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In this episode of Motley Fool Hidden Gems Investing, Motley Fool contributors Tyler Crowe, Jon Quast, and Matt Frankel discuss:
Microsoft is rewarded for having more moderate capex.
Why investors are worried about GE Vernova's massive backlog.
What could potentially be the start of a troubling trend for Sterling Infrastructure.
Rumors of Marvell Technology acquiring Lumentum and other M&A deals.
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Tyler Crowe: Alphabet almost sets a record no one really wants. Motley Fool Hidden Gems Investing starts now. Welcome to Motley Fool Hidden Gems Investing. I'm your host Tyler Crowe, and today I'm joined by longtime Fool contributors, Jon Quast and Matt Frankel. Guys, it is deep into earning sessions, and probably one of the biggest earnings days of the particular quarter. We have both Microsoft and Google reporting this morning, and it was a bit of a doozy as we said, the record no one wants is as of right now, Alphabets has lost about $500 billion in market cap shares are down about 12% as we're recording. That only is short, I think of Nvidia's $525 billion loss on the first quarter of 2025. The market doesn't seem to like what Google is saying or the parent of Google, Alphabet. Guys, I want to start here, and Matt, I'm going to start with you. What is the big narrative here that everyone seems to be piling onto Google and do you buy that narrative?
Matt Frankel: Well, the first thing is Alphabet, or Google. I might still call them Google didn't have a bad quarter. It had an expensive quarter. That's really the narrative here. I mean, revenue growth looked great. For a company of this size, revenue grew 25%, operating income was up 30%. Those are huge numbers for such a large and honestly, quite a mature business. The real problem is cash. For this quarter, their capex was over $51 billion. That's more than double a year ago, and free cash flow is negative $9 billion compared to almost 25 billion in positive free cash flow the same quarter last year. Not only that, they're expecting capex to rise from about 200 billion this year to 300 billion next year. Now, I've said before that at some point, the numbers are going to get too big to convince investors that this spending is going to be worth it. I think we might be at that point. Google Cloud's revenue growth their growth rate has accelerated for six consecutive quarters and is now over 100%. But if the company's not making money on the bottom line or generating positive free cash flow, the market's not convinced it's going to be worth it.
Tyler Crowe: Jon, you and I, we were actually talking about this before the show a little bit because you got to spend money to make money. With hyperscalers, all of these data centers, there's going to be a drag here. You have to spend all this money for these data centers before they come online. We're seeing this, maybe this decline in returns, this big outflow of capital. But the argument you are making is like, well, but once those things start to come online, we should start to see the returns start to bounce back. Do you still believe that after you're seeing this most recent earnings?
Jon Quast: There's naturally going to be a lag in between the investment and the return on the investment. That can't happen instantaneously in cases like this where you're spending so much money into a data center, that data center is not going to start to generate a return for you until sometime later. You're going to be spending money, think about just pouring concrete before you're actually generating some compute and revenue from that. Naturally, there's going to be a lag and there is so much interesting details here as we dig down. Maybe you've heard the expression first-world problems. This is first-magnitude tech problems when you look at it. If you look over the last three years here, as Matt pointed out, this is incredible revenue growth for a company of this scale.
Over the last three years, trailing 12-month revenue up 53%. But if you look at the cash from operations, that's up 76% over the same time. The business is generating more cash per revenue than it was three years ago, the incredible thing here, when you look at the scale, there are some things that do naturally drag. Google has its own compute hardware called TPUs, tensor processing units. This is in competition somewhat to Nvidia's GPUs. Right now, there's an inventory buildup there because they're preparing to service commitments that customers have already made to spend.
Tyler Crowe: We're going to pivot earnings in a quick section here. But before we move off of Google, guys, we saw some revenue declines at the ad revenue because more people are using AI. Do you think a burn the ship moment where it's like focused way more on AI or should we maybe just continue to think of ad revenue? It's going to be there for a while.
Jon Quast: No, this isn't a pivot away from advertising in my view, specifically because you do have YouTube still. This is a mega advertising revenue generator, and as the company's pointing out, this is still the king, if you will, of the living room because that's what my family is watching on our Smart TV. We tend to not stream so much content, but we do do a lot of YouTube, and that's a major, major ad revenue driver when it comes to search, maybe it is starting to decline. But to me, that's little focus and a lot of money still to be made.
Matt Frankel: I'd also say no. A lot of other companies we've seen report that you have done a great job of making ads better with AI, and I think that's still Google's long-term goal.
