The Everything Risk

Nvidia Corp. and Tesla Inc. stood out in what was a stellar earnings season for most of the US technology megacaps. The two companies are outliers in more ways than one among the so-called Magnificent Seven tech stocks.

Megacap tech companies have been rewarding investors not just for their growth potential but also by acting as havens during times of turbulence. That’s not the case, however, for Nvidia and Tesla.
Tesla is the only one of the Mag 7 that missed earnings expectations with revenue actually declining.
Nvidia can still benefit from greater AI adoption across enterprises. But its rate of growth largely depends on spending from the other large tech companies — and exceptional as it may be, it’s starting to slow.
For now, all of the Internet-centric tech companies, as well as Apple, have a steady, above-market average return on earnings, thanks to products that have wide appeal and adoption.
The risk: the two weak links in the Mag 7 complex could puncture the tech sector’s power run.

High but stable earnings like a bond?

“Overall, strength in company fundamentals, such as high cash balances, can provide investors with a feeling of safety during difficult economic periods.”

That’s how Segal Macro Advisors described the biggest technology companies in 2023 — that’s when the Magnificent Seven title was conceived to describe the largest and fastest growing US technology companies. The appeal of safety — typically reserved for AAA-rated bonds — isn’t usually cited for high-growth stocks. Segal’s analysis was framed as a question: “Is Mega-Cap Tech a Safe Haven or a Bubble?,” ultimately concluding that big tech would be a port of safety when the seas turned rough.

I looked at the numbers and found that since the pandemic that’s mostly true for five of the Magnificent Seven technology companies, Alphabet Inc., Amazon Inc., Apple Inc., Meta Platforms Inc. and Microsoft Corp. Alphabet, for example, has delivered a return on common equity between 20% and 35% for each and every of 18 quarters since 2021.

It makes sense. These companies offer almost utility-like functions in the tech-centric world we live in — so much so they have drawn antitrust concerns. Alphabet via Google search, Amazon via shopping and Internet infrastructure, Microsoft via the cloud and business productivity, Meta for its dominance in social networks and Apple’s for its ubiquitous iPhones.

But what does Tesla do that we all depend on? Right now, it just makes high-end vehicles. Its dispensability shows in its eroding return on equity as electric vehicle competition has increased. That’s down every single consecutive quarter from 28% in the fourth quarter of 2023 to a measly 8% in the past quarter.

As for Nvidia, for sure they make the chips powering a revolution in generative artificial intelligence. This potential shows up in returns on common equity of over 100% for six quarters in a row. But for all the capital investment, Generative AI has famously yet to yield a ‘killer app’ everyone is willing to pay for.

It does suggest that when the storm does come, the five utility-like companies will provide a cushion compared with the risk rewards in Tesla and Nvidia’s valuations.

Nvidia carries more promise — and risk

Nvidia is meeting the current moment like no other given its $4 trillion size. Revenue is up by a multiple of six times since ChatGPT was released in November 2022, setting off an enormous investment cycle in GenAI. The company looked incredibly expensive in July 2023 trading in excess of 200 times earnings. It has since grown into that price while still delivering a 10-fold increase in share price for shareholders.

Still, the upside revenue surprise this past quarter of 1.1% was the smallest consensus beat since January 2023, the quarter that captured ChatGPT’s debut. Brook Selassie, a Vice President in technology consultant Gartner's Business Growth Strategies team told me:

“GenAI has passed its hype peak, with failures, cutbacks, and superficial “checkbox” deployments pushing it toward the Trough of Disillusionment by 2026; fewer than one in five projects will realize business value.”

Most enterprises remain confined to narrow productivity gains—often barely measurable— with less than 30% of initiatives pursued by the top 8 industries being disruptive, enterprise-level projects, Selassie said.

MIT found that 95% of AI pilots failed to yield any discernible results. So, while the big tech companies have promised to keep spending on artificial intelligence, the slowdown in the pace of that spend is already evident. And many other companies outside of big tech are highly skeptical about what AI will deliver for the bottom line. Sam Altman, the leader of the company that makes ChatGPT, has even used the term ‘bubble’ to describe what’s happening now.

