AI Remains Focus of Second-Quarter Tech Earnings

After stumbling in April, info tech stocks ended up enjoying a stellar second quarter. Investors now await earnings and guidance from the biggest players in artificial intelligence, cloud, chips, and software, wondering what they can do for an encore and how long the good times can roll.

It's no secret that AI is the big story, with mega cap Apple (AAPL) getting a major Q2 boost after announcing new plans to incorporate the technology across its devices. While chip firms scooped up most investor dollars aimed at AI earlier this year, Apple's ascent and the rally in shares of large software, hardware, and internet ad companies showed there's power here beyond semiconductors alone. 

But AI is costly, and tech firms continue to run up large bills buying the chips they need to run it even as they hope to cut out the middleman to some extent with their own chips. This raises concerns about margins, so guidance might prove more influential in some respects than quarterly results, barring any large hits or misses.

Nearly all mega-cap tech stocks trade at relatively high valuations, historically, meaning investors might expect them to surprise even more to the upside on both Q2 results and guidance than average analyst estimates. Failure might lead to selling, with investors recently demonstrating willingness to punish firms harshly for coming up short when valuations are high. Still, it's been a familiar theme for money to flow into tech with bullish momentum this year.

"With Q2 earnings season around the corner, the question is whether these companies will be able to deliver enough to satisfy lofty expectations," said Nathan Peterson, director of derivatives analysis at the Schwab Center for Financial Research.

Another question, he added, is how quickly companies can monetize AI after spending so much on AI infrastructure, and when they'll start discussing actual revenue figures generated by their AI initiatives. So far, investors haven't demanded much evidence, but that could start to change. 

"Everyone assumes demand will be monumental," Peterson said. "Is this the quarter where investors need to see more evidence of demand for AI-enabled offerings from software and IT services companies, or will they get a pass for another quarter?"

Tech companies are increasingly building AI into their cloud offerings, an effort that appeared to improve profitability for some in the first quarter. If that trend continues, it might suggest chances for a relatively quick return on AI investment. Microsoft (MSFT), Meta Platforms (META), Amazon (AMZN), and Alphabet (GOOGL) all rode that idea to gains early this summer following April's disappointing tech market action.

If profit growth slowed in the second quarter or guidance disappoints, that could hurt not only their shares but also shares of high-flying AI chipmakers like Nvidia (NVDA) and Advanced Micro Devices (AMD) because they supply the chips companies are snapping up so quickly.

Keep in mind that there's a bit of circular logic here. About 40% of Nvidia's revenues represent expenses for its largest customers. Though companies like Microsoft and Amazon have embraced Nvidia's AI-powered chips in part due to growing demand from their own customers, and there are signs that AI is helping profit growth at tech mega caps, it's worth keeping an eye on their expenses. Rising costs hurt margins, and if tech margins start to flag, Nvidia's expensive chips might be a topic of C-suite discussions elsewhere. 

Another thing to watch as Q2 tech earnings hit the tape starting next week are fresh signs of cost-cutting efforts, which could suggest tech firms getting wary of all the spending and looking for places to chop. Layoffs across the industry last year helped margins and possibly contributed to the rally after the tech bear market of 2022, and the trims aren't necessarily over. Investors might welcome leaner operations, but cost-cutting could mean less spending on new endeavors that could ignite future growth.

Texas Instruments (TXN) and Alphabet (GOOGL) kick off the tech calendar next Tuesday, followed by IBM (IBM) Wednesday, according to Earnings Whispers.

The following week brings a host of players including Amazon, Microsoft, Intel (INTC), Qualcomm (QCOM), Meta, AMD, and, to bring things to a crescendo, Apple. Several major players like Nvidia, Salesforce (CRM), Broadcom (AVGO), and Cisco (CSCO) report later in the quarter. 

Though Alphabet and Meta officially live in the S&P Communication Services sector and Amazon is a consumer discretionary stock, these firms often get casually grouped with tech because aspects of their businesses, especially cloud, are squarely in the tech arena. And all have massive AI exposure.

AI can improve the function of computers so they can reason and learn more like humans and process vast amounts of data more quickly, among other uses. Advancements in semiconductor chips built by companies like Nvidia and AMD are being incorporated across multiple industries to help improve everything from online advertising to warehousing efficiency to phone performance. AI chips also play a vital role in the cloud, allowing data centers to harvest insights about sales trends and customers more quickly. 

Cloud industry revenue growth, led by Amazon, Microsoft, and Alphabet, had been slowing until about a year ago when AI excitement picked up. Now, the cloud businesses appear resurgent as AI-related demand for data grows. Cloud growth intensified in Q1, and follow-through in Q2 could give these shares more spark. 

Though AI gets most of the headlines, don't discount the cloud space's potential impact on sentiment once earnings begin. Though the mega-cap cloud companies mentioned above seem to be thriving, a series of less-than-stellar earnings from other firms raised questions about overall industry health. The enterprise cloud software space recovered exceptionally well in June thanks to Oracle (ORCL) and Adobe (ADBE), but going back, there was softness in Salesforce, Palo Alto Networks (PANW), Workday (WDAY), and Paycom (PAYC), said Schwab's Peterson. 

