Hardware is Eating the World

By Johnny Russell, CFA

“While the hardware and software layers in technology are mutually dependent, the location of talent and resources across their respective ecosystems is not static.”

In 2011, Marc Andreesen famously wrote that “software is eating the world”. It’s a fun article to read 13 years on. Consider just how voracious software’s appetite has been over the past couple of decades:

• Amazon developed the now indispensable software layer for retail shopping;
• Google organized the world’s information and upended the advertising economy in the process;
• Salesforce pioneered the delivery of Software-as-a-Service (SaaS), paving the way for entirely new business models to be deployed over the internet;
• Social media companies connected billions of people around the world;
• Netflix stole hundreds of millions of eyeballs from legacy cable and media companies;
• Entirely new modes of commerce like Airbnb and Uber were developed on mobile software applications.

Software companies are wonderful businesses from the perspective of an investor. They are traditionally “asset-light” and require very little capital to grow. They have healthy margins and generate lots of cash. The software subscription model makes those cash flows steady and predictable. Quite simply, owning a great software business (when purchased at a reasonable price) can be a beautiful thing.

Over the last 30 years, there have been a handful of major leaps in technological advancement thanks to the unique contributions of both software and hardware:

• The internet revolution that kicked off in the early 1990s
• The mobile revolution of the mid 2000s
• The cloud revolution of the 2010s

Over the last 18 months, rapid advancements in large-language models (LLMs) and artificial intelligence (AI) have, arguably, catapulted us into the next era of computing that promises to change markets and society in profound ways.

For each of these leaps in digital innovation, there is a consistent theme of both hardware and software pushing and pulling each other forward:

• The initial internet revolution of the 1990’s was also a story about telecom companies rapidly building real-world infrastructure for high-speed broadband alongside the internet economy.
• The subsequent mobile revolution would not have been possible without major advancements in battery technology, touchscreen displays, and 3G wireless broadband that gave birth to the iPhone and the “app” economy.
• Cloud computing conjures images of data and software code magically bouncing around in the sky, but the reality is that the “cloud” is just a bunch of big data warehouses (full of hardware) physically located on solid ground.

More recently, advancements in semiconductor technology laid the groundwork for the budding revolution in artificial intelligence. While machine learning and various forms of AI have been in use for decades, it is the latest generation of GPUs (graphical processing units), pioneered by companies like NVIDIA, that have allowed for large language models to train on incomprehensible amounts of data more efficiently and effectively.

Andreesen’s 2011 article about software gobbling up the world preceded a period in the stock market from 2015 to mid-2020 when software companies handily outperformed hardware companies on a relative basis. Interestingly, hardware companies have now outperformed software companies on a relative basis over the last four years.

While the hardware and software layers in technology are mutually dependent, the location of talent and resources across their respective ecosystems is not static. Higher economic profits may accrue to either the software or hardware side at different points in time, and then the cycle eventually resets as technological progress stalls and/or overinvestment leads to excess capacities in the market.

In some ways, we can look at the success of software companies in the 2010s as a necessary catalyst for the impressive growth in hardware businesses over the last few years. Software companies have huge cash flows to invest in “the next big thing”, and at this stage of the cycle, that means companies like Microsoft, Google, and Meta buying a lot of GPUs from companies like NVIDIA to build out new data centers and train advanced AI models.

What’s particularly interesting about this cycle is that the lines are blurring between the players on each side of the hardware vs. software stack. While we would typically think of Microsoft as a software company that operates a “capital-light” business model, they are starting to resemble a capital-intensive infrastructure company thanks to the investments they are making into hardware on their own balance sheet.

Consider this: Microsoft’s capital expenditures eclipsed Exxon Mobil’s (XOM) in 2020. In the last twelve-month period, they invested $18 billion more than Exxon back into property, plant, and equipment. If that’s not a sign that hardware is currently eating the world, I don’t know what is!

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