While AI spending is still growing rapidly, much of this growth is coming from just a handful of tech giants. AI hyperscalers including Microsoft., Meta, Amazon and Alphabet now comprise a record 31% of the total capex spend of firms in the S&P 500 Index, according to data compiled by Strategas Asset Management, LLC’s Ryan Grabinski. By comparison, that figure stood at 19% at the end of 2019.

Tesla is obviously different

In some ways, Tesla shows the risk inherent in Nvidia’s stock price since the mania over electric vehicles was the hype that preceded AI. In early 2023, when Tesla practically owned the EV market, the auto maker had a reasonable P/E ratio similar to that of other large companies, having realized much of the potential in its share-price run up until that point. But then sales growth waned and turned to shrinking revenue. The auto maker saw its sales drop 12% year-on-year in the latest quarter. Continued underperformance will soon start eating into the stock’s valuation.

Tesla CEO Elon Musk says 80% of the business value will come from robots, a market where the company has no real sales revenue to speak of today. Truist Securities’ William Stein, said “the company offered remarkably little detail on some of the most important factors” during their latest quarterly earnings. That made their outlook more about the promise of the future “than realistic targets.”

Here’s a company that missed Wall Street’s already lowered earnings estimates and whose CEO admitted in response that “we probably could have a few rough quarters.” Given Tesla is a company with a market capitalization of $1 trillion and a extremely high multiple, that ‘blue sky’ outlook contains a lot more downside risk than upside.

Two-sided risk for Nvidia, downside risk for Tesla

When this business cycle ends and a new one starts, will market leadership shift as it always does? Or is big tech so dominant and utility-like that the safety status will keep them on top?

The downside risk deserves our attention. Beyond that, Tesla has a clear problem the other Mag 7 firms don’t, in that it looks fully priced while revenue in its core business is declining. On top of that, no sales in new business lines have developed to make up for it. So it takes a lot of faith to buy the stock at 200 times earnings. A few more earnings misses without clear progress on robotics means one of the Mag 7 will have succumbed.

Nvidia, is different. There is still a lot of upside, perhaps more than in any of the other tech megacaps. Gartner says:

“Overall AI spending is forecast to be $1.5 trillion in 2025 and will rise to $3.3 trillion through 2029, resulting in a five-year compound annual growth rate of 27.5%.

That tells you right there why this AI-driven rally could have legs, benefitting Nvidia more than any other company. What’s more Gartner says its latest enterprise survey showed AI implementation is “not yet as pervasive as some may think.” Only 21% of firms reported to Gartner they were implementing AI across all parts of their enterprise.

Source: Gartner

Still, much of that is built into the share price. Nvidia’s shares lost about 7% in the three days of trading after it reported earnings that barely beat estimates and missed expected data center forecast. That shaved nearly $300 billion off its market cap — more than the total market cap of 95% of S&P 500 companies. If Amazon, Microsoft, Alphabet and the like stop investing as much in AI as they have done, Nvidia stands the most to lose.

AI technology will eventually become transformational. But, as with the Internet, it may take much longer than this investment cycle, putting Nvidia at risk. Once Nvidia starts to wobble, the run to safety could be massive. The question is, whether the rest of the tech power complex will be able to provide that cushion this time.

Quote of the week

‘AI Shockwaves’—the second- and third-order effects of AI... will extend AI’s impact beyond productivity and unlock new business models, compress value chains, and create entirely new competitive arenas.

Brook Selassie

Vice President, Business Growth Strategies, Gartner

Things on my radar

GenAI company Anthropic just completed its latest funding round at a valuation of $183 billion.
Is Apple going to be an AI winner? Yet another exec in its Apple Intelligence platform just left for a competitor.
One of the biggest risks (but also an area for upside) for Nvidia is China. The US, with its latest action on TSMC, showed it will restrict chip sales there.
Of course, the fact that an Appeals Court found many of Trump’s tariffs illegal also puts some doubts on, legally, how restrictive the US government can be on chip exports.