Show Me the Cash Flow

Record Growth, Falling Stocks

This week, the three largest cloud computing providers reported some of their strongest revenue growth in years, and investors sold off their stocks anyway. Amazon Web Services' revenue grew 39%, Microsoft Azure’s grew 49% and Google Cloud’s more than doubled. Yet, Alphabet shares fell roughly 11% the following morning, and Amazon's fell about 6% in after-hours trading within minutes of its report.

The market's message was clear: demand for artificial intelligence is no longer in question. Seemingly, what investors now want to know is what that demand costs and when that spending will turn back into real cash.

What Changed: Cash Flow, Not Revenue

For two years, the stock market rewarded companies simply for spending heavily on AI. This earnings season, investors apparently shifted their focus to free cash flow, which is the cash a company has left over after expenses, including paying for data centers, computer chips and power infrastructure.

On that measure, the financial picture has shifted:

• Amazon spent $42.4 billion more cash than it brought in over the past 12 months, compared to generating a positive $14.8 billion just a year earlier.

• Alphabet reported a quarterly cash flow deficit of more than $9 billion.

• Meta also saw its quarterly free cash flow dip below zero.

Investors are beginning to reward discipline. Microsoft spent $45.2 billion on capital projects this quarter, about $5 billion less than analysts expected, and its stock rose. Oracle, another large cloud provider, promised at its investor day to limit new outside funding to $20 billion through fiscal 2030, and said its spending should peak within two years. Its shares rose about 11% that day. Spending restraint seems to have become a selling point.

The Depreciation Wave and the 2027 Test

A company’s cash flow takes an immediate hit when it makes big purchases, but accounting earnings absorb those expenses over time. Data centers and servers are depreciated (expensed) across several years. This means the record hardware budgets of 2025 and 2026 will gradually weigh down reported profit margins in 2027 and 2028, even if revenue stays strong.

Amazon expects to spend roughly $220 billion in cash on infrastructure in 2026, while Meta raised its 2026 spending forecast midpoint to $140 billion.

That is likely to make next year a key test. Meta has indicated that its AI initiatives should begin generating incremental revenue by 2027. Investors will watch closely to see whether cloud and AI revenues can grow fast enough to offset the multi-year accounting costs already locked in.

A valid counterargument is that aggressive spending ahead of demand built the profitable cloud businesses these tech giants rely on today, and a company that underinvests now risks falling behind for a decade. Negative free cash flow during a major technology build-out is not inherently a flaw, it only becomes one if the expected financial returns fail to materialize.

Ripple Effects Across the Market

This shift from pure enthusiasm to strict financial scrutiny extends well beyond giant tech firms:

• Index Concentration: Because major stock indexes are heavily weighted by market capitalization, movements in a handful of mega-cap tech stocks can drive overall market directions.

• Suppliers: Manufacturers of chips, networking hardware, power equipment and utilities continue to benefit from large technology budgets. However, investors are watching for signs of demand fatigue, such as potential peaks in chip memory pricing.

• Financing Models: Companies that rely on debt to finance infrastructure face greater market pressure than those funding projects out of existing operating cash. Specialized AI cloud providers such as CoreWeave and Nebius each fell over 6% this week on debt and financing concerns.

• Software: Several traditional software providers saw sell-offs over concerns that new AI tools could compete directly with their product suites.

The Ferguson Wellman View

Because we manage portfolios largely through individual security selection, we are not required to hold every company in proportion to its size in an index. This flexibility lets us favor businesses that fund AI initiatives directly from operating profits while exercising greater caution with those that rely heavily on debt.

Some primary metrics we track include:

• Free cash flow conversion (how efficiently profits turn into spendable cash)

• Capital spending as a share of operating cash flow

• Cloud contract backlogs and committed future revenue

• Depreciation relative to total revenue

The broader economic backdrop continues to support staying invested in equities. According to FactSet, third-quarter S&P 500 earnings are on track to grow 29.5% year over year, with consensus estimates pointing to 33.1% earnings growth for 2026 and 16.0% for 2027.

With corporate earnings expanding and recent market pullbacks keeping share prices in check, the S&P 500 currently trades at 18.7 times forecasted 12-month earnings - below both its 5-year average (19.8x) and 10-year average (19.1x).

Strong earnings growth paired with below-average valuations reinforces our conviction in keeping most clients invested in equities. Artificial intelligence is not a bubble in our estimation, but the era of easy market gains is giving way to fundamental accountability. Going forward, we expect capital discipline to separate the long-term winners.

Takeaways for the Week:

• Financial markets digested the Federal Reserve's latest policy decision and interest rate commentary this week. The Federal Reserve held rates at 3.75% to 4% on October 28, with two officials voting to raise them. Futures markets put the odds of a December hike at roughly 85%.

• On Thursday, GDP was released for the third quarter. The economy grew at a 3.4% annual rate, up from 2.2% in the second quarter, and beating consensus estimates of 3.2%.

• The earnings parade continues next week with key quarterly reports scheduled from Apple, Advanced Micro Devices (AMD) and Palantir. Investors will evaluate whether these tech leaders are maintaining strong end-user demand while keeping infrastructure spending within reasonable bounds.

• Midterm election results begin arriving next Tuesday. Close races could take days or longer to resolve, potentially leaving control of the House and Senate uncertain beyond election night.

Disclosure

The views expressed represent the opinion of Ferguson Wellman. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Statements of future expectations, estimates, projections and other forward-looking statements are based on available information and Ferguson Wellman’s views as of the time of these statements. Past performance may not be indicative of future results. Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational purposes only and not as a substitute for qualified counsel who can determine how this information applies to you. We believe the information provided is from reliable sources but should not be assumed accurate or complete.

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