Google: When Will Pichai Drop The Axe?

Summary:

• Google’s stock was an underperformer relative to its FAANG peers in 2022 and continues to lag behind the early-year recovery that broader markets have benefitted from.
• After a consecutive run of earnings and sales misses last year, investor confidence in the stock remains fragile ahead of its upcoming fourth quarter earnings call.
• The following analysis will look into some of the resolves that remain on the table for Google to deploy and mitigate exposure to further market downside risks in the near term.

Google (NASDAQ:GOOG/NASDAQ:GOOGL) remains one of the few within big tech and megacaps that have yet to announce mass layoffs (or reduction in forces, “RIFs”) as the industry braces for growing macroeconomic uncertainties in the near term. Only its AI-driven life sciences arm, Verily, has turned to job cuts recently as it “eliminates some programs and streamlines operations”. But unlike Google’s big tech peers, Verily’s recent decision to reduce its workforce by 200 jobs, or 15%, is unlikely to have a great impact on the consolidated company’s bottom line. This is because the unit is currently housed under “Other Bets”, a segment that accounts for the tech giant’s investments in “early-stage technologies”, which are typically nominal contributors to the consolidated top line and likely a cost center with no positive net income yet.

Google’s stock was one of the biggest decliners among the FAANG megacaps in 2022, while 2023 year-to-date gains continue to lag behind peers as the broader market kicks off one of the “best starts to a year for global equities”. Investor confidence in the stock has buckled at the sight of consecutive earnings misses and sales deceleration incurred at Google last year, while visibility on the company’s near-term outlook remains low, given inherent vulnerability to cyclical headwinds at its core advertising business. Meanwhile, Google Cloud Platform (“GCP”) continues to face stiffening competition from leading hyperscalers like Microsoft’s Azure (MSFT) and Amazon’s AWS (AMZN), despite demand risk mitigation from growing enterprise adoption of a multi-cloud strategy to improve reliability and cost-efficiencies. Accelerating “cloud spend optimization” across the enterprise sector to enhance “applications, performance, and business needs in the cloud while eliminating costs and inefficiencies” also risks further squeezing GCP’s margins – which remain in the negative – in the near term.

As such, reducing headcount could be a “low-hanging fruit” for Google to preserve and expand its profit margins, and lift sentiment on the stock’s sluggish performance. Looking ahead, profit margins will be a key performance indicator at Google at its upcoming earnings call, especially after rolling out several cost-cutting and productivity enhancement initiatives in the second half of 2022. Continued weakness in fundamental performance, which CFO Ruth Porat has repeatedly warned of last year, is largely expected to remain a persistent theme at upcoming earnings releases, as macro uncertainties spanning rate hikes, inflation, and a looming recession persist through at least the first half of 2023. The challenges will likely dial up the urgency for Google to ultimately embrace RIFs within the near term, as it may be within the company’s prudence and interest to drop the axe soon before investors shift gears from rewarding companies that have actively sought to optimize profitability during challenging times (e.g., Meta Platforms/META), to punishing those that have failed to promptly counter inefficiency instead.

But what we know is that investors want to see estimate revisions bottom in a “one and done” scenario to set up a faster recovery vs. “death by a thousand cuts”.

Source: RBC Capital Markets TMT Equity Research

The Fraying Tech Job Scene

Job postings across the tech sector have been weakening prevalently in recent months. Sequential job posting declines from the sector have been consistently accelerating, reaching double-digits since November – weekly tech job postings as of January 15th were 12.3% lower over the past 30 days, extending a trend of average declines in the 12% to 13% range in recent months.

And related headcount reductions are unlikely to be “one-and-done”, with more to come as recession risks play out. This is consistent with Amazon’s recent turn to a more aggressive than expected job cut earlier this month, as it looks to better optimize operations ahead of the looming economic downturn. Meanwhile, Google’s ad peers like Meta and Snap (SNAP) are already well underway with unprecedented job cuts in anticipation of the upcoming downturn.

As a result, tech sector headcount reductions have already exceeded 18,000 positions in the first two weeks of January, accelerating the pace of job cuts that reach 154,000 positions through 2022 by twofold. Although investors have largely responded positively to the latest string of tech layoffs, as related cost reductions could help preserve the bottom lines underpinning the sector’s valuations, the rapid unravelling of the tech job scene remains a leading indicator of weakening demand ahead, in line with Google’s recent warnings of macroeconomic challenges.

