Macro: Sandcastle economics
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Alphabet and Microsoft earnings beat; Meta earnings on tap
Peter Garnry
Chief Investment Strategist
Summary: Microsoft and Alphabet earnings releases last night confirmed that mega caps are able to thrive in an environment of uncertainty and slowing economy. Microsoft in particularly delivered strong results fueled by rising demand in its cloud business Azure which is also expected to grow 26-27% in the current quarter. However, Microsoft is not winning every game and today the UK anticompetition regulator blocked the company's acquisition attempt of Activision Blizzard. Finally, we also preview tonight's earnings from Meta where investors are hoping to see Mark Zuckerberg doubling down on cost-cutting and reducing investments on its metaverse bet.
Will Mark Zuckerberg kill the Metaverse?
Mark Zuckerberg’s epic bet on the Metaverse which involved a company name shift from Facebook to Meta and considerable increase in capital expenditures came at the worst possible time. 2022 became a nightmare year for US technology companies as the Fed began hiking interest rates causing technology stocks to correct. The reopening economies also meant a shift in consumer behaviour towards consuming services rather than goods and that meant subsequently that online advertising growth slowed down dramatically. To make things worse for Meta, the new data privacy changes from Apple eroded pricing power on online advertising. The FY23 expectations for EBITDA went into a freefall declining from around $90bn in October 2021 to just $48bn in October 2022.
The bold bet on metaverse got some initial traction but throughout 2022 it became evident that Meta had difficulties muster excitement among consumers and the adoption was incredibly low. By late 2022 Mark Zuckerberg for the first time admitted wrongdoings and started laying off a lot of employees in combination with reducing the company’s planned investments in the Metaverse. At this point the stock hit $89 down 76% from its peak in September 2021. This would turn out to be the bottom for Meta and the stock price has since recovered to $207 and expectations for EBITDA this year have risen.
In tonight’s Q1 earnings releases investors are looking for two things. Improving operating margin due to cost cutting and this should ideally carry into the Q2 and 2023 outlook. The earnings release from Alphabet (Google’s parent company) last night confirmed the online advertising market is in better shape than feared, so this bodes will for Meta tonight. Secondly, investors are hoping that Mark Zuckerberg will announce an even bigger reduction in capital expenditures related to the Metaverse. He might not go aggressive, killing the idea of the Metaverse, but just signalling disappointment and giving the usual spin of moving too early, but still being committed, will be enough for investors to celebrate.
Microsoft earnings beats estimates and then loses Activision Blizzard deal
Many observers have pointed out the narrow US equity market rally this year driven by the mega caps. One interpretation of this move is that it masks the real weakness and this interpretation is not wrong. A different take is, that the equity market was correctly pricing that mega caps would be better at growing earnings and beating estimates. Microsoft proved this last night with their FY23 Q3 (ending 31 March) earnings result beating on both revenue and EPS. Revenue for the quarter was $52.9bn vs est. $51bn and EPS was $2.45 vs est. $2.24 driven by strong growth in its cloud business Azure which is expected to grow 26-27% in the current quarter excluding currency effects. Microsoft said that AI will be a dominant driver of growth in the future and capital expenditures have risen to accommodate the demand for data centers as new AI systems are rolled out-
While the FY23 Q3 earnings result was a clear win for Microsoft and its shareholders the company lost another potential win in its attempted acquisition of the gaming company Activision Blizzard. The UK Competition & Markets Authority has chosen to block the $75bn acquisition as the regulators is fearing that Microsoft will be to tempted to make Activision’s games available exclusively on its cloud service eliminating competition and carving out console makers such as Sony’s PlayStation. Our general view is that when companies become as big as Microsoft then large acquisitions should not be allowed because markets should not concentrate further in the hands of a small group of companies. Instead excess cash flows should just be returned to shareholders through dividends and buybacks. While the acquisition at this point is lost for Microsoft shareholders are celebrating, thinking previously that Microsoft is overpaying, pushing the shares 8% higher in trading.
Alphabet’s advertising revenue confirms early green shoots
Advertising is a pro-cyclical industry and leading indicator on the economy because companies are increasing their marketing budgets if they improve their outlook on the economy. Google, the main business of Alphabet, reported better than expected advertising revenue at $54.6bn vs est. $53.8bn and also delivered its first operating profit in its cloud business signaling an important turning point for that business that has been lagging terribly on profitability relative to its competitors Amazon’s AWS and Microsoft’s Azure. Alphabet also delivered Q1 operating profit of $17.4bn vs est. $16.2bn as cost-cutting exercises are beginning to improve the underlying profitability.
Alphabet also announced a $70bn buyback programme indicating that management has a positive and improving outlook on the advertising industry. Alphabet’s CEO also said on the conference call that new AI technologies could add value to its advertising business and as such the Q1 results have helped calm investors about Google in the new era of AI.
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