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.
We posted the following on the forum. If you scroll down, I’ve added additional commentary. This is primarily driven by personal computing which is expected to decline from $17.5 billion in the December quarter last year to $14.7 billion in the upcoming quarter, at the midpoint. Productivity and Business is expected to be soft by 7 points decel YoY and Intelligent Cloud softer by 3 points deceleration YoY.
Why Microsoft Sold Off After Earnings:
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.
The primary reason for this decel was this comment from the CEO, which is the most comprehensive view we have of Microsoft’s expected deceleration in cloud:
“With that context, this quarter, the Microsoft Cloud again exceeded $25 billion in quarterly revenue, up 24% and 31% in constant currency. And based on current trends continuing, we expect our broader commercial business to grow at around 20% in constant currency this fiscal year, as we manage through the cyclical trends affecting our consumer business.”
That’s a 11% deceleration over the next few months. Some of this may be 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.
From the CFO:
“Revenue will continue to be driven by Azure, which, as a reminder, can have quarterly variability primarily from our per-user business and from in-period recognition depending on the mix of contracts. We expect Azure revenue growth to be sequentially lower by roughly 5 points on a constant currency basis.”
Notably, Azure missed management’s guidance by one point, coming in at 42% on a CC basis compared to guidance of 43% on a CC basis.
This was preceded by this comment, which helps provide color but didn’t stop the AH price from slipping:
“In commercial bookings, continued strong execution across core annuity sales motions and commitments to our platform should drive solid growth on a moderately growing expiry base against a strong prior year comparable, which included a significant volume of large long-term Azure contracts.
As a reminder, the growing mix of larger long-term Azure contracts which are more unpredictable in their timing, always drives increased quarterly volatility in our bookings growth rate.”
The comment is primarily about bookings which were at 37% growth on a CC basis for fiscal Q2 of last year compared to 14% on a CC basis in fiscal Q1 of last year.
However, Azure as a revenue driver did not have high comps (to clarify the comment). Our records have Azure at 46% on a CC basis for fiscal Q2 ending in December with fiscal Q1 last year at 48% on a CC basis and fiscal Q1 was at 49% on a CC basis. The neighboring quarters were both higher.
The other thing to note is the FX headwinds result in more to unpack in this particular earnings report. Some articles online are reporting substantially lower EPS and a declining net margin – however, this is a wrong takeaway from the report. At a quick glance, it could appear that Microsoft saw a net margin decrease of 14% but net margin actually saw an increase of 11%.
The lower net margin and EPS is due to a one-time tax benefit of $3.291 billion in the year ago quarter, which resulted in unusually high net income of $20.5 billion. In all previous quarters, Microsoft had $16 billion to $18 billion in net income, and thus, the $17.6 billion from this quarter is actually in-line. Excluding the one-time tax benefit, the net income in the year ago quarter would have been $17.2 billion.
Therefore, the correct EPS comparison is actually EPS of $2.35 this quarter compared to EPS of $2.27 in the year ago quarter after adjusting for the one-time tax benefit. On an adjusted constant currency basis, this is 11% growth YoY.
Regarding the segments, the rest were in line except Azure’s 1% miss. Despite the slight miss, Intelligent Cloud came in as expected at 20%. What the market is concerned about is Azure being the leading indicator for the slowing Commercial Cloud growth that was stated at the beginning of the call by the CEO (the 11-point decel).
Productivity and Business saw a slight beat with growth of 15% on a CC basis compared to guidance of 12% to 14%. Personal Computing was in line at flat growth for $13.3 billion.
Interesting enough, the CFO reiterated FY2023 guidance as “At the total company level, we continue to expect double-digit revenue and operating income growth on a constant currency basis. Revenue will be driven by around 20% constant currency growth in our commercial business, driven by strong demand for our Microsoft cloud offerings. That growth will be partially offset by the increased declines we now see in the PC market.”
Additional Commentary on Next Quarter’s Low Revenue Growth:
The 2% growth rate is being dragged down by personal computing. Here’s more on the breakdown of what to expect:
Personal Computing is expected to decline (19%) from $17.5 billion in the December quarter last year to $14.7 billion on CC basis in the upcoming quarter. This will be down from growth of 15% in the year ago quarter.
· The 19% deceleration is coming from PCs with Windows and Surface declining in the 30-percentile range.
· The segment is being held up (somewhat) by advertising with 6% growth.
· Gaming is expected to decline in the mid-teens
Productivity and Business is expected to be soft by 7 points decel YoY for growth of 11% to 13% and revenue of $16.75 billion on CC basis. This will be down from 19% in the year ago quarter.
· On-premise business is dragging down the results with a decline in the low to mid-30s
· Office 365 is expected to report seat growth and ARPU growth
· Office Consumer will decline single digits
· LinkedIn will grow low to mid-teens
· Dynamics will grow low double digits to low 20s, which is Microsoft’s business solutions and ERP such as for financials, operations and other business tasks. It’s also CRM similar to Salesforce designed for larger companies.
Intelligent Cloud will softer by 3 points deceleration YoY for growth of 22% to 24% and revenue of $21.25B to $21.55B on a CC basis. This is down from 26% growth on a CC basis.
· Azure is expected to decelerate by 5% to 37% growth on a sequential basis yet Intelligent Cloud is expected to be flat. Energy costs for Azure will be $250M per quarter. Notably, the company believes they will see more public cloud migrations from the rising costs of energy as the cost of on-prem is rising.
· Enterprise services will be in the low single digits
A note on Commercial RPO:
Commercial Remaining Performance Obligations have been oddly strong, and this was pointed out on the call. This quarter, Commercial RPO was up 31% YoY from $137 billion to $180 billion. 45% will be recognize the next twelve months and the remaining 55% will be recognized after 12 months.
This can certainly decelerate moving forward yet the management did call out that Azure tends to be volatile and so this is technically a sign of underlying strength despite the volatility. Commercial Bookings were (3%) due to FX yet was up 16% on a CC basis. This is up 2 points on a CC basis from last year.
Here is what was discussed in terms of Commercial RPO and how it translates to Azure growth:
Mark Moerdler:
Thank you. I'd like to follow-up on the last question on Azure specifically. So next quarter, you're guiding to sequential further slowing in the business. Is that the factor of optimization? Is it something else that's going on in here? How should we think about that specific component of the guidance, given the fact that you've got good bookings, strong RPO growth, et cetera?
Amy Hood:
Thanks, Mark. I'll – you're right. Let me go ahead and reiterate part of that, which is that this quarter, as you saw, we did have very good bookings growth. And within the RPO number that you're referring to, we had what we would call long-dated growth, which means we're having and seeing customers continue to sign commitments to the platform, and that goes really to what Satya mentioned is that the plans to invest here remain intact. And so, it's about both the optimization that you're talking about, and we are seeing and the guide includes that, and it also includes new workload starting. And those also may not be matched up one-to-one to see sort of a consistent pattern. And that does result in some volatility.
The other piece of it, Mark that we didn't talk on before because I was really focused on consumption is that there is per user headwinds as well, right, because we're getting and seeing some of these [loss] (ph) of large numbers in terms of the per seat business. So, there's a couple of things going on here Mark again, as you said, a very large base. So, it's not just the optimization to new workloads. It's also some per user work as well.
Translation:
It’s primarily loss of headcount affecting Azure and not renewals in contracts. It’s also not surprising that Microsoft is prioritizing optimization as the recent keynote at Ignite was about “Do More with Less.” We actually covered this early-on in this analysis here where we stated “increase in cloud spending and wanting to lower costs. This is differentiated from budget cuts, such as headcount. Most importantly, our slides showed that despite Gartner’s forecast for 2020-2021 shifting by $100 billion to what became actual spend (or essentially a pull forward). Pull forward might not be the right term, however, as cloud growth is not slowing down as a result, instead it’s predicted to be a tick higher from 2019 to 2022, if we remove the anomalous 2020-2021.
Therefore, we wanted to emphasize that the trend towards reducing costs should not be confused as being prohibitive to the trend for cloud adoption, rather, it can offer investors an edge if they identify what companies serve both needs.
As you can see from our portfolio, we are best-of-breed investors and I do not believe Microsoft is a best-of-breed company, rather they aggregate cloud services to help drive down costs. This is especially attractive for the Fortune 500 whereas startups, SMBs and mid-sized enterprises are likely to seek out and manage a larger portfolio of cloud services from various vendors. We can easily evidence this by Microsoft’s Fortune 500 penetration with 95% using Azure, which was achieved through hybrid computing where Microsoft was first-to-market on serving a mix of on-premise, private and public clouds for their large enterprise customers. Secondly, as this analysis is about, Microsoft is undercutting other services on price to win the aggregate, long-term contract.”
Microsoft Making Headway with AI:
Microsoft is a sleeping AI/ML giant. Google gets a lot of attention here yet I think they are equally prepared to serve this market. Maybe Microsoft even more so because of its penetration in the Fortune 500, which are the companies most likely to invest in AI/ML for the practical reason it requires a certain size budget. Here are some comments on the call:
“In Azure machine learning, provides industry-leading ML apps, helping organizations like 3M deploy, manage and govern models. All up, Azure ML revenue has increased more than 100% for four quarters in a row.”
To help Microsoft rival Google and DeepMind, the company has been investing in OpenAI, which is a large R&D operation that is breaking ground with AI algorithms that help computers to create images from text, reduce the amount of code that developers need to write, and to also help robotics think and act like humans, among other things. GPT-3 is the language generation model that has gotten quite a bit of attention for its ability to build websites and games using a language like English rather than a programming language. As of now, GPT-3 is known as the advanced text autocomplete program.
DALL-E is a “12-billion parameter” version of GPT-3 that creates images from text. The partnership with Microsoft will bring DALL-E to apps and services, including the Designer app and Image Creator tool in Bing and Microsoft Edge – this was announced earlier this month at Ignite. According to TechCrunch, 1.5 million users were using DALL-E 2 to create images with brands such as Nestle and Heinz piloting DALL-E for ad campaigns.
Here is what was said on the call:
Mark Murphy
Yes. Thank you, very much. Satya, this quarter, we're seeing an inflection in many of your AI breakthroughs, thinking of GitHub Copilot and the image generation in your designer product. What is it that's enabling you to innovate so rapidly and essentially to be first to market? I'm wondering if it’s the OpenAI relationship or maybe some of your inferencing capabilities or something else?
Satya Nadella:
“Thanks for the question. First, yes, the OpenAI partnership is a very critical partnership for us. Perhaps, it's sort of important to call out that we built the supercomputing capability inside of Azure, which is highly differentiated, the way computing the network, in particular, come together in order to support these large-scale training of these platform models or foundation models has been very critical.
