Microsoft Shows the Mag7 What AI Investment Looks Like

0:01Tyler Crowe:Two stocks diverge on an earnings day. Today, on Motley Fool Hidden Gems Investing.

0:09Tyler Crowe: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 Matt Frankel. It is the depths of earnings season, so we're going to try to hit as many companies as we can in what we would call a relatively short show that we have here. We're also going to hit some earnings questions. And we want to start with earnings, especially with the two Magnificent Seven companies that happened to report after the close yesterday, and that's Microsoft and Meta. And guys, there was some pretty large divergence between what the market thought of those results.

0:41Tyler Crowe:As we're taping right now, shares of Meta are down about 8.8%, while Microsoft is up a whopping 15%. Now, last quarter and throughout the show, we have kind of discussed metas. What is all this spending for? Question quite a bit. But what stands out to me, kind of in the stark contrast of these two earnings reports, is that Microsoft is the first major AI CapEx spending company to announce earnings and see a positive earnings reaction in the quarter. Is this just like a one-time blip? Like, yeah, things look nice comparatively? Or is there some sort of through line here that shows Microsoft is doing the right thing, while others, you know, as we discussed previously with Alphabet and here with Meta, that they're making riskier bets?

1:27So, yeah, I'm not at all surprised to see Microsoft spike like it is after earnings. I mean, it isn't the only major AI CapEx spender, like you said, to report solid earnings and accelerating growth in the right ways. I mean, Google or Alphabet reported that Google Cloud revenue was accelerating as well, and that stock fell right after earnings. Microsoft's Azure revenue accelerated to 43 % growth in the first quarter, but it's also showing a clearly solid ROI on that CapEx you're mentioning without having to constantly increase these like eye-popping numbers. I mean, Microsoft actually trimmed, we haven't heard that word, trimmed its full year CapEx projection a little bit in this quarter.

2:10I mean, now it's an accounting change mostly related to how long they assume the useful life of their AI data centers are. But it's still like a welcome reduction in a sea of companies that just seem to not be able to announce enough spending. Speaking of not being able to announce enough spending, Meta's story was kind of the opposite here. I mean, Meta missed estimates for profitability, kept its Q3 revenue guidance the same, and didn't do anything to reduce its CapEx forecast, which a lot of investors were kind of thinking they might. it isn't showing investors yet that their money is being well spent.

2:45Now, to be totally fair, we've said before on these shows that Meta is great at one thing, social media advertising. That business is still growing very strong, but it's not what the bulk of their money is being spent on. And that's what's concerning people. Right.

2:59Lou Whiteman:The whole AI trade is basically suffering right now due to one question. And Microsoft did a better job of answering the market's biggest question than anybody else has. It's really that simple. With Meta, the spending is continuing. Guidance for revenue is eh. But there is no answer to the question of when sales growth from all of the spending will emerge or how this all ends with a rosier future. Where is the pot of gold? Microsoft, meanwhile, reminded the market of what a diversified business looks like. They saw strong software results, strong Azure AI expansion, real growth across the business.

3:37Lou Whiteman:It isn't really about this quarter's business for any of these companies in the stock reaction. It's about the narrative about what the business will look like in two years due to all of this AI excitement. And Microsoft just presented a much better, clearer picture of the future.

3:53Tyler Crowe:and the market's rewarding it. So as we've been, we and other investors have been assessing the, we'll call it like the best of the cloud hyperscalers or the best investors in AI right now. Microsoft has never, I haven't seen it really out in the lead. I think last year, the big narrative was Google was winning the race. Apple was falling behind. And at some various point, one company was doing the best of the other. But if we were to look at Microsoft stock, prior to today's jump, basically before the market opened, that stock was more about the same as January of 2024. So it's been a up and down, but at the same time, hasn't really done much in terms of performance for investors.

4:38Tyler Crowe:And some of that's with the concerns of CapEx, some of it was that very question about ROI and stuff like that. But today, after this earnings report kind of showing that, you know, answering the question to your point, Lou, shares of Microsoft are trading about 25 times trailing earnings. Based on that, based on where the stock has gone and where it kind of has positioned itself in this AI race, it kind of begs the question to me, is Microsoft now like the best bargain stock among like the Mag7 companies out there?

5:13Lou Whiteman:Yes. I mean, to me, Microsoft and Alphabet are the only two Mag7s that really interests me right now. And Microsoft has a better multiple. So yeah, my answer is yes. Both of these companies are, again, don't want to sound like a broken record, but there's just a lot more ways to win with these guys than there are. Most of the Mag 7 are just very, very good at one thing. Microsoft and Alphabet stand out to me as diversified bets. Yeah, I mean, I completely agree with what Lou just said, that Microsoft and Alphabet are the two most attractive in the Mag7. I mean, if you're just looking at a purely PE basis, video looks kind of cheap, especially relative to that growth rate that it's posting.

