AAfter several challenging quarters, the setup for the cloud stock looks much more favorable in 2H23. While flight-to-safety is providing support for mega-cap stocks, the valuation gap is getting harder to ignore.
Contents
- Earnings Report Findings: AWS, Azure, GCP
- Positioning for 2H – Easy Comps and AI Tailwinds
- Mid-caps lagging behind mega-caps are creating huge opportunities
Earning from cloud data-points – not getting worse
While the earnings upside from hyperscalers didn’t exactly surprise, any incrementally positive commentary resulted in outsized reactions. Microsoft reported the strongest results, while GCP and AWS followed suit with disappointing results. The most important point echoed by all the companies was that cloud optimization trends aren’t getting better, but they aren’t getting worse either. This is important because we believe that to find the bottom during a downtrend, it is all about focusing on other derivatives. This comment indicated below.
- Microsoft’s Azure grew 31% on a ~$60bn basis. The company guided for 26-27% growth, with 1% coming directly from AI. While this may not sound like a lot, this is a roughly >$400mm run-rate for AI services, which is a strong starting point. The interesting commentary that came out of the earnings call is that while companies are still optimizing spend, Microsoft is starting to see new workloads in areas they haven’t seen before (life sciences etc.). In addition, management made a comment that while optimization is expected to continue, “at some point the workload may not be further optimized”.
- Amazon’s AWS Revenue grew 16% on a ~$85bn basis (vs guide to mid-teens). While this was interpreted positively at first, management noted that April is headed for an 11% increase. Investors were already expecting slower growth in 2Q23 versus 1Q23, but the magnitude of the delta was not well received.
- Google’s GCP grew 28% on a ~$30bn basis and generated operating profit in the quarter. Google is the smallest and least profitable of the three.
Overall, Microsoft’s results were notable as the company is now guiding to higher $ growth in 2Q23 versus Amazon, if April’s trends hold through the quarter. The biggest takeaway was that while companies are expecting slower growth in 2Q23, the underlying trend (customer optimisation) is not waning.
Easy Comps Short Term; AI long term
While the declining trend in cloud spend growth over the past four quarters is easy to see, what isn’t clear is the difference in set-up in 1H23 versus 2H23. As we head into the second half of 2023, the comparison becomes much easier, especially in the fourth quarter, as this is when we’ve seen the first signs of a slowdown.
While we expect easy comps to set a floor for cloud stocks, we believe we are past the crest of a major cloud spending wave. Three key points:
- While cloud bills are higher, cloud is still more cost-effective than on-premises for most use casesS. In fact, one of the reasons why we’re going through a down-cycle is because customers have the ability to reduce their usage based on demand rather than capitalizing on it.
- We expect AI to be a catalyst for the next cloud spending cycle. Training large AI language models is expensive. Accessibility and flexibility will be paramount. Outside of a select group of mega-caps that are likely to train their own models, most companies will take advantage of hyperscalers. In fact, Nvidia is in the process of partnering with several cloud vendors to make their hardware available as a service.
- Important Runway Ahead: According to Amazon CEO Andy Jassy (1Q23 earnings call), 90%+ of global IT spending is still on base, which provides the company with confidence for the next cycle.
Mid-caps lagging behind mega-caps are creating huge opportunities
While “flight to safety” favors mega-caps, the valuation gap is becoming too large to ignore. The multiple differential between small caps and large caps in the software space is now at a 10-year low.
Mid-cap companies such as Snowflake, Datadog, Cloudflare, and Zscaler typically grow revenue at multiples of the growth of hyperscalers.
What came to our notice during this quarter is that while these mid-cap stocks are getting hit hard (down ~50-60% since Jan/22) hyperscalers/semis are diverging in performance , the gap in fundamentals is not widening. Typically, a company like Datadog has historically grown at 2X the AWS growth rate. In the most recent quarter, the company guided for 11% growth in AWS versus the 2Q23 mid-point of 23%, meaning the gap is set to, at least, remain stable.
What’s especially attractive to fundamental investors is that these mid-cap companies have proven business models (already generating $1 billion in revenue) and maintain positive free cash flow. Their growth and volatility profiles resemble those of a company like Nvidia, with the primary difference being that Nvidia is “early-cycle”. As a result, while we still expect strong performance from Nvidia, the difference could narrow significantly over time.
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The views and opinions expressed here are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
