Artificial Intelligence Infrastructure Cycle Comes into Question

Microsoft “Cancels” Data Center Plans

A research note from TD Cowen floated around last weekend stating that Microsoft (MSFT) is canceling data center leases across the U.S. The analysts stated that a “couple hundred megawatts” of data center leases were canceled, with a considerable portion of international spending to be reallocated to the U.S. The note was contrary to MSFT’s most recent earnings call; chief financial officer Amy Hood emphasized the significant investments in long-lived assets (data centers), which are crucial for meeting the demand across Microsoft Cloud. With that said, more than half of MSFT’s recent cloud and AI-related capital expenditures have gone towards long-lived assets. CEO Satya Nadella reiterated these comments, stating that the company has more than doubled its data center capacity in the last three years.

Amy mentioned that in the future, capital expenditures will shift towards more short-lived assets. The change will be more correlated to revenue growth, reflecting a pivot from infrastructure build-out to investments in CPUs and GPUs. She highlighted that there can be quarterly spending variability due to cloud infrastructure buildouts and the timing of delivery of leases. The TD Cowen note was old news to us, given that this idea of variable cap ex-spend was already floated on MSFT’s earnings call.

On Monday, MSFT confirmed its plans to invest over $80 billion in capital expenditures this year. The company acknowledged that it may “strategically pace or adjust our infrastructure in some areas”. Again, this was acknowledged in MSFT’s earnings call, when they stated that they expect the growth rate of capital expenditures to be lower in 2026 than in 2025. To note, capital expenditures are expected to be nearly $63 billion in 2025, up 36% y/y, and expected to be $71 billion in 2026, up 15% y/y. Amid large investments back into the company, MSFT’s return on invested capital remains near all-time highs – a similar theme seen across other hyperscalers.

Chart 1: MSFT’s Return on Invested Capital Remains High as the Company Increases Capital Expenditures^[1]

Our view is that the data center theme is here to stay. Along with MSFT, Amazon (AMZN), Alphabet (GOOGL), and Meta (META) all increased their forward-looking capital expenditure guidance in the most recent quarter. We are in the early innings of artificial intelligence, and broader AI adoption will equate to a greater need for data centers. The DeepSeek news increased our view on the need for data centers – greater AI adoption will mean more data storage, processing, and power. Globally, there are 11,400 data centers, with 5,400 in the U.S. The U.S. will need at least 10,000 data centers to fully supply AI infrastructure. We have heard many of the top hyperscalers mention that they remain supply-constrained through high demand for their products with little supply on the storage and infrastructure side of the equation.

Dominion Energy (D) is a utility provider in the data center-rich region of Virginia. As of December 2024, the company has approximately 40 gigawatts in various stages of contracting, 88% above the 21 gigawatts reported in July 2024. Data centers now account for about 26% of the company’s total sales as a result of Virginia’s attractive business climate, world-class fiber networks, and access to clean energy. The PJM DOM zone tracks the average daily electricity prices in the Pennsylvania-New Jersey-Maryland region (PJM). D projects a peak summer load growth of 6.3% per year for the next decade, with a peak load in 2034 of 41.5 gigawatts, 60% more than previous estimates in 2022. Utility providers are seeing a rise in electricity output due to increased data center and electricity demand, with no signs of deterioration.

To summarize, TD Cowen’s note was the first time we heard of a hyperscaler declining AI/data center investment, which MSFT quickly refuted. The top hyperscalers all increased capital expenditure guidance, with strong sentiment and performance from utility providers and data center infrastructure companies – such as Eaton (ETN), which boasts a $15.5 billion backlog. Furthermore, Quanta Services’ (PWR) backlog reached record levels last quarter at $34.5 billion, up 14% y/y. Electrical power infrastructure solutions are PWR’s fastest-growing segment, up 38% y/y with improving margins and a $19.9 billion backlog, a main beneficiary of increasing demand for data centers. We believe in the data center theme and remain positioned for its growth.

Earnings Broadening is Leading to Widening Market Participation

With 86% of S&P 500 constituents having reported fourth quarter results, the reported earnings per share (EPS) growth rate is at 17.3%. The expected EPS growth rate for the quarter was 11.8% – companies are reporting far better results than previously expected. Over the past number of quarters, earnings growth has been confined to mega-cap technology companies; these handfuls of companies have done much of the heavy lifting for the index, but this trend is beginning to shift.

With a blended growth rate of 17.83% in Q4 ‘24, the Magnificent 7 is currently contributing ~38% to the S&P 500’s earnings growth. If this holds, it would be the lowest contribution the Mag 7 has made to the index’s EPS growth rate since Q4 2022. For much of the past two years, the Mag 7 has been the reason the index has seen positive earnings growth, but the trend looks to be breaking this quarter – earnings are broadening away from the Mag 7. The financials sector has accounted for 45% of the index’s EPS growth this quarter, with healthcare accounting for nearly 10%. This is flowing into performance this year, with health care the top-performing sector, nearly 8% year-to-date.

In our portfolio, technology is the largest underweight sector. Tech is home to high valuations, and we see more favorable opportunities in areas such as industrials, financials, and energy, where we remain overweight. Earnings are broadening beyond technology, and performance is following as a result. Our favorite long-term investment themes in data centers, power and grid infrastructure, U.S. consumer, housing, and many more remain intact.

Chart 2: For the First Time in Two Years, Ex-Mag 7 Companies May Have a Larger Contribution to Index EPS Growth than the Mag 7^[2]

Stephanie Link’s TV Schedule:

Sources:

^[1] Source: Bloomberg. As of February 24, 2025.

^[2] Source: FactSet. As of February 24, 2025.

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