Welcome to Episode 60 of The Transcript Podcast where we discuss the key themes and takeaways from the Q1 2022 earnings calls.
This is a special episode of a recording of a Twitter Spaces conversation we held on Wednesday, 18th May with our guests:
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Show Notes
00:00:00 Introduction
00:07:18 Macro Perspective from the Earnings
00:17:27 Historical Context for the Current Market State
00:32:32 Intersection of Tech & Consumer
00:36:48 Valuations
00:41:12 Q2 Outlook & Closing Thoughts
Introduction
[00:00:00] Mokaya: Welcome to our Twitter spaces. Thank you so much for joining us. My name is Erick Mokaya. I co-write the Transcript. Once every quarter we get to analyze what we learned from the earnings. We tried to hold it after the earnings season is over. Mostly the earning season for Q1 is behind us, except for retail companies, which are reporting this week. But most of the companies have reported, especially the big tech, the banks, and all.
We have really good speakers today. Sam Ro writes a lot about some of the key takeaways, especially the macro stuff from the earnings calls. MBI does really deep dives on specific companies, and Alex Morris does a lot of deep dives on specific companies especially trends in streaming. I’d want them to introduce themselves and start with the Sam Ro, then MBI, and Alex Morris in that order. Sam, welcome.
[00:00:50] Sam: Thanks for having me. I'm Sam Ro, I write the Tker Newsletter. You can find it on tker.co. It's also all linked on my Twitter profile. I spend a lot of time writing about how market activity and short-term economic news and data fit into longer-term themes and longer-term trends. I write a lot for longer-term investors who are looking for some historical context and data that'll help them understand what's going on in the news today in the context of their long-term investments. So yeah, that's me. Anything else you wanted me to add off the top?
[00:01:24] Mokaya: Maybe you can tell us, how did you develop your interest in earning calls?
[00:01:28] Sam: I used to write for a couple of stock picking newsletters about 15 years ago before the financial crisis if you can believe that was a thing then. I spent my entire full-time job, I guess about a third of the time, thumbing through earnings calls to get the details you need to fill out DCF models and stuff like that. But I was always really interested in what executives would say on earnings calls because every once in a while you get those sort of interesting anecdotes from the front lines of business where they'll tell you what is going on with their customer behavior.
And consumer behavior can provide some really unique insights as to what's actually going on in the economy. I'm a huge fan of what's going on, especially with earnings calls because a lot of this stuff is off-script and even though all these execs go through all of that training to not say anything ridiculous, they will go off script a little bit and we'll share things that you normally don't see in press releases. Earnings calls are incredibly interesting and insightful and if you have time, it's always great to be listening to them.
[00:02:32] Mokaya: Great. MBI.
[00:02:33] MBI: Hi Mokaya and everyone. Thanks for inviting me. My name is Abdullah Alrizwan. People usually call me MBI on Twitter. MBI is the abbreviation of my Twitter name Mostly Borrowed Ideas. I write MBI deep dives. I write one deep dive every month. Apart from doing a company-specific deep dive, I try to follow closely the companies I own in my portfolio and also follow earnings calls from time to time whenever they're happening. That's pretty much what I do. Mokaya asked me before to talk about why I love to follow earnings calls. Well, first of all, many of the companies that I follow are in my portfolio, so just based on pure self-interest I need to follow these companies.
The other thing is it's just a better way to grasp how things are going in the economy. Earnings calls in many ways can be a great way to understand businesses. Sometimes the management as Sam was mentioning is willing to share things that you wouldn't find just by going through the public filings, like 10Ks or 10Qs. Sometimes an analyst would ask questions and in response to these questions, management would share some interesting sometimes unique insights. And also just because of the sheer size of some of these companies, you tend to gain a better understanding of how certain aspects of the economy are fairing. I remember back during COVID time there was pretty much a dichotomy between reality and what we are kind of seeing in the stock market.
The market was 35% drawdown, macro was kind of going up against our intuition. And at the same time, we were stuck at home, so there was a kind of a dichotomy between how we are kind of living our day-to-day life and how the market was reacting. And similarly even today we are kind of seeing a similar dichotomy now. We are going out, people seemingly spending more time outside, they're spending money, and they're generally enjoying life much more than probably they did in the last couple of years but in the market, we're seeing quite the opposite. The market is going down so obviously markets trying to tell us what may happen maybe a year from now or two years from now.
[00:04:36] Mokaya: Alex.
[00:04:37] Alex: Thanks to the Transcript for putting this together as always and excited to be here with Sam and MBI, some good speakers. My name is Alex Morris. I run the TSOH Investment Research Service. Long story short, I worked on the buy-side for about a decade and I've been writing online for about a decade. In April 2021, I left my role to launch a full-time research service where I essentially share all the research that I'm doing on a daily basis for subscribers. And then anytime I make any portfolio changes, I disclose those to subscribers before doing so.
I use quarterly calls and transcripts really as a way to kind of verify and build confidence in my long-term investment process, which is really focused on partnering with honest and able management teams. I think when management is communicating with you directly, whether it's at an investor day or a quarterly call or shareholder letter, those are the opportunities where you get to see someone in action. And you can find things that are really encouraging or at times you find red flags that can be checked on and maybe informative in terms of how you react to your investment. So that's really how I use it as trying to frame the commentary in terms of the long-term strategic direction of the company and the quality of the management team.
