Tech needs traditional companies to generate billions of dollars in AI development

Tech mega-caps are collectively making multibillion-dollar bets that their infrastructure spending will result in many years of profitable growth. But that’s all in the future.

For now, they rely on their traditional businesses – whether online advertising, enterprise software or e-commerce – to fund their artificial intelligence ambitions.

This quarter’s results revealed new levels of pressure on these core businesses and offered an early test of whether these businesses can sustain extended periods of spending. Meta joined Alphabet And Amazon by reporting negative free cash flow, leaving Microsoft as the only hyperscaler to remain positive in this area.

Meta reported negative free cash flow of $2.12 billion, while Amazon’s outflows reached $42.4 billion and Alphabet’s outflows reached $9.07 billion. Microsoft’s cash generation declined significantly for a second straight quarter, this time falling 27% to $18.63 billion, and the company announced it would now turn to the bond market as it continues to increase its spending on AI infrastructure.

Hyperscalers’ profits over the past two weeks have coincided with growing concerns about the overall health and stability of the broader AI sector. Rising interest rates make debt more expensive for companies, which puts pressure on neoclouds, consumers of liquidity, which have become essential to global construction.

While tech giants have a cushion that neoclouds and other players don’t, investors ultimately need historic spending rates to translate into massive new revenue streams. Nervousness is hitting stocks this week, with Alphabet suffering its biggest drop on record on Thursday and Amazon slipping in extended trading after its report.

Amazon said growth in its retail and advertising businesses had slowed. Online sales rose 2% year-over-year, decelerating from 10% a year ago and below analysts’ estimates. The midpoint of Amazon’s revenue forecast came in below the $244.5 billion analysts expected, a particularly disappointing figure for the quarter that includes the holiday shopping period.

Meanwhile, Amazon expects its capital spending this year to reach $220 billion, and analysts predict that figure will exceed $280 billion next year, according to FactSet, as the company continues to produce negative free cash flow.

At Meta, investors have responded favorably to the company’s early success with its Muse AI agent application and associated foundation models, which present potential new revenue streams outside of advertising.

But it will take time for these efforts to have a meaningful impact on the company’s overall business, while continuing to spend on data centers and hardware. Investments will reach $145 billion this year, the company says, and analysts predict they will exceed $210 billion in 2027, alongside a widening cash flow deficit.

Investors sent Meta shares down 7% after last week’s earnings release, even though the company reported higher revenue. Meta followed its report by announcing on Monday that it plans to raise a total of $95 billion in equity to support its investments in AI.

It was Alphabet’s report that had investors most concerned.

The company’s core search business experienced a third straight quarter of slowing growth and missed analyst projections, highlighting the challenges it faces with the rise of ChatGPT, Claude and other AI-based bots and agents. YouTube-related advertising revenue was also highlighted.

Evercore analyst Mark Mahaney told CNBC’s “Closing Bell Overtime” on Wednesday that while Google’s strong cloud revenue was “good news” for the company, the slowdown in its digital advertising business represented “the overwhelming bad news.”

Forrester analyst Tracy Woo said in an email that Alphabet’s “massive investments in infrastructure construction have been tolerated for now” but that the company “walks a fine line” due to failed online ad sales.

“Weak search and YouTube revenue compared to expectations points to growing concern that AI is displacing the company’s biggest revenue generators,” Woo said. “The problem is less the current shortfall than the possibility that future AI spending will grow faster than the cash generation of the franchises meant to support it.”

But not everyone is affected. Bullish investors say tech leaders have a long history of operations and legacy businesses dominant enough to sustain them for the foreseeable future.

Christopher Ballard, managing director at Check Capital Management, noted that Alphabet’s negative free cash flow of $9 billion is tiny compared to the company’s overall business. Its operating profit exceeded $40 billion for the quarter.

Unlike AI model companies OpenAI and Anthropic, which are still unprofitable and spending billions of dollars per quarter on infrastructure, Alphabet has a strong balance sheet, Ballard said.

“They are borrowing in the present moment to invest in the future,” Ballard said. “I think it’s okay and they’re doing it responsibly.”

Although the hyperscalers did not provide specific investment projections for next year, they all hinted that their data center spending would continue to grow, even if it meant releasing uncomfortable metrics.

“Would it be more practical if this type of acceleration and opportunity happened over 25 years, and you could spread the investments over 25 years?” Amazon CEO Andy Jassy said Thursday during the earnings call. “Yes, maybe it’s more convenient, but that’s not the world we live in, and it’s not an opportunity.”

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