Every quarter, we provide an overview of the cloud sector including hyperscalers and best-of-breed companies. We had discussed in our last analysis that the hyperscalers are showing signs of stabilization. In a further positive development, the hyperscalers growth accelerated in the recent quarter, helped by a much-needed boost from AI.
Below, we look at best-of-breed companies that are expected to decline sequentially by 4 points, the same deceleration we noticed in Q3 to Q4. This is an improvement from an 11 point decline in Q1-Q2 of last year. We also discuss various financial metrics that can help determine which cloud companies will continue to lead.
Tracking the Cloud ETFs YTD performance, SKYY beat the QQQ (tracks the Nasdaq-100 Index) by one percentage point and other ETFs are trailing with WCLD with (1.37%) return and CLOU with (4.06%) YTD returns.
Big Tech is the Best Proxy for Cloud
Big Tech Companies are more insulated than Best-of-Breed cloud and offer a 360-degree view of how the cloud industry is faring. The Big 3 cloud providers are the best proxy since they account for 67% of the cloud market. They also represent the layer in the tech stack that tends to be the most resilient in terms of churn. The switching costs are quite high for cloud IaaS services.
Microsoft Azure had the fastest growth of 30% among the Big 3 and all the three companies showed an acceleration that was helped by AI revenue. Microsoft Azure Q4 growth rate and AWS accelerated by 1%, while Google Cloud accelerated by 4%. This is an improvement from the trend in the previous quarter when we noted, “Microsoft Azure’s Q3 growth rate was the outlier among the Big 3 as its growth rate accelerated by 3%, while AWS remained steady albeit at a slower growth rate, and Google Cloud decelerated by 6%. The steep deceleration in Google Cloud was a negative surprise as analysts were expecting it to grow 26% compared to the actual 22%.”
According to Synergy Research Group the combined Q4 YoY growth of the Big 3 cloud providers marked the highest growth compared to the previous three quarters and also the largest sequential increase ever. “The year-on-year growth rate was 20% in Q4, markedly higher than the previous three quarters. Notably, the market grew by $5.6 billion from Q3. That is by far the largest quarter-on-quarter increase ever achieved.”
Microsoft
- Microsoft Azure grew 30% YoY and 28% in constant currency, including a 6% incremental contribution from AI.
- Growth accelerated from 29% in the previous quarter and was slightly down from 31% in the same period last year.
- The company’s CFO, Amy Hood, said Azure growth will remain stable in the next quarter. “In Azure, we expect Q3 revenue growth in constant currency to remain stable to our stronger-than-expected Q2 results. Growth will be driven by our Azure consumption business with continued strong contribution from AI.”Growth will be driven by our Azure consumption business with continued strong contribution from AI.”
AI’s impact on Azure was notable: Microsoft said that Azure’s 30% growth stemmed from “strong demand for our consumption-based services including 6 points from our AI services.” This 6-point contribution is impressive, given that AI services contributed 3 points to growth last quarter and 1 point in fiscal Q4. While that may seem small, it is significant considering the scale that this growth is attached to, with Azure’s revenue at a $74 billion run rate.
Microsoft’s earnings call reflected growing AI optimism, with strong key metrics for its AI offerings across its product suite. Satya Nadella also signaled in the earnings call Q&A that optimization is over for now on traditional workloads, which is positive. “I'll call it, optimization only and no new workloads start, that I think has ended at this point. So what you're seeing is much more of that continuous cycle by customers, both whether it comes to AI or whether it comes to the traditional workloads.”
AWS
- AWS revenue grew by 13% YoY to $24.2 billion and is now approaching a $100 billion annualized run rate.
- Growth accelerated by one percentage point from 12% in the last quarter yet was lower than the 20% in the same period last year.
The company’s CEO, Andy Jassy, sounded very optimistic in the earnings call on the prospects of AI. “Gen AI is and will continue to be an area of pervasive focus and investment across Amazon, primarily because there are a few initiatives, if any, that give us the chance to reinvent so many of our customer experiences and processes, and we believe it will ultimately drive tens of billions of dollars of revenue for Amazon over the next several years.”we believe it will ultimately drive tens of billions of dollars of revenue for Amazon over the next several years.”