5:52But I have more questions about the growth sustainability than I do with Microsoft. Like Lou said, they do one thing really, really, really well. Microsoft grew revenue by 18 % year over year. It's not an eye-popping number like NVIDIA is producing. And the most important part of the business, that AI cloud revenue, is accelerating. And like you said, the stock's trading for about 25 times earnings today. I would actually argue that Microsoft is also probably the most bulletproof business in the Mag7, even ahead of Alphabet, given that enterprise software moat that it has. There's no moonshot story that it's depending on, like robo-taxis, like chip pricing power staying at historically elevated levels or anything like that.

6:31It's just a solid business with a rare combination of a relatively low valuation and growth that's accelerating in

6:39Tyler Crowe:all the right ways. There's something else to be said about Microsoft and Google not exactly shelling out hundreds of billions of dollars to guarantee revenue for some of its clients. So, you know, maybe a little bit less of that. Hey, is this circular revenue thing going to be a problem or not with these two as well? So kind of a little bit of the story here looks a little bit more complete, a little bit more assured than some of the other things that happen to be going on at the other ones. Coming after the break, we're going to do a lightning round of earnings, mostly related to stocks that we consider in the hidden gems universe.

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8:08Tyler Crowe:So when you hear the term hidden gem, you obviously probably think that we're talking about companies nobody's ever heard of or really obscure stocks, those things that are just kind of hiding in the markets. But we have a little bit more of an approach of sometimes there are businesses that have hidden assets, hidden appreciation that can even be well-known companies. And in the terms of The Motley Fool, the hidden gems universe can span a lot of the member services that we have in terms of recommendation services and things like that. So I kind of call it like the extended universe of hidden gem stocks because there's a lot of services that apply these hidden gem principles.

8:43Tyler Crowe:And what we're going to do now is do a quick lightning round of companies that have basically reported earnings in the past 24 hours or so that have shown some relatively large moves or something that really excited us. So I asked you guys before the show here to pick two, and we're just going to go back and forth. Matt, The first one you picked was MasterCard, and shares are up 2.5 % after earnings reports. Yeah, not exactly a hidden company, as you just mentioned, but it's a company that often gets overlooked as, say, a legacy financial. And it's really not. They're investing heavily in stablecoins, for example.

9:16They're owning the rails in that area of financial infrastructure. The cross-border payments continue to grow. They just posted a pretty solid beat on both the top and bottom lines. Operating margin expanded by 150 basis points. And MasterCard and Visa are both very high margin businesses. A lot of people don't realize just how high the net margins on these companies are. The payment network revenue grew by 10 % year over year, well ahead of inflation. So it's not just inflation driven or anything like that. Cross-border activity was surprisingly strong, given that the Iran conflict continues to pressure that.

9:49So it was a very solid quarter. Nothing terribly surprising. MasterCard is just an excellent long-term compounder, has been for years. And this quarter was just really further proof of that.

10:01Tyler Crowe:Lou, probably hidden gems more in the traditional sense, because I'm sure not as many listeners have heard this company as well. But Shares of MCOR, Electrical Mechanical Contractor, very much associated with the AI infrastructure build-out. That stock's up 19 % after reporting earnings this morning. Yeah.

10:19Lou Whiteman:Glass half full or glass half empty here, Tyler? Because yes, it's up almost 20%, but it's also just back to the same price it was trading in an early to mid-July. So pick your narrative here, right? The narrative going into earnings was picks and shovels AI trade was under pressure. We have questions about data center spending. We have questions about how sustainable it is. And Amcor, which as you say, is a construction company that is up 500 % over the last few years, thanks to data center construction spending, was feeling the pressure. So coming to earnings today, they topped expectations.

10:51Lou Whiteman:More importantly, they raised full year guidance. So the takeaway here, I think, is the sky is not falling, at least not yet. And so the stock is reacting by taking back what it had given up in the few weeks leading up to this. Good to see. I don't want to get too excited about up 20 % given that it's just a round trip, but good to see kind of the pressure reversing post earnings.

11:13Tyler Crowe:For all the fitness enthusiasts out there probably may be wearing a Garmin watch. shares are down 1.5 % today, but they reported yesterday and shares were up 17%. And a move like that, we did want to at least highlight it because, hey, that's a big move. And I'm sure there's a lot of investors that are excited about that, Matt. Yeah. And it is a kind of a hidden company in a way. People who don't wear Garmin watches often think of this as just a company that used to make their navigation system for their car. But they've done a tremendous job with fitness smartwatches. Just the differentiation of that product line, they make, for literally every outdoor hobby you might have, they make a different purpose-built smartwatch for.

11:55They reported an absolute blowout quarter. Revenue and earnings were both, were up 11 % on revenue, 29 % on earnings. Earnings came in 20 % higher than expected. The operating margin improved by over four percentage points in the quarter. That fitness segment grew by 25%. That was the real highlight. But guidance was really what stood out to investors. I mean, management raised guidance significantly for both revenue and earnings in the third quarter, for the full year rather, and not just to reflect those excellent second quarter numbers. So they're expecting higher earnings and higher revenue than the market thought they would for the rest of the year as well.

