Please reference our recent editorial “Microsoft –AI Will Help Drive $100 Billion in Revenue by 2027” for more information on Microsoft’s AI positioning. The below information discusses in more detail our buy plan and what to look for with this AI leader.

Financial and Valuation Impact

The Q3FY23 earnings was better than expected. Microsoft’s Q3 FY23 revenue grew 7% YoY and 10% in constant currency to $52.9 billion. EPS came at $2.45 and was up 10% YoY and 14% in constant currency. The company beat revenue estimates by 3.6% and EPS estimates by 9.6%. All three main businesses – Intelligent Cloud, Productivity and Personal Computing – performed better than expected with Azure standing out.

Microsoft Azure grew by 31% YoY in constant currency and came at the higher end of the management guidance of 30% to 31%.

The management guidance for Q4 FY23 is $54.85 billion to $55.85 billion, representing a YoY growth of 6.7% at the midpoint. It was better than the consensus analyst's YoY growth estimate of 5.9%. 

In the call, Satya Nadella also highlighted Azure gaining market share and the opportunities in AI.

“Azure took share as customers continue to choose our ubiquitous computing fabric from cloud to edge, especially as every application becomes AI-powered. We have the most powerful AI infrastructure and it’s being used by our partner, OpenAI, as well as NVIDIA and leading AI start-ups like Adept and Inflection to train large models.” 

Interestingly, looking at the recent reported growth rates amongst the Cloud Big 3, suggests AWS is losing share to Azure and Google.

Meanwhile, Microsoft’s reported group operating margins of 42.3% are superior to Alphabet’s 25% and Amazon’s 3.8%.

Amy Hood, the CFO of the company, also highlighted the strong growth in AI and outlook for Q423. She said in the earnings call, “In our largest quarter of the year, we expect customer demand for our differentiated solutions, including our AI platform and consistent execution across the Microsoft Cloud to drive another quarter of healthy revenue growth. Last year, we had our largest commercial bookings quarter ever with a material volume of large multiyear commitments.”

“On that comparable, we expect growth to be relatively flat. We expect consistent execution across our core annuity sales motions with strong renewals and continued commitment to our platform as we focus on meeting customers' changing contract needs, which include shorter term, quick time to value contracts in this dynamic environment. Our key focus remains on delivering customer value.”

Against these tough y/y comps at a group level, Microsoft’s Q4FY23 Azure revenue guidance is 26% to 27% in constant currency, which includes roughly 1% from AI services. This indicates that Azure has barely scratched the surface and has plenty of room to grow.

Comps are getting easier

In the Q3FY23 call, Amy Hood also added, “Mark, maybe the one thing I would add to those comments is, we've been through almost a year where that pivot that Satya talked about from we're starting tons of new workloads, and we'll call that the pandemic time, to this transition post, and we're coming to really the anniversary of that starting. And so to talk to your point, we're continuing to set optimization. But at some point, workloads just can't be optimized much further. And when you start to anniversary that, you do see that it gets a little bit easier in terms of the comps year-over-year. And so you even see that in a little bit of our guidance, some of that impact from a year-over-year basis.”

Looking at quarterly eps estimates (calendar year adjusted)

Typically, Microsoft provides qualitative guidance for the next fiscal year at the Q4 earnings call which is upcoming. The current FY24 consensus forecasts about 11% sales and 14% earnings growth, which don’t appear to be aggressive.  Microsoft’s AI story will unfold over multiple quarters. If we’re right, we expect a consistent pattern of better than expected earnings reports to emerge driven by continued growth in Azure and Intelligent Cloud coupled with a stabilization in Personal Computing. 

Valuation:

In the case of Microsoft, we have used a sum-of-the parts valuation model alongside traditional metrics to determine a price target. The SUTP helps to separate and value the three main businesses – Intelligent Cloud, Productivity and Personal Computing – as each have different growth profiles. 