That's what's driven, in fact, the progress OpenAI has been making. And of course, we then productized it as part of Azure OpenAI services. And that's what you're seeing both being used by our own first-party applications, whether it's the GitHub Copilot or Design even inside match […] The AI comment clearly has arrived. And it's going to be part of every product, whether it's, in fact, you mentioned Power Platform, because that's another area we are innovating in terms of corporate all of these AI models. So, yes, so I think AI is a place where I think we have differentiated capability at an infrastructure layer for training and inference and the model that sells or platforms for third parties and our first-party applications are getting better because of the use of those AI models.”
Side note: I know it’s hard to be excited about innovation right now but I do believe Big Tech’s AI fortresses will be built during a recession when other companies are comparatively weaker.
SentinelOne had an excellent earnings report. There are a few things to unpack, yet the 10,000-foot view is that the company has continually proven its capable of growth during a time of uncertainty for other cloud peers.
Key metrics accelerated including customers with ARR over $100,000 and dollar-based retention rate. The most notable positive surprise was the company’s dollar-based net retention rate of 137%. This is a record for the company and marks an acceleration from 131% last quarter and from 125% in the year ago quarter.
You can reference our product overview on SentinelOne from a year ago here on Forbes and updated in January here on the premium site.
Financials:
SentinelOne reported revenue growth of 124% for $102.5 million compared to a consensus of 109% growth based on revenue of $95.7 million. The company raised Q3 guidance to 98% growth for $111 million compared to a consensus of 93% growth based on $108 million consensus. The full year guide was also raised to $416 million, up from $406.4 million previously. This represents growth of 103% for FY2023 ending in January, up from guidance of 98% growth for the full year.
The Attivo acquisition adds ARR of $35 million to the numbers stated above and SentinelOne is not breaking out the numbers any further now or in the future. Management stated the growth outlined above does not come from Attivo, rather came from growth in the organic business. They do feel identity will grow in the future but did not in the immediate quarter.
Remaining performance obligations for SentinelOne, which includes deferred revenue and other non-cancelable contract revenue was $444.7 million with 84% recognized as revenue over the next 24 months.
The margins are where the rubber meets the road with SentinelOne. The GAAP gross margin of 65% is improving from the GAAP gross margin of 59% in the year ago quarter. The adjusted gross margin of 72% also shows significant improvement from the 62% adjusted gross margin a year ago.
We’ve previously covered in detail how the company operating expenses in sales and marketing, R&D and also stock-based compensation contribute to a weak operating margin. This has resulted in an GAAP operating margin of (106%) and adjusted operating margin of (57%). This is an improvement from a GAAP operating margin of (147%) and an adjusted operating margin of (98%) in the year ago quarter. This is also an improvement from the previous quarter at (115%) GAAP operating margin.
This was a beat for Q2 as operating margin was previously guided to be (75%) to (73%). We noted this would make meeting the FY2023 guide a bit tough so it’s good to see this in line with the FY2023 guide on operating margin.
Notably, the company has doubled its spend in sales and marketing, research and development and G&A from the year ago quarter. Stock based compensation was 40% of revenue in Q1 at $31.6 million and is still roughly 40% of revenue in Q2 at $41 million in the current quarter.
However, the management team has delivered on its promise to greatly improve its margins. At the onset of the year, it was stated the company would reach Non-GAAP operating margin in FY2023 of (60%) to (55%). The company is now stating: “we're improving our full year range to negative 58% to 55%, a one-point improvement at the midpoint from our prior range.”
Management is guiding for the same margins next quarter in Q3 which is 71% adjusted GM and (57%) OM.
The company has stated its goal is to become cash flow positive by 2025. The company’s free cash flow was ($66) million. If we assume the company spends $250 million in cash per year with $1.2 billion in cash, cash equivalents and short-term investments, there shouldn’t be a capital raise unless there are more unforeseen acquisitions. The Attivo acquisition cost $351.5 million in cash and 6.032 million shares of Class A stock for an aggregate value of $185.9 million and 379K assumed options to purchase shares of Class A stock.
The company’s adjusted net loss per share is ($0.20) compared to ($0.38) for the same period last year. It beat the analysts’ consensus estimates by $0.05.
The company’s valuation is 17 forward P/S. Bottom line valuations don’t work well in cloud due to how few companies are profitable. With that said, SentinelOne’s valuation is in line with Crowdstrike and is between cybersecurity companies such as Cloudflare and Zscaler.
Key Metrics:
The company provided ARR of $438 million for growth of 122%. It was unclear if Attivo’s $35 million was included in the ARR provided. If it was, then organic ARR for the quarter was $403 million for growth of 103%. I’m assuming it’s the 103% as total customer count combined both organic and acquired. This marks a deceleration from 110% in the previous quarter.
Regardless of the ARR growth, the customer segment with ARR above $100K grew 117% to 755 total customers, up from 348 in Q2 of last year, and this is unlikely to have been affected by Attivo. Total customer count was 8,600 with 750 organic adds and 350 acquired from Attivo, up from 5,400 in Q2 of last year. According to the SEC Filing, no customer accounts for more than 4% of revenue and 33% of revenue is from outside the United States.
“Our financials now incorporate the acquisition of Attivo, which performed in line with our expectations and is on track for our full year ARR target of $45 million or more. We do not intend to break out Attivo financials going forward as it becomes part of our broader platform offering as our identity suite.”
Note: Attivo’s current ARR is $35 million with a target of $45 million for the full year.
Dollar-based net retention rate was 137%, up from 131% in the previous quarter and up from 125% in the year ago quarter. This is record DBNRR for the company. The company noted it fits the Rule of 60 and has plans to continue fitting the Rule of 40. SentinelOne’s Magic Number is above 1.3.
According to management, the fastest growing module is Singularity Cloud, followed by data retention and Ranger. The company mentions that even in cases where companies are using a competing security company on endpoint, they will use SentinelOne for cloud run time protection.
When asked if SentinelOne has had success in replacing the endpoint provider by leveraging it’s best-of-breed cloud protection, the company responded it provides a back door yet the bigger opportunity is in protecting the cloud architectures. “But to be honest, I mean, when we look at how these cloud opportunities, especially with the cloud-native companies, they're probably 4x, 5x, sometimes 10x the size of the endpoint footprint and the endpoint opportunity.”
We covered from the Q4 earnings call that management expects cloud to be equal or greater than the endpoint opportunity. We also covered that “Cloud is a Growth Lever” in our full length premium report.
The company has recently expanded its platform to include data ingestion on the backend that is now seamless with the user interface on the front end. When we discussed the differences between SentinelOne and competitors, we pointed toward the company’s data-forward approach. The company reiterated this in the recent earnings call, stating the platform runs petabytes of data everyday while “competitors can handle only a fraction” of this scale. The company also points towards data retention, which helps to reduce storage costs while maintaining critical information.
Data retention is important because it drives down costs. Per management: “So our ability to process more data for customers, our ability to retain it for longer and really be a cost saver for customers. Obviously, in this macro environment, that's fixed volumes.”
From the Q4 call, we discussed that by going with a different EDR vendor, customers have to then figure out how they are going to retain data on the backend of a different platform, which can be costly.
In addition to the data retention, the new platform product is the DataSet, or the ingestion of data from the backend that is now seamless with the front end.
Here is what the company stated about this new platform development:
“We completed the migration of our back-end DataSet, which was a meaningful undertaking that we completed in just over a year [..] It positions us extremely well in the future of XDR, a unified, scalable and efficient data back end, gives us a significant competitive advantage. And evident by our Q2 gross margin, it's already supporting our path towards our long-term gross margin targets.”
We’ve covered the Ranger product in the past, which is the product that helps to identify unsecured endpoints through a fingerprinting engine that runs an inventory of IP-enabled devices. Ranger and Ranger Pro detects and notifies IT teams of unsecured endpoints.
Overview of Earnings Call:
We’ve referenced how management teams in cloud are hesitant to pull forward the Q2 beats to an equal or greater full year fiscal guide. Rather than these management teams becoming bold macro economists who feel they can predict with certainty Q3 and Q4, they are instead playing it safe.
SentinelOne beat Q2 by $6.8 million and guided for a Q3 beat of $3 million. The company carried this entirely through to the full year guide but did not go any further to raise Q4 at this time. This is marginally better its cloud peers who did not pull the Q2 beat forward, in some cases.
Additionally, this is what management said about the current macro environment:
Demand is strong, and we remain extremely well positioned. At the same time, enterprises across all sectors of the economy are being impacted in different ways by evolving macro conditions. Like other software companies, we've seen some signs of cost consciousness and prudence around IT budgets. This has resulted in marginally longer sales cycle and more budgetary approvals.”
The company was asked again in the call about macro and any impact it may have had on visibility around demand, and the CEO stated: “We still feel pretty good about demand. I think what you see reflected in our guidance is the level that we feel we need to be conservative and prudent. And all in all, again, things remain incredibly strong.”
The analysts on the call believe that part of SentinelOne’s success in the face of global budgetary slowdowns partly rests on the company’s channel partner strategy, which includes resellers and distributors, managed service providers (MSPs) and managed security service providers (MSSPs).
Whether customers are direct or through the channel partner network, customers adopt the Complete product first and then upgrade across any combination of 15 modules. The modules upgrade is helping to drive a higher DBNRR as customers stay to spend more on the platform with the CEO stating 30% of revenue comes from the modules. They feel this is where the expansion opportunity remains.
When asked about the high net retention rate, management responded with the following:
“I think one of the very most exciting things about our business is the incredible demand that we're seeing from MSPs, MSSPs and – investments partners, many of which have become MDRs or managed detect and response providers themselves. And I think there's a couple of fascinating elements to this part of the business. One, it really lets us, in a very efficient way, cover a tremendous part of the market. Two, it absolutely fits amazingly well in today's macro environment where folks are looking to efficiently protect their networks, efficiently protect their data and their users and expand their security prowess without having to make a lot of capital investments. And managed services do exactly that. Third is incredible velocity in terms of deal cycles.”
Later, the CFO emphasized the channel partners by saying:
“As we've gone through an evolution of MDR and other more sophisticated security service providers, we're starting to see small, medium and large enterprises go with a managed service. And so, we've seen from an overall global trend perspective, I think the scrutiny around spend has lent itself to an upsell in that type of business.”
Another reason SentinelOne has performed well in the current macro backdrop is because it’s best-of-breed across many attack surfaces, including cloud and now identity with Attivo. The company also allows now data to be ingested for a stronger, singular platform and drives down costs with data retention.
Conclusion:
I agree that SentinelOne is best-of-breed and is combining modules to accelerate DBNRR – this is one of the best indicators we have in tech as to a product’s strength. It also helps to illustrate that growth is not at any cost as this typically includes a high churn rate and lower retention if S&M is bringing in lower quality leads. Since its IPO, SentinelOne has illustrated its competitive prowess, whether it’s through product development and R&D or an impressive acceleration in key metrics. For example, ARR accelerated in January of 2021 and continued to accelerate for many quarters. We are seeing this again with DBNRR.
