The Four Horsemen of the Tech Recession

Stephanie Palazzolo wrote on Twitter:

It really was jarring to see those employment figures the same week that tech company after tech company reported mostly disappointing earnings, and worse forecasts, all on the heels of layoffs. Even Meta, which saw a massive uptick in its stock, reported revenue that was down 4% year-over year; the stock increase was a special case where too many investors bought into Meta Myths that convinced them a company with a still strong and growing core business was somehow doomed.

That’s not to say that tech is an echo chamber: all tech companies are facing unique headwinds that don’t affect most of the economy; let’s call them the four horsemen of the tech recession.

The Four Horsemen of the Apocalypse, as imagined by MidJourney
The Four Horsemen of the Apocalypse, as imagined by MidJourney

The four horsemen, for those who didn’t grow up Christian or weren’t paying attention in Sunday School, come from the Book of Revelations sixth chapter, which opens:

And I saw when the Lamb opened one of the seals, and I heard, as it were the noise of thunder, one of the four beasts saying, Come and see.

I trust it’s not sacrilegious to have a bit of fun with the four horseman prophecy and use them to explain exactly why the tech industry is in a funk.

The COVID Hangover

The first horse was white:

And I saw, and behold a white horse: and he that sat on him had a bow; and a crown was given unto him: and he went forth conquering, and to conquer.

To quote Wikipedia, for reasons that aren’t entirely clear, in popular culture the white horseman “is called Pestilence and is associated with infectious disease and plague.” I’m not here to parse Scripture, so I’m going to go ahead and run with it, and for good reason: COVID is the single biggest issue facing tech companies.

Now that may seem like a bit of an odd statement given that COVID is for all intents and purposes over in most of the world. To state the obvious, COVID obviously still exists (and will forever), but it isn’t the dominant factor in the economy. That’s good for the vast majority of businesses — and by extension the broader economy — which were decimated by COVID.

Remember, though, that tech didn’t just survive COVID: it thrived. Consumers with no way to spend discretionary income and flush with stimulus checks bought new devices; people stuck at home subscribed to streaming services and ordered e-commerce; businesses thrust into remote work subscribed to SaaS services that promised to make the experience bearable; and all of this ran on the cloud.

That last paragraph actually touches on a couple of the horses I’ll get to in a moment, but two of the most important ones are e-commerce and cloud computing, which first and foremost means Amazon. The Wall Street Journal reported: Inc. warned of a period of reduced growth and signaled the difficult economic environment is denting the performance of its cloud-computing business that has been a profit engine for the company. “We do expect to see some slower growth rates for the next few quarters,” Brian Olsavsky, Amazon’s chief financial officer, said Thursday on a call with reporters. The guidance, he said, reflects the uncertainty the company continues to have about both consumer and corporate spending in the U.S. and overseas.

CFO Brian Olsavsky said on the company’s earnings call:

By and large, what we’re seeing is just an interest and a priority by our customers to get their spend down as they enter an economic downturn. We’re doing the same thing at Amazon, questioning our infrastructure expenses as well as everything else…I think that’s what we’re seeing. And as I said, we’re working with our customers to help them do that.

CEO Andy Jassy added:

It’s one of the advantages that we’ve talked about since we launched AWS in 2006 of the cloud, which is that when it turns out you have a lot more demand than you anticipated, you can seamlessly scale up. But if it turns out that you don’t need as much demand as you had, you can give it back to us and stop paying for it. And that elasticity is very unusual. It’s something you can’t do on-premises, which is one of the many reasons why the cloud is and AWS are very effective for customers.

This is certainly true, and predictable; I wrote about this dynamic in an Update last year:

This approach mirrors the overall business model of cloud computing, wherein Amazon and Microsoft are spending billions of dollars in capital expenditures to build out a globe-spanning network of data centers with the goal of selling access to those data centers on an as-needed basis; it’s arbitraging time, up-front cash, and scale. The selling point for their customers is that not only is it much easier to get started with a new company or new line of business when you can rent instead of buy, but that you also have flexibility as the business environment changes.

For most of the history of cloud computing, that flexibility has been valuable in terms of scaling quickly: instead of buying and provisioning servers to meet growing demand, companies could simply rent more server capacity with the click of a button. That promise of flexibility, though, also included big slowdowns; that certainly has included microeconomic slowdowns in the context of an individual business, but what is very interesting to observe right now is a macroeconomic slowdown in the context of the broader economy.

