The slowdown in the revenue growth rate of hyperscalers Amazon AWS and Microsoft Azure is not too surprising because we have seen some slowdown in the quarter before this recent quarter.
Amazon and Microsoft indicated no signs that the trend will reverse soon.
Based on the most recent quarter’s results:
- AWS revenue grew by 28%, which was down from a guidance of 31%. During the same period last year, revenue grew by 39%.
- Microsoft’s intelligent cloud division grew by 26%, down from 31% in the same period last year.
Amazon and Microsoft have different business segments that can be massaged to make the overall earnings look better. Still, we always question whether the market values them for their resilient terminal quality or because they can grow at a reasonably high rate (despite their size).
Given how the share price behaves after the earnings & guidance, the market values them more as growth businesses. Then their cloud business is very important because people buy them due to the TAM (total addressable market) and the high growth rates.
From the earnings call of both (as well as Google), we can see some language indicating greater discounts to clients in exchange for more extended lock-in. This is similar to the lease incentives that traditionally permeate the US leasing market, which makes the clients sign a longer lease or sign with them at a lower rent, but the discount is spread out over the lease period.
However, could there be even darker clouds on the hyper-scale horizon?
What Could Kill Hyperscaler’s Operating Earnings More?
Akram, on his most recent podcast, highlighted the potential problems that can dramatically kill the operating earnings of the hyperscalers:
- The rising US dollar. Akram pointed out that if we were not using constant-currency figures (as Amazon’s management uses), the operating income would be much flatter.
- Not optimizing stock-based compensation (SBC) better. Amazon’s technology & content SBC increase was massive.
- Their clients, particularly SAAS companies, optimise their cloud spending. Research says 40-60% of every venture capital dollar ultimately lands in Facebook, Google or Amazon in the form of customer acquisition cost or infrastructure cost.
Akram explained that people had some misconceptions about the companies in the dot-com era. The tech giant’s earnings did not drop by 80% (what he thinks people are thinking currently). A large tech company like Cisco saw double-digit earnings decline but not the massive numbers in most minds. Microsoft’s earnings were flat but grew by 10% in the next year.
Companies like Sun Microsystems fared poorly because many internet businesses went out of business. The Sun servers of busted internet business landed on eBay, and this totally fxxk with the demand of their new servers.
In other words, this is similar to the recent GPU correction after the crypto mining debacle.
Many think that the clients of the hyperscalers are more resilient than the companies during the dot-com era because the clients have real businesses (e.g. Mcdonalds, UPS and Exxon Mobil). These businesses would not go off the cloud, but at this time, clients will be seeking efficiency.
Twilio is a case study explaining how they shaved millions from their AWS bill. Twilio’s board say that their gross margins are a problem for their valuation and by hook or crook, Twilio has to improve the gross margins. They do this by optimizing their AWS spec.
During the infant stage of a startup, you do not optimize your cloud storage costs, you expense them. You are more worried about whether you can find developers who can set and configure them successfully.
In 2021, Sarah Wang and Martin Casado of VC Andreessen Horowitz published the degree of cost of revenue that SAAS firms stand to save if they optimize their cloud spending.
They cite the example of Dropbox:
Cloud spending a significant cost component of many SAAS businesses:
A combination of the three will cut operating margins, which could cause a massive shave on operating earnings.
Taxing the Hell out of Big Tech
Akram also pointed out that the average corporate tax rate for the Nifty Fifty (a collection of the fifty biggest blue chip companies listed on the NYSE) in the high-inflation 1970s was closer to 50%. Since then, the tax code has gone through changes and was eventually reduced to 21%.
Now, both parties are always looking to find ways to tax the right parties that would not make them look bad.
The government’s tax expenses just ballooned. Every 1% increase in interest cost is equivalent 1/3 of the annual defence spending (Vitaly Katsenelson).
Big tech is the ideal target for any political party.
Here is the evolution of the top-tier corporate tax rate:
The 2017 Tax Cuts and Jobs Act created a single corporate tax rate of 21%.
