VCLO - Why This Cloud Slowdown Is Temporary And Why This Presents An Opportunity

Summary

• Fortune 500 decision makers expect a dramatic slowdown in IT spend.
• Interestingly, cloud spending is expected to fare worse than the average IT spending.
• In this post, we dive deeper into the drivers of the current underperformance and highlight the medium-term upside potential.

Cloud spend optimization

There are two effects that are driving a temporary slowdown in enterprise spending (1) fear of recession is forcing companies to cut spending (2) after two years of robust growth, companies are optimizing their cloud spend.

Fortune 500 decision makers expect a dramatic slowdown in IT spend. Per a recent ETR survey, respondents expect 2023 IT spend to grow only 1.4% vs. expectations for 4.4% yoy only 2-3 months ago (based on data surveying over half of the Fortune 500).

Interestingly, cloud spending is expected to fare worse than the average IT spending. In addition to broader slowdown in IT spend, companies are optimizing their cloud usage and delaying new projects.

Per Microsoft's F2Q23 earnings call, the company expects the optimization to last several quarters (but not years). Microsoft noted that in addition to the delays, "when the new projects start, they don't start at peak usage... They start and they scale. So the two cycles are creating an air-pocket in demand".

Not all cloud companies are the same

According to Gartner, the global spending on public cloud services totaled $490.3bn and is expected to grow to $590bn. The three large areas for cloud spending are Infrastructure (PaaS and IaaS) and Applications (SaaS)

• Cloud infrastructure (PaaS) and (IaaS) represented ~50% of the total ($227bn). The hyperscalers (AWS ( AMZN ), Azure ( MSFT ), GCP ( GOOG , GOOGL )) represented 70% of that.
• SaaS applications represented ~35% ($167bn). The use cases for SaaS are very broad (from CRM systems to design software). Within SaaS, there are several new entrants that sit on top of the cloud infrastructure platforms and provide ways of using the platforms more efficiently and securely, e.g., separating storage from compute, sharing data without having to store it twice, etc.

There are several different types of business models within cloud. In general, the infrastructure services are project-/decision-based and many of the application that sit on top of the infrastructure platforms are consumption-based.

Consumption-based businesses models were the first ones to go into the downturn, and the companies noted deteriorating demand since 1H22 (e.g., Snowflake ( SNOW ) pointed to optimization efforts, Datadog ( DDOG ) noted weakness in their logs business). As we went through the year, the consumption side stabilized at lower levels, but the headwinds broadened to the project side, where recession fears started influencing investment decisions (e.g., hyperscalers just started experiencing demand softening in the second half of 2022).

We believe that while the hyperscalers may be facing 1-2 more quarters of weaker demand, the consumption-based models will start facing easier comps.

Interestingly, this cyclical downturn in IT spend is coming at a time when Artificial Intelligence ((AI)) adoption is reaching an inflection point, creating a meaningful medium-/long-term tailwind for many of these companies.

Strong medium-term outlook driven by AI inflection

AI is undergoing a significant breakthrough driven by several successful applications of a new foundational model (Transformer) in large language model training. The Transformer model is a neural network that learns context and can therefore be used for "generative" rather than "predictive" applications.

We believe that this will be transformational for many industries and has already generated a fair amount of hype. But investors are not appreciating the amount of data and compute power that these applications will require, which will likely provide a meaningful tailwind for cloud spending.

According to an ETR report surveying companies and their budgets, the cloud spending CAGR (for PaaS and IaaS) may be as high as 67%. Among all respondents, the median annual spend on IaaS/PaaS is currently $375,000 and is expected to increase to $1,750,000 in 3 years. Looking at large organizations, spend is currently $750,000 today but is expected to increase to $3,750,000 over that same time period.

These spend projections tie to commentary that we are hearing from companies, such as Snowflake. Once their costumers see what they can do with their data, the spend grows exponentially. While we are using a more conservative ~40% growth estimate, we believe that there is room for upside.

Another interesting observation from the same survey is that respondents expect that while AWS and Azure will remain the top platforms, there will be an opportunity for new entrants and smaller players to gain market share.

In summary, while recession expectations are impacting cloud spending, several quarters of below-trend spend could create pent-up demand as we go into what we expect to be a meaningful AI-driven investment cycle.

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