October Update

In this update, we’re shifting away from the usual monthly market recap. Instead, we've decided to highlight key insights and interesting talking points that have been coming across our desk, offering a more focused take rather than the general market updates you can find elsewhere.

Zombie companies in the U.S. are on the rise, with many struggling to cover debt costs amid high interest rates, particularly within the Russell 2000 index. Meanwhile, major tech companies like Meta, AMD, and ASML saw growth but faced stock price declines due to lapping higher hurdles from previous reporting periods, and some market concerns, including slowing demand and geopolitical risks for ASML. Tesla’s focus on AI and robotics at its Investor Day took the spotlight, while exciting for the long term, disappointed some analysts on the street hoping for updates on its EV lineup.

Zombie Companies are on the rise

The trend of "zombie companies" in the U.S. – firms that cannot cover their debt service costs with operating income – has seen a significant increase, particularly in small-cap stocks on the Russell 2000 Index. Notably, 43% of companies in this index are currently unprofitable, a level not seen since the early days of the COVID-19 pandemic. Rising interest rates have intensified this issue, making debt servicing more burdensome for these financially fragile companies. The current interest expense as a percentage of total debt for Russell 2000 firms has hit 7.1%, the highest level since 2003, underscoring the financial stress being placed on these firms as borrowing costs climb.

Concerning the Russell 3000, which includes both large- and small-cap U.S. companies, around a third of firms reportedly do not generate sufficient operating income to cover their interest expenses over the past 12 months. This aligns with trends observed in broader indices, where companies reliant on cheap financing in the last decade are now struggling under tightened monetary policies. Rising interest rates are placing substantial pressure on these firms, many of which could face restructuring or default if the environment persists or worsens.

In this environment, rate cuts could ease the financial burden on these companies, reducing interest expenses and potentially acting as an earnings upside catalyst, as lower rates would relieve some pressure on cash flow and debt repayment needs. However, if current high rates persist, financially weak companies may face restructuring or default risks, which could lead to further market volatility, especially in high-yield corporate bonds where many of these firms are concentrated.

Source: Bloomberg, Apollo

Picking Winners - Consistent Sales Growth

Sustaining high revenue growth over many years is a challenging feat that few companies manage to achieve. Growth naturally follows an S-curve: early expansion is rapid, but it tapers as the market matures and competition increases. Most companies experience strong growth for a few years, but maintaining it long-term requires either entering new markets or innovating in ways that create fresh demand.

At GSP, we focus on identifying companies that have not only mastered their current growth phase but also have potential to pivot or add new growth engines, extending the S-curve. This might mean discovering companies that are expanding vertically or launching new product lines at scale, showing adaptability and resilience. Successful examples include companies that, even when mature, are able to introduce new revenue streams that propel growth further, ensuring that they stay ahead in their markets. Identifying these companies early, when they still have room to expand in innovative ways, is core to our investment strategy.

Source: Computsta, Factset, Goldman Sachs Global Investment Research

Earnings Roundup: Key Takeaways from Big Tech Q3 2024

The third-quarter earnings for 2024 have once again highlighted the dominance of major tech players like Meta, Tesla, Microsoft, AMD, Google, ASML, and Amazon. These companies continue to adapt and innovate, leveraging key growth areas such as cloud computing, artificial intelligence (AI), and advertising to sustain their leadership positions and drive future growth.

EVs / Humanoid / Automation

Tesla’s Q3 2024 earnings report showed strong revenue growth of 7.9% year-over-year (YoY), reaching $25.18 billion, with earnings per share (EPS) beating estimates by 24.14%. While the company’s automotive segment grew modestly, its energy generation and storage business saw an impressive 52.4% YoY increase, totaling $2.38 billion. However, despite the revenue gains, Tesla's vehicle deliveries came in slightly below expectations, particularly for the Model 3/Y.

At Tesla's recent Investor Day, analysts were expecting a more substantial update on the Model 3 and Model Y lineup, particularly regarding new features, design changes, or potential new models to sustain demand and drive growth in the competitive EV market. Instead, the event was dominated by a focus on Tesla’s innovations in AI and robotics, including the unveiling of its humanoid robot and Robo-taxi concept. While these new ventures into AI and robotics are significant and have strong long-term growth potential, the lack of updates on Tesla's core automotive lineup disappointed some investors and analysts.

For many, Tesla’s automotive business has always been the centerpiece of its growth story. Yet, as we’ve emphasized in the past, Tesla is not just a car company—it’s a tech company with a broad portfolio that includes energy, AI, and robotics. This shift in focus during the Investor Day reflects Tesla's ambition to diversify and solidify its position as a leader in the emerging AI and robotics markets. We believe these new growth verticals—especially AI-driven robotics—could offer substantial upside and represent the future of Tesla’s innovation.

In our view, Tesla’s long-term value is not tied solely to its vehicle production. While the EV market continues to be an important revenue stream, Tesla's advancements in AI and robotics could drive new growth opportunities and create a more resilient and diversified business.

Artificial Intelligence (AI)

Meta’s Q3 earnings were strong, with $40.12 billion in revenue, reflecting a 20% YoY increase. EPS of $3.88 exceeded expectations. The company benefited from continued growth in advertising, driven by AI-powered ad tools. Meta’s ability to integrate AI into its ad systems has allowed it to remain resilient in a competitive and slowing global digital ad market.

Both AMD and ASML have been key beneficiaries of the booming AI and semiconductor markets, with their Q3 earnings highlighting impressive revenue growth. Yet, despite strong performances, both stocks saw a decline post-earnings. Understanding the reasons behind this market reaction sheds light on investor sentiment amid shifting expectations.

AMD's Q3 revenue came in at $5.9 billion, reflecting a 10% YoY increase, with a strong contribution from AI accelerators and gaming chips. The company is well-positioned to capitalize on the increasing demand for AI-powered hardware. Despite these positives, AMD's stock price fell following the report. Investors were particularly concerned about slowing growth in gaming and data center markets, key drivers for the company. AMD's Q4 guidance indicated a potential slowdown in these sectors, especially as the AI boom could be less of an immediate driver than anticipated. The broader macroeconomic conditions, including global chip inventory levels and pricing pressures from competitors, likely contributed to the pessimism around AMD's near-term prospects.

ASML’s Q3 earnings showed a 28% YoY revenue growth, driven by its exclusive position in extreme ultraviolet (EUV) lithography. ASML’s dominance in the production of advanced semiconductors essential for AI, 5G, and cloud infrastructure positions it as a vital player in global tech. However, despite its impressive growth, the stock fell due to concerns about the cyclical nature of semiconductor demand, in addition to trade provisions regarding Chinese exports. Investors fear that demand for EUV equipment may slow in the short term, especially as companies might reduce spending amid a potential global economic slowdown and adjustments in capital expenditures for chipmakers. Additionally, geopolitical tensions surrounding semiconductor supply chains, particularly in China, have raised questions about long-term growth rates, dampening investor enthusiasm.

The Big 3 - Cloud

In Q3 2024, Google reported $74.5 billion in revenue, up 7% YoY, with its core advertising business remaining the dominant revenue driver. However, Google Cloud emerged as a standout performer, growing by 27% YoY, signaling its ability to challenge the dominant players in the cloud space, Amazon's AWS and Microsoft Azure. Google’s robust investments in AI and automation are also transforming its advertising and cloud services, positioning the company to capture more market share in these critical areas. Although AWS continues to lead the cloud market, Google's rapid expansion of Google Cloud is narrowing the gap, making the competition more intense in the cloud computing space. Microsoft's Q3 revenue reached $56.2 billion, growing 13% YoY, with the cloud business serving as the major growth driver. The company's Azure cloud division saw a remarkable 27% increase, underscoring its ongoing success in capturing a larger portion of the cloud market. Alongside cloud growth, Microsoft's investments in AI-driven solutions for products like Office and LinkedIn are solidifying its position as a top player in the enterprise software market. Amazon’s Q3 earnings exceeded expectations, with $145.2 billion in revenue, up 10% YoY. Amazon's AWS business grew by 14%, contributing significantly to its overall revenue growth. AWS continues to be a leader in the cloud space, and its market share is increasing as businesses continue to migrate to the cloud. Beyond AWS, Amazon’s advertising division showed impressive growth, driven by increased investment in AI to enhance ad targeting and optimization.

A growing story has been how big tech companies are increasingly investing in small modular reactors (SMRs). Amazon Web Services (AWS), Google and Microsoft are making massive investments in nuclear energy as part of their long term energy mix to power their growth. “Revitalizing America’s nuclear sector is key to adding more carbon-free energy to the grid and meeting the needs of our growing economy — from A.I. and data centers to manufacturing and health care,” US energy secretary, Jennifer M. Granholm, said in a statement. AI computing requires far more electricity than traditional operations, prompting the companies to seek out reliable, emissions-free energy sources. Microsoft has partnered with Constellation Energy to restart the Three Mile Island plant, while Amazon and Google are backing SMR projects. Amazon has invested in X-Energy's reactors, aiming for 300 megawatts of power in Virginia and Washington. Google plans to buy energy from Kairos Power's reactors, with both companies pushing for small-scale nuclear to meet growing energy demands​. This is all in relation to growing demand in AI applications, which require much larger cloud native infrastructure, which require much more energy demand.

Source: Statista