Big earnings failed to answer the big AI questions
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Second quarter profits were huge. But they were still not big enough to put lingering questions about the AI boom to rest.
Why it matters: The giant results provided little proof that companies are capable of generating a reasonable return on the biggest investment boom in recent memory.
By the numbers: With Nvidia's report last week, Q2 earnings season is basically done and dusted. It was one for the books.
- Earnings per share for S&P 500 companies rose 52.6% in the second quarter as of Monday, compared with the same quarter the prior year, according to FactSet.
- That's the biggest year-on-year increase since the economy sprang back to life in 2021 after the worst of the pandemic.
The big picture: That sounds like pretty great news. And it is, more or less. But there are a couple of big caveats to keep in mind.
- First, a giant chunk of second quarter profits consisted of paper gains related to the rising value of the stock that Alphabet and Amazon own in other tech companies.
- In other words, large, unusual one-off gains goosed the results.
Zoom in: As we've pointed out before, Google's parent company — Alphabet — posted a roughly $98 billion net gain related to its stake in SpaceX.
- Amazon also reported a similar gain of about $53 billion tied, in part, to its ownership stake in Anthropic.
- Separately, Nvidia reported a gain of more than $7.5 billion on its stock holdings of other tech companies. (Though FactSet did not incorporate those investment gains into its earnings growth calculations.)
Zoom out: These are not small numbers.
- For example, the smallest of those — Nvidia's roughly $7.5 billion investment gain — is about the same size as all of the Q2 profits produced by the bottom 70 companies in the S&P 500.
Reality check: To be sure, even if you discount gains related to tech company holdings in other tech companies, profitability still looks very strong.
- FactSet analyst John Butters noted that even if you strip out the earnings impact of Alphabet and Amazon, earnings would still be up a sizzling 33.8% in the quarter.
- Still, the key contributors to that pile of profits are the suppliers of the debt-driven AI infrastructure boom, such as Nvidia and Micron Technology. (Energy stocks also contributed a bit, benefiting from the Iran war's price spikes.)
- It's true that we have seen profitability improve in less AI-centric areas of the market, such as industrial stocks. But when you dig into it, the AI buildout turns out to be driving those companies as well.
The bottom line: This is all OK, as long as the building boom continues. But...
- The investment surge has become more reliant on debt and off-balance-sheet backstops. And at some point people will want to see tangible proof that end users will pay enough for AI so these companies can make a decent return. This quarter provided little conclusive evidence on that front.
- Investment booms, by their nature, involve spending now and paying back later. In the aggregate, that tends to boost revenues for companies selling into the boom — chipmakers, for example — and collecting their money today.
- The costs of that investment are only recognized slowly over time. That could be making the profit picture look better right now than it will turn out to be over the long term.
What we're watching: The recent rise in interest rates and whether those increased borrowing costs could become a challenge for the AI trade.
