Motley Fool Hidden Gems Investing - Mag 7 Starts Burning Cash (for Real)

Starting point is 00:00:00 Mag 7 earnings are getting off to a rough start. Today on Motley Fool Hidden Gems Investing. Welcome to Motley Fool Hidden Gems Investing. I'm your host, Tyler Crowe, and today I'm joined by longtime Fool contributors, Lou Whiteman and Jon Quast, doing a little bit of analyst shuffleboard this week with people filling in for a little bit of vacation. So we're going to get into earnings because this week is one of the busiest earnings weeks that we have. Tons of companies are reporting. We want to dive into some of the companies we consider in the hidden gems universe, some of the things we're looking forward to this earnings season. But we wanted to start with the big moves on the day, which were obviously

Starting point is 00:00:38 Tesla and Alphabet, two of the Mag7 that are getting this earnings started. And it didn't look great. Both reported after the close yesterday, and both stocks, Google and Tesla, are down 7% and 13% respectively as we tape. And the largest reason, at least as far as I could tell, is that both companies are now solidly in cash burn mode with their investments. So this was a fascinating tidbit. I think I saw it in the Financial Times

Starting point is 00:01:07 before we got started, guys. For the first time since going public back in 2002, 2003, Alphabet posted its first quarter ever of negative free cash flow. Wow. That sounds pretty egregious or, you know, very stark and something we've been talking about for a while. So what did these numbers kind of look like across the board? Yeah. So, look, we've known this was coming forever. And the interesting thing to me is

Starting point is 00:01:32 we're finally starting to care about it because Alphabet, yeah, the numbers were great on one side of the ledger. Eighty two percent revenue growth. The cloud backlog continues to go up double digits. But they are spending every bit of money that they bring in and more. Like you say, they actually went free cash flow negative. They actually boosted their CapEx spending. You know, we thought last quarter, it's like, well, I can't go any higher than this. Well, hold my beer, as they say, right? They are now expecting to spend $195 billion to $205 billion in CapEx this year. That's a $15 billion boost from what they said previously. that's how you end up with negative free cash flow. This is a narrative story, Tyler,

Starting point is 00:02:18 because for most of its history, as you said, they had a ton of money and they didn't know what to do with it all. That's why they had the other bets. Now, suddenly, this is looking like one of those boring old industrial businesses that I follow that for every dollar you make, you have to spend 98, 99 cents, even maybe a dollar one. It should be temporary, but how long is temporary and how long does this drag out? These are the questions I think the market's asking today. Yeah, I will point out too that there is a big difference between the cash burn in Tesla and Alphabet's results. Really, Alphabet is falling in with the other hyperscalers in their cash burn. They're really spending that all on the AI compute and the infrastructure to go along

Starting point is 00:03:03 with that. Tesla, on the other hand, moving cars is why they're burning cash. They're lowering those prices to get cars out the door. That's a very different scenario than what the other players are facing. And I think really you can make an argument. Maybe there's disagreement in the argument, but I think you can make an argument that Alphabet is making a good move here. You look at the Google Cloud segment, revenue up 82% year over year, operating income in the Google cloud segment up over 200% year over year. So there are real results here. There is real momentum with the AI investments. You can say that they're investing way more than what justifies the return that they're getting, and I understand that. But there is some sort of economic benefit

Starting point is 00:03:53 that we can see, we can measure. Hopefully it's a long tailwind. Whereas Tesla, I think that there's more questions on the cash burn segment. Yeah, to that point too, and Lou, you and I were mentioning it before the show, was that not only is Tesla getting into cash burn mode now, their CapEx spending that they said they were going to do this year, which is about $25 billion, you could say so far this year, they're actually a little behind schedule. I think they've only spent like $8, $8.5 billion so far. So the expectation is that the cash ramp for them over the rest of the year and presumably over the next several years is going to ramp up significantly from here.

