Cloud Giants Pour Investment Into AI Amid Monetization Concerns

S&P Global Ratings expects revenue from these three players to continue growing above 20% in 2025 as more AI capacity becomes available and demand for general purpose compute remains strong to support enterprises' digital transformations.  Growth trends for cloud services providers (CSPs) have improved over the previous couple of quarters owing to less defensive enterprise IT budgets. The optimization cycle that has played out over the past several quarters is drawing to a close because most of the easy opportunities have been captured. CSPs are seeing improved on-premises to cloud migrations and more new workloads. And AI workloads are coming online.

Amazon Web Services' (AWS) revenue growth accelerated to 19% year over year, up from 17% the previous quarter. Microsoft Corp.'s Azure posted an impressive 30% growth in constant currency. While the company guided for high-20% growth next quarter, it said revenue would accelerate in the second half of the fiscal year (ending in June) as more AI capacity comes online. Google Cloud grew 29% and Google Cloud Platform (GCP) growth was even higher. These figures are bolstered by strong leading indicators, with AWS's backlog and Microsoft's current remaining performance obligations (RPO) both growing at 19%. Azure and GCP are benefitting from multi-cloud strategies to reduce costs, gain buying power, and take advantage of ongoing aggressive pricing and credits to attract AI workloads.

AI is gaining traction, as demonstrated by the revenue run rate for AWS and Azure both in the multiple billions of dollars. AI contributed multiple billions to Google Cloud's revenue in the first half of 2024. Azure reported that AI contributed 8 percentage points to its growth, an increase from 7 points the previous quarter. The number of Azure AI customers surged by nearly 60% year over year and average spend per customer continues growing as usage expands across a wider range of models.

Overall, we believe the path to AI monetization and maturity will be longer than previously expected.The major players are making substantial capital expenditure investments to support AI initiatives despite concerns about the timeline for monetization. Microsoft, Alphabet, and Meta saw their combined capital expenditures (capex) grow by 60% year over year in the latest quarter, and we expect 50% growth for 2024. Meta raised its capex guidance for 2024 to $37 billion-$40 billion and signaled a significant increase for 2025. Microsoft, too, has indicated higher capex for fiscal 2025 compared with 2024 spending.

Google's Sundar Pichai captured the moment when he said that the risk of underinvesting is dramatically greater than the risk of overinvesting. New models are still being built and the cost is rising. Meta said that Llama 4 would take 10 times the compute to train as Llama 3. Beyond building the foundational models, solutions need to be built on top of them, which will take time. The lead time for building data centers is also long. Half of Microsoft's investments are for data center infrastructure with useful lives of 15 years or more. It will fill those data centers with compute based on demand signals. Furthermore, AI adoption by enterprises is still modest. They are still sorting through the proliferation of models and figuring out use cases. We think these factors point to a longer path to monetization and maturity than previously expected.

Cloud Supports IT Spending While Enterprises Restrain Other Categories

Our forecast for IT spending remains at 8% for 2024, but the environment is bifurcated between AI and everything else.   Spending on cloud services remains robust while the environment is weaker in enterprise hardware and non-AI areas (see "Midyear 2024 IT Forecast Update: Robust Cloud Spending Offsets Still-Cautious Enterprise Budgets," published July 17, 2024). Enterprises are delaying some noncritical, long-term projects but continuing cloud transitions. However, management teams generally have more confidence in the macroeconomic environment than six months ago. We expect a stronger second half of the year with signs of gradual recovery across most subsectors. Many segments are benefitting from the release of pent-up demand held over from 2023. The U.S. IT spending environment remains stronger than in Europe.

Smartphones

The smartphone segment is rebounding, with global unit growth of over 6% year over year for the second quarter according to International Data Corp. (IDC).   This is the third consecutive quarter of mid- to high-single digit growth, led by the recovery in Chinese original equipment manufacturers (OEMs) who are doing well in Latin America and Africa. In the second quarter, Samsung Co. Ltd. and Apple Inc. grew units in the low-single digit area while Xiaomi Corp. and Vivo S.A. grew more than 20%. Competition is increasing among the leaders and pricing tiers are becoming polarized. Apple and Samsung win at the high end and benefit the most from premiumization. Chinese OEMs push the low end to capture volume share amid weak demand.

In addition to strong performance by Chinese OEMs, Apple did better in China. Its revenue in the country was down just 3% in constant currency last quarter compared to 8% last quarter and 13% the previous one. Also, Qualcomm Inc.'s China OEM revenue grew more than 50%.

