Citi's Bailin says Amazon, Microsoft, Alphabet undervalued as AI spend hits $673B

David Bailin argues Amazon, Microsoft and Alphabet are undervalued as investors underestimate the long-term impact of AI adoption on earnings.

"Investors are overestimating near-term earnings expectations and underestimating the long-term adoption cycle of AI," David Bailin, chief investment officer at Citi Global Wealth, said.

The Magnificent Seven now trade at their cheapest valuation relative to the S&P 500 in more than a decade, with the price-to-earnings premium narrowing to about 10% from above 30% for most of the 2020s, according to Morgan Stanley. Amazon's forward P/E of 25.98X exceeds the Internet-Commerce industry average of 21.95X, yet the stock carries a Zacks Rank #2 (Buy) as AWS revenue reaccelerated 28% to $37.6 billion in the first quarter. Microsoft and Alphabet face similar dynamics: heavy AI capital spending is compressing near-term free cash flow even as cloud revenue growth accelerates.

The thesis carries implications for the broader AI trade. Hyperscaler capital expenditure is projected to rise 76% this year to $673 billion, according to UBS, before growth slows to 25% in 2027 and 6% in 2028. Some active managers have already reduced chip exposure and added hyperscaler shares, betting that a deceleration in infrastructure spending will benefit the companies funding the buildout.

Bailin's call aligns with a growing divergence between chipmakers and the cloud giants that buy their products. Nvidia, Micron, Broadcom and Applied Materials are expected to generate a record $430 billion in combined free cash flow over the next 12 months, according to Bank of America, more than triple the level of two years ago. By contrast, the combined free cash flow of Amazon, Alphabet, Meta, Microsoft and Oracle is projected to turn negative for the first time on record, a reversal from the $260 billion peak in 2024.

Amazon's AWS business remains the centerpiece of the bull case. Cloud revenue grew 28% year over year in the first quarter to $37.6 billion, the fastest pace in 15 quarters, as enterprise customers increased generative AI workloads on Amazon's Bedrock platform. Bedrock customer spend climbed 170% quarter over quarter, and Amazon's custom silicon business, spanning Trainium and Graviton chips, crossed a $20 billion annual revenue run rate. The company's record Prime Day generated $26.4 billion in U.S. online sales, reinforcing consumer resilience heading into the second half.

The valuation discount reflects investor skepticism about the return on roughly $200 billion in planned 2026 capital expenditure at Amazon alone. But Bailin argues the spending is demand-backed rather than speculative, pointing to signed compute commitments that underwrite future revenue. UBS estimates total hyperscaler capex will approach $900 billion by 2028, though the pace of growth is expected to moderate sharply after this year.

For holders, the message is one of patience. If AI adoption follows the trajectory Bailin expects, current valuations will prove conservative as earnings catch up to the infrastructure buildout. The next test comes in late July, when Amazon, Microsoft and Alphabet report second-quarter earnings and provide updated capex guidance.

This article is for informational purposes only and does not constitute investment advice.