The artificial-intelligence trade is getting harder.
Consider Alphabet's second-quarter earnings report -- and the market's response to it. The Google parent reported negative free cash flow of $5.9 billion and guided third-quarter free cash flow estimates to about $453 million, down from pre-earnings estimates of $7.7 billion.
It isn't every day that one of the world's largest companies spends more than it makes. The surprising news comes at a bad time. Investors are increasingly skeptical, and impatient, over how much money companies are spending, and borrowing, for AI. Pending earnings reports from other major tech companies will further stress this point.
The AI trade is now in the contentious "show me, don't tell me" phase. A critic might deride it as an example of faith-based investing, pointing out that revenue, expenses, and earnings are real, and everything else is commentary.
Alphabet, with quarterly revenue of about $120 billion, had about $242.4 billion in cash and marketable securities as of June 30, but it has also sold a lot of debt, in different currencies, that is thought to total about $100 billion.
The AI sector's self-financing is another complication. Nvidia, for instance, just guaranteed $250 billion for OpenAI to build an Ohio campus.
AI may change life on earth, which is how supporters hail the technology, but it's unlikely to change how investors analyze companies -- at least not anytime soon.
Most investors struggle to balance near-term financial results against unknown futures, a choice that AI companies are increasingly forcing upon them. Investors worried about their AI exposure can collar shares -- a cost-effective way to hedge against losses in Alphabet or other tech stocks.
The strategy involves selling a call option with a strike higher than the stock, and buying a put option with a strike lower than the stock and the same expiration. (Calls give holders the right to buy an underlying asset at a specific price and time, while puts give holders the right to sell such an asset.)
With Alphabet at $333.71, investors could buy the September $320 put and sell the September $370 call. The collar costs about $4.30.
If the stock trades at $290, the put is worth $30. The trade-off is limited gains. If the stock is above $370 at expiration, investors must sell the stock or adjust the call to avoid assignment.
During the past 52 weeks, Alphabet has ranged from $187.82 to $408.61. It's up 7% this year and 73% over the past year.
Alphabet's estimated forward 12-month price/earnings ratio is about 22.5, around the high end of Wall Street's estimates for the S&P 500 index. If investors become more skeptical, Alphabet's stock could trade at a lower valuation than the index given Alphabet's free-cash flow issues and debt issuance.
Of all the measures of a healthy company, free cash flow might be the most important. Warren Buffett has sung its praises. He also happens to own about $17 billion of Alphabet shares. Buffett has retired as CEO of Berkshire Hathaway, and it is unclear if his successor, Greg Abel, has similar views.
In practical terms, free cash flow is important. It funds dividends and stock buybacks, which benefit money managers whose performance is judged each quarter. It also funds capital expenditures -- those expensive, multiyear investments.
We saw this conflict between shareholder payouts and capex emerging in late May, though we never imagined one of the world's largest companies could have negative cash flow.
Investors are now stuck deciding how much they trust corporate spending sprees while waiting to see if it amounts to anything. The exercise isn't without a recent parallel.
For years, China was heralded as the next big opportunity. Though many companies, and even more investors, invested, it isn't clear if many have ever made meaningful returns.
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