This article was originally published on Forbes on Aug 10, 2023,07:15 am EDTForbes Forbes on Aug 10, 2023,07:15 am EDT
Given the macro headwinds, not many investors expected the magnitude of the Nasdaq-100’s rally through the first six months of 2023. Going into this year, we were positioned for bottom-line focused investment themes that we felt would be able to deliver earnings growth due to secular demand for its products, and in some cases, be able to reduce costs to maintain profitability.
Big Tech versus Tech Sector earnings
Below is an analysis of consensus earnings estimates from Zack’s on Q2 Technology Sector earnings trends through July 26 plus expectations for the next three calendar quarters.
For the past three quarters, sales and earnings have declined on a year-over-year basis. However, there appears to be stabilization as year-over-year comps get easier and the market is estimating a modest resumption of growth in Q3 and an acceleration in Q4 to Q124.
Meanwhile, Zack’s looked at the earnings picture for the “Big 7 Tech Players” – Microsoft, Alphabet, Meta, Nvidia, Apple, Tesla and Amazon. The earnings profile for the Big 7 is estimated to be more robust compared to the overall technology sector.
In addition to a better earnings profile, Big Tech prices and valuations have benefited from other factors that investors are seeking
Focus on their AI capability and having the financial resources to make the required investments so that they make a positive contribution to future earnings.
Company size (i.e. large cap) and the ability to manage margins in the face of macro headwinds by meaningfully reducing costs but not at the expense of critical high ROI investments.
Credit quality – following Fitch Ratings’ downgrade of U.S. government debt to AA+. Big Tech Credit worthiness is on par if not greater than US debt. For example, Alphabet has the same AA+ rating.
Amongst the Big 7, we believe Alphabet stands out for several reasons:
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Year of Execution – Alphabet
Beginning in mid-2022, IO Fund began to transition allocation toward larger cap tech stocks because we felt they are in a better position to navigate a macro downturn. Big Tech has levers at its disposal to manage its margins by rightsizing its cost base. Importantly, at the same time they have the financial strength to make the investments required to capitalize on the AI opportunity and take market share from its weaker competitors. The medium-term bull case is that once revenue begins to meaningfully reaccelerate helped by its AI offerings, the combination of optimizing its cost structure and efficiencies garnered from technology investments leads to expanding margins. This is similar to Meta and its “Year of Efficiency”.
At the moment we prefer Alphabet (GOOGL) over Meta (META). We see a similar story playing out for Alphabet and its “Year of Execution”. We believe it’s in an earlier stage than Meta in its self-help process and its core business areas are just now showing signs of stabilization. Alphabet’s margins are beginning to rebound and have now returned to the percentage they were at in Q1 2022. Meanwhile 1) Resilience in Search, 2) stabilization in YouTube Ads, 3) Market share and profitability gains in Cloud and 4) Growth in Other Google (i.e. YouTube subscription) make us optimistic that revenue will accelerate and there is upside to margins for the remainder of the year.
In the recent Q223 earnings call, management commented on the QoQ strength in margins: “A quick comment on the sequential improvement in operating margins in the second quarter. There are two factors to note. First, the benefit from an acceleration in search advertising revenue growth in the second quarter. Second, the vast majority of the charges related to our workforce reduction and optimization of our global office space were taken in Q1.”
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Search moat is strong
For all the hoopla surrounding ChatGPT and the belief that it will provide MSFT an opportunity to take share from Alphabet’s core search business, it has yet to happen according to Search Engine. According to their analysis, Microsoft is losing market share. It peaked at 9.92% in October 2022 and is now at 7.14%. With its market position firmly entrenched, Alphabet has the audience to roll out its Search Generative Experience (SGE). On its own, the Search business has proved resilient because it provides advertisers an attractive ROI on their ad spend. Looking ahead, SGE will improve advertisers’ ROI and will likely provide Alphabet additional pricing power. This will also improve their retail vertical. Meanwhile, consumer interest will further strengthen Alphabet’s dominant market position in Search.
However, let’s not forget about anti-trust trial
One of the reason we’re very positive on the AI potential for Google’s businesses is that it is sitting on the world’s very best consumer data, which is not an exaggeration in the least bit. Its ability to lead in artificial intelligence and large language models should not be underestimated.
Therein lies the issue. Google undisputedly has the world’s best consumer data, but did this grow to become part and parcel with operating a monopoly? The Department of Justice has asserted anti-trust violations against Google with the trial beginning in September 2023.
We anticipate two outcomes. The antitrust outcome will be mild, and Google will be empowered to continue to dominate. Or, the outcome will require the ad properties to be broken up, leading to a weaker stance for Google. This could benefit smaller ad-tech players, which we have identified and are monitoring closely.
The I/O Fund Analyst Team contributed to this analysis
Alphabet impressed on the top line with revenue of $74.6 billion compared to estimates of $72.7 billion. This resulted in growth of 7%, or 9% on a constant currency basis, compared to 4% expected. What is important to note is that Alphabet is rebounding on margins and has now returned to the percentage they were at in Q1 2022.
This is important because margins had contracted about 500 basis points at their trough with a 23.9% operating margin in Q4 and have now returned to a 29% operating margin. This is a QoQ increase of 400 basis points. Operating profit of $21.8 billion matches Q4 of 2021 for record operating income. Cash flow margin was also up 440 basis points.
In our pre-earnings write-up, we highlighted that Alphabet was in the Year of Execution when we said: “One of the reasons the IO Fund has invested in larger cap stocks is that they are in a better position to navigate downturns. Big Tech also has more levers to pull to manage margins such as reducing operating expenses. Importantly, at the same time they have the financial strength to make the investments required to capitalize on the AI opportunity and take market from its weaker competitors. The medium-term bull case is that once top-line begins to meaningfully reaccelerate, the combination of right-sizing costs and efficiencies garnered from technology investments leads to expanding margins.”
Also, per our pre-earnings write-up, the CFO has said in the past they are in “Execution mode” in reducing costs and this will be evident not only in 2023 but “you will see more of it in ‘24.”
Management comments on the QoQ strength in margins were: “A quick comment on the sequential improvement in operating margins in the second quarter. There are two factors to note. First, the benefit from an acceleration in search advertising revenue growth in the second quarter. Second, the vast majority of the charges related to our workforce reduction and optimization of our global office space were taken in Q1.”
Another highlight we were looking for, per the pre-earnings write-up, was stabilization in YouTube and increased growth in Search revenue. Both materialized with Search up 5% and YouTube up 4%. These numbers are small for growth investors such as ourselves, but they also represent the strongest growth Google has reported in a year. We entered our current position with the idea that Google has bottomed and will accelerate from here.
Network advertising was weak at (-5.7%) but this is to be expected as mobile identifiers continue be sorted out and first-party data driven ads are more favored. Other revenues was a bright spot, up 24% and driven by “significant subscriber growth” for YouTube subscriptions plus the Pixel 7A.
Google Cloud was “better than peers” at 27.4% growth for an operating margin of 5%. The operating margin is double what it was last quarter, which was the first quarter to turn a profit. This is a positive on the evening of Microsoft’s report as Azure dipped below Google Cloud’s growth rate at 26%.
The CFO is moving to the new role of President and Chief Investment Officer.
Scorecard:
Stated in YoY growth % unless otherwise stated:
EPS and Revenue:
Consensus of $1.34 (+11% y/y) vs $1.45 EPS Reported
Consensus of $72.75B (+4.4% y/y) vs $74.6 billion Reported and 7% growth/9% on CC Basis
Sales by division in Q123 versus Q223:
Google Search and other advertising – 2% versus 5% Q2
YouTube advertising – (-3%) versus 4% Q2
Network advertising – (-8%) versus (-5.7%) Q2
Other – +9% versus 24.2% in Q2
Google Cloud – +28% versus 27.4% in Q2
Margins:
Q1FY23 gross margin of 56.1%% vs Q422 of 53.5% vs Q323 of 54.9% versus Gross Margin of 57.20% in Q2
Q1FY23 operating margin of 25% vs Q422 of 23.9% vs Q322 of 24.6% versus Operating Margin of 29% in Q2
Cash flow + Cash:
Q1FY23 operating and free cash flow was $23.5B and $17.2B for a margin of 33.7% and 24.7%, respectively versus 38.40% op cash flow and 29.10% FCF in current quarter
Earnings Call:
Perhaps the most important question is why did Google grow this quarter when other ad-tech players are slowing down (or expected to slow down).
The answer was: “a lot of companies are focused on profitability, driving efficiencies, and they're carefully evaluating the effectiveness of their budgets. And our goal is really to help them maximize efficiency and drive strong ROI. And Ithink we have the proven AI-powered tools and solutions to actually do it. I called out Search and Other revenues being led by solid growth in the retail vertical. We talked about the DR and brand side on the YouTube side. I think those are the key points I would make.”
There were the obligatory questions about AI, of which this is probably the most important quote:
“It is an exciting moment overall in Cloud because there is definitely a lot of interest from customers on AI, and they definitely are engaging in many more conversations with us. So I would say, without commenting on the short term, but when I think about it long term, I view the AI opportunity as expanding our total addressable market and allows us to win new customers. Scale of investments that we can directly bring to cloud now. As I said earlier, we have over 80 models across Vertex, Enterprise Search and Conversational AI, and we are taking all of them, translating it into deep industry solutions. So, I'm excited about it. Second, it gives us an opportunity to upsell and cross-sell into our installed base.”
As Nvidia, AMD and Marvell investors (as a proxy), we want to keep an eye on capex. The comments were quite bullish in that regard:
“[..] that's why we wanted to be really clear that we do expect elevated levels of investment in our technical infrastructure, and that would be increasing through the back half of 2023, consistent with the comments we've made previously that we expected 2023 to be higher given the slower start at the front half of the year and then continuing to grow into 2024 [..] And the primary driver of this, as you know well, is to support the opportunities we see in AI across the Company, including the investments that we've already talked about, proprietary TPUs, all that we're doing with GPUs as well as data center capacity. And as we continue to see the pace of innovation accelerate, we just want to make sure we're positioned to address the opportunity across Alphabet.”
