Category: Cloud Software

Cloud Q1 Update: When Will the QoQ Decel Find a Bottom?

Posted on by io-fund

Cloud stocks have treated investors well with recurring revenue, resiliency during Covid, and some of the strongest examples of product-market fit available on the public markets. However, not even this can overcome the effects of lower budgets and cloud spending, which is the top driver in terms of year-over-year comparisons. Due to macro uncertainty, companies are optimizing their cloud spending.

We track the results of big tech companies and best-of-breed cloud stocks to gauge the sentiment of the cloud sector. We came up with our premium analysis in December when we said, “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.”

We noticed the sequential decline in cloud stocks in December and saw a steeper decline during our analysis in March. Best-of-breed cloud reported a 71% slowdown in QoQ/YoY growth for Q4 guides and a 83% slowdown in QoQ/YoY growth for Q1 guides. There’s technically 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.

However, the drastic slowdown will begin to run out of room until either one of two things happen:

  1. The low comps that cloud begins to lap in Q3 becomes a tailwind and companies are able to bounce back from the sudden drop off in growth that was reported last year, beginning in Q3.
  2. Or, the sequential growth will soon turn negative, which will result in a negative reaction in the market. The objective data below shows which stocks are most at risk for this happening.

Cloud Trends: Big Tech is the best proxy.

Big Tech Companies are more insulated than Best-of-Breed, yet offer a 360-degree view as to how the cloud industry is faring. We had said the following in our premium analysis in December.

“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 the Big 3 are decelerating it simply makes it much harder for Best-of-Breed to accelerate given the Big 3 represents an appetite for cloud budgets and provides strong clues if we are in a period of expansion or a period of optimization and digestion.

Source: Company Results

Key Highlights from the Big Three Earnings:

Microsoft

  • Azure grew by 27% and 31% YoY in constant currency.
  • The growth is down 31% in the last quarter and 46% in the same period last year.
  • The company’s guide for the next quarter is 26% to 27% (in constant currency), an expected deceleration of 4-5% from the recent quarter.
  • Even though cloud growth is decelerating, there are some bright spots like AI and the guide for the next quarter includes roughly 1% from AI services.

The company’s priorities are related to the cloud, and subsequent AI spend. Satya Nadella said in the earnings call, “We continue to focus on three priorities. First, helping customers use the breadth and depth of the Microsoft Cloud to get the most value out of their digital spend. Second, investing to lead in the new AI wave across our solution areas and expanding our TAM.” Second, investing to lead in the new AI wave across our solution areas and expanding our TAM.” He further highlighted that Azure is taking market share, especially benefiting from the AI trend.

You can read our recent editorial on Microsoft here.

AWS

  • AWS revenue grew by 16% YoY to $21.4 billion.
  • The growth is lower than the 20% the last quarter and is a remarkable slowdown from 37% in the same period last year.
  • Management discussed in the earnings call that April revenue growth for AWS further decelerated to 11%. This is due to the ongoing tough macro environment, causing customers to optimize their cloud spending in the recent quarter.

The company’s CEO, Andy Jassy, highlighted that enterprise customers were being cautious. “In AWS, what we’re seeing is enterprises continue to be cautious in their spending in this uncertain time. Customers are looking for ways to save money however they can right now. They tell us that most of it is cost optimizing versus cost cutting, which is an interesting distinction because they say they’re cost optimizing to reallocate those resources on new customer experiences.”cost optimizing versus cost cutting, which is an interesting distinction because they say they’re cost optimizing to reallocate those resources on new customer experiences.”

Google Cloud

  • Google Cloud revenue grew by 28% YoY to $7.45 billion.
  • The growth is lower than the 32% growth reported last quarter and 44% in the same period last year.

The company’s CFO, Ruth Porat, said in the earnings call, “Our investments in product innovation, our go-to-market organization and our partner ecosystem delivered strong results as customers across industries and geographies increasingly rely on Google Cloud to digitally transform their businesses. That being said, in Q1, we continued to see slower growth of consumption as customers optimized GCP costs reflecting the macro backdrop, which remains uncertain. In terms of operating performance, we remain focused on driving long-term profitable growth in Cloud, while continuing to invest given the substantial opportunity.”we continued to see slower growth of consumption as customers optimized GCP costs reflecting the macro backdrop, which remains uncertain. In terms of operating performance, we remain focused on driving long-term profitable growth in Cloud, while continuing to invest given the substantial opportunity.”

More on Best-of-Breed Cloud Stocks

To help illustrate how the deceleration has continued for some best-of-breed names, we took a sample of the top-ranking cloud stocks on revenue growth, free cash flow, adjusted operating margin and/or valuations.

Among the best-of-breed cloud stocks, only MongoDB’s guide shows sequential growth. The company’s QoQ growth was 6% last year and is expected to be 7% this year. The largest deceleration was in HashiCorp, which grew 13% last year and is expected to have flat 0% sequential growth this year.

