Q3 Tech Sector Earnings: Slower Growth Scrutinized

Info tech stocks had their worst quarter relative to the broader market since late 2022, but that doesn't necessarily cast a cloud over sector earnings ahead. What might raise concern is slowing growth among many of the biggest tech stocks outside of semiconductors over the last year.

"Slowing earnings growth estimates for mega-cap tech could suggest that the law of large numbers may be coming into play and perhaps explains some of the recent relative underperformance from mega-cap tech," said Nathan Peterson, director of derivatives analysis at the Schwab Center for Financial Research. 

For instance, analysts expect Microsoft's (MSFT) fiscal year earnings per share (EPS) to rise 10.8%, down from the five-year average growth of 18.7%, according to Yahoo Finance. Apple's (AAPL) fiscal year EPS is seen up 16.4%, down from the five-year average of 19.3%. At Cisco (CSCO), it's –4% versus the five-year average of 4.4%.

The slowing earnings growth now baked in may explain some of the recent lethargic stock performance in the tech sector.

"With the exception of Meta Platforms (META) and Apple, most mega-cap tech stocks have been kind of flat to down over the past couple of quarters in terms of performance, and it might have to do with growth deceleration compared with the potential for growth acceleration for small caps if the Federal Reserve keeps lowering rates," Peterson said.

Apple, Microsoft, IBM (IBM), and other major data center and device companies report third-quarter earnings starting later this month and in early November. This follows much better-than-expected second-quarter results where sector EPS rose more than 20% year over year compared with around 11% earnings growth for the overall S&P 500^® index (SPX), according to research firm FactSet. Analysts had entered the second quarter expecting 16%. 

Profit margins also improved notably in the second quarter for tech stocks from a year earlier. Much of this was driven by semiconductor firms, not so much the traditional tech names. Chip-leader Nvidia (NVDA) drove a good deal of the annual improvement in both earnings and margins sector wide as its business continues to grow parabolically amid AI chip demand. But traditional tech stocks like Apple and Microsoft, as well as cloud leaders like Alphabet (GOOGL) and Amazon (AMZN), were no slouches, either. 

The slouching, if you want to call it that, came in actual trading on Wall Street where the third quarter saw info tech shares slip marginally even as the SPX climbed more than 5%. That made info tech one of the worst-performing sectors, but that doesn't necessarily call the sector's health into question. Instead, it's a possible sign of investors rotating out of tech and into other sectors amid hopes for Federal Reserve rate cuts that might light a fire under so-called cyclical sectors that tend to ebb and flow more with the overall economy.

To some extent, that played out even ahead of the first actual rate cut in late September, but it's unclear if the rotation trade is mostly in the books or if there's more to come. As of early October, market breadth across the S&P 500 was very healthy, with more than 80% of shares trading above their respective 50-day moving averages. This could imply that much of the move out of tech is already priced into the market.

Investors still expect tech earnings, including semiconductors, to grow solidly in the third quarter. Info tech is seen leading all sectors in year-over-year quarterly EPS growth at 14.9%, down sequentially from 20% in the second quarter, research firm FactSet said. Much of the increase again gets credited to Nvidia, but five of six tech subsectors are expected to grow EPS year over year, led by semiconductors at 25%. 

The concern isn't so much growth itself for mega-cap tech outside of semiconductors. It's more about possible growth deceleration. 

AI remains front and center. It's the focus of heavy spending by cloud, internet ad, and device companies, but it is also a possible profit driver down the road. The debate continues to rage about whether the costs will ultimately be justified, and investors increasingly will ask companies to "show me the money" in coming quarters. 

Despite their slight backtrack in the third quarter, most heavily capitalized tech firms trade at high price-to-earnings (P/E) multiples on a forward basis. This puts them under more pressure to at least meet earnings expectations, if not exceed them, to avoid being punished by investors. 

Back in August, Nvidia shares tumbled briefly despite surpassing analysts' earnings expectations, and the explanation on Wall Street was that investors wanted something even better than analysts had expected. The more hype around AI and the cloud and the higher valuations climb, the more will be expected of AI firms. At the same time, costs will be closely watched as well as the impact of those costs on margins amid worries that AI spending could have at least a short-term negative impact on profits.

Nvidia's fortunes, as well as the strength of chip competitors like Advanced Micro Devices (AMD) and Micron (MU), are tied to some extent to outcomes from major traditional tech firms like Apple and Microsoft and the cloud units of Amazon and Alphabet. These companies drove the massive demand for AI chips in recent quarters, so their results and guidance in the third quarter will likely have an impact on chip shares. Forty percent of Nvidia's revenues represent expenses for its largest customers.

