A chink in AI’s armour
We have written frequently about the powerful and transformational potential of generative artificial intelligence (AI), as well as the risks for investors who mistakenly believe that returns to shareholders will equate to the benefits garnered by consumers and the world generally.
As we have noted over more than a decade, history is replete with transformational and once novel technologies such as commercial flight, television, and the motorcar that benefitted society far more than shareholders, sometimes even at the expense of shareholders.
Generative AI has indeed emerged as one of these transformational, world-changing technologies, and right on cue, investors have adopted the position that it will also become a powerful tool for driving profits across a plethora of sectors, particularly the tech sector.
However, the AI segment is not one homologous sector. As with any industry supply chain, there are ‘downstream’ and ‘upstream’ companies. Upstream companies are those that supply the tools or the raw materials. They are today’s equivalent of the ‘Picks and Shovels’ suppliers of the gold rush of the 1800s. The downstream companies use those picks and shovels to create new products or services or improve them. They are the ‘appliers’.
Upstream are companies like Nvidia (NASDAQ:NVDA), Intel (NASDAQ:INTC), Qualcomm (NASDAQ:QCOM), Oracle (NYSE:ORCL) and other semiconductor companies that have been among the biggest beneficiaries of the AI revolution. In this upstream segment are cloud computing infrastructure companies such as network communications hardware suppliers and data centres. Nvidia has tripled sales in the past year, but in the absence of the AI revolution, these companies would be reporting much slower, if any, earnings growth. Nvidia, for example, might be selling its chips to autonomous vehicle projects.
Downstream companies in this ecosystem are those that develop and implement AI tools, such as the large language models popularised by OpenAI’s ChatGPT. This group includes Apple (NASDAQ:AAPL), Alphabet (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT)and Meta (NASDAQ:META), along with IBM (NYSE:IBM), Adobe (NASDAQ:ADBE), and Salesforce (NYSE:CRM).
Obviously, Amazon (NASDAQ:AMZN) and Alphabet bridge the divide, having a foot in both streams and may perhaps be described as mid-streamers. These companies enjoy the AI-related revenues from the provision of AI-enabling cloud infrastructure, but their AI applications are very large sinkholes for the dollars required to develop AI-powered applications and user experiences.
The current reporting season is beginning to reveal the gap in sales and profits from AI between the upstream and downstream companies. Now that the second quarter reporting season in the U.S. is well underway, S&P500 earnings are on track to rise at their fastest rate since 2021. However, a closer examination reveals that upstream companies – those supplying the ‘picks and shovels’ to the downstream AI appliers – are the companies raking in the dollars.
In fact, according to the U.S.-based Bespoke Investment Group, companies involved in AI infrastructure have witnessed a 50 per cent annual increase in second-quarter earnings, significantly outpacing the growth of downstream appliers.
The significant profit growth reported by these upstream companies has exceeded expectations and thus been a major driver of overall market performance. Many believe the performance of the broad market indices is, therefore, dependent on the continued earnings growth of the upstream AI companies.
Importantly, it seems to now be transpiring that the profitability of AI ‘appliers’ appears to be slowing. After growing at 50 per cent last year, annual earnings growth for these companies is expected to slow to just over 20 per cent this quarter, dropping to less than 10 per cent in the fourth quarter. Keep in mind, of course, analysts have thus far been very precise about their forecasts but have also been precisely wrong. Nevertheless, as the challenges of monetising AI become more evident, the relative share price performances of the upstreamers and downstreamers will grow wider with the benefits increasingly accruing to those further upstream.
It is telling that AI appears to be displaying the same pattern of consumer benefit and shareholder returns as previous transformational technologies but on a much faster timeline. Consumers are benefitting from the AI tools but the suppliers aren’t able to charge any more for them. It’s not unlike commercial air travel between Sydney and Melbourne, which costs less than it would cost someone to ride a bicycle between the two cities – not great for the service supplier.
And what if, as I have suggested here before, the benefits of AI are over-hyped this time around? What if the real benefits occur in AI boom 2.0? Many industries outside the IT sector have yet to adopt AI and don’t have it on their horizon anytime soon. That would mean this boom is a bubble. The recent market reaction to Alphabet’s earnings, driven by concerns over its high capital expenditures, is a warning shot over the bow for investors. Remember, the profitability of downstream firms, which ultimately drives the demand for AI infrastructure and the profits of upstream firms, will be crucial to maintaining the boom.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
