Cloud giants' results show that hypergrowth software stocks may be overvalued

The cloud giants (AWS, Azure, and Google Cloud) delivered earnings for the quarter ending September 30, 2023, and as a result, the Nasdaq 100 cratered. Despite earnings beats across the board! Superficially, what looked like good results were "etsy ketsy" results diving deeper. Especially as far as the core cloud business, ex AI is concerned.

The second take: The Google cloud business seems to be not fully competitive regarding AI vis-a-vis AWS and Azure. It may be losing market share and has been unable to build the anticipated growth momentum.

The third take: Azure, on the other hand, may be the clear winner and catch up on AWS.

Oracle is the new entry in the club and still the wild card in the business.

Software multiples and cloud optimization

Today's Software multiples are at the same levels on average as in spring 2023 when the 10Y was around 3.5%. Market participants must either believe that the 10y will return to these levels in 2024 or that software earnings will grow substantially to justify current valuations.

After the cloud behemoths reported this week, the timing of the presumed re-acceleration of growth and earnings may need to be revised. Why?

This week, the message delivered by the cloud behemoths was more like "optimizations are continuing" instead of "optimizations will be largely done by year-end," as could be interpreted from the tones during the earnings calls three months ago.

Cloud optimizations started in Q3 '22, and the process seems to be still ongoing. New workloads coming online are still reduced - except for Cloud AI. AI is oftentimes not an add-on to typical cloud expenditures but a (partial) replacement. For the entities with the weakest AI offering, AI may mean a net negative as they lose revenue from their more traditional businesses without being able to gain new AI business, as this seems to be heavily tilted towards a few winners. This trend can also be seen in the semiconductor industry.

AWS, Azure, and Google Cloud in a nutshell

That being said, AWS and Azure sounded the most upbeat regarding trends around optimizations. Looking at the quantitative figures, here is a comparison of the three players - AWS, Azure, and Google Cloud:

1. AWS (Amazon): $92B run rate growing 12% YoY (last quarter increased 12%)

2. Azure (Microsoft): ~$66B run rate (estimate) growing 28% YoY (previous quarter grew 27%)

3. Google Cloud (includes GSuite): $34B run rate growing 22% YoY (prior quarter increased 28%).

Azure may be stealing market share - because of AI

Azure reported a robust performance with a 28% YoY growth in constant currency, a slight increase from 27% in the previous quarter. However, there were hints that challenges related to optimization remained consistent with no significant improvement or deterioration. Microsoft anticipates similar growth rates for H2 (ending March '24 and June 24) based on ongoing optimization and workload trends. Despite the buzz around potential cloud growth acceleration, current insights indicate steady growth only.

A noteworthy contributor to Azure's growth is its AI services. Azure AI contributed 3% to the growth this quarter, indicating a remarkable $1.5B run rate, a significant leap from the previous quarter's $500m.

However, Azure's growth is approximately 25% YoY if we exclude AI. Despite the overall positive outlook, Azure's growth rate, excluding AI, dipped slightly this quarter. Their future projections hint at a 26-27% growth, with AI's contribution possibly increasing.

Azure anticipates steady growth for the first half of 2024.

Google Cloud

Google Cloud also saw a decline in its growth rate, from 28% in the previous quarter to 22%. Despite the significant drop, it's essential to note that Google Cloud had an impressive Q3 in 2022, making the current YoY comparison challenging.

AWS - still the gorilla in the room, but Azure is catching up

In contrast, AWS expressed a more optimistic outlook regarding optimization trends. Their message echoed the previous quarter's sentiment about the decreasing pace of optimizations and the continued strength of new workloads.

They forecast an acceleration of growth from 12 % to 16 % in the next quarter, primarily related to AI.

While AWS still leads the pack regarding market share, Microsoft may be picking up business because companies want to run their AI models on Azure. Microsoft already provides the underlying computing power for the ChatGPT chatbot and other products from OpenAI.

Bernstein Research analysts noted to clients that they viewed Microsoft's results as evidence that the company "has taken the AI mantel from Google and that Azure could become a bigger and more important hyperscale provider than AWS" They also noted the significance of Microsoft's capital expenditures rising to $11.2 billion from $10.7 billion in the prior quarter.

