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Tech's Bill Is Coming Due. Investors Aren't the Only Ones Who Will Pay. -- Barrons.com

Barron's · 01/06/2023 11:12
By Tae Kim

For two years now, tech companies have spent massive amounts of money building the capacity to serve what they believed would be a higher level of postpandemic demand. If you build it, they will come. Except they didn't. And now, the bill is coming due.

For workers, it means more layoffs. For consumers, it means paying more for products and services they took for granted over the past decade. And for investors, it means further declines in already beaten-up tech stocks.

The tech-stock declines -- the Nasdaq Composite just finished its worst year since 2008 -- are a continuing unwinding of rapid changes that took place early in the pandemic, when homebound consumers spent lavishly on technology products, digital services, and physical goods. Along the way, venture capitalists urged start-ups in their portfolios to boost spending in order to capture trends and increase growth. And they gave them the funds to get that done.

All that spending was fueled by a flood of money from government stimulus and interest-rate cuts, making it easier to borrow.

The technology giants went on a hiring binge to satisfy new consumer habits based on the assumption that increased demand was permanent.

"Companies optimized for the highest growth number possible because the market was rewarding you with an orders-of-magnitude higher valuation regardless how much it cost to get to that growth rate," says Mike Puangmalai, a private investor and author of the NonGAAP Investing newsletter.

But extrapolating growth turned out to be a bad assumption. As economies reopened, spending shifted back to real-world experiences and away from technology.

Tech pioneers such as Amazon.com (ticker: AMZN) and Shopify (SHOP) have since conceded that they overbuilt, and issued mea culpas as they decided to pull back. "Ultimately, placing this bet was my call to make and I got this wrong," Shopify CEO Tobi Lütke wrote last summer when he announced the company would have to lay off workers. "Now, we have to adjust."

The end of cheap money -- driven by central banks shifting toward a more hawkish monetary policy to combat inflation -- compounded the problems. Walt Disney (DIS), Apple (AAPL), Netflix (NFLX), and Amazon all boosted the prices they charge for streaming packages over the past year. Ride-hailing prices have surged, as well.

The tech-stock debacle stems from two related and significant problems: the growth slowdown and fast-rising interest rates. Rates have a larger impact on growth stocks because most of their value comes from profit streams further in the future -- with every rate hike, those future earnings become worth less in today's dollars.

Every part of the tech complex has declined, from semiconductors and software to internet and hardware. The megacap tech names, which have been a stock market refuge over the past decade, were anything but in 2022, falling far more than the S&P 500.

Meanwhile, the U.S. initial public offering market virtually shut down last year, closing the primary avenue that venture capitalists and company founders use to monetize their holdings. According to Renaissance Capital, 71 IPOs generated just $7.7 billion in proceeds for 2022, an 82% drop in the number of deals and a 95% decline in proceeds from 2021. It was the worst showing for IPO proceeds in decades.

It's tempting to see the 2022 bloodletting in tech as sufficient penalty for the sector's problems. But there's a better case to be made that the pandemic hangover has yet to abate, that the reckoning isn't over, and the recent headwinds haven't receded.

Companies are still dealing with a host of issues, including wage pressures, energy security in Europe, higher interest rates, and a slowing global economy.

Geopolitics are another. On top of the unpredictable nature of the Russia-Ukraine war, the lessons learned from supply-chain disruptions during the pandemic will be long lasting. Corporate leaders know that semiconductor shortages alone caused several hundred billion dollars of disruption to the auto industry.

The good news is that chip makers are building safeguards so it doesn't happen again; bringing production back to the U.S. and adding supply redundancies are becoming top priorities. The bad news is those moves will permanently increase the cost structure for goods.

John Arnold, the billionaire philanthropist and former hedge fund manager, says the risk of significantly higher inflation shouldn't be underestimated. "The multidecade trend of globalization, for all its harms, created the capacity for massive monetary and fiscal stimulus without inflation," Arnold tells Barron's. "I don't think there's an appreciation, especially from the political system, of how the reversal of this trend has the opposite effect."

Morris Chang, the founder of Taiwan Semiconductor Manufacturing, has said the U.S. government's push for domestic semiconductor manufacturing won't be cheap for consumers, even after TSMC spends billions of dollars on new plants in Arizona.