Now, maybe not everyone would be affected, but if you have a few candidates that produce so much EBITDA, even if you tax them at 40% will cause a significant hit to their net income.
Akram estimates that these big tech can still see their income go up, but the increase in taxes would still change the picture.
Can Tech Companies Scale Back Sales & Marketing and Research & Development Costs? How would things look?
Bill Brewster and his guest value investor Vitaliy Katsenelson discussed the potential complex restructuring some of these tech businesses may have to go through (34 minutes into the podcast).
Bill tells a 2019 encounter his friend, who is in the tech space, had with some of the tech executives. The tech executives told his friend they were not hiring the tech people due to need but because it allows them to “brag” to people how many they are hiring.
Their company’s valuation depends on the growth they were having.
Cloud cost may be significant, but what is a significant component resulting from your focus on growth? S&M and R&D expenses.
And what makes up S&M and R&D expenses?
If you hire engineers to indicate you are growing, what happens when the market wants to know what you are doing to be free cash flow positive?
They want you to cut the people.
Recently, I reflected upon a cash flow diagram a couple of my colleagues prepared for a prospect. They assume that the income of this prospect will grow at a constant rate till the end of the prospect’s life. This prospect will never run out of money, even if his spending is in an annual six figures, growing at a constant-inflation rate.
How realistic is it for our income to stay that consistent? Even so, how realistic can we earn this kind of high income for so long and not have other areas of our lives give way?
One of the reasons for the high income is to compensate for performance and so what happens when a company cannot pay for that performance?
Akram mentions that SBC is part of a compensation package, and SBC is strategic if you wish to attract people yet be tied to specific company KPIs aligned to YOUR pay package.
With the plunge in the stock prices of many SAAS companies with no to low non-GAAP income, the compensation structure would likely to be changing. If not, how do you attract people to jump ship into your company?
If there is a more significant retrenchment in this space, residual consumption spending might be affected if the engineers cannot find pay compensation that is high enough.
Large ticket items might be affected.
Perhaps the AUM/AUA of wealth advisory firms will also be affected.
What does all this mean?
Maybe the following sequence of outcomes:
- Significant money stimulus to cushion the effect
- Stimulus stayed for too long, plus war, plus China COVID lockdown, supply chain inefficiency equals high inflation
- Interest rate jacked up 400%
- Money gets pulled out of the system in a rapid pace
- Higher interest rate == higher discount rate => long duration business with cash flow far into the future gets revalued downwards.
- #5 means less VC, Angel, any sort of funding
- Companies funded by #7 need to be more “appealing”. They cannot be seen as long-duration assets, but the greater appeal is a quality business model that has shorter duration cash flow.
- #8 means cut expenses == layoffs, scrutinise costs
- Government interest expense just went up and they need some ways to make up for it == Some tax increases.
- Lower S&M cost == TTD, PINS, YouTube, FB, TWTR, APPS, Roku fight for a smaller pie
- Lower R&D cost + Less funding == Less new projects to absorb workers laid off
- #2 affect highly skilled STEM workers ==> Affect cash flow ==> forced sale, halt RSP and investments ==> lower AUM ==> lower AUM-based revenue ==> wealth advisory firm cut manpower.
- More slack in manpower supply ==> reduces services-based inflation and lowers rental inflation.
- Cut in hyperscalers’ operating income ==> Affect share price ==> Affect market capitalization-based funds. If this is a significant regime change, this may affect the aura of invincibility of Google, Amazon and Microsoft ==> Underperformance of market capitalization-based funds relative to more active funds.
- Overvalued countries such as the US take longer to correct to reasonable valuations.
- #15 and #16 means wealth advisory firm with a more strategic and passive investment philosophy looked less appealing in a long period of poor investment performance ==> AUM outflows ==> lower AUM-based revenue ==> wealth advisory firm cut manpower.
How much will the above happen? To a different degree. Most likely, the FED will start printing money again but we do suspect that the next infusion may not be directly into the market but more fiscal due to very nationalistic ideas.
In that case, we might have a more dead markets but in the main street, things may be better.
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