AI high-stakes bet faces earnings "cash flow stress test": Microsoft Corporation (MSFT.US) favored, with both it and Alphabet (GOOGL.US) CDS hitting records

Since their last earnings reports, Microsoft Corporation (MSFT.US) and Alphabet (GOOGL.US) share prices have diverged, with Wall Street increasingly focused on the drag of massive AI spending on corporate earnings. The two tech giants will report results after Wednesday's US market close, and recent market trading shows investors favoring Microsoft Corporation: since its July 29 earnings showed cloud business growing at the fastest pace in four years and triggered its best single-day performance since 2008, Microsoft Corporation shares have surged 36%; while Alphabet has fallen 6.3% since its July 22 earnings, when a sharp increase in AI capital expenditure turned free cash flow negative. The market expects Alphabet Inc. Class C's parent company to post negative free cash flow in 2026 and 2027, while Microsoft Corporation's free cash flow is expected to decline in the current fiscal year (ending June) before recovering in the foreseeable future. "Companies that can demonstrate they are generating cash for shareholders have an advantage in this market over those that can't," said Luke O'Neill, portfolio manager at Catalyst Dynamic Alpha Fund. "That's why Microsoft Corporation has outperformed other hyperscalers over the past few months. It has shown a better ability to navigate this spending-and-returns environment." Traders are seeking hedging protection in case massive AI spending fails to deliver returns. The price of Alphabet's five-year credit default swaps (CDS) hit a record, rising 16% this month. Microsoft Corporation's five-year CDS also hit a record, rising nearly 9% in October and on track for a fifth consecutive monthly increase, the longest streak on record. Both stocks have underperformed the broader market this year: Microsoft Corporation is up 9.9% and Alphabet is up 2.4%, while the S&P 500 is up 13% and the tech-heavy Nasdaq 100 is up 17%. When judging the two companies' spending, investors will focus on their cloud computing business growth, which is typically seen as a proxy for AI-related demand. "Seeing further acceleration in cloud growth would be very reassuring, because it would strengthen investors' confidence in their AI investments," said Ted Parrish, chief investment officer at Parrish Capital. He holds Microsoft Corporation shares and is considering adding to his position. Earlier this week, Anthropic PBC's IPO filing highlighted the AI giant's deepening reliance on cloud giants. Anthropic committed to spending at least $114 billion with Alphabet Inc. Class C and about $45 billion with Microsoft Corporation over the coming years, regardless of whether it uses their compute capacity. It also committed to spending $110 billion with Amazon.com, Inc. through 2036; Amazon.com, Inc. will report earnings on Thursday. The market consensus expects Microsoft Corporation's Azure cloud business to grow 45% at constant currency. TD Cowen analyst Derrick Wood wrote in an October 14 report that Azure has the potential this quarter to "beat by a wider margin than normal," because third-party data showed its "screening results were the strongest in history." For Alphabet, Alphabet Inc. Class C cloud third-quarter revenue is expected to be about $29 billion, up 91% from about $15 billion a year earlier and further accelerating from 81% growth in the second quarter. "Monetizing this is becoming clearer," said Dan Sheehan, director of portfolio management at Telos Wealth Advisors. "We're starting to see incremental returns, although that doesn't ease the pressure on its balance sheet." If the two companies disappoint on cloud growth or fail to demonstrate that spending is generating returns, their shares could suffer as Meta Platforms did after last week's earnings. Although Meta showed several encouraging trends, its plan to raise future spending commitments by $125 billion to $825 billion overshadowed those highlights and sent the stock down 7% the next day. "Right now, the fear gauge is clearly highly alert to all these spending and ROI questions," said Catalyst's O'Neill. Microsoft Corporation "benefits from its focus on that discipline." Analysts expect Microsoft Corporation's capital expenditure to exceed $190 billion in fiscal 2027, up 65% from about $116 billion last year. Its free cash flow is expected to be less than $32 billion in fiscal 2027, down from $67 billion last year, before rising to $47 billion in fiscal 2028 and $87 billion in fiscal 2029. Consensus estimates show Alphabet's 2026 capital expenditure is expected to more than double from last year's $91 billion to $202 billion. As a result, the company is expected to generate negative free cash flow of $3.6 billion this year and negative $30 billion in 2027, turning positive in 2028. In 2025, its free cash flow was positive $73 billion. "I'm not worried about Alphabet having negative free cash flow," Sheehan said. Given the durable growth of these mega-cap tech companies, he sees it as a safe haven in the market. "If it wanted to, it could stop spending somewhere and cash flow would suddenly come back."