Andy Jassy, Amazon’s CEO and formerly the head of AWS, admitted that the company has been surprised by the pace of growth in generative AI.

Jassy said companies, including Adidas, Booking, Merck, and United Airlines, are building generative AI apps in AWS. Still, Amazon’s Bedrock service became only available in September, while the Azure OpenAI Service opened to the public in January.

Oracle

The new kid on the block in cloud computing is Oracle, which reported 66% growth in the August quarter, citing business from Maersk, Skanska, and Starbucks. In the prior quarter, Oracle’s business even rose 76%.

Here’s how the company did:

• Earnings: $1.19 per share, adjusted, vs. $1.15 per share as expected by analysts, according to LSEG.

• Revenue: $12.45 billion vs. $12.47 billion as expected by analysts, according to LSEG.

“As of today, AI development companies have signed contracts to purchase more than $4 billion of capacity in Oracle’s Gen2 Cloud. That’s twice as much as we had booked at the end of Q4,” Larry Ellison, company chair and technology chief, was quoted as saying in the statement.

Further details can be gleaned from the recent earnings calls of the three cloud behemoths. Here are some quotes from all three earnings calls:

Azure

"In Azure, as expected, the optimization trends were similar to Q4 [Q4 for Microsoft is the quarter ending June 30]."

"Second thing, of course, is the workloads start, then workloads are optimized, and new workloads start. And that cycle continues. We'll lap some of those optimization cycles that were fairly extreme, perhaps in the second half of our fiscal.[The second half of their fiscal year is January - June 2024. This implies the strongest optimizations were in the first half of 2023]."

"For H2, assuming the optimization and new workload trends continue and with the growing contribution from AI, we expect Azure revenue growth in constant currency to remain roughly stable compared to Q2."

"We've been consistent that the optimization trends have been consistent for us through a couple of quarters. Customers are going to continue to do that. It's an important part of running workloads. That is not new."

AWS

"AWS' year-over-year growth rate continued to stabilize in Q3. And while we still saw elevated cost optimization relative to a year ago, it's continued to attenuate as more companies transition to deploying net new workloads."

"While optimization remains a headwind, we've seen the rate of new cost optimization slowdown in AWS, and we are encouraged by the strength of our customer pipeline."

Google Cloud

"On cloud, we had started seeing customers looking to optimize spend. We leaned into it to help customers, given some of the challenges they were facing. And so that was a factor."

Cloud stocks

Based on the earnings results from Google, Microsoft, and Amazon, we may need to become more picky and careful about the prospects of the cloud stocks we like and hold in our portfolio.

Their exposure to AI and how quickly they can turn AI into revenue growth and profits may decide their price performance in 2023 and 2024. Earnings season for some of our core holdings starts next week.

ServiceNow

ServiceNow, one core holding, has already delivered exceptional results, beating on the top and bottom lines. We continue to like the stock and will add to current positions on any meaningful dip. We hope the other holdings can mimic the success of ServiceNow.

Cloud stocks

1. The table lists metrics for ten tech companies: Snowflake, MongoDB, Cloudflare, Palantir, CrowdStrike, Datadog, Samsara, Adobe, Atlassian, and ServiceNow.

2. Valuation Ratios: EV / NTM Rev: Snowflake has the highest ratio at 13.8x, while ServiceNow has the lowest among the listed companies at 10.8x. The average ratio for these companies is 11.8x, and the median stands at 11.1x.EV / 2024 Rev: Ranges from a high of 11.9x (Snowflake) to a low of 10.0x (Atlassian).EV / NTM FCF: There's a wide range here, with Samsara having a significantly high ratio of 644x and Adobe has one of the lowest at 27x.

3. Growth: NTM Rev Growth: Cloudflare has the highest near-term revenue growth projection at 30%, whereas Adobe has the lowest at 12%. The average for these companies is 22%.

4. Profitability: Gross Margin: Adobe stands out with a very high gross margin of 88%, while Samsara has the lowest at 72%. On average, these companies have a gross margin of around 77%.

5. Operating Margin: Adobe also leads in this metric with an operating margin of 34%. In contrast, Snowflake has a notably negative operating margin of -41%.

