Not so magnificent - What Microsoft and Alphabet's results reveal about the market's AI obsession

Recently, Microsoft and Google’s parent company Alphabet, two of the 'Magnificent Seven' tech companies, released their third-quarter earnings.

The results were initially well received with both companies exceeding the market’s revenue and earnings expectations.

Alphabet reported quarterly sales of US$76.69 billion, 11% higher than a year ago, with profits of US$19.69 billion. Meanwhile, Microsoft posted revenue of US$56.5 billion, up 13% year over year, with quarterly profits of US$22.3 billion, up 27%.

Despite the apparently solid result, Alphabet shares took a hit, falling as much as 10 per cent on the day with lower-than-expected growth in its cloud computing division spooking investors.

In fact, Alphabet’s cloud business grew at its slowest rate since 2021. Its revenue rose 22.5% to US$8.41 billion in Q3, well behind Microsoft's Azure cloud business, which grew 28 per cent to US$24.3 billion. This is despite Alphabet’s continued investments in Gen AI on the enterprise and consumer fronts.

While Alphabet and Microsoft both trail Amazon in the cloud space, Microsoft has been stepping up its AI game, thanks to its investment in OpenAI, the company behind ChatGPT. This is noteworthy because the cloud is the key to the AI investment theme that has been brewing since the start of the year, and collectively, Amazon, Alphabet, and Microsoft are projected to invest US$116 billion on cloud services next year.

Is Alphabet losing ground in the AI race?

Alphabet has encountered significant scrutiny this year around its core search business due to a slumping digital ad market as well as the potential for ChatGPT-enabled chatbots to take over search traffic in the future.

Most investors know Alphabet is a leader in search, and its search revenue has continued to grow despite Microsoft integrating ChatGPT in the Bing search engine early this year. Its positive overall performance got a boost from the US$59.65 billion in ad revenue for the quarter, exceeding analyst expectations.

However, its cloud division, the driving force behind its AI efforts, tells a different tale. Here, it goes head-to-head with the giants, Amazon Web Services and Microsoft Azure.

While Alphabet is actively integrating AI into everything it does, from Google search and YouTube recommendations to AI photography tools and Google Workspace, the slowdown in the global economy has led companies to cut back on their spending for cloud-related services, including expensive artificial intelligence tools.

This contrasts with Microsoft's rapid growth, which stems from its first-mover advantage in generative AI after making a US$10 billion investment in OpenAI, the company behind ChatGPT. Microsoft continues to spend aggressively on AI, with its capital expenditure expected to surpass the US$44 billion next year.

The magnificent seven stumbles amid headwinds

The pain is not restricted to Alphabet alone. Despite the significant gains made earlier this year, the performance of the big seven during this reporting season has seen a substantial reduction in their combined market value. In October alone, they incurred a combined market cap loss of some US$386 billion, primarily driven by Alphabet's staggering loss of nearly US$180 billion.

A major contributing factor to this value loss is the sharp increase in interest rates and the prevailing belief in a "higher-for-longer" rate world. As inflation continues to rise and the reality of higher rates sets in, the allure of future earnings growth from exciting technology stocks is becoming less attractive.

But, AI continues to dominate

Despite these challenges, AI remains an undeniably dominant theme in the tech landscape. In fact, all of the top seven tech giants — Apple, Microsoft, Meta, Amazon, Alphabet, Nvidia, and Tesla — are making significant strides in AI, and it continues to be a central focus for these companies.

Nevertheless, optimism is diminishing due to higher interest rates and ongoing conflicts in the Middle East, resulting in the S&P 500 dropping nearly 10% from its July high following the Big 7's quarterly earnings. It's worth noting that the Big 7 collectively represent more than a quarter of the S&P 500's total value, underscoring the significant value the market places on technology, particularly AI-related technology.

Looking Ahead

The big tech stocks showed resilience in the first half of this year fuelled by excitement about generative AI. However, they are currently grappling with the dual challenges of high inflation and a sluggish global economy as they pivot their focus toward monetising AI.

During this uncertain economic climate, compounded by geopolitical unrest, the results from Alphabet and Microsoft offer valuable insights for investors into what the AI revolution might have in store in 2024.

Key takeaways for investors