Microsoft and Alphabet Fail to Show at the AI Party

Microsoft and Alphabet are focusing on AI’s applications in search, which while it could be a long-term growth driver, is also expensive to develop.

Microsoft warned of a slowdown in cloud and business software sales, while Alphabet pointed to lower demand for search advertising. (REUTERS)

Artificial intelligence is the buzziest of buzz words on Wall Street. Apart, that is, for the two firms that are seen to be at the cutting edge of the technology.

While the likes of Nvidia Corp. and lesser-known AI plays have soared on the back of excitement over the potential boost to their business, Microsoft Corp. and Google parent Alphabet Inc. have underperformed this year.

Their stock lethargy reflects both payback from AI investment that will likely be slower than for others, as well as the tougher backdrop for tech shares more broadly as the Federal Reserve aggressively raises interest rates to combat inflation. Both are up roughly 5% this year, not even half the gain of the Nasdaq 100 Index and far behind the nearly 60% surge in Nvidia, which is expected to see a more immediate impact as its graphics chips are used in powering AI applications. C3.ai Inc. is up more than 120% this year, including a gain of 17% on Friday after its revenue topped expectations.

“If you're only buying Microsoft and Alphabet for AI, you might be disappointed by how slowly it rolls out and translates to revenue growth,” said Gregg Abella, chief executive officer of Investment Partners Asset Management. “The rate environment is less favorable, and while earnings are robust, they're not as exciting as they used to be in terms of growth.”

Microsoft and Alphabet are focusing on AI's applications in search, which while it could be a long-term growth driver, is also expensive to develop. The former is investing $10 billion in OpenAI, and recently unveiled a new version of its Bing search engine and Edge browser that incorporate the technology. Google is also integrating AI into search.

“These companies are walking a delicate tightrope as developing AI will require enormous investments at a time when companies are getting credit for slowing down capex, not stepping it up,” said Abella, who sees AI investments as necessary for long-term growth.

In their latest quarterly results, Microsoft warned of a slowdown in cloud and business software sales, while Alphabet pointed to lower demand for search advertising.

The AI market is expected to grow rapidly. UBS Group AG analysts estimate the broad AI hardware and services market will reach $90 billion by 2025, up from $36 billion in 2020, and say this may prove conservative.

While both megacaps are seen as leaders in the space, sentiment has largely favored Microsoft, especially after an underwhelming demonstration of Google's AI chatbot. Much of Alphabet's year-to-date weakness followed that event, and according to Bank of America Corp. analysts, OpenAI's ChatGPT has led to a surge in interest for Microsoft's Bing, though “we are not aware of any slowing in Google search revenues.”

Despite their underperformance, both Microsoft and Alphabet remain consensus favorites among analysts, with roughly 90% of those tracked by Bloomberg having buy recommendations on both.

Alphabet trades at less than 16 times forward earnings, below its five-year average and the multiple of the Nasdaq 100. Microsoft is also below its five-year average multiple.

“While the short-term backdrop is not good, I'm bullish about these two and the exciting services that will come from them over the next couple of years,” said Sylvia Jablonski, chief executive officer at Defiance ETFs. “They're great companies, but AI is the cherry on top.”