US cloud titans bet big on AI

Sales for the North American tech sector grew 7.2% year over year and EBITDA grew 15.1%. Trailing 12 months sales grew 4.5%, indicating growth is accelerating. The robust EBITDA growth demonstrates significant operating leverage gained from the "year of efficiency" in 2023 when companies managed their costs very tightly.

There's somewhat of a bifurcation in the U.S. tech sector, highlighting a small number of very large companies exposed to cloud and AI that are doing much better than the industry average, while companies exposed to mature markets (e.g., PCs and smartphones) or markets undergoing inventory corrections (e.g., industrial, automotive, and networking equipment) are underperforming the average. Still, we view the current environment for U.S. tech as exemplifying midcycle conditions--and not indicative of a recession.

Another 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.

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.

US cloud titans bet big on AI

• Cloud giants are heavily investing in AI despite uncertain monetization timelines, with combined capital spending for Microsoft, Alphabet, and Meta up 60% year over year.
• Our global IT spending forecast remains at 8% for 2024, with cloud services robust while enterprise hardware and non-AI areas are weaker. We expect a stronger second half across most subsectors.
• Semiconductor industry revenue was up 18% year over year, but only 4% excluding memory and likely negative excluding AI chips. Memory makers are seeing skyrocketing prices, driven by strong AI demand and supply management.
• Rating trends in the U.S. tech were mixed for the first half of 2024, with negative actions slightly outnumbering positive ones. Companies with large floating-rate debt face increasing pressure from rising interest expenses.
   

Cloud giants pour investment into AI amid monetization concerns

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.

Christian Frank, Technology Director, S&P Global Ratings, says: "Cloud giants are heavily investing in AI despite uncertain monetization timelines, with combined capital spending for Microsoft, Alphabet, and Meta up 60% year over year.  Rating trends in the U.S. tech industry were mixed for the first half of 2024, with negative actions slightly outnumbering positive ones."