In the previous quarter, we stated the following:

“Among the best-of-breed cloud stocks, only ServiceNow’s guide shows sequential growth. The company’s QoQ growth was 7% last year and is expected to be 8% this year. The largest deceleration was in GitLab, with revenue that grew 12% QoQ last year, is expected to decline (4%) sequentially this year.

Overall, the category is slowing down sequentially (a rather drastic) 83% for Q1 guides compared to the previous year — from an average of 12% QoQ last year to 2% QoQ growth this year.

For example, best-of-breed cloud reported a 71% slowdown in QoQ/YoY growth for Q4 guides and is now guiding for 83% slowdown in QoQ/YoY growth for Q1 guides.”

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.

Source: YCharts/Seeking Alpha

In our writeups following last earnings season, we were wary of flat guides on YoY basis given cloud has decelerated ever since these companies went public. Due to the slowing revenue growth, companies must report perfect earnings reports. Otherwise, the stock is sold off after hours.

We had seen in the recent earnings season that companies like HashiCorp (lost 25% of its value), SentinelOne (lost about 35% of its value), Cloudflare (lost 25% of its value), and Snowflake (lost 10% of its value) as their guidance missed the Wall Street expectations. This is why we prefer to wait until the Cloud sector reports flat to accelerating growth on a QoQ basis. Due to the strength of the products, we believe this could be early 2024 (see below).   

Our Snowflake premium article in January 2022 explained the downside of the consumption-based pricing model, especially during increased macro uncertainty. “Consumption-based pricing has a few drawbacks. For example, its less predictable than subscription revenue and there isn’t a ‘floor’ on revenue, because if consumption declines then so will sales.”

We further highlighted this point in the risks. “Another risk is the company’s consumption billing model, which is inherently unpredictable. This can make growth lumpy and some quarters may disappoint the Street. Investors should expect increased volatility in growth from Snowflake in the near term as new customers ramp consumption.”

In the quarter following this premium note, Snowflake guided for slower growth during the announcement of the Q4 results in March 2022, which led to the stock being down 30% in after-hours. Similarly, the company missed the Q1 earnings, and Wall Street analysts grew concerned, mainly due to the company’s consumption-based model.

Price Action

There has been an improvement in the price action of cloud stocks in Q2 till date, particularly after May, as seen in the chart below. MongoDB is leading among the best-of-breed cloud stocks after announcing the strongest results in the group pictured above. HashiCorp and SentinelOne rank at the bottom, and are reporting steeper deceleration QoQ – 25% for SentinelOne and then a thin 0% QoQ growth for HashiCorp.

Source: YCharts

The I/O Fund’s Cloud Plan:

Generally speaking, the cloud category has weaker bottom lines and is unprofitable. Therefore, it’s our view that the cloud category will need to return to top line acceleration QoQ before it becomes an obvious buy. This is not true for all tech categories as some can lean on operational efficiencies to drive bottom line growth, and this is rewarded by the market.

Certainly, there are outliers each earnings season, yet the outliers last quarter failed this quarter – and vice versa. As discussed, Cloudflare and Snowflake did quite well last quarter yet missed their guidance this quarter. This is not due to the strength of their product rather how unpredictable budgets are in the current environment.

Per Cloudflare’s CEO: “In the first quarter, we continue to witness a challenging business environment, which deteriorated significantly in March when negative headlines emerged related to SVB, the broadening banking crisis and the worsening macroeconomic outlook. With intensifying business uncertainty, companies became increasingly cautious in more deeply scrutinized field, which impacted numerous areas of our business, including a material lengthening of sales cycles, delays in collections and the significant back-end weighting in the linearity for the quarter.”

Snowflake’s CFO said the following: “In Q1, consumption varied from month to month. We benefited from strong consumption in February and March. Starting in April, consumption slowed after the Easter holidays through today.”

For the most part, many cloud stocks are underperforming the Nasdaq YTD, whereas in the past, this category greatly outperformed the Nasdaq.

Source: YCharts

Conclusion:

In order for cloud companies to outperform the Nasdaq again, we will want to see a return to top line growth QoQ and YoY. The reason we track QoQ is because this shows deceleration quickly compared to YoY. The QoQ data above predicts MongoDB would be the strongest stock, and HashiCorp and SentinelOne would be the weakest stocks, and this matches the market’s reaction.

Below are the forward estimates for MongoDB. Assuming consensus is correct for this stock, the rebound would happen around October 2024 with an entry best timed in January 2024 when the company reaches a low point of 10.95%. One area of concern is the 29% in the current quarter won’t return until nearly two years later.

H2 2024 and 2025 look optimal. Should anything change before then on the fundamentals, we will keep you updated.

