Cloud Earnings Review: Signs of Stabilization

Posted on by io-fund

The rise of generative AI has necessitated hyperscalers to develop their own large language models (LLMs), build platforms that enable their customers to create AI applications, and also offer AI in their product offerings. AI has been a boon for hyperscalers that were otherwise affected by tightening budgets due to challenging macro conditions.

We have been following the cloud sector closely with a regular review of hyperscalers and the best-of-breed cloud companies. This analysis shows that the hyperscalers are showing signs of stabilization. In a positive development, the best-of-breed cloud company’s expected sequential deceleration is slowing from a decline of 11 points in Q1 to Q2 of this year to a decline of 4 points in Q3 to Q4 of this year. This means we may near a bottom. We also discuss various financial metrics that can help determine which cloud companies will lead once the declining growth does find a bottom.

Notably, cloud has lagged broader tech’s rally this year, and on a 3-year basis, returns are still negative. Cloud ETFs like SKYY are down (-8.9%), CLOU down (-18.8%), and WCLD down (-35.1%) compared to a 27.4% gain for the QQQ. Timing has been crucial for cloud given the 1-year returns (from Jan 1st 2023) look nearly identical to the 4-year returns (from Jan 1st 2020), meaning there were losses in-between that took time to recoup.

Big Tech is the Best Proxy for Cloud

The Big 3 cloud providers are considered the best proxy for gauging overall cloud market trends because their reports reflect the most resilient cloud infrastructure layer with the highest market concentration. Cloud IaaS services are less prone to churn due to high switching costs, and the Big 3's dominance in this market (66%) provides a more concentrated view of the overall cloud landscape. By analyzing the Big 3's performance, we can comprehensively understand the infrastructure that supports the cloud ecosystem.

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%.

Microsoft

  • Azure grew by 29% and 28% YoY in constant currency, including about 3% incremental gain from AI services.  OpenAI and Microsoft are estimated to hold a combined 69% share of the generative AI model and platform market, followed by AWS at 8% and Google at 7%.
  • Growth accelerated from 26% in the previous quarter yet was down year-over-year from 35%.
  • The company’s guide for next quarter is 26% to 27% in constant currency. Azure's consumption business is driving growth, and the company expects this trend to continue in the next quarter.

The company’s CFO Amy Hood said in the recent earnings call, “While the trends from prior quarter continued, growth was ahead of expectations, primarily driven by increased GPU capacity and better-than-expected GPU utilization of our AI services, as well as slightly higher-than-expected growth in our per-user business.”

The company’s CEO, Satya Nadella, highlighted its efforts to offer AI in its product offering. He said, “With Copilots, we are making the age of AI real for people and businesses everywhere. We are rapidly infusing AI across every layer of the tech stack, and for every role and business process to drive productivity gains for our customers.”

AWS

  • AWS revenue grew by 12% YoY to $23.1 billion.
  • The growth has stabilized as AWS grew 12% in the previous quarter. However, it decreased significantly from 27% in the same period last year.

Our previous analysis highlighted optimizing due to the tough macro environment. Now the company is seeing a reduction of cost optimization by its customers as companies deploy new workloads, which is positive. A similar trend was observed in the previous quarter.

The company’s CFO Brian Olsavsky said in the recent earnings call, “On a quarter-over-quarter basis, we added more than $900 million of revenue in AWS as customers are continuing to shift their focus towards driving innovation and bringing new workloads to the cloud. Similar to what we shared last quarter, while optimization still remain a headwind, we've seen the rate of new cost optimization slowdown in AWS and we are encouraged by the strength of our customer pipeline.”we've seen the rate of new cost optimization slowdown in AWS and we are encouraged by the strength of our customer pipeline.”

Google Cloud

  • Google Cloud revenue grew by 22% YoY to $8.4 billion.
  • The growth is lower than the 28% in the previous quarter and 38% in the same period last year.

Optimization continues to weigh on the slowdown of growth. The company’s CEO, Sundar Pichai replied to an analyst’s question on deceleration in Cloud and optimization. “On Cloud, maybe what I would say is, overall, we had definitely started seeing customers looking to optimize spend. We leaned into it to help customers given some of the challenges they were facing. And so that was a factor. But we are definitely seeing a lot of interest in AI. There are many, many projects underway now, just on Vertex alone, the number of projects grew over 7x. And so we see signs of stabilization, and I'm optimistic about what's ahead.”But we are definitely seeing a lot of interest in AI. There are many, many projects underway now, just on Vertex alone, the number of projects grew over 7x. And so we see signs of stabilization, and I'm optimistic about what's ahead.”