Conclusion:
We write out a lengthy and thorough pre-earnings report so our Members are aware of what to look for, and what in our eyes constitutes a strong report (or a weak report). It also helps us to eliminate biases. If a company isn’t up to par on the criteria we objectively set forth prior to the call, then we have to trim. Or, if a company clears a bar we set, then we look to add.
Suffice to say, Google has cleared the bar we set forth for our Members on Monday. You can look for us to add to this position soon.
As the women’s world cup commences, perhaps it’s apropos that both Microsoft and Google will report on 7/25 (amc). It will be a Big Tech “battle” of who can generate the most excitement on the AI opportunity and how that may impact their businesses in the future.
Given its cyclical exposure to advertising, Google’s valuation declined until it bottomed in early 2023, and has since increased due to the resilience of Search and optimism that AI will help strengthen it. Meanwhile, there are hopes that YouTube and the Network advertising businesses will stabilize. An aggressive focus on the stabilizing costs was another catalyst.
We recently initiated a position and we’ll discuss a few things we’ll be looking for in order to add to the position.
Here are the Q2FY23 estimates going into earnings announcement on 7/25 (amc).
EPS
Q2FY23 consensus earnings of vs $1.34 (+11% y/y) vs Q123 $1.17 actual
Q3FY23 consensus of $1.34
Group Sales
Q2FY23 consensus of $72.75B (+4.4% y/y)
Q3FY23 consensus of $74.3B
Sales by division in Q123
Google Search and other advertising – $40.4B, +2% y/y
YouTube advertising – $6.7B (-3%) y/y
Network advertising – $7.5B (-8%) y/y
Other – $7.4B +9% y/y
Google Cloud – $7.5B, +28% y/y
Margins –
Q1FY23 gross margin of 56.1%% vs Q422 of 53.5% vs Q323 of 54.9%
Q1FY23 operating margin of 25% vs Q422 of 23.9% vs Q322 of 24.6%
Cash flow + Cash
Q1FY23 operating and free cash flow was $23.5B and $17.2B for a margin of 33.7% and 24.7%, respectively
Q1FY23 cash stood at $115B and $14B in debt
One of the reasons the IO Fund has invested in larger cap stocks is that they are in a better position to navigate downturns. Big Tech also has more levers to pull to manage margins such as reducing operating expenses. Importantly, at the same time they have the financial strength to make the investments required to capitalize on the AI opportunity and take market from its weaker competitors. The medium term bull case is that once top-line begins to meaningfully reaccelerate, the combination of right-sizing costs and efficiencies garnered from technology investments leads to expanding margins.
In Q123, this is how Ruth Porat, Google CFO, characterized the impact of focusing on opex that began in late 2022.
Question
“And then, Ruth, backing out the one-time charges, it looks like OpEx growth is now 8%, so real progress there. Could you give us a flavor of where you are, you think in your optimization cycle?”
Ruth Porat
“We remain extremely focused on these various work streams that we have talked about. It starts with the pace of hiring. It goes to the various work streams that both Sundar and I referenced around using AI and automation to improve productivity, all that we are doing with suppliers and vendors to be as efficient as possible, all that we are doing around optimizing how and where we work. You have seen some of those announcements this quarter beyond the workforce reduction, things that we are doing in, for example, office services, and we are executing against each of these various work streams. So, our view is that there is more to do. And as we try to be clear, we are in execution mode. You will see some of the benefit in ‘23. You will see more of it in ‘24, and we are going to continue building against it beyond.”
Meta has described 2023 as the Year of Efficiency. We’ll refer to Google’s 2023 as the Year of Execution.
Here are the things we’ll be looking for:
Google AI integration and impact across its business – This year Google introduced its chatbot BARD. Organizations are using large language models integrated within Google’s Search, Cloud, Workspace and Cybersecurity platforms.
To improve targeting in Core Search, Google has updated search keyword relevance using the latest natural language processing from MUM models to improve the relevance and performance of shown ads. Smart Bidding uses machine learning tools to optimize the bid of the advertisers. ML tools can analyze millions of data signals and can better predict future ad conversions.
We wrote about the potential impact AI may have here. here.
Google Search – Q1 results demonstrated the resilience of search with its unique ability to surface demand and deliver measurable ROI. We will look for signs of accelerating growth.
YouTube – look for continued signs of stabilization in its advertising exposed businesses and growth in its subscription based services. This is how Ruth Porat described it:
“YouTube, we saw signs of stabilization in ad spend on a sequential basis.”
Network advertising – look for signs of stabilization and improvement. According to the CFO, investors can expect YouTube to be somewhat stabilized whereas Network is still decelerating: “And I would contrast that last quarter, we talked about both a pullback in YouTube and Network, and we were pleased that we saw the stabilization in ad spend on a sequential basis in YouTube. We still saw an ongoing pullback in Network, which tends to be a mix of businesses, as you know well.”
Continued momentum in its Cloud business – for the first time Google had an operating profit in its cloud division. Q123 operating margins were 2.6% and represented 11% of sales. This is how Ruth Porat described it (which is bullish for AI accelerators from NVDA and potentially AMD and MRVL in the future):
“At the same time, I think at the core of your question, and what we were trying to convey is we will continue to invest to support long-term growth, in particular, given the opportunities we see delivering AI capabilities to our customers.”
However, the 28% growth rate may not be the bottom for Google Cloud:
“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.”
Capex outlook for FY 2023 – in Q1 Google raised their capex outlook and stated:
“Finally, as it relates to CapEx, for 2023, we now expect total CapEx to be modestly higher than in 2022. As discussed last quarter, CapEx this year will include a meaningful increase in technical infrastructure versus a decline in office facilities.”
This was reiterated later: “And then as we talked about last quarter, the increase in CapEx for the full year 2023 reflects the sizable increase in technical infrastructure investment, on the flip side, a decline in office facilities relative to last year.”
FY2023 profitability and beyond – Now that Google is half way through their Year of Execution, we will look for any indications on this how may improve profitability once Network and YouTube advertising begin to improve.
September 2023 anti-trust trial – We don’t expect anything from the call but wanted to remind our Members as that date is fast approaching. We wrote about the possible ramifications here.
Here’s what analysts are saying:
Stifel raised the firm's price target on Alphabet to $135 from $130 and keeps a Buy rating on the shares ahead of the company's upcoming earnings report. The firm is "slightly" revising higher its digital advertising growth forecasts for 2023 and 2024, though it is only expecting "slightly better results" for ad-based names relative to the top-line outperformance witnessed in Q1
BofA raised the firm's price target on Alphabet to $142 from $128 and keeps a Buy rating on the shares ahead of the company's Q2 report due on July 25. BofA forecasts revenue and GAAP EPS at $60.7B and $1.42 versus the Street at $60.4B and $1.34, respectively. The firm is constructive on stable search share trends, which it thinks will enable Google to control the pace of large language model integration
Jefferies said the firm's checks indicate overall higher ad spend growth in Q2 for larger platforms after a cautious start to the year due to economic uncertainties and core Google search holding up, "albeit still at muted growth rates." Alphabet is up 41% year-to-date and the firm notes higher expectations, but argues the valuation is "still low" and it believes the stock "could work" into the second half thanks to improved ad checks in Q2 and the advertiser outlook for the second half. The firm, which expects a beat from Alphabet and has a $150 price target on the shares.
KeyBanc analyst Justin Patterson raised the firm's price target on Alphabet to $140 from $122 and keeps an Overweight rating on the shares ahead of quarterly results. The firm believes Q2 is largely improved and growth should re-accelerate. In its conversations, investors perceive Alphabet as a "grind higher" stock given there is likely more limited upside to revenue from Search's vertical exposures and a theoretical ceiling on the multiple due to AI risk. That said, most investors acknowledge Street EPS forecasts appear conservative and that re-accelerating revenue growth provides some near-term reasons for optimism
Credit Suisse analyst Stephen Ju raised the firm's price target on Alphabet to $150 from $135 and keeps an Outperform rating on the shares ahead of quarterly results. Conservatively assuming ongoing headwinds in 2024 and normalization in 2025, the takeaway for Alphabet's shares is that even leaving upside potential from improving monetization potential for YouTube, Maps, and other non-Search surfaces off the table, the firm arrives at a positive investment conclusion. Switching focus to the more near-term, Credit Suisse's checks suggest an acceleration of year-over-year Search budget growth for Q2, as would be expected given easing comparisons. As for YouTube, the firm has received improving advertiser feedback quarter-over-quarter of increasing ad budgets, as CPG vertical spend recovers coinciding with what looks to be increasing ad loads.
Jefferies said the firm's checks indicate overall higher ad spend growth in Q2 for larger platforms after a cautious start to the year due to economic uncertainties and core Google search holding up, "albeit still at muted growth rates." Alphabet is up 41% year-to-date and the firm notes higher expectations, but argues the valuation is "still low" and it believes the stock "could work" into the second half thanks to improved ad checks in Q2 and the advertiser outlook for the second half. The firm, which expects a beat from Alphabet, maintains a Buy rating and $150 price target on the shares.
The I/O Fund Analyst Team contributed to this analysis
We recently wrote about Microsoft’s $100B revenue opportunity in AI and the potential valuation impact of its strategic AI initiatives that go beyond traditional valuation metrics. One approach treated the opportunity as a separate business unit aka Microsoft AI. Using conservative margin assumptions under this approach, we estimated that MSFT AI could earn $4-5 in eps and our bull case price of MSFT + MSFT AI is about $485 (+40%).
As you know, we are incredibly bullish on AI and these are starting points, not ending points. Specifically for Microsoft, we stated that it’s enterprise customer base would propel the company forward as an AI leader because enterprises are the perfect customer for AI. This is because enterprises can drive down costs and increase productivity for immediate ROI whereas consumers may be slower to adopt AI and/or see how it benefits them directly. The ability to directly monetize enterprise customers with AI features faster than peers is materializing with the $30/month CoPilot 365 plan.
MSFT is just beginning to incorporate AI into its core offerings – starting with Microsoft Bing Chat enterprise and Microsoft Co-Pilot 365 – which by its own estimates AI will only contribute 1% to its Azure division in q4. For example, based on an analysis done by Macquarie bank, AI could add $14B to sales in its first full year.
