growth declining from 94% in the first quarter. Nvidia, a leader in AI-infused hardware, saw a massive earnings increase of 400% last quarter, projected to grow by about 134% now. Other hardware firms, like Broadcom Inc., are also benefiting, with forecasted sales jumping 46% and strong earnings growth despite lagging behind revenue growth.

Investors are increasingly aware of the need for returns on AI investments, amid mixed signals from users. According to a recent Gartner report, 49% of companies struggle to estimate and demonstrate the value of AI projects. Ram Palaniappan from TEKsystems Global Services pointed out that many companies find it challenging to prove ROI, especially when deploying sophisticated AI solutions like ChatGPT-like bots, which are trained on data that may be outdated for enterprise needs.

Meanwhile, examples like Klarna showcase AI's potential, with their AI assistant replacing 700 call-center agents and projected to save $40 million annually. Despite such successes, Jason Tauber from Neuberger Berman believes this earnings season won't definitively show AI's impact beyond hardware, noting ongoing high levels of investment benefiting semiconductor supply chains and cloud-service providers.

The uncertainty around AI's tangible benefits may leave investors pondering its long-term payoff. This earnings season, however, is unlikely to offer conclusive insights into AI's current impact beyond its hardware applications.