AI smartphones are coming. Samsung has already rolled out an AI-capable phone. Apple will potentially roll one out in 2024. We expect Apple units to be about flat in 2024 but it will benefit from higher average selling prices (ASP) on AI phones in 2024 and into 2025. We expect the AI upgrade cycle to be bigger than 5G for all OEMs with the potential for a longer cycle beyond 2026 with rapid advancements in AI features

Personal computers

The PC market continued a tepid recovery with units growing 3% year over year according to IDC, the second quarter of low-single digit growth after eight quarters of declines from the COVID-related peak.   The past four quarters totaled 260 million units, consistent with levels before the onset of the pandemic. PC sales in China have been weak. Excluding China, units would have grown 5% last quarter. We expect a stronger second half on enterprise upgrades to get ahead of Windows 10 end of life and to refresh an aging installed base. AI PCs should boost units too, and they'll have an outsized impact on revenue given their higher ASPs. We expect these trends to accelerate growth in 2025. The market has overcome excess inventory from last year leading to unit growth and revenue will likely benefit from a better mix of higher-end configurations and reduced discounting.

Servers and storage

We expect an improvement in the server and storage segments for the second quarter and for the momentum to continue in the second half of 2024 due to pent-up demand requiring a refresh cycle and AI servers.   We see improvement in servers in the second half of the year compared to the weakness of the first half. The inventory correction is no longer a headwind. We expect AI server shipments to double in 2024, while we don't expect AI to benefit storage until 2026. AI server OEMs are starting to benefit from tier 2 cloud players and enterprises. We expect server units to grow 12% in 2024 but revenue may grow in excess of 50% due to high AI server ASPs.

Networking

Networking is weak on inventory digestion and there has been a shift in spending to refresh other IT priorities like compute.  Customers have lower appetite for large projects and there are more delays. We expect these conditions to extend for another quarter or two after which OEM sales should rise as they more closely match end consumption.

Software

Software is slowing down on alternative AI spending and increasing budget scrutiny, but we still expect it to grow 10% in 2024.   Some pressure is starting to emerge for some seat-based software-as-a-service (SaaS) companies as enterprises slow hiring and implement restructurings. Buying decisions have been cautious over the past two years. It's taking longer to make decisions, especially for large deals. Conversion rates are lower and there are more "no decision" outcomes. Enterprises are focusing on the top one or two priorities, leading to weakening demand for projects outside the core. Software needs to demonstrate a clear value proposition to get funded. The killer AI application has not yet emerged in software. Software makers are holding on until they can deliver more AI features with a demonstrable return on investment (ROI).

AI

We expect global AI spending to grow in the high-20% area through 2028 when it will be 14% of total global IT spending, up from 6% in 2023.   However, we believe spending will be lumpy given the concentrated customer base among hyperscale datacenter operators. The proliferation of new and quickly evolving models and products is causing some paralysis in decision-making among enterprises. We also think enterprises are pushing out AI projects due to low confidence in the use cases and a lack of reference architectures. We expect to see more projects come online in 2025.

Microsoft is the top beneficiary of enterprise AI spending by a wide margin. Microsoft 365 Copilot customers were up more than 60% quarter over quarter and daily active users doubled. In addition, Microsoft 365 Copilot appears to be sticky with a majority of customers returning for more seats. We believe AI budgets are coming partially at the expense of hardware and from software to a lesser extent, but a good portion of AI spending is incremental.

Intel On CreditWatch: Large Gross Margin Miss, Weak Revenue Guidance

We placed our 'A-' issuer credit rating on Intel Corp. on CreditWatch with negative implications on Aug. 2 following a large gross margin miss and weak revenue guidance. Non-GAAP gross margin came in at 38.7% compared with guidance of 43.5% due to an accelerated ramp of its AI PC product, shifting Intel 4 and 3 wafers from Oregon to Ireland, which will yield long-term cost savings, charges related to noncore businesses, charges for unused capacity, unfavorable product mix, and more competitive pricing.

Guidance for next quarter is for gross margin to fall to 38% and for revenue to grow only 1% at the midpoint of guidance due to weaker spending across consumer and enterprise markets, especially in China.

The second half of 2024 will be more challenging than anticipated as customers decrease inventory and the company will likely miss cash flow and possibly leverage targets that we view as consistent with the rating. The company will implement a headcount reduction targeting more than 15% of the workforce by 2025 that will yield operating expenses 20% below prior estimates and a reduction in 2024 gross capex of more than 20% of the original plan. The company also suspended its remaining dividend. It is unclear to us if these steps will be sufficient to maintain competitiveness and enable healthy growth.

