Hyperscaler Q3 2022 Earnings Review

As we kick off Q3 earnings season for software infrastructure companies, the hyperscalers set the tone with mixed results. AWS and Azure experienced further deceleration in revenue growth, while Google Cloud surprised with a slight acceleration. On the surface, one could conclude that the growth story for cloud infrastructure is coming to an end. However, I think the broader behaviors we are witnessing are expected reactions to tightening macro conditions following periods of robust spending over the last two years. Additionally, some other factors may be impacting the growth of the hyperscalers that are separate from demand for cloud infrastructure and digital transformation in general. Let’s look at the results.

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Microsoft Azure

Microsoft reported their quarterly results on October 25th. This encompassed the period from July to September 2022 and represents their Q1 FY2023 report. Microsoft’s cloud infrastructure service (Azure) falls under their Intelligent Cloud business unit. Leadership reports total revenue and operating expense for the business unit as a whole, but not down to the Azure level. For Azure, they provide revenue growth numbers and some commentary on contribution to expenses. Additionally, they provide adjustments to reflect changes in constant currency to normalize comparisons across time periods.

For the most recent quarter, revenue growth decelerated by 4% to 42% on a constant currency basis. Coming out of the prior quarter’s report, management had projected a slowdown of 3%, which would have delivered 43% growth. This quarter’s growth represents the slowest over the past two years. For the upcoming quarter (Q2 FY2023), management stated that they expect Azure revenue growth will be sequentially lower by 5% on a constant currency basis. This signals a growth rate of 37% next quarter. This quarter’s currency impact of 7% was the largest in the last two years.

Management attributed the slowdown to customers focusing on optimizing the use of existing workloads and prioritization of new workload migration. In the Q&A portion of the earnings call, in response to an analyst question, the CFO mentioned that optimization existed across all customer segments, but that small and mid-sized customers applied optimization more extensively than enterprise. She shared that those customers tend to work through the partner channel, which was likely more proactive in optimization exercises. Customers are still signing large commitments to Azure, but are trying to optimize their spend in the near term. Azure’s customer success teams are even incentivized to proactively help customers find efficiencies in their infrastructure utilization, as a retention tactic.

On the positive side, management highlighted another quarter of solid bookings and healthy demand across their commercial businesses. Azure Arc, their hybrid infrastructure product, now has more than 8,500 customers, which is double the number from a year ago. They also called out the direct connection between Azure and Oracle Cloud Infrastructure, which allows fast and secure access to Oracle databases. This is helping large enterprises like FedEx, GE and Marriott leverage both clouds. Azure ML revenue has increased more than 100% annually for four quarters in a row. GitHub is being used by 90M users and now generates over $1B in ARR. None of this activity reflects a reversal of cloud adoption.

Google Cloud Platform

Alphabet (Google) reported their Q3 FY2022 results on October 25th as well. Google reports results for the Google Cloud Platform (GCP) as part of the Google Cloud business unit. This also includes Google Workspace, their cloud-based collaboration tools for enterprises, with offerings like Gmail, Docs, Drive, Calendar and Meet. On the call, management stipulated that GCP grew faster than Google Cloud overall, but we don’t know by how much or the relative revenue split.

Unlike Azure or AWS (discussed shortly), the revenue growth rate for Google Cloud actually increased y/y from 36% to 38%. Sequential growth also ticked up from 7.8% to 9.4%. I think these trends can be generally extrapolated out to GCP performance. Management highlighted significant growth in both infrastructure and platform services. Looking forward, they didn’t provide guidance for Google Cloud, but are “excited about the opportunity, given that businesses and governments are still in the early days of public cloud adoption and we continue to invest accordingly.” They are also focusing investments in hiring and CapEx on the technology and cloud segments.

While the effect is not showing up in the revenue growth numbers, management did reference that certain customers are extending sales cycles and are committing to deals with shorter terms or smaller deal sizes. But overall, they are pleased with the momentum and plan to continue to invest in the business.

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AWS

Amazon reported their Q3 2022 results on October 27, 2022. Management provides total revenue for AWS directly, making growth rates easy to calculate. For Q3, they reported $20.5B in revenue for AWS. This was up 27.5% annually on an as-reported basis. Sequential growth was 4.1% over Q2. They did mention that AWS growth was 28% “excluding changes in foreign currency”. The annualized run rate for AWS is a staggering $82B.

Q3’s growth rate is down about 6% from Q2’s rate of 33.3%. Sequential growth was lower as well. This revenue growth rate appears similar to that of AWS back in 2020, when COVID-19 impacted IT budgets. Management mentioned that the growth rate dropped into the mid-20% range near the end of the quarter, implying this would likely be the starting point for Q4 growth. AWS did contribute the majority of Amazon’s overall operating income, as in prior years.

In terms of explanation for the slowdown in growth, like the Microsoft team, Amazon management highlighted cost optimization. They provided examples of transitioning customers to lower cost server tiers and shifting workloads to higher performance chips (lowering overall usage).

With the ongoing macroeconomic uncertainties, we’ve seen an uptick in AWS customers focused on controlling costs. And we’re proactively working to help customers cost optimize, just as we’ve done throughout AWS’ history, especially in periods of economic uncertainty. The breadth and depth of our service offerings enable us to help them do things like move storage to lower-priced tiers options and shift workloads to our Graviton chips.

Amazon Q3 Fy2022 Earnings call

Looking forward, management did highlight ramping up investments in AWS, adding product builders and sales personnel. They are also allocating capital for new infrastructure to meet capacity needs, add new geographic regions and enhance existing services. They are increasing their AWS investment by $10B y/y to innovate and expand the AWS footprint. Guidance does include a significant impact from foreign exchange of 460 bps for the business as a whole. They mentioned that customers are cutting their AWS budgets and trying to save money in the near term. The AWS team is helping them through this with optimization efforts.