The I/O Fund Analyst Team contributed to this article

Recommended Readings:

Cloud Q1 Update: When Will the QoQ Decel Find a Bottom?

Posted on by io-fund

Cloud stocks have treated investors well with recurring revenue, resiliency during Covid, and some of the strongest examples of product-market fit available on the public markets. However, not even this can overcome the effects of lower budgets and cloud spending, which is the top driver in terms of year-over-year comparisons. Due to macro uncertainty, companies are optimizing their cloud spending.

We track the results of big tech companies and best-of-breed cloud stocks to gauge the sentiment of the cloud sector. We came up with our premium analysis in December when we said, “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.”

We noticed the sequential decline in cloud stocks in December and saw a steeper decline during our analysis in March. Best-of-breed cloud reported a 71% slowdown in QoQ/YoY growth for Q4 guides and a 83% slowdown in QoQ/YoY growth for Q1 guides. There’s technically 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.

However, the drastic slowdown will begin to run out of room until either one of two things happen:

  1. The low comps that cloud begins to lap in Q3 becomes a tailwind and companies are able to bounce back from the sudden drop off in growth that was reported last year, beginning in Q3.
  2. Or, the sequential growth will soon turn negative, which will result in a negative reaction in the market. The objective data below shows which stocks are most at risk for this happening.

Cloud Trends: Big Tech is the best proxy.

Big Tech Companies are more insulated than Best-of-Breed, yet offer a 360-degree view as to how the cloud industry is faring. We had said the following in our premium analysis in December.

“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 the Big 3 are decelerating it simply makes it much harder for Best-of-Breed to accelerate given the Big 3 represents an appetite for cloud budgets and provides strong clues if we are in a period of expansion or a period of optimization and digestion.

Source: Company Results

Key Highlights from the Big Three Earnings:

Microsoft

  • Azure grew by 27% and 31% YoY in constant currency.
  • The growth is down 31% in the last quarter and 46% in the same period last year.
  • The company’s guide for the next quarter is 26% to 27% (in constant currency), an expected deceleration of 4-5% from the recent quarter.
  • Even though cloud growth is decelerating, there are some bright spots like AI and the guide for the next quarter includes roughly 1% from AI services.

The company’s priorities are related to the cloud, and subsequent AI spend. Satya Nadella said in the earnings call, “We continue to focus on three priorities. First, helping customers use the breadth and depth of the Microsoft Cloud to get the most value out of their digital spend. Second, investing to lead in the new AI wave across our solution areas and expanding our TAM.” Second, investing to lead in the new AI wave across our solution areas and expanding our TAM.” He further highlighted that Azure is taking market share, especially benefiting from the AI trend.

You can read our recent editorial on Microsoft here.

AWS

  • AWS revenue grew by 16% YoY to $21.4 billion.
  • The growth is lower than the 20% the last quarter and is a remarkable slowdown from 37% in the same period last year.
  • Management discussed in the earnings call that April revenue growth for AWS further decelerated to 11%. This is due to the ongoing tough macro environment, causing customers to optimize their cloud spending in the recent quarter.

The company’s CEO, Andy Jassy, highlighted that enterprise customers were being cautious. “In AWS, what we’re seeing is enterprises continue to be cautious in their spending in this uncertain time. Customers are looking for ways to save money however they can right now. They tell us that most of it is cost optimizing versus cost cutting, which is an interesting distinction because they say they’re cost optimizing to reallocate those resources on new customer experiences.”cost optimizing versus cost cutting, which is an interesting distinction because they say they’re cost optimizing to reallocate those resources on new customer experiences.”

Google Cloud

  • Google Cloud revenue grew by 28% YoY to $7.45 billion.
  • The growth is lower than the 32% growth reported last quarter and 44% in the same period last year.

The company’s CFO, Ruth Porat, said in the earnings call, “Our investments in product innovation, our go-to-market organization and our partner ecosystem delivered strong results as customers across industries and geographies increasingly rely on Google Cloud to digitally transform their businesses. That being said, in Q1, we continued to see slower growth of consumption as customers optimized GCP costs reflecting the macro backdrop, which remains uncertain. In terms of operating performance, we remain focused on driving long-term profitable growth in Cloud, while continuing to invest given the substantial opportunity.”we continued to see slower growth of consumption as customers optimized GCP costs reflecting the macro backdrop, which remains uncertain. In terms of operating performance, we remain focused on driving long-term profitable growth in Cloud, while continuing to invest given the substantial opportunity.”

More on Best-of-Breed Cloud Stocks

To help illustrate how the deceleration has continued for some best-of-breed names, we took a sample of the top-ranking cloud stocks on revenue growth, free cash flow, adjusted operating margin and/or valuations.

Among the best-of-breed cloud stocks, only MongoDB’s guide shows sequential growth. The company’s QoQ growth was 6% last year and is expected to be 7% this year. The largest deceleration was in HashiCorp, which grew 13% last year and is expected to have flat 0% sequential growth this year.

