Cloud spending optimization
There are two effects that are causing a temporary slowdown in business spending (1) fear of recession is forcing companies to cut spending (2) after two years of robust growth, companies are optimizing their cloud spending.
Fortune 500 decision-makers expect a dramatic slowdown in IT spending. According to a recent ETR survey, respondents expect IT spending to grow by just 1.41% year-over-year in 2023, compared to the 4.41% year-over-year expectations just two to three months ago (based on survey data from more than half of the Fortune 500 companies).
Interestingly, cloud spending is expected to outperform average IT spending. In addition to a broader slowdown in IT spending, companies are optimizing cloud use and delaying new projects.
According to Microsoft's Q2 2023 earnings call, the company expects the optimization to last several quarters (but not years). Microsoft noted that, in addition to the delays, "when new projects start, they don't start at peak usage… They start and scale. So the two cycles are creating a gap in demand."
Not all cloud companies are created equal
According to Gartner, global spending on public cloud services was US$490.3 billion and is expected to grow to US$590 billion. The three major spending areas for cloud are Infrastructure (PaaS and IaaS) and Applications (SaaS).
- Cloud infrastructure (PaaS) and (IaaS) accounted for about 50% of the total (US$ 227B). Hyperscalers (AWS (AMZN), Azzurro (MSFT), PCG (GOOG, GOOGL)) accounted for 70%.
- SaaS applications accounted for approximately 35% (US$167 billion). The use cases for SaaS are very broad (from CRM systems to design software). Within SaaS, there are several new entrants positioning themselves on cloud infrastructure platforms and offering ways to use the platforms more efficiently and securely, for example, by separating storage from compute, sharing data without having to double-archive, etc.
There are different types of business models within the cloud. In general, infrastructure services are project/decision-based, and many of the applications that sit atop infrastructure platforms are consumption-based.
Consumption-based business models were the first to decline, and companies noted a deterioration in demand starting in the first half of 2022 (e.g., Snowflake (SNOW) pointed to optimization efforts, while Datadog (DDOG) noted weakness in its log activity). Throughout the year, the consumption side stabilized at lower levels, but headwinds spread to the project side, where recession fears began to influence investment decisions (e.g., hyperscalers began to see weakening demand in the second half of 2022).
We believe that while hyperscalers may face another 1-2 quarters of weaker demand, consumption-based models will start to face easier tradeoffs.
Interestingly, this cyclical slowdown in IT spending comes at a time when the adoption of Artificial Intelligence (AI) is reaching a tipping point, creating a significant medium- to long-term benefit for many of these companies.
Strong medium-term outlook driven by AI inflection
AI is undergoing significant advancement, fueled by several successful applications of a new foundational model (the Transformer) in training large language models. The Transformer model is a neural network that learns context and can therefore be used for "generative" rather than "predictive" applications.
We believe this will be transformative for many industries and has already generated a fair amount of publicity. But investors aren't appreciating the amount of data and computing power these applications will require, which will likely provide a significant advantage for cloud spending.
According to an ETR report analyzing enterprises and their budgets, the CAGR for cloud spending (for both PaaS and IaaS) could reach $671,000. Among all respondents, the average annual IaaS/PaaS spend is currently $375,000 and is projected to increase to $1,750,000 within three years. Looking at large organizations, spending is currently $750,000 but is projected to increase to $1,750,000 over the same period.
These spending projections reflect the feedback we've heard from companies like Snowflake. Once their customers see what they can do with their data, spending grows exponentially. While we're using a more conservative growth estimate of around 40%, we believe there's room for upside.
Another interesting observation from the same survey is that respondents expect that while AWS and Azure will remain the best platforms, there will be an opportunity for new entrants and smaller players to gain market share.
In short, while recession expectations are impacting cloud spending, several quarters of below-trend spending could create pent-up demand as we enter what we expect to be a significant AI-driven investment cycle.
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Editor's note: The summary points in this article were chosen by Seeking Alpha editors.
This article was written by
Ivana Delevska is the founder and CIO of SPEAR Invest and portfolio manager of the Spear Alpha ETF (SPRX). She has worked for Millennium Management, Citadel Asset Management, and five years in sales at Deutsche Bank as a vice president, with Gordon Haskett as director of multi-sector companies. Ms. Delevska holds a degree in economics from the University of Chicago. SPEAR Invest specializes in fundamental research and industrial technology investments.
