Microsoft and Alphabet Q3 results disappoint; Meta on tap tonight Microsoft and Alphabet Q3 results disappoint; Meta on tap tonight Microsoft and Alphabet Q3 results disappoint; Meta on tap tonight

Microsoft and Alphabet Q3 results disappoint; Meta on tap tonight

PG
Peter Garnry

Head of Equity Strategy

Summary:  Microsoft and Alphabet did little to help the Q3 earnings season improve on the clear trend of margin pressure. Rising wage pressures, energy costs, lower advertising prices, slowing PC sales and too much hiring impacted operating income and the outlook against estimates. Later tonight Meta is on stage delivering Q3 earnings and given the signals from Snap and Alphabet on the global advertising market we expect significant pressure on Meta's business. Zuckerberg has only one option to please investors and that is by dialing down his efforts on Metaverse which is burning cash on an unprecedented scale.


Margin compression is indeed a theme for technology companies

Apple recently raised its prices on various of its services offerings from music to TV, and Spotify is also considering raising its prices. The culprit is rising wage pressures and higher energy costs that are hitting energy hungry applications running in the cloud. Microsoft gave the best hint of this saying that it expects $800mn more in energy costs in the current fiscal year which is approximately 1% of its current operating income. As the net profit margin chart below shows, US technology companies are right now facing the biggest margin compression since the Great Financial Crisis.

Microsoft and Alphabet disappoint investors

The two technology giants, Microsoft and Alphabet, delivered a weaker than estimated outlook. Microsoft’s Q3 revenue and earnings per share were slightly above estimates, but its guidance on growth was lower than estimated. Higher energy costs, wage pressures, slowing PC sales, slowing ad sales and a strong USD are contributing to the expected hit to the operating margin. In order to mitigate some of the cost headwinds and slowing growth the software maker has more or less introduced a hiring freeze.

Alphabet was hinted to be weak as Snap last week reported weak advertising sales, but investors did not take the hint adjusting their expectations lower as Alphabet has previously been decoupled from Snap’s performance. But this time investors should have listened to Snap as Alphabet reported a miss on both revenue and operating income with revenue at $69.1bn vs est. $70.8bn and operating income at $17.1bn vs est. $19.7bn. The company added 10,000 new employees in Q3 which is an aggressive increase given the slowdown in the economy but it says that hiring will be significantly lower going forward. Alphabet’s EBIT margin was declining in the 10 years leading into the pandemic which then turbocharged ads pricing because of the high growth in the online economy, but the past year has been a different story with the operating margin declining from 32.3% to 24.8% in Q3 this year.

Zuckerberg has one mission tonight

Meta is one other Silicon Valley company that is following Alphabet’s hiring bonanza and its bet on the Metaverse, which seems to have hit critical road blocks in terms of user adoption, is burning cash on an unprecedented scale. In Q2, Meta’s operating margin fell to 29% from 42.5% a year before as advertising prices were coming down hard after Apple’s new data privacy rules are making it more difficult for Meta to serve targeted ads. Given the earnings reports from Alphabet and Snap we expect Meta to show margin compression and revenue pressure in Q3 and in our view the pressure is significantly increasing on CEO Mark Zuckerberg to rein in operating expenses. This includes a hiring freeze, or maybe even cuts, and a drastically less ambitious target for Metaverse, and if Zuckerberg dares to admit failure on Metaverse then investors might reward the company with a much higher valuation.

European earnings are a bright spot

It is still early days on Q3 earnings, but the initial indications suggest that European earnings are doing better than US and Chinese earnings with the strong USD of course creating a tailwind for profits outside Europe. Given relatively better earnings dynamics, lower equity valuations, and a lower discount rate there is a good case to be made for being more positive on European equities rather than US equities.

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