The recent volatility in the stock market has not been for the faint of heart. Over the last one month period as of writing (August 12), the semiconductor index (SOXX) dropped 18.5%, the NASDAQ fell 9%, and the MAG7 shed nearly $3 trillion in market cap since early record highs at the beginning of July.
We also went through one of the largest volatility index (VIX) spikes in recent memory. But it’s time for a history lesson in what happens after these vol spikes. The chart below shows a lot of green.
We must remember that the stock market is an aggregated marketplace of buyers and sellers with different intrinsic motivations. Humans, by nature, are pack beings, and the stock market is a second-by-second voting machine with a mob mentality.
This is not a business where we get annual evaluations based on abstract goals, but rather daily P&Ls that can be highly visceral when you see exact dollar figures.
In these times, zooming out and checking your notes is important.
Instead of focusing on daily and weekly volatility, emphasis should be placed on checking and rechecking theses on given stocks. This does not mean we should ignore short-term movements. Rather, we should check and constantly verify (or disprove) our positions based on new information that builds on first principal thinking.
Macro Backdrop
The macro backdrop we saw over the last month was focused on two core pieces of new information: 1) The carry trade unwind and 2) Increased concerns for recession. I’ll give a one-paragraph summary on these. I’m sure your inbox has already been inundated with catchy headlines where macro tourists have shifted their attention to monetary policy and the labour market.
What we experienced over the last month was a carry trade unwind. A carry trade unwind in the stock market occurs when investors who have borrowed funds in a low-interest-rate currency (Japan) to invest in higher-yielding assets (US Equities/bonds) start to reverse those positions. This usually happens when interest rates in the funding currency rise (Japan hiked rates) or when risk aversion increases (concerns for recession), causing the borrowed currency to appreciate. As investors sell their higher-risk assets to repay their loans, stock prices can fall sharply, leading to market volatility. The unwinding of these trades can trigger a broader sell-off, as the rapid exit from riskier positions exacerbates downward pressure on asset prices.
I want to focus on what the industry stalwarts told us over the earnings period. Earnings periods give us a boots-on-the-ground look at how companies are performing. The four most important things were:
- Cloud growth is chugging along.
- The Capex buildout cycle is still very much evolving.
- AI revenue is still pending.
- Software may be turning a corner.
Cloud Growth
The three megacap players in this space are Google (GCP), Amazon (AWS), and Microsoft (Azure), commonly referred to as the “hyperscalers.” The business of cloud computing has been experiencing impressive growth from a very large base. It’s origins were fueled by digital transformation by brining workflow processes online, and this is now being accelerated by AI workloads.
We went through a period over COVID where nearly everything was being brought online. This accelerated growth rates amongst the cloud companies. After this explosion in IT budgets over the course of 2021, we went through a period over 2022-2023 where we were lapping tough comps, and there was a period of “optimization.” Over this time, budgets were rationalized, as a lot of the growth was pulled forward, and IT spending was scrutinized more heavily. It now looks like we are back to accelerating growth rates, largely due to AI workloads.
In these charts, we can see an inflection where growth rates are starting to accelerate again. One of the most important figures is the chart in the middle with Microsoft’s Azure. Microsoft discloses the contribution of YoY growth attributable to AI. Intelligent cloud is Microsoft’s largest portion of revenue, growing the fastest and with the highest gross margins. By adding a new growth vector to this business, they have proved that incumbents can dominate this space.
Cloud growth has not only stopped its deceleration, but it is also now accelerating.
Cloud growth is alive and well.
Capex Spending Cycle
We are amid the greatest Capex supercycle in recent memory. Demand for semiconductors, specifically Nvidia’s GPUs, is far outstripping supply as an immense amount of compute capability is required to power this new technology. Pulling quotes from the most recent quarterly calls:
- “I want to offer some broader perspective on the AI platform shift. Similar to the cloud, this transition involves both knowledge and capital-intensive investments” – Satya Nadella, CEO of Microsoft
- “The amount of compute needed to train Llama 4 will likely be almost ten times more than what we used to train Llama 3, and future models will continue to grow beyond that” – Mark Zuckerberg, Meta CEO
- “I think that it's -- the reality right now is that while we're investing a significant amount in the AI space and in infrastructure, we would like to have more capacity than we already have today. I mean, we have a lot of demand right now, and I think it's going to be a very, very large business for us” – Andy Jassy, Amazon CEO
- “I think the one way, I think about it is when you go through a curve like this, the risk of under-investing is dramatically greater than the risk of over-investing for us here. Even in scenarios where if it turns out that we are over-investing, we – clearly these are infrastructure which are widely useful for us” – Sundar Pichai, Alphabet CEO
Going off of these remarks, it looks like this spend is not slowing anytime soon. We can see below that over the past couple quarters, Capex spend has ballooned.
