Q4 Tech Earnings: Will CapEx Take Bite of Profits?

Fourth quarter tech earnings approach just after DeepSeek sent a shockwave through U.S. markets Monday. Worries that the Chinese artificial intelligence (AI) startup could bring a cheaper AI model running on less advanced chips capsized the U.S. tech sector and threatens to remain a concern.

The mega caps reporting this week already faced investors worried about how their spending on AI might affect future earnings and whether it will offer return on investment. Now they're under increased scrutiny due to ideas that an Nvidia (NVDA) rival could do things cheaper with less energy. 

"This week's earnings results from mega cap tech, and perhaps more importantly how they position their recently announced ramp up in AI CapEx spending, will be subject to higher scrutiny from investors following claims from China's DeepSeek," said Nathan Peterson, director of derivatives analysis at the Schwab Center for Financial Research.

Even before DeepSeek, tech companies faced an uncertain earnings season.

To date, 25 info tech companies have issued negative fourth quarter guidance, compared with 20 that are positive, FactSet notes. Also, several major firms received analyst downgrades in late December and early January. These include Salesforce (CRM), Advanced Micro Devices (AMD), and Apple (AAPL). 

"These type of analyst moves were not common six months ago," Schwab's Peterson noted. "Nvidia has helped create an AI halo around tech in general over the past two years and it appears more discernment around individual AI winners and losers is underway."

Apple, Nvidia, Broadcom (AVGO), and other major firms fell sharply earlier this month as Wall Street watched Treasury yields climb, but there are some sector-specific reasons for these declines, too.

"Apple, Amazon, Alphabet and Meta are all coming into fourth-quarter results just off all-time highs, and they need top-line guidance beats to avoid potential post-earnings sell-offs in my view," Peterson said. "The reasoning: Expectations are high given recent price appreciation, capital expenditures are expected to continue to increase, and growth, while still robust, may see some deceleration in 2025."

Tech led all S&P sectors in revenue growth during the third quarter, according to research firm FactSet. Looking ahead, however, analysts expect fourth quarter revenue to grow a slower 11.1%. The question is whether slowing growth at the end of 2024 will prove an outlier, or if companies signal they can't match analysts' more robust 2025 expectations. FactSet pegs info tech revenue growth at 12.6% for the full year, up from 10.3% in 2024.

Slowdown concerns aren't new and have several roots. In semiconductors, worries persist that demand for chips used in applications like laptop computers, gaming, and automobiles remains slow. Apple, which rolled out its aggressive AI plan six months ago, has seen an underwhelming uptake and faces heavy phone competition from domestic producers in China. Digital ad spending for firms like Alphabet (GOOGL) and Meta (META) may fall now that the election surge is over. For AI chipmakers, there's concern that raging demand might eventually slow now that data center firms have invested so much and as cloud companies develop their own AI chips.

For now, tech companies continue to spend heavily on AI, and that's a concern. Microsoft (MSFT) announced early this month it's on track to invest approximately $80 billion in fiscal 2025 to build out AI-enabled data centers to train AI models and deploy AI and cloud-based applications around the world. This follows heavy spending on AI by Alphabet, Apple, Amazon (AMZN), and Meta over the past two years. Meta also has said it expects heavy increases in capital expenditures this year.

Then came the January 21 announcement that a new joint venture involving OpenAI, Oracle (ORCL), and SoftBank would invest up to $500 billion for infrastructure linked to AI as part of an initiative called Stargate promoted by President Donald Trump. The joint venture would start building out data centers and the electricity generation needed for the further AI development, The Associated Press reported.

While cash out the door for AI helps the semiconductor arena, capital spending can be a drag on profits. Investors aren't always patient waiting for future benefits to sprout and might want evidence that AI spending has delivered green shoots in the form of revenue. If it doesn't show up in this quarter or next (in guidance), this may challenge investor's patience.

"If top-line guidance comes in above estimates, this could help ease concerns that the CapEx spending isn't paying off, or at least not fast enough for investors," Schwab's Peterson said. 

In other words, if companies like Apple and Microsoft satisfy investors with their revenue guidance, it might support ideas that the companies can continue to spend heavily on AI without threatening their growth trajectory. 

