Cloud digestion has continued into Q1 19. Our Cloud CapEx indicator (Figure 1) signals a decline in cloud spending growth in Q1 2019. The CapEx for the top 14 companies with exposure to cloud computing was down 1% YoY. A sharp reversal from the 19% YoY growth in Q4 18. We see lower spending for all 14 companies. The top 5 hyperscales (Figure 2) exhibit a similar trend and declined 1% YoY with Alibaba (BABA) and Google (GOOGL) experiencing the largest decline in spending. BABA’s CapEx declined 34.5% YoY while GOOGL’s CapEx declined 43.2% YoY. In our view, there may still be some weakness in cloud spending for Q2 and Q3 due to lower guidance of these companies. But we are starting to see new sprouts as hyperscales such as Microsoft (MSFT) reaccelerated CapEx. Component vendors, especially in the optical space, are seeing a pickup in demand for the later months of Q1.

Cloud services revenue growth of the hyperscales remain strong against the backdrop of enterprises switching to hybrid cloud.  Despite ongoing cloud digestion, cloud services revenue growth for hyperscales remain robust. Amazon Web Services (AWS) and Microsoft Azure recorded 42% and 75% constant currency YoY growth YoY respectively for Q1. Amazon (AMZN) noted continuing momentum in enterprise migrations to AWS, with usage growth higher than revenue growth rates. In terms of data centre pipeline, AWS continues to expand its infrastructure as it launches AWS Hong Kong Region (data centre) in April. It also announced plans to add 12 more Availability Zones and four regions in Bahrain, Indonesia, Italy, and South Africa. The recent Q2 results for MSFT also affirmed the continued enterprise demand as constant-currency bookings growth was 25%, driven by larger long-term Azure contracts. MSFT highlighted that CapEx growth for Q3 would be flat following the large increase in CapEx growth for Q2. MSFT also guided that Intelligent Cloud revenue will grow by 2 points (21% Constant-Currency YoY in Q2) despite softer capex growth. Similarly, GOOGL reported strong growth in Cloud services revenue and expected sequential dollar increase in capex as they meet growing customer demand.

Mixed results from component vendors signal softer cloud CapEx for Q2, but most affirmed that cloud digestion is fading. On the memory semiconductors, Seagate (STX) reported exabytes shipment down 12% QoQ and guided flat business environment in Q2 with similar demand conditions across all end markets. Western Digital (WD) also noted a slowdown in investments from hyperscale customers. They expected exabyte shipments to be flat to slightly up for Q2. As for data centres, results were largely mixed. CyrusOne (CONE) reported strong demand from US hyperscales in Europe (Dublin, Amsterdam and London) while Digital Realty (DLR) pointed out that cloud remains in digestion mode for Q1, but there would be greater demand from hyperscales for connected campus colocation services.

Networking also echoed mixed results. Arista (ANET) saw less than normal order strength in late March and in April while Juniper (JNPR) saw a pickup in orders towards the end of Q1. ANET guided that Q2 will remain in a period of absorption after the excess purchases from hyperscales in 2018, while JNPR expected the momentum to improve over the next few quarters. ANET also reaffirmed that 400G spend is not expected until ZR (Extended Reach) optics are available mid next year. We expect hyperscales to continue deploying 100G until the infrastructure is available and it is unlikely for them to make a sudden transition to 400G. As hyperscales typically provide one or two-quarters of CapEx forecast to networking, we look towards the Q3 guidance in the upcoming month to firm up our expectations for 2H. On the optical side, no one has noted cloud digestion. Both Acacia (ACIA) and Ciena (CIEN) implied that the optical space is less dependent on CapEx growth as hyperscales are prioritising capacity expansion and improvements in network utilisation.

Cloud CapEx pipeline remains strong amidst the slowdown. We see long-term CapEx remain optimistic as hyperscales and tech firms continue to expand data centre buildouts. GOOGL announced in June to invest US$1.1bn to build a new facility in Amsterdam and expand its existing site north in Eemshaven. Early this year, Apple (AAPL) announced that it would build a second data centre in Ulanqab City in the Mongolian Autonomous Region. Facebook (FB) reaffirmed its strategy to expand its data centre presence in Asia following the shift of its user base growth to Asia.

Recommendation

We are encouraged by the pickup in orders towards the end of Q1 and positive guidance from most of the component vendors for the next few quarters. Except for memory, we believe cloud spending will likely reaccelerate in 2H 19 as hyperscales exhaust their excess capacity from the purchase in 1H 18. As enterprises migrate workloads to cloud at a faster pace, we think cloud computing remains a great opportunity in 2019. Therefore, we remain OVERWEIGHT in the cloud computing industry.