Factoring in the AI/ML drivers we’ve described, we revisited our sum-of-the parts analysis. These drivers will have the biggest impact on the Productivity and Intelligent Cloud Businesses. The Productivity Unit consists of Microsoft Office Commercial and Consumer, LinkedIn, and Dynamics Business Solutions. Intelligent Cloud consists of Azure, other Cloud and Enterprise services.

We believe the implied market multiple assigned to the Intelligent Cloud and Productivity businesses still undervalues the potential revenue opportunities. As Microsoft continues to further integrate AI/ML into its offerings, this will further strengthen its core offerings and be the catalyst for new ones. This will provide new revenue opportunities from its installed Fortune 500 client base which we believe warrants a higher multiple. 

Under our base case scenario, these drivers increase the SUTP by $40 per share and under the bull case by $70 leading to a total SUTP of between $360 and $390 versus the current price of $330. 

Conservatively assuming that Microsoft’s group operating margins remain at current levels, a $100 billion increase in revenue could potentially add an additional in $40B in operating profit.

Based on this scenario, MSFT AI could earn $4.67 (vs MSFT consensus of $9.65 FY 2023). Placing a 30x multiple on gets you about $140 per share. So MSFT + MSFT AI = $485.

To be conservative for now, we can say MSFT AI may generate between $4.00 to $5.00 per share in earnings.

We can also take the avg of the 2 SUTP (390 + 485) for a SUTP value of about $440 over the next few years under the 100B AI scenario.

Buy Plan:

Considering where we are in the business cycle, it’s best to understand Microsoft within the context of the broader market. Our general market outlook is that the market will likely experience a bout of volatility into the summer. As long as the S&P 500 holds the 3900 – 3805 region, we can continue to see another swing higher into later 2023 before the recession starts to get priced into equities. Until the FED starts a fresh liquidity cycle, and we get eyes on the extent of damage the 2022 rate cycle caused in the economy, we expect choppy price action with a downward bias.

That being said, there are two general paths we are tracking in MSFT

Blue – As bullish as price action in Microsoft has been, we only have a 3-wave move off of the January low in Microsoft. This leaves the door open to the uptrend in 2023 being the corrective bounce in much larger corrective pattern that began in early 2022. The catalyst would likely be macro, as it relates to the manifestation of a credit cycle downturn that is not currently being priced into equities right now. We would need to see price break below $260.50 in the coming summer volatility. If this happens, then we will be targeting a retest of the January lows.

Red – On the other hand, this 3-wave move off the January low, can turn into a 5 wave move. This would require the summer volatility to hold within the green target box below, and then turn back up to make a fresh high. If this happens, then THE low is likely in for MSFT. 

Our buy plan is to accumulate based on both scenarios playing out. So, we will start adding to our position in the $300 – $265 region.

The I/O Fund Analyst Team contributed to this analysis

Recommended Readings:

• Microsoft Q3 FY23: Strong earnings report
• Microsoft Pre-ER: Will We See Evidence of a Bottom?
• Big Tech Capex, the Next Act – AI Take a Bow
• AMD’s Q1 Pre-Earnings Notes: The Soon-to-Materialize AI Market
• Cloud Earnings Review: Digging Deeper on Best-of-Breed

Amdocs is due to report their Q223 earnings on Wednesday, May 10 after the market close. Please check the forum for an updates to the earnings report.

We recently did a deep dive here and discussed how its 12-month backlog, large recurring revenue stream and multi-year engagements with large telecom clients made for a compelling investment case. We expect the quarter to be at least in line with market expectations and demonstrate a steady progression toward meeting its FY2023 targets. 

These are the key points we will be looking for.

1.     Has the macro environment impacted their business?

2.     Growth in backlog? Contract wins?

3.     Profitability improvements?

4.     Free cash flow generation targets?

5.     Price action since April 20th?

6.     Earnings expectations?

Importantly, we will look for signs that they may reach or exceed the upper end of their 2023 guidance, which hasn’t yet been priced into earnings expectations. Since our report, the stock has presented an attractive entry point if Q2 proves to be “business as usual”.