[00:05:49] Mokaya: Great. In the Transcript, my co-author is Scott. Scott's here now. Maybe you can introduce yourself.
[00:05:55] Scott: Hey everybody, Scott Krisiloff. I am a co-author of the Transcript. Erick and I have done this together over the course of like 10 years now, it seems like Erick. We rebranded as the Transcript, I think two or three years ago. We were Avondale Asset Management earnings call notes before that. Why do I read transcripts? I think that the management teams that contribute to the transcripts obviously are leading these companies have some of the best views of what's going on in the economy. Where information asymmetry really comes out is in earnings call transcripts. My theory on this always was that everybody has a story to tell, but not everybody's listening. Every one of these management teams has people on the call, but the whole market doesn't necessarily digest all of the insights that they have on those calls.
There have been many many times well-documented throughout the life of the Transcript, where we read a tidbit of information in one company's earnings calls that actually means something else for a different company, and we're able to highlight that for readers as an actionable investment catalyst. Personally, I manage my own money based on the things that we see in the Transcript. So really whatever the headline is in the Transcript from week to week, whatever the coincident indicator of the economy seems to be the right way to position my portfolio over and over again. So this is really core to my personal investment process.
Macro Perspective from the Earnings
[00:07:18] Mokaya: All right. Thanks, Scott. Let's dig right into it. I'll start with Sam. Sam, maybe you can give us a macro perspective from what you learned from the earnings calls this Q1.
[00:07:28] Sam: Great. Thanks. I was preparing for this call last night and thumbing through my notes, and I think it's really hard to compete with what Target said today. In their earnings call on their press release, they really sort of checked off a whole lot of boxes. And of course, because their earnings announcement was today, it's probably the most timely perspective on what's going on both in retail as well as sort of the macroeconomic situation. I think there are probably like three things that came out. I'll start with this first quote, “Guests are focused on getting back to many of the habits and behaviors they suspended during the heart of the pandemic, including travel, out-of-home activities, and social gatherings. Importantly, even as the mix of what they're buying continues to evolve, their spending capacity continues to benefit from elevated savings rates, high employment, and healthy wage growth.”
Those are two gigantic macro themes that are happening right now in the economy. So that first part, what they said about people getting back to travel, out-of-home activities, and social gatherings reflects this huge shift that we're seeing in consumer spending right now, where we're consumers are shifting from buying goods that they were spending on during the early part of the pandemic since they couldn't go on anywhere, they just shop on Amazon all day long buy furniture, home gardening equipment or whatever it is. People are going out and doing stuff. And this was echoed earlier this week when United Airlines filed that 8K where they had to revise upward their revenue estimates for the rest of the year. The consumer is doing stuff. They're probably not buying as much stuff as they used to, but they’re certainly doing stuff. So anything that involves services especially when it comes to travel and vacationing, all those areas are doing particularly strong, and, Target was willing to say that upfront. Related to that second part of that quote, I just mentioned they're talking about consumers, “Their spending capacity continues to benefit from elevated saving rates, high employment, and healthy wage growth.” These are the big three things that are driving the consumer's capacity to spend.
Excess savings is one that a lot of folks have been talking about but sometimes gets under-covered. This is all the extra money above-trend savings rates that consumers put away since the beginning of the pandemic. This has accumulated to about $2 trillion worth of extra savings that consumers have. And high employment, I think is also something that's really important to remember. Just in the first four months of this year, US employers have added 2.1 million jobs. These are 2.1 million people who went from not having income to having an income. This is very important, especially in the context of wage growth conversations.
You can't forget the fact that a lot of these wage growth measures don't account for the fact that there are these 2 million people who are now working as opposed to not working. Now, I understand some of these are second jobs or whatever, but the point is that this is a considerable source of incremental income for the consumer. So the consumer is very healthy. And the other thing I would note is that this is why I particularly see value in listening to earnings calls, Target didn't have to say this, they could've very easily managed expectations and shifted the tone a little bit and they did mention this a little bit, but they could've really focused on this whole idea that we're starting to see cracks in the consumer.
Consumers are getting a little bit more conservative and all this stuff. And while they may have mentioned that a little bit the fact that they are continuing to reiterate this point of elevated savings rates and high employment is just as solid a confirmation as it gets that here's yet another business that understands that the consumer is strong. So those are the first two points in terms of the macro. And then the third point and Alex just tweeted this before the call, this is another quote from Target, and this is in regards to cost. And so the quote starts, “Actual conditions have been much more challenging than expected. For the year, we're now expecting around $1 billion of incremental freight costs, even compared to our expectation three months ago.”
For you guys who have been following the corporate story and the inflation story, inflation has been a concern for at least a year now. The word inflation itself has been repeated over and over, and it's really sort of coming to a head right now. But even with all of that lead time in terms of understanding that there was inflation in the pipeline a company like Target has all the information in the world when it comes to logistics, lowballed their costs by about a billion dollars. That speaks to how unexpected, how intense, and how sort of unprepared a lot of companies were for the amount of inflation that we're continuing to see.
Maybe it's a matter of people sort of not expecting inflation to have persisted for this long, but I guess that's what we can say about the Fed as well. But I think that Target really sums things up from my perspective today. And just to summarize consumers are going out and doing stuff far more than they're actually purchasing stuff. Two, consumers are very healthy. They have a lot of savings, people are still going back to work, and they are experiencing wage growth. And three inflation has been higher and hotter and more persistent than even some of the savviest corporations could have expected. That's sort of from my perspective, the state of the business environment as told through Target's eyes.