Remember, AWS didn’t launch S3 until 2006; when the Great Recession rolled around two years later Amazon was still busily harvesting the low-hanging fruit that was available to the company who was first in the space. AWS also benefited from the launch of the iPhone in 2007 and the App Store a year later: cloud computing has grown hand-in-hand with mobile computing, and just as Apple didn’t really feel the Great Recession, neither did AWS.

Today, though, is a different story: while AWS and Azure (and GCP) are still growing strongly, that growth is much more centered in the sort of businesses that are heavily impacted by recessions; moreover, all of those companies that grew up on cloud computing are much more exposed as well. What that means is that the same time, cash, and scale arbitrage play is going to reverse itself for the next little bit: AWS and Azure are going to bear some of the pain of this slowdown on behalf of their customers.

What is notable about this analysis is that it assumes that we are in for a broad-based economic slowdown; that, though, takes things back to Palazzolo’s observation: it sure doesn’t seem like there is much of a recession in the broader economy. This, in turn, brings back the concept of a COVID hangover.

Go back to work-from-home, and the flexibility of cloud computing. When corporations the world over were forced literally overnight to transition to an entirely new way of working they needed to scale their server capabilities immediately: that was only realistically possible using cloud computing. This in turn likely accelerated investments that companies were planning on making in cloud computing at some point in the future. Now, some aspect of this investment was certainly inefficient, which aligns with both Amazon and Microsoft attributing their cloud slowdowns to companies optimizing their spend; it’s fair to wonder, though, how much of the slowdown in growth is a function of pulling forward demand.

Amazon’s e-commerce business is, as Olsavsky noted, facing many of the same sort of challenges, albeit on a far greater scale than just about anyone else. Jassy explained:

I think probably the #1 priority that I spent time with the team on is reducing our cost to serve in our operations network. And as Brian touched on, it’s important to remember that over the last few years, we took a fulfillment center footprint that we’ve built over 25 years and doubled it in just a couple of years. And then we, at the same time, built out a transportation network for last mile roughly the size of UPS in a couple of years. And so when you do both of those things to meet the huge surge in demand, just to get those functional, it took everything we had. And so there’s a lot to figure out how to optimize and how to make more efficient and more productive.

The problem for Amazon is that not only did they (inevitably) build inefficiently, but they almost certainly overbuilt, with the assumption that the surge in e-commerce unleashed by the pandemic would be permanent. Olsavsky said on Amazon’s first quarter earnings call:

The last issue relates to our fixed cost leverage. Despite still seeing strong customer demand and expansion of our FBA business, we currently have excess capacity in our fulfillment and transportation network. Capacity decisions are made years in advance, and we made conscious decisions in 2020 and early 2021 to not let space be a constraint on our business. During the pandemic, we were facing not only unprecedented demand, but also extended lead times on new capacity, and we built towards the high end of a very volatile demand outlook.

That high end did not materialize: when I covered that earnings call Amazon’s retail growth had pretty much reverted to what it was trending towards pre-pandemic; the last two quarters have slowed further.1

In addition, I suspect that part of the challenge for both and especially AWS is that they are also exposed to the other three horsemen.

The Hardware Cycle

The second horse was red:

And when he had opened the second seal, I heard the second beast say, Come and see. And there went out another horse that was red: and power was given to him that sat thereon to take peace from the earth, and that they should kill one another: and there was given unto him a great sword.

The easy analogy here would be the Ukraine War, but I don’t think that is particularly relevant to tech company earnings. Rather, when you think of war it is very zero sum: you either control territory, or you don’t. You either live, or you are captured, or dead. The analogy here — and I admit, this is a bit of a stretch — is to the hardware cycle. If you have a new PC, you’re not going to buy one for a while. This applies to all consumer electronics and, in the case of, applies to a whole host of durable consumer goods.

The most obvious victim of the hardware cycle was Apple, whose revenue was down 5%, despite the company benefiting from a 14-week quarter. The biggest impact on the company’s revenue was the COVID-related slowdowns in iPhone production in China: a phone not made is a phone not sold, a zero-sum game in its own right. Mac and Wearable, Home, and Accessories revenue, though, was down even more, which makes sense give how much both categories, particularly the former, exploded during COVID.

Of course Apple has plenty of countervailing factors, including pent-up demand for the company’s Apple Silicon-based processors, that was largely sated over the last two years; the obliteration of the PC market, though, is an even better example of COVID’s impact. Microsoft reported that Windows OEM sales were down 39%, which particularly impacted Microsoft’s long-time strategic partner Intel. Even mighty TSMC is forecasting a decline in revenue, and is struggling to fill advanced-but-not-cutting-edge nodes like 7nm.