A big part of this is positioning. I think the most notable comments made were Zuckerberg and Sundar saying they’d rather build too fast “rather than too late” and allow competitors to get a big lead in the AI race.
It is important to note here that this infrastructure buildout is somewhat hedged by existing operations. While many of the megacap players are investing heavily in data centres for the use case of AI, they can also use this capacity to power their existing core businesses.
But this begs the question, are we seeing revenue from it yet? If not, when?
AI Revenue
The clearest example of immediate monetization for products (not chips) in AI is the Microsoft and Open AI partnership. Most recent figures indicate that OpenAI’s revenue run rate is in the neighbourhood of $3.5B1.
On the Microsoft side, analysts estimate that Microsoft added roughly $1.6 billion in revenue last year from AI-related cloud services and more than $1 billion in the quarter that ended in March, so roughly a ~$4B run rate. Microsoft’s revenue primarily comes from the Azure OpenAI Service and OpenAI’s payments to rent Microsoft servers. That brings the total AI revenue for the two largest players in the space to around a $7.5B run rate.
While that figure is nothing to sneeze at, this means that the answer to “How much AI revenue do companies have right now?” is… not that much in the grand scheme of things. However, what happens in FY25 will be vital to proving the return on investment behind all this Capex. Sticking with our Microsoft case study, Morgan Stanley provides the following projections for AI revenue in FY25 for Microsoft.
Whether or not these projections materialize will largely dictate the market’s perception of just how real AI is.
Another component that has been discussed is the cost savings that all these companies will benefit from by implementing these solutions in-house, with the potential to drive significant margin improvement. Megacaps are equal parts customers and suppliers of AI applications.
Software
Year to date, software has been left for dead. As I wrote in my previous commentary: Is AI Eating Software?, investors were concerned that AI would kill software. However, I believe that software will be a critical distribution layer, and software companies that either act as a system of record or power data infrastructure will emerge to benefit from AI.
We’re seeing more and more software companies start introducing AI SKUs and adding enhanced capabilities to their products. It will take a couple more quarters to play out, but it's a largely attractive risk/reward exchange that could pay off if you get ahead of it.
Fear is very much baked into the multiple compression of these companies that we have seen over the past couple of years. For example, on a blended forward basis, Salesforce now trades at 6x EV/Revenue, 15x EV/EBITDA, and 24x P/E. We do not need to get back to anywhere near 2020 multiples for the risk/reward profile to look extremely attractive for these companies. In a lowering-rate environment, the software also tends to flourish. Rates look like they're only headed in one direction.
Wrapping Up
At the end of the day, technological adoption takes time. Of the estimated 25 billion invoices sent each year, 18 billion of those are still paper-based. Real people are behind fundamental workflow changes, and human beings must overcome hurdles of adapting to change, breaking prior habits, and, quite frankly… not getting fired. While the path of least resistance is slow adoption, these changes tend to happen very slowly, then all at once.
Zuck gave a masterclass on building the product first and monetizing after reaching critical scale. He is now doing the same through his open-source LLM, which builds a strong developer community and introduces numerous monetization avenues down the line. I’d bet on him again.
Despite the turbulence in the markets, cloud companies are demonstrating resilience and continuing their steady climb to higher altitudes. The future looks promising, with clear blue skies ahead.
Stay the course.
Strong convictions. Loosely held.
—Nick Mersch, CFA
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Sources
1The Information (June 12, 2024) OpenAI’s Annualized Revenue Doubles to $3.4 Billion Since Late 2023, Stephanie Palazzolo and Erin Woo. https://www.theinformation.com/articles/openais-annualized-revenue-doubles-to-3-4-billion-since-late-2023
2The Information (June 27, 2024) In a Surprise, OpenAI Is Selling More of Its AI Models Than Microsoft Is, Aaron Holmes. https://www.theinformation.com/articles/in-a-surprise-openai-is-selling-more-of-its-ai-models-than-microsoft-is
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