“Layoffs should be a move of last resort, so it can’t be good circumstances if you’re getting rid of 10,000 people,” said Ashwin Alankar, head of global asset allocation at Janus Henderson Investors. “It tells me demand is much worse than the market expects, which suggests multiples need to contract more.”

Source: Bloomberg News

Google’s Resolve

As mentioned in the earlier section, many of Google’s ad peers, in addition to megacaps, have embraced job cuts to preserve margins ahead of a rapidly deteriorating macroeconomic climate painted by rising cost pressures and slowing demand. In streaming – a fast-growing digital advertising format – industry blockbusters like Netflix (NFLX) and Warner Bros. Discovery (WBD) have refined their headcounts as part of a “savings drive”. Meanwhile, in social media – a harder-hit corner of digital advertising due to both macro and industry-specific challenges – incumbent leaders like Meta and Snap have turned to RIFs to better align productivity with the marked reduction in demand. And in retail media – another fast-expanding digital advertising format – Amazon has slashed positions across its core retail, devices and cloud divisions, in addition to administrative cost-centers that typically get let go first.

These are just a few examples that have drawn greater market attention to the extent of the rapid downsizing that is taking place “in an industry that hired prolifically during (the) pandemic boom”. And investors have largely responded positively to the headcount reductions, praising the industry’s efforts to preserve margins, which underscores the constitution of preference for profitability over growth under the current market climate.

But Google has yet to pull the trigger, though CEO Sundar Pichai never ruled out the possibility of massive layoffs after setting expectations for a cooldown in headcount expansion in recent earnings calls:

Given the uncertain global economic outlook and the hiring progress achieved to date… we intend to slow the pace of hiring. We expect our actions on hiring to become more apparent in 2023. Our headcount additions in the third quarter will reflect we already have a strong number of commitments, including new graduate hires.

Source: Google 2Q22 Earnings Call Transcript

In terms of profitability, we have an effort underway to ensure we redeploy investments against our most compelling opportunities. As we noted on our second quarter call, our actions to slow the pace of hiring will become more apparent in 2023… As in prior quarters, the majority of hires were for technical roles. In the fourth quarter, we expect headcount additions will slow to less than half the number added in Q3. Within this slower headcount growth, next year, we will continue hiring for critical roles, particularly focused on top engineering and technical talent.

Source: Google 3Q22 Earnings Call Transcript

Instead, Google has turned to a combination of refined performance review metrics and cost-cutting efforts that do not include RIFs, with an emphasis on sharpening “focus”, to improve company-wide efficiency by 20% – a mandate set by Pichai last summer. This includes the implementation of “Googler Reviews and Development” (“GRAD”) and “Support Check-Ins“, two of Google’s newly refined performance review systems aimed at improving “development, coaching, learning and career progression throughout the year”, while also driving better compensation for employees. But early employee feedback on the new performance review procedures indicates “the overhaul has left more room for ambiguity in ratings at a time when the company is looking for ways to cut costs”, escalating angst that they may be up next on the chopping block.

Meanwhile, the company-wide mandate to improve efficiency by 20% has also lacked specific elaboration on the aspects (e.g., cost efficiency, time efficiency, etc.), metrics, and timeline involved. But birthed out of the mandate is a new feedback solicitation system, dubbed “Simplicity Sprint“, to “crowdsource ideas for quicker product development (and) get better results faster”. Pichai has also placed a heavy emphasis on staying focused, citing there is still room to optimize productivity given the massive workforce Google has built over past years:

Google’s productivity as a company isn’t where it needs to be even with the head count it has, Pichai told employees in the meeting… He added, “There are real concerns that our productivity as a whole is not where it needs to be for the head count we have.” He asked employees to help “create a culture that is more mission-focused, more focused on our products, more customer focused. We should think about how we can minimize distractions and really raise the bar on both product excellence and productivity.”

Source: CNBC News

In addition to setting a tone at the top that enhancing workplace productivity will be key to mitigating job security risks, Pichai has implemented tangible cost-cutting efforts to drive the message home that achieving incremental company-wide efficiency of 20% would be critical to dodging the talent bloodbath happening in the here and now across tech. These included the cancellation of investments and projects with low immediate returns, as well as reduction in unnecessary entertainment and travel expenses that many employees have viewed as perks of working at the company. Specifically, Google has shut down continued development of its next-generation Pixelbook laptop, despite robust demand for its predecessor during the pandemic, especially from the education sector. The company has also “slashed funding to its Area 120 in-house (tech) incubator” and reduced half of the entrepreneurial unit’s projects.

