AI arms race costs money

good morning. The 10-year Treasury yield rose to 4.7% yesterday, a nine-month high, on the back of a strong ISM services survey and a Jolts report showing an increase in job openings. Inflation breakeven and the dollar both rose. It appears to us that the market is pricing in a strong economy. Send us your cool thoughts: robert.armstrong@ft.com and Aiden.reiter@ft.com.

Magnitude 7 capital investment

Accounting is boring but important. Of particular importance is the difference between capital expenditures and operating expenses. Capital expenditures (e.g., purchasing large equipment), unlike operating expenses (e.g., paying salaries), do not count directly to revenue on the income statement. Instead, capital costs appear in the income statement over time, theoretically matching the impact on profits to the useful life of the capital asset. This spread out cost appears in a line called “Depreciation”.

I see you sleeping in the back. But the reason I’m dragging this point on is because the world’s most important companies, the Magnificent 7 Big Techs, are making huge capital investments in data centers, mostly for artificial intelligence. is. Although this is immediately cashed out today, this expense will only show up in earnings per share over time. The AI ​​arms race has not yet achieved its full benefits. The question is whether the market has digested the fact that it will soon have to do so.

Here are five of the seven companies with more or less large increases in capital spending (Apple’s capex has been stable, Nvidia’s capex money is coming in rather than going out). ).

This is a staggering number and is still increasing.

Amazon may seem like an outlier, but it’s not. Spending needs to be scaled up with the rest of the company’s finances. For example, you can view capital expenditures as a percentage of revenue.

At Meta and Microsoft, one dollar out of every five dollars that comes in goes out in capital expenditures. In the alphabet, it’s one in seven people. And the trend is on the rise (wondering how much spending will happen in the meta in 2022? Remember the metaverse?).

Now you know the size of your expenses. But what is important for our topic is the size of capital expenditures compared to what is currently charged against profits. In other words, how much is capital expenditure versus depreciation?Here’s where we are as of the last 12 months.

Using Meta as an example, depreciation is 9% of revenue and capital expenditure is 20%. This means that depreciation expenses will have to increase significantly over the next few years. This does not mean that the group’s operating margin must ultimately fall by that difference (11%). Data center capital investments will be made over four to five years. However, if current spending levels are maintained, the impact on profit margins will be significant.

So how much do Wall Street analysts expect these five companies’ margins to compress over the next few years as AI capital spending ramps up? Nothing. In fact, operating margins for all five companies are expected to expand slightly over the next few years. Of course this is possible. With the exception of Tesla, all of these companies have rapidly growing revenues and their models have good operating leverage. But it’s not easy. Optimism about Big Tech’s earnings momentum trumps everything.

Is bankruptcy the canary in the coal mine?

Our colleague Will Schmidt pointed out yesterday that U.S. corporate bankruptcies will reach a 14-year high in 2024. At least 686 companies filed for bankruptcy last year, 8% more than in 2023 and the highest number of bankruptcies since 2010.

Is this evidence that interest rates for insolvent companies are finally rising? Or has the US economy slowed more than we have been giving it credit for?

Five of the top 10 largest bankruptcies in 2024 were privately held companies. One of them, Red River Talc, is the holding company for Johnson & Johnson’s baby powder debt. We focused on the remaining four companies and added two other well-known companies. Houseware store Big Lots, container maker Tupperware, fabric retailer Jo-Ann Stores, shoddy department store Party City, low-cost airline Spirit Airlines, and Franchise Group. , owner of retail chains such as The Vitamin Shoppe and Pet Supplies Plus.

The theme is obvious at first glance. All are discount stores or franchise stores for low-income customers. Like dollar stores and other discount stores, many suffered as low-income Americans cut back on spending amid high inflation. One of them, Big Lots, claimed that this problem was the direct cause of the company’s downfall. Together, these are notable examples of a “K-shaped” recovery in the United States.

However, these companies, and by extension the number of bankruptcies in 2024, are not clear evidence of an economic slowdown. Many were dinosaurs. Perhaps it’s surprising they lasted this long. Brick-and-mortar stores like Joan, Party City, franchises, and Big Lots have not been able to catch up with big box stores like Amazon, Walmart, and Costco. The same goes for Tupperware and its anachronistic peer-to-peer sales model. Spirit Airlines is a more unique case. All airlines struggled in the early days of the pandemic, but then they struggled to stay competitive, experienced problems with their planes, and ultimately failed in their merger with JetBlue.

Was it because of the Fed’s interest rate hike? Financial situations vary. All companies have variable rate debt, and many took on additional debt in the aftermath of the pandemic (especially Big Lots, Spirit, and Franchise). However, not all companies experienced ballooning interest expenses. Spirit was able to reduce its payments over time after significant interest payments in 2019, JoAnne and Party City reduced their interest payments, and Tupperware further reduced their interest payments.

For most of them, the problem was declining profits, not rising debt. This is a graph of net debt to EBITDA ratio. All companies except Tupperware were above 6, a ratio that typically makes financiers desperate.

Judging by the largest bankruptcies of 2024, our economy is not weaker, but lopsided.

(writer)

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