[00:12:47] Alex: It's a great introduction. I think there are a couple of things I just add to that. On the first one, in terms of Sam's comment on goods to services, you look at a company like Airbnb, they just reported the strongest quarter in the company's history. Nights and experience booked crossed the hundred million bookings for the first time. Another example, Disney domestic parks are absolutely slammed. People are spending significant amounts of money. And again, in both of those cases, there's still a fairly significant problem with international travel. It's a meaningful part of both of those businesses, and yet they're still seeing some of the strongest results we've ever seen.
So I think it really speaks to that good to services shift that Sam talked about. On the other point about, Target and Walmart collectively generate more than half a trillion dollars in retail sales in the US alone. And it's pretty amazing to think as Sam called out, retailers have been talking about the cost of shipping and freight costs for six months, a year now or longer. It's pretty amazing when you hear a company like Target come out and say, the change in the past three months has blindsided us so much that it's a billion dollars of incremental cost. As a reminder, this is a company that had a huge tailwind in the last couple of years, but this is a company that in 2019 generated less than $5 billion of EBIT. That's a very significant cost increase. It's about a hundred bips on sales.
I think the other really interesting comment that they made and it really echoes what Walmart said yesterday is it's always the last lever we pull, but external conditions led us to raise prices across a broad set of items in multiple categories. As you've seen in recent quarters, overall costs have been rising much faster than retail prices resulting in year-over-year declines in our gross margin rates. So they're taking pricing because they have to, and it's pretty clear from their commentary that for the core, call it CPG and food products that people need. Obviously, they're going to keep buying those things.
In some of these other general merchandise categories, whether it's TVs, appliances, outdoor furniture they're seeing a major headwind there in terms of what they're putting through. And, Walmart specifically said, “While we're happy, our inventory is up because we need to be in stock. It was a 32% year-over-year increase, that's higher than we want it. And it's going to take us a couple of quarters to work through all this.” It's an interesting time, and the consumer certainly seems strong when you look at certain businesses, but a data point like that to me, kind of suggests maybe that's starting to crack a little bit, especially as costs continue to skyrocket as we all see when we go to the grocery store.
[00:15:06] MBI: Just to add to both Alex and Sam's point, when I think about all the transcripts that I read and all the earnings that I followed over the last quarter, one thing that kind of became quite clear to me is that the last two years have been an insanely difficult operating environment for these businesses. And I don't think we as investors, perhaps appreciated how insanely difficult the last couple of years has been. Just quickly refreshing our memory we had COVID and if you think about a key e-commerce operator, like Amazon, demand overshot, and Amazon in the last earnings call, they mentioned we quickly transitioned from being understaffed to being overstaffed resulting in lower productivity.
And so you started from COVID, demand shot, and then you have Omicron, China COVID shot, Ukraine war, this led to supply-side disruption, and you've had persistent high inflation, 8% that's like 40 years high in US history. You also had the work from home and the rising cost for tech talent, so it's been just incredibly difficult to forecast demand, resolve supply chain issues, and also manage costs. It's like the perfect storm, as Alex mentioned. It's been a very difficult environment even for some of the best operators out there. And, one of the concerns that I personally had as an Amazon shareholder is whether this is an Amazon-specific thing, whether they have kind of bungled it up in terms of how to respond to some of these challenges.
And just listening to Walmart or Target's calls, it's abundantly clear that it's not an Amazon-specific thing. It's just an incredibly difficult operating environment for these businesses, and it may take a while to transition into a more normalized environment. But this feels like more of a macro thing rather than an individual company's specific thing. Usually, in an environment like this, the difference between good operators and average or below average operators becomes and more clear the longer it goes on. The difference between a competitively advantaged business versus a less competitively advantaged or commoditized business will be more and more apparent.
That's one of my biggest takeaways, just this realization of how incredibly difficult this has been for the operators. I know investors have lost money and investors have their own issues and problems and challenges but I think we should probably take a moment and understand how incredibly challenging the last two years have been for the management and operators who are running these businesses.
Historical Context for the Current Market State
[00:17:27] Mokaya: Scott, maybe you could give us a little bit of historical context as to some of the happenings in the market
[00:17:32] Scott: Sure, thanks for the plug, Eric. For those who don't know, I read every Time Magazine in history from 1923 to 2000. Eric and I on our podcast weekly cover a lot of, not only the Transcript but also historical trends from different cycles. And in the quarterly letter that we wrote this week and distributed to readers, we talked about a little bit at the end, some of the historical analogs for the period, and we've covered a lot of management teams talking about how no one's ever really operated in an environment like because we've had relatively low inflation for the last 40 years. If you were 20, 40 years ago, you're 60 now, you're basically towards the end of your career.
But there's certainly have been massive inflationary periods in US history. And one that always felt super analogous to me, in this case, is the post-World War Ⅱ period because in the 1930s you had deflation. The deflationary period was ended really by a global event in World War II. In which that global event, you had the federal government investing heavily into the economy to address the event, and in that case, putting money directly into consumers' pockets by employment, because we had a really labor manufacturing economy at the time. So you had that, and then you also had the supply chain shocks that you have today.