12:32And management flagged higher memory costs. We've talked about companies like Micron and just how big the memory bottleneck is as a headwind for the second half of the year. And in my opinion, that makes Garmin's expectations even more impressive.

12:47Tyler Crowe:And coming, rounding out for the last one, we have L3 Harris, one of the, what should be in theory, one of the biggest beneficiaries of rebuilding America's munitions after a round of wars in Iran and in Ukraine. But the stock didn't exactly reflect that with it's down about 10 % after earnings today, Lou.

13:08Lou Whiteman:Right. Yeah. Yeah. And look, this was down 10 % after beating on the top and bottom line, raising its full year guidance and reporting a record high backlog of$42 billion in future business. So why is the stock down? For one, they're delaying the plan spinoff of their Missile Solutions unit until 2027, basically due to choppy market conditions. They claim it's nothing to do with the company. It's just this isn't when they want to float an IPO. The market really likes that spinoff, and so do I. So I think that's kind of hitting at the stock. And at the same time, they are continuing with the CapEx to boost missile production.

13:44Lou Whiteman:They're going to spend now for that business, but they aren't going to get the payoff. I think that's good business, but it does hurt the near term. There's also a bit of margin pressure on the space side. That tends to be choppy quarter to quarter. I see nothing that's worrisome. I think they are a big winner from space and munitions and a lot of the trends. But look, defense businesses tend to be choppy quarter to quarter, and we're certainly seeing that today.

14:07Tyler Crowe:All right. So we got four companies here. MasterCard, MCOR, L3 Harris, and Garmin. All of them, I was just checking, all of them trade somewhere between 22 and 33 times earnings. So it's not like there's a huge disparity in terms of valuation from one or the other. Guys, if I had to put you on the spot right now, which of these four companies looks the most attractive to you? I'd have to go with Garmin here. I mean, it's impressive execution quarter after quarter recently. Yeah, I look, I own L3 Harris.

14:33Lou Whiteman:So I'll do MasterCard, I guess, and say on L3 Harris. All right.

14:39Tyler Crowe:I own it, but I think I'll go with the other one. That's that's a diversification. Fair enough. All right. Coming after the break, we're going to hit the mailbag.

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16:21Tyler Crowe:Hey, y 'all. As always, a quick reminder, if you want to get an email into us and have it read on air, go ahead and email us at podcastiffool.com. That's podcast with an S at fool.com. The email is also in the description. The three requests we always have is, number one, keep it foolish. Two, keep it short. And number three, make sure that it's not personalized advice so we don't get in any trouble. Today's question comes from Ben from Sacramento. And his question is, Hi, Fools. As always, appreciate your insight on the nature of the stock market. How would you approach the idea of owning two companies that operate in the same space and may even rival each other?

16:53Tyler Crowe:And the examples he gave are Caterpillar and Deere, Home Depot and Lowe's, NVIDIA, AMD. Do you think it's best to call your shot on one company outperforming the other, or is it okay to own both, potentially mitigate the upside by doing so? Thanks. And, you know, I find this interesting because several years ago and several hosts ago, Matt, you, Jason Mothership, put together a thing called the War on Cash Basket. And I think it was one of the more popular topics that we had on the podcast several years ago was building baskets of stocks based on kind of themes. And it's kind of the theory here is, is it better to build baskets of themed ideas or, you know, go, as Ben says, shoot your shot on a single company?

17:35Lou Whiteman:Yeah. So for me, I don't know, it's going to kind of be a weird answer because I don't have a rule here because I don't think of investments in this way. Kind of. I'm not too worried about diversification in my stocks. I have a lot of index funds and that's my diversification. So when I buy stocks, I'm buying the best ideas. And if the best ideas are tied to some trend that's going to affect multiple companies, and that means I'm buying two companies that compete, I'm fine with that. But if it's, I like this one company because of what they're doing, I'm probably just going to be one company. For me, this is more about the opportunity you see than picking a winner in the category.

18:12Lou Whiteman:I have zero issue with buying like a Lowe's or Home Depot if I wanted to get into there or something like that. But I'm also not necessarily looking to just like, okay, I need big box retailers. And so I need to check this box by a couple. So it's just not the way I'm thinking of investing. Yeah, I mean, for me, the key question here is whether you're more confident in picking a winner or investing in a trend. Like, Lou's talked about Rocket Lab on the show before. That's clearly a case of picking a winner rather than just buying a space ETF. But look at the war on cash basket that Tyler just mentioned.

18:51For those who weren't listening years ago, it included both Visa and MasterCard, which have both performed incredibly well. But it also included PayPal, which has not. So the basket approach served investors well here because the trend was directionally correct, but not every company that was a leader then is still a leader. If the pie is growing, there's not necessarily a need to figure out who is going to get the bigger slice of the pie just to invest in the trend. But the listeners also write that you're trading away potentially some of your upside by trying to nail down a winner. But you're also helping to limit your downside risk if you're wrong.