Big Tech needs to show returns on AI spending: Davis

Key Concepts

AI Chips: Specialized processors designed for artificial intelligence tasks.
AI at the Edge: AI processing performed on devices rather than in centralized data centers.
Hyperscalers: Large cloud computing providers like Microsoft, Alphabet, and Meta.
Return on Equity (ROE): A measure of profitability that calculates how much profit a company generates with the money shareholders have invested.
Return on Investment (ROI): A performance measure used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments.
Free Cash Flow (FCF): The cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
Valuation: The process of determining the current worth of an asset or company.
Commodities: Raw materials or primary agricultural products that can be bought and sold.
Picks and Shovels: A metaphor referring to companies that provide the essential tools and infrastructure for a growing industry, rather than directly participating in the industry's end products.
Biopharmaceutical Development: The process of discovering, developing, and bringing to market new drugs and therapies.

Qualcomm's AI Chip Ambitions and Competition with Nvidia

US stocks showed upward momentum as the market anticipated significant earnings reports from major tech companies this week. Qualcomm has already seen a surge following its announcement of new AI chips intended to compete with Nvidia. Christopher Davis, partner at Hudson Value Partners, discussed the competitive landscape for chipmakers aiming to challenge Nvidia's dominance.

Key Points:

Nvidia's high profit margins and pricing are attracting significant competition.
Potential competitors include Qualcomm, AMD, Intel, Broadcom (with its ASICs), and Alphabet (with its TPUs).
The market is expected to become more fragmented.
Hudson Value Partners is optimistic about Qualcomm's ability to capture a portion of this market.

Qualcomm's Strengths in AI:

Qualcomm is a leader in "AI at the edge," utilizing its Snapdragon family of chips.
These chips are integrated into automotive applications and are dominant in Android devices.
Qualcomm is rapidly gaining market share in laptops, particularly in the more expensive "Copilot Plus AI PCs," achieving approximately 20% market share from a standing start at the end of last year, displacing Intel and AMD.
The company's potential to perform inference work in data centers, in addition to its edge AI leadership, is seen as a powerful combination.

Tech Earnings and AI Spend: A Focus on Return on Investment

The current week is crucial for tech earnings, with reports expected from major players like Microsoft and Apple, while Nvidia's report is scheduled for later. Hudson Value Partners, as owners of Microsoft, Alphabet, and Meta, is closely watching for demonstrable returns on the substantial investments being made in AI.

Key Points:

The firm seeks evidence of return on equity (ROE) and return on investment (ROI) from AI spending.
Demonstrable examples of new products, services, features, increased seat licenses, and overall demand are critical.
A cautious approach is warranted due to the significant stock run-ups in these companies over the past six to eight weeks.
A "win" would be defined as maintaining guidance or achieving a slight upward revision, even with a muted market reaction.
Hyperscalers have engaged in massive AI spending, with Meta planning $100 billion next year, up from approximately $70 billion this year.

Demonstrable AI ROI:

Microsoft: The most clear case for AI ROI is seen with the adoption of Copilot and its integration into Office 365 licenses and Azure cloud services.
Alphabet: Similar positive trends are observed in Alphabet's commercial and business cloud applications, Gemini in the browser, and its advertising business.
Funding: Microsoft and Alphabet are primarily funding their AI investments through free cash flow. Meta's reliance on debt issuance for its AI investments is a point of concern.

AI Bubble Concerns and Valuation Discipline

With the S&P 500 reaching record highs, concerns about an "AI bubble" are present, given AI's significant proportion of the index and its current market dominance.

Key Arguments and Perspectives:

There will be both winners and losers within the AI sector.
The focus should remain on companies demonstrating strong ROI and avoiding "putting good money after bad."
Continued technological evolution is expected to drive productivity gains.
The primary risk is overpaying for AI investments.
A disciplined approach to valuation, investing in AI themes at reasonable prices, is a defensible strategy.

Canadian Gold and Franco-Nevada: A Cautious Approach to Commodities

The discussion shifted to the Canadian gold royalty company, Franco-Nevada, and the recent decline in gold prices from their record highs.

Key Points and Methodology:

A degree of patience is advised when considering commodities or stocks that have experienced rapid, meteoric rises.
The pace of an increase can often dictate the pace of a subsequent decline or correction.
Gold Price Observation: The speaker is looking for gold to hold the approximately $4,000 mark, with a need for several more closes to confirm if this level can transition from resistance to support. Recommitment to investment would be considered from this point.
Franco-Nevada and Canadian Gold Miners: Year-over-year earnings for companies like Franco-Nevada are expected to be substantially higher.
Realizations: Third-quarter realizations, based on gold sold at market prices, are anticipated to be very strong.
Underwriting: Models from the previous year did not typically underwrite gold prices at $4,000.
Opportunity: The current period of consolidation presents an opportunity for investors to "nibble" into positions or increase exposure over the next couple of weeks.

Thermo Fisher Scientific: A "Picks and Shovels" Play in Biopharma

The final pick discussed is Thermo Fisher Scientific, a company involved in health instruments, consumables, and related services. Despite a challenging start to the year for the stock, it is presented as a compelling investment opportunity.

Key Points and Rationale:

Thermo Fisher Scientific exemplifies Hudson Value Partners' strategy of investing in strong franchise companies when sentiment is at its lowest.
The firm began building its position earlier this year and in the summer.
Growth Projections: An estimated 8-10% growth in earnings per share (EPS) is projected over the next two years.
"Picks and Shovels" Investment: The investment is viewed as a significant bet on the infrastructure supporting biopharmaceutical development.
Services Offered: Thermo Fisher provides a comprehensive suite of services, including testing, clinical trial management, instruments, consumables, and contract manufacturing.
Life Cycle Support: For smaller biopharmaceutical companies, Thermo Fisher can support the entire lifecycle of drug development and production.
Healthcare Sector: Increased investment in healthcare is expected to benefit Thermo Fisher.
Investor Opportunity: The healthcare sector has been challenging for investors over the past two years, suggesting a potential need for portfolio adjustments. Thermo Fisher is recommended as a company worth considering.
Long-Term Ownership: The company is expected to become more attractive over time as its earnings grow, justifying long-term ownership.

Synthesis/Conclusion

The discussion highlights two key investment themes: the burgeoning AI sector and the resilience of established healthcare infrastructure. In AI, while competition is intensifying for Nvidia, Qualcomm is positioned to gain market share with its edge AI solutions and potential data center inference capabilities. For major tech players, the focus remains on demonstrating tangible returns on massive AI investments, with Microsoft and Alphabet showing clearer evidence of ROI. The market's caution regarding an AI bubble is tempered by the belief in long-term productivity gains, emphasizing the importance of disciplined valuation. In the commodities space, a patient approach to gold is recommended, with Franco-Nevada and other Canadian gold miners poised to benefit from strong realizations. Finally, Thermo Fisher Scientific is presented as a strategic "picks and shovels" investment in the biopharmaceutical sector, offering growth potential through its comprehensive support services for drug development and production, particularly appealing during a period of investor caution in healthcare.