(PA)
(Picture: PA Archive)The calendar gives all of us working in the City cues to reflect – if it’s the month-end, quarter-end, year-end then that means it’s time to take stock and measure.
These dates are arbitrary, but they help us compartmentalise what’s happening in the world. Last week there was a slew of commentary about it being the worst first half since the 1970s. For example, the NASDAQ Composite Index – home of the largest US technology companies -- was down 30% in H1. For those who have been sceptical of valuations for the past decade, H1 2022 provided an opportunity to be correct.
Meta Platforms also made the headlines last week, with a report that the company plans to reduce hires of software engineers by 30%. Spun as “Meta slashes hiring plans” it made a good headline. I clicked and saw a different story. Companies that were previously growing rapidly are accounting for most of the layoffs in technology (Coinbase, Tesla, Robinhood, Peloton). Some companies are struggling to raise capital (Klarna). Valuations of private companies are falling when they do raise capital (SumUp). Central banks, such as the Bank of England and US Federal Reserve, are openly talking about the risk of recession. They may even cause one, for the sake of avoiding a prolonged period of inflation. Faced with this, Meta is planning to hire 6,000 – 7,000 engineers this year. And that’s on top of staffing increases in 2020 and 2021.
Many businesses will be in the press with bad news this year, but not all with equally bad news. A tougher economic environment is likely to favour companies with large cash balances, higher margins, and profits. With higher inflation looming, shrewd investors will be less willing to fund business models that have a long path to profitability.
The barriers to competing against the established technology companies, in the form of network effects, remain significant. The market outlook for some business lines remains robust. For example, demand for cloud computing services continues to grow by double digits each year. These services tend to be more efficient than companies managing their own servers, so in a downturn you could see more firms adopting this approach. Technology companies have made revenues more sticky and predictable over the past decade. In simple terms, once you’re an iPhone owner, Apple gets a cut of all the app fees you pay. Microsoft charges ongoing fees for office workers using word and excel.
However, the established technology companies won’t be immune to the overall economic climate. Businesses pull-back on advertising in tough times, and technology companies dominate that market. That will reduce some of the excess cash flow they use for investment now. Meta and Alphabet are leaders in online advertising. More under the radar, advertising has grown so big at Amazon ($31 billion revenue in 2021) that it’s finally earned its own line in financial reporting, moving out of the “Other” category.
Stock prices will continue to be blown around by interest rates, independent of what companies do on a daily basis. Interest rates determine how investors value the future profits they expect companies to earn. With higher interest rates, the value of £1 profit in five to ten years is lower.
The interesting thing will be what happens when we get to the other side of the inflation story, when interest rates are falling or at least flat. If not as many start-ups are raising money today, then there might be less competition. Firms that had to cut back will have invested less in their products and services. In contrast, Meta put $10 billion into its ‘metaverse’ projects in 2021.
Even with slower earnings growth and reduced margins, the established technology companies still stack up well compared to other sectors. The threat of regulations increasing costs or requiring firms to break up remains. We may see more innovative and well-funded competitors come from Asia – like TikTok. Despite that, they look well-placed to weather what comes next.
