Two Scenarios for Cloud Software

For our Essentials members, we are expanding on a free analysis. For ease of access, we are copying the free article before we expand further on the Essentials analysis located under the section “Two Scenarios for Cloud Software”

Slowing Growth in Cloud Stocks: When Will We Hit a Bottom

Nearly all cloud companies are reporting a notable, sequential slowdown between Q3 to Q4. Amazon and Microsoft’s cloud infrastructure services slowed from mid-30 percent growth in prior years to 24 percent growth and 30% growth. Only a quarter ago – in Q2 – the growth was at 29 percent and 35%. This quarter marks a 5 percent decline sequentially, which is considered a rapid decline for these two companies.

For many more highly valued cloud software companies, the sequential decline is much steeper and is closer to a 15% sequential decline. On a YoY basis, the Q3 to Q4 growth is 70% lower than it was tracking last year. For example. Snowflake grew 15% QoQ last year and is expected to grow 3% QoQ this year, marking a 12% decline YoY in its growth rate. This is true for most best-of-breed cloud stocks.

We covered this point on popular cloud software stocks in granular detail in a premium note for our research Members when we said:

“In some ways, the Q4 guides – assuming most come in at or near those guides – marks a historic slowdown for cloud as it’s always been a resilient category.”

The question is, at this rate of rapid decline, when will we hit a bottom on slowing growth?

Gartner, a reputable and accurate third-party analyst firm, is indirectly calling for a bottom in cloud in 2022, per its recent two surveys. However, judging by the most recent earnings results provided by the Big 3 and cloud’s top performing stocks, I believe this could be premature and it’s more likely we bottom sometime in 2023.

Gartner 2023 Surveys

In a recent report, Gartner predicted that in 2023, IT spending will recover from a notable low in 2022 in all areas except Data Center Systems. Devices will still remain negative to flat, yet show a remarkable recovery from (8.4%) to (0.6%), per the CFO 2023 survey. Software will accelerate from 8% to 11.3% while IT services will double in growth from 4.2% to 7.9%.

Across all categories of IT spending, Gartner is calling for combined growth of 5.1% in IT budgets compared to 0.8% growth in 2022. This will be down from 10.2% in 2021.

Gartner is also forecasting that 2022 is the bottom for a few public cloud end-user verticals with a year-over-year increase in software-as-a-service (SaaS), cloud management and security, and infrastructure-as-a-service (IaaS).

Of these, Cloud IaaS is expected to see the most growth from 27% in 2022 to 30% in 2023. This is on a large revenue base of $115 billion, expected to grow to $150 billion in 2023. Software-as-a-service is the largest category in cloud with revenue of $167 billion, expected to grow to $195 billion at a rate of 17%.

Notably, some areas are expected to decline, such as BPaaS and DaaS.

Shown below, the overall cloud market is expected to grow 21%, up from 19% in 2022. This will outpace overall IT spending with growth of 5.1% by over 5X.

The 5.1% growth lags the current inflation rate of 6.5%.

Source: Gartner: Public Cloud End-User Spending

Cloud IaaS Growth Saw 3% Headwind in 2022, More to Come?

Gartner released the 2023 survey results in October, and later that month, Q3 earnings results from Big Tech reported a decline in Cloud IaaS. Perhaps the survey is predicting a rebound from H2 2022 to H1 2023, but this would be hard to determine until budgets are set in the earlier part of next year.

In most cases, we are seeing a 10% deceleration from the early part of the year to the second half of the year. For now, actual results from the Big 3 Cloud IaaS providers disagree with Gartner’s survey predictions that a rebound is coming. This is despite Cloud IaaS predicted to be the more resilient line item in public cloud end-user spending.

 

Mixed Reports Following Q3 Results

Gartner’s prediction that cloud budgets will expand contrasts with other surveys that suggest the opposite. For example, according to a survey by Wanclouds, 81% of companies were directed by the C-suite to reduce cloud spending or to occur no additional costs. 

The venture capital firm Accel published a report that showed private funding for cloud companies dropped as much as 42% across Europe, Israel and the United States in Q3. This often translates to lower valuations and/or lacking a clear path to a strong exit on the public markets or through an acquisition.

This doesn’t mean the migration to the cloud is slowing down, by any means. According to Accel, spending on automation and digital transformation is expected to rise from $1.8 trillion to $2.8 trillion by 2025. The drawback to these kinds of forecasts is that it may slow considerably in 2023 before a rebound occurs.

Takeaway:

Cloud spending may turn out to be softer than industry surveys indicate, especially until inflation cools off. This is because surveys capture a perception while earnings results are the culmination of a 7.1% inflation rate, plus a softer Chinese market and a softer European market.