Chang has said that factories in the U.S. won't be cost competitive with the firm's Taiwan fabrication plants, or fabs. Chips currently made at the company's Oregon site cost 50% more than the same semiconductors made in Asia, Chang said during an interview last year at the Brookings Institution.

What Happens Next

With rising costs, the prospect of still-high inflation, slowing growth, and investor demand for profits, corporate expenses still need to be dramatically reduced. Companies can't afford to ignore stock declines, since share prices and option grants are key to recruiting and retaining the best talent. Profits will need to emerge to get stocks moving again, and that means reducing payrolls back to prepandemic levels. There's no way around it.

Large technology companies went on a hiring binge beginning around the end of 2019. Alphabet (GOOGL) added 57% more employees, reaching 187,000, while Amazon nearly doubled its staff to 1.54 million.

"The current head count is way out of sync," says Loup Ventures managing partner Gene Munster. "Big Tech has done a horrible job. They are not even close to getting back to where they should be."

Facebook parent Meta Platforms (META) is a clear example of the disconnect between company spending and financial results. For the September quarter, the social-media giant's revenue and operating profit dropped 4% and 46%, respectively, compared with the prior year, while expenses rose 19%.

Founder and CEO Mark Zuckerberg apologized when he announced 11,000 layoffs in November, saying he mistakenly believed the company's growth in prior years would be sustainable. Those cuts are unlikely to be sufficient. Meta's workforce reduction represents only one-quarter of the staff added since the end of 2019. Meta did not respond to a request for comment about staffing levels.

Amazon just announced a layoff of 18,000 employees on Wednesday, but, like at Meta, that is a fraction of what the company added in recent years.

Also this past week, Salesforce (CRM), one of the cloud sector's largest players, announced it was laying off 10% of its staff, or about 8,000 employees.

NonGAAP's Puangmalai says he expects to see more restructuring announcements during the first quarter, along with disappointing financial outlooks for 2023. "These are big organizations. It's not something you can flip a switch," he says. "The reality is the annual budgeting processes can take several quarters."

Michael Nathanson, a senior research analyst at MoffettNathanson, a division of SVB Securities, says Walt Disney under Bob Iger will likely serve as a good model of how companies should adapt to the new market environment. Iger took over the CEO reins from Bob Chapek in November after investors revolted over rising costs in Disney's streaming-video business. Losses more than doubled in the latest reported quarter, to $1.5 billion, versus the prior year.

"We are expecting Iger to come in there and revisit those streaming targets, revisit the return on investment for spending, and revisit some of the international expansion," Nathanson says.

Nathanson cites Iger's prior tenure as Disney CEO, when he refocused the company on its core competence around premium brands. He predicts that Iger will pull back on Chapek's moves to expand into generalized entertainment.

It's a game plan other companies should follow: Find core strengths and let the rest go. "Maybe it's a better business model to call your brand limited to a specific area rather than chase a rainbow that delivers a bad return on investment," Nathanson says.

But what benefits investors could hurt customers, who will continue to pay more for tech's services and could be left with lower-quality products.

On the back of rising costs and expenses, price hikes were widespread in 2022 for a variety of streaming and internet services, including Disney+, Apple Music, Netflix, Amazon Prime, and Peloton Interactive (PTON).

Uber and Lyft have been raising their prices aggressively since 2019 due to rising energy costs and a scarcity of drivers. Uber and Lyft have both boosted their per-ride prices by more than 30% since 2019, according to market research firm YipitData.

Customers should expect further cutbacks on the service side, too. Content budgets will face more scrutiny. Warner Bros. Discovery (WBD) canceled Batgirl and removed movies and kids programming from its HBO Max streaming service to cut costs. That could prove to be an inflection point in a streaming business that for years grew content libraries and never took anything away in the process.

Warner Bros. Discovery also announced it would be pulling Westworld and other shows off HBO Max and relicense them elsewhere to "maximize audiences and monetization opportunities for its content."

What's Priced In?

The challenge for investors is how to know when the cuts -- and the pain -- are done, setting stocks up for future gains.

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January 06, 2023 11:12 ET (16:12 GMT)

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