We anticipate that MSFT will build upon its momentum from Q3 into Q4FY23. Meanwhile, 1hFY24 comps will also be supportive. MSFT’S commentary on the AI potential across its businesses in FY24 will be a clear, key focus. The upcoming quarters will be important to follow the growth and stability in Azure, Productivity and Intelligent Cloud businesses, as well, while looking for signs of the bottom in the Personal Computing division.
Fundamentally, we will monitor the impact on revenues and over time the margin impact on these units.
Here are the Q4 estimates going into earnings announcement on 7/25 (amc).
EPS
Q4FY23 consensus earnings of $2.54
Q1FY24 consensus of $2.60
Group Sales
Q4FY23 MSFT midpoint guidance of $55.35B (+7 y/y) vs Consensus of $55.42B
Q1FY24 consensus of $54.9 – we will want commentary on FY2024 in the call, not sure if CFO will provide as recently MSFT has pulled full year guidance given uncertainty in PCs
Microsoft sales guidance by division
Azure & other cloud – +26-27% y/y in constant currency, includes about 1% from AI services
Productivity & Business Processes – $17.8B to $18.28B, +8.7 y/y at the midpoint. CC guidance is 10% to 12%
Intelligent Cloud – $23.6B to $23.9B up 13.6% y/y at the midpoint, CC guidance is 15-16%
Personal Computing – $13.35B to 13.75B, (-5.6%) y/y at midpoint
Margins
Q4FY23 MSFT gross margin of guidance of 69.5% vs Q323 of 69.5% actual vs Q223 of 67% actual
Q4FY23 MSFT operating margin of guidance of 42.1% vs Q323 of 42.3% actual vs Q223 of 41% actual
Cash flow + Cash
Q3FY23 operating and free cash flow was $24.5B and $17.8B for a margin of 46% and 34%, respectively
Q3FY23 cash stood at $104B and $48B in debt
Here are the things we’ll be looking for:
Microsoft Bing Chat and Microsoft Co-Pilot 365 – further insights into AI products, how it expects to impact sales, how it may evolve and the “domino” effect it may have on its other businesses
Big Tech has prioritized higher ROI capex (i.e., AI infrastructure) in 2023 calendar year. Analysts may ask CFO about FY2024 capex.
FY24 and Q124 guidance – MSFT will likely provide qualitative 2024 FY and financial Q1FY24 guidance. Meanwhile consensus is estimating a decline in sales in q4/q1. Anything better will be viewed positively. Consensus is forecasting FY2024 sales and eps growth 11.8% and 14.2%, respectively. Neither of which appear to be demanding given the underlying secular demand drivers.
FY2024 profitability outlook – In FY2023, MSFT pulled several levers to manage its margins from corporate restructurings to accounting change to equipment useful life. We will look for the key drivers that will drive FY2024 margins.
Azure and cloud competitive dynamics and growth – is MSFT taking market share in its Azure cloud related businesses and what is the growth outlook. Plus, comments on the overall corporate IT spending environment.
Current PC environment, the channel inventory situation and if it’s closer to the bottom. Macro and how it’s impacting its consumer related businesses
Update on Activision merger – recently Microsoft and Activision Blizzard jointly agreed to extend the merger agreement deadline from July 18, 2023, to October 18, 2023, to allow for additional time to resolve remaining regulatory concerns.
Here’s what analysts are saying
Stifel raised the firm's price target on Microsoft to $380 from $320 and keeps a Buy rating on the shares. The firm believes Azure should post "solid upside" to management's 26%-27% year-over-year constant currency growth guidance given strong enterprise checks, management's commentary that implied optimization activity should begin to abate as customers lap initial efforts and the firm's expectation of greater than expected AI contribution. The firm expects new Cloud project go-live growth to stabilize as customer's return to reinvesting into cloud migrations
Citi raised the firm's price target on Microsoft to $425 from $340 and keeps a Buy rating on the shares. The analyst remains positive on the shares into the company's fiscal Q4 results. Citi's reseller survey shows improving target achievement levels and an expected acceleration in growth into fiscal 2024, the analyst tells investors in a research note. To reflect signs of improving channel partner inputs and generative artificial intelligence tailwinds, the firm raised estimates "more substantially" across Office 365 Commercial and Azure.
Mizuho analyst Gregg Moskowitz raised the firm's price target on Microsoft to $420 from $390 and keeps a Buy rating on the shares. The big news from day one of Microsoft Inspire came in the form of a $30 per user per month add-on for Microsoft 365 Copilot, the analyst tells investors in a research note. The firm estimates the cumulative incremental revenue from Microsoft 365 Copilot by the end of fiscal 2025 could exceed $9B using a 20% attach rate, and approach $19B using a 40% attach rate. It remains confident that Microsoft's growth opportunities over the medium term and beyond are "greater than many realize."
JPMorgan raised the firm's price target on Microsoft to $385 from $350 and keeps an Overweight rating on the shares. The analyst left the company's Inspire conference "incrementally positive" on its category leadership in artificial intelligence. The announced M365 Copilot pricing of $30 per user per month is an "upside shocker" versus investor expectations closer to $10, the analyst tells investors in a research note. The price point aligns with the perspective that Copilots are far exceeding expectations in the private preview stage
BofA analyst Brad Sills raised the firm's price target on Microsoft to $405 from $340 and keeps a Buy rating on the shares. BofA expects Microsoft to report "healthy 1% upside" to the firm's Q4 revenue estimate of $55.45B, based on Azure and O365 strength. The firm also expects upside to its Azure estimate of 27% year-over-year constant currency growth due to better AI/ML workloads and baseline migration strength, the analyst tells investors in an earnings preview note. BofA forecasts double digit constant currency FY24 revenue growth guidance, assuming "conservative" low 20s percentage Azure growth, low/mid-teens O365 growth and Windows OEM growth of 2%.
Bernstein analyst Mark Moerdler notes that Microsoft announced Bing Chat Enterprise and Microsoft 365 Copilot pricing earlier, which is higher than the firm expected, at $30 per user per month for Microsoft 365 E3, E5, Business Standard, and Business Premium editions. This is a price uplift of 53% to 240%, to list price of these SKUs, depending on what Microsoft 365 edition being used. The price lift is similar to that of Microsoft GitHub Copilot. It is important to note that this announcement is only for Microsoft 365 and not Office 365, Bernstein notes. While Microsoft offers Office 365, their go-to-market focus has been in driving the Microsoft 365 bundle, Bernstein has an Outperform rating and a price target of $380.
The I/O Fund Analyst Team contributed to this analysis
“Following the most recent earnings reports, our prediction is playing out that the slowdown we had predicted in Cloud would worsen. For example, best-of-breed cloud reported a 71% slowdown in QoQ/YoY growth for Q4 guides and is now guiding for an 83% slowdown in QoQ/YoY growth for Q1 guides.
This is important because the cloud category has treated investors quite 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 spend, which is the top driver in terms of year-over-year comparisons.”
Digging Deeper on Best-of-Breed
Our analysis on cloud best-of-breed should not be confused for excessive bearishness. We like this category quite a bit and will continue to watch it closely to build position(s) in the future. Rather, we prefer to not stand in front of the train (which for growth stocks, can be defined as rapid deceleration on the top line) and to simply wait for a signal that growth will resume. Others will choose to remain invested for the long-term story, and that may fit another investment profile.
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 ServiceNow’s guide shows sequential growth. The company’s QoQ growth was 7% last year and is expected to be 8% this year. In this article we want to expand the data below to see which companies are outperforming and underperforming based on the various metrics.
We did a similar analysis in December. Since then, Gitlab stands out for its revenue growth profile that increased from a 10% decel to a 16% decel expected for Q1 from the previous year. If this continues, Gitlab will see an approximate 50% decel from FY2022. HashiCorp is also turning negative in terms of QoQ/YoY, as is Bill.com and MongoDB. Two of these stocks lag cloud on YTD returns with Bill down (30.25%) and Gitlab down (27.13%).
Below we look at companies that beat revenue and adjusted EPS. HashiCorp was the leading cloud stock to have the highest revenue beat. The company’s revenue grew by 41% YoY to $135.79 million and beat estimates by 9.3%. BILL revenue grew by 66% YoY to $260 million and beat estimates by 7%. MongoDB revenue grew by 36% YoY to $361.31 million and beat estimates by 6.9%.
Both MongoDB and BILL, despite the top-line and bottom-line beat, dropped after the earnings due to decelerating revenue. Per Barclays analyst Raimo Lenschow, who has an overweight rating on MongoDB, the guidance only implies 16% growth and a meaningful slowdown in the company's Atlas and Enterprise Advanced segments.
We do not place much weight on earnings beats in the current macro environment. This helps to perfectly illustrate why beats can actually be a dangerous way to evaluate a stock. In all cases – HCP, MDB and BILL, the companies were beating on decelerating revenue and/or bottom lines. We had pointed this out in our January Q1 Webinar when we stated: “We won’t be buying beats on decelerating top line or beats on deceleration bottom line.”
Bottom Line and Free Cash Flow
Below we look at the best-of-breed cloud stock’s GAAP operating margin and free cash flow margin. Note that some cloud companies are reporting better free cash margins.
Snowflake reported a higher free cash flow margin of 35% when compared to 15% in the same period last year. ServiceNow has an impressive 52% free cash flow margin when compared to 46% in the year-ago period.
GAAP profitability is another important metric to closely monitor, especially with macroeconomic uncertainty. Adobe ranks the highest in the best-of-breed cloud companies with an operating margin of 34% and ServiceNow ranks second with an operating margin of 8%.
Cloud investors should remain cautious as cutting back on expenses may weigh on growth long-term. We do not have all of the information yet on how these companies will perform a year out when they’ve decreased head count, gone remote, cut back on sales and marketing and/or cut back on R&D. During the bull market, cloud was spending for growth and this had a direct relation to helping the top line. The effects of pulling back on this spending will not be immediately seen. We are very new to cloud deceleration, which I estimate began to occur in Q3 2022. We’ve stated various reasons for this being the quarter where earnings were a bit unusual, including the Q2 beats weren’t being carried through to a full year raise on guidance.