Starting point is 00:04:31 Right. Right. You said Tesla's down more than Alphabet, significantly more. And I think for a good reason. This was I don't think we had high expectations for this quarter. So that's the good news. But this was a lousy quarter. Like John said, a lot of this was almost crazy. Elon's new car Emporium. No deal is too good. Right. And that is why, look, even on what they made, two thirds of the earnings per share that they recorded, two thirds was market to market the SpaceX holding, not operations so look i mean it was literally rocket ships not automobiles that that kind of drove this quarter and hey spacex shares are down big for since june 30th so even that's not looking

Starting point is 00:05:13 great but tyler as you said free cash flow negative 1.1 billion dollars but for the second straight quarter the company underspent its capex budget uh so that's good if they don't need to spend it. But unfortunately, they still have a lot of spending that they intend to do, investing in Optimus, investing in AI, all of what they're going to do. If they stick to their full-year guidance and they haven't said that full-year guidance is coming down with these first two quarters of not hitting their guidance, that means CapEx is going to double in the second half of the year. So all of these free cash flow numbers we're looking at now, they're only going to get worse. You know, right now we're in a world where, yes, deliveries are up. But, you know,

Starting point is 00:05:58 when you grow deliveries by 34 percent, but your auto gross profit is only up one percent, that I think even better than margin tells the tale. They're just moving inventory here. We knew this was a period of transition, but it's only just begun and we're already seeing these numbers. That's kind of the I think that's why the market is reacting so negatively. I really I have this image in my head now or like, you know, you always hear like radio or or local TV commercials where it's the guy who owns the auto dealership. It's like I've bought too many. I made a business mistake. I need to clear this inventory and you're going to. I really now I want an Elon Musk version of that in front of a Tesla store because now that's just going to be etched in my mind forever. It's like Elon's crazy discount inventory. Everything must go sale going on.

Starting point is 00:06:49 So I want to back the lens up. And this is where I think it really starts to fall into context here is that we saw both of these companies go into cash burn. Like I said, Google for the first time ever, Tesla for the first time in a long time, with it going to presumably happen for a while. And this is where, to me, it is where it starts to become challenging as an investor and how to figure this out, because every single analyst McKinsey study projection of what AI infrastructure spending is going to be is it's just going up, up, up, up, up for the next five to six years. And if we are in a period where cash burn is now and we're expected to continue on this path for the next five years, this is where I start to wonder, like, how sustainable is this without some sort of change in the trajectory of what we're doing here? I have to assume that if we were to see these companies just burn through cash for two to three years, yes, they can put up better earnings numbers. But doing that for that sustained period of time is going to really test investors resolve. Definitely. And there's kind of a prisoner's dilemma here, isn't there? Because all of these hyperscalers that have committed all this money and are putting their basically betting the company on these frontier models. It is a weird

Starting point is 00:08:20 moment if they're going to stop this before they have to. So you're kind of just, you know, the snowball has started rolling down the hill. How and when is it going to start? And, you know, here's what worries me about it is that I think, and I'm not an AI expert, I'm not going to pretend to be, but I think there is growing credible evidence that a lot of the return on investment generating enterprise AI tools don't need the frontier models. There are millions of open source models out there. Not all of them are of good quality. Not all of them have security. Some of them are from foreign countries that they don't want to use, but there are good models out there. What if this is the kicker? And this is kind of a nightmare scenario. What if we're spending these

Starting point is 00:09:08 billions and billions for the frontier models that maybe do the hardest 5% of the work and 95% of the revenue and the AI goodness kind of bypasses these models that we're spending on. How do you make that spending payoff then? Hopefully there's another path. Hopefully that isn't the path we're headed on, but that is what kind of keeps me up at night with the hyperscalers. Well, I think Lou, if that's the case, I think it underscores the fact that Apple played this perfectly because it is one of the companies that is in a very strong position to benefit from local AI and the open source models do benefit the local AI. So this is basically having your own hardware, running your own models. That's what we're talking about when we say local