The good thing for all of these companies is twofold: first, hardware has always been cyclical, and the implication of a downward cycle is that an upwards one will come eventually, particularly as those year-over-year comparisons become easier to beat. Secondly, Microsoft released some encouraging data that suggested that PC usage — and in the long run, sales — may be up permanently. I suspect this applies broadly: the COVID pull-forward was massive, but underneath the inevitable hangover there was a meaningful long-term shift to digital broadly.

The End of Zero Interest Rates

The third horse was black:

And when he had opened the third seal, I heard the third beast say, Come and see. And I beheld, and lo a black horse; and he that sat on him had a pair of balances in his hand. And I heard a voice in the midst of the four beasts say, A measure of wheat for a penny, and three measures of barley for a penny; and see thou hurt not the oil and the wine.

This is another horseman the meaning of which is under some dispute; I’m going to interpret the pair of balances as investors discovering that the cost of capital input in their equations can be something other than zero, and the price they are wiling to pay for growth without profitability is falling through the floor.

SaaS was actually the first sector in tech to crash, back in late 2021; a driver was likely another manifestation of the COVID hangover. High-flying stocks like Zoom that exploded during lockdown were the first to slowdown significantly, and the realization that COVID wouldn’t be a persistent economic force soon spread to SaaS companies of all types.

The real problem, though, was increased interest rates. The SaaS model, as I have documented, entails operating unprofitably up-front to acquire customers, with the assumption being that those customers will pay out subscription fees like an annuity; moreover, the assumption was that that annuity would actually increase over time as companies used their initial product as a beachhead to both increase seats and average revenue per user.

This is fine as far as it goes, but the challenge from a valuation perspective is that it is difficult to model those annuities far into the future. First off, predicting the future is hard! Second, one of the biggest lessons to Microsoft’s dismantling of Slack is that it is problematic to extrapolate “big enough to get the attention of Microsoft” growth rates from “popular with startups and media” growth rates. Third, any valuation of long-term revenue streams is subject to a discount rate — money now is worth more than money in the future — and rising interest rates increased the discount rate, which is to say it devalued long-term revenue. This in turn reduced the current valuation of SaaS companies across the board, no matter how strong their moat or large their addressable market.

This devaluation has had the most visible impact on public companies, but the true famine — one of the interpretations of what the black horseman represents — will likely be amongst startups. Companies without clear product-market fit won’t be given time to find one, while those who have it will face much more skepticism about just how much that market is worth and, crucially, when it will be worth it.

What is notable is how this blows back onto the public clouds: those SaaS companies mostly run on AWS (Microsoft is much more exposed to corporate pullbacks), and to the extent they slowdown their spend or curtail their loss-driving growth AWS will feel the pain.

The ATT Recession

The final horse was pale:

And when he had opened the fourth seal, I heard the voice of the fourth beast say, Come and see. And I looked, and behold a pale horse: and his name that sat on him was Death, and Hell followed with him. And power was given unto them over the fourth part of the earth, to kill with sword, and with hunger, and with death, and with the beasts of the earth.

This sounds like the most dramatic analogy, but it is arguably the most apt: I have been arguing for two years that Apple’s App Tracking Transparency (ATT) initiative was a big deal, and I may have been understating the impact.

Every company that relies on performance marketing, from Snap to YouTube to Meta to Shopify has seen its revenue growth crash from the moment ATT came into force in late 2021, even as companies and products that were isolated from its effects, from Amazon to Google to Apple advertising has seen growth. Notably, this crash preceded and continued through the Ukraine War, the hike in interest rates, and this very weird recession where the economy is in fact adding record jobs. That’s why Eric Seufert coined the term The App Tracking Transparency Recession; he writes in the introduction:

One might assume that the economy has utterly imploded from reading the Q3 earnings call transcripts of various social media platforms. Alphabet, Meta, and Snap, in particular, cited macroeconomic weakness, headwinds, uncertainty, challenges, etc. in their Q3 earnings calls…

But aside from various corners of the economy that are particularly sensitive to interest rate increases, such as Big-T Tech, homebuilding, and finance, much of the consumer economy is robust. Nike reported 17% year-over-year revenue growth in its most recent earnings release last month; Costco reported year-over-year sales growth for December of 7% on January 5th; Walmart’s 3Q 2023 results, reported in November 2022, saw the retailer grow year-over-year sales by 8.2%; and overall US holiday retail spending increased by 7.6% year-over-year in 2022, beating expectations. Of course, these numbers are nominal and not real, but for comparison: holiday retail sales in 2008 were down between 5.5 and 8% on a year-over-year basis, and the unemployment rate in December 2008 stood at 7.3%. And as I’ll unpack later in the piece, many participants in the broader digital advertising ecosystem saw strong revenue growth in 2022 through Q3.