As stated on Real Vision, this was a flag to us and we began to decrease our exposure to cloud around this time. I think we will need at least a year to 18 months to see the full effects of reduced spending in relation to the top line. Our December cloud report had said – do not be surprised if we see best-of-breed dip below 20% — and we are already quicker than I thought was possible with MDB reporting 16% growth. Perhaps I should update this and say – do not be surprised if best-of-breed reports below 10% growth. With the information we have today, we are headed in this direction.
More on Margins:
The below chart shows the GAAP operating margins of the best-of-breed cloud companies. Apart from ServiceNow and Adobe, other cloud names have negative GAAP operating margins.
Datadog was GAAP profitable but recently lost their positive margin from +3% to (7%). CrowdStrike is low negative single digits at (5%). Datadog’s management had stated in the earnings call that the previous year’s operating margin benefitted from less in-person office costs and travel costs due to Covid policies.
Most of the names listed below that are unprofitable on a GAAP basis are paying high stock-based compensation. BILL has the highest percentage of stock-based compensation at 45.9%, followed by Snowflake at 42.6%, and 36.6% for SentinelOne.
The high stock-based compensation is something to be on watch for, because when companies report, they will overemphasize non-GAAP earnings. For example, BILL has a GAAP operating margin of (43%) and an adjusted operating margin of 12%, with the primary difference being stock-based compensation.
Stock-based compensation is a non-cash expense added back to adjusted earnings. However, in practice this is an expense as per GAAP rules. Warren Buffet said the following, which relates to the importance of GAAP earnings over adjusted earnings when stock-based compensation is involved. “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?”
In the below chart, we ranked companies based on the forward P/S ratio. Snowflake and Cloudflare have the highest forward P/S ratio. These have come down considerably over the past few months. Eventually, cloud will hit a bottom on valuations and be cheap enough for risk-adverse investors to consider.
Ranking based on revenue estimates change for current quarter.
Zscaler’s revenue estimates have been revised up 2.4% and CrowdStrike’s revenue estimates have been revised up 1.6% in the past 30 days. On the other hand, GitLab’s revenue estimates have been revised down (6.6%), Datadog’s revenue estimates have been revised down (2.6%), and MongoDB’s revenue has been revised down (1.7%). This is another reason that earnings beats are not the best way to determine the outcome of an earnings report. Because the market is forward-looking, you’ll see a company beat current estimates while being revised down on forward estimates. This is a trap that retail should try to avoid at all costs.
Ranking based on adjusted EPS estimates change for the current quarter.
MongoDB’s adjusted EPS has been revised up 47.4% in the past 30 days. We also noted earlier in our analysis that the company had a very strong adjusted EPS beat in the recent quarter. Similarly, Zscaler’s estimates have been revised up 27%, and CrowdStrike’s by 16.8%. On the other hand, Snowflake’s estimates have been revised down (26.4%) and Gitlab’s by (10.1%).
A Few Best-of-Breed highlights and lowlights in Q4.
According to the data above, Adobe and ServiceNow are best positioned to weather the new macro. This is due to favorable bottom lines, which includes the elusive GAAP profitability for this category. Their stock-based compensation ranks margin lowest on our list and their respective GAAP operating margins reflects this.
ServiceNow and Adobe also have two of the strongest free cash flow margins in the category and are essentially flat QoQ/YoY on the top line while many cloud stocks are deeply decelerating.
Crowdstrike is guiding for QoQ growth from Q4 to Q1 on both the top line and bottom line.
CrowdStrike revenue grew by 48% YoY to $637.4 million (beat estimates by 1.7%) and adjusted EPS was $0.47 (beat estimates by 10.4%). The free cash flow was also strong as it grew by 65% YoY to $209.5 million with a free cash flow margin of 33%.
Crowdstrike guided for $676M, at the midpoint and EPS of $0.50 to $0.51.
Wedbush analyst Taz Koujalgi said, "We calculate that the [annual recurring revenue] guide appears conservative, and if macro conditions do not deteriorate, net new [annual recurring revenue] growth if high single digits are doable."
The management also highlighted that the company had been ranked No.1 for the third consecutive year in IDC’s annual Worldwide Modern Endpoint Security Market. The company was able to increase its market share by 3.8% to 17.7%.
Cloudflare Grows Free Cash Flow Margin
Cloudflare revenue grew by 42% YoY to $274.7 million (beat estimates by 0.23%) and adjusted EPS was $0.06 (beat estimates by 31.6%).
The company had a free cash flow of $33.66 million with a free cash flow margin of 12% compared to a free cash flow of $8.64 million with a free cash flow margin of 4% in the year-ago quarter.
The management highlighted some of the key deals in the quarter, particularly a leading generative AI company signing a one year $1 million deal. The AI company has been a user of free tier since 2017. Cloudflare was also awarded a five-year deal of $7.2 million to operate the .gov registry. The company also got the moderate status of the FedRAMP authorization in December.
Zscaler Grows Free Cash Flow but Billings Slow
Zscaler revenue grew by 52% YoY to $387.6 million (beat estimates by 6.3%) and adjusted EPS was $0.37 (beat estimates by 26.1%). The free cash flow grew by 113% YoY to $62.8 million with a free cash flow margin of 16%. However, the weak point in the company’s report was the calculated billings that grew by 34% in the quarter from 37% growth reported in Q3 and 59% growth reported in the year-ago quarter.
The management mentioned in the earnings call, “Billings were impacted by new customers being more deliberate about their large purchasing decisions at the start of the calendar year. These deals have not gone away, and we have closed a few already in February.” The billings guide for the next quarter was also low. “For Q3 (Q1), we are assuming billings to decline by approximately 9% sequentially, compared to the mid-single digit percentage declines we have seen in the last few years.”
Conclusion
The cloud sector has many moving parts as it mixes strong product stories with weak bottom lines. In addition to this, eventually the valuations will become attractive especially for those that can weather the new macro by cutting costs and maintaining category-leading growth. Across the board, cloud investors should be prepared for a sustained slowdown on the top line. This could worsen over the next year, as typically there’s a direct relationship between spending/investing in growth and top line results 12-18 months later. The opposite will also be true, cutting back on spending/investing in growth will lead to a lower top line.
Our preference is to remain on the side lines for now while identifying the strongest one or two cloud stocks fundamentally for when the technicals show give us a clear signal that it’s time to hold exposure here again. This could happen quickly so we prefer to be prepared in advance with what companies’ charts should take priority.
Deep dives plus trade alerts and weekly webinars are offered on our premium service, you can find out more information here.
“Following the most recent earnings reports, our prediction is playing out that the slowdown we had predicted in Cloud would worsen. For example, best-of-breed cloud reported a 71% slowdown in QoQ/YoY growth for Q4 guides and is now guiding for an 83% slowdown in QoQ/YoY growth for Q1 guides.
This is important because the cloud category has treated investors quite 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 spend, which is the top driver in terms of year-over-year comparisons.”
Digging Deeper on Best-of-Breed
Our analysis on cloud best-of-breed should not be confused for excessive bearishness. We like this category quite a bit and will continue to watch it closely to build position(s) in the future. Rather, we prefer to not stand in front of the train (which for growth stocks, can be defined as rapid deceleration on the top line) and to simply wait for a signal that growth will resume. Others will choose to remain invested for the long-term story, and that may fit another investment profile.
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 ServiceNow’s guide shows sequential growth. The company’s QoQ growth was 7% last year and is expected to be 8% this year. In this article we want to expand the data below to see which companies are outperforming and underperforming based on the various metrics.
We did a similar analysis in December. Since then, Gitlab stands out for its revenue growth profile that increased from a 10% decel to a 16% decel expected for Q1 from the previous year. If this continues, Gitlab will see an approximate 50% decel from FY2022. HashiCorp is also turning negative in terms of QoQ/YoY, as is Bill.com and MongoDB. Two of these stocks lag cloud on YTD returns with Bill down (30.25%) and Gitlab down (27.13%).
Below we look at companies that beat revenue and adjusted EPS. HashiCorp was the leading cloud stock to have the highest revenue beat. The company’s revenue grew by 41% YoY to $135.79 million and beat estimates by 9.3%. BILL revenue grew by 66% YoY to $260 million and beat estimates by 7%. MongoDB revenue grew by 36% YoY to $361.31 million and beat estimates by 6.9%.
Both MongoDB and BILL, despite the top-line and bottom-line beat, dropped after the earnings due to decelerating revenue. Per Barclays analyst Raimo Lenschow, who has an overweight rating on MongoDB, the guidance only implies 16% growth and a meaningful slowdown in the company's Atlas and Enterprise Advanced segments.
We do not place much weight on earnings beats in the current macro environment. This helps to perfectly illustrate why beats can actually be a dangerous way to evaluate a stock. In all cases – HCP, MDB and BILL, the companies were beating on decelerating revenue and/or bottom lines. We had pointed this out in our January Q1 Webinar when we stated: “We won’t be buying beats on decelerating top line or beats on deceleration bottom line.”
Bottom Line and Free Cash Flow
Below we look at the best-of-breed cloud stock’s GAAP operating margin and free cash flow margin. Note that some cloud companies are reporting better free cash margins.
Snowflake reported a higher free cash flow margin of 35% when compared to 15% in the same period last year. ServiceNow has an impressive 52% free cash flow margin when compared to 46% in the year-ago period.
GAAP profitability is another important metric to closely monitor, especially with macroeconomic uncertainty. Adobe ranks the highest in the best-of-breed cloud companies with an operating margin of 34% and ServiceNow ranks second with an operating margin of 8%.
Cloud investors should remain cautious as cutting back on expenses may weigh on growth long-term. We do not have all of the information yet on how these companies will perform a year out when they’ve decreased head count, gone remote, cut back on sales and marketing and/or cut back on R&D. During the bull market, cloud was spending for growth and this had a direct relation to helping the top line. The effects of pulling back on this spending will not be immediately seen. We are very new to cloud deceleration, which I estimate began to occur in Q3 2022. We’ve stated various reasons for this being the quarter where earnings were a bit unusual, including the Q2 beats weren’t being carried through to a full year raise on guidance.