Tyler Crowe: Microsoft's earnings, maybe a little not quite as exciting, certainly not as much of a reaction that we saw in this most recent quarter. Was there anything in particular that stood out that was different for Microsoft in terms of Google? Was it just basically the spend rate where everyone's like, this is not as bad?
Matt Frankel: It's a story of investors don't hate AI spending. They hate negative free cash flow. Google Cloud, I mentioned their growth rate. It actually grew a whole lot faster than Azure, 103% versus 48%. But Microsoft's CapEx was actually below expectations. I don't know when the last time we heard that for a Mag 7 company was. Free cash flow was still very positive. For the first time, it specifically disclosed its Azure revenue in dollars, I guided for growth acceleration in the next quarter when spending less than the market expects. I think that's really the narrative.
Tyler Crowe: Jon, as we finish up here, as we are thinking about this, there was also an announcement that Microsoft was doing a $25 billion bond sale. Is this basically like, hey, they're free cash flow now, but we might probably expect them to be free cash flow negative like Google in the upcoming quarters. Do you think so, or are we maybe getting ahead of ourselves here?
Jon Quast: Well, I'll say this. The remaining performance obligations for both companies is incredibly massive. We can't even comprehend the numbers that they're putting out. There is potentially, yes, a lot of spending still to happen with these companies because of how much demand from their customers future demand, and that's what RPO is measuring. Now, I will say one thing that I'd like to point out differences here in the RPO for these two companies, Microsoft's remaining performance obligations, 683 billion massive, but actually down one billion sequentially. Compare that to Alphabet, 568 billion in remaining performance obligations. That is up 48 billion just from last quarter, massive ongoing performance obligation growth for Alphabet compared to Microsoft, especially.
Tyler Crowe: I'm going to make a small prediction here, not a huge one, but I bet as we see the IPOs of Anthropic and OpenAI go live probably within 6-9 months from now. I bet those RPOs are going to go up quite a bit. Now, since they will have that cash to deploy. Coming up after the break, we're going to drill down into some of the companies that have been benefiting immensely from all of the spending from Microsoft and Google. We'll call them the pick-and-shovel plays and how they've been performing this most recent earnings season.
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Tyler Crowe: We have seen all of these massive spending bills, all of those capital expenditures that Microsoft, Google, Alphabet, Amazon, all of the hyperscalers have been putting into this one of the common themes we have been looking at. In the Hidden Gems investing universe is these AI infrastructure picks-and-shovels businesses. The ones that are making all this deployment of AI infrastructure possible. What I wanted to do this most recent quarter is do a follow-up because we've seen all this money going out the door, which means somebody's bringing it in. What I did is I asked you guys for three companies that we could discuss here that are within our Hidden Gems investing universe, companies have been getting a lot of this spending and how they've been performing.
The three that we're going to talk about is GE Vernova, Sterling Infrastructure, and KLA Corporation. GE Vernova's up 2.5% today, even though they reported yesterday. Sterling's up about 6% on their earnings, and KLA Corporation is up 7%. Clearly, all this spending has been beneficial to them as well as their earnings. Matt, I want to start with you because you did GE Vernova. One of the questions I want to know is the earnings were good, but is this like a one and done service, or is there a lot of recurring revenue that we're going to see from these picks-and-shovels beyond the initial build-out of AI infrastructure?
Matt Frankel: First, this is going to be a recurring theme. Before they reported earnings, the stock was down about 14% in a month. The reason is that it's not that there's no demand. It's that no one knows how hyperscalers are going to pay for all this. I mentioned Google's $300 billion figure that no one seems to put too much faith in. But they're the leading manufacturer of gas turbines. Orders were almost doubled year over year. They have a backlog of nearly $200 billion in business for a gas turbine manufacturer. But it's not a one and done, and it's because every turbine they ship, it feeds their services business. They also service and maintain the turbines they sell. They have the largest installed base of gas turbines of any manufacturer, and each one adds to their services book that should provide steady revenue well into the 2030s, not forever, but for years into the future.
Tyler Crowe: It's been an interesting thing, and one of the things I have followed a lot as an investor is this idea of the rapid growth in electricity, not just from data centers, but also we talk about electric vehicles and things like that. There's a lot of things going at play with the GE Vernovas and like you said, there's not just the sale, there's that long term revenue coming from actually maintaining the stuff over the long term. Jon, I want to go to you. We're going to go from power to almost like the picks and shovels of the picks and shovels, and that's KLA corporation. Maybe not everyone knows this company. Give me a 10-second pitch on exactly what it does. Maybe that same question, is this a one and done thing, or is there going to be some lasting revenue for a company like KLA beyond this initial build-out of AI infrastructure?
