Part Three: Generative AI, Investing in the 21st Century Megatrend

Feature Stories | May 14 2024

How are global Generative AI tailwinds impacting on Australian companies, and which stocks are in the sweet-spot to benefit?

-Tailwinds from BigTech earnings
-NextDC and Goodman Group are just two of the winners
-Key takeaways from Global Portfolio Manager at Alphinity Investment Management

By Danielle Ecuyer

The story below is the third installment in a series on Generative AI. The first installment was published on 2 May 2024

The second installment was published on 9 May 2024

Stock prices only tell part of the macro story

Differentiating between the stock price moves of companies associated with artificial intelligence versus the growth and potential size of the total addressable markets will be an ongoing challenge for investors.

Comparisons can be drawn between previous secular trends such as electrification, mobility, telephony, the internet, and industrialisation, but like most historical precedents, the present circumstances are similar but different. 

The clean energy transition is a case in point. Despite the billions of dollars being committed to the transition, including major incentives such as the US Inflation Reduction Act, the top-down secular growth in clean energy/decarbonisation has been far from a straightforward investment proposition for investors. 

FY24 results for Macquarie Group ((MQG)) highlight the short term versus longer term challenges of investing in a megatrend. Demand for the clean energy assets owned by Macquarie Asset Management is proving to be more cyclically impacted than forecasts due to the higher interest rate environment.

Tesla is also case in point. As the electric vehicle market grew, competition, particularly from the subsidised Chinese manufacturers commoditised the product.

Secular megatrends do not grow in a straight line. Electric vehicles will ultimately replace internal combustion engines, however, the path to transition is likely to exhibit some of the normal cyclical demand and supplier drivers.

Top-down analysis of a total addressable market (TAM) to company specifics makes for a strong narrative, but ultimately the driver of stock prices will be revenue and earnings growth, alongside strong cashflow generation to support new investment.

The question of whether earnings are pulled forward or front loaded into the present should also be at the forefront of investors’ minds. The market will set earnings expectations and compare against actual results. Strong growth can be either rewarded or punished depending on expectations and recent performance.

“We encourage investors to do thorough due diligence on the technology underpinnings of these companies and differentiate real AI winners from the short-term AI beneficiaries likely to end up short in the long term.” The quote is from RBC ImagineTM: The Software Investor's Handbook to Generative AI

Big Tech’s latest earnings offer insights into artificial intelligence investment trends

The latest quarterly results for the Magnificent 7 revealed impressive 43% growth in earnings compared to 14% a year ago, which includes the not so hot Tesla and META earnings, and also includes forecast earnings from Nvidia (to be released on May 22).

RBC Capital Markets analysis of the recent US big tech companies' quarterly results extrapolates the trend to Australia’s data centre and ancillary service companies, noting hyperscalers are emerging from a period of consolidation and re-entering a growth phase.

Amazon Web Services (AWS), owned by Amazon, is the world’s largest hyperscaler with revenues split 60% from America, 23% internationally and 17% for AWS. 

AWS reported better than expected 1Q24 results including revenue growth of 17% on the previous corresponding period, with a 400-basis point acceleration in growth via its AI expansion. 

Management guided to ongoing growth between 7% to 11% in net sales growth for 2Q, or US$144bn to US$149bn.

Amazon’s commentary confirmed the company’s ongoing commitment to artificial intelligence through multiple levers, including Amazon Q, an AI powered assistant for software development; the flywheel effect from AWS growth and demand, and ‘over 100,000 of Amazon’s selling partners are using one or more of their GenAI tools’.

Microsoft also delivered 1Q standout results. Revenue was split 43% from the “Intelligent Cloud”, 32% from Productivity and Business Processes, and 25% Personal Computing.

Microsoft's Azure is the second largest cloud operator/hyperscaler after AWS and reported 31% growth versus consensus expectations of 28%, against the previous corresponding period.

Revenue growth for ‘Intelligent AI’ rose 21% to US$26.7bn. Looking ahead management expects revenue to expand between 19% and 20% in constant currency.

Like its competitors, capital expenditure will continue to be driven by strong demand. Azure has continued to take market share and recently announced a US$1bn plus multi-year deal with Coca-Cola, with 88% year-on-year (yoy) growth in US$100m-plus sized Azure contracts, plus a doubling in the US$10m-plus segment.

Github reported 45% growth yoy and over 90% of the Fortune 500 is using the product.

The third largest hyperscaler after AWS and Azure is the Google Cloud Platform from Alphabet.

Alphabet generates 78% of revenue from Google Advertising, 11% from Google Cloud, and 11% from other sources.

Google Cloud reported 1Q revenue growth of 28% on the previous corresponding quarter to US$9.6bn, 2.4% above market consensus, and up 26% on the December quarter.

Management noted a doubling of capital expenditure to -US$12bn from -US$6bn compared to the previous corresponding quarter, driven by data centre demand.

Google is working across multiple artificial intelligence platforms including Nvidia GPUs with Google’s own TPU or application-specific integrated circuit (ASIC) in its neural networks; it added AI features to pixel, photos, Chrome, messages as well as Gemini (formerly Bard, the LLM) via a Gemini App on Android and the Google app on IOS.

 “We have developed new AI models and algorithms that are more than 100 times more efficient than they were 18 months ago.” 

In reference to Meta, this company reported a 12% rise in capital expenditure to -US$37.5bn for FY24 from -US$33.5bn previously, due to rising investment in AI related infrastructure.

RBC research concludes that even a snapshot from the 1Q big tech results are all positive tailwinds for Australia’s data centre exposed companies, as the trickle-down impact from higher investment feeds through. 

Catching the Big Tech cloud investment tailwinds, which Australian companies are in the sweet-spot?

Morgan Stanley takes a more in-depth and nuanced approach to the domestic data centre industry in its research.

With a base case of an 8% compound annual growth rate (CAGR) out to 2030 for the Australian data centre market, and a bull case of a 20% CAGR, the outlook looks structurally robust.

Australia is already the fifth largest data centre operator globally, in line with London (after US, Europe, Northern Virginia and Beijing/Shanghai). The market is forecast to expand from 1050MW currently to 2500MW by 2030, at a 13% annual rate.

Citi observes Australia has circa 1GW of live data centre capacity. Sydney is the largest market locally having expanded 2.5 times in the last 5-years and is in the top 20 globally.

Melbourne capacity has doubled in the same period and the research indicates Melbourne has little available capacity.

The demand from government for the digital and cloud first strategy, as well as data sovereignty requirements, are driving the forecast 14% compound average growth to 2030 of some 2.5GWs.

Morgan Stanley estimates there could be revenue uplift of between $5.6bn to $8.4bn p.a. on the back of an estimated total spend between $21bn to $28bn in data centre development over the next 8 years.

Against such a favourable backdrop, how does the earnings outlook shape up for NextDC ((NXT)), Megaport ((MP1)), and Goodman Group ((GMG))?

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