SentinelOne’s stock price hinges on the company keeping its word to improve its margins. There are ample catalysts to sustain the company’s growth, primarily Singularity Cloud and data retention. Both emphasize SentinelOne’s strength in automation which now includes data ingestion on the backend.
Investors will want to see a clearer path toward profitability next year as SentinelOne will need to assuage any concerns it’s a “growth at any cost” company. Additionally, acquisitions will need to remain limited until the company is free cash flow positive as the company has enough cash until 2025 barring any new acquisitions. Analyst consensus has SentinelOne with positive EPS in January 2025 in a predictable path; if SentinelOne can deliver on this then I believe it will be one of the better performing cybersecurity stocks on the market.
There are a few reasons MongoDB saw a severe reaction its earnings report. The first is that the cash flow is much lower than it’s been in recent quarters. We wrote in May that this is the top thing to watch across cloud stocks and we positioned our portfolio for those that were FCF positive.
Here is what I have for MongoDB’s FCF:
($22M): Q2FY22
($9M): Q3FY22
$16.9M: Q4FY22
8.4M: Q1FY23
($48.6M): Q2FY23*
In Q1, MongoDB was expected to report ($0.06) adjusted EPS and the company reported $0.20 EPS instead. This was a $0.30 beat. In Q2, MongoDB reported a beat of ($0.23) adjusted EPS versus ($0.28) adjusted EPS expected. However, Q3 and the full year guide missed on adjusted EPS consensus with Q3 at ($0.13) expected versus ($0.16) to ($0.19) EPS guided. For FY2023, consensus was at ($0.21) versus ($0.28) to ($0.35) EPS guided. I break down the reasons for the miss in the Financials section below.
Q1 was a “perfect 10” quarter. The company stood out as insulated to discretionary spending compared to its peer Snowflake who analysts questioned at length due to its rumored exposure to Coinbase and other heavyweight consumer-facing companies. Perhaps most importantly, in Q1, MongoDB posted adjusted profitability for the first time.
Another reason for the AH selloff is that in Q2, MongoDB and Snowflake switched seats. Analysts are now more concerned MongoDB has outsized exposure to macro conditions rather than Snowflake, as Q2 was a perfect quarter for Snowflake.
Current revenue growth would suggest there is robustness to MongoDB, yet this management team is mirroring more of Datadog’s approach, which is they are not raising full year guidance to match the Q2 revenue beat. If a company does this, it implies the other two quarters will be weaker than expected. MongoDB gave a solid raise to Q3, so that implies that Q4 will be weak despite being seasonally strong.
I also want to be a messenger and say that another reason we are seeing strong price activity 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’ 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.
Any sign of weakness is being interpreted as this more serious concern. Whether it’s overblown or whether it’s being prudent is something every investor must decide for themselves as it requires a time machine to truly know when the macro environment will clear, and most importantly, the depth of the effects it will have on cloud.
Some cloud companies can show immediate effects and MongoDB, Snowflake, Confluent, etc, would be that group due to being the consumption model as usage can be increased/decreased fairly quickly whereas SaaS models would require subscription cycle to show these effects. This is not a company or developers electing to reduce usage on MongoDB, rather it’s a trickle down effect from lower usage within applications.
Here’s a quote as this was discussed many times:
“As we discussed last quarter, it's important to understand that the slower than historical consumption growth is a result of slower usage growth of our customers' underlying applications due to macro conditions.
Our customers spend on our platform is well aligned with the performance of their business. In the current environment, some businesses and consequently, their applications are growing more slowly.”
It’s important to note that slower usage from the underlying applications is distinguished from discretionary spending. However, for our purposes as investors, the result is similar, which is that even if MongoDB is a core product, it’s impacted by macro.
The company also stated that it’s a lower rate of workload expansion contributing to their cautious Q4 guide rather than a lower rate of new customers: “As you think about the business more holistically, new customers and new workloads are what really determine the long-term outcome and the long-term success […] As it relates to expansion of existing workloads, which is sort of the other piece of the equation, that's more relevant in the short term not as relevant in the long term. And so, that's where we've seen the slower growth that we've described. And so, we're continuing to take a long-term orientation”that's where we've seen the slower growth that we've described. And so, we're continuing to take a long-term orientation”
Financials:
MongoDB reported revenue of $304 million, which beat consensus of $282 million by 7.6%. In terms of percentage, this was a larger beat than Q1 at 6.9%. The company is guiding for Q3 revenue of $301.5 million at the midpoint compared to $294.5 million consensus. The two quarters combined translate to $29 million in additional revenue. However, the company is only raising full year guidance by $16 to $18 million as the previous guidance was $1.8 billion for FY2023 and is now $1.196 to $1.206 billion. This would imply Q4 being lower than anticipated by $10 million at $320 million instead of consensus of $330 million.
It seems like this market is splitting hairs but it’s what the overall Q4 miss represents, which is, will cloud see extended lumpiness from the recession.
The adjusted operating margin fell from 6% in Q1 to (4%) in Q2 during a time when the market is especially bottom line sensitive. This is the lowest adjusted operating margin over the past five quarters.
The company stated the increased opex is due to an increase in sales and marketing and R&D. Translation: tech companies spend for growth, it’s part of their DNA. Tech companies spend on growth if they think it will help them expand market share at critical point of adoption. The current market doesn’t like this but previous market conditions have not cared. (Tech companies have not changed and how they operate, the market has). This puts extreme pressure on a company — do you stop spending and risk growth and losing market share OR do you ignore the market and continue spending. It’s not good for MongoDB’s stock right now but spending to increase market share is almost always the right answer.
The GAAP operating loss also increased in the recent quarter. It came at ($114.8M) compared to an operating loss of ($72.5M) in the same quarter last year and ($75.9M) in the Q1 FY23. The operating margin was -38% in the recent quarter compared to -36% in Q2 FY22 and -27% in Q1 FY23.
Net income also saw a deceleration and the current market conditions do not take kindly to this. MongoDB adjusted net loss was ($15.6M) down from adjusted net loss of ($7.7M) in the year ago quarter. MongoDB had demonstrated a path to profitability recently and this has now been reversed.
The cash from this quarter (noted in the intro) was impacted by the conference MongoDB World, yet we aren’t getting much from management in terms of a turnaround on the bottom line as the year continues. For our purposes, MongoDB is no longer a positive FCF company and this is a marked change in the fundamental story. We felt very strongly that our cloud positions must be free cash flow positive this year.
The guide is adjusted operating loss in Q3 to be ($10M) to ($8M). The FY2023 guide is for adjusted operating loss to be ($13M) to ($8M). At the midpoint this is ($10.5M) which implies a weaker bottom line the rest of the year at ($9M) for Q3 and ($4M) for Q4.
The company’s stock-based compensation is high. In the recent quarter, it was $96.56 million (32% of revenue) and in the Q1 FY23, it was $83.57M (29% of revenue), which is one of the key metrics investors are tracking in the recent quarters.
Key Metrics including Atlas
Atlas decelerated from 82% growth last quarter to 73% growth this quarter. This was the larger decel we’ve seen in the previous four quarters, which have been range bound between 82% to 85% growth. Atlas customer growth was at 29% compared to 33% last quarter. However, the contrast is clearer when compared to the year ago quarter at 44% Atlas customer growth.
Management expects this trend for lower Atlas growth (compared to the previous four quarters) to continue.
“First, we expect the Atlas consumption trends we experienced in Q2 to continue for the remainder of the year. Second, in the second half of last year, as we called out at the time, we had exceptionally strong Atlas consumption growth leading to difficult Atlas year-over-year compares to the back half of the year. And third, we expect a sequential decline in Enterprise Advance in Q3 as the renewal base is sequentially lower. Looking into Q4, we expect a seasonal uptick in revenue from EA. But recall, we faced a very difficult year-over-year comparison given strong EA new business activity we saw last year.”
Customers over $100,000 were up 27%, this is down from 30% growth last quarter. Overall customers grew 27.5%, down from 31% growth last quarter. The net ARR expansion rate was “over 120%” which is the same information provided in previous quarters.
Comments on the Call:
The call centered around a few things. The first is how macro headwinds affect MongoDB’s business where management described puts and takes. There are actually tailwinds, according to management, as the migration away from legacy databases is now more prioritized:
“On your first question, I just want to remind everyone, we're not seeing any change in deal sizes or sales cycle times. I think your point about as customers face this macro headwind, is there an opportunity for them to essentially drive more efficiency in their business? And we're definitely seeing customers starting to do that. We're definitely seeing customers look at their legacy platforms and recognize how expensive and brittle those platforms are and are more motivated to move on to more modern platforms like MongoDB.We're definitely seeing customers look at their legacy platforms and recognize how expensive and brittle those platforms are and are more motivated to move on to more modern platforms like MongoDB.
Frankly, to help customers in that journey, that was a motivation for us to release the Relational Migrator product because this is not a new trend to help customers just reduce the cost of moving off relational to MongoDB. And I think you're going to see more and more customers take a hard look at their legacy infrastructure and think about modernizing potentially sooner than later.”that was a motivation for us to release the Relational Migrator product because this is not a new trend to help customers just reduce the cost of moving off relational to MongoDB. And I think you're going to see more and more customers take a hard look at their legacy infrastructure and think about modernizing potentially sooner than later.”
There was quite a bit of conversation around “digital native” companies. There are many large enterprises that are digitally native (Amazon, for example) and so I took the mid-market digital natives to mean startups, especially e-commerce, which are seeing slower usage and strapped for funding right now. It can also mean any other consumer-facing applications that are stagnant/not growing but e-commerce comes to mind.
“Moving on to the mid-market channel. For context, the customers in this channel tend to be traditional medium-sized businesses. This channel included — tend not to be traditional medium-sized businesses. This channel includes a disproportionate share of digital native, fast-growth companies that have built their businesses on MongoDB […] Our expectation that the mid-market slowdown we saw in Europe in Q1 would become global in Q2. This is what we experienced, but the slowdown was more significant than we had expected, specifically the digit layer subset of the mid-market experienced slower growth in their applications as a result of macroeconomic conditions, and therefore, their underlying consumption growth of MongoDB slowed as well.”
Of course, the softer operating income was drilled into and this is what was stated:
“Jason Ader: Guys, in thinking about the lower op income guide, are you basically saying that the mix of new customers versus existing customers is different than what you expected a quarter or two ago and basically new customers are more expensive to transact with? Is that the right way to think about the lower op income for the year guidance?
Michael Gordon: No, that's not how I think about it. I think about it as being — we are continuing to see good customer wins and strong receptivity in the market that underscores or translates into strong customer unit economics. And so, we are continuing to invest in building out sales. And as you think about what the implication is in terms of rolling through some of the slower cohort expansion of existing Atlas customers that we're seeing. And when you run the math through, that winds up having a slight impact to our full year op income guide.