1.     Any impact from the macro?

Amdocs Q1 beat expectations and during the call management described the macro.

“As we mentioned, yes, we are not immune. I mean, we like ourselves that we are a very strong company, but we are not immune to everything that's going on around us. But I think that overall, we see a lot of demand for our services. The area of growth for Amdocs, today are highly strategic for our customers.

Everyone wants to be successful in — when they deploy 5G use cases, fixed wireless, network automation. Everyone wants to move to the cloud. So while there is some uncertainty, I can tell that we see that we continue the project with our customers. These are highly important for them and we see a very rich pipeline ahead of us.”

While addressing the uncertain macro vs solid company fundamentals, Amdocs revised their full year 2023 sales target range upward during the earnings call. A few snippets are worth pointing out.

“Strong reputation for successfully delivering mission-critical systems transformation.”

Amdocs is providing critical software to telecom companies as they upgrade their networks to 5G, migrate their legacy systems to the cloud and monetize their subscriber base. This is not opex that the telecom companies can afford to reduce, which is why there is a strong backlog.

“Highly recurring revenue streams”

Amdocs estimates that 75% of their revenue is recurring due to its managed services business. This  provides earnings and cash flow stability during difficult macro environments.

“Multi-year engagements”

The majority of Amdocs clients are large telecom companies in their respective regions. In the US, ATT, T-Mobile and Verizon make up about 50% of total revenue. These multi-year arrangements provide visibility into future revenue and managing the cost base.

“We see a lot of demand for our services. The area of growth for Amdocs, today are highly strategic for our customers.”

The competition for mobile subscribers is intense. Companies like Amdocs that can help increase a telecom operator’s competitive advantage are highly valued. The multi-year engagements are a reflection of that.     

2.    Growth in backlog? New contract wins?

Amdocs ended q123 with a record high 12 months backlog of $4.09 billion. This increased 6% from a year ago and went up $120m sequentially, reflecting continued sales momentum. According to management, the 12-month backlog has traditionally served as a good leading indicator of their business and has consistently averaged around 80% of forward-looking 12 months revenue over the years. We will look for continued growth in the backlog.

Amdocs has long standings relationships with large incumbent providers globally such as AT&T, T-Mobile, Verizon, Comcast, Dish, and Claro Brazil in the Americas; Vodafone and Three Group in Europe, Globe in the Philippines. In the most recent quarter, they announced new contract wins with regional providers in Europe and Latam. We will listen for new business engagements within its core client base and new clients.

3.    Profitability improvements?

Amdocs has shown steady and incremental improvement in its non-gaap operating margin and currently stands at 17.7%. Amdocs has guided between 17.5% to 18.1% for the year. We will look for comments as to whether they may reach or exceed the upper end of guidance.

4.    On track to meet 2023 free cash flow target?

In the Q1 call, management affirmed their free cash flow target.

“We are reiterating our full year free cash flow outlook of roughly $700 million, with free cash flow in the first half of fiscal 2023, tracking in line with our expectations, taking into consideration the normal seasonal timing of annual bonus payments in the second quarter.”

At current stock levels, this implies an attractive free flow yield of almost 7%.

5.    Price action since April 20th

In our April 4th Amdocs deep dive, Knox’s technical analysis indicated that he was targeting better entry levels after its strong performance post Q1 earnings. Since April 20, Amdocs has declined more than the market. With only a 0.6 beta to the market, there was no company specific news to explain the price action.

One possible explanation is that Amdocs’s decline began at the same time ATT began its 12% decline post its Q123 earnings release on April 20th.  ATT is one of Amdocs’s largest clients.  The market reacted negatively to ATT’s reported fcf of $1.1 bn vs $2.9b consensus. Prior to Q1, ATT had already indicated that Q123 FCF, much like Q122, would be about of 5% of their total 2023 $16b FCF target due to seasonality issues. So this should have not been a surprise to the market. Management stated:

“We remain confident in our full year outlook for free cash flow of $16 billion or better. This expectation is largely due to the timing of capital investments, device payments, incentive compensation, which all peaked in the first quarter.”