You've had massive disruptions. We didn't actually produce any automobiles for several years during the war. And so when you came back out of the war, you had a retransmission phase where you were bringing the economy back into a consumer mode, you had supply chain disruptions, and you also had consumers with just a lot of money in their pockets. And the way that they dealt with inflation at that time was with price controls. So you had price controls that were kind of being lifted and you have large double-digit inflation. And actually, during that period, you had transitory and the fact that it was like a few years' worths of inflation and then ended up going away.
The reason it went away was the federal reserve ultimately came in and started raising interest rates there, and so that was kind of the end of that. You had a big inflationary period, and that was where you saw the value of the dollar get cut in half just through that. And then you have the other big inflationary period in the 20th century, which is kind of 1966 through 1981/82. And that was driven just by monetary push inflation, the federal reserve, and government spending being much higher than it should have been. And you had just this chronic inflationary period in which you would have the economy recover from recession with easy monetary policy, and then you would have the Fed come in and tighten monetary policy again, and then you would go back into recession. You just had a ratcheting up of interest rates.
The Fed always has had a bias towards being looser than the economy probably needed until Volcker came in. And that's again where we find ourselves today. The federal reserve talked about this transitory inflation throughout 2021 and never really addressed the thing that we saw management teams talking about consistently throughout the year, which was, that this is actually the largest inflation that we've ever seen. There's nothing transitory about this and policymakers should be addressing this. The federal reserve decided not to address it, and consistently just has a bias towards dovishness it seems throughout the last 15-year period. We may be entering an inflationary cycle, higher costs of capital, and that's what on a macro basis we're seeing in markets today.
[00:20:42] Mokaya: Despite the challenges in terms of inflation and all, the consumer is of course a bit resilient. And most of the earnings calls are talking about how the consumer is doing well, and how he is strong. And even the federal reserve chair yesterday was also saying the same thing. Something else that we noticed is that the Microsoft CEO said that IT budgets are not being cut and that some of the companies that are benefiting in these kinds of times are companies that have been in the tech space. I know MBI, you follow a lot of the big tech companies and also Alex. So maybe you could give us a bit of perspective on some of the key things that you heard in the earning calls of some of these big tech companies. We can start with Alex.
[00:21:19] Alex: Yeah. I don't follow a ton of these companies, I follow the really big ones fairly closely, and there was a lot of consternation about what the results would look like. And I know especially well for Microsoft because I followed it for a long time, and at the end of the day, I think it's pretty fair to say that they just crushed it. It was another very impressive quarter across the board. And as you noted, Satya Nadella said, companies don't really look to this as an area cut, because it's what drives efficiency and is so important to productivity, strategic vision, and everything about running a business. So it's a place that you might actually look to spend in tough times as opposed to cutting because it's the way that you become more efficient.
In terms of actual results, the Microsoft Cloud is now at just shy of a hundred billion dollars in run-rate revenue. It's still growing mid-thirties, and it's just become a massive business. It's larger than the company's entire revenues were five or six years ago. AWS was widely accepted as the leading player in this space, call it 15 years ago now, and it's just really amazing how this has just really flipped things in the tech world and in the business world broadly. But I think the results there have been really strong. These companies have a lot of considerations on things like compensation and when the stock market starts to do really poorly, especially for some of the smaller players in the tech land.
I'm sure it's very difficult for them to retain employees who see a fairly significant percentage of their compensation stock and, might wake up one day and go, Hey, my comp over the last four years, I thought it was 400K a year, and now it's 180K a year or whatever the swings can be. So you're even seeing companies like Microsoft have to come out and be pretty public about ensuring that they're continuing to improve employee relations through higher comps. So I think they'll see this as well, but they certainly seem to be well-positioned relative to some of the smaller and younger companies that are in a much less secure place in terms of the strength of their balance sheet, but also just in terms of the underlying strength of the business.
[00:23:15] MBI: Alex made some pretty strong points here. I did not get a chance to go through Microsoft earnings or Apple earnings, but I kind of did go through Amazon, Meta/Facebook, and Google's earnings calls. Broadly speaking, I think earnings this last quarter were generally okay to find markets at this point are much more concerned about maybe two, three quarters from now, than what's going to happen like this and next quarter. Markets are always an expectations game and it's always trying to understand or incorporate the future. There weren't a lot of concerning materials that I have heard or read in the earnings calls. Amazon mentioned Prime members have meaningfully increased their spending since the start of the pandemic and that they are consistently renewing at high renewal rates.
But they did also mention that they're not immune from inflation pressures on the cost side which is generally known and acknowledged especially with rising fuel and transportation costs and all that. The retail side of the business is much more exposed to the inflationary situation. But they're first-party businesses certainly much more exposed down there. Services business, which is the third-party business, or even AWS. AWS, GCP, or even Microsoft Azure, are oligopolies and reasonably competent, really advanced multi businesses. I know most people are talking about inflation and how exposed they are to the retail side of the business, but what really stood out to me from Amazon's earnings is basically AWS's EBIT margin. They posted a 35% GAAP EBIT margin.
I remember when I started looking at Amazon sometime in 2019, and the biggest concern at that time around AWS was that their margins are too high. It used to be probably 30% in 2018 or somewhere around that, and in one quarter or two, it came down to 26, 27%. And then the talk of the town was that these margins are too high, it’ll eat the commodity business, Microsoft Azure is coming, GCP is coming, and margins are going to go down. And since then in the last two, three years nothing of that sort has happened. All three companies have continued to grow at a rapid pace. GCP is growing at a 45% CAGR rate over the last two, three year period. AWS is growing at a pretty crazy rate.