"The question is was their soft guidance a reflection of overall weakness in the enterprise-software space, or is the AI investment cycle diverting some dollars otherwise spent within this space?" Peterson said. "If you get another data point on weak enterprise cloud and software spend, it could hurt the tech sector."

Looking at the big-three cloud companies, Amazon's Amazon Web Services (AWS) cloud business growth might've troughed and could be bouncing back. Some analysts went into the year thinking Amazon had fallen behind in AI, hurting growth at AWS. But in the first quarter, Amazon's results pushed back against those ideas, rising 17% to $25 billion and easily exceeding the average Wall Street estimate of 12%. 

Late last year, AWS growth had fallen as low as 13% year over year but found more life in early 2024. The question is how Amazon followed up in the second quarter for the business that represents more than 60% of its operating profit.

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.

Microsoft has gained cloud share on Amazon lately with big growth in its Azure cloud platform, so keep an eye on that. Azure and other cloud revenue rose 31% in Q1, up from 30% in the previous quarter. The growth race between Azure and AWS is a long-running story in tech, but Microsoft still lags Amazon by quite a bit as both compete for customers anxious to add AI capabilities.

"Currently, near-term AI demand is a bit higher than our available capacity," said Amy Hood, Microsoft's chief financial officer, in the first quarter call with analysts. Those words likely gave AI chip stocks like Nvidia and AMD a boost back in late April when she uttered them.

Outside of AI and the cloud, another element to watch when Microsoft reports is its More Personal Computing business, which rose a higher-than-expected 18% in revenue in Q1. That was driven by video games, Windows, search, and Surface PCs, CNBC noted. 

AI advances also permeate the internet advertising business, where top players Meta and Alphabet duel it out each quarter. Meta's online ad business grew 27% in the first quarter but shares of the company initially plunged after its earnings report because market participants didn't like the company's modest guidance. Chinese spending buttressed Meta's ad business early this year, and one question is whether that continued despite more struggles for China's economy this spring.

Alphabet said Google ad revenue grew 13% in Q1, up sequentially from 11% in Q4. Cloud growth outpaced analyst expectations, and the company announced its first dividend.

Other AI developments to watch in tech earnings include uptake on Microsoft's Copilot Pro AI-powered assistant and Alphabet's Gemini Advanced chatbot. Both are priced relatively low, but the question is whether customers are interested.

After lagging most mega-cap peers early this year, Apple shares resumed their old winning ways over the last month following the company's well-received June developers conference. That's where the company presented an AI strategy that enthused market participants, promising to weave the technology into many of its products. Shares rose 23% in the second quarter to new all-time highs above $200, but the stock's gains still trail many of its tech rivals over the last two years.

At the conference, Apple introduced Apple Intelligence, which the company said is a personal intelligence system combining "the power of generative models with users' personal context." This technology will be available through iPhone, iPad, and Mac. Apple also announced major updates to iOS 18, a large redesign of the Photos app, and new markets for Apple Vision Pro.

Wall Street liked what it heard, with many analysts raising their price targets for Apple and some commenting favorably on how Apple's reputation for user privacy could give it a leg up in AI. Earnings this quarter could shed more light on timing for some of the AI improvements and the next-generation iPhone 16. There were reports in the trade media earlier this month that Apple is ramping up chip purchases ahead of the iPhone 16 launch, possibly a sign it sees heavy demand.

Even for Apple, however, privacy could be a major issue as it tries to incorporate AI into its phones. 

"How comfortable will consumers be with an AI-enabled phone tracking everything they do?" Peterson asked. He noted that in China, Alibaba (BABA) and Baidu (BIDU) recently slashed prices for AI services including large language models used to power generative AI products, perhaps a sign that demand isn't ramping up as hoped.

Pulling back to look at all of tech, analysts expect the second-highest earnings-per-share (EPS) growth rate among the 11 S&P 500 sectors at 16.4%, according to research firm FactSet. That said, without Nvidia's contribution, growth for the sector would be just 6.9%. Nvidia is the only mega cap not reporting between now and early August, with earnings expected later in August.

Among info tech subsectors, earnings results from semiconductors and semiconductor equipment manufacturers along with software makers are expected to lead the pack. 

The sector's expected 16.4% EPS growth would be down sequentially from 25.3% in the first quarter, but revenue growth in the second quarter is seen rising to 9.5% from 8.3% in Q1. Tech also could remain solid on the earnings front in coming quarters because analysts expect 2024 year-over-year EPS gains of 18.7% and revenue gains of 10.1%.

For the major tech firms reporting this week, analysts expect the following, according to Yahoo Finance:

• MSFT: EPS of $2.93, up 9% from a year ago, on revenue of $64.34 billion, up 14.5% from a year ago
• GOOGL: EPS of $1.84, up 27% from a year ago, on revenue of $84.16 billion, up 12.8% from a year ago
• META: EPS of $4.70, up 57% from a year ago, on revenue of $38.26 billion, up 25.8% from a year ago