Jim Covello of Goldman Sachs Group stated that investors seeking to profit from the artificial intelligence infrastructure boom should favor "hyperscale cloud providers" making significant expenditures, rather than semiconductor manufacturers.
Covello, who serves as co-head of equity research and is a senior semiconductor analyst, wrote in a client report on Thursday, "We recommend a long position in hyperscale cloud providers and an underweight stance on semiconductor stocks. This perspective is based on the view that the market has already priced in significant skepticism regarding the return on investment for hyperscale cloud providers, which is reflected in the substantial compression of valuation multiples for this sector."
Covello's assessment runs counter to recent trading trends. Over the past few months, semiconductors have been the market's favored AI investment play, while hyperscale cloud providers—including tech giants Amazon.com, Oracle, Microsoft, Alphabet, and Meta Platforms Inc.—have lagged in performance. This is due to investor concerns over their massive capital expenditures on data centers. The Philadelphia Stock Exchange Semiconductor Index, or SOX, has surged nearly 150% over the past year.
Covello believes this relative value trade could pay off under two potential scenarios. The first scenario involves hyperscale cloud providers beginning to demonstrate positive returns on investment, alleviating investor concerns about their spending and driving share prices higher, thereby leading to a re-rating of these companies' valuations. He noted that semiconductor stocks would have less upside potential because the market has already rewarded this sector.
The second favorable scenario would be if hyperscale cloud providers continue to face challenges with their return on investment, forcing them to scale back expenditures.
He stated, "We consider this the best-case scenario for this trade idea, as we believe hyperscale cloud providers would experience a significant relief rally as cash flow prospects improve, while semiconductor stocks would face a major impact because a decline in hyperscale cloud provider capital expenditure would negatively affect their revenues."
Currently, semiconductor manufacturers are trading at elevated valuations, while large technology companies are valued below their historical norms. The SOX index's 12-month forward price-to-earnings ratio has climbed to nearly 24 times, compared to its 10-year average forward P/E of 19 times. Although hyperscale cloud providers also currently trade at a 24-times multiple by this metric, this category of companies typically commands higher valuations due to their recurring cash flows and growth prospects.
Covello added that the only potential negative scenario would be a "status quo" situation, where hyperscale cloud providers continue heavy spending despite return on investment challenges, thereby supporting semiconductor company valuations while squeezing their own cash flow positions.
Capital expenditure has been a significant drag on large U.S. tech stocks, with investors worried that AI-driven spending will outpace cash flow. As early as February, a Bank of America survey showed a record number of investors warning of excessive corporate spending, with a quarter of respondents identifying an "AI bubble" as the top tail risk for the market.
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