iCapital Market Pulse: Tech and AI Take Center Stage as Earnings Season Ramps Up

Key Takeaways:

• Strong Start to Earnings Season: 86% of companies, that have reported thus far, have beaten estimates, led by banks with 20% YoY growth, reinforced by confidence in consumer resilience.¹  
• Tech & AI Take Center Stage: Big Tech and AI firms will dominate the next leg of earnings, with many of the Mag 7 companies reporting the week of October 27.
• Valuations Look Justified: Despite bubble concerns, solid earnings growth and return on equity (ROE) suggest the rally for technology and AI stocks have been supported by fundamentals.
•  Favor AI Semiconductors and Power: CapEx confirmation should boost AI Semiconductors and Power.

While the Q3 reporting season has only just begun (12% of firms have reported² ), we are off to a strong start. Currently, 86% of companies that have reported earnings have surpassed expectations, growing at 8.5% year-over-year (YoY) – above the 6% that was expected heading into the quarter.³  This strength was particularly pronounced with the Banks, where earnings are growing at 20% YoY – above the 13% expected.⁴  In addition, the commentary around the consumer, improving credit card spending and credit quality, reaffirms our conviction in a resilient economy – especially given the lack of data over the past month.

Now our attention will shift to the large-cap Tech and AI companies, many of which report the week of October 27. During this week, 44% of the S&P 500 market capitalization will report, with names like Alphabet reporting on 10/29 (After Market Close or AMC), Microsoft 10/29 (AMC), and Amazon 10/30 (AMC). It is not just limited to the Magnificent 7 (Mag 7), 50% of the Morgan Stanley Broad AI basket will report earnings between 10/27 and 11/17. But, it is Nvidia that will receive the most attention on 11/19 – late in the reporting season.

Investors will be particularly focused on the durability of the AI theme, especially given the questions and concerns about the “circular” nature of recent deals – Nvidia and OpenAI, and OpenAI and AMD to name a few. With the Hyperscaler’s expected to spend $385Bn on capital expenditures (CapEx) this year (+61% YoY) there will be scrutiny about the return on invested capital (ROIC).⁵

This earnings season comes at a critical juncture, given the data vacuum that markets have been trading in and as we are near the high end of our fair value range of 6,800-6,900.⁶  While quarterly earnings for Q3 and Q4 have not been revised down by the historical average of 4% heading into the start of the reporting season (see exhibit 1), we do not necessarily think the bar is set high. Indeed, 6% YoY growth is a slight deceleration compared to the last few quarters, but the S&P 500 has on average surpassed expectations by four percentage points (pp) over the last four years – which could mark a fourth consecutive quarter of double digit earnings growth.⁷  Therefore, this earnings season should confirm the strength in fundamentals and ultimately support markets moving higher into year-end.

Even if markets do consolidate around current levels, there are opportunities within equities that we would favor. Themes like AI Semiconductors and Power should benefit from hyperscalers confirming their CapEx forecasts.

What is Expected from Tech Earnings?

Heading into the bulk of the big tech earnings, the information technology sector is expected to grow earnings by 20.9% YoY.⁸  The semiconductor and semiconductor equipment industry is expected to be the largest contributor of this growth, as their earnings are projected to expand by 45% YoY.⁹

Given its concentration, there will be much focus on the Mag 7, which is expected to grow by 14.5% YoY.¹⁰  This seems like a low bar, as the group has grown by an average of ~35% YoY going back to the start of 2023, (see exhibit 2), and has been responsible for 26% of the S&P 500 earnings growth over the last twelve months.¹¹

Tech Earnings or CapEx Season?