As stated on Real Vision, this was a flag to us and we began to decrease our exposure to cloud around this time. I think we will need at least a year to 18 months to see the full effects of reduced spending in relation to the top line. Our December cloud report had said – do not be surprised if we see best-of-breed dip below 20% — and we are already quicker than I thought was possible with MDB reporting 16% growth. Perhaps I should update this and say – do not be surprised if best-of-breed reports below 10% growth. With the information we have today, we are headed in this direction.
More on Margins:
The below chart shows the GAAP operating margins of the best-of-breed cloud companies. Apart from ServiceNow and Adobe, other cloud names have negative GAAP operating margins.
Datadog was GAAP profitable but recently lost their positive margin from +3% to (7%). CrowdStrike is low negative single digits at (5%). Datadog’s management had stated in the earnings call that the previous year’s operating margin benefitted from less in-person office costs and travel costs due to Covid policies.
Most of the names listed below that are unprofitable on a GAAP basis are paying high stock-based compensation. BILL has the highest percentage of stock-based compensation at 45.9%, followed by Snowflake at 42.6%, and 36.6% for SentinelOne.
The high stock-based compensation is something to be on watch for, because when companies report, they will overemphasize non-GAAP earnings. For example, BILL has a GAAP operating margin of (43%) and an adjusted operating margin of 12%, with the primary difference being stock-based compensation.
Stock-based compensation is a non-cash expense added back to adjusted earnings. However, in practice this is an expense as per GAAP rules. Warren Buffet said the following, which relates to the importance of GAAP earnings over adjusted earnings when stock-based compensation is involved. “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?”
In the below chart, we ranked companies based on the forward P/S ratio. Snowflake and Cloudflare have the highest forward P/S ratio. These have come down considerably over the past few months. Eventually, cloud will hit a bottom on valuations and be cheap enough for risk-adverse investors to consider.
Ranking based on revenue estimates change for current quarter.
Zscaler’s revenue estimates have been revised up 2.4% and CrowdStrike’s revenue estimates have been revised up 1.6% in the past 30 days. On the other hand, GitLab’s revenue estimates have been revised down (6.6%), Datadog’s revenue estimates have been revised down (2.6%), and MongoDB’s revenue has been revised down (1.7%). This is another reason that earnings beats are not the best way to determine the outcome of an earnings report. Because the market is forward-looking, you’ll see a company beat current estimates while being revised down on forward estimates. This is a trap that retail should try to avoid at all costs.
Ranking based on adjusted EPS estimates change for the current quarter.
MongoDB’s adjusted EPS has been revised up 47.4% in the past 30 days. We also noted earlier in our analysis that the company had a very strong adjusted EPS beat in the recent quarter. Similarly, Zscaler’s estimates have been revised up 27%, and CrowdStrike’s by 16.8%. On the other hand, Snowflake’s estimates have been revised down (26.4%) and Gitlab’s by (10.1%).
A Few Best-of-Breed highlights and lowlights in Q4.
According to the data above, Adobe and ServiceNow are best positioned to weather the new macro. This is due to favorable bottom lines, which includes the elusive GAAP profitability for this category. Their stock-based compensation ranks margin lowest on our list and their respective GAAP operating margins reflects this.
ServiceNow and Adobe also have two of the strongest free cash flow margins in the category and are essentially flat QoQ/YoY on the top line while many cloud stocks are deeply decelerating.
Crowdstrike is guiding for QoQ growth from Q4 to Q1 on both the top line and bottom line.
CrowdStrike revenue grew by 48% YoY to $637.4 million (beat estimates by 1.7%) and adjusted EPS was $0.47 (beat estimates by 10.4%). The free cash flow was also strong as it grew by 65% YoY to $209.5 million with a free cash flow margin of 33%.
Crowdstrike guided for $676M, at the midpoint and EPS of $0.50 to $0.51.
Wedbush analyst Taz Koujalgi said, "We calculate that the [annual recurring revenue] guide appears conservative, and if macro conditions do not deteriorate, net new [annual recurring revenue] growth if high single digits are doable."
The management also highlighted that the company had been ranked No.1 for the third consecutive year in IDC’s annual Worldwide Modern Endpoint Security Market. The company was able to increase its market share by 3.8% to 17.7%.
Cloudflare Grows Free Cash Flow Margin
Cloudflare revenue grew by 42% YoY to $274.7 million (beat estimates by 0.23%) and adjusted EPS was $0.06 (beat estimates by 31.6%).
The company had a free cash flow of $33.66 million with a free cash flow margin of 12% compared to a free cash flow of $8.64 million with a free cash flow margin of 4% in the year-ago quarter.
The management highlighted some of the key deals in the quarter, particularly a leading generative AI company signing a one year $1 million deal. The AI company has been a user of free tier since 2017. Cloudflare was also awarded a five-year deal of $7.2 million to operate the .gov registry. The company also got the moderate status of the FedRAMP authorization in December.
Zscaler Grows Free Cash Flow but Billings Slow
Zscaler revenue grew by 52% YoY to $387.6 million (beat estimates by 6.3%) and adjusted EPS was $0.37 (beat estimates by 26.1%). The free cash flow grew by 113% YoY to $62.8 million with a free cash flow margin of 16%. However, the weak point in the company’s report was the calculated billings that grew by 34% in the quarter from 37% growth reported in Q3 and 59% growth reported in the year-ago quarter.
The management mentioned in the earnings call, “Billings were impacted by new customers being more deliberate about their large purchasing decisions at the start of the calendar year. These deals have not gone away, and we have closed a few already in February.” The billings guide for the next quarter was also low. “For Q3 (Q1), we are assuming billings to decline by approximately 9% sequentially, compared to the mid-single digit percentage declines we have seen in the last few years.”
Conclusion
The cloud sector has many moving parts as it mixes strong product stories with weak bottom lines. In addition to this, eventually the valuations will become attractive especially for those that can weather the new macro by cutting costs and maintaining category-leading growth. Across the board, cloud investors should be prepared for a sustained slowdown on the top line. This could worsen over the next year, as typically there’s a direct relationship between spending/investing in growth and top line results 12-18 months later. The opposite will also be true, cutting back on spending/investing in growth will lead to a lower top line.
Our preference is to remain on the side lines for now while identifying the strongest one or two cloud stocks fundamentally for when the technicals show give us a clear signal that it’s time to hold exposure here again. This could happen quickly so we prefer to be prepared in advance with what companies’ charts should take priority.
Of these names, we plan to do a deep dive in April for our premium members on the front runner(s). Stay tuned.
It may feel like the words “Google” and “lawsuit” are commonplace, but the trial in September carries enormous weight and is unlike the lawsuits of the past. Not only do we want to keep an eye on ad-tech names that could benefit should Google’s monopoly be broken up and the juggernaut come out weaker, but we also want to be prepared if the tech giant is able to hold off regulators.
Considering that Google is sitting on the world’s very best consumer data, which is not an exaggeration in the least bit, its ability to lead on artificial intelligence and large language models should not be underestimated. For our purposes, the company is far from sitting on its laurels and there’s a predictable path where the company competes in a duopoly with Microsoft.
Therein lies the issue. Google undisputedly has the world’s best consumer data, but did this grow to become part and parcel with operating a monopoly? The Department of Justice has asserted anti-trust violations against Google with the trial beginning in September 2023. The trial is expected to last ten to 12 weeks, although a lawyer for the DOJ told CNBC it could be as brief as five weeks.
Why it matters:
With Google and other ad-tech companies trading this low, one of two outcomes will happen. The antitrust outcome will be mild, and Google will be empowered to continue to dominate. Or, the outcome will require the ad properties to be broken up, leading to a weaker stance for Google. This could benefit smaller ad-tech players.
The Goal — Looking back:
A few years back, I analyzed the potential outcome of a government decision when the Pentagon was evaluating cloud providers. Clearly, this decision is far outside of anyone’s control and requires some speculation. At the time, I speculated Azure would be a winner. For a year or so, Microsoft did secure the Pentagon contract over the more-favored Amazon. This decision was ultimately reversed, and the contract was split between four tech companies.
The exact outcome of the Pentagon contract was not particularly important because the analysis led to my conclusion that Microsoft’s hybrid computing was a material advantage and this would be the path Nadella would most likely use to take market share from AWS’s heavily-slanted public cloud strategy.
I’m hoping for something similar, which is to acknowledge something very important is going on with ad-tech, which is Google’s antitrust case. This is not a headline to simply dismiss. It’s the first time the DOJ has brought a case of this kind against a technology company since Microsoft. If there are even minor cracks in Google’s monopoly, there could stand to be a stock or two that starts a new trajectory.
On similar note, Cambridge Analytica is what sparked my coverage on Facebook. Similar to Google’s antitrust case, it became apparent to me that Facebook was peaking in terms of its ability to monetize through third party data. I covered this extensively, for example here and here.
Brief Overview of Antitrust Case:
According to Lanier Law Firm, which is the litigation team for the State of Texas in the state coalition case, a primary argument against Google is that the company went above and beyond to become the default search engine on iOS devices by paying Apple $12 billion per year.
The lawsuit includes other deals that Google struck with Apple’s Safari browser, the Mozilla browser and Android device manufacturers where Google either paid up or imposed restrictions on Android device makers to strongarm having their suite of apps pre-installed on the home screen.
The company has already lost an antitrust case in Europe in 2018 with a $4.4 billion Euro fine for forcing Android manufacturers to pre-install Google’s bundle of apps on the device, including Chrome, Maps and the Play Store.
Google’s market share of Search is at 91% and the argument is being made this was accomplished through anti-competitive practices, especially since Google owns Android and had leverage over the many device makers that used this operating system.
In addition to being pre-installed and the default browser/search engine, Google also attempts to keep people on its search engine by using a website’s data on its page. For example, if you look up “Best Dog Breed” Google scrapes Wikipedia and puts the results onto the search page instead of sending you to Wikipedia. This is seen as anti-competitive as it takes a website’s data to profit from it, rather than directing the traffic to the rightful copyright owner, which is the function of a search engine.
Part of Microsoft’s antitrust case was based on Microsoft using its dominance on Windows to force a Microsoft Explorer to be the default browser. At the time, the decision was that default settings are anticompetitive.
