The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

By Jeffrey Goldfarb

NEW YORK, May 7 (Reuters Breakingviews) - Big Tech is attempting the mother of all pivots. Although startups from Twitter to Instagram are renowned for remaking their businesses on the fly, none compares to the scale of the transformations underway at Microsoft MSFT.O and other software giants that historically steered clear of owning too much property or equipment. They are now pouring resources into physical assets, jeopardizing profitability and rich valuations in the process.

It is broadly accepted that capital-intensive businesses typically lead to lower returns. The telecommunications boom of the 1990s, and the massive spending that led to a supply glut, is a prime example of why investors tend to prefer companies with fewer factories, warehouses and other similar holdings, and a greater dependence on intangible ones, such as patents and brands, which are harder to copy and easier to parlay into more income. Simply put, an automaker needs to build more cars and plants to boost sales, whereas Mark Zuckerberg only had to create one Facebook.

The world’s biggest tech companies have broadened their focus, however, setting 11-figure capital expenditure budgets, largely for the chips and data centers used to develop artificial intelligence. For now, their core businesses are so profitable that CEOs including Alphabet’s GOOGL.O Sundar Pichai can pull off these herculean investment feats while still rewarding shareholders. Google’s owner just unveiled a third $70 billion stock buyback program in as many years and boosted its annual dividend by 5%, all the while sticking to a $75 billion capital expenditure plan for 2025.

Others have joined the spending splurge, too. Alphabet, Amazon.com AMZN.O, Meta Platforms META.O and Microsoft are on track for about $320 billion in capex this year, or 13 times more than a decade ago. The quartet’s aggregate invested capital will be $1 trillion in 2025, which also represents a 13-fold increase over 10 years, according to Visible Alpha data. The figure sums up the cost of all the assets a company uses to run its business, or its total funding since inception. Past purchases of equipment and the like feature prominently.

The quantum is less concerning than the ballooning amount of money it takes to produce $1 of revenue. In 2015, for example, Meta’s capex equaled 14% of its sales. The proportion is projected to more than double this year to around a third of revenue, about the same as for chipmaker Taiwan Semiconductor Manufacturing 2330.TW.

At Microsoft, the change is even more dramatic. For most of its existence, the company behind the Windows operating system was defined by large profit and low upfront spending: capex equaled roughly 10% of sales as recently as 2021, just before ChatGPT prompted an AI explosion. Microsoft’s invested capital that year was almost $80 billion according to Visible Alpha, while net operating profit after tax was about $65 billion, for a handy 80% return on invested capital, a financial measure favored by investors including Warren Buffett.

Since then, CEO Satya Nadella has boosted capex to almost a quarter of sales, based on Wall Street forecasts for the calendar year. It's closer to a third after including the amount ploughed into capital leases. All that spending is lifting Microsoft’s invested capital to an unprecedented level. There’s about $290 billion penciled in for 2025, based on analyst forecasts, alongside $110 billion of post-tax operating profit. The upshot is that even though profit has surged, returns will tumble to less than 40%.

With Microsoft now hurtling toward more than $500 billion of capex over five years, future income will have to be truly gargantuan to justify the outlay. It will be a long climb. Nadella said in January that its AI business, which includes parts of Azure and 365 Copilot machine-learning services, was generating just $13 billion of revenue on an annual basis.

The upside is tantalizing, and extends beyond enhanced cloud computing services, human-like chatbots and advertising income. What if AI replaces 10% of the workforce? It would potentially translate into an epic windfall for Microsoft, Alphabet and its mega-peers. The longer the capital outlays take to bear fruit, however, the bigger the deferred profit will have to be. And there is also a chance the hype will fizzle out and leave heaps of squandered spending in its wake.

It’s a chance Big Tech CEOs may need to take. “Part of the capital intensity is an existential reality that these big companies either must invest or risk not growing,” says Tony Kim, a BlackRock managing director who leads the money manager’s fundamental equities technology group.

Timing will be an important element. All the cash being spent on building and powering colossal server farms will soon turn into depreciation and amortization expenses that erode profit. If the financial rewards don’t start accruing, too, investors might get restless. Alphabet, Amazon, Meta and Microsoft, which together account for more than $8 trillion of market capitalization, trade at an average of 21 times expected 2026 earnings, per Visible Alpha, a nearly 20% premium to the broader market.

Technology may retain a prime position in many investment portfolios on a relative basis, but the gap also could easily narrow. Among 2,200 companies separated into five groups by their degree of capital intensity, the most asset-dependent quintile generated the weakest returns across multiple time periods, according to one investor study. Businesses also tend to be rewarded with a higher valuation when their returns on invested capital far exceed the costs of capital, according to separate research from Michael Mauboussin of Morgan Stanley’s Counterpoint Global.

It’s possible that the headlong rush to set up infrastructure for an artificially intelligent world will turn out better than, say, the value-destructive race 30 years ago to accommodate an explosion in internet traffic. Even a clunky AI model, however, would probably be skeptical.

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CONTEXT NEWS

Microsoft said on April 30 that its capital expenditures including finance leases were $21.4 billion in the quarter ending March 31, slightly lower than it expected because of the variable timing for data center leases. The company added that it anticipates capex to increase in the current three-month period, and that it was not changing its earlier half-year guidance.

“We expect capex to grow,” CFO Amy Hood said, according to a transcript of a call with analysts posted on the company website. “It will grow at a lower rate than (fiscal year 2025) and will include a greater mix of short-lived assets which are more directly correlated to revenue than long-lived assets.”

(Editing by Liam Proud and Pranav Kiran)

((For previous columns by the author, Reuters customers can click on GOLDFARB/jeffrey.goldfarb@thomsonreuters.com))