The Big 3 are the best proxy because their reports 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. The Big 3 also afford a more concentrated view by owning 66% of market share across three companies whereas SaaS is spread across thousands of companies (if not tens of thousands).

Two Scenarios for Cloud Software

Cloud software is at a cross roads as the first 3 quarters of the year were quite strong while the Q4 guides are out of character to the downside. Q4 will either mark a fleeting moment of weakness for cloud or it’s the beginning of a bottoming process that needs to play out.

In a true recessionary environment, data rarely shows a bottom and a reversal in fundamentals all wrapped up in one quarter. Therefore, we are favoring the second scenario outlined below. If we are wrong, then we will simply step back into our cloud positions and a larger cloud allocation once more supporting evidence is provided. Microsoft tends to be the bellwether, so the next round of data will come end of January. The data that I’m referring to, specifically, is 2023 budgets which have not been determined yet.

Scenario #1: Cloud Will Prove Resilient

There are a lot of cloud software bulls and for good reason, this category has treated investors well with predictable revenue growth.

Scenario #1 is that cloud software is resilient because it drives down costs and increases productivity. We know this scenario well as we wrote about it many times in the past few years to defend cloud. Often these cooling off periods were welcomed to position for a 6-month bounce back after the category sold off (40%) or more.

Here is what I said in the past here on the free side and reiterated here on MarketWatch (behind paywall) in 2019 (i.e., when we weren’t facing a brick wall on growth).

“My prediction is this may be one of the last cycles when tech is considered less safe than value stocks. As the market will find out (the hard way), cloud software is actually very safe. It is insulated from trade wars and overseas manufacturing issues. It reduces costs for enterprises, which is ideal for a recession. Lastly, cloud software is at the beginning of a rapid growth cycle compared to its counterparts in tech — such as mobile, e-commerce and advertising — which are reaching saturation, are finding themselves in the cross hairs of anti-trust and are susceptible to consumer spending changes.”

Gartner is aligned with what I stated in 2019, although I believe there are key differences today as we move into 2023 (reference Scenario 2 below). Here is what Gartner stated in the article Gartner Forecasts Worldwide Public Cloud End-User Spending to Reach Nearly $600 Billion in 2023

“Current inflationary pressures and macroeconomic conditions are having a push and pull effect on cloud spending,” said Sid Nag, Vice President Analyst at Gartner. “Cloud computing will continue to be a bastion of safety and innovation, supporting growth during uncertain times due to its agile, elastic and scalable nature.”

The issue with this assumption, which supports Scenario #1 is that Cloud growth is actually slowing downCloud growth is actually slowing down — that is the reality of things — and this wasn’t true in 2019 and wasn’t true when this survey was performed –the change has occurred as recent as a few months ago. My argument about a value rotation in 2019 playing out based on high valuations was supported at the time by industry-leading growth.

Scenario #2: Q4 is Foreshadowing a CY2023 Slowdown

A picture is worth a thousand words and what is seen below is a sequential slowdown that (collectively) cloud companies have not experienced in the past.

In some ways, the Q4 guides – assuming most come in at or near those guides – marks a historic slowdown for cloud as it’s always been a resilient category.

If the slowdown continues, cloud could remain stagnant for some parts of 2023. We will know more next month starting when Microsoft reports. If Microsoft and others forecast softer budgets in 2023, then I would expect the analyst estimates pictured below to come down.

We’ve contrasted the next 6 months expected growth and the next 9 months expected growth with the current growth reported recently to show that the estimates may not be aligned with recent budget cuts.

Pictured Above: H1 and First 9 Months growth estimates for CY2023 not aligned with the slowdown guided for in Q4. Either estimates will need to come down or cloud will need to see a quick rebound. Average was taken from earnings data and earnings estimates for 10 best-of-breed cloud companies.

If the Q4 pattern continues, many best-of-breed cloud companies (on average) will see 10% growth across two quarters, or roughly 20% growth across four quarters rather than the 30%-35% growth estimates currently in place.

Takeaway: We will find out over the next few months if Q4 is foreshadowing a steeper deceleration than what is currently baked in.

Conclusion:

The I/O Fund is being cautious with cloud until we get more information. The Q3/Q4 deceleration is not broadly discussed yet and we prefer to remain (somewhat) on the sidelines with the anticipations the narrative will eventually catch up to the data we saw come out of the most recent earnings reports. We’ve trimmed some of our cloud positions while remaining in one position at a 10% allocation. If we are wrong, and Q1 and/or Q2 shows a reliable rebound, then we will buy back the positions that we owned recently and cut.

Note, reliable means not only one or two lumpy beats but rather a predictable trajectory.

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