Starting point is 00:09:54 AI. Apple hardware is really optimized to do this well. And so Apple didn't get into the crazy CapEx game that the other companies did. Its hardware is already positioned to take advantage if that is a shift that is going to take place. So I really think that that's an incredible thing. And to circle back to something you said earlier, imagine a scenario where this is just kind of the cost of doing business now if you are a hyperscaler. It doesn't matter what the ROI is. What matters is staying in business. And so it is somewhat of a prisoner's dilemma. And so, yeah, you are having to spend this much money on the AI infrastructure and compute and staying ahead of the game. And that's just how it is now. In that scenario, you're no longer the free cash flow machine. The cash flow is flowing out, but into the other companies downstream, the smaller fish that are now the bigger beneficiaries of that spending. So I think if you are an equipment maker or an equipment manufacturer, one of these companies, I mean, they are seeing amazing tailwinds right now. That could continue, and it is something to watch. I think I've said it here once before, and I'll say it again.

Starting point is 00:10:57 One of these companies is the Ask Jeeves of the AI world. We just don't know which one it is yet. Coming up after the break, we'll keep on doing earnings. new from nespresso blend wellness into your coffee routine with a coffee plus range infused with functional benefits choose the coffee you love with added b vitamins like coffee plus b12 to help support immune function and coffee plus b6 to keep your day moving or go with the flow and choose ginseng delight our new double espresso with ginseng extract whatever lies ahead don't change your morning. Let your morning change you. Discover Coffee Plus on Nespresso.com.

Starting point is 00:11:40 We're about a 20, 25 minute podcast on any given day. So trying to break down every single company that's delivering earnings this week would be practically impossible. I think there was 150 companies that were reporting today alone. So we have to do pick and choose what we want to do here. So what we did before the show is we kind of went through the universe of companies that are recommended in the various Hidden Gems universe that we have. And I'm going to give you guys the floor to highlight some earnings results from this Hidden Gems universe. But before we do that, last week, IBM kind of telegraphed and said, hey, we're not going to have great results. And IBM is part of some of the Hidden Gems universe. So I wanted to just do

Starting point is 00:12:20 a quick follow-up, Lou. Was it as bad as they said it was last week when they're like, ah, revenue might not be a little bit short here? Yeah, the funny thing is it was never that bad. But yes, it came in as Telegraph. Revenue was $17.16 billion, which is short of $17.9 billion. But come on, really? The interesting thing here was the guidance. I mean, I think what freaked the market out was this idea that IBM saying that, look, people are spending on hardware, not our software. You can read that as temporary or you can read that as, you know, it's a want to have, not a must have, which is not a great position to be in. IBM expects revenue growth in the four to five percent range for the rest of the year. That's not great, but it's something at

Starting point is 00:13:03 least. And I think it's calming. The stock's down somewhat, but I think it is kind of calming nerves relative to last week. Well, I think the other thing to go along with that, Lou, is the fact that IBM CEO saying it didn't fully anticipate what played out. And so, yeah, there is CapEx budgets already set for the year. For the most part, there is a shift happening from the software budget to the hardware budget because hardware simply costs more. And the CEO saying, we did expect that shift to happen, but it played out way more than what we expected. I think that in a fast moving space like this, you really want your companies to have a firm handle on what is happening in real time. And IBM kind of admitting a little bit that

Starting point is 00:13:46 we don't fully know what's going on here. So I think that is the concern a little bit, maybe overblown, but I think that's what investors are responding to. yeah the one that kind of stood out to me the most and they it sounded like a timing thing they're like mainframe uh business was way down which i'm like but you said this was a shift to hardware and maybe i'm not quite as uh up to ibm but i was like that sounds a little more hardware-y than software but either way we're going to follow up on that one obviously some other time because it's it's a it's a big movie here but guys of the hidden gems universe what was a stock that stuck out to you that's reported in the last couple of days? John, we'll start with

