Some investors are questioning the scale of capital expenditures by tech giants on artificial intelligence, sparking concerns over profit margins and the risk that depreciation costs could weigh on stock prices before companies see a return on investmen

Jim Morrow, founder and CEO of Callodine Capital Management, said: "On a cash flow basis they've all stagnated because they're all collectively making massive bets on the future with all their capital. We focus a lot on balance sheets and cash flows, and so for us, they have lost their historically attractive cash flow dynamics. They're just not there anymore."

According to compiled data, Alphabet, Amazon, Meta, and Microsoft are projected to spend $311 billion in capital expenditures this fiscal year, rising to $337 billion by 2026. First-quarter spending surged more than 60% year-over-year, while free cash flow plummeted 23% over the same period.

Morrow warned: "There is a tsunami of depreciation coming." He is avoiding these stocks, believing profits will deteriorate without corresponding revenue growth.

Much of the spending is directed toward semiconductors, servers, and networking equipment - critical for AI computing. However, these assets depreciate much faster than long-term assets like real estate.

Combined depreciation expenses for Microsoft, Alphabet, and Meta totaled $15.6 billion in Q1, up from $11.4 billion a year earlier. This includes Amazon, which allocates more cash to capex than stock buybacks or dividends, and the figure nearly doubles.

The AI Rebound

Still, given tech giants' dominant market positions, strong balance sheets, and profit growth that - while slowing - still outpaces the rest of the S&P 500, investor enthusiasm remains high. This explains the recent surge in AI-related stocks.

Since April 9, when former President Donald Trump suspended global tariffs - triggering a market rally - the largest AI-focused ETF (Global X Artificial Intelligence & Technology ETF) has surged 34%. Meanwhile, AI chipmaker Nvidia soared 49%, Meta climbed 38%, and Microsoft rose 33%, all outperforming the S&P 500's 21% gain and the tech-heavy Nasdaq 100's 28% rise.

However, as more depreciating assets hit balance sheets, the drag on net income will pressure these companies to demonstrate higher returns on investment.

Tackling the Depreciation Problem

This is why depreciation was a recurring theme in Q1 earnings calls. Alphabet CFO Anat Ashkenazi warned that these costs will rise throughout the year, adding that management is trying to offset non-cash expenses by streamlining operations.

"We're focusing on continuing to moderate the pace of compensation growth, looking at our real estate footprint, and again, the build-out and utilization of our technical infrastructure across the business," she said during Alphabet's April 24 earnings call.

Other companies are taking similar measures. Earlier this year, Meta extended the useful life of certain servers and networking assets from 4-5 years to 5.5 years. The change boosted Q1 net income by approximately $695 million, or $0.27 per share, according to a filing.

Microsoft made a similar move in 2022, extending server and networking equipment lifespans from 4 to 6 years. When asked on the April 30 earnings call whether efficiency gains could prompt another extension, CFO Amy Hood said such decisions depend more on software than hardware.

"We like to have a long history before we make any of those changes," she said. "We're focused on getting every bit of useful life we can, of course, out of assets."

Amazon, however, went in the opposite direction. In February, the e-commerce and cloud giant shortened the useful life of similar equipment from 6 to 5 years.

The Big Risk: What If AI Spending Doesn't Pay Off?

For Callodine's Morrow, the biggest risk is what happens if AI investments fail to drive significant revenue and profit growth. A similar market shock occurred in 2022 when shrinking profits and rising interest rates triggered a tech selloff, dragging down the S&P 500.

"If it works out it will be fine," said Morrow. "If it doesn't work out there's a big earnings headwind coming."