Jon Quast: I would be really surprised if the majority of our listeners had heard of this company. It's essentially trying to find defects on computer chips and helping companies identify them so that they're not pumping out a bunch of chips with problems. Think about it as your iPhone. You got a speck of dust on it, you put a screen protector on it, you trap the dust underneath. That's not good. In the same way, computer chips, you don't want a defect on them. If you're pumping out chips down the line with problems, that's not good. It's an increasingly big problem and here's why. AI needs better hardware, faster hardware and you've maybe heard of the memory shortage. They're trying to make more high bandwidth memory and the newer generations of this high bandwidth memory, they're trying to make it in many cases by layering this technology on top of each other and these layers somewhat magnify the potential problem in having a defect in your line. They employ a company like KLA.
This is inspection tools, this is a way to identify those defects early. We're not making a lot of expensive hardware at this point. It's getting more and more expensive because it's more and more complex. We don't want to make a turn so the investment makes sense in KLA's products. Yeah, 29% revenue growth year over year, that's 15% growth quarter over quarter. If you're worried about the free cash flow issue of the hyperscalers, that free cash flow is flowing out of the hyperscalers and into companies like KLA, a 32% free cash flow margin in the most recent quarter, that is just dandy.
Tyler Crowe: The equipment and services of semiconductors is also going to be a fascinating thing too, because unlike a building or a gas turbine that lasts 30 years, semiconductors, maybe, six, seven, eight years, certainly the turnover there is going to be much more, and so there is the case to be made that manufacturing output for semiconductors and all of this inspection equipment is going to be much more valuable over the short term than maybe say some other companies that might be a one and done. That's where we want to finish here, Matt, because you brought to the world Sterling Infrastructure, which I think if we're going to talk about that one-and-done, we're going to do one thing and then it's over, Sterling might be the one of the three that we're talking about here.
Matt Frankel: Sterling, if you looked at the company a few years ago, it was like built highways and things like that. Now it builds data centers for the most part. The concentration's pretty huge. They called this their E-infrastructure segment, and even a year ago, when the AI build-out was already in full swing, this made up 60% of their revenue. Now it's at 83%. They are an AI company now. This is not a highway contractor anymore. There are some yellow flags coming up. You mentioned this is certainly a one and done. You only have to build your data center once. The book-to-burn ratio is one thing that really stood out to me this quarter. It was 0.9 X, meaning they worked through more of their backlog than they added to their backlog in this quarter.
Now, 0.9 is pretty close to one to one, and one quarter is not a cause for alarm, which is why I call this a yellow flag and not a red flag. The numbers from the business look fantastic. But even the most optimistic AI bulls believe that this build-out is not going to last forever. That's why they're calling it the build-out. It's going to last for a few years, and then we're going to have the data center infrastructure that we need to develop AI. Sterling, it's just a matter of how long is it going to last and how much is that future revenue worth? Because most stocks we value based on how much they're going to earn in perpetuity, that's really tough to do with some of the one-and-done AI plays.
Tyler Crowe: One of the ways, if I remember correctly, Sterling Infrastructure is trying to address this is they are starting to acquire other contractors that aren't just pouring concrete, doing the site preparation work. I think they recently bought an electrical contractor and maybe bringing that in-house as well, maybe solidifying their business to move just not having that one-and-done aspect of their business. Speaking of mergers and acquisitions, and I guess you could say shoring up the business. After the break, we're going to talk about some of the M&A activity that's going on that's either happened or happens to be in the rumor mill these days. It is earnings season. There's a lot of news, but we do like to get your questions as much as possible when the earnings season starts to draw down. If you do have a question for us, please email us at podcasts at fool.com. That's podcast with an S. I've also left the email in the show description so you can get it there.
But today, because it's been such a busy news cycle and we were talking about earnings, but also we've seen a lot of M&A activity lately. Following up from Tuesday when we were talking about Instacart and DoorDash maybe wanting to get together in an M&A deal. That deal was actually announced today. DoorDash is going to buy Instacart for $17 billion. Within hours, we got the next rumor of the next big M&A deal coming down the pipe, Marvell Technologies, which is a semiconductor connectivity, very much a AI picks and shovel company looking to buy Lumentum, which is a Photonics company, the new wave of how things are connected in server rooms. Instead of using copper wire, it starts to use fiber optic cables, and that's where momentum comes into play. It's a big rumor. Both companies, the shares are moving a lot today. We'll talk about it if the deal actually happens. But what I want to discuss with this today is that we're seeing more and more of these, and some of the analysts I was talking to before the show were saying that we're likely to see a surge in M&A in part because there's been some more tolerance for regulations. Considering that, M&A can go both ways. I want to ask you guys, over the past year or so or maybe even further back, what are some of the M&A deals that you have seen that you either loved or maybe you loathe.