So I wouldn't take it as any kind of judgment or try to do any math unless some sort of incremental value of workloads or slicing and dicing it that way, just simply us, saying, us looking at the market, having a long-term orientation, continuing to see strong new wins, no increases in customer churn, continuing to have the value proposition resonate and being sort of at the top of the customer priority list.”
Translation: Management was consistent in saying the operating expenses are increasing to help attract more new customers, an area of strength for them (note: although recent quarter did show a deceleration in new customers). Where MongoDB has been impacted is in “cohort expansion” or workload expansion.
Conclusion:
The economy is tough right now and it’s being echoed across many management teams. As much as we want to believe there are companies that are immune (Snowflake this quarter, MongoDB last quarter), it seems macro headwinds are catching up to nearly every industry. What the market is most concerned about is whether enterprise budgets will follow in the footsteps of consumer spending, with enterprise budgets typically being slower to cut and slower to add back in.
There’s nothing inherently wrong with MongoDB’s report except the company can’t grow as rapidly as it can during perfect market conditions. In addition, the company wants to spend to grow new customer accounts while the expansion opportunity presents itself. There’s nothing inherently wrong with that, it’s simply the market conditions aren’t favoring free cash flow negative companies right now which puts immense pressure on management teams to decide between growth or profits.
MongoDB has leverage and they have cash of $1.8 billion. There shouldn’t be any reason in the foreseeable future the company has to dilute shareholders to raise cash. That’s the most logical reason to care about negative cash flow but the market is sensitive and emotions are running high. Valuation, of course, is also key as the top cloud companies in terms of valuation are all free cash flow positive which means MongoDB cannot be in the top 5 on valuation until it returns to FCF positive.
Coupled with the decreasing margins, MongoDB is not being able to provide anything on the horizon to look forward to as a few cloud companies have asserted to do so would be to become an economist. Right now, Q3 and Q4 are expected to mirror Q2.
If you join the webinar today, Knox is going to speak about a long overdue bounce that we still hope is coming and will provide us the opportunity re-arrange positions. I don’t see us holding MDB at this high of allocation and I also don’t see us closing it – it’ll be something in-between.
This article was originally published on Forbes on Aug 8, 2022,11:06am EDT
Most investors agree that cloud is a critical trend to have in a portfolio as the category’s growth has been resilient due to increasing productivity while reducing costs. This is especially true for software-as-a-service whereas cloud infrastructure as-a-service does not always result in lower costs compared to on-premise servers.
The overall cost savings and/or overhead can often rely on the size of company, where it makes sense for startups to rent servers as they don’t have the budget to own servers and manage an IT department. However, despite the many advantages that cloud offers, it requires scaling through outside vendors, which can result in a hit to margins. A report came out that repatriation, or moving some workloads back to on-premise, has resulted in quite a bit of cost savings for companies like Dropbox and Zscaler, who use hybrid approaches. One example in the report is Dropbox, a company that reported savings of $75 million in two years after repatriation, which in turn, helped the company’s gross margins increase from 33% to 67%.
If you add up the cloud infrastructure, platforms and software costs across a company, it can often become costly to manage and deploy a full cloud stack.
To put it simply, Sayta Nadella said in the fiscal Q3 call in April: “More value for less price means you win.”
The company’s recent results prove that the company is able to better withstand the challenges of the macro uncertainty better than other cloud peers.
For example, Azure & other cloud services revenue grew by 40% and 46% in constant currency. As stated, Azure’s growth was a major highlight considering Google Cloud’s revenue in the recent quarter increased 36% YoY to $6.3 billion. Notably, GCP is on a lower revenue base which makes Microsoft’s outsized growth even more impressive. The market leader Amazon Web Services revenue grew by 33% YoY to $19.7 billion in Q2.
Here’s how the major cloud IaaS competitors compare:
Cloud Services Market Share – I/O FUND
Furthermore, Microsoft’s Fortune 500 penetration is staggering with 95% using Azure. This was achieved through hybrid computing where Microsoft was first-to-market on serving a mix of on-premise, private and public clouds for their large enterprise customers. We covered Microsoft’s competitive edge on hybrid dating back to 2018 when Azure was frequently doubted by the market as it was overshadowed at the time by AWS.
Today, Microsoft is leveraging its lead in hybrid by undercutting other services on price in order to win the aggregate, long-term contract. By owning the entire cloud stack, Microsoft can offer the ultimate differentiator during macro headwinds, which is “more value for less price” whereas competitors do not own enough of the stack to undercut on price quite like Microsoft.
We originally covered this for our research customers in both our Q2 webinar and a research note last April.
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Microsoft’s Financials:
Microsoft’s revenue grew by 12% YoY to $51.9 billion for the Q4 FY2022 ending in June, and for the FY2022 ending in June, it grew by 18% YoY to $198.3 billion.
The company’s strong guidance for the full year was a testimony to the management's confidence as many of its tech peers failed to give guidance. Amy Hood, CFO of the company said in the earnings call, “We continue to expect double-digit revenue and operating income growth in both constant currency and U.S. dollars. Revenue growth will be driven by continued momentum in our commercial business and a focus on share gains across our portfolio.”
Notably, Microsoft’s stock has outperformed the market with returns of 290% in the last five fiscal years from 08/01/2017 to 07/31/2022. The stock has the second highest returns among the FAAMG stocks, behind Apple which is up 330% during this period.
Microsoft’s stock has outperformed the market with returns of 290% in the last five fiscal years from 08/01/2017 to 07/31/2022. – YCHARTS
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Microsoft’s Revenue Segments:
The company reports its revenues in three segments.
Productivity and Business Processes Segment:
The Productivity and Business Processes segment revenue grew by 13% YoY to $16.6 billion, which includes Office Commercial, Office Consumer, Dynamics, and LinkedIn. LinkedIN came in at 24% growth yet this was lower than the management’s expectation due to a slowdown in advertising revenue. According to management, Teams continues to “take share across every category” and is “seeing higher usage intensity.”
The operating income of this segment increased by 12% YoY to $7.2 billion. The segment accounts for 32% of the total revenue and 35% of the group’s total operating income. The management expects the Productivity and Business Processes segment revenue to be $16.1 billion at the mid-point of the guidance in the next quarter for a slight decline sequentially.
Intelligent Cloud Segment:
The Intelligent Cloud segment revenue grew by 20% YoY to $20.9 billion. The management’s guidance was $21.05 billion, the negative impact from the strong dollar led to the slight miss in this segment. The server products and cloud services revenue grew by 22%, helped by Azure & other cloud services growth of 40%. On a constant currency basis, Azure grew by 46% and the management is guiding for a growth of 43% (constant currency) in the next quarter.
The company also saw strong commitments from its customers as it witnessed a record number of over $100 million Azure and $1 billion deals this quarter. This has a flywheel effect for Microsoft’s data solutions and platforms, as well. Satya Nadella said in the earnings call, “More than 65% of the Fortune 1000 use 3 or more of our data solutions, and we are growing faster than the market.” Cosmos DB data volumes and transactions grew over 100% YoY for the fourth consecutive quarter.
This segment’s operating income increased by 11% YoY to $8.7 billion. The segment accounts for 40% of the Microsoft’s total revenue and 42% of the total operating income.
Intelligent Cloud revenue is expected to be $20.45 billion in the next quarter, or essentially flat sequentially.
More Personal Computing Segment:
The More Personal Computing revenue grew by 2% YoY to $14.4 billion. It was below the management’s guidance of $14.69 billion. The slowdown in this segment was expected since there is weakness in the PC business. Tracking the recent IDC preliminary results suggest that global traditional PC shipments fell 15% in Q2 2022, and the company results were good taking into consideration the macro numbers. Amy Hood said in the earnings call, “Despite the deteriorating PC market, we saw share gains again this quarter and volumes remained above pre-pandemic levels.”
The management expects More Personal Computing revenue to be $13.2 billion in the next quarter, which will be lower sequentially.
Microsoft Flexes Its Muscle on Margins
Microsoft flexed its muscle on margins during a time when many companies are stumbling on the bottom line. This was especially evidenced by Microsoft announcing an accounting change to the life of its servers to offset FX headwinds. We detail this in the section below.
The company’s gross profits increased 10% YoY to $35.4 billion. The gross margin was 68.3% compared to 69.7% in the same period last year. Excluding the impact of the change in the accounting estimate, the gross margin was relatively unchanged.
The operating margin was 39.6% compared to 41.4% in the same period last year. Excluding the impact of the change in the accounting estimate and FX, the operating margin would be relatively unchanged.
The net income was $16.7 billion or $2.23 per share compared to $16.5 billion or $2.17 per share. The strong US dollar negatively impacted revenue by $595 million and EPS by $0.04 in the recent quarter.
The company’s cash flows continued to be strong in the recent quarter. Cash from operations grew by 8% YoY to $24.6 billion (47% of revenue) and free cash flow increased by 9% YoY to $17.8 billion (34% of revenue).
The company has cash and investments of $104.8 billion and a debt of $49.8 billion. The company returned 12.4 billion to the shareholders in the form of share repurchases and dividends in Q4 FY2022, up 19% YoY, and the company spent a similar amount in Q3 FY2022.
FX Headwinds Expected to Ease in 2023
The management expects Q1 FY2023 revenue to grow 10% YoY at the mid-point of the guidance to $49.75 billion. They expect FX headwinds to be higher in the first half of the fiscal year when compared to the second half. For the full year, they expect double-digit revenue and operating income growth. The management expects to complete the acquisition of Activision Blizzard by the end of this fiscal-year and the guidance excludes the impact from the acquisition.
The company also made an accounting change in the useful life for server and network equipment assets from four to six years which will extend the depreciation expenses for the company. This will have an immediate benefit to the company’s bottom line. Amy Hood said in the earnings call, “First, effective at the start of FY '23, we are extending the depreciable useful life for server and network equipment assets in our cloud infrastructure from 4 to 6 years, which will apply to the asset balances on our balance sheet as of June 30, 2022, as well as future asset purchases.
As a result, based on the outstanding balances as of June 30, we expect fiscal year '23 operating income to be favorably impacted by approximately $3.7 billion for the full fiscal year and approximately $1.1 billion in the first quarter.”
On the other hand, Apple did not give the exact revenue guidance for the next quarter. The company’s CFO said in the earnings call, “Given the continued uncertainty around the world in the near term, we are not providing revenue guidance but we are sharing some directional insights based on the assumption that the macroeconomic outlook and COVID-related impacts to our business do not worsen from what we are projecting today for the current quarter.
Overall, we believe our year-over-year revenue growth will accelerate during the September quarter compared to the June quarter despite approximately 600 basis points of negative year-over-year impact from foreign exchange.”