The secondary argument filed by a 10-state group led by Texas, is that Google leverages its properties to be the buyer and the seller via its ad exchange. Per Lanier Law Firm, the Texas case states Google and Facebook “unreasonably restrained trade and harmed competition through an unlawful agreement to allocate auction wins and to fix prices in violation of Section 1 of the Sherman Act, 15 U.S.C. § 1”
This is where it gets very messy, and so I’ve dedicated a specific section below to break down these details. The purpose of understanding the minutiae is not to only determine if we should buy Google and when, but also what companies could stand to benefit if Google’s products are shutdown or broken up.
My long-ago analysis on Facebook pointed toward a conflict of interest in the company owning a third-party ad network called Audience Network while also being publisher. At the very least, the conflict of interest created a risk since Facebook was essentially siphoning oil from real estate the company didn’t own (iOS users). This was a serious, material risk for investors that played out over time (note: it certainly wasn’t immediate, it took four years from the first time I covered the topic).
If you’re a Meta investor, you’ll want to watch the CPMs on the company and make sure the erosion below is not permanent. Despite Apple only impacting third-party data, it’s unclear how much of that third-party data was informing its first party data. The unusually high CPMs that Meta charged points towards enhanced targeting – that in my opinion – was likely due to mixing both first-party data with third-party data. This means there will be an eventual erosion, over time, of the CPMs Facebook can charge even on its own applications.
Pictured above: Although subtle, there is an erosion to Facebook’s otherwise high CPMs. You can see that Nov 2022 made a lower high over Black Friday compared to the two previous years. Many factors could be at play, such as lower ad budgets, but it’s something investors should keep a close eye on.
Google currently does the same thing that Facebook used to do, which is to run an ad exchange that is undeniably a conflict of interest. The difference is that rather than renting real estate, like Facebook did with iOS, Google is a real estate tycoon. There isn’t a tech company that can kick Google off their turf because Google owns all of the turf – primarily Chrome, Android, Google Search, and YouTube.cBy conflict of interest, I’m referring to AdX, DoubleClick and DV360, collectively known as the Google Network.
Below, you can see Google Network is a $32 billion annual revenue stream. Not exactly peanuts.
To further the lawsuit, a 30-state coalition has issued a third claim that Google uses its monopoly to rip off smaller companies, such as Yelp, DoorDash, and Kayak. You can see evidence of this when Google Search returns flight searches powered by Google at the top, with a large embedded format, rather than producing a fair search result that includes competitors. Yelp has been in a battle with Google over this for over a decade. After Google Reviews were launched, Google pushed Yelp down the page in terms of search results.
The two search engine allegations are fairly straight forward. Most of us who use Google Search can reasonably understand those arguments.
The Messy, Blackbox that is AdExchange (AdX):
DoubleClick was acquired in 2007 for $3.1 billion. As author Tony Yiu points out on Toward Data Science, this was twice the amount paid for YouTube a year earlier. Google Network is a by-product of many acquisitions including AdMob for $750 million and AdMeld for $400 million, among others, yet DoubleClick truly set the supply side dominance in motion as the company owned 60% of the desktop publisher market at the time of acquisition.
DoubleClick allows Google to set a cookie on a website so that online publishers can better target visitors with ads. The DoubleClick cookie provides the time and date a user saw an advertisement, as well as a unique ID that identifies a user by their browser. Publishers are then able to auction inventory to advertisers.
DoubleClick was a major move by Google to expand beyond search advertising. This was the first time Google entered the market on display ads. As stated, DoubleClick owned 60% of the publisher market when it was acquired, which means Google would eventually profit from monetizing millions of websites.
This led to a concentration of power for Google, because with this advantage, it was able to grow quickly as a predominant ad server for publishers. Naturally, Google wanted to maximize this advantage, and so the company made the appropriate acquisitions to operate on the demand side (advertiser side) in addition to the publisher side.
Through a series of acquisitions, Google built DV360, which allows advertisers to use their own data to target customers across publisher inventory. Google always has strong ties to data, in this case powering DV360 with Google Analytics 360. In addition to this, Google’s AdX allows advertisers to create campaigns across Google-owned properties in addition to millions of websites from third-party publishers on the DoubleClick publisher side, as mentioned above.
An easy analogy here would be to compare it to a real estate transaction, since ads are transactional between a buyer and seller. In this case, Google was representing both the buyer and the seller, and in some cases brokered its own real estate to the buyers. You can imagine due to Google’s scale of doing millions of transactions a day, things might get unethical real quick.
Here’s how a Google executive put it:
“[I]s there a deeper issue with us owning the platform, the exchange, and a huge network?” the executive allegedly asked. “The analogy would be if Goldman or Citibank owned the NYSE.”
With that in mind, let’s continue because the depth of Google’s black box is quite deep.
The product AdSense further pools the data provided by publishers. When millions of websites join AdSense to pool data, Google can record more information on a person’s browsing history. It provides a complete view of the consumer for more enhanced targeting. Another area that Google allegedly monopolizes the market is that the company mixes its first party data with this third party data, but only in instances where Google will benefit.
The AdMob acquisition in 2009 provided a similar strategy as DoubleClick but on mobile. It deepened Google’s reach on the supply side for the mobile market. This, of course, was especially advantageous considering Google bought Android in 2005.
You can imagine, that the depth of Google’s data on desktop users and mobile users is deep (and likely quite dark). Meaning, Google knows more about you than you know about yourself. Now, take that depth of data and add the serious conflict of interest that can occur when Google bids against competitors.
Where Google (Allegedly) Went Wrong with AdX
Despite the allegations below that Google was unethical, I want to point out that antitrust could be harder to prove for AdX. This is because many corporations combine first-party publisher data with a third-party ad exchange, such as Amazon, Facebook, Disney and Comcast. Microsoft is building its ad exchange, as well right now, after acquiring Xandr from AT&T. However, Xandr/Microsoft’s strategy is to support the “free and open web” by adopting the Unified ID.
Point being, if the product AdX is found to be anticompetitive, it could have far-reaching implications for other companies. This wasn’t the case with Microsoft, as the company was rather isolated on its throne in the late 90s. With that said, Google is the worst offender in terms of the sheer advantages it has compared to other corporations with large media properties.
Here are some of the more unethical things Google is being accused of:
According to the lawsuit, there was a 65% drop in revenue if publishers chose to not use Google on the demand side. Advertisers are also stating this was a conflict of interest as Google restricted inventory in this case. This would be like a real estate agent refusing to show a house if they did not have both the buyer and the seller to double-end the transaction.
Google also allegedly circumvented waterfall auctions to prioritize their own bids on AdX. Waterfalls were prevalent throughout the ecosystem because they allow exchanges to be ranked by bids. Based on historical bids, if the ad exchange in the number one position doesn’t buy the inventory, it goes to the next ad exchange in the waterfall (the number two position).
Where Google may have manipulated the bidding is by allowing their exchange to meet only floor prices to win the bid, even when another exchange would have bidded higher in a waterfall-like auction. This would be like a real estate agent only presenting their Buyer’s offer to a Seller even if they knew they could get higher offers from another agent.
Due to DoubleClick and AdX waterfalls having the issues described above, programmatic header bidding was introduced to offer true, real-time bidding to increase publisher yield. It essentially increased competition by holding an open auction rather than a closed, blackbox auction that pushes inventory back and forth in an attempt to sell the inventory.
Per Digiday written in 2015: “One notable side effect of header bidding adoption is that it puts pressure on Google’s DoubleClick for Publishers ad server, which, through its dynamic allocation feature, lets AdX — but no other exchange — see and bid on every impression.”
That sentence and general understandingand general understanding of what AdX did to manipulate the waterfall process nicely sums up where Google could face trouble in a courtroom. According to the lawsuit, publishers saw 30% to 40% more revenue through header bidding by simply removing Google’s ability to manipulate the waterfall auction. I bolded “general understanding” because Google is so powerful that the ad ecosystem knew full and well that it was using its monopoly in anticompetitive ways but there was nothing any publisher or advertiser could do about it.
Google has tens of thousands of engineers and is a very advanced company, which is why the allegations are quite complex. The lawsuit points out that Google then later manipulated header bidding by allowing AdX to bid last. As long as AdX beat the previous bids, then it would win the bid. Going back to the real estate agent scenario, this would be like having multiple offers on a house, and the listing agent going to their exclusive buyers to reveal what the prices are to help the buyers win the bidding war.
Google is also accused of using more acquisitions for ad technology that would later be leveraged to subsidize bids. This means Google paid the difference on an advertiser’s bid in order to be the winning bid. In this case, Google simply increased its margin or cut in order to make up for the amount that was subsidized.
Google’s DSP called DV360 was also allegedly engineered to decrease bids from competing ad exchanges, including those who were using header bidding for a more fair auction process. This was done by setting the highest competing bid at the floor price while AdX was able to bid higher.
Google is accused of suppressing header bidding through covert mechanisms by reducing header bids by up to 90%. Meanwhile, Google’s own DV360 bid was not decreased. This was done even when Publishers attempted to set a lower floor for competing ad exchanges, meaning, Publishers were without recourse even if they agreed to a lower bid.
Conclusion:
Given the sheer impact a weaker Google could have on the ad-tech ecosystem, we wanted to do a deep dive and get in front of this. I believe this is the number one catalyst across ad-tech this year and we want our readers to benefit no matter the outcome. As the market can often do, there may be some price movements ahead of the trial, and if so, we will be watching for entries closely.
We offer an Advanced service with specific stock picks that may benefit from Google’s lawsuit and we also offer real-time trade alerts for all of our portfolio entries and exits. You can learn more about this service here.about this service here.
Tech growth is a certain style of investing; it’s a mix of grand slams but more strikeouts. Value investing is a mix of singles, doubles and even bunts, but with fewer strikeouts. Investing style and risk appetite runs a large spectrum from high risk/high reward to low risk/low reward.
Similarly, there are different management styles. Datadog falls firmly in the candid, conservative style of management. They are the best-of-breed team that is least likely to overpromise and under-deliver, hence the perfect record on beating on the top line and bottom line.
Both the CEO and CFO will tell investors exactly like it is, even it’s hard to hear. This is very different from other management teams that will take risks on guidance, with the hope of meeting the numbers somehow, and will smooth over anything negative so as not to raise alarm bells.