Tech company leaders understand this and spent time on their third-quarter earnings calls outlining ways that AI spending has already begun to pay off.

"We're seeing AI have a positive impact on nearly all aspects of our work—from our core business engagement and monetization to our long-term roadmaps for new services and computing platforms," said Meta CEO Mark Zuckerberg on the company's earnings call last quarter. "Improvements to our AI-driven feed and video recommendations have led to an 8% increase in time spent on Facebook and a 6% increase on Instagram this year alone. More than a million advertisers used our GenAI tools to create more than 15 million ads in the last month, and we estimate that businesses using Image Generation are seeing a 7% increase in conversions—and we believe that there is a lot more upside here."

Microsoft, in its blog post this month announcing AI spending plans for the fiscal year, said AI "promises to drive innovation and boost productivity in every sector of the economy." AI is "transforming search, browsers, and digital advertising," Microsoft noted in its last earnings call. And AI is helping drive stronger growth at the company's Azure cloud platform, which saw revenue rise 33% in the third quarter and will again be under scrutiny when Microsoft reports this month.

Earnings per share (EPS) growth for the tech sector is expected to rebound to 13.9% from third EPS growth of 9.1% that fell well short of analysts' expectations. Analysts had entered the third quarter expecting 15%. 

The relatively soft earnings performance last quarter turned the spotlight toward the tech sector's lofty price-to-earnings (P/E) ratio, which has long been one of the highest for any S&P 500 sector. Post-election euphoria sent stock prices for Apple, Broadcom, and Nvidia up even more. Those shares and much of the tech sector then came off their post-election highs in December, hurt by rising U.S. Treasury yields.

"When yields are rising, mega cap tech still sees money flow as a perceived safety trade," Schwab's Peterson noted. "But the rise in stock price lifts valuations generally, and therefore investor expectations."  

In other words, through no fault of their own, the big tech firms might disappoint investors who want to see the "E" part of P/E keep pace with the "P" part.

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.

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. One question every quarter is whether Microsoft and Amazon can continue growing share and nipping at the heels of AWS.

AI advances also permeate the internet advertising business, where top players Meta and Alphabet duke it out each quarter. The fourth quarter likely will show benefits from the U.S. November election, but the question is whether that can translate into the new year when there's no U.S. vote.

Another question facing the industry 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. Last year, a U.S. federal judge proclaimed Alphabet's Google search engine an illegal monopoly and now Alphabet may be forced to sell its Chrome browser, among other things. 

The new wave of legal challenges to companies like Apple and Alphabet could eventually impact the moat-like fundamentals most mega-cap tech companies have profited from over the years. However, the new U.S. administration has talked about a smaller regulatory footprint, and major tech company leaders recently demonstrated their willingness to work with President Trump. In his last term, Trump wasn't always seen as a friend of the tech industry, so listen for possible discussion on this quarter's earnings calls for any first impressions of his second term.

Just before reporting season began earlier this month, several worrisome developments hurt tech stocks. The outgoing Biden administration announced new export restrictions on chips to most countries, Meta announced it would lay off 5% of its employees, targeting "lowest performers," and data firm IDC announced that Apple's phone shipments fell amid heavy competition from Chinese smartphone makers. Microsoft also announced a new round of layoffs, and the European Commission is reassessing probes into Apple, Meta, and Alphabet under the E.U.'s Digital Markets Act. 

None of these developments necessarily affect fourth quarter results but all could affect guidance and the layoffs could also reflect struggles as companies try to balance heavy spending and profit growth.

All this comes as the S&P 500 info tech sector trades at a forward P/E multiple of just above 30, according to research firm CFRA, compared with about 22 for the S&P 500^® index. That's up from around a 28 P/E a year ago and 21 two years ago after the 2022 tech bear market. While historically info tech has often enjoyed a higher P/E than the broader market due to its tendency for strong earnings growth, the current level is on the high side and may be making investors nervous. Any failure of the biggest firms to meet earnings expectations in this climate could bring more selling pressure considering the relatively high valuations.

For the major tech firms reporting over the next two weeks, analysts expect the following

• MSFT EPS of $3.13
• GOOGL EPS of $2.12.
• META EPS of $6.76.
• AAPL EPS of $2.35.
• AMZN EPS of $1.49.