So what’s the source of the pain for the largest social media advertising platforms?

Apple introduced a new privacy policy called App Tracking Transparency (ATT) to iOS in 2021; with iOS version 14.6, that policy reached a majority scale of iOS devices at the end of Q2 2021, in mid-June. ATT fundamentally disrupts what I call the “hub-and-spoke” model of digital advertising, which allows for behavioral profiles of individual users to be developed through a feedback loop of conversion events (eg. eCommerce purchases) between ad platforms and advertisers. In this feedback loop, ad platforms receive conversions data from their advertising clients, they use that data to enrich the behavioral profiles of the users on their platform, and they target ads to those users (and similar users) through those profiles. I’ve written extensively about how ATT disrupts the digital advertising ecosystem, but the disturbance is most pronounced for social media platforms as I’ll describe later in the piece. The shocks of ATT became discernible in Q3 2021 (the quarter after ATT was rolled out to a majority of iOS devices) but were substantially troublesome for Meta in particular in Q4 2021. The disruptive forces of ATT have compounded over time.

My general belief is that the impact of ATT has been underestimated; ascribing the advertising revenue headwinds being felt most profoundly by social media platforms and other consumer tech categories with substantial exposure to ATT to macroeconomic factors is misguided.

Seufert’s piece is well-argued and a must-read. I’m biased, to be sure: the piece aligns with my own views on the significant impact of ATT. Moreover, to double-down on Seufert’s point, the impact goes far beyond Meta: every company that sells on Meta was impacted, which in turn means that cloud providers like AWS were as well. Jassy noted that one of the headwinds for AWS was “things tied to advertising, as there’s lower advertising spend, there’s less analytics and compute on advertising spend as well.” As Seufert notes, though, most advertising was fine: all of the pain is in industries impacted by ATT.

This is not, to be clear, an argument that ATT was bad, or good. I personally think it was solving a problem that largely doesn’t exist and hurting small businesses more than it was helping end users, but I understand and respect arguments on the other side (even if most of them don’t realize that they’re actually opposed to tracking in all forms, which means Apple isn’t necessarily an ally). What this is is an acknowledgment that ATT, which happened to land right in the midst of the pandemic, rivals said pandemic in its contribution to the disconnect between tech earnings and layoffs and the broader economy.

I’m not a macroeconomist: I am certainly cheering for a soft landing, and have always attributed more weight than most to the idea that the impact of the COVID shutdowns was so great that it would in fact take years to unwind. One thing that is certain is that the surest way to be wrong about what would happen with the economy is to put a prediction down in writing.

To that end, I do rue my prediction that the pandemic would permanently pull forward certain behaviors that were already on the increase, particularly e-commerce. This prediction wasn’t totally wrong — e-commerce is meaningfully up, but it is down from pandemic highs, and it pains me to see so many companies citing optimism about maintaining COVID highs in their layoff letters.

What I do feel justified about are my predictions about ATT: what made digital advertising, particularly of the Facebook variety, so compelling is that most advertisers were entirely new to the space. Facebook and other performance advertisers weren’t so much stealing advertising dollars as they were creating the conditions for entirely new businesses; the viability of those businesses took a major hit with Apple’s changes, and every dollar in reduced revenue for Facebook ultimately means that many more dollars in foregone e-commerce or app sales, corresponding spend on cloud providers, and overall fewer only-possible-on-the-Internet jobs as it became that much harder to find niche audiences in a worldwide addressable market.

At the same time, it is precisely because these jobs — and similarly, many of the COVID-specific workloads like work-from-home and e-commerce — were digital that it is tech that is in a mini-recession even as the so-called “real” economy is doing better than ever. Perhaps that is for the greater good; at a minimum the increasing distinction between the digital and analog is exactly what Palazzolo is missing.

  1. Note: this Article previously included a chart of Amazon’s Net Sales; the accurate chart should be gross merchant volume which Amazon only reports occasionally. I have removed the chart and apologize for the error.