Datadog’s guide does not necessarily foreshadow lower growth than other cloud companies that have reported, especially as we can assign a high level of probability the actual report will come in higher than the guide. Rather, it was the tone on the call that was very different. Ultimately, as we covered in our Q1 Earnings Prep Webinar, there is a lot of built-up anticipation for a H2 rebound. The rebound may or may not happen; I imagine next earnings season will be a real line in the sand given it takes place four to five months into the year.
The rebound comes from analyst estimates, so of course, analysts are keen to make sure their estimates are correct with the bulk of questions aimed at what 2023 will look like. Datadog told analysts on the call they do not see evidence of a rebound yet, and with what they know today, their guide assumes optimization will continue throughout the year. They do believe eventually optimizations will slowdown, and that cloud migration will again become a tailwind. They are unwilling to provide guidance on when this will happen.
Management specifically called out a bigger slowdown in December on usage than what they saw in October and November. So far, 2023 has more closely resembled December. They also specifically called out larger customers as the primary cohort optimizing and lowering usage and/or spend, while smaller customers are seeing little to no change. Large customers have more to gain from lowering costs, and face more uncertainty.
Datadog’s financials are similar to what we posted on the forum, which is a slowdown from this time last year (to be fair, all cloud has slowed on a YoY basis from Q1 2022 to Q1 2023E). RPO was flat but Billings were down QoQ. Datadog still has a top position for bottom line strength in best-of-breed, although notably, the bottom line has softened.
Financials:
Datadog beat estimates in the current revenue, yet guided below analyst consensus for Q1 and FY2023.
In the current quarter, revenue of $469.4 million represents growth of 44% year-over-year. This beat previous management guidance and analyst consensus of $449M, for a beat of +6% on the top line. This led to a beat on FY2022 revenue at 63% growth compared to 60.8% expected.
Guidance for Q1 is for $460 to $470 million, for growth of 28%. Due to being conservative, as discussed in the intro, the fiscal year guidance is lower than Q1 at 23.8% for $2.08 billion.
You can reasonably assume these estimates will be beaten with a 5% to 10% beat, if we rely on previous earnings surprises, but there’s no guarantees, of course.
Adjusted EPS of $0.26 comfortably beat estimates of $0.19. GAAP EPS came in at ($0.09).
Q1, Datadog management provided a guide in line at $0.22 to $0.24 compared to estimates of $0.24. For FY2023, there was a miss with guidance of $1.02 to $1.09 compared to analyst estimates of $1.13.
Cash flow was up sequentially due to seasonality yet was down on a year-over-year basis. Despite Datadog decelerating, it still ranks high on FCF margins for cloud best-of-breed. Operating cash flow margin was at 24.3% and free cash flow margin of 20.50% equaling $96.4 million in cash flow.
Let’s say we have a deeper recession than expected. Datadog is likely to survive this, but at what valuation is the question. There’s a solid chance cloud remains range bound at these valuations until there’s a return to growth, which means fluctuations up in price/down in price that ultimately provide little movement or gains. I don’t think Datadog is going to be the company that has an unpleasant surprise from an unexpected miss in their earnings report, which is my preference certainly for management style. Rather, they will take the hit up front, like we saw today.
The company has cash and marketable securities of $1.9 billion on the balance sheet with fairly high stock based compensation of $112 million.
Margins:
· Datadog has a high gross margin of 79.3%.
· GAAP operating margin beat at (7%) actual compared to (10%) guide. This is a deceleration from 3% in the year ago quarter.
· Adjusted operating margin was 18% compared to 22% in the year ago quarter.
· GAAP net margin of (6%) compares to 2% net margin
Key Metrics:
· Datadog reported RPO of 30% YoY which was flat from the previous quarter. Notably, the Q4 to Q1 quarter tends to be flat for Datadog with more variability in Q2.
· Billings softened to 31% growth YoY compared to 86% in the year ago quarter. This was a deceleration from Q3 with billings of 51%.
· Customers with ARR of > $100K grew 38% compared to 64% last year
· Customers with ARR > $1 million grew 46.7%. This is a newer metric for Datadog with no year-over-year comp available
· DBNRR is above 130 but management stated on the call they expect this to dip below 130.
Earnings Call:
In the opening remarks, the company stated the following about large customers in Q4:
“Now moving on to this quarter's business drivers. Overall, we observed slower usage growth with existing customers while continuing to scale our new logo acquisition and new product cross-sells. Starting with usage. Usage growth of existing customers in Q4 was overall slightly lower than what we observed in Q2 and Q3, which we attribute first to a continuation of cloud cost optimization by our larger spending customers; and second, to a seasonal annual slowdown in the second half of December that was more pronounced than in previous years.
As in Q2 and Q3, we continue to see more optimization from customers as a larger cloud footprint, while our smaller spending customers are exhibiting higher growth.”
The CFO later provided more color in his opening remarks:
“Next, similar to Q2 and Q3, we saw larger-spending customers grow slower than smaller spending customers. As with Q2 and Q3, we saw relatively more deceleration in the consumer discretionary vertical, particularly in e-commerce and food delivery. Geographically, we saw solid and relatively similar growth across all regions.”
And the CFO also stated this:
“We are incorporating an expectation for seasonally weaker growth in the first quarter due to the subdued growth in the month of December that creates a lower growth trajectory to start the first quarter. While our customers are continuing to expand with us, we are assuming in our guidance that cloud optimization continues to affect our expansion rate in 2023.”
In regards to Datadog’s specific business, they essentially believe they are the next in line on optimization following cloud hyperscalers. In other words, companies are optimizing with the hyperscalers now and working their way through the stack with Datadog second in line, in terms of what order makes the most sense:
“What we see, though, is that customers save money where it matters, which tends to be the very large line items, which for customers that are fairly far along into the cloud, is going to be, first, their cloud provider deals that are, again, one or two others are larger than their observability bills.
And then we're going to be affected by that and maybe with some optimization more specific to observability as well. So that's what we see there.”
Also, management clarified with analysts the slowdown (for Datadog) is not related to headcount, given the many layoffs announced, rather it’s more usage based and related to reducing budgets.
In regards to the larger trend of cloud migrations, Datadog said the following:
“So that's where we're going. I think you're right, though, that the underlying wave that is — has been a tailwind throughout the of the company was cloud migration and digital transformation. I think that we might be a bit more of a headwind over the next few quarters. But we strongly believe that it will become a tailwind again in the future.”
Conclusion:
Datadog is a company we will watch closely and return to in the future. Knowing that I can’t control macro, it feels like 2023 should be used as an opportunity to build tech generals in the belly of a recession rather than guess on companies that are reporting tapering growth (although formally were very high growth). Please note, many companies are reporting tapering growth despite the market rewarding the companies with earnings pops. This is entirely based on expectations for future growth which may or may not materialize.
It’s our preference to take advantage of the lower prices by focusing more on key tech generals for now while allowing time for smaller companies to prove their ability to withstand macro pressure. This strategy can be a win-win, because if we see a deeper recession than normal, the risk of picking the wrong company is much lower than if we bet on decelerating growth from less defensible companies. However, if we see a soft landing, then we are still positioned to participate in growth.
We will continue to identify outliers, such as AEHR, with a heavy focus on this in March and early April. Look forward to new coverage and deep dives coming soon as we wrap up the last of our portfolio’s earnings season next week.
This article was originally published on Forbes on Dec 29, 2022,09:41pm ESTForbes on Dec 29, 2022,09:41pm EST
CrowdStrike has one of the better fundamental profiles out of the cloud category. This is due to its 50%+ revenue growth rate, GAAP operating margin of (7%) and free cash flow margin of 31%. The company also has one of the best Rule of 40 numbers in the cloud category at 89%. The companies that have higher growth rates or higher Rule of 40 numbers tend to be IPOs, which are designed to be strong out the gate and then fade over time. Meanwhile, CrowdStrike has consistently offered best-of-breed performance for over three years.
Therefore, it’s important to look into what caused CrowdStrike’s weak price action following its earnings report particularly because the stock is widely recognized as one of the strongest cloud stocks on the market. CrowdStrike’s steep selloff of (27%) over the past 30 days isn’t fully satisfied by the $10 million miss on forward revenue and ARR in the last earnings report. Forward Q4 revenue was expected to be $634M and the company guided $619M to $628M for a miss of about $10 million, if we take a midpoint of $624 million (about 1.5% miss). ARR was $2.34 billion compared to analyst expectations of $2.35 billion, for a $10 million miss (less than 1% miss).
Although this likely contributed, I believe the analyst we quoted in our Pre-ER write-up for premium members may be providing a missing link. An analyst from Barclays was modeling for net new ARR of $224M to $230M-plus for this key metric compared to actual results of $198 million.
At the midpoint, this would be more of a miss of 14.6%.
Here is what was said in the Pre-ER write-up for our premium members:
“An analyst note from Barclays’ Saket Kalia is modeling ARR net addition of $224 million “but thinks upside could be $230M-plus given strong pipeline commentary.” At $230M, it would represent 5% sequential growth and 35% YoY growth. This would be down from 15% sequential growth in the previous quarter and 45% YoY.”
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The reason we flagged this prior to earnings is because the net new ARR at a high point of $230M would still mark a strong deceleration to 5% sequential growth down from 15% sequential growth last quarter. This means the company would have to meet the number the Barclays analyst modeled or we would be nearing flat to negative sequential growth on net new ARR. Therefore, we emphasized the importance of this number prior to the earnings report as it was truly a “line in the sand” moment for CrowdStrike’s earnings performance.
With the actual of $198 million reported, this dropped the net new ARR to negative sequential decline of (9%) down from $218 million last quarter. This marks a change compared to the comp of +13% sequential growth from Q2 2022 to Q3 2022.
In August/September time frame, during the Q2 reports, we also emphasized that the market is nervous that cloud will become the other shoe to drop by stating: “I also want to be a messenger and say that another reason we are seeing strong price activity [with cloud stocks] is that analysts are concerned that enterprise spend will be the next shoe to drop. This concern was expressed across quite a few cloud companies’ [Q2] earnings calls. The thinking is that enterprise spend will follow consumer spend, (eventually), yet is slower because budgets are cut more slowly and added back more slowly.”