I don't think in the history of capitalism, any company with this sort of a top-line is growing at a speed that AWS is growing. They're growing at 68% year over year which is just insane when you think about it. So the fact is that after all these concerns AWS has accelerated its growth and at the same time they are posting higher and higher margins. To me, that's going to be perhaps the bigger story three, four years down the line. Inflation is consuming all of our attention today and that's no doubt that's a relevant topic, and that can derail things, and the operating environment can be very challenging for the retail side but the more I look forward to it, I think one of the biggest takeaways from going through earnings calls is how strong it always has been.
And it's not like, they are growing at the expense of the other two, everyone is growing. And I think that the Cloud has been a strong secular force, and that's going to be tested if we face a recession. One of the uncomfortable things about big tech is some of these companies weren't really built at this size and scale during the global financial crisis, everyone talks about how digital ad, advertising like Google and Facebook or Meta, like will face severe headwinds if there is a recession because advertising tends to be cyclical. But we just don't quite be sure to what extent and whether they will be affected. There are some points and counterpoints about whether they’ll be affected at all, or even if they do, maybe it's not going to be as devastating for them as it used to be, let's say, in the linear world or in the physical world.
Lots of unknowns and markets seem to be at this point trying to price all the unknowns, but the fact of the matter is in many cases we don't have a quite clear-cut answer. We don't know how affected Cloud will be. Intuition says that it's actually much more cost-conscious to move from on-prem to cloud, and there is a reasonable case to make that secular force would probably be accelerated during a recessionary period, but that remains to be seen. At the same time, in digital advertising, there's a point that even if we faced a recession next year, it's possible that we may see strong positive nominal growth. Real GDP may see some headwinds and may decline a year from now, but if inflation presses this would be a positive nominal growth environment.
And in that case, it's possible that since these are auction-based systems, the revenue top-line may not be affected much for Google and Facebook. The other thing from Facebook call, the operating environment has changed a lot in a very short period of time. The companies are probably reassessing a lot of the costs to make sure that they are spending in a way that has a greater ROC and greater profitability going forward. And, it's going to be much more under the scanner as we kind of navigate through this challenging environment. Facebook is freezing their new hires. They're also cutting down on some of their expenses in Facebook reality labs. One of the things that I personally I'm trying to understand and look forward to figuring out more as we go through the rest of the year is to what extent some of these big tech companies have discretionary expenses.
Amazon talked about overbuilding, Facebook's costs have risen at a crazy rate, and its capital has gone up at a crazy rate. Google has been hiring a lot, and they have said they'll continue to hire at an accelerated rate going forward. Although I doubt they'll be able to follow through with that promise. If they have a lot of discretionary expenses in a difficult operating environment, their earnings may not go down, even if their growth slowed down materially. Even if they are, gross margins get somewhat pressured for some of them but overall maybe operating margins or net margins or net profitability may not go down as materially as perhaps the market is pricing at the point. But then again, I just also want to disclose that Google, Facebook, and Amazon are three of my largest holdings, so I may have my own biases there as well. I look forward to kind of figuring it out as we move to the rest of the year.
[00:29:26] Sam: Hey Eric, I just wanted to add something real quick to your initial question about CapEx and IT/tech investment. And just real quick zooming out a little bit, early a couple of weeks ago we got the latest monthly report on durable goods orders from the census. This is surveying every business in America. And one of the sub-components of this survey is technically its called non-defense capital goods orders, excluding aircraft and the shorthand for that as core CapEx and a little bit more informally, this is CapEx business investment. As of March, which is the most recent reading, that number for core CapEx orders, these are business investment orders by businesses, hit a record high of 80.8 billion.
And there's also an outstanding backlog for this equipment, this stuff hasn't been shipped yet and has also reached new record highs that are way above pre-pandemic levels. So just sort of like a general matter when it comes to CapEx spending, businesses are still ordering equipment like crazy and the stuff hasn't even shipped yet. And so as far as what the outlook looks like for the businesses that provide capital equipment, whether it's computer machinery or water pumps or whatever it might be, the outstanding demand and excess demand for a lot of this stuff are still really high. It's one of these huge tailwinds when it comes to the manufacturing industry, this whole matter of businesses still trying to get CapEx equipment under their roof so that they can conduct business.
[00:31:01] Alex: I just want to add one thing real quick to what MBI said because I think it's really interesting, at least less than for me or something that I'm seeing now, especially as we come out of this quarter and probably the best place to see this is in the video-on-demand space. Most notably, Netflix came out and had a very difficult quarter with big changes in long-term expectations. And, I think that was met with, on the subsequent calls from every other major media company, some assurances that, Hey, we're focused on spending efficiently, which they always should be, but a company like Disney came out and said, Hey, we're not going to spend 33 billion this year. It's going to be 32, really small changes, but just kind of signaling where their attention and focus go.
And I think you can just focus on the industry that a company operates within, direct competitors, and think about how those things flow through the whole industry, and what impact that has as we see a different part of the cycle. But even to MBI's point on a company like Amazon, you think about it, the big tech companies have their hands in a lot of different places where direct competitors are somewhat supplemental to the other operators in the business, whatever it may be. You can imagine that someone like Jassy coming in as CEO and very new in the job kind of reassessing some of the priorities and thinking about whether it's retail stores, whether it's their interest in the video business, whether it's their interest in podcasting. There are a couple of different layers where I think you can see how a period like this may have a pretty big impact on how companies think about where they want to focus their resources and their time and attention.
Intersection of Tech & Consumer
[00:32:32] Mokaya: I want to pivot a little bit to maybe the intersection of tech and consumer something that has been a big talk of the town, the past two or three months is the issue of streaming services and how they're doing. And one of the quotes we picked this quarter was about YouTube and the scale at which YouTube is operating, which is pretty impressive, and the way they're positioning themselves as competitors to the streaming services. I want you to find out what your hot takes are on this area of streaming, and what's your key takeaways, especially as Disney and Netflix, pivot into providing ad-supported tiers. Maybe you could start with Scott this perspective because you've also been following this on the Transcript for a while.
[00:33:09] Scott: Yeah. We've been talking about this for several months Mokaya and we have a podcast from a month or two before Netflix reported earnings talking about how it could be down 25%, and that ended up being the case. I think that what we're seeing is saturation for subscription services and people have been subscribing. There hasn't been quite that much competition for a long time, and we saw competition has been intensifying over the last several years like Disney Plus, Paramount Plus, Peacock coming into the market, and Hulu. But you're just starting to see them sort of mature into having enough distribution and distribution channels where there's fragmentation now in the streaming market. And it's actually hard to figure out where you're going to watch anything.
And the last few months, even nights, just as a consumer, I've been flipping around trying to find channels on my Apple TV or things to watch. And it feels like we're back to the old TV joke of, well, I have a hundred channels and nothing to watch. Now it feels like the entire world of content is at my fingertips and I can't figure out anything to watch. I ended up just watching old movies and shows that I've already watched before. So I think that speaks to me too. Again, the old notion of content is king speaks to how important a brand is on the internet, a brand of specific shows, a brand of people, and historical artifacts, things that really matter and have the cultural gravity to survive the long term. These are all things that have become more and more important with the internet as a distribution mechanism and streaming is just seeing that as the tip of the iceberg.
[00:34:45] Mokaya: Alex, you write a lot about this. What have you noticed in the Disney versus Netflix world?
[00:34:27] Alex: Well, there's a couple of layers to that. I think one of the biggest ones, and it's not really a story from this quarter, but it's the success that Disney has had with their D2C strategy out of the gates and relatively early, it's only been not even three years since Disney Plus launched, and it's just shy of 140 million paid subs globally, and has a significantly lower ARPU on average than something like Netflix. But you can see how its strategy is starting to unfold. A big question will be over the long term what type of spend do you need to commit in order to support the business and what the economics eventually look like.
I think the market and investors rightly looked at a company like Netflix that very clearly laid out a margin progression over the course of a period of I think, five or six years, and they lived up to what they told the market that they could achieve. Now we've had a very rapid change in terms of what people are looking for over the next handful of years. And, to Scott's point, if it's not meeting a need for the consumers and the companies, I do think that there's going to be some change in that one way or the other. A good example of something like Avon and a company saying they're not going to do something, it's very different to frame it relative to what we kind of all came to experience, at least in the US in terms of an ad-supported TV product, which was linear. I think Kantar dat had it at 20 minutes an hour of ads. When you're comparing it to something like Disney Plus coming out and committing to a four-minute ad load per hour, you're just talking about completely different worlds. I think as technology evolves, there has to be some presumption that the ARPU on a product like that will be justified by the CPMs or the economics of that advertising portion of the business. I certainly think you'll see companies try different approaches and, as a management team, I think what you probably need to do is not be so dead set on one route versus the other and be open-minded. And when the world starts to change, you need to try to react as effectively as possible.
Valuations
[00:36:48] Mokaya: Speaking of reactions in markets, I think this is a quarter that valuations have come down significantly. So I'm wondering, how are you positioning yourselves, especially in the market with regards to some of the valuations that have come down and some of the companies have significant challenges. I think it was Facebook, they were speaking about employee retention issues given that valuations have come down and that some of the employees are a little worried about some of the stock-based competition that they have. So any takeaways in that regard, but generally also on the state of the market currently, thinking more not just for the short term, but also positioning yourself with the long term. Maybe you can start with MBI.
[00:37:25 ] MBI: In earnings calls, there are some positive, some negative, and some neutral stuff that management talks about depending on the macro and market sentiment. Investors seem to focus on just one of those three aspects predominantly. In 2021, it used to be mostly just the positive stuff. People tend to kind of brush through the negative or neutral stuff but I feel like we have gone to the opposite extreme these days. As I mentioned, for example, in Amazon's earnings call they talked about how they're not immune from inflation, how the cost side, and the retail side of the business, and the fact that they have probably overbuilt those are some of the negative that they talked about and investors need to account for those things.
But I also think investors sort of overlooked the fact that AWS has been posting a 35% GAAP EBIT margin. Two years from now if AWS consistently puts a 35% GAAP EBIT margin I think that's going to be a much bigger talking point than whatever we are discussing, the inflation and stuff, or overbuilding and CapEx investments in the retail side. We would probably be discussing for maybe a quarter or two or maybe the rest of this year but I don't think that's going to be a bigger story if we are having another discussion in 2025 or 2026. And also on the retail side, when I was going through Shopify's earnings call, I also felt investors ignored some of the positive elements. People are much more focused on Value Prime, how Amazon is doing on their platform business, and potentially they’re matching solutions revenue.
