Learnings from Earnings 2Q 2024
We see evidence of orderly economic deceleration and earnings remaining relatively resilient. Companies demonstrated cost discipline in a weakened demand environment, which supported margin expansion in 2Q 2024. The Magnificent 7 stocks drove much of the growth in both revenue and profit in the US, although even within that group results have been mixed. Tesla notably missed on earnings, while Meta posted growth above market expectations. The magnitude of “beats” and “raises” for NVIDIA earnings narrowed this quarter, with a further deceleration possible if the company’s next generation Blackwell product continues to face delays.
We believe there are early signs of a broadening market participation, with the S&P 493 (excluding the Magnificent 7) showing positive year-over-year earnings growth for the first time since 2022. European earnings came in better than the market had expected but were quite uneven. Cyclicals lagged, with many cutting guidance, signaling consumer weakness. Despite the downturn in China, earnings among emerging market companies were strong, with India being a steady bright spot.
We maintain our cautious optimism on the earnings outlook and continue to expect earnings growth to broaden out beyond the Magnificent 7, beyond the US and beyond large capitalization stocks.
AI: Today’s Investment Fuels Tomorrow’s Revenue
The companies leading the development of frontier models—the most advanced and capable large language models (LLM)—include Google, OpenAI, Anthropic, and Meta. These companies have said their generative AI (GenAI) capabilities are advancing rapidly, while also emphasizing that their models are still at an “undergraduate” level. There is a shared understanding that we are still in the very early stages of frontier model development.
Nevertheless, companies at the forefront of GenAI development continue to express optimism in the long-term potential of the technology. NVIDIA said that it believed its graphics processing units (GPUs) would become 1 million times more efficient at AI processing over the next decade using the same kind of chip infrastructure.
While the magnitude of long-term return on investment (ROI) is yet to be determined, technology companies—hyperscalers in particular—have continued to invest in building out their GenAI capabilities. Yet, aware of the long runway ahead of GenAI, they are taking their foot slightly off the gas. Although most reaffirmed their full-year capex expectations, capex growth estimates for the next year did not move materially higher. Google reported capex slightly ahead of expectations this quarter but guided to an unchanged full-year capex outlook. At the same time, it reaffirmed the importance of staying at the leading edge of LLM development and expressed confidence in its ability to monetize the technology. The remaining hyperscalers have spent robustly on capex for AI development, demonstrating their long-term conviction.
Some technology companies’ capex takes the form of in-house custom AI semiconductor solutions, potentially leading to competitive pressures on NVIDIA going forward. Though still expected to remain the dominant player, there is a risk of NVIDIA losing some market share to companies with greater exposure to application-specific integrated circuits (ASICs). These circuits enable large cloud players to build their own, internal custom capabilities as opposed to relying on NVIDIA’s graphics processing units (GPUs). Examples of such players include Marvell which in 2Q delivered its first “beat” and “raise” in six quarters. Marvel mentioned that it was likely to “significantly” exceed its prior AI revenue forecast, citing meaningfully higher order backlogs.
While the risk of new players disrupting the incumbents is part of any technological transformation, there is a significant difference this time. The current incumbents are large and established companies that appear to be very well positioned to withstand the competition in GenAI. Their exceptional access to vast datasets used to train AI models and their ability to fund the huge capital expenditure requirements may make their competitive moat particularly strong.
Source: Bank of America Research and Bloomberg Intelligence. As of April 2024. The above graph shows an estimate of the total addressable market for GenAI based on a 41% CAGR. The economic and market forecasts presented herein are for informational purposes as of the date of this page. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this page.
Infrastructure – Re-shoring and Data Centers are Driving a Strong Capex Cycle
We believe the growth of global electricity demand is on course to accelerate as trends in mobility, construction and manufacturing are leading to the “Electrification of Everything,” with AI data centers being the main driver.
AI data centers are five times more energy-intensive than traditional data centers. The magnitude of their future electricity demand has been underappreciated until recently. Estimates now show that power demand in the US could grow at a rate of 2.75% per year through the end of the decade. Two thirds of that growth is likely to be driven by AI data centers.1 It is estimated that up to 8% of capacity will need to be added to the US energy grid to meet the power demand. Companies throughout the value chain have increasingly turned their attention, and their dollars, toward building the necessary infrastructure.
Source: Wells Fargo Securities. As of June 30, 2024.
In 2Q, gas-based turbine orders were up by 200% year-over-year and grid-related orders were up by 150% year-over-year in the US, providing a tailwind to power producers’ earnings. WEC Energy cited Microsoft’s $3 billion data center in its jurisdiction as one of the key drivers of its earnings "beat" this quarter. PJM, a transmission organization that coordinates wholesale electricity around the Northeast and Midwest, posted a clearing electricity price – the price at which demand matches power providers’ supply – that was nine times higher than last year’s in its capacity auction. In our view, this was a very clear indication that to mitigate the impact of increased electricity demand on customer bills, power capacity needs to be built quickly.