Matt Frankel: I agree that we're likely to see a surge in M&A. It's not just because of the regulatory environment. There are a lot of other factors. A lot of these AI stocks are trading at five times they were a year ago, so an all stock deal is more appealing than it used to be, for example. But when it comes to deals recently, I love the tie-up of NextEra and Dominion in the utility space. Dominion's my utility. They're a pure utility. Power is the big AI bottleneck. We've talked about it many times on this show, and scale is a massive advantage when it comes to being able to build it efficiently and to be able to fulfill orders. Financial flexibility comes with scale. It builds NextEra's utility business up. It essentially doubles that, and it gives the company more potential and flexibility in the renewable side of the business because it will have a more massive scale of that utility side and the financial flexibility that comes with it. I really love that tie-up.
Tyler Crowe: Jon, what about you? Is there a deal that you have seen recently where you're like, this is what I'm looking for in an ideal M&A deal?
Jon Quast: No. In fact, I've seen the opposite. I'm going to highlight here AMD's $8 billion acquisition of World Labs. I'm not a fan of this deal and I say that as an AMD shareholder. World Labs is a AI lab. It has a physical AI angle, it's all about spatial intelligence, how AI can read a room in three dimensions. Basically think robots. You're going to have a robot maybe one day moving around your house, it needs to know how to operate that three dimensional space. World Lab is building out that way, AMD saying it's acquiring World Lab so that it can have this compute data, this intelligence data so that it can map out future generations of hardware to better meet those needs. Now, I'm not necessarily against the premise of that. It does make sense to build out your AI hardware or your physical AI hardware pipeline with informed data. That makes sense to me, but $8 billion for a start-up AI lab, that just seems like a really expensive deal to me, and that's why I'm not really a big fan here.
Tyler Crowe: Sticking with the M&A thing, let's play a little bit of a game here and the dream scenario for you when it comes to M&A. If we're thinking about companies that are going to be doing M&A right now because maybe this is one of those last gasps to do it for a while. Valuations are really rich. There's a loose regulatory environment when it comes to that stuff, what do you see as an M&A deal that you would like to see happen right now? Jon, why don't you go first?
Jon Quast: I'm not really a fan of any potential deals. I was thinking hard about this. In the AI world, I just don't think that you're going to find many attractive deals, quite honestly. If you're halfway decent business performing halfway decently, your valuation is going to be very pricey right now. That can really make an acquisition difficult even when it makes all the sense in the world. You're just not going to get a good price, and that does play into it. If you can get a good price in this realm, in this industry, in this sector, it's probably a business that is performing really badly and now you're acquiring a turnaround play, I'm not a big fan of that either.
Tyler Crowe: I'm going to guess that's probably foreshadowing. If this Marvell Lumentum deal actually does happen, I think we all know what Jon's going to say. Matt, is there any M&A deals that you're a fan of right now, or at least you'd like to see happen?
Matt Frankel: Well, as you said, if the Marvell-Lumentum deal happens, we'll talk about that in a later show. But if it does happen, it's going to leave essentially one laser suppliers to the industry that's of scale, which is Coherent. I think Broadcom should really take a look at Coherent if the Marvell-Lumentum deal happens because it will need its own laser supplier to keep pace at that point. That's one that I think is like an if-then situation.
Tyler Crowe: It sounds like we could have a pretty good bull-bear argument. Jon's already shading the Marvell Lumentum deal, and Matt, you're already suggesting that maybe the competitors should get together, too, because at the same time, valuations might be pretty stretched here. I think that could make a fun argument section. Probably not today, though, because we got to wait for those deals to actually happen. That is all the time we have for today.
As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards, and it's not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. Thanks to our producer Dan Boyd and the rest of The Motley Fool team. For Jon, Matt, and myself, thanks for listening, and we'll chat again soon.
Jon Quast has positions in Advanced Micro Devices. Matt Frankel, CFP® has no position in any of the stocks mentioned. Tyler Crowe has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Advanced Micro Devices, Alphabet, Broadcom, Coherent, DoorDash, GE Vernova, KLA, Lumentum, Marvell Technology, Microsoft, NextEra Energy, and Sterling Infrastructure. The Motley Fool recommends Dominion Energy and Instacart. The Motley Fool has a disclosure policy.
Alphabet Almost Sets a Record No One Wants was originally published by The Motley Fool