And as mentioned in the earlier section, management has warned both employees and investors earlier on that hiring will slow through 2023 as it prioritizes deployment of resources to more critical opportunities, which is consistent with Google’s history of heavy R&D spend on next-generation innovations such as AI developments. This is further corroborated by management’s pinpointed call-out of “top engineering and technical talent” as a priority. However, tech peer and rival Microsoft’s latest update on its ongoing headcount reductions underscores how no talent in the sector is truly immune against the workforce consolidation efforts underway across the industry. The productivity software and cloud-computing giant indicated the planned job cuts will now eat into its core engineering divisions as well, as the “industry prepares for a prolonged slump in demand”. With Pichai fixed on streamlining operations and consolidating investments to ensure resources are adequately re-deployed towards higher priority areas ahead of tightening financial conditions and contracting demand environment, widespread layoffs at Google remain an option that is still very much on the table.

This leads to the topic of fraying employee morale at the company in recent months, as concerns over job security rise, while Pichai continues to crackdown on “fun” in favour of belt tightening ahead of ongoing macroeconomic challenges:

“I remember when Google was small and scrappy,” he said. “Fun didn’t always – we shouldn’t always equate fun with money. I think you can walk into a hard-working startup and people may be having fun and it shouldn’t always equate to money.”

Source: CNBC News

The latest “Googlegeist” survey, which the company conducts with its employees on an annual basis, indicated growing workplace dissent on Google’s “pay, promotions, and execution“, which is also consistent with recent complaints over the cutback of “(company) swag, travel and holiday celebrations”. Employees are also becoming increasingly concerned over the likelihood of potential layoffs, with the matter being at the center of most questions raised during recent “all-hands meetings”. The increasingly anxious work atmosphere is likely to reinforce a negative spiral in workplace morale, and backfire on team efforts required to achieve the efficiency targets required within the near term to dodge widespread job cuts that Pichai is trying to prevent.

Looking Ahead

It is largely expected that Google will continue to experience deceleration within the foreseeable future given the macroeconomic overhang on its core advertising business, and the weight of tightening IT budgets on GCP (previously discussed in detail here and here). Specifically, global ad spending is likely to remain muted, or even contract, within the near term given the industry’s inherent sensitivity to macroeconomic headwinds -a recent SMB agency sentiment check conducted by RBC Capital Markets during the fourth quarter indicated that “digital ad spend is tracking below expectations” due to both conservatism in the industry due to macro uncertainties, as well as format-specific challenges like Meta’s Apple (AAPL) signal loss and a “recent SEO algo update proving disruptive” at Google Search.

Meanwhile, although GCP may be benefitting from added demand stemming from growing enterprise adoption of a multi-cloud strategy, uncertain IT budgets ahead of the deteriorating macroeconomy continue to drive net downsides on near-term hyperscaler needs. And growing user demand for cloud optimization also exposes the unprofitable unit at Google to further risks of margin contraction within the near-term, adding pressure to Pichai’s efforts to preserve the company’s consolidated bottom line without massive layoffs.

Investors’ growing preference for profitability also heightens focus towards whether the company’s latest cost and productivity enhancement efforts are delivering results as expected to preserve the generous cash flows that Google’s valuation has been primarily supported by. Taken together, headcount reduction remains a low-hanging fruit that is still very much within Google’s discretion to preserve – and perhaps, even bolster – margins, which the market likely has yet to price in.

Management’s repeated attempts in tempering investors’ expectations by cautioning “a more challenging macro environment” in recent quarters are also welcomed under the current market climate. This is further corroborated by analysts growing call for further reductions to 2023 and 2024 growth estimates “by another 1% to 7%” below current consensus projections for most names. Taking Google’s realistic view of the near-term operating environment, together with its option to pull the cost lever that is still on the table, supports our views that the stock’s valuation correction sustained over the past year has created a favourable risk/reward opportunity at current levels. This accordingly makes the stock one of the more compelling investments at current levels among its megacap peers, given its anticipated negatives – counting macro-driven ad spending weakness and cloud competition – have likely been already priced in.

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Disclosure: I/we have a beneficial long position in the shares of GOOG either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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