The bottom line is that cloud growth is lumpy across key players with a positive surprise from Microsoft, yet a steep, negative surprise from Google Cloud. We see similar trends in Best-of-Breed.

Best of Breed

We took a sample of the top-ranking cloud stocks on revenue growth, free cash flow, adjusted operating margin, and valuations.

The best comparison is the sequential growth from Q3 to Q4 in 2022 compared to sequential growth in Q3 to Q4 2023 estimates as this will take into account any seasonality from the Q4 period.

Per our last write-up in June: “We now see an improvement in the recent quarter, as the best-of-breed cloud stocks are guiding for a 72% slowdown in QoQ/YoY growth for Q2 guides – from an average 15% QoQ last year to 4% this year.”

We saw a further improvement in the current quarter, as the best-of-breed cloud stocks are expected for a QoQ/YoY decline of 47% from Q3 to Q4 estimates – from an average 9% QoQ last year to 5% this year.

All the best-of-breed cloud companies showed a deceleration. Bill Holdings has minimal deceleration as the company’s QoQ growth was 13% last year and is expected to be 12% this year. ServiceNow ranks next as it grew 6% last year and is expected to grow 5% this year. MongoDB was accelerating by 1 point in our June analysis yet is now decelerating 8 points in the upcoming period.

Source: YCharts

Earnings Beats

MongoDB is the leading stock with a revenue beat of 7.2%. The strong performance of the Enterprise Advanced Business largely drove the solid beat. The company’s revenue grew by 30% YoY to $432.9 million. However, the deceleration is expected to persist in the upcoming quarter, as the company’s revenue guidance of $429 million to $433 million represents a YoY growth of 19% at the mid-point.

GitLab’s revenue exceeded analyst expectations by 6.1%. The company’s revenue grew by 32% YoY to $149.7 million. The guide for the next quarter is $157 million to $158 million, representing a YoY growth of 28% at the mid-point. The deceleration of four points is reasonable compared to peers.

SentinelOne ranked third with a revenue beat of 5%. The revenue grew by 42% YoY to $164.2 million. The guide for the next quarter is $169 million, representing YoY growth of 34%.

Source: YCharts

GitLab’s adjusted EPS came in at $0.09 compared to a (-$0.10) for the same period last year, with an adjusted EPS beat of 1710%. HashiCorp reported $0.03 compared to (-$0.13) for the same period last year, with a beat of 169%. It was the company’s first quarter with positive adjusted EPS. MongoDB reported $0.96 compared to $0.23 for the same period last year, with a beat of 93.5%.

Source: YCharts

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 as they are paying high stock-based compensation. ServiceNow has the best operating margin among the cloud companies with 10%, followed by CrowdStrike at break even, and Datadog at (-1%).

Many cloud companies have been improving their margins, which is positive. In our analysis of CrowdStrike, we said, “A key item in the report was that Q3 marked CrowdStrike’s first quarter with positive operating income. CrowdStrike now has to prove that it can continue to expand operating margin further into positive territory.”

Bill Holdings has improved its operating margin to (-19%) from (-38%) in the same period last year. Similarly, Gitlab’s has improved to (-27%) from (-50%), HashiCorp to (-38%) from (-62%), SentinelOne to (-50%) from (-90%), and Zscaler to (-9%) from (-19%).

Source: YCharts

Zscaler has the highest free cash flow margin of 45%. It has improved from 27% in the same period last year. CrowdStrike ranks second with a free cash flow margin of 30% and Datadog ranks third with 25%.

Source: YCharts

Stock-Based Compensation

Stock-based compensation is a non-cash expense that is added back to adjusted earnings. However, in practice, this is an expense as per GAAP rules. Among the best-of-breed cloud stocks, Snowflake has the highest stock-based compensation as a percentage of revenue at 40.6%, followed by SentinelOne at 33.4%, and HashiCorp at 30%. The high level of stock-based compensation reflects what the competitive cloud industry must do to retain talent. However, it is a double-edged sword since it dilutes ownership of existing shareholders.  

Source: YCharts

Valuations

Snowflake has the highest fwd P/S ratio of 22.5 among the best-of-breed cloud stocks. It is followed by Cloudflare at 20.2 and CrowdStrike at 19.1.

Source: YCharts

Ranking based on revenue estimates change for next quarter

Gitlab’s revenue estimates have been revised by 5.9% after the company’s recent strong results. MongoDB’s estimates have been changed by 4.8% followed by SentinelOne by 1.6%.