In the previous quarter, we stated the following:

“Among the best-of-breed cloud stocks, only ServiceNow’s guide shows sequential growth. The company’s QoQ growth was 7% last year and is expected to be 8% this year. The largest deceleration was in GitLab, with revenue that grew 12% QoQ last year, is expected to decline (4%) sequentially this year.

Overall, the category is slowing down sequentially (a rather drastic) 83% for Q1 guides compared to the previous year — from an average of 12% QoQ last year to 2% QoQ growth this year.

For example, best-of-breed cloud reported a 71% slowdown in QoQ/YoY growth for Q4 guides and is now guiding for 83% slowdown in QoQ/YoY growth for Q1 guides.”

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.

Source: YCharts/Seeking Alpha

In our writeups following last earnings season, we were wary of flat guides on YoY basis given cloud has decelerated ever since these companies went public. Due to the slowing revenue growth, companies must report perfect earnings reports. Otherwise, the stock is sold off after hours.

We had seen in the recent earnings season that companies like HashiCorp (lost 25% of its value), SentinelOne (lost about 35% of its value), Cloudflare (lost 25% of its value), and Snowflake (lost 10% of its value) as their guidance missed the Wall Street expectations. This is why we prefer to wait until the Cloud sector reports flat to accelerating growth on a QoQ basis. Due to the strength of the products, we believe this could be early 2024 (see below).   

Our Snowflake premium article in January 2022 explained the downside of the consumption-based pricing model, especially during increased macro uncertainty. “Consumption-based pricing has a few drawbacks. For example, its less predictable than subscription revenue and there isn’t a ‘floor’ on revenue, because if consumption declines then so will sales.”

We further highlighted this point in the risks. “Another risk is the company’s consumption billing model, which is inherently unpredictable. This can make growth lumpy and some quarters may disappoint the Street. Investors should expect increased volatility in growth from Snowflake in the near term as new customers ramp consumption.”

In the quarter following this premium note, Snowflake guided for slower growth during the announcement of the Q4 results in March 2022, which led to the stock being down 30% in after-hours. Similarly, the company missed the Q1 earnings, and Wall Street analysts grew concerned, mainly due to the company’s consumption-based model.

Price Action

There has been an improvement in the price action of cloud stocks in Q2 till date, particularly after May, as seen in the chart below. MongoDB is leading among the best-of-breed cloud stocks after announcing the strongest results in the group pictured above. HashiCorp and SentinelOne rank at the bottom, and are reporting steeper deceleration QoQ – 25% for SentinelOne and then a thin 0% QoQ growth for HashiCorp.

Source: YCharts

The I/O Fund’s Cloud Plan:

Generally speaking, the cloud category has weaker bottom lines and is unprofitable. Therefore, it’s our view that the cloud category will need to return to top line acceleration QoQ before it becomes an obvious buy. This is not true for all tech categories as some can lean on operational efficiencies to drive bottom line growth, and this is rewarded by the market.

Certainly, there are outliers each earnings season, yet the outliers last quarter failed this quarter – and vice versa. As discussed, Cloudflare and Snowflake did quite well last quarter yet missed their guidance this quarter. This is not due to the strength of their product rather how unpredictable budgets are in the current environment.

Per Cloudflare’s CEO: “In the first quarter, we continue to witness a challenging business environment, which deteriorated significantly in March when negative headlines emerged related to SVB, the broadening banking crisis and the worsening macroeconomic outlook. With intensifying business uncertainty, companies became increasingly cautious in more deeply scrutinized field, which impacted numerous areas of our business, including a material lengthening of sales cycles, delays in collections and the significant back-end weighting in the linearity for the quarter.”

Snowflake’s CFO said the following: “In Q1, consumption varied from month to month. We benefited from strong consumption in February and March. Starting in April, consumption slowed after the Easter holidays through today.”

For the most part, many cloud stocks are underperforming the Nasdaq YTD, whereas in the past, this category greatly outperformed the Nasdaq.

Source: YCharts

Conclusion:

In order for cloud companies to outperform the Nasdaq again, we will want to see a return to top line growth QoQ and YoY. The reason we track QoQ is because this shows deceleration quickly compared to YoY. The QoQ data above predicts MongoDB would be the strongest stock, and HashiCorp and SentinelOne would be the weakest stocks, and this matches the market’s reaction.

Below are the forward estimates for MongoDB. Assuming consensus is correct for this stock, the rebound would happen around October 2024 with an entry best timed in January 2024 when the company reaches a low point of 10.95%. One area of concern is the 29% in the current quarter won’t return until nearly two years later.

H2 2024 and 2025 look optimal. Should anything change before then on the fundamentals, we will keep you updated.

The I/O Fund Analyst Team contributed to this article

Recommended Readings: