Oct. 27, 2022

The Reckoning 2: Apple and Amazon

We are in the middle of one of the most significant earnings seasons in a generation or more. We are seeing the full impact of this inflation tsunami in the quarterly earnings statements reported each day.

High Inflation is incredibly challenging for most of America's corporate managers. Most of today's executives have lived through a time when markets were expanding, and every quarterly report focused on the sales side of the ledger.

Reading through this quarter's earnings report is like reading a sales brochure. Each company I've reviewed has begun its presentation with how sales are expanding, and market share is climbing. The marketing and salespeople are featured at the shareholders' meeting. And its Sales and marketing who go on those annual trips to the most delightful tropic paradise to celebrate yet another record-breaking sales year. And it's been that way for quite a while now.

But those times may be changing. The latest report by Microsoft shows new forces at work in the economy. In the future, it will be ops (operations), not sales, that will make or break the company.

In any tech organization, cost management is the purview of operations, service, and production. While sales can enhance revenue, it's operations that control expenses.

With that in mind, let's take a quick look at the Microsoft Earnings Statement just released. As you'll see, it's a confirmed case of good and bad news: some improvement, some decline.

The first thing that stands out is the nearly $5 billion gain in revenue. But a closer review shows that the entire gain is due to service fees. In this case, the Microsoft cloud provides the real impetus behind Microsoft's income this quarter. Product sales, the Microsoft P/C, tangible software CDs, and so on, declined this quarter. Product sales were down nearly a billion dollars.


In conclusion, fee-based income has become Microsoft's number one revenue source. And I expect to see similar trends throughout the tech industry as the "cloud" becomes an ever more dominant "back office system" for businesses across the country.

At Microsoft and elsewhere, sales and marketing are in for a tough time. Product sales declined at the same time that S&M expenses grew. Never a good thing to see. And this trend is likely to continue. Costs of all kinds will likely continue to grow. Especially personnel expenses, salaries, insurance, and other expenses are all bound to increase. I'm looking for a very soft holiday sales period directly ahead.

Overall top-line revenue increased by nearly $5 billion for Microsoft for the quarter. But here's that other side of the story. The bottom line, net income was only up $1 billion. I'm disregarding a $4 billion increase in Microsoft taxes and only looking at income before taxes and comparing apples to apples (sorry about that!). There was an overall increase in operating expenses of $4 billion.

Operating expenses will be the number one concern this quarter as we work through this heightened period of Inflation. And controlling expenses, not enhancing income, will mean the difference between survival and bankruptcy for some companies.

So here's today's moral: take your eyes off the sales and income, and pay particular attention to the expense side of the ledger. It's terrific to see sales expand, but only if the company controls expenses. In the case of Microsoft, I'm looking at the net income, not top-line revenue, as the objective measure of how the company is performing.

This afternoon the final two of the big five tech companies will report their results: Apple Computer and Amazon.

Now, Apple has a more challenging course ahead, as trouble with sourcing components and the lockdown of an iPhone plant may cause some delivery issues for Apple. We are likely to see softening sales for both companies.

Overall, customers feel the full impact of the rising cost of living. And this will cause them to cut back on year-end spending. It will lead to possible sales declines for Apple and fewer deliveries for Amazon.

But both companies will be just fine if they control their expenses. Cost control will be incredibly challenging for Amazon, with higher fuel and transportation costs.

It is early in this inflation cycle, but I remember the last time Inflation hit back in the early 1980s. I worked for a major financial services company when they reported an abysmal quarter's results. Like many companies, they had allowed their expenses to climb too high.

The next thing I knew, the board of directions appointed the Chief Financial Officer as President. At least he can get expenses under control, was their thinking. Who better to get costs under control than the company's accountant? In times like this, the quicker companies adopt that approach, the better.

 

Econ Briefs

 

For the first time in three quarters, the American Economy recorded positive growth. GDP is up 2.6%, exceeding Wall Streets' estimate by 2/10th percent. This GDP Growth is very positive news indeed. Combined with the GDP Price indicator, the economy is improving. GDP Inflation came in a complete 5% BELOW last quarter's level. And a sign that inflation may be cooling.

The Federal Reserve is now in an exciting position. The Fed meets next Wednesday to set the new interest rate. Many on Wall Street think the Fed can dial back on its rate hikes. Raising rates by only half a percent, rather than the three-quarters percent we saw last month.

Lower rates are why we've seen bonds rallying for the last two days.

This GDP Report is excellent news, with better-than-expected economic growth and lower and expected inflation.

It doesn't get much better than this.

Let's see if we can get some good news when Apple computer and Amazon report their results later this afternoon.