Shopify is pretty big on Shopify payments and if Value Prime starts eating into those sides of the business that's pretty bad news for Shopify. But I also felt the fact that Shopify’s GMV grew faster than Amazon was kind of a big thing, at least to me. That wasn't the case ever. Shopify, GMV increase divided by Amazon's GMV increase used to be like 25% in 2020 and 50% in 2021. Now Shopify GMV increase in the first quarter was actually higher than Amazon's GMV increase. We all talked about how Shopify is going to suffer because of Apple's IFDA changes and all that, and despite all these headwinds, Shopify’s GMV was a bit of a surprise, especially in the context of Amazon's GMV.
They did not meet analysts' expectations or customers’ expectations, but when you set the context, what was Amazon's GMV? What was Shopify GMV? Shopify came out much better than probably many people give them credit for. We don't know if Value Prime is going to be a big hit, that's not going to be good news for Shopify but that remains to be seen. We don't know yet how they’re going to respond and frankly speaking, there are not many details either from Shopify or from Amazon on how Value Prime is going to play out. I guess there are positives and negatives in almost all earnings calls. For example on Facebook's call, there was the fact they focused and they reiterated that they want to grow earnings even after funding reality labs' ambition.
That was probably a reassuring thing for shareholders, they're just not going to burn money in order to chase metaverse ambitions. Mark clearly understands the importance of growing operating income, and then the fact that they have kind of held back their hiring ambitions, and they also cut down the expense guidance. And my guess is that expense guidance is going to be cut throughout this year. I suspect analysts will be surprised how much they will pull back even for next year. So I was just checking Meta’s operating expenses is 102 billion, I wouldn't be surprised if it's like 92 billion next year. So there can be a $10 billion divergence between what analysts are expecting and what Facebook may actually declare in Q3 this year. So those are kind of the things that I'm thinking about, and I feel these are real concerns. I'm not saying investors are not right to think about this stuff, but many of the short-term concerns that I see, I just feel like we're not going to talk about it maybe two, three years down the line.
Q2 Outlook & Closing Thoughts
[00:41:12] Mokaya: Alright. We’re almost coming to the end, maybe any quick thoughts and anything that you're watching going into Q2 and maybe something that you may not have covered this far.
[00:41:22] Sam: Just two real quick things, especially in the wake of Walmart and Target disappointing on the bottom line because of profit margin concerns, I think that's going to be the hot thing for Q2 earnings announcements, the degree to which profit margins hold up or how much should they contract. I think I sent you a chart and the notes that we have, but analysts continue to expect profit margins to be at record levels for 2022. If Walmart and Target are any sort of indicator of what's to come in terms of the direction of margins and it could be trouble for earnings broadly speaking. And getting back to what you were talking about with what's going on in the stock market and valuations, valuations have come down obviously with stock prices coming down, but forward earnings expectations continue to hold up really well.
Of course, those could certainly come down if we do find out that margins are contracting and all this stuff. But even if earnings hold up and margins hold up it could be a pretty difficult time in the stock market for a little while because if you've been following the federal reserve has very explicitly said it's actively tightening financial conditions and its effort to get inflation to cool down. And stocks are a huge part of how most folks calculate financial conditions. So a stock market rally isn't exactly the kind of thing that the Fed is looking for in the near term. Again, they've signaled that they'll get more hawkish if financial conditions stay loose. It looks like the stock market probably has a cap on it for a little while until we actually start to see inflation and inflation expectations come down materially. It should be a bumpy ride, but I'm looking forward to when we do this call again in three months.
[00:43:05] Alex: The thing I'm probably watching most closely is for companies and management teams that are always looking to strengthen their long-term competitive position and to find paths to really improve their business. And, in the short term that includes being cognizant of the risks that arise as conditions change and appropriately reacting to those developments. But something I believe more and more is that a truly great CEO and a really great management team is about strategic vision and the ability to execute against that vision. But it's also things like understanding when there are opportunities to do things inorganically and ways to really strengthen your business when dislocation occurs. And I think that certainly fits with what's happening more broadly and in some of the sectors and some of the companies that I follow pretty closely, it's probably been even more painful than kind of the general pain that's been felt.
So it's monitoring the companies and those industries seeing the reactions of the different competitors, and if someone makes a move and does something that seems really smart, being prepared to act. The only other layer on top of that, that I know, and this isn't investment advice, but it's also ensuring that when dislocation occurs that you don't let, at least for me, let these many given single investments take precedence over having a thoughtfully diversified portfolio and having a portfolio that you are really comfortable with for the long-term. For someone like myself, who's fairly concentrated that might still mean a smaller number of positions, but it's thinking about it in a way where you're not really introducing too much risk or being exposed to any single trend. As always balancing that aggressiveness and that need to be conservative.
[00:44:42] Mokaya: Before MBI and Scott give their closing thoughts, I wanted to give some time to the sponsor for today's Transcript call. Stratosphere, are you able to speak?