To meet the power demand, companies are exploring “behind-the-meter” capabilities: direct contracts to supply large electricity consumers, specifically data centers, off-grid. This quarter, the first known data center powered directly by gas turbines and back-up generator sets was supplied by Caterpillar in Ireland. Talen and AWS had such an agreement for a data center in Pennsylvania that was halted by the Federal Energy Regulatory Commission, but companies like Constellation Energy commented on staying focused on closing a direct power deal with a data center this year.
Mega-projects and the infrastructure build-out to support the reshoring of manufacturing in the US are still top of mind. Though we are seeing some delays in 2Q as companies monitor rate cuts and the US election, the second half of the year is expected to be a busy time for large infrastructure projects ramping up into 2025. Public initiatives like the 2021 Infrastructure Investment and Jobs Act (IIJA) and 2022 Inflation reduction Act (IRA) have significantly improved project economics, shifting the center of gravity toward US companies building new energy facilities and associated infrastructure. We are seeing IIJA projects begin to flow through to earnings. For example, Advanced Drainage Systems noted that “infrastructure revenue remains a bright spot for the company as we see the tailwind from the IIJA.” IRA projects are getting approvals and we expect them to show their impact on earnings in 2025/2026.
Reshoring remains an area of focus with the CHIPS and Science Act spurring semiconductor manufacturing, and healthcare manufacturing showing increased momentum. In its 2Q earnings release, Eli Lilly announced an additional $5.3 billion in manufacturing investment at its Indiana site, and we are seeing companies make capital investments to support about 25% growth over five years for glucagon-like peptide (GLP) manufacturing. Interest rate relief and policy continuity may drive the next wave of reshoring and capital projects.
Consumer: Discernment and Bifurcation Continues
This earnings season demonstrated that US consumers have been more cautious with their spending and retailers have come under pressure. While pricing remained largely stable across the Retail sector in 2Q, promotional activity has picked up in certain categories (e.g., food retail, restaurants, home furnishings, select leisure travel) as companies fight for market share in the face of more price-sensitive customers.
In the restaurant industry, we noted the shift to at-home consumption in 1Q. This quarter saw increasing promotional deals in the $4 to $6 price range as restaurants attempted to retain market share. This is consistent with the broader food industry: Heinz, for example, cut prices by 30%-40% in its US portfolio, and Mondelez announced plans to increase output of its lower-priced snacks like Chips Ahoy and Ritz. Other industries where we have seen weaker global demand include beauty products, spirits and big-ticket discretionary goods.
Conversely, wallet share gainers have been those companies that have helped the consumer navigate higher price levels by providing value. Retailers like Walmart and Target's value proposition around price/affordability, selection, and convenience resulted in strong earnings. Similarly, membership warehouse clubs like Costco and BJ’s Wholesale Club reported better-than-expected 2Q sales. While cutting back on consumer goods and travel, customers are still spending on other services and experiences. Live Nation reported another strong quarter of demand and revenue growth. This is expected to further accelerate in Europe next year as venues used in the summer of 2024 for the European Championship soccer tournament in Germany and the Summer Olympics in France are repurposed for concerts and other public events.
Another recurring trend across industries and regions is the bifurcation of the high-end and lower-end consumer, which we have already observed in previous quarters. In 2Q, we continued to see an uneven consumer environment globally, with resilient demand from higher-income consumers and more value-seeking behavior among low-and middle-income consumers.
European luxury companies’ earnings season has been at the epicenter of consumer weakness in China as well as the bifurcation trend. While the slowdown in Chinese demand has proved a significant headwind for all luxury companies, those with heavier exposure to the less affluent, aspirational consumer have been challenged more. Aspirational luxury demand saw a significant deceleration, with industry sales growth turning negative over the quarter. Companies such as Swatch and HUGO BOSS issued profit warnings. This is in stark contrast with ultra high-end luxury, which remains a safe haven within the industry. Companies such as Hermes and Ferrari reported not seeing any significant demand slowdown.
Back in the US, Citi noted that “while we continue to see an overall resilient US consumer, we also see a divergence in performance and behavior across Fair Isaac Corporation (FICO) and income band.”2 Top quartile earners have more savings than they did at the beginning of the pandemic, and the segment of consumers with FICO scores over 740 is driving spending growth and maintaining high payment rates. On the other hand, delinquency rates related to consumer debt have increased meaningfully. While latest commentary from banks’ earnings suggests that credit trends remain consistent with market expectations, the question arises: are we indeed witnessing post-pandemic credit normalization or is this deterioration indicative of mounting pressures on the lower-income consumer? We look forward to further clues, or perhaps a clear answer to this question, in the next quarter’s corporate earnings.