Similarly, Meta Platforms guided revenue of $26 billion to $28.5 billion, or a YoY decline of 6% at the mid-point of the guidance. The guidance considers the weak advertising demand the company experienced in the recent quarter and the foreign exchange headwinds of 6%. Meta’s guidance disappointed investors as they were expecting a return of growth in the next quarter after the revenue declined for the first time in Q2.
Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.
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 Jul 29, 2022,11:24am EDTForbes on Jul 29, 2022,11:24am EDT
Big Tech earnings were off to a solid start last week when Microsoft and Google reported stable revenue growth and margins that are unchanged from recent macro conditions. The strong margins were especially welcomed as many companies have been missing on operating margins and cash flow. Meanwhile, Microsoft delivered free cash flow of $17.8 billion and net profits of $16.7 billion along with upbeat guidance for the year. Similarly, Google reported strong free cash flow of $12.6 billion and net profits of $16 billion in the recent quarter.
The same was not true for Meta, which primarily stumbled on its Q3 guide. The company reported its first decline in revenue in company history and guidance for next quarter missed due to FX headwinds. Analyst expectations for Q3 were for $30.4 billion, or 5% growth. Instead, the company guided for $26 billion to $28.5 billion, or a YoY decline of 6% at the mid-point of the guidance with the current exchange rates creating a 6% headwind.
Alphabet: Search is Resilient
The company reported revenue of 13%, or 16% in constant currency, for a total of $69.7 billion. The operating margin was flat year-over-year, which is a win. Operating expenses grew 24% yet the operating margin was in line with previous quarters at 28% for $19.58 billion in operating income.
The net margin was a bit weaker than previous quarters in 2021 at $16 billion yet in line with last quarter. The company has free cash flow of $12.6 billion. The company has $125 billion in cash and marketable securities. The company reported EPS of $1.21 compared to $1.36 for the same period last year.
Search was stable given the current environment at 13.5% growth to $40 billion and this provided relief that not all ad spend has been paused. Search was strong last quarter at 24% growth to $40 billion, and was flat sequentially in terms of total dollar amount.
The effects of Google’s large R&D department and advances in AI cannot be overstated when it comes to the resiliency of Search in the current environment. We are getting a very slight glimpse of what’s to come for Google in terms of its advertising dominance.
The expectations were that YouTube would weigh on the report yet YouTube provided a bit of growth at 5% year-over-year. The company was adamant that YouTube growth is low because of the tough comps. The tough comps was touched on many times, such as this: “the modest year-on-year growth rate primarily reflects lapping the uniquely strong performance in the second quarter of 2021.”
Notably, Google Cloud slowed to 35.6% growth down from 43.8% growth last quarter. This means Google Cloud is growing slower than Azure on a lower revenue base. This is something to monitor in the future.
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Microsoft: Double-Digit Guide for FY2023
Many tech companies are declining to give guidance while Microsoft’s management provided strong guidance in both Q1 FY2023 and for FY2023. For Q1 FY2023, management provided a 10% guide across product lines for next quarter (this includes FX headwinds) and also provided guidance for fiscal year 2023 ending in June: “We continue to expect double-digit revenue and operating income growth in both constant currency and U.S. dollars. Revenue growth will be driven by continued momentum in our commercial business and a focus on share gains across our portfolio.”
Revenue grew by 12% YoY to $51.9 billion (missed Wall Street analysts' estimates by 0.94%) and EPS came at $2.23 (missed estimates by 2.9%). The strong US dollar negatively impacted the revenue by $595 million and EPS by $0.04. Microsoft Cloud revenue grew by 28% YoY to $25 billion. The company’s results are good considering the various macro uncertainties, China lockdown, and the strong US dollar. FY2022 revenue grew by 18% YoY to $198.3 billion and net income increased by 19% YoY to $72.7 billion.
The company’s gross profits increased 10% YoY to $35.4 billion. The gross margin was 68.3% when compared to 69.7% in the same period last year. Excluding the impact from the change in the accounting estimate, the gross margin was relatively unchanged.
The operating income increased by 8% YoY to $20.5 billion. The operating margin was 39.6% compared to 41.4% in the same period last year. Excluding the impact from the change in the accounting estimate and FX, the operating margin would be relatively unchanged.
The company’s cash flows continued to be strong in the recent quarter. Cash from operations grew by 8% YoY to $24.6 billion (47% of revenue) and free cash flow increased by 9% YoY to $17.8 billion (34% of revenue). The company has cash and investments of $104.8 billion and debt of $49.8 billion.
Despite weakness in PCs, the company’s other segments continue to grow. Intelligent Cloud grew 20% YoY to $20.9 billion and Productivity and Business Processes segment grew 13% YoY to $16.6 billion.
The company also made an accounting change in the useful life for server and network equipment assets from four to six years which will extend the depreciation expenses for the company.
Amy Hood said in the earnings call, “First, effective at the start of FY '23, we are extending the depreciable useful life for server and network equipment assets in our cloud infrastructure from 4 to 6 years, which will apply to the asset balances on our balance sheet as of June 30, 2022, as well as future asset purchases.
As a result, based on the outstanding balances as of June 30, we expect fiscal year '23 operating income to be favorably impacted by approximately $3.7 billion for the full fiscal year and approximately $1.1 billion in the first quarter.”
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Meta: Misses Q3 Expectations
The market does not need a perfect quarter for Q2 given the numerous headwinds facing tech companies. What the market does need is a sign that a company may have bottomed and is able to guide growth (even if minimal) from Q2-Q3.
In Q2, Meta’s revenue declined for the first time in history. This was expected. However, what was not expected was the lower guide for the next quarter. The company guided for $26 billion to $28.5 billion, or a YoY decline of 6% at the mid-point of the guidance. The guidance takes into consideration the weak advertising demand the company experienced in the recent quarter and also the foreign exchange headwinds of 6%. The investors were expecting a return of growth in the next quarter.
The company had a slight beat on DAUs at 1.97 billion versus 1.96 billion expected. Monthly users were 2.93 billion slightly missed expectations of 2.94 billion.
Total expenses rose 22% YoY to $20.4 billion. This led to the drop in the operating margin to 29% in the recent quarter compared to 43% in the same period last year. It also led to the 36% YoY drop in the net income to $6.69 billion. The EPS came at $2.46 compared to $3.61 in Q2 2021.
The company is looking to further reduce the total expenses for the year to $85 billion to $88 billion from the last quarter guidance of $87 billion to $92 billion and the prior estimate of $90 billion to $95 billion.
We discussed why Meta is likely to continue to face headwinds in an in-depth webinar here:
Apple: Strong results despite challenges
Apple released strong results despite the challenging macro environment, strong US dollar, and supply chain issues. Revenue grew by 1.9% YoY to $83 billion, which was in-line with the analysts' estimates. It reported EPS of $1.20, which beat estimates by $0.04 (4% beat).
The product segment revenue declined marginally by 0.9% YoY to $63.4 billion and the services segment revenue grew by 12% YoY to $19.6 billion. The company’s installed base of active devices reached an all-time high. It had more than 860 million of paid subscriptions, up 160 million in the past year.
The company did not give exact revenue guidance for the next quarter. Tim Cook, CEO of the company, said in the earnings call, “We’re going to accelerate revenues in the September quarter as compared to the June quarter and will decelerate on the Services side.”
The company’s gross margin was 43.26%, compared to 43.75% in the previous quarter and 43.29% in the same period last year. It was above the management’s guidance of 42% to 43%.
Net income was $19.4 billion or $1.20 per share compared to $21.7 billion or $1.30 per share in the same period last year. It beat the analysts' EPS estimates by $0.04.
The company had cash and marketable securities of $179 billion and a debt of $120 billion. The company reported strong operating cash flows of $23 billion (28% of revenue). The company returned over $28 billion to the shareholders in the recent quarter in the form of dividends and share repurchases.
Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.
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.
Microsoft released its Q4 FY2022 results for the period ending June 30th. Revenue grew by 12% YoY to $51.9 billion (missed Wall Street analysts' estimates by 0.94%) and EPS came at $2.23 (missed estimates by 2.9%). The strong US dollar negatively impacted the revenue by $595 million and EPS by $0.04. Net income grew by 2% YoY to $16.7 billion. Microsoft Cloud revenue grew by 28% YoY to $25 billion. The company’s results are good considering the various macro uncertainties, China lockdown, and the strong US dollar. FY2022 revenue grew by 18% YoY to $198.3 billion and net income increased by 19% YoY to $72.7 billion.
The company’s CEO Satya Nadella sounded more confident about the company’s prospects. He said, “In this environment, we are focused on 3 things: first, no company is better positioned than Microsoft to help organizations deliver on their digital imperative so that they can do more with less. From infrastructure and data to business applications and hybrid work, we provide unique differentiated value to our customers. Second, we will invest to take share and build new businesses in categories where we have long-term structural advantage. Lastly, we will manage through this period with an intense focus on prioritization and executional excellence in our own operations to drive operational leverage.”
The company’s gross income increased 10% YoY to $35.4 billion. The gross margin was 68.3% when compared to 69.7% in the same period last year. Excluding the impact from the change in the accounting estimate, the gross margin was relatively unchanged.
The operating income increased by 8% YoY to $20.5 billion. The operating margin was 39.6% compared to 41.4% in the same period last year. Excluding the impact from the change in the accounting estimate and FX, the operating margin would be relatively unchanged.
The company’s cash flows continued to be strong in the recent quarter. Cash from operations grew by 8% YoY to $24.6 billion (47% of revenue) and free cash flow increased by 9% YoY to $17.8 billion (34% of revenue). The company has cash and investments of $104.8 billion and debt of $49.8 billion.
Segment results:
The Productivity and Business Processes revenue grew by 13% YoY to $16.6 billion. This was in line with the midpoint of the management’s guidance given in June. The Office Commercial revenue grew by 9% and Office 365 commercial revenue grew by 15%. Dynamics revenue grew by 19%, which was helped by Dynamics 365 growth of 31%. It was slightly below the management’s growth expectation. LinkedIn revenue increased by 26%, which was lower than the management’s expectation due to the slowdown in advertising revenues.
The operating income of this segment increased by 12% YoY to $7.2 billion. The segment accounts for 32% of the total revenue and 35% of the group’s total operating income. The management expects the Productivity and Business Processes segment revenue to be $16.1 billion at the mid-point of the guidance in the next quarter.
The Intelligent Cloud segment revenue grew by 20% YoY to $20.9 billion. The management’s guidance was $21.05 billion, the negative impact from the strong dollar led to the slight miss in this segment. The server products and cloud services revenue grew by 22% helped by Azure & other cloud services growth of 40%. On a constant currency basis, Azure grew by 46% and the management is guiding for a growth of 43% in the next quarter. Google Cloud revenue in the recent quarter grew by 36% YoY to $6.3 billion.
