February 27, 2024

Cloud computing growth is the new benchmark

Microsoft (US:MSFT), Amazon (US:AMZN) and Alphabet (USA:GOOGL) They may be the market favorites, but right now the only thing investors really care about is the performance of their cloud computing. Microsoft and Alphabet reported their recent third-quarter results on the same day and both beat consensus earnings expectations. However, Microsoft’s share price rose 4 percent and Alphabet’s fell 9 percent.

The reason? Microsoft’s profit growth was based on cloud computing, while Alphabet’s was due to a recovery in its advertising market.

Microsoft’s cloud computing division Azure grew 29 percent year-on-year in the three months to September, beating market expectations of 26 percent. This additional growth came from artificial intelligence (AI), with CFO Amy Hood confirming that approximately three percentage points came from AI services. “Although the trends of [the] “Continuing from the previous quarter, growth exceeded expectations, driven primarily by higher graphics processing unit (GPU) capacity and better-than-expected GPU utilization from our AI services,” Hood said.

In the three months to September, Alphabet’s revenue rose 11 per cent to $76.6bn (£63bn), 1 per cent above market expectations. Meanwhile, earnings per share rose 46 percent to $1.55, more than 6 percent ahead of analysts’ predictions. The problem was Google Cloud. It grew “only” 22 percent year-on-year, a slowdown from 29 percent last quarter and below what analysts expected.

On Thursday, Amazon’s share price rose just 5 percent even though its earnings beat brokers’ expectations. Between Monday and Friday of that week, its share price remained basically stable. This obvious disappointment was again linked to its cloud division, which earned $23.1 billion, slightly below the forecast of $23.2 billion. This 12 percent year-on-year growth was the same as last quarter. Fortunately for investors, earnings per share of $0.96 beat expectations by more than 60 percent, thanks to surprisingly strong performance from its retail and advertising businesses.

On the earnings call, CEO Andrew Jassy sought to allay fears that the company had fallen behind in the AI ​​race. He mentioned the custom Trainium chip he has designed, the recent deal with OpenAI rival Anthropic, and its ‘AI-as-a-service’ platform called Bedrock. He verified the names of clients building AI applications on the platform, including Adidas, Booking.com, Relx (REL), Merck (DE:MERK) and United Airlines (US:UAL).

In total, the phrase “generative AI” was used 31 times on the call as management pressed the issue. “It’s a huge new generative AI opportunity that I believe will generate tens of billions of dollars in revenue for AWS over the next few years,” Jassy said.

The stock prices of Microsoft, Alphabet and Amazon have risen this year, not because of their legacy businesses, but because of their cloud computing potential. All have spent billions in capital expenditures to build the physical infrastructure necessary for widespread AI adoption.

The great advantage of Microsoft

The problem for Amazon and Alphabet is that they have legacy businesses that are mostly unrelated to cloud computing. Amazon is dragging down one of the world’s largest retail businesses, which is struggling to break even. AWS has a 30 percent operating margin, but it represents only 16 percent of total revenue.

Similarly, 78 percent of Alphabet’s revenue comes from advertising through YouTube and Google Search, while only 19 percent comes from the cloud. The good thing is that advertising is a profitable business, with operating margins of around 35 percent, but it is not a growth industry. Digital advertising is now dominant and will not grow much faster than the overall economy.

The advantage Microsoft has is the crossover with its legacy business. Microsoft has more than 300 million Office 365 users, the majority of whom use its software “on-premise.” In other words, they downloaded the software to their own computers and servers, rather than accessing it through Microsoft Azure.

Now, thanks to its strategic investment in OpenAI, Microsoft has moved ahead of its competitors. It has already launched Github Copilot, an artificial intelligence assistant that speeds up coding and has more than 1 million paid users and 37,000 subscribed organizations. It is now launching an Office 365 Copilot, which will add generative AI to its suite of Office 365 products, including Excel, Word and Powerpoint.

Analysts like the fact that Microsoft already has a large customer base to whom it can sell more of its AI products. “Microsoft is still in the early stages of a big opportunity with AI and we believe its cloud product could reach 50 percent of its installed base,” said Dan Ives of Wedbush Securities.

A couple of weeks ago, Well-informed person reported that Amazon had signed a billion-dollar deal with Microsoft for its cloud productivity tools. Jefferies analyst Brent Thill believes this deal shows how reliable Microsoft is as a partner. “Amazon is willing to give its data and money to one of its biggest competitors so that it can access its artificial intelligence tools,” he explained.

To use these AI products, customers must be in the cloud. Traditionally, software ran “on-premises.” However, the computing power required to run AI-enabled software means it must be done on huge cloud servers. Microsoft can go to its existing customers, sell them its new AI software, and then transition to the cloud.

IT services company Byte Technology (BYIT), Microsoft’s largest reseller partner in the UK, is starting to benefit from AI interest. In the six months to August, its gross billed revenue rose 38 percent year-on-year. “We’ve been inundated with questions about AI and how to prepare to incorporate this technology and what kind of infrastructure they need,” said CEO Neil Murphy. Investor Chronicle last week.

Exposure to the clouds, without anything else

If investors just want exposure to cloud computing, there are software infrastructure companies that aren’t held back by any slow-growing legacy businesses.

Cloud monitoring company Data Dog (US:DDOG) allows customers to monitor their technology stack and collect data on cloud usage, network traffic, and memory. It’s more like having a smart meter of cloud computing costs.

In the three months to June, Datadog’s revenue rose 25 percent to $509 million. Meanwhile, the number of customers with more than $100,000 in annual recurring revenue increased 24 percent to 2,990. It just announced an “observability solution” for a large language model (LLM). In other words, if a company builds a chatbot using its proprietary data, as Relx has done with its AI legal assistant, it can use Datadog’s software to monitor its functionality and detect problems.

The other beneficiary of the infrastructure is the cloud data storage and analysis company. Snowflake (US: SNOW). Its software allows customers to collect and analyze their data in the cloud, and with the growth of generative AI, the benefits of being able to organize and process data grow substantially.

Its new product, Snowpark, allows customers to train AI models with Snowflake’s underlying data, rather than ingesting it into the platform, cleaning it, and then exporting it to train and run proprietary models. Snowflake’s $2.1 billion in revenue in the year through January was up 248 percent from two years ago.

The promise for these companies lies in the flywheel effect. As AI improves, software solutions to emerging problems will become cheaper. GitHub research showed that developers are 55 percent more efficient using Github Copilot. Of course, these exact figures can be debated, but it is undeniable that AI is facilitating development. This means more software solutions to problems and more data to analyze, and more cloud infrastructure services.

Soon all telephone communications will be carried out in the cloud. In 2025, BT (BT.) is shutting down its public switched telephone network (PSTN), which will force all communications to be over fiber optic cables. This is part of the investment case for Gamma Communications (GAMA), whose software allows businesses to make calls over the Internet using their existing phone number. This will be in the cloud, where conversations will be stored as data and likely used to create AI call center products. Read more about Gamma here.

As the economy stumbles, it is rare to find growth in places that are not tied to cloud computing, data warehousing and generative AI. With billions of dollars invested, it has to work. Even small stumbles toward this promised future can be enormously damaging.

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