We do not believe that this should impact Amdocs. ATT recently renewed its managed services engagement until 2026. Given the mission critical services that Amdocs provides, it is not likely ATT will reduce them. 

Additional comments from the ATT’s conference call reinforced this.

“The second (priority) is the repositioning of our business to focus on exclusively communication services, particularly 5G and fiber. As the last few years have demonstrated, the solutions we provide are more critical than ever before, and we only expect the demand for purpose-built, best-in-class Internet access to grow. The resiliency of the services we provide, coupled with our improved financial flexibility, provide us with the right tool set to navigate the economic environment.”

“We recognize that in order to do that, we had to increase our investments in the business to enhance our customer value proposition and make more memorable and lasting connections with our customers.”

“In mobility, our largest business unit, we're growing subscribers and taking share. We also continue to see very healthy ARPU. This translates to growth in wireless service revenues and EBITDA, while improving margins”

We will listen to the call to see if anything has changed. If it’s business as usual, the price decline has presented a good entry point.

6.    Earnings expectations

Amdocs has a recent history of telling the market what they will do and then doing a little bit better when they report quarterly through a combination of better than expected revenue and incremental improvement in non-gaap operating margins.  We like this type of consistency and believe the market will pay higher multiples for businesses like this if Amdocs continues to deliver and the macro continues to weaken.

During the Q123 call, Amdocs reiterated FY 2023 sales, provided Q2 sales and revised up 2023 FY earnings guidance.

“We are reiterating our guidance for full year revenue growth of between 6% to 10% on a constant currency basis in fiscal 2023, with all three operating regions contributing positively over the full year.”

“Our annual outlook includes second fiscal quarter revenue within a range of $1.2 billion to $1.24 billion. On a reported basis, we expect full year revenue growth within an improved range of 5% to 9% year-over-year as compared with 4% to 8% year-over-year previously. The new outlook anticipates an unfavorable foreign currency impact of approximately 1% and year-over-year compared with an unfavorable impact of 2% year-over-year previously.

Moving down the income statement, we anticipate quarterly non-GAAP operating margins to fluctuate around the midpoint of our annual target range of 17.5% to 18.1%. Below the operating line, we anticipate that foreign currency fluctuations and cost of hedge will continue to impact our non-GAAP net interest and other expense lines, in the range of a few million dollars on a quarterly basis. We expect that our non-GAAP effective tax rate will remain within an unchanged annual target range of 13% to 17%, for the full fiscal year 2023.

Bringing everything together, we are raising our outlook for non-GAAP diluted earnings per share growth to a new range of 9% to 13% for the full year fiscal 2023”

For Q223

• Amdocs has guided sales of between $1.20 to 1.24b vs consensus of $1.22b (+6.45% y/y)
• Consensus expects a normalize eps of $1.47 lower y/y (-4.59%) vs a tough Q222 comp

We will be looking to see if Amdocs meets or exceeds consensus eps forecasts and if it can meet the upper of end of its sales guidance of 10%. Currently, the market is pricing 6%.

Recommended Reading:

AMD Q1 Earnings: Yes, I’m Still Feeling Zen
First Solar Q1 Earnings: IRATC Timing, Strong Backlog, Higher ASP Per Watt
AMD’s Q1 Pre-Earnings Notes: The Soon-to-Materialize AI Market
Amdocs (DOX) – Software Downstream from Big Telecom Capex

For our premium members, we are expanding on a free analysis and also an Essentials analysis. For ease of access, we are copying the free article and Essentials article here before we expand further.