Some of the key wins in the recent quarter include American Airlines that chose the company’s cloud platform to run its operations. Telecommunications company, Telstra will use Microsoft Azure for its internal IT workloads. The operating income increased by 11% YoY to $8.7 billion. The segment accounts for 40% of the group’s total revenue and 42% of the total operating income. Intelligent Cloud revenue is expected to be $20.45 billion in the next quarter.
The More Personal Computing revenue grew by 2% YoY to $14.4 billion. It was below the management’s guidance of $14.69 billion. The slowdown in this segment was expected since there is weakness in the PC business. Windows OEM revenue fell 2% and despite the deteriorating PC market the company witnessed some share gains. Surface revenue grew by 10%, which was helped by commercial sales. The gaming revenue declined 7% and was in line with the management’s expectations. The operating income fell by 5% to $4.6 billion. The segment accounts for 28% of the total revenue and 22% of the operating income. The management expects More Personal Computing revenue to be $13.2 billion.
Guidance
The management expects Q1 FY2023 revenue to grow 9.8% YoY at the mid-point of the guidance to $49.75 billion. The strong dollar and PC weakness might be the reason for the company to give a cautious guidance for the next quarter that was lower than the analysts' initial estimates. They expect FX headwinds to be higher in the first half of the fiscal year when compared to the second half.
They sound more optimistic on the full year guidance as they expect revenue to grow double digits for the full year. Amy Hood, CFO of the company said in the earnings call, “We continue to expect double-digit revenue and operating income growth in both constant currency and U.S. dollars.” The management guidance does not take into consideration the impact from the acquisition of Activision Blizzard which they expect to complete by the end of the fiscal year 2023.
The company also made an accounting change in the useful life for server and network equipment assets from four to six years which will extend the depreciation expenses for the company. Amy Hood said in the earnings call, “First, effective at the start of FY '23, we are extending the depreciable useful life for server and network equipment assets in our cloud infrastructure from 4 to 6 years, which will apply to the asset balances on our balance sheet as of June 30, 2022, as well as future asset purchases.
As a result, based on the outstanding balances as of June 30, we expect fiscal year '23 operating income to be favorably impacted by approximately $3.7 billion for the full fiscal year and approximately $1.1 billion in the first quarter.”
Conclusion
Microsoft is in a better position to withstand the macro challenges with stable revenue, consistent margins and the company’s strength in Microsoft Cloud. The company’s forward guidance for the next fiscal year looks positive. Despite PC’s weakness, the company’s other segments continue to grow. Notably, Microsoft Azure’s growth is very solid and outpaced Google Cloud.
Google and Microsoft both flexed their muscle in terms of margins with nearly no impact over the past few quarters due to the macro headwinds. The quarter was stable in terms of both revenue and margins.
There’s a chance the market is sniffing out that Q2 could be a bottom for financials. We need more information (this is not a statement written in stone) but there is evidence that some companies may have bottomed – Netflix’s return to (minimal sub growth), Tesla’s H2 deliveries guide, and Microsoft is a double-digit growth guide for FY2023 while predicting FX headwinds will ease between January-June.
I believe Google’s rally is due to the company’s category leading strength in ads, specifically Google Search, and the prospects of what it will look like when YouTube bounces back. Due to lack of guidance, we don’t have any hints on whether Google bottomed or not, but comparatively the company is stronger than expected.
The company reported revenue of 13%, or 16% in constant currency, for a total of $69.7 billion. The operating margin was flat year-over-year, which is a win. Operating expenses grew 24% yet the operating margin was in line with previous quarters at 28% for $19.58 billion in operating income.
The net margin was a bit weaker than previous quarters in 2021 at $16 billion yet in line with last quarter. The company has free cash flow of $12.6 billion. The company has $125 billion in cash and marketable securities.
Search was stable given the current environment at 13.5% growth to $40 billion and this provided relief that not all ad spend has been paused. Search was strong last quarter at 24% growth to $40 billion, and was flat sequentially.
“The strength in Search highlights the advantage that having first-party data provides. This is because Search is primarily done on a browser, allowing Google to capture valuable first party data from ownership of Google Chrome, Google Search and also from Android OS. Moreover, Google is releasing new products, such as Topics API, which enables behavioral targeting. This is a direct shot at Meta Platforms, who is known to be quite competitive on behavioral targeting through taxonomies.”
The effects of Google’s large R&D department and advances in AI cannot be overstated when it comes to the resiliency of Search in the current environment. We are getting a very slight glimpse of what’s to come for Google in terms of its advertising dominance.
On the call, an analyst asked what is the company’s north star, given their margins are very strong. Later, the CEO discussed that his focus is using their cash to drive more R&D in AI, which flows through to Google Search and YouTube, which then generates more cash to drive more R&D, etc.
“So, for example, we are obviously investing deeply in AI. We do everything from pure research to applied research to research, which is now things AI work, which is actually happening very close or within the areas like Search and YouTube, et cetera.
And so, you can imagine a scenario in which we are prioritizing and on the margin moving resources to making sure we are driving product improvements, which flow through a moment like that. That would be an example of sharpening focus for me.
And when I think about the opportunities out of AI, just coming out of I/O this year, looking at the progress we have made, how much we have made progress with multisearch, how multimodal things are getting and the fact that people are now actually doing voice searches a lot, visual searches a lot, all that is a good example of how we are driving value in our core products.”
The expectations were that YouTube would weigh on the report yet YouTube provided a bit of growth at 5% year-over-year. The company was adamant that YouTube growth is low because of the tough comps. The tough comps was touched on many times, such as this: “the modest year-on-year growth rate primarily reflects lapping the uniquely strong performance in the second quarter of 2021.”
The other issue is that just like hiring is seeing a reversion to 2019 levels, so is ad spend. The levels of ad spend seen in 2020-2021 are not sustainable which is why we are reverting back to 2019 in many of these growth rates. Regardless, the overall tone was positive about YouTube especially as YouTube shorts alone now has 1.5 billion signed-in users per month and 30 billion daily views.
Retail was discussed on the call. Although the management team declined to be granular with analysts, they did feel their products are better positioned to serve retail, as evidenced by the current growth rates compared to competitors, due to Omnichannel. Retailers prefer to drive both offline and online sales through multiple channels for in-store, online, curbside pickup which Google helps with across Search both mobile and browser, YouTube, and location-based searches/maps. Google introduced a new way to buy ads across all of Google’s channels called Performance Max with a single campaign to help more retailers tap into omnichannel.
We discussed in our recent Q3 webinar the importance of Big Tech capex, especially for semiconductor investors. This will be something to closely monitor in Q1 reports of next year in terms of expected capex.
So far, so good for this quarter. We got the following from Ruth Porat, CFO:
“Turning to CapEx. The largest investments in the second quarter were in servers followed by data centers and office facilities. After several large transactions closed in the first quarter, investment in office facilities was once again focused on fit-outs and ground-up construction on existing projects. We continue to expect an increase in CapEx in 2022 versus last year. For the balance of 2022, the increase will be particularly reflected in investments in technical infrastructure globally with servers as the largest component.”
Google Cloud slowed to 35.6% growth down from 43.8% growth last quarter. This means Google Cloud is growing slower than Azure on a lower revenue base. This is something to monitor in the future.
The company announced $70 billion in buybacks last quarter which is up from $50 billion in the previous year. This is also a marked increase from 2019 which saw $25 billion in buybacks.
Conclusion:
We had said this the following in our last write-up which pulls the pieces together to answer why Google has demonstrated stability in the face of ad-tech headwinds:
“Google also reiterated this point during their Q1 Conference Call when CBO Philipp Schindler explained that being able to fully measure what users do after they click on an ad is critical to measuring ROI. He added that “Measurement is also obviously a key component to success [in CTV], and we want to make sure that advertisers can fully measure their YouTube CTV video investments across YouTube and YouTube TV for an accurate view of true incremental reach and frequency and so on.”
CBO Schindler’s comments highlight the importance of measurement, a key aspect of digital advertising that has been challenged following the changes to iOS cookies. If advertisers cannot measure ROI, they tend to limit their ad expenditures, so it's critical that ad platforms find solutions to measure ROI in order to sustain growth.”
Ultimately, in addition to Google’s many channels, Google is resilient right now due to AI driving stronger ROI for advertisers. For example, AI-powered Performance Max has grown 5X year-to-date with case studies driving 60% more revenue.
The company is also more defensible following Apple’s attribution and measurement changes as the Google can provide this on their OS and browser while offering an omnichannel strategy.
We pointed out recently that the market has indiscriminately penalized tech stocks across the board and cybersecurity stocks are simply caught in the cross fire. Q1 earnings proved that cybersecurity stocks are insulated from supply chain issues and remain a number one priority across corporate budgets. Specifically, cybersecurity-related companies reported top line and bottom-line beats plus a handful raised guidance while consumer-related tech and less cash efficient cloud verticals lowered or missed guidance this past quarter.
We also covered the high probability that cybersecurity would show strength prior to earnings in our quarterly webinar. You can reference this discussion in our Q2 webinar at minute 30:09.
If you look closely, the market has been efficient recently across the cloud sector as the top valuations in the category are those with healthy top lines balanced with a positive free cash flow margin.
Source: YCharts
CrowdStrike recently released strong results as revenue grew 61% year-over-year to $487.8 million and beat the Wall Street revenue estimates by 5%. The company has also been delivering strong free cash flow, and in the most recent quarter, the company reported a free cash flow margin of 32%. The company’s modern cybersecurity products and good fundamentals has prompted us to revisit the stock. Notably, we've owned Crowdstrike twice in the past and the stock has treated us well.
Security Software Market
According to the C-Suite surveys, cybersecurity remains a top priority in corporate spending. Enterprise spending is expected to increase in 2022 from the previous year, according to Chief Information Security Officer (CISO) surveys. Considering the level of cloud spending in both 2020 and 2021, an increase in already high budgets is impressive. The CISO survey states that 44% expected budgets to increase in 2022 compared to 41% in 2021, and only 2% expected a decrease compared to 6% the previous year.
According to the Morgan Stanley CIO surveys, security software is the least likely to be cut if the economy worsens in 2022. To some degree, this could make cybersecurity a safe haven for investors over the next few years.
Similarly, Security Software ranked the second highest priority among CIOs when asked which external IT spending will see the most significant increase in spending in 2022.
According to Gartner’s CIO survey concluded in 2021, cyber and information security is the top priority of planned investments by companies for 2022. Monika Sinha, VP at Gartner, said, “There is a continued need to invest in cybersecurity as the environment becomes more challenging. A high level of composability would help an enterprise recover faster and potentially even minimize the effects of a cybersecurity incident.”