The company’s CFO pointed out that optimizations are slowing. “Similar to what we shared last quarter, we continue to see the diminishing impact of cost optimizations. And as these optimization slow down, we're seeing more companies turning their attention to newer initiatives and reaccelerating existing migrations.”
Google Cloud
- Google Cloud revenue grew by 26% YoY to $9.2 billion, helped by the increasing contribution from AI, beating the estimates of $8.94 billion.
- Even though the growth is lower when compared to the 32% growth in the same period last year, it has accelerated from 22% in the previous quarter.
- The strong growth in the quarter also helped the company narrow the gap to 4 percentage points with Microsoft Azure’s leading growth of 30% compared to 7 percentage points in the previous quarter.
In the earnings call, CFO Ruth Porat said, “The Cloud team is intensely focused on bringing the benefits of Gemini, our industry-leading AI technology, to enterprises and governments globally, and we are gratified with the level of engagement. The strong demand we are seeing for our vertically integrated AI portfolio is creating new opportunities for Google Cloud across every product area.” The company launched Gemini in December and offers three versions: Gemini Ultra, Gemini Pro, and Gemini Nano.
The company’s CEO Sundar Pichai also echoed the thoughts of Microsoft and Amazon’s management on cost optimizations reducing, saying “the cost optimizations in many parts are something we have mostly worked through.”
Best of Breed
We took a sample of the top-ranking cloud stocks on revenue growth, free cash flow, adjusted operating margin, and valuations.
Best-of-breed cloud companies are expected to decline sequentially by 4-points; from 5% QoQ growth last year to the expected 1% QoQ this year. This is the same as we noticed in Q3 to Q4, wherein it showed an improvement from a decline of 11 points in Q1 to Q2 of last year.
However, on a percentage basis, the recent QoQ/YoY deceleration is 72% compared to the 47% decline in Q3 to Q4 estimates and slightly better than the 83% decline in the same period last year.
All the best-of-breed cloud companies showed a deceleration similar to the trend seen in our previous analysis. CrowdStrike has the lowest deceleration, from 9% last year to 7% expected this year. Bill Holdings has the highest deceleration, from 5% growth last year to (4%) this year. In our previous analysis, Bill Holdings had the lowest deceleration.
Earnings Beats
Bill Holdings led with a revenue beat of 6.8%. The company’s revenue grew by 22% YoY to $318.5 million. The core revenue, which includes subscription and transaction fees, grew by 19% YoY to $275 million. Management highlighted the better-than-expected standalone total payment volume (TPV) growth of 10%. However, they are still cautious on macro, “It's too early to call a trough in B2B spend, and we expect the current interest rate environment will continue to depress overall spend growth.” The management guide for the next quarter is $299 million to $309 million, representing a YoY growth of 11.5% at the midpoint.
MongoDB’s revenue exceeded analyst expectations by 5.2%. The company’s revenue grew by 27% YoY to $458 million. However, the stock sold off post earnings as the FY guidance missed estimates. Management FY revenue guide was $1.9 billion to $1.93 billion below the estimates of $2.03 billion. The adjusted EPS guide was $2.27 to $2.49, far below the estimates of $3.22.
HashiCorp’s revenue grew by 15% YoY to $155.8 million, beating estimates by 4.3%. Management revenue guide for the next quarter is $152 million to $154 million, representing a YOY growth of 10.9% at the midpoint. The management highlighted in the earnings call that they are targeting 20% growth sometime in FY2026. Per CFO, “And then what follows is basically progressive improvement on the growth rate until it reaches 20% in the fiscal 2026 period, not that fiscal '26 will be 20%, just to be clear. So what we're signaling is that — the fourth quarter was a great quarter, and we feel like the optimization cycle is abating. There are signs of positive activity. We're not out of the woods.”we feel like the optimization cycle is abating. There are signs of positive activity. We're not out of the woods.”
