Microsoft, Magnificent 7 must justify AI hype this earnings season

Big tech gains and the hype surrounding AI have powered the so-called Magnificent 7 stocks to records this year. But the sector faces a stern series of tests over the coming weeks as investors look for profit outlooks that justify the trillions added to their market values. 

The Magnificent 7 — Microsoft, Apple, Alphabet's Google, Amazon  (AMZN) - Get Free Report, Meta Platforms, Tesla and Nvidia — were responsible for around two-thirds of the S&P 500's overall gains last year. And they'll be crucial for earnings forecasts heading into the start of the fourth-quarter reporting season.

Much of those gains were tied to the hype around new artificial-intelligence-related technologies and their impact on both big tech earnings and the broader economy.

Nvidia,  (NVDA) - Get Free Report which holds a commanding share of the market for AI-focused semiconductors, has added more than $1 trillion in value over the past 12 months. 

Microsoft,  (MSFT) - Get Free Report meanwhile, the leader in generative AI products and a key investor in ChatGPT creator OpenAI, has overtaken Apple  (AAPL) - Get Free Report as the world's most valuable company and is now approaching a market cap of around $3 trillion.

"We believe the key narrative for 4Q earnings season is the beginning of the AI Revolution hitting the shores of the broader tech landscape being led by (CEO Satya Nadella and Microsoft along with the Godfather of AI (CEO Jensen Huang) and Nvidia," said Wedbush analyst Dan Ives.

"A key theme from our recent December quarter-end checks in the field has been that AI monetization has begun to positively impact the tech sector with Nvidia, Microsoft, Google  (GOOGL) - Get Free Report, Datadog and Palantir all showing that AI use cases are multiplying across the enterprise and consumer landscape," he added.

Heavy lifting ahead for the Magnificent 7

All the big tech giants, however, will play key roles in the fourth-quarter earnings season, beginning with updates from Microsoft and Tesla  (TSLA) - Get Free Report early next week.

LSEG data points to collective S&P 500 earnings for the three months ended in December rising 4.5% from 2022 levels to $454.2 billion. But it says the overall forecast has fallen around 3% since November of last year.

FactSet pegs the decline in profit-growth forecasts at around 6.8%, more than double the 10-year average. So with nine of the 11 major sectors providing downward profit revisions since last autumn, the Magnificent 7 stocks will need to do a lot of heavy lifting.

FactSet data suggest the Magnificent 7 will contribute around half the S&P 500's overall fourth-quarter earnings growth. Without them, the benchmark's profits would likely fall by around 7%.

Looking ahead, the S&P 500's information-technology sector, home to Magnificent 7 members Apple  (AAPL) - Get Free Report, Microsoft and Nvidia, will likely contribute around 20% of the benchmark's collective first-quarter earnings forecast of $468 billion.

"Results for this important group will be a key factor in determining whether S&P 500 earnings can generate attractive upside to current estimates," said Jeffrey Buchbinder, chief equity strategist for LPL Financial in Boston. 

"We expect results to be solid given [that] estimates have been revised higher for this group in recent months and the enthusiasm around artificial intelligence continues to build," he added.

Microsoft to set tone for Mag 7 earnings

Microsoft is likely to set the tone for Magnificent 7 earnings with its fiscal-second-quarter update, slated for after the close of trading Tuesday.

Analysts expect the software group to post a bottom line of $2.78 per share, up nearly 20% from the same period in 2022, with revenue rising 16% to a record $61.1 billion.

Ives from Wedbush predicts the monetization of Co-Pilot, a tool Microsoft sells to clients to manage their AI projects, is moving at an "eye-popping pace." He adds that "our checks are indicating the group is humming on the AI front heading into 2024."

Revenue from Microsoft's Intelligent Cloud division, including the flagship Azure platform, which powers much of the group's AI products, is forecast to rise 17.5% to around $25.3 billion.

Microsoft told investors in October that Azure revenue would likely rise as much as 27%, easing from the 29% pace recorded in the fiscal first quarter.

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However, Angelo Zino, a vice president and senior equity analyst at CFRA Research, says AI will contribute only a small portion of Microsoft's overall bottom line, putting its near-term forecasts in sharp focus.

"This may disappoint some investors, but the bull thesis remains very much intact. Growth from AI services will be gradual as Azure AI scales and copilots start becoming readily available to the enterprise space," Zino said. 

"The AI contribution numbers will likely be dependent on Microsoft's ability to get its hands on more advanced [graphics-processing units], with supply constraints still an issue."

Don't forget the AI chips

Lisa Su, the highly respected CEO of chipmaker Advanced Micro Devices AMD, told investors last month that GPU availability "is the single most important driver of AI adoption.” That's as large-language models "continue to increase in size and complexity, requiring massive amounts of memory and compute."

That could mean Microsoft's March-quarter outlook will be tied to both AMD  (AMD) - Get Free Report and Nvidia, both of which are ramping production in an AI chip market that Su predicts will be valued at as much as $45 billion over the coming years.

AMD last forecast fourth-quarter sales in the region of $6.1 billion, a modest 9% increase from 2022 levels, while Nvidia sees revenue of around $20 billion, a staggering 162% increase from the year-earlier period.

Tobi Opeyemi Amure, lead tech analyst at Trading.Biz, however, isn't worried about short-term issues linked to capacity.

"The rapid pace of AI innovation makes it nearly impossible to halt progress in the field at this point," he said. "With AI poised to broadly impact industries and services globally in the years ahead, it's no surprise investors are betting big on companies leading the AI race."

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