Micron's earnings late in September were a shot across the bow, showing solid chip demand across a wide variety of products that use the technology, including phones, laptops, and data centers. Micron is sometimes seen as a helpful barometer for the overall tech sector, with earnings preceding the rest of tech and exposed to so many facets of the industry.

"Micron's guidance going into 2025 and 2026 suggests demand remains healthy," Peterson said. "That could be the saving grace for any growth deceleration."

Tech companies are increasingly building AI into their cloud offerings, an effort that appeared to improve profitability so far this year. If that trend continues, it might suggest chances for a relatively quick return on AI investment. 

Microsoft's recent announcement that it's made a deal with Constellation Energy (CEG) to reopen the shuttered Three Mile Island nuclear plant to support AI-related energy needs is more evidence that AI continues to grow. It's unclear why else Microsoft would spend such money if AI weren't real.

That said, investors may be getting impatient with Microsoft and other companies for their seeming reluctance to provide more granular data on how AI demand is growing.

"We're seeing bullish commentary from Microsoft regarding the increasing adoption of CoPilot Pro (Microsoft's fee-based generative AI chatbot) users, though quantifiable metrics are a bit lacking, but on the consumer front, there still appears to be hesitation due to privacy concerns," Peterson said. "If Microsoft is dropping about $50 billion per year in capital expenditures, investors will want to see return on investment. The question is not necessarily whether AI monetization will occur, but whether end-user adoption will ultimately be large enough, and occur quickly enough, to justify the billions currently being spent on the infrastructure build-out."

Microsoft is far from the only mega-cap tech firm where investors await AI proof of concept. Apple is also on the hot seat after introducing a full suite of AI-related products over the summer and now incorporating those into its phones and other devices. The launch of iPhone 16, now in process, is an early shot across the bow to see how interested customers are in getting access to these AI features, but recent analyst reports suggest the iPhone 16 rollout hasn't been explosive. Apple is likely to provide more color on that debut when it reports.

AI is deeply wrapped up in cloud computing demand, and that seems to be in good shape. Last quarter saw Microsoft's Azure cloud continue to gain share along with Alphabet's cloud product versus industry-leader Amazon and its Amazon Web Services (AWS). However, AWS growth has accelerated after slowing last year.

Another thing to watch as Q3 tech earnings cross the wire is possible new evidence of cost-cutting efforts, which could suggest tech firms getting wary of all the spending and looking for places to chop. Tech layoffs soared this summer, according to the outplacement firm Challenger, Gray & Christmas, topping 41,000 in August alone. That dropped to around 11,000 in September, but industry job cuts still exceed 100,000 through the year's first nine months.

Much of the recent growth in cloud sales reflects companies adding cloud applications as the U.S. economy continues to recover and AI demand surges. That's also been a wind at the back of Microsoft and Alphabet, the second- and third-largest cloud companies in the world. 

AI advances also permeate the internet advertising business, where top players Meta and Alphabet duke it out each quarter. This time out, election-related advertising adds a new twist to that part of the tech business. If Meta and Alphabet struggle to grow ads despite hundreds of millions of political dollars aimed at the internet, that might raise questions.

Another question that may come up, especially on quarterly earnings calls, is the increasing antitrust burden on tech companies both in the United States and Europe. To just name an example, Alphabet faces a lawsuit from the U.S. Justice Department and several states that call its online advertising practices into question. Earlier this year, a U.S. federal judge proclaimed Alphabet's Google search engine an illegal monopoly.

"Anti-trust is picking up heat," Peterson said. "Normally in the past, tech companies have paid fines and sometimes had to unbundle products" in response to such lawsuits. But the new wave of legal challenges to companies like Apple and Alphabet could have even larger consequences, and this could eventually impact the moat-like fundamentals most mega-cap tech companies have profited from over the years.

For the major tech firms reporting over the next two weeks, analysts expect the following, according to Yahoo Finance:

• MSFT EPS of $3.09, up 13.1% from a year ago, on revenue of $64.48 billion 
• GOOGL EPS of $1.84, up 18.7% from a year ago, on revenue of $86.34 billion
• META EPS of $5.22. up 30.5% from a year ago, on revenue of $40.18 billion
• AAPL EPS of $1.55, up 14% from a year ago, on revenue of $94.39 billion