The AWS backlog for Q3 was $104B, which is up 57% y/y. This compares to 65% growth in Q2 and 68% in Q1. Some customer segments have been more impacted than others, like financial services in mortgages and cryptocurrencies. Customers are looking to save money near term, relative to their long term committed spend. This was also different than 2020, when some industries did experience a surge in demand, particularly for those COVID-19 beneficiaries, which offset large reductions in spend from other industry participants.

Other Performance Indicators

While the recent quarterly results from the hyperscalers are indicating a near term slowdown in cloud infrastructure spend, Gartner just released a report on cloud spending that predicts the growth rate will be higher in 2023 than this year. They forecast that spending on public cloud services will increase 20.7% in 2023 to reach $591.8B. That is up from $490.3B in 2022. The growth forecast for 2022 is just 18.8%, indicating that cloud spend growth would re-accelerate in 2023 by about 190 bps. The analyst predicts that “Cloud computing will continue to be a bastion of safety and innovation, supporting growth during uncertain times due to its agile, elastic and scalable nature.” He does acknowledge the dependencies of this forecast on macro and IT budget stabilization next year. Further, he commented on the financial benefits of cloud spend.

Cloud migration is not stopping,” said Nag. “IaaS will naturally continue to grow as businesses accelerate IT modernization initiatives to minimize risk and optimize costs. Moving operations to the cloud also reduces capital expenditures by extending cash outlays over a subscription term, a key benefit in an environment where cash may be critical to maintain operations.

Gartner press release, October 2022

Of the segments of cloud spending, the analyst sees IaaS and PaaS being the primary beneficiaries. He predicts those two categories will experience 29.8% and 23.2% growth in 2023 respectively. This is higher than SaaS at 16.8% and other categories like business process (BPaaS) and desktop services (DaaS) growing more slowly.

Looping back on the current cost optimization efforts by enterprises reported by the hyperscalers, I can rationalize them. During COVID-19 in 2020 and 2021, IT budgets were flush with digital transformation projects and growth investment without strict cost controls. With IT budgets tightening this year, activities by enterprises would logically loop back on those efforts to find efficiencies and lower costs. In many cases, these represent a one-time reset, freeing up spend for newer projects. Once the efficiencies have been wrung out, we would likely see the pace of new investment resume. This assumes, of course, that we don’t enter a steep recession. Even then, IT projects can be viewed as deflationary by themselves.

As an example, I recently observed a cost optimization project for a start-up. The technology team reviewed their current spend on AWS and focused on those line items that represented the highest spend, looking for ways to reduce these. Often the changes were straightforward, involving setting realistic capacity ceilings for workloads and jettisoning experimental projects that are no longer relevant. Some examples of optimization activities were reducing the instance sizes dedicated to several RDS databases, turning off experimental services and archiving older log files to cold storage. In these cases, the company was simply taking advantage of savings that were available, after a rush in the prior year to set up new infrastructure. In times of flush IT budgets and rapid growth, it is easy to put off this kind of optimization work.

As a final data point, some other second-tier PaaS and IaaS providers are still experiencing healthy demand. IBM Consulting services grew by 16% year/year. This is down from 18% in the prior quarter, but not as distinct a drop as AWS and Azure. SAP reported accelerating cloud momentum, with cloud revenue up by 38% and now makes up 42% of the total. Backlog for their S/4HANA cloud product is up 108% y/y.

Most impressive has been the rapid growth of Oracle’s cloud offering, called Oracle Cloud Infrastructure (OCI). Oracle’s recent quarterly report on September 12th reflected 52% reported revenue growth y/y and 58% in constant currency for OCI. Larry Ellison, their founder and current CTO, predicted that 50% revenue growth for cloud services would continue. At their Analyst Meeting on October 20th, management reiterated their optimistic growth targets going forward. Interestingly, leadership has also been hinting at some upcoming announcements of big wins for OCI over the other hyperscalers. Larry Ellison specifically singled out AWS in a comment on the quarterly earnings call.

I personally have been talking to some of Amazon’s most famous brands that are running at AWS. And the AWS bill is getting very large, and they can save a huge amount of money by moving to OCI. And we, I expect next quarter, will be announcing some brands, some companies moving off of Amazon to OCI that will shock you. I’ll stop there.

Larry Ellison, Oracle Q1 FY2023 Earnings call

With all that said, I think we can expect volatility in cloud spend for the remainder of 2022 and even into 2023. A lot of this is being driven by the macro environment, where enterprises are hesitating to spend aggressively until they have a better sense of the direction for their businesses and the economy. It is natural to use this pullback as an opportunity to optimize their spend. This isn’t a signal that enterprises don’t value cloud infrastructure.

There will likely be some knock-on effects for the independent software providers that offer cloud software services on top of hyperscaler infrastructure. They too benefited from high spend in 2020 and 2021, and would also be logical candidates for optimization. However, as Gartner predicts, we will likely see this spend pick back up in 2023, as enterprises finish optimization work and renew investment in new digital transformation initiatives and migration of software workloads. We will also be lapping the difficult year over year comparisons from 2021 and early 2022, setting companies up for more normalized annual growth in the second half of 2023.

NOTE: This article does not represent investment advice and is solely the author’s opinion for managing his own investment portfolio. Readers are expected to perform their own due diligence before making investment decisions. Please see the Disclaimer for more detail.