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Good morning. Shares in the homebuilder Lennar fell 4 per cent yesterday after the company said it was cutting prices and offering incentives to draw in customers struggling to afford a home. Should the employment picture — now fine but no better than that — worsen, the housing market could go from weakness to real distress. Email us: unhedged@ft.com
Big Tech’s AI business models
We’ve looked at charts like this before:
That’s capital expenditures at the five Big Tech companies that are making the biggest plays on artificial intelligence (Nvidia, as a chipmaker rather than a service company, is big too, but is in a different category). The pattern of increasing spending looks similar at all of them. But the scale of the increase is not similar. Here is the same chart, with each company’s spending scaled to where it was four years ago:
Microsoft has doubled its capital spending in order to compete in AI. Alphabet, Amazon and Meta have tripled theirs. And Oracle has pushed up spending elevenfold.
This difference in spending has had a correspondingly disparate effect on free cash flow at the five companies:
At Microsoft and Alphabet, operating cash flow is growing strongly enough to keep free cash flow more or less steady in the face of higher capital spending. At Meta, cash flow has started to wilt (and is expected to wilt more next year). Amazon — where cash flow is always volatile — has seen a sharp downturn, too. Finally, Oracle has begun to burn cash outright.
Unhedged’s argument has been that the market, far from blindly throwing money at AI and Big Tech, is making distinctions that appear to be based on cash generation. This continues to play out recently, with Oracle shares getting badly beaten up and Meta’s struggling. Alphabet’s shares have been relatively resilient partly because they were previously oversold on concerns about the future of the search business. One might be surprised that Amazon’s shares have not been hit harder, given the fall in free cash, but it has long been a company that prioritises reinvestment over profit.
The market has lost patience with Oracle and Meta. Might the same happen to the other three before long? In a recent piece, Jason Thomas of Carlyle argues that it might, saying that the five companies have moved from an asset-light/software model that deserves a high valuation to something like an industrial model. But they are still valued the same way:
When these companies were “asset-light,” paying 7x their accounting [book] value made a lot of sense; you don’t value a money printing machine based on the cost of the paper or printing press! But at current price-to-book ratios, when they acquire $100mn in data centre assets, shareholders are effectively asked to pay $1bn, on average, for the purchase. Does this make sense?
If we assume that the PP & E on balance sheet should be valued at cost and assign a 10x P/B multiple to the rest, these companies’ market caps would be roughly half of what they are today.
Perhaps this is too restrictive an assumption . . . But it does provide a framework to think about valuations in an era where previously “virtual” companies suddenly need to concern themselves with industrial era minutiae like capacity utilisation and depreciation rates
Harvard Business School professor Andy Wu takes something like the opposite view in a recent interview, arguing that, rather than fundamentally changing their business models, they have
taken a shrewd and conservative strategy for AI. They positioned themselves well to benefit from the rise of AI, but they don’t stand to lose that much if AI grows slower than anticipated.
Microsoft has mostly outsourced AI to a third party, OpenAI . . . Amazon will support anybody’s AI model . . . Meta spent billions of dollars building an open-source AI model that they hand out for free to the world . . . these companies don’t really think that core AI technology is a meaningful business in and of itself.
Instead, they’re focused on profiting from all the adjacencies to AI. I often use a gold rush analogy: OpenAI, Anthropic and xAI are out there digging for gold.
Nvidia is the consummate shovel seller, designing the chips needed by the gold diggers. And Meta is the consummate jewellery maker: Meta’s social media, advertising, wearables and metaverse businesses stand to benefit . . . Microsoft does a bit of shovel selling and jewellery making, but the key thing is they’re not stuck digging for gold.
Certainly, it’s plausible that Amazon and Microsoft and Google might make less money on their cloud computing than they ideally would like if AI growth slows or declines, but they would not end up in financial distress.
We might sum up Wu’s view by saying that while Big Tech’s data centre spending is significant, it is supplemental to the companies’ core business models, which remain “virtual” or asset-light. They are not making an existential bet on AI; they are spending to make sure that their core businesses can coexist with AI, should they need to. This implies that those core businesses should still be valued on high multiples of cash flows.
I’m not sure where I land on this. A crucial question is how long the current highly elevated level of spending persists. Three years? Ten? Forever? As the timeline extends, it will become harder to argue that these are still, at core, virtual businesses (again, this point applies less neatly to Amazon, which has always straddled the industrial/virtual line). And it’s not clear anyone knows the answer to this question, because it depends on how the technology and the market for it evolves. The market is giving the benefit of the doubt to Big Tech, as Thomas points out. But again, it is not doing so indiscriminately, as the weak performance of Meta and Oracle shows.
One good read
Some nice meals.
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