Starting point is 00:14:25 you. For me, Tractor Supply, ticker symbol TSCO. This is a business that I really like and one that I've highlighted before. It's valuation, it's fallen a lot here recently and the valuation is historically quite low and I've thought that this is a good stock to buy because I see the business is very resilient. One of the reasons that I believe the business is resilient is just how much of the business is with companion animals or pets, in other words. So about a quarter of the business is addressing the pet market. Roughly another quarter is for livestock. So 50% of the business is towards the animals. I really see that as people spend money for their animals. That's just how it is. This is in the Q2 report here that just came out. The company owns 209

Starting point is 00:15:10 PetSense stores, they're actually going to close 75 of those. So about a third of that part of the business, it's closing. Also saying that the companion animal segment of the business within tractor supply is struggling. And so they're going to put some emphasis on there. For me, this is really the foundation of an investment thesis with tractor supply is that this part of the business remains resilient. And right now it's under pressure a little bit. So I think this is something to monitor if you're an investor or tractor supply over the next several quarters. Is this a trend or is this a one-off? Yeah, that's interesting because, you know, people are feeding their pets. Are they just not feeding their pets?

Starting point is 00:15:53 From tractor supply. Yeah, that is. Look, guys, one more for you. A quick shout out to RTX, the artist formerly known as Raytheon Technologies. Ticker is, unsurprisingly, RTX. They're up 8% today, up 22% for the year after a strong report fueled by growth on both the commercial and defense side of the business. They also raised full-year guidance, so they see this continuing. All segments were up across the board, which you rarely see with RTX. That's been one of the problems with them. Special shout out here for the defense side, 18% revenue growth, massive quarter for new orders to listen to this. They book two dollars and forty two cents worth of new business for every one dollar they build out in the quarter. That is a great way to telegraph

Starting point is 00:16:40 growth from here. I think all you have to do is pick up the newspaper and know what's going on on the defense side. On the commercial side, airplanes are still running hard. They are really set up well to take advantage of what looks like two two big a big set of tailwinds on each side of business. I want to do a quick thing and try to flip the script on both of you because each pitch of stock, you know, Lou, you got Tractor Supply. It's down about 45% over the past year, trading at about 14 times earnings. Based on some of the things that Lou said, or sorry, the things that John said, are you interested in buying? And I'm going to flip the question to you as well, John, interested in RTX based on up 36% trading at 39 times earnings.

Starting point is 00:17:23 So I'm generally scared of retail, but tractor supply is always one I've looked at. Maybe if they get cheap enough, I might look at it. But look, in retail, I just, I'm not much of a shopper. And so I'm really bad at spotting trends. So I just kind of hide from retail most of the time. This is a very uninspiring podcast as I say the same thing about defense contractors. I will say I don't own any of my portfolio. Lockheed Martin have always been a big fan of.

Starting point is 00:17:47 So if I was to plunge in there, I'd probably go Lockheed first. But, you know, this is a space that I always worry about what is going to shift over every four year presidential cycle. And so I've just never taken the dip. But I will admit that Lou has me interested here after posting some really interesting numbers here, especially with the 242 to every dollar they fill out. Very interesting metric. Certainly a lot of moving parts at RTX with the defense and the commercial side. So interesting to see. And also nice that, you know, didn't hear anything of like, yeah, Pratt & Whitney, we've got some problems that we need to fix.

Starting point is 00:18:22 I think that's the first time we finally passed that, right? Yeah. So coming up after the break, we're going to take a look ahead for the rest of the earnings coming up this earnings season. New from Nespresso, blend wellness into your coffee routine with the Coffee Plus range, infused with functional benefits. choose the coffee you love with added b vitamins like coffee plus b12 to help support immune function and coffee plus b6 to keep your day moving or go with the flow and choose ginseng delight our new double espresso with ginseng extract whatever lies ahead don't change your morning let your morning change you discover coffee plus on espresso.com hey we normally do