Source: Seeking Alpha

Ranking based on adjusted EPS estimates change for the next quarter

MongoDB’s adjusted EPS estimates have been revised up by 29.9%, followed by Bill Holdings by 0.5% and CrowdStrike by 0.4%.

Source: Seeking Alpha

Highlights and Lowlights in Q3

GitLab reports first positive non-GAAP operating profit

GitLab reported a revenue beat of 6.1% and an adjusted EPS beat of 1710%. The company reported its first adjusted operating income in the recent quarter and guides a positive adjusted operating income for the next quarter. GAAP operating margin improved from (-50%) to (-27%).

The company’s CFO, Brian Robins, mentioned in the earnings call that sales cycles have lengthened and buying behavior in the enterprise segment has stabilized. Mid-market and SMB customers continue to be cautious.

He said, “Looking back at the quarter, I want to share some of the areas we have been closely monitoring. These include sales cycles, win rates, contraction, and Ultimate. In comparing Q3 with Q2 of FY ‘24, we have seen overall sales cycles lengthen. During Q3 buying behavior in our enterprise segment stabilized. However in the mid-market and SMB, we see customers continue to be cautious in the uncertain macro environment. […] Contraction during Q3 also improved for the third consecutive quarter and is in-line with levels from Q3 last year.”

Solid Results from SentinelOne

SentinelOne stood out as one of the only companies with QoQ acceleration in billings at 33% YoY and 2% QoQ. We covered here a few stocks that struggled with billings, in particular. Revenue grew by 42% YoY to $164.2 million, with a revenue beat of 5% and an adjusted EPS beat of 63.7%.

 ARR grew by 43% YoY to $663.9 million and net new ARR grew by 11% YoY. The adjusted operating margin improved by 32 percentage points to (-11%). Free cash flow margin improved by 40 percentage points to (-16%). Management expects the company to achieve positive free cash flow in the second half of next year.

Dave Bernhardt, the company’s CFO, said in the recent earnings call, “Our margin improvement is indicative of healthy pricing and the value and innovation we deliver to customers. It also demonstrates the success of our land and expand strategy. Our unified security and data architecture in a single platform is delivering meaningful value for SentinelOne as well as our customers.”

HashiCorp reports first positive non-GAAP net income

HashiCorp reported a 2% revenue beat. However, the revenue YoY growth was 17%, ranking at the bottom of the best-of-breed cloud stocks. Operating margin improved from (-62%) to (-38%) and adjusted operating margin improved 17 percentage points to (-7%). Free cash flow improved 18 percentage points to 4% and was the company’s second positive free cash flow. The management expects positive free cash flow going forward other than in Q2, which is low due to booking seasonality. The adjusted EPS beat was solid 169% and the company reported the first positive adjusted net income.

Zscaler reports strong billings growth. However, full-year guidance unchanged

Zscaler reported a 4.9% revenue beat and a 36.9% adjusted EPS beat. The company’s operating margin improved by 10 percentage points to (-9%) and the adjusted operating margin improved by 6 percentage points to 18%. The free cash flow margin improved by 18 percentage points to 45%, ranking the top among the best-of-breed cloud stocks.

Billings growth remained strong, at 34% YoY to $456.6 million. However, management did not raise its full-year billings outlook as it tends to do. Its outlook remained unchanged at 24% to 26% YoY growth or $2.52 billion to $2.56 billion. That outlook suggests that billings growth will decelerate through the remainder of the fiscal year. We have discussed the company further in our Cybersecurity analysis here.

MongoDB solid beat, however, cautious management tone

MongoDB reported a solid 7.2% revenue beat and a 93.5% adjusted EPS beat. As observed in the above paragraphs, the analysts have also increased their estimates after the company’s strong results.

Dev Ittycheria, CEO of the company, said in the earnings call, “We had a healthy quarter of new business acquisitions, led by continued strength in new workload acquisition within our existing customers. In addition, our Enterprise Advanced business again exceeded our expectations, demonstrating strong demand for our platform and the appeal of our run-anywhere strategy.”

However, the results failed to impress investors due to management’s comments on macro conditions. We have discussed the consumption business model here in depth. In this model, the revenue can be lumpy.

Michael Gordon, CFO of the company, said in the earnings call, “As a reminder, we recognize Atlas revenue primarily based on customer consumption of our platform and that consumption is closely related to-end user activity of the application, which can be impacted by macroeconomic factors.”

Conclusion

The cloud sector has demonstrated resilience amid the recent macro uncertainty and exhibits signs of stabilization. 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 will continue to look for outliers in the cloud category as we move into next quarter’s earnings season.

Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.

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