We see a challenging road ahead with good execution required to meet the company's goal to deliver production wafer start volumes in the first half of 2025 on Intel 18A, the core process fueling its internal manufacturing and system foundry approach. Intel will face inventory corrections in the second half of 2024 and we see risk of additional share losses to Advanced Micro Devices Inc. (AMD) in the data center segment. Despite the cuts to gross capex plans, spending will remain very high at around 50% of revenue for 2024. AI PCs are a growth factor for the company as it remains on track to ship more than 40 million units by year-end and over 100 million cumulatively by the end of 2025. AI PCs carry higher average selling prices than general purpose PCs.

We will resolve the CreditWatch placement after reviewing the business outlook with management in the coming weeks.

Memory And AI Lead The Way In Semiconductors; Broad Markets Struggle

In the quarter ended in June, the global semiconductor industry revenue was up 18% year over year but only 4% excluding memory.   If we exclude AI chips, the quarter was very likely negative. Broad markets were weaker than expected due to inventory corrections and crowding out by AI spending with NVIDIA being the main beneficiary. We believe the second quarter was likely the bottom. Next quarter will likely look better with most end markets expected to improve albeit off a low base. We also expect the recovery to be gradual through the end of 2024, with potential for acceleration in 2025 as edge AI products become more prominent. For 2024, we expect the global industry to grow 18%, 8% excluding memory, and negative 2% further excluding NVIDIA.

The inventory correction is taking longer in the industrial market following excess shipments in 2023. Demand is recovering underpinned by edge applications supported by decent macroeconomic conditions. We expect long-term demand to remain strong from the proliferation of smart machines requiring connectivity. Bookings are growing quarter over quarter from a low base while cancellations and push-outs are stabilizing.

The automotive market also faces inventory corrections on top of weak demand generally--and a slowdown in electric vehicle growth specifically--as well as softness in China.   We expect the automotive correction to continue for a few more quarters, while industrial may have already bottomed. We also believe the automotive correction will be shallower because of still growing content per vehicle and long-term trends toward electrification.

Analog segment revenue was down 4% year over year while microcontrollers (MCU) were down 22%.   This reflects a longer, more gradual correction in analog, which has seen six quarters of decline compared to two quarters of sharp declines for MCU. In fact, analog is down 15% against the same quarter two years ago, compared to MCU, which is only down 12%. We think the second quarter is very likely the bottom for analog and probably the bottom for MCU. Industry bookings are growing sequentially off a low base, with the book-to-bill ratio improving but the recovery will be gradual through the end of 2024 with potential for acceleration in 2025. We think analog is poised for a better recovery because the correction has been more gradual.

Pricing pressure is a key risk.   Pricing rallied due to a surge in demand and supply shortages following the onset of COVID-19. While we believe the industry has made some price concessions in recent quarters, pricing remains well above pre-COVID levels. The industry could experience more mean reversion if the macroeconomic picture worsens, hurting demand.

In the data center segment, AI chips are leading the growth while general purpose chips squeeze out modest gains.   Between Intel and AMD, data center grew 31% year over year and 9.4% quarter over quarter. Stripping out the changes in AMD's graphics processing unit (GPU) business, we estimate general purpose data center revenue grew about 10% year over year and 2% quarter over quarter. While Intel was flat sequentially, AMD was up 21% mostly due to AI but also on some general purposes share gain. Given Intel's execution issues, we expect AMD to pick up share over the next 12 months.

The outlook for AI in the data center remains robust.   Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC) said cloud AI demand remains too strong to fulfill all requests, which bodes well for NVIDIA. We believe supply will likely stay tight through 2025 with the possibility of easing in 2026. In this context, TSMC is raising prices. AMD increased its 2024 AI revenue guidance to $4.5 billion from $4 billion. It had over $1 billion in AI revenue last quarter and we estimate about $1.6 billion in the first half of the year so the guidance suggests more sequential gains through the rest of the year.

Intel's client segment grew revenue 9% year over year as the AI PC ramp contributed to higher volume and pricing.   In the third quarter sequential revenue growth will be below seasonal norms, with Intel's client segment expected to be flat to down on some inventory digestion.

Memory Makers Enjoy Skyrocketing Prices

The memory market had another superlative quarter with dynamic random access memory (DRAM) revenue up 97% year over year and NAND up 87% owing to a significant price recovery with DRAM prices up 90% and NAND up over 130%. The industry is seeing very strong demand for AI applications, which include high bandwidth memory (HBM) in DRAM and enterprise solid state drives (eSSD) in NAND. The players have curtailed capex investment and made production cuts in legacy products to align supply with demand. They are shifting capacity to HBM from general purpose DRAM, which is tightening the supply of general purpose DRAM and pressuring prices higher. Restocking demand is also high in DRAM. Demand is very strong from the data center market, but muted in other markets like PC and smartphones. Our recent upgrade of SK hynix Inc. to 'BBB', with a stable outlook, reflects the strong industry outlook for the HBM market leader.