6. FCF Margin: Snowflake and CrowdStrike have the highest free cash flow margins at 25% and 30%, respectively, while Samsara has a negative FCF margin at -3%.

The Rule of 40 principle states that, at scale, the combined growth rate and profit margin of a SaaS business should be equal to or larger than 40%.

The calculation is straightforward: the revenue growth rate is added to the EBITDA margin for a given period (usually a year). By tying growth to a measure of profitability, namely the EBITDA margin, the Rule of 40 captures one business' operational efficiency, offering a better balance between revenue growth and cost-effectiveness. Its typical components are:

1. Monthly Recurring Revenue (MRR) = Number of paying users * Average revenue per user (ARPU)

2. ARR = MRR x 12

3. ARR Growth Rate = (ARR Current Year / ARR Past Year) / ARR Past Year

4. EBITDA = Revenue - Operational Expenses

5. EBITDA Margin = EBITDA / Revenue

To calculate the Rule of 40's score using these components, the formula is:

Rule of 40 = Annual ARR Growth + EBITDA Margin

Using the provided metrics from the table above:

• Growth Rate: We can use "NTM Rev Growth" as a proxy for the growth rate.

• Profit Margin: We can use "Operating Margin" or "FCF margin" as a profit margin measure.

Rule of 40 for each company:

1. Snowflake: 27%+(−41%)27%+(−41%) = −14%

2. MongoDB: 17%+(−18%)17%+(−18%) = −1%

3. Cloudflare: 30%+(−18%)30%+(−18%) = 12%

4. Palantir: 18%+(−3%)18%+(−3%) = 15%

5. CrowdStrike: 31%+(−6%)31%+(−6%) = 25%

6. Datadog: 18%+(−6%)18%+(−6%) = 12%

7. Samsara: 31%+(−34%)31%+(−34%) = −3%

8. Adobe: 12%+34%12%+34% = 46%

9. Atlassian: 17%+(−10%)17%+(−10%) = 7%

10. ServiceNow: 21%+6%21%+6% = 27%

Using "Operating Margin," only Adobe complies with the Rule of 40, with a value of 46%. ServiceNow comes second with 27% respectively (Calculation is not based on actual figures provided during the earnings call this week).

Let's re-evaluate the Rule of 40 by summing the "NTM Rev Growth" and "Gross Margin" for each company:

1. Snowflake: 27%+66%27%+66% = 93%

2. MongoDB: 17%+74%17%+74% = 91%

3. Cloudflare: 30%+76%30%+76% = 106%

4. Palantir: 18%+79%18%+79% = 97%

5. CrowdStrike: 31%+74%31%+74% = 105%

6. Datadog: 18%+79%18%+79% = 97%

7. Samsara: 31%+72%31%+72% = 103%

8. Adobe: 12%+88%12%+88% = 100%

9. Atlassian: 17%+82%17%+82% = 99%

10. ServiceNow: 21%+78%21%+78% = 99%

Based on this calculation, all companies listed indeed comply with the Rule of 40. Let's evaluate the Rule of 40 by summing the "NTM Rev Growth" and "FCF Margin" for each company:

1. Snowflake: 27%+25%27%+25% = 52%

2. MongoDB: 17%+3%17%+3% = 20%

3. Cloudflare: 30%+6%30%+6% = 36%

4. Palantir: 18%+18%18%+18% = 36%

5. CrowdStrike: 31%+30%31%+30% = 61%

6. Datadog: 18%+22%18%+22% = 40%

7. Samsara: 31%+(−3%)31%+(−3%) = 28%Adobe: 12%+40%12%+40% = 52%

8. Atlassian: 17%+24%17%+24% = 41%

9. ServiceNow: 21%+29%21%+29% = 50%

Based on this calculation using NTM Rev Growth and FCF Margin:

• Snowflake, CrowdStrike, Datadog, Adobe, Atlassian, and ServiceNow comply with the Rule of 40.

• MongoDB, Cloudflare, Palantir, and Samsara do not comply with the Rule of 40 based on the provided metrics.

Rule of 40 calculations above must be used with care. These are approximations only. A more in-depth calculation of the ratios with reference to AI exposure will be provided in one of the following articles.

Actionable advice

We will update our list of cloud favorites in one of the following articles.