Because enterprise and cloud budgets are slower to be cut than ad or marketing budgets, there is outsized pressure being placed on sequential growth. The market does not care about YoY because it’s assuming enterprise spending wasn’t affected yet this time last year. We cautioned in a previous analysis two weeks ago “Slowing Growth in Cloud Stocks: When Will We Hit a Bottom” to be careful of YoY guidance as QoQ growth in cloud saw a remarkable slowdown.
CrowdStrike Q3 Financials:
CrowdStrike beat both top line and bottom line for Q3. In fact, an area where CrowdStrike continues to stand out from its peers is the health of the bottom line and both Q3 actual and Q4 guide was no exception in this regard.
For example, the free cash flow margin of 30% is exceptional for the cloud category. The company reported revenue of $581 million for growth of 53% compared to revenue of $574 million expected for growth of 51%. This is a slight deceleration from 58% last quarter.
For Q4, the company guided for revenue of $619 million to $628 million compared to expectations of $634 million. At the midpoint of $623.5million, this is a $10.5 million miss. This represents growth of 44.7%.
Adjusted EPS for Q3 came in at $0.40 compared to $0.32 expected. Adjusted EPS guide for Q4 also beat at $0.42 to $0.45 compared to $0.34 EPS expected.
GAAP operating margin of (9.70%) compares to (9%) last quarter and (10.5%) in the year ago quarter. This resulted in GAAP operating loss of ($56.4) million which is a tad higher than the $48 million losses last quarter and the $40 million losses in the year ago quarter.
The adjusted operating margin was a beat in Q3 and Q4. This was a bright spot in the report with adjusted OM of 15.4% compared to 13% estimated. This compares to 16% Adj OM last quarter and Adj OM of 13% last year. This was essentially flat and it’s important it did not contract. The guide on adjusted operating income of $87.2M to $93.7M implies an adjusted operating margin of 14.5%.
CrowdStrike is very strong on cash flow and is one of the top-ranking cloud stocks in this regard. This quarter the company reported a free cash flow margin of 30% for FCF of $174 million. The company is guiding for a FCF margin of 28% to 30% next quarter. The operating cash flow was $242.9 million for a margin of 41.8%.
There is $2.47 billion in cash on the balance sheet. The company paid $140 million in stock-based compensation for a margin of 23.7%.
The I/O Fund has launched a new$99/year Premium Newsletter called "Essentials" — this newsletter delivers premium samples for our readers who want more actionable analysis for their tech portfolios. This month, we released a stock pick that we believe will be a leader in 2023 plus a video with the buy plan.$99/year Premium Newsletter $99/year Premium Newsletter called "Essentials" — this newsletter delivers premium samples for our readers who want more actionable analysis for their tech portfolios. This month, we released a stock pick that we believe will be a leader in 2023 plus a video with the buy planbuy plan.
Key Metrics:
To recap, CrowdStrike reported a quarter with 52% growth and forward growth in Q1 of 44.7%. The company leads popular cloud stocks on free cash flow with a 30% margin and has a healthy adjusted operating margin of 15%. Although stock based compensation weighs on GAAP operating margin, it still ranks high compared to peers with a GAAP operating margin of (9.7%) —- so why did the stock selloff after hours and is down (27%) over the last 30 days?
The answer is found in the key metrics.
RPO was up 44% year-over-year for $2.797 billion and was up 11.6% sequentially. However, management reminded analysts that ARR is the leading key metric for their business.
Ending ARR grew 54% year-over-year to $2.34 billion and grew 9.3% sequentially. Therefore, because ending ARR was strong, the net new ARR could be easily underestimated in terms of impact. The net new ARR at $198 million in fiscal Q3 compared to $218 million net new ARR in fiscal Q2 indicates a 9% sequential decline.
The market has the jitters right now so the sequential decline is important to pay attention to especially because management said to expect further weakness in the upcoming Q4 quarter. Here is what the CFO said:
“Even though we entered Q3 with a record pipeline, we are expecting the elongated sales cycles due to macro concerns to continue, and we are not expecting to see the typical Q4 budget flush given the increased scrutiny on budgets. While we do not provide net new ARR guidance given the current macro uncertainty, we believe it is prudent to assume that Q4 net new ARR will be below Q3 by up to 10%.”While we do not provide net new ARR guidance given the current macro uncertainty, we believe it is prudent to assume that Q4 net new ARR will be below Q3 by up to 10%.”
This implies a net new ARR of $178.3 million for Q4 (10% lower than the current quarter at $198.1M) compared to net new ARR of $216 million in the year ago quarter. This is important because it’ll mark not only a sequential decline but a year-over-year decline in net new ARR. The market had already sold off for what I presume was a sequential decline in CrowdStrike’s leading key metric, and management then stated the decline would be steeper for Q4 on the call. Once the comment above was made, we were certainly not going to see a reversal in the stock price from the earnings call.
Customer count was strong at 44% growth. The mix of domestic versus international was slightly lower than usual for North America at 69% with EMEA being slightly higher at 15%. Deferred revenue grew 56.4% year-over-year and backlog grew 19%.
Additional Commentary:
CrowdStrike was transparent about the importance of ARR even in the face of net new ARR being lower than expected.
Here is what was said by the CFO:
“And then finally, just to comment on ARR. You pointed out that's how we run our business. ARR, though, is really an X-ray into the contracts themselves. And as we view that as the most important — or most transparent metric into the outlook for our business, that's the one where we're focused on. So, hopefully, that gives some more clarity on how we think about cRPO and ARR.
Later on, an analyst did zero-in on the (9%) decline.
“Andrew Nowinski
Great. Thank you for taking the question this afternoon. So total ARR of $2.3 billion, growing 54% is still absolutely amazing, I was – and it's at scale. But I was wondering, were you surprised that the net new logos that you added were down 9% this quarter?
Burt Podbere
Thanks, Andy. So when we think of the net new logos, it really corresponds to what we talked about in terms of what we saw in that SMB space. The SMB space is the one that drives the velocity of our net new logos. And as we talked about, we saw an 11% increase in our sales cycle in the SMB space. And that actually equated into $15 million in terms of deals in that space that could push out. And so when you think about 15 million in that space and what it means in terms of logos, where you can do the math, it's a pretty big number.
So that's how we think about net new logos corresponding to what we saw in net new ARR from the SMB space. So from that perspective, we weren't surprised at the end of the day when we saw that what happened with respect to the increased sales cycles and the amount of money that got pushed out in the SMB space.
“Push out” refers to a delayed sales cycle for an impact of $15 million. The CFO did reiterate the 10% further sequential decline in net new ARR between Q3 and Q4 when he said:
“When we do talk about net new ARR, I did talk about in the prepared remarks about how we think about up to 10% headwinds going into Q4 from Q3, and that's just to coincide with some of the headwind activity that we saw accelerated at the end of this quarter. So that's how we think about that.”
Conclusion:
The market is cooling off from previously popular cloud stocks. The reason is that QoQ likely hints at what is to come for enterprise budgets that are typically determined in January of the new year. There will certainly be some cloud stocks that are stronger than others, comparatively. Attempting to guess which ones these will be carries outsized risk if the QoQ trends we saw in Q4 continue into Q1.
The quarter from CrowdStrike sounded very familiar, in my opinion.
Here is a brief overview from our Microsoft’s post-earnings report:
“Microsoft is guiding down for next quarter with analyst expectations for the December quarter at $56.04 billion compared to management guidance on the call for revenue of $52.75 billion, at the midpoint. This represents 2% growth. […] That’s a 11% deceleration over the next few months. Some of this is coming from Azure as the company is expected Azure to decline 5% next quarter for its current growth rate. This will be 37% growth on a constant currency basis, down from 42% this quarter.”
While some investors believe this is a stock picker’s market – we disagree with this thinking. In May, we pivoted to hedging up to 100% of the I/O Fund portfolio as macro will eventually affect even the strongest companies. We are seeing that now with Tesla – a strong consumer company that is following its consumer peers into a material slowdown that is entirely macro based. Our macro coverage, such as Divergences Point Toward the Market Moving Higher, which called the October low, is published bi-monthly for our free readers and published daily for our premium readers along with real-time trade alerts. The hedging strategy has proven successful since we pivoted 8 months ago, primarily it has removed the pressure of the market’s intense selloff while allowing us to build key positions at valuations that are extremely low.
Ultimately, we started to move toward a neutral stance with cloud after Q2 reports after we saw initial signs of weakness and continued to trim/cut following some Q3 reports. We continue to hold one cloud name at a high allocation and we hold three more at medium sized allocations. We call this a neutral stance to where we are participating but not overweight. If we get additional signs that cloud is too weak to withstand macro pressure, we have a short candidate in mind. If we get signs that cloud will be resilient in 2023, we will buy into those with underlying strength.
Notably, the I/O Fund portfolio manager sees a relief rally of sorts coming in the early part of this year. That will be the time that we determine what to do with our remaining cloud positions — whether we sell into strength or buy into weakness.
Note: This analysis was originally published on November 30th 2022 and accompanies our previous free analysis: Slowing Growth on Cloud Stocks: When Will We Hit a Bottom.Note: This analysis was originally published on November 30th 2022 and accompanies our previous free analysis: Slowing Growth on Cloud Stocks: When Will We Hit a Bottom.Slowing Growth on Cloud Stocks: When Will We Hit a Bottom.
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
This article was originally published on Forbes on Dec 15, 2022, 10:27pm ESTForbes on Dec 15, 2022, 10:27pm EST
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 point decline 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.
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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%.
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.
The biggest names in tech are reporting their earnings right now, and our premium members are getting updates almost daily. Learn more about about our premium membership here.The biggest names in tech are reporting their earnings right now, and our premium members are getting updates almost daily. Learn more about about our premium membership here.Learn more about about our premium membership here.
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.
Conclusion:
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.
For our premium members, we dig deeper into mid-cap cloud companies to determine which ones are decelerating more quickly than their peers and also which leading cloud stocks we plan to buy when we sense there is a rebound. You can learn more here.
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