CrowdStrike Product Overview:
CrowdStrike was founded with the goal of reinventing security for the cloud era. CrowdStrike’s Falcon platform delivers comprehensive breach protection against today’s most sophisticated attacks on the endpoint. Due to the sheer number of endpoints in a corporate network, this is where the majority of attacks are made. Compromised credentials across desktops, laptops, and mobile devices are often the hardest points of access to secure.
Ponemon Institute conducted a survey in 2019 where IT security professionals reported that 68% of IT professionals had experienced one or more endpoint attacks, up from 54%. The survey is a bit outdated yet illustrates how hackers use endpoints specifically to gain access to data assets and IT infrastructure. At the time, the average endpoint breach costs $9 million.
CrowdStrike’s AI based security model is focused on collecting large amounts of data, centrally storing it in a single model, and continuously training its algorithms with vast amounts of data. The more data that the Falcon Platform collects, the more intelligent the platform becomes in detecting and stopping breaches.
The company’s cloud-native Falcon platform was built to provide automated protection to stop sophisticated cyber-attacks. It is capable of protecting workloads across servers, laptops, virtual machines, mobile, cloud, and the Internet of Things (IoT). With hybrid deployments, and the internet of things, the risk of cyber-attacks has increased, and the need to protect digital assets has increased.
The Falcon platform has 22 modules offered via a subscription-based model under various categories like cloud security, endpoint security, Crowd XDR, Security & IT Operations, Managed Services, Threat Intelligence, Identity Protection, and Log Management. These modules can be easily deployed on the customer’s endpoints and workloads and can be easily scaled depending on the needs of each customer.
One of the most popular upgrades is Falcon Complete, Crowdstrike’s fully managed detection and response solution that offers Fusion no-code security automation to proactively remediate issues. Translation: less technical employees can work alongside Falcon Complete throughout IT and security departments. This is important due to a cybersecurity training gap between the small talent pool and the dire need for larger security teams.
The upgrade process for modules within the Falcon Complete tier is driving Crowdstrike’s ongoing growth. For example, the company recently reported over 100% growth year-over-year in ending ARR for the Discover, Spotlight, Identity Protection and Log Management modules. The company also stated “the number of customers adopting 6 or more and 7 or more modules grew more than 100% year-over-year” –this is due to Crowdstrike increasing the number of modules they offer for trial from 4 to 12 in the most recent quarter.
This is not to be confused with subscription customers that adopted 6 or more modules, which grew 35%, yet may be a leading indicator of what is to come if the trials were this popular. At the end of Q1 FY2023, 71% of subscription customers had four or more modules and 59% had five or more modules. The company is “retiring” the four or more modules key metric moving forward as it’s becoming commonplace to upgrade to this number of modules.
The users need to download a lightweight agent on each endpoint and cloud workload with only a single agent required to upgrade to the various modules. The agent also protects workloads when offline and sends data to the Falcon platform. The data from workloads are analyzed by machine learning models and are capable of preventing future attacks. The events are sent to the Threat Graph in real-time to be further analyzed.
The Threat Graph is a proprietary and a dynamic graph database. It continuously looks for malicious activity by using Artificial Intelligence. The data needs to be collected only once and can be used to analyze how to prevent future attacks. It also enables the company to introduce new products by using the same data and this is one of the reasons that CrowdStrike was able to rapidly introduce new modules.
The company has a smart filtering system that helps filter enormous amounts of data. The company estimates that a typical endpoint generates 100 GB of unfiltered system event data daily. A typical corporation will have several endpoints. The company’s smart filtering helps reduce the noise, and the Falcon agent only sends the crucial data required for detecting, preventing, and investigating attacks. It thereby improves the performance and allows for efficiently analyzing large volumes of data.
The Threat Graph is a powerful product in preventing breaches as it predicts and prevents modern threats in real-time through endpoint telemetry, threat intelligence and AI-powered analytics. This works alongside the modules to offer a best-of-breed endpoint security solution that offers a combination of agent-based and agentless solutions on one dashboard across public cloud, multi-cloud, and hybrid deployments. The company feels that agent-based is still essential to offer pre-runtime and runtime protection, whereas according to Crowdstrike, agentless-only solutions offer partial visibility and lack remediation capabilities (i.e., the company is referring to SentinelOne which we’ve covered here and also here).
The company has three graphs: Threat Graph, Intel Graph and the recently-launched Asset Graph.
Threat Graph: As discussed, takes trillions of data points from millions of sensors and enriches the threat intelligence from third-party sources (hence “crowd” strike). This offers full visibility and provides automated threat prevention.
Intel Graph: Offers threat intelligence by correlating massive amounts of data and provides insights into any shifts in tactics or techniques
Asset Graph: Newly-launched to increase protection across attack vectors such as cloud, on-premise systems, mobile, IoT and connects them into a unified, visual graph rather than a list.
We’ve discussed with both Datadog and SentinelOne why standardization is key to a cloud company’s long-term growth (and survival really). Crowdstrike is a prime example of this as endpoint security companies are able to slowly move into new territory. The Humio acquisition was discussed on the call as analysts were wondering if Crowdstrike has been taking territory from SIEM vendors. Because the endpoints are arguably the most difficult to protect, I would expect both Crowdstrike and SentinelOne to successfully take more turf across security vendors as they move through product expansion.
According to the recent report from International Data Corporation (IDC), CrowdStrike is ranked No.1 in Worldwide Corporate Endpoint Security Market Share with 12.6% of the $10.3 billion market, up from 6.3% in 2019. The company is also the largest vendor in the modern endpoint security submarket with a 15.5% market share in 2021, up from 12% in 2020. Similarly, CrowdStrike has been named as the leader in ‘The Forrester Wave’ Endpoint Detection and Response Providers, Q2 2022. Source: Investor Presentation. It has also ranked No. 1 in the coveted 2021 Fortune 50 list, which is the list of companies that have best prospects for future growth.
As we discussed in our Q2 webinar at minute 30:09, cybersecurity is one of the only areas where spending is increasing following tech-heavy budgets in 2020 and 2021. Here is what Crowdstrike in regards to this point:
Joseph GalloJoseph Gallo
You’ve alluded to it and so far the numbers appear to indicate that cyber and your business is resilient. But George, in your convos with customers and Burt, in your guidance methodology, is the world a little less rosy than it was a quarter ago? Are you seeing any change in the velocity of deals closing or hesitation from customers? And if you could break that into by geo or deal size, that would be great. Thanks.
George KurtzGeorge Kurtz
Yes, I’ll try the first part. No, we haven’t seen any slowdown in terms of the willingness to buy security. It continues to be the number one risk factor for any Board of Directors. Again, when you look at some of the e-crime impact and taking out business, it is not a discretionary spend. It’s — in the hierarchy of corporate needs, it’s probably shelter.No, we haven’t seen any slowdown in terms of the willingness to buy security. It continues to be the number one risk factor for any Board of Directors. Again, when you look at some of the e-crime impact and taking out business, it is not a discretionary spend. It’s — in the hierarchy of corporate needs, it’s probably shelter.
We’ve also hammered on standardization and the driving down of costs in the Q2 webinar at 34.45 prior to this earnings season. Here is what Crowdstrike’s CEO George Kurtz had to say about this in the most recent earnings call following our webinar:
And in fact, when you look at the current environment, we have a customer saying we want to consolidate more. We want to go in with — all in with CrowdStrike. We want to get rid of this extra spend that we have in other areas, too many agents. And we can upsize our deals while decreasing the overall security spend by consolidating things like vulnerability management, by consolidating log management capabilities, et cetera. We can put it together and give them a much more effective technology with better outcome, lower cost and lower management concerns.we have a customer saying we want to consolidate more. We want to go in with — all in with CrowdStrike. We want to get rid of this extra spend that we have in other areas, too many agents. And we can upsize our deals while decreasing the overall security spend by consolidating things like vulnerability management, by consolidating log management capabilities, et cetera. We can put it together and give them a much more effective technology with better outcome, lower cost and lower management concerns.
The company’s total addressable market (TAM) is growing. It was $25 billion during the company’s IPO in 2019 and is expected to reach $126 billion in 2025 with planned new offerings. The TAM is expected to be $71 billion in 2024 with the current portfolio offering.
Financials:
The company’s revenue growth has been strong. In the recent quarter, revenue grew by 61% YoY to $487.8 million. Subscription revenue which accounted for 94% of the total revenue, grew by 64% YoY to $459.8 million. The management expects revenue to grow 52% in the next quarter to $515 million at the mid-point of the guidance.
Source: YCharts
The company’s key performance metrics are strong. Its annual recurring revenue (ARR) grew by 61% YoY to $1.92 billion, with a net new ARR of $190.5 million in the recent quarter. The company’s dollar-based net retention rate (DBNRR) was above 120% in the recent quarter. This is the 17th consecutive quarter of above 120% DBNRR which shows the company’s strong retention metrics.
The company’s subscription customers grew by 57% YoY to 17,945. It has a strong base of enterprise customers. As of January 31, 2022, the company’s customers include 65 of the Fortune 100, 254 of the Fortune 500, and 15 of the top 20 U.S. banks.
The company has stable gross margins. In Q1 FY2023, the company reported a gross margin of 74% which was at the same level as Q1 FY2022. It shows that the company has been able to maintain its cost of revenue in proportion to the increase in its revenues. Similarly, the subscription gross margin was 77% in both Q1 FY 2023 and Q1 FY2022. The adjusted subscription gross margin was 79% and was within management’s target of over 77% to 82%.
The operating margins are improving. The loss from operations reduced from -$31.3 million (-10%) in the Q1 FY2022 to -$23.9 million (-5% of revenue) in the recent quarter. The company’s operating expenses as a percentage of total revenue fell by 5.53%. Particularly, sales and marketing expenses fell by 4.95%. Its strong subscription business model is also helping the company to improve its operating leverage. The adjusted operating income was $83 million (17% of revenue) in the recent quarter when compared to $29.8 million (10% of revenue) in the same period last year. The management’s target range for the adjusted operating margin is over 20% to 22% which it expects to reach in FY2025.
Source: YCharts
The net loss was -$31.5 million (-6.5% of revenue) in Q1 FY2023 compared to -$85 million (-28% of revenue) in the same period last year. While the company’s margins are improving, as explained in the above paragraph. The wider difference in the net loss reduction was primarily due to the provision of taxes related to the Humio acquisition, which was included in the Q1 FY2022. The company reported an adjusted net income of $74.8 million compared to an adjusted net income of $23.3 million in the same period last year.
The company's cash flows are also good. In the recent quarter, the company reported a free cash flow of $157.5 million (32% of revenue). In the words of George Kurtz, President, CEO, and Co-Founder, “In 8 out of the last 10 quarters, we have delivered 30% or greater free cash flow margin. Our powerful combination of growth, profitability and cash flow is reflected in our continued performance well in excess of the SaaS industry’s Rule of 40 benchmark. In Q1, we achieved a Rule of 78 on a non-GAAP operating income basis and when calculated on a free cash flow basis, a Rule of 93.”