HashiCorp’s adjusted EPS came at $0.05 compared to ($0.07) in the same period last year, beating estimates by 501%. This was the second consecutive non-GAAP profitability for the company. Snowflake’s adjusted EPS grew by 150% YoY to $0.35, beating estimates by 98%. MongoDB ranked third with a beat of 82.6% and its adjusted EPS grew by 50.9% YoY to $0.86.
Bottom Line and Free Cash Flow
GAAP profitability is another crucial metric to monitor closely, especially with macroeconomic uncertainty. Most of the names listed in the chart below are unprofitable on a GAAP basis because they pay high stock-based compensation.
This is one of the more important metrics that separates the winners from the laggards. For example, CrowdStrike recently achieved the feat of four consecutive quarters of GAAP profits and a full year in GAAP profits. The stock has been up 140% in the past year.
Bill Holdings has improved its operating margin to (13%) from (43%) in the same period last year. CrowdStrike has improved to 4% from (10%) in the same period last year. Zscaler reported (9%) compared to (17%) last year.
ServiceNow has the highest free cash flow margin of 55%, up from 52% in the same period last year. Snowflake ranks second with a free cash flow margin of 42% and Datadog ranks third with a free cash flow margin of 34%.
Valuations
CrowdStrike has the highest forward P/S ratio of 19.5 among the best-of-breed cloud stocks. It is followed by Cloudflare at 19.3 and Datadog at 15.5.
Ranking based on revenue estimates change for next quarter.
GitLab’s revenue estimates have been revised by 2.5% and Zscaler ranks second with a positive revision of 1%. MongoDB had a negative revision of (2.1%) after the company’s FY guidance came in below analyst expectations.
Ranking based on adjusted EPS estimates change for the next quarter.
Zscaler had the highest adjusted EPS revision of 10.5% among the best-of-breed cloud stocks. It is followed by CrowdStrike at 8.3% and Snowflake at 0.8%.
Highlights and Lowlights in Q4
CrowdStrike reported the fourth consecutive quarter of GAAP profits and the first full year of GAAP profits. The turnaround in GAAP profitability is most impressive compared to its cloud peers. The company’s key metrics are also accelerating. Notably, the net new ARR accelerated by 14% to 27% growth in the recent quarter from 13% in Q3. The company is in a unique position by combining cybersecurity with AI in a single platform with a data-centric architecture. Our complete post-earnings analysis is here.
Cloudflare beat revenue estimates by 2.7% and adjusted EPS by 26.3%. The company’s adjusted operating margin grew by 500 bps to 11% in the recent quarter. The free cash flow margin improved by 200 bps to 14%. CEO and co-founder Matthew Prince said in the earnings call, “The machine that underlies Cloudflare is firing efficiently on all cylinders, and we've been able to execute even as the macro environment remains choppy.” Key metrics accelerated, RPO accelerated to $1.245 billion, up 37% YoY compared to 30% YoY growth last quarter. We have discussed the company further in our post-earnings analysis here.
Zscaler beat revenue estimates by 3.6% and adjusted EPS estimates by 31%. On the macro, the company’s CFO said in the earnings call, “We believe we are still operating in a challenging macroenvironment and customers continue to scrutinize large deals.” Despite the beat and raise, the stock sold off post-earnings since the company guided for a (7%) sequential decline in calculated billings, suggesting further deceleration in this key metric to the low-20% range. We have discussed the company further in our cybersecurity analysis here.
Conclusion
The hyperscalers growth accelerated with a boost from AI. Cloud optimizations are reducing, which is positive. However, the macro conditions are still challenging. We will continue to look for outliers in the cloud category as we move into next quarter’s earnings season. We added CrowdStrike and Cloudflare to our portfolio partly informed by scans such as these, which revealed bottom line strength coupled with strong growth. We also use these overviews to keep an eye on valuation, of which cloud stocks are particularly sensitive to in this environment with very few successfully trading over 20 Fwd P/S since Q4 of 2021.
Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.
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