Cross-market game | The hidden worries of large technology companies behind the big bet on AI

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originalPublished in Hong Kong Economic Times

Investors are used to the financial statements of large technology companies, but perhaps they underestimate how capital-intensive these companies are becoming. Capital expenditures of Microsoft (MSFT), Google’s parent company Alphabet, and Facebook’s parent company Meta Platforms (META) will easily exceed $150 billion in 2024, an annual growth rate of about 70%. The speed at which these companies “burn money” is staggering. These investments are not immediately reflected in the income statement, but are amortized year by year in the form of depreciation of assets. This means that the profit figures that investors currently see are just the “tip of the iceberg.”

Microsoft, Google and Meta’s capital expenditures are now more than three times their depreciation expenses. Here are the latest figures for these companies: Microsoft: $15 billion in depreciation expenses, $40 billion in capital expenditures, expected to reach more than $60 billion this year; Google: $13 billion in depreciation expenses, $38 billion in capital expenditures, expected to reach $50 billion this year; Meta: $12 billion in depreciation expenses, $27 billion in capital expenditures, expected to reach $35-40 billion this year.

Capital expenditures at Microsoft, Google and Meta are now more than three times their depreciation expenses. (Reuters file photo)

From these figures, we can see that these companies are increasing their investments at an alarming rate, especially in AI infrastructure. Meta made it clear in its recent earnings call that capital expenditures will increase to $35 billion to $40 billion in 2024, while Google and Microsoft also stated that they will significantly increase their investments in AI and cloud infrastructure.

Of course, the real question is how effective these expenditures will be in the long run. If these investments can generate high returns, then sales growth can naturally absorb these higher expenses. However, this is not a foregone conclusion, as I personally believe that most of these assets will need to be replaced, which means that the capital expenditure levels currently seen are likely to continue. Therefore, while these companies have price-to-earnings (P/E) ratios between 25 and 35 times, the price-to-free cash flow (P/FCF) ratios are between 40 and 50 times.

Likewise, if these investments can earn a good return, then margins will remain stable, but it is important to note that while free cash flow margins (FCF margins) remain strong, they have not kept pace with margin growth. In the case of Microsoft, its free cash flow margins have fallen from 28% to 26% over the past decade, while net profit margins have increased from 25% to 36%. Eventually, if growth slows, these margins will converge as depreciation expenses “catch up” with cash capital expenditures.

Walmart and Home Depot experienced similar capital expenditure challenges in their early development, but these companies were able to succeed through high returns on capital (ROIC). In contrast, can the current tech giants get a reasonable return on the $150 billion of capital invested in 2024? This is an unknown. At a 10% return rate, $15 billion in after-tax profits need to be added in the first year. The theory of “stock god” Bifede tells us that if there is no profit in the first year, $32 billion will be needed in the second year, and $50 billion in profits will be needed in the third year.

Walmart and Home Depot experienced similar capital expenditure challenges in their early stages of development, but these companies were able to succeed through high returns on capital. (AFP file photo)

If these companies grow 10% per year over the next decade (not a small goal for a tech giant), that would result in a 2.6x growth return. However, if the P/E ratio drops from 30 to 20, the return drops to just 5.6% per year, not counting dividends and buybacks, which might add a few percentage points. Long-term assumptions can’t be made with precision, but these companies are already fairly valued today, and future returns may not be as stellar as they were in the past.

The core issue of investment is risk management and opportunity cost. As Benjamin Graham said, a company can be an excellent investment at one price and a bad investment at another price. Apple may be a good example. Although it is still a great business, the current valuation may no longer be attractive.

In summary, these large technology companies are undoubtedly great businesses, but their current high valuations mean that their investment returns may not be as attractive as in the past. In this era of AI and cloud computing, increased capital expenditures are inevitable, but investors need to carefully weigh the risks and rewards. After all, the goal of investing is not just to choose the best business, but to choose the best investment.

Family Office Investment Manager

Xu Liyan (This column is published every Monday)

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