[00:44:51] Stratosphere: Hey Mokaya. Just hopped off a little podcast recording, I was catching the end of this. This is awesome stuff. Thanks for letting us have the opportunity to sponsor today's Transcript. Really cool, I like tuning in at the end here. I know Alex and MBI, I don't know Scott and Sam, but we'll have to connect over the next coming week. Stratosphere is a data platform where you can search any North American listing, find all the financial data you'd look for, and data visualizations, you can set your watchlist tons, tons more and it's available for free at stratosphereinvesting.com. If you want to give it a try, we will be happy to have you there.
[00:45:31] Mokaya: Thank you. MBI, do you have some closing thoughts? And then Scott can close for us.
[00:45:36] MBI: Yeah, one of the quotes that kind of stood out to me during this earning season is a quote by ISS CEO Joe Livin. He said, “Market reaction is driven by an appropriate resetting in valuation frameworks rather than an exogenous Black Swan event. And this time there's no shot in the arm, literally or figuratively on the horizon to snap things back.” I think he has gotten that right. I think it's going to be a draining experience for both the operators and the management team and investors as well. I don’t think it's going to be a rapid snapback, like the one we experienced during COVID time, it's going to be probably a much more draining experience for everyone involved.
To Alex's point, I think it goes back to the management teams and how good they are going to be and how well they are going to navigate this challenging period over the course of this year and probably the next couple of years as well. I think once these things are kind of back to normalizing we will begin to appreciate the difference between the good, average, and below-average operators and management teams. And the next one or two quarters will be a lot of interesting things to look forward to. For example, just off the top of my head, I know in the next quarter I'll be keen to kind of understand whether Meta guides on revenue acceleration in Q3.
They talk about hiring, a tough comp in Q1 and Q2 but there's a general expectation that the revenue may accelerate once they wrap the ATD impact and the last year COVID related impact. So that's something I kind of look forward to. The other question I have is whether Google will be able to keep its hiring pace. They mentioned they will keep the pace of hiring for this year. It'll be interesting to see whether their tone kind of changes in the next earnings calls. And, AWS, there’s this kind of meme or joke that's going around that, basically at this price you'll get retail for free. So I was kind of doing this exercise, like, what we need to forecast for AWS to get the retail side of the business for free.
And we just need to maintain the revenue like a dollar growth that AWS has seen in the last year or throughout this decade, I think roughly $20 billion. If your AWS keeps $20 billion revenue growth for the rest of this decade there is a strong case to remain that you probably get the retail side of the business for free. I'd be very keen to see whether that dollar revenue growth for AWS and the top-line growth maintains the pace and at the same time that GAAP EBIT margin they talked about, 35%, whether that's a one-off thing for reducing credit reasons, there's probably some exchange rate effects margins. So it would be interesting to see whether that sustains at a 34, 35% level, or it comes the back to high twenties or low thirties. Those are the kinds of things that I'd be looking at.
Also, I think SBC stock-based compensation has all of a sudden become an important topic for all these tech companies. Some of these big tech companies generate a lot of cash, a lot of free cash flow, and probably all of them are going to buy back stock, especially given how stock prices are going down these last few weeks. So it's going to be interesting to see to what extent they are issuing stocks and to what extent they are buying back stocks. Whether they are issuing more stocks to kind of increase retention or to maintain retention or whether they're just being aggressively buying back stock, especially, that's probably more relevant for Google and Facebook and less relevant for Amazon.
[00:48:47] Scott: All super interesting. I want to jump in real quick just to close up because I have to run to something else. I wanted to say thank you to everybody who participated today and joined us. Sam, thank you as always Alex and MBI for the first time joining us, thank you very much. Closing thoughts, two weeks ago, we titled our newsletter at the end of an era question mark. And I think the reason we titled that was because we had seen a lot of quotes in the same week of people questioning, whether we've moved finally from an era of easy money and deflation into an era of inflation. And I think it still is definitely a question mark. Nobody can predict the future, but certainly, people are thinking about that today and that is what's driving financial markets and driving our investment environment.
And I think the biggest thing to me that signifies is throughout the deflationary period, we talked about the Greenspan put that started in the nineties and certainly has happened since the financial crisis. Anytime you started to get a hint of deflation or a potential recession, the Fed would come to the rescue. And I think the difference, again, going back to that 1960s period and the period potentially today is that put kind of turns into a call where if you have inflation starting to pick back up, the Fed puts a clamp back down on the economy until it goes away. And if that's the case, we could be in for a period where you have the longer-term lid on securities markets, capital markets valuations, and a trend lower towards what may be a more normalized cost of capital. We have existed in the abnormal world for a long time here, and that could cause some dislocations and we will be tracking that through earnings calls. So thanks again to everybody. Eric, do you have any closing thoughts?
[00:50:27] Mokaya: My closing thought would be there's a quote yesterday, “I would say there would be some pain involved in restoring price stability.” My hunch is that we are in for a bit of a painful period for the few months ahead. I don't know how long that would last, but I think to be prepared as you position yourself and your portfolio for that. That would be my closing thoughts. For our speakers, if you want to see where to find them just posted a tweet showing where various write-ups happen so you can follow them there. You can find us at thetranscript.substack.com and you can always sign up. We have a podcast every week, we release it every Tuesday and every Monday we send out the newsletter, so you can catch up with us there. Thank you so much for joining us today. We do this every quarter, the next one will be three months from now. Thank you so much and have a lovely evening.
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