With Microsoft (MSFT) reporting after the bell, now is a good time to talk mega-cap earnings. 

Recently, mega-cap layoffs have been in vogue. The market has embraced these announcements, bidding up shares of the associated company 3-5% and creating a spark of positive momentum. Investors are interpreting layoffs as a sign that mega-caps have found fiscal religion. The layoffs represent cost-cutting measures that protect profit margins and right-size the business for a more normalized, post-COVID, demand outlook. While I agree with this interpretation, the potential implication to 2023 guidance warrants caution. 

To explain these implications, let’s put ourselves in the armchair of any mega-cap CEO. 

Imagine, you are the CEO of any mega-cap firm. You are a few months into COVID, and the initial fear has died down. Now, businesses are rapidly trying to modernize by building an online presence and ecommerce channel to survive. Demand for your mega-cap products and services is far higher than previously anticipated. Consequently, your workforce is stretched thinner than butter on hot toast. What do you do? You hire. What does that require? A substantial investment of financial (money) and human (time) capital.

Now, you are in the first half of 2021. You built up your workforce. It was no small effort, but it paid off. You were able to meet overwhelming demand, beat expectations, and create value for all stakeholders. However, the world is beginning to reopen. No one is exactly sure what demand looks like as some degree of normalcy returns to the world. Which COVID habits will stick? Which will fade? Is the size of my workforce still justifiable? 

You study the market and discover that competition has increased for cloud and software services. You know that if you cannot meet demand, then you will lose market share. You decide the risk of not being able to meet demand is higher than the risk associated with being too big in a slowdown. You keep your workforce. Perhaps, you even continue to hire as you monitor the situation.  

Now, you are a few months away from the end of 2022. There is no denying it. The economy is slowing. The new employees brought in are no longer accretive: their costs exceed their revenue. Margins are under pressure. Bringing them on was costly, but you no longer believe demand will reaccelerate enough to justify keeping the newer hires. You decide you have to layoff employees.

That catches us up to the present. Despite an admiral job as CEO, you are back to being a portfolio manager. Unfortunately, there is no golden parachute for armchair CEOs. What’s the takeaway?  

Mega-cap tech names have been stubbornly hoarding talent for the better part of 12-16 months because they assigned greater risk to being unable to capitalize on a reacceleration in demand than being oversized if demand normalized or slowed. Consequently, these layoffs suggest that management has finally folded on the idea of reacceleration, which means management may revise guidance down further at upcoming earnings calls. If guidance does not meet expectations, then recent gains are in jeopardy.  

The primary reason to invest in mega-cap technology is for above-market revenue and earnings growth. Everything else is secondary. Mega-cap tech trades at a premium multiple relative to the market principally because of their attractive expected growth rates. If 2023 guidance suggests mega-caps will not live up to expectations, then their premium valuations are at risk. 

Let’s leave AMZN aside. No valuation-based approach to date would profitably trade AMZN. Furthermore, the consensus for AMZN forward earnings is negative. However, the market priced-out META’s premium valuation. While that does not mean the same is certain for AAPL, MSFT, and/or GOOG, it shows it is possible. 

This is not a recommendation to buy, sell, or hold these names. I am long GOOG, AMZN, and MSFT. In earnest, I think the market was correct to reward companies that laid off employees. Investors asked for discipline; investors got it. The point of this discussion was to think critically on what these layoffs may imply for long-term growth despite the enticing optimism short-term price action has generated. It also serves as a reminder that the future direction of these companies’ stocks will be related to future growth expectations not past layoffs.