Don't count out Gen-AI's software.

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Instagram Group Join Now – A number of high-profile software companies offered weak future guidance during last quarter's earnings season, but Goldman Sachs advises investors to avoid the excitement surrounding Gen-AI. And don't rule this sector with enthusiasm.

The influential investment bank noted exceptional strength for a number of software companies in their fourth-quarter 2023 results, which is in line with expectations of rate cuts and lower inflation. Those expectations changed sharply in the first quarter of 2024.

Oracle (NYSE: ) and Adobe (NASDAQ: ) offered reasonably healthy numbers last week, but the likes of Snowflake (NYSE: ) recently posted disappointing first-quarter product revenue forecasts. That consumers will cut back on spending in an uncertain economy.

The news came despite accelerating hyper-scalar growth, raising questions about whether the issues driving weak demand are cyclical or structural.

Hyperscalers are large cloud service providers, which can provide services such as enterprise-scale computing and storage, and include Microsoft (NASDAQ: ), Alphabet's (NASDAQ: ) Google and Meta Platforms (NASDAQ: ).

The gap between hyperscalar acceleration and deceleration in enterprise software has been remarkable, Goldman Sachs analysts said in a June 3 note, because hyperscalar creative artificial intelligence will require substantial additional capital to generate revenue. I have been successful. (Gen-AI)

“We estimate incremental capital expenditures on top of regular cloud CapEx to be in the $60 to $80 billion annual run rate. This adds to estimated Gen-AI revenue in the $14 to $16 billion range. ” said Goldman.

The global software industry is now worth $700 billion and is one of the largest capital intensive commodities, if not the largest, making it prone to high capital costs.

The bank added that it is a reasonable case that new AI priorities have pushed aside consideration of more mature well-established expenditure items. Software has always been about productivity and now a cognitive aspect has been added, resulting in changes to the value proposition and sales cycle.

This raises the question of whether hardware is finally disrupting software, while software has dominated for most of the past decade.

To answer this, Goldman points out that tech cycles follow a pattern – first, the cycle is about building infrastructure. Then there are the platforms that allow optimal use of this infrastructure, while providing the building blocks to build next-generation applications, and the final step is building the applications.

“For any tech cycle to be successful, a killer application,” Goldman said, referring to enterprise resource planning in the late '90s, search and e-commerce during the dot-com bubble, and cloud applications after the Great Must be.” financial crisis.”

“In each of these cycles value creation started at the infrastructure layer and moved into platforms and applications,” Goldman said. “In terms of generative AI, we're still waiting for a killer application or something that can deliver massive results for different end-user domains, whether it's front office, middle office or back office.”

Although the pace of Gen-AI technology continues to evolve, it is not to the point where killer applications are evident today.

A major difference in this cycle of generative AI is that while the client server incumbents of the previous era were slow to adopt the cloud, this cycle is the responsibility of application software, whether Salesforce (NYSE: ), SAP (ETR:), be Oracle. , ServiceNow (NYSE: ), Adobe, Intuit (NASDAQ: ) or Workday (NASDAQ: ), are developing Gen-AI products with a strong sense of urgency.

Furthermore, data will be a critical factor for the success of an AI company, and the data incumbency advantage achieved by companies such as Salesforce, Adobe, Intuit, ServiceNow, and Snowflake cannot be taken lightly.

Application software companies are trading at cyclically depressed valuation multiples, the bank said, and this is a relevant time.

Goldman Sachs said, “We believe that in the short term, the cyclical aspects of higher rates, if mitigated, will ease the buying cycle and hence the demand picture for the group in the coming quarters. Gotta get better,” said Goldman Sachs.

Companies that take creative AI technology architecture more seriously and are willing to thoroughly test and re-architect their platforms will be successful.

Nevertheless, a surprising amount of shareholder value creation from 2010 to 2020 came from incumbent software companies such as Adobe, Microsoft, Intuit, and Autodesk (NASDAQ: took over and surprised investors.

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