The company also raised the revenue guidance for FY 2023 ending January to $2.19 billion to $2.21 billion from the earlier guidance of $2.13 billion to $2.16 billion, representing a YoY growth of 52% at the mid-point of the revised guidance.
Valuation
The company is currently trading at a P/S ratio of 23 and a forward P/S ratio of 17. Its forward P/E ratio is 137. When we compare on a fwd P/S ratio, the company has a slightly higher valuation than SentinelOne and Cloudflare. However, the company ranks the best when we compare on a fwd P/E ratio. This metric will gain importance since, in the current environment, investors are looking for companies with profits. So, we believe that CrowdStrike has a better chance to outperform. The valuation is good when compared to its peers and taking into consideration the cash flows along with improving margins.
Note: Zscaler is not an exact comparable in the below chart since its fiscal year ends in July, while the other companies have their fiscal year ending December/January.
Wall Street Analysts notes
Morgan Stanley analyst Hamza Fodderwala upgraded the stock to overweight from equal weight. The analyst said, “CrowdStrike (CRWD) is seeing further adoption based on conversations with Chief Information Officers and is seeing 100% growth from its non-endpoint offerings, which now account for 15% of its annual recurring revenue, showing that its total addressable market could be $30B bigger than first thought.”
Oppenheimer analyst Ittai Kidron lowered the company’s price target to $250 from $300 and kept an Outperform rating. He said, “CrowdStrike reported a strong Q1, beating expectations behind continued momentum for its emerging modules and strong customer growth.” He adds, “While the guidance is somewhat conservative and takes into account the potential for macroeconomic headwinds, the analyst remains bullish and believes CrowdStrike is in the early innings of addressing a massive growth opportunity.”
Piper Sandler analyst Rob Owens lowered the company’s price target to $230 from $250 and kept an Overweight rating on the shares. He said, “The company reported another strong beat and raise quarter that saw all metrics come in ahead of Street expectations.” He adds, “While a $22M annual recurring revenue beat on the Street number is a smaller magnitude beat compared to recent quarters, the solid growth and margin dynamics at near $2B scale is impressive”.
Risks to consider
CrowdStrike faces tough competition from legacy providers and also innovative companies like SentinelOne. We have SentinelOne in our portfolio because we like this company’s growth profile while being centered within the (relative) safe haven of cybersecurity. We feel this is a great sector to hold a higher growth position.
The company has been undergoing losses since its inception. At the same time, the losses are being narrowing. However, if the company cannot achieve consistent profitability in the coming years, it could adversely affect the stock.
Valuation is less of a concern now than it was in the past.
Conclusion
The Cybersecurity sector will perform well as corporations and governments must protect their digital assets as breaches are very costly. We believe that companies like CrowdStrike, which have their products built for the cloud and specialize in endpoints, will stand to benefit, and will have defensible positions as they expand into other markets. We also like the improving financials, particularly the solid free cash flows, which is an important financial metric in the current uncertain macro environment.
We recently added back Microsoft as a LTBH position and we are now adding Alphabet as our second FAANG. We understand our editorials are often behind paywalls on Forbes and Seeking Alpha, and so we have copied the article from April 28th below.
Article on GOOGL Begins Here:
If an investor were to believe market price action this week, it would appear Facebook had strong earnings while Alphabet stumbled. Yet, the opposite is true. Primarily, it was strength in retail ads that led to Alphabet reporting healthy growth of 23%. Meanwhile, Meta Platforms (Facebook) reported revenue growth of 9.7% and is guiding for roughly 0% growth from $28.5 billion in Q2 2021 to $29 billion, at the midpoint for Q2 2022. This analysis looks at why Alphabet is able to provide higher revenue guidance despite 80% of its revenue coming from ads while Facebook is guiding for flat growth.
Notably, Q2 is particularly hard because there are three heavy macro headwinds: supply chain issues, Ukraine-Russia situation, and the transition that Apple has forced with changes to attribution and measurement on iOS. When you add the one-time event of Covid, which plummeted ad spend in Q2 2020, only to lead to a surge in ad spend the following year Q2 2021, the hurdle to clear for revenue growth is at a historic high. We believe those ad-tech stocks that can show top line growth right now are providing important clues for when macro headwinds clear.
BACKGROUND:
The ad-tech industry remains in a whirlwind of changes following iOS privacy changes that limit third-party tracking on Apple mobile devices. I am hyper focused on identifying who the winners and losers will be following these changes, as it will determine who will lead ad-tech going forward. This issue is important because it impacts leading FAANG ad-tech companies, such as Facebook (Meta) and Google (Alphabet). Wall Street particularly likes ad-tech’s bottom line, and will aptly reward those stocks that can capture more ad spend.
In the below analysis, I review Google’s Q1 2022 results and focus on its ad platform (I am ignoring Google Cloud for now) and look for hints if Google is being impacted by the recent iOS changes. You’ll find that Google has held up well relative to other app-based advertising platforms, such as Facebook, following the changes to third-party identifiers. This is because Google has a first-party data advantage, which is critical during a time that attribution and measurement is limited by third parties. I explain why in more detail below.
Google’s Q1 Ad Growth Remains In-Line
While the market is still digesting the macro headwinds previously mentioned – supply chain and Ukraine-Russia; the third headwind of attribution and measurement changes is the headwind that investors should pay most attention to as it leads to a material change in story for ad-tech companies. Meanwhile, the other two headwinds will resolve in time.
Q1 earnings are provide valuable data of who is most and least impacted. Two critical data points will be Facebook’s and Google’s Q1 results, as most of their sales come from mobile ads. Google recently reported that sales grew 23% YoY to $68 billion, which were in-line with estimates.
Furthermore, Google’s Search business slightly outperformed and grew 24% YoY to $40 billion. This follows the outperformance in Q4 as Search sales grew 36% YoY in Q4 while total Q4 sales grew 32% on a year-over-year basis. It may appear that Alphabet’s search revenue is slowing from 30% in the year-ago quarter, but the deceleration in search revenue is due to the tough comps, and relative to Facebook, is outperforming.
The strength in Search highlights the advantage that having first-party data provides. This is because Search is primarily done on a browser, allowing Google to capture valuable first party data from ownership of Google Chrome, Google Search and also from Android OS. Moreover, Google is releasing new products, such as Topics API, which enables behavioral targeting. This is a direct shot at Meta Platforms, who is known to be quite competitive on behavioral targeting through taxonomies.
However, while Search remained strong, both YouTube and Google Network sales underperformed during the quarter. For instance, YouTube grew sales just 14% YoY to $7 billion, a steep slowdown from the 25% and 49% YoY growth rates from last quarter in Q4 and Q1 2021, respectively. Google Network sales increased 20% YoY to $8 billion. This also represented a deacceleration from the 26% YoY growth rate in the prior quarter.
In aggregate, total ad sales increased 22% YoY to $55 billion, a deacceleration from the 33% YoY growth rate in the prior quarter. It is notable that despite the headwinds in YouTube and Google Network, Google’s sales vastly outpaced Facebook’s Q1 revenue growth. As shown below, Google’s ad sales grew nearly 3x faster than Facebook’s 7% growth.
I believe this outperformance was driven by Google’s first-party data advantage. Moreover, YouTube revenue was the biggest laggard during the quarter and YouTube sales grew 14% YoY to $7 billion during the last three-months (fun fact: YouTube is larger than Google Cloud). The slowdown in YouTube may suggest that ads have been impacted by iOS changes, but its important to consider that YouTube grew sales 49% YoY in the year-ago quarter, leading to a tougher comparable base period.
During the Q1 call, Google’s management team explained that the tough comp and “modest” growth from direct response advertising had also impacted the segment, but noted that brand advertising remained an area of strength. The diversification across content types and ability to offer at true omnichannel strategy across mobile, browsers and CTV likely contributed and suggests that brands have shifted ad budgets to YouTube, likely due to its ability to measure ROI at the expense of competing platforms.
Google also reiterated this point during their Q1 Conference Call when CBO Philipp Schindler explained that being able to fully measure what users do after they click on an ad is critical to measuring ROI. He added that “Measurement is also obviously a key component to success [in CTV], and we want to make sure that advertisers can fully measure their YouTube CTV video investments across YouTube and YouTube TV for an accurate view of true incremental reach and frequency and so on.”
CBO Schindler’s comments highlight the importance of measurement, a key aspect of digital advertising that has been challenged following the changes to iOS cookies. If advertisers cannot measure ROI, they tend to limit their ad expenditures, so its critical that ad platforms find solutions to measure ROI in order to sustain growth.
Perhaps the most important comment during the Q1 Conference Call was a statement by management that Google continues to see strength in Retail, reiterating comments made during the Q4 2021 Earnings Call that retail (e-commerce) continues to be strong.
This brief statement is very important, as it adds support that Google will not be as impacted by the iOS changes. Given the signal loss from iOS changes, e-commerce has been one of the hardest hit verticals. Google’s strength here is likely due to its first-party data advantage.
Here is what Facebook CFO David Wehner said about Google’s strength in the retail vertical during Facebook’s Q4 2021 Conference Call:
“e-commerce was an area where we saw a meaningful slowdown in growth in Q4. … But on e-commerce, it's quite noticeable — notable that Google called out, seeing strength in that very same vertical. And so given that we know that e-commerce is one of the most impacted verticals from iOS restrictions, it makes sense that those restrictions are probably part of the explanation for the difference between what they were seeing and what we were seeing.”And so given that we know that e-commerce is one of the most impacted verticals from iOS restrictions, it makes sense that those restrictions are probably part of the explanation for the difference between what they were seeing and what we were seeing.”
Google’s statement that it continues to see strength in retail suggests that it is not as impacted from the iOS changes relative to app-based peers such as Facebook. Importantly, Search is often based on a web browser (Google Chrome), allowing Google to capture first party data and limiting the signal loss from the removal of cookies on mobile based apps.
Our thesis is that in this new cookie-less world, owners of first-party data will outperform going forward. We expect that Google will remain strong given its ownership of first-party data on both its Search platform and also its YouTube platform. However, Facebook will likely continue to struggle here due to its reliance on third-party data and not owning “the real estate,” or essentially the device and/or operating system while needing to collect data from this device in order to support its high ARPU.
Conclusion
Notably, Q2 is particularly hard because there are three heavy macro headwinds: supply chain issues, Ukraine-Russia situation, and the transition that Apple has forced with changes to attribution and measurement on iOS. When you add that the one-time event of Covid, which plummeted ad spend in Q2 2020, and later led to a surge in ad spend the following year Q2 2021, the hurdle to clear for revenue growth is at a historic high. We believe those ad-tech stocks that can show top line growth right now are providing important clues for when macro headwinds clear.