For the year, our forecast calls for memory industry revenue to be up 60%, after a 40% cumulative decline from 2021 to 2023, and the risk is to the upside. Excess inventory is falling, PC and smartphone markets are stabilizing, and demand for AI applications will remain strong, driving a richer mix. Edge AI devices will catalyze more demand in the second half of 2024 and in 2025. We see ongoing price increases through the end of the year due to the players' supply actions.

While DRAM benefitted from higher bit shipments and higher prices, NAND bit shipments actually fell. NAND supply actions were so significant they drove skyrocketing prices despite lower volume and NAND revenue growth was comparable to DRAM. The shrinking NAND bits shipments resulted from the slow demand recovery in consumer-facing end-markets such as PC and smartphone, and elevated inventory in these segments. Western Digital's NAND gross margin was 36.5% compared to the guidance range of 32%-34% and we think margin could climb multiple percentage points next quarter. We consider these levels to be slightly better than midcycle conditions, which we did not expect to see until 2025.

The players are increasing their capex budgets after a period of curtailment but this is constructive because the investments will support AI products, particularly in DRAM, which are more capital intensive. NAND capex remains well below the peaks with no pick-up anticipated for several quarters, which should keep prices firm. We expect supply to remain tight in 2025, despite these increasing investments.

U.S. Tech Ratings Trends Mixed Since Last Earnings

Negative rating actions outnumbered positive ones in the first half of 2024.   A common theme has been companies with large floating-rate capital structures, usually leveraged buyouts, facing increasing interest expense in addition to challenges in their businesses resulting in weakening cash flow and liquidity, thereby increasing default risk. Since the last earnings reports, three negative actions on U.S. tech companies fit this profile. Our downgrade of Magenta Buyer LLC (dba Trellix and Skyhigh Security) to 'CCC' from 'CCC+', due to what we considered an elevated risk of a default or distressed transaction within the next 12 months. And the revision of our outlooks to negative from stable for 'CCC+' rated Quest Software US Holdings Inc. and 'B-' rated Project Leopard Holdings Inc. (dba Tungsten Automation.

Most of our positive actions were on companies rated 'BB' or higher.   We based the revision of our rating outlook to positive from stable on Analog Devices Inc. on the potential for us to take a more positive view of the business within the next 12 to 24 months, pending its recovery from a recent inventory correction. A counterexample is our upgrade of MicroStrategy Inc. to 'B-' from 'CCC+' based on an incrementally more positive view of the bitcoin ecosystem. We are still skeptical of long-term durability so we do not net the value of its large bitcoin holdings against its large debt issuance, but our view became incrementally more constructive.

Other notable actions include our CreditWatch placement of Intel Corp. due to performance challenges and very large investments, and the revision of our outlook on Pitney Bowes Inc. to developing from stable on the strategic review of its e-commerce business. A divestiture could be favorable, while a winddown could result in business disruption or significant implementation costs.

Defaults have been surprisingly few in U.S. tech given the rapid increase in rates and some very highly leveraged capital structures. Most companies have been able to adjust their cost structures or get by with their higher interest burdens. Nevertheless, since the last earnings reports, we determined that a debt exchange by Astra Acquisition Corp. (dba Anthology) constituted a distressed exchange due to unfavorable changes in priorities for some lenders, and we revised our issuer credit rating to selective default ('SD').

There is not yet enough information available to merit a rating action on CrowdStrike Holdings Inc. following the July 19 global outage caused by an update to its Falcon agent (see the bulletin published July 19, 2024). The company is in a strong position to deal with the fallout with $3.7 billion in cash and significant cushion within the rating parameters. It would take a $4.5 billion swing in net debt for the company to reach our 2x downgrade threshold. The company's response has generally been viewed favorably. Management was quick to respond, it was transparent, and rolled out a fix quickly. The incident occurred on July 19 and by July 25, 97% of Windows sensors were back online. On July 31, 99% of Windows sensors were online.

Nonetheless, it could take months to fully understand the impact to the company. The risks we see include revenue loss, reputational damage, costs to respond, and litigation. We think the first two are well mitigated because the company's response was good and the problem stemmed from a development operations (DevOps) mistake that we think will be effectively mitigated, rather than a breach in the security of its products, which are considered by the market as best of breed. We think costs to respond should be low because the company rolled out the fix quickly and now 99% of systems are online. Litigation risk is more opaque at this point. Global losses from the incident may go into the tens of billions of dollars. CrowdStrike's contracts may limit its liability to fees paid by customers, but we are uncertain about how legally impenetrable the contracts are. We will monitor new developments regarding this matter, particularly litigation risk, and update our credit rating rationale as it changes.