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

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

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

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

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

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

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

Gartner 2023 Surveys

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

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

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

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

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

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

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

Source: Gartner: Public Cloud End-User Spending

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

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

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

Mixed Reports Following Q3 Results

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

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

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

Takeaway:

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

The Big 3 are the best proxy because their reports represent the layer in the tech stack that tends to be the most resilient in terms of churn. The switching costs are quite high for cloud IaaS services. The Big 3 also afford a more concentrated view by owning 66% of market share across three companies whereas SaaS is spread across thousands of companies (if not tens of thousands).

Two Scenarios for Cloud Software

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

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

Scenario #1: Cloud Will Prove Resilient

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

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

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

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

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

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

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

Scenario #2: Q4 is Foreshadowing a CY2023 Slowdown

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

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

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

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

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

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

Takeaway:

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

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

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

Best-of-Breed Cloud Hints More Slowing Growth to Come for 2023

To help illustrate the deceleration, we took a sample of best-of-breed stocks that are often seen in the Top 10 ranking on revenue growth, free cash flow, adjusted operating margin and/or valuations.

The best comparison is the sequential growth from Q3 to Q4 in 2022 compared to sequential growth in Q3 to Q4 (estimates) as this will take into account any seasonality from the Q4 period. Some companies maintain their Q4 is busier than usual due to the budget flush we previously discussed, while others maintain their Q4 is less busy because engineers and data scientists are out of the office, resulting in a softer consumption pattern.

There is also evidence from the CrowdStrike after hours reaction that sequential growth is most important to determine future growth as it’s in the Q2 time frame that discussions around softer budgets began. We covered Crowdstrike’s sequential slowdown in net new ARR here.

If we look at lagging information, we can see the deceleration this past year has not been too drastic. It’s primarily the Q4 guides that show a more drastic slowdown. In fact, you could say the resiliency of Q1 through Q3 this year may be creating a false sense of security.

Analysts are also maintaining high growth estimates despite weak Q4 guidance. We highlighted that up above, but here’s how the data compares on an individual level for the top 10 stocks. Looking at this data, it would appear as though cloud is quite resilient.

Yet, the Q4 guidance is out of character as we see a 2/3 decline in average sequential growth rate from 17% to 5%. This is the more severe drop off because Q4 2021 was much better than Q2 2022 in terms of the economy. However, my contention is that Q4 could be reflecting what is to come in 2023 rather a reflection of budgets from 2022 as the slowdown is more pronounced in Q4 than it has been in previous quarters from 2022.

It’s important to note that Q4 is typically strong as there is a “holiday flush” where companies use the remaining fiscal budget in this quarter. Microsoft’s weaker cloud forecast indicates this is not only a SMB problem as Microsoft’s core customers are the Fortune 500.

Conclusion:

This analysis is not meant to say that cloud software and big data/analytics companies won’t make great stocks – in fact, we have a list of stocks that we hope will provide enormous, future gains. Due to driving down costs and the ability to quickly scale, cloud is capable of being an industry-leading category again. I don’t doubt for one minute that the cloud companies that persevere will reward investors in the long-term.

With that said, I don’t believe all cloud companies will preserve. Cloud consolidation requires a separate analysis, but for brevity’s sake, my point is that cloud is overdue to be the next sector that sees consolidation as mobile has finished its consolidation cycle. This means heavy M&A activity or some stocks fading into a low growth plateau (similar to Box or Dropbox). I’ll write this up when we see more signs of this, but it’s likely on the way as part of the typical hype cycle curve and where cloud software is on the hype cycle.

I am also realistic that cloud tends to have weak bottom lines as we detailed in this analysis “Compartmentalizing Cloud Stocks.” So, the point is that if we see slowing growth, which I would define as sub-30% and certainly sub-20% fits the criteria, then given these bottom lines and subpar growth rates, the market is likely to find other places to wait out the soft economy.

Our plan is to either validate or invalidate this thesis. If it’s invalidated, we will move back into cloud stocks we like the best for 2023 (you’re seeing some of this right now with a large allocation in Datadog). If it’s validated, we will be in a wait-and-see mode to build positions again once we think cloud growth is bottoming and ready for a rebound.