Starting point is 00:19:06 a question and answer section here but it is earning season so we're going to skip it today but I do want to remind you, if you want to get your question in, go ahead and email us at podcasts at fool.com. That's podcasts with an S at fool.com. We always ask, number one, keep it foolish, keep it short, and keep it in compliance with SEC. We can't give out any individualized advice. With that in mind, like I said, we're going to look forward to the rest of the earnings season coming up. I want to ask you guys, I'm going to put you in the position, you are my stock sommeliers for the rest of this quarter. Sell me on two companies that you think are worth following this upcoming earnings season. So I don't know if this will be bitter

Starting point is 00:19:40 or sweet, but on Tuesday morning, PayPal is scheduled to release results and hold a conference call. The report could be interesting because we have a chance to see if that under new management, there's any signs of growth at PayPal. But more interesting, I think, is the conference call because management will almost certainly be asked a lot of questions about the reported $53 billion takeover offer for the company. Now, guys, I get all of my financial advice these days from PolyMarket. And PolyMarket says there's a 73% chance that this deal gets done. I'll be honest, I'll take the under. I'm a lot more skeptical at $60.50 per share, which is the offer price, if that's good enough. But really, what matters is, I'm curious what management thinks. Based on

Starting point is 00:20:22 last quarter's free cash flow trends, I think $60.50 is way too low. I think maybe they have to sweeten it by $15 or so. I'm really interested to see if that free cash flow held up and whatever commentary we have. PayPal just got a lot more interesting to me. Polymarket and Kalshi, not gambling sites, futures commodity contracts, right? That's right. That's right. John, what are you seeing? Well, Airbnb isn't scheduled to report until August 5th, but that's the one this earnings season that I am very interested in, probably because I think Airbnb is simply my favorite business in the world. I really do. I know some people hate it. I'm taking a trip next week. I'm staying in two different great places on Airbnb. So I mean, I really love the business

Starting point is 00:21:05 and the model here. But I have to be honest, the stock is an absolute dud over the last five years, actually down 2% over the last five years. And the benefit here is that it is trading at nearly its cheapest valuation over the last five years at only 19 times free cash flow. This business generates gobs of cash flow. It's a fantastic business model in that regard. But what I am watching and what I need to see at some point from Airbnb is, can it use its free cash flow effectively to generate shareholder value? So far, not really. Now, the company is investing in some new product lines that it hopes will drive growth over the long term, hopefully profitable growth. But that just hasn't played out so far. Recently, it spent over $80 million

Starting point is 00:21:54 to buy an office building in Manhattan. I don't think that's a great use of cash personally as a shareholder. So I'm not thrilled about that. So I know for a fact that Airbnb can generate cash flow, but can they use it to create value for shareholders? That's what I need to start seeing at some point. As much as I love Airbnb, at some point they've got to show me that they can grow this stock? Over the past 12 months, Airbnb has bought back about $4.6 billion worth of stock, and they've been doing somewhere between $3 to $4 billion every year since 2023. I actually have a strange harebrained idea, almost like a half-baked idea, if you will, for Airbnb. They always hold a ton of cash, which is basically in escrow for when somebody orders a place, but then it doesn't

Starting point is 00:22:46 actually give it to the the person who owns the facility until like the the service is actually rendered airbnb needs like a chief investment officer like an insurance company who actually gets to like invest and manage the float because they have a float of money almost similar to an insurance company they got 10 billion dollars just sitting on the balance sheet right now in this kind of hey it's held for other reasons i don't see why they aren't like getting some sort of chief investment officer because, hey, why not? That's another investment opportunity. My idea for them was, you know, they can charge a cleanup fee to anyone who attends the conference call. Oh, that's rough. That's rough.

Starting point is 00:23:26 As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisers are sponsored content provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. Thanks to our producer Dan Boyd and the rest of the Motley Fool team. For Lou, John, and myself, thanks for listening

Starting point is 00:23:49 and we'll chat again soon.

Motley Fool Hidden Gems Investing - Mag 7 Starts Burning Cash (for Real)

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