Tech Giants Face Investor Concerns Over Rising Costs of Generative AI Development

Alphabet and Microsoft report increased cloud revenue but face investor backlash due to mounting expenses in pursuing AI innovation.

Alphabet and Microsoft shares dip amidst investor concerns

Investor expectations took a hit as tech giants Alphabet and Microsoft reported strong increases in their cloud revenue for the December quarter, surpassing Wall Street estimates. However, these gains were overshadowed by the skyrocketing costs of developing and deploying cutting-edge generative AI-powered features. 

Consequently, Alphabet shares plummeted by 6 percent, while Microsoft shares dipped about 2 percent in premarket trading. This downturn in tech stocks also impacted other industry giants, including Apple, Meta, and Amazon.

Alphabet and Microsoft boasted impressive growth in cloud revenue as customers eagerly adopted new AI features and ventured into creating their AI-based services. Nonetheless, the costs associated with expanding infrastructure, including servers, data centers, and extensive research, underscored the substantial investments required to stay competitive in the rapidly evolving AI landscape.

Alphabet’s capital expenditure for the quarter surged by 45 percent, reaching a staggering $11 billion. Meanwhile, Ruth Porat, Chief Financial Officer of Alphabet, hinted that spending would be even more significant in the upcoming year than in 2023.

Microsoft, too, reported a substantial 69 percent increase in capital expenditure, which amounted to $11.5 billion. The company anticipates a further material increase in this metric in the near future.

Investor expectations vs. AI realities

These developments have left investors somewhat dissatisfied, given the market’s heightened expectations following a recent rally fueled by the promise of AI technology. Gene Munster, a managing partner at Deepwater Asset Management, expressed his desire for more substantial contributions from AI in Alphabet’s and Microsoft’s portfolios. 

While he acknowledged Microsoft’s AI uptick, he emphasized the need for Alphabet to demonstrate more significant progress.

Additionally, shares of chipmaker AMD took a hit, with a 7 percent decline, as they revised their 2024 forecast for AI processors to $3.5 billion. Analysts had previously set higher expectations, projecting sales of $4 billion to $8 billion for AI chips. Summit Insights analyst Kinngai Chan noted that the stock’s valuation was closely tied to these figures.

Cloud Players Facing Fierce Competition

The increasing capital expenditure and costs incurred by Alphabet and Microsoft highlight the intense competition among cloud service providers vying for a share of the lucrative AI market. The need to invest substantially in infrastructure and research reflects the companies’ determination to secure new customer dollars in an ever-evolving tech landscape.

Despite the initial investor backlash, analysts like Gil Luria from D.A. Davidson believe that Microsoft can continue increasing margins by maintaining a relatively flat overall headcount and reducing investments once they have sufficient data center capacity to meet growing demand. 

However, Alphabet and Microsoft must deliver on their growth trajectories to justify higher share prices and regain investor confidence.

Market valuations and prospects

Alphabet’s shares, which witnessed a remarkable 58 percent increase in value in 2023, were trading at approximately 22.26 times expected earnings. In comparison, Microsoft’s forward price-to-earnings (PE) ratio stood at 33.09, reflecting the market’s confidence in its growth prospects.