When the Hyperscalers report, there will be a particular focus around CapEx forecasts and their ROIC. Currently they are expected to spend $104B this quarter, which is up from $96.6B the prior quarter, see exhibit 3.¹²  But, there are signs that CapEx figures could come in slightly better than or at least meet expectations. Last week (week of 10/13), Taiwan Semiconductor raised the lower end of their CapEx forecast by 5% – to $40B from $38B.¹³  This was coupled with comments from the CEO who stated that: “…our conviction in the AI megatrend is strengthening…”¹⁴

However, concerns were raised about the ROIC on AI investment when the Massachusetts Institute of Technology (MIT) released a study stating that 95% of organizations have seen no return on their investment.¹⁵  But, a recent Goldman Sachs report mentioned how this was overstated because first, the MIT study focused on bought applications vs. applications that are being built internally.¹⁶  Second, they focused on projects that were sourced from frontline managers and not central labs.¹⁷  And finally, they looked at targeted automation of specific tasks vs. general automation.¹⁸

While there are questions on the depreciation of this investment, which could cause a revenue realization mismatch, companies have already started to realize returns of their investment. Based on estimates, for every $1 that is invested in AI, this has resulted in a return of $2-$3.7.¹⁹  Also highlighting the growing importance of ROIC datapoints, Microsoft now breaks out AI contribution to Azure growth. Last quarter, they reported that 16% of Azure growth came from AI, up from 5% in Q1 2024 – when the company started reporting this metric.²⁰

This trend should continue as the AI adoption grows. Currently, AI investment only makes up 1% of GDP, which is well below the 2-5% that we have seen in other technological advancement cycles.²¹  In addition, AI is only responsible for the production of 9.7% of final goods and services and is expected to increase as adoption trends remain healthy.²²

While widespread AI adoption may take time, we believe there are early signs that the tremendous/substantial investments in the space are beginning to yield returns. This momentum is likely to accelerate as consumers increasingly bring AI into the workplace (via use of Chatbots and other consumer-oriented AI tools) and as enterprises gradually adopt more advanced AI tools and solutions. Together, these trends should drive meaningful productivity and ROI.

Are We in a Bubble? How Do Things Compare To 2000

Given the Nasdaq 100 elevated valuation – forward P/E of 27.9x vs. its peak of 31.5x in 2002²³ – investors are wondering if we are in a bubble. While there are some trends worth monitoring, we see three reasons why we are not in a bubble at this juncture.

1. Performance has been supported by earnings growth: Technology and AI stocks have posted strong returns over the last few years, which in part has been supported by their earnings growth. Going back to November 30, 2022 (the launch of ChatGPT), 55% of the gains for the Nasdaq 100 have been driven by earnings growth.²⁴
2. Profitability of the hyperscalers is better than 2000: Metrics such as the ROE would suggest that the profitability of today’s Tech leaders is better than what we saw in the run-up in 2000. The ROE of Mag 7 companies is currently 46%, higher than the 28% from the Tech leaders in 2000.²⁵
3. CapEx doesn’t look as elevated when compared to sales: In 2000, the height of the tech bubble, the communications service sector had a CapEx-to-Sales ratio that was above 30%, which compares to the ~15% today for the hyperscalers, see exhibit 4.

While the comparisons to 2000 will continue to arise, we think the rally in technology and AI companies have been supported by fundamentals and would expect this trend to continue during this earnings season.

Investment Implications: Stay Invested, But Favor AI Semiconductors and Power

Despite the -2.71% decline in the S&P 500 on 10/10, we are already back above 6,700 on the index.²⁶  Given this is near the high-end of our fair value range, we do think equity markets could consolidate around current levels. However, we do think a strong earnings season should help support equities move higher into year-end. While upside might be capped from an index perspective, especially given where valuations are, we think there are sectors and themes that should be key beneficiaries from this reporting season.

In particular, if hyperscalers meet or confirm their CapEx estimates, we would view this as supportive for AI Semiconductors and Power, especially given the recent concerns about the sustainability around this investment. While the bar does seem like it has shifted higher of late – look at the performance of Taiwan Semiconductors and Oracle – we do think a confirmation of these forecasts continues to indicate the strength in end market demand, rather than just dollars changing hands as indicated by recent “circular” deals.” Given the commentary we are already seeing from certain tech companies, we believe these AI themes stand to benefit from this earnings season.