Microsoft (US: MSFT), Amazon (US:AMZN) and Alphabet (US:GOOGL) may be the darlings of the market, but right now the only thing investors really care about is their cloud-based performance. Microsoft and Alphabet both reported their latest third-quarter results on the same day, and both beat consensus expectations. However, Microsoft’s share price rose by 4 percent and Alphabet’s fell by 9 percent.
The reason? Microsoft’s profit pace was built on the back of cloud computing while Alphabet’s depended on a recovery in its ad 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 extra growth came from artificial intelligence (AI), with chief financial officer Amy Hood confirming that around three percentage points came from AI services. “While trends from (the) previous quarter continued, growth was above expectations, primarily driven by increased graphics processing unit (GPU) capacity and better-than-expected GPU utilization of our AI services,” Hood said.
In the three months to September, Alphabet’s revenue rose 11 percent to $76.6 billion (£63 billion), which was 1 percent above market expectations. Meanwhile, earnings per share rose 46 percent to $1.55, more than 6 percent ahead of analysts’ forecasts. The problem was Google Cloud. It grew “only” 22 percent year-on-year, down from 29 percent last quarter and below what analysts were hoping for.
On Thursday, Amazon’s share price rose just 5 percent despite earnings beating broker expectations. Between Monday and Friday of that week, the share price was basically unchanged. This apparent disappointment was again linked to its cloud division, which earned $23.1 billion – slightly below the $23.2 billion forecast. This 12 percent year-over-year growth was the same as last quarter. Thankfully for investors, earnings per share of $0.96 were more than 60 percent above expectations, thanks to a surprisingly strong performance from its retail and advertising businesses.
On the earnings call, CEO Andrew Jassy was keen to allay concerns that the company had fallen behind in the AI race. He mentioned the custom Trainium chip it has designed, the recent deal with OpenAI competitor Anthropic and its “AI-as-a-service” platform called Bedrock. He name-checked clients building AI apps on the platform, including Adidas, Booking.com, Rex (REL), Merck (DE:BRAND) and United Airlines (US:UAL).
In total, the phrase “generative AI” was used 31 times on the call as management was on point. “It’s a giant new generative AI opportunity that I believe will be tens of billions of dollars in revenue for AWS in the coming years,” Jassy said
Microsoft, Alphabet and Amazon’s share prices have risen this year, not because of their legacy companies, but because of their cloud computing potential. All have spent billions on investments to build out the physical infrastructure needed for widespread use of AI.
Microsoft’s big advantage
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 companies, which is struggling to break even. AWS has an operating margin of 30 percent, but it only represents 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 upside 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 economy at large.
The advantage of Microsoft is the crossover with its legacy business. Microsoft has more than 300 million Office 365 users, most of whom use its software “on-premise”. In other words, they downloaded the software to their own computers and servers, instead of accessing it through Microsoft Azure.
Now, through its strategic investment in OpenAI, Microsoft has moved ahead of its competitors. It has already launched Github Copilot, an AI assistant that speeds up coding and has more than 1 million paid users and 37,000 organizations subscribed. It is now rolling out 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 base of customers to which it can sell its AI products for more. “Microsoft is still at the beginning of a big opportunity with AI and we think its cloud product could reach 50 percent of its install base,” said Dan Ives of Wedbush Securities.
A couple of weeks ago, Insider reported that Amazon had signed a $1 billion contract with Microsoft for its cloud productivity tools. Jefferies analyst Brent Thill thinks this deal shows how trusted 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 AI tools,” he explained.
In order to use these AI products, customers must be on the cloud. The software was traditionally run “on-premise”. But the computing power required to run AI-enabled software means it has to be done on the massive cloud servers. For Microsoft, it can go to its existing customers, sell its new AI software, and then transfer them to the cloud.
IT service company Replacement Technology (BYIT), Microsoft’s largest retail partner in the UK, is starting to capitalize on the AI interest. In the six months to August, gross invoicing increased by 38 percent compared to the previous year. “We’ve been inundated with questions about AI and how we’re going to prepare to bring these technologies and what kind of infrastructure they need,” CEO Neil Murphy told Investor’s Chronicle last week.
Cloud exposure, without the rest
If investors just want exposure to cloud computing, there are companies in software infrastructure that aren’t held back by any slow-growth legacy companies.
Cloud monitoring company Datadog (US:DDOG) allows customers to monitor their technology stack and collect data on cloud usage, network traffic and memory. It’s rather like having a smart meter for 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 grew 24 percent to 2,990. It has just announced a large language model (LLM) “observation solution.” 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 infrastructure recipient is cloud data storage and analytics companies Snowflake (US:SNOW). Its software allows customers to collect and analyze their data in the cloud, and with the growth of generative AI, the returns on being able to organize and process data grow significantly.
Its new product, Snowpark, lets customers train AI models on the underlying Snowflake data, rather than feeding it into the platform, cleaning it, and then exporting it to train and run their own models. Snowflake’s revenue of $2.1 billion in the year to 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 problems that arise will become cheaper. Research from GitHub showed that developers are 55 percent more efficient with Github Copilot. Of course, these exact numbers are debatable, but AI is undeniably making development easier. That means more software solutions to problems and more data to analyze and more cloud infrastructure services.
Soon all telephone communication will take place in the cloud. Year 2025, BT (BT.) is shutting down its public telephone network (PSTN), which will force all communications over fiber optic cables. This is part of the investment case for Gamma Communication (GAMA), whose software enables businesses to make calls over the Internet using their existing phone numbers. This will be in the cloud, where conversations will be stored as data and presumably used to build AI call center products. Read more about Gamma here.
As the economy stumbles, it’s rare to find growth in places unrelated to cloud computing, data storage, and generative AI. With billions of dollars invested, it has to work. Even small stumbles towards this promised future can be hugely damaging.
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