U.S. tech companies are facing a significant inventory correction as their customers draw down excess inventories built up in response to supply chain shortages that are now easing and increasing macroeconomic concerns that weigh on demand. Our forecast for global IT spending growth of 3.3% in 2023 depends on a second-half rebound that could be boosted by a recovery in China after it dropped most of its COVID-19 restrictions. Memory is the weakest part of the market given its exposure to falling mobile, PC, and data center markets, and their products face the most severe inventory corrections that we don't expect to ease until the second half.

"…the most significant inventory decline at our customers that we've seen in recent history"  In describing the inventory correction at Intel's customers on the latest earnings call, CFO David Zinsner captured the essence of the operating environment for U.S. tech. Inventory destocking is hitting every end market--smartphones, PCs, and data center. Even industrial, which we expect to provide good long-term growth, is taking a hit. Automotive remained strong because its supply was so tight and demand so robust over the last three years that backlogs are still very large, evidenced by NXP Semiconductors N.V.'s guidance for its auto segment to be up in the midteens percentages next quarter on a year-over-year basis.

The inventory correction touches memory, digital and analog chips, hard disk drives, servers, and storage. Networking equipment is the firmest product category because it is in the middle of a product upgrade cycle and supply has been constrained (although it is easing marginally) leading to still robust backlogs and long lead times. Enterprises are delaying projects due to a cautious macroeconomic view, lead times are coming down, and customers are double ordering and canceling orders less.

We expect this inventory correction to play out over the first half of 2023 before a rebound in the second half. This coincides with our view for an improving macroeconomic environment with U.S. real GDP declines in the first half followed by growth in the second spurring IT budgets to loosen, and our view that easing COVID-19 restrictions in China will drive a rebound in tech demand, smartphones in particular. We expect hyperscale data centers to pause investment growth and digest their inventories, but they face such insatiable demand that they will need to resume spending to keep up despite their efforts at streamlining their data centers. Production cuts should speed inventory drawdown at the expense of gross margin over the next quarter or two, and falling input prices and logistics costs will stimulate some demand at the margin. We expect all these trends to culminate in the second half.

For our comprehensive outlook for 2023, see our "Industry Top Trends 2023: Technology," published Jan. 23, 2023.

Hyperscale Spending Growth On Pause

In line with other end markets, we expect spending growth from hyperscale data center customers will pause in the first half as they focus on optimizing spend and digesting inventory. To be clear, spending from these players will still grow around 10%, just much slower than the more than 20% growth in 2022 which has been more the norm as revenue growth among the participants had fallen in the 30%-50% range over the last few years. Meta is the most significant contributor to the slowdown guiding spending to the $30 billion to $33 billion range compared to $32 billion from the year before which grew 66%. Similarly, its revenue growth will be below that of prior years but remain robust. Amazon Web Services revenue growth fell to the midteen percent area in January from 27% in the third quarter, Google Cloud slowed to 32% in the fourth quarter from 38% the quarter before, and Microsoft Azure revenue exited last quarter at a constant currency rate in the mid-30% area compared to 42% last quarter. Even during slowdowns, these hyperscale companies sustain good growth, which we expect to accelerate when the macroeconomic picture improves in the second half. We think this means that inventory digestion cycles in this segment will be shorter lived and the rebound will be sharper than in markets like smartphones or PCs.

Two trends in this space that bear watching are new rollouts of AI services and rationalization of data center architectures. We believe Microsoft's partnership with OpenAI represents an inflection point for a broader roll out of more AI products after years of research. Since then, the Financial Times reported that Google invested in OpenAI challenger Anthropic, Google announced it will make its chatbot Bard more widely available in the coming weeks, and it recently launched an event on Feb. 8 to share more about its AI work. Separately, we note that many of these companies are depreciating data center assets over longer periods which we believe reflects a real extension of the useful lives of their equipment that allows capital spending to grow slower than revenue. Also, Meta announced data center architecture changes aimed at drawing down capital spending as a percentage of revenue. They involve designs that will support both AI and non-AI workloads in the same location, and more phased build outs with smaller footprints and less capital outlay up front but that can be scaled up quickly if needed. This may be a headwind to aggregated spend (although increasing AI workloads are more capital intensive) but phased rollouts should moderate the volatility of capital spending.

China Reopening Impact To Be More Second-Half Weighted

China will be an important market in 2023 because while it accounts for just 10% of global IT spend, it makes up 20% of hardware and semiconductor outlays, and our base case incorporates an expectation for a second-half rebound driven in some part by China reopening. For now, the boost to demand has been minimal possibly due to the spike in COVID-19 cases after the Zero-COVID policy was scuttled; Qualcomm Inc. and NXP confirmed this view. Reopening is also important for keeping supply chains running. We estimate the COVID-19 lockdowns in Zhengzhou had at least a $6 billion impact on Apple's iPhone revenue, a level we had not seen since the last December quarter.

China's most important demand center for U.S. tech is in smartphones as it represents 25% of global consumption. In 2022, Chinese smartphone units fell 13% according to IDC, but Apple picked up share, only declining 4% while Oppo, Vivo, and Xiaomi fell in the range of 20%-30%, demonstrating the cyclicality of the low- to mid-range models and the resilience of high-end ones. The global market reaching our forecast for 1% unit growth in 2023, even after an easy comparable period in 2022 during which units declined 11%, requires a marked improvement in the low- to mid-range segment in China in the second half. Reopening is particularly important because retail channels account for 70% of smartphone sales in this market.

Bad Memory Turning Into A Nightmare

The depth of the memory downturn is hard to overstate. Industrywide, DRAM revenues were down 48% year-over-year last quarter with NAND down 45%. ASPs were down in the 20%-30% range quarter-over-quarter, but bit shipments were up which we think points to opportunistic buying which will leave inventories elevated for longer. The major end markets are all weak. PC has reverted from high levels as buying to support work-from-home has run its course. Smartphone demand has sunk, particularly from Chinese OEMs. Hyperscale data centers are starting to digest inventory and slowing data center builds next quarter.

We expect memory revenue to be down 35% in 2023, which includes an expectation for a second-half rebound. Guidance for next quarter is in line with this view. Micron said revenue would be down more than 50% year-over-year at the midpoint of guidance. We think Western Digital's comments point to NAND revenues being down in the mid-40% area with negative gross margin.

Supply actions were somewhat more encouraging this quarter with Western Digital instituting a 30% production cut and reducing its capital spending plan over the next two quarters. Micron and SK Hynix Inc. had already cut their capital spending plans last quarter by 40% and more than 50%, respectively. However, Samsung is still holding its capital spending flat from 2022 and has no plans to curtail production other than for line optimizations, node migrations, and research runs. We think this is a play to gain share by leveraging its other business lines that allow it to take more pain for longer than its memory peers.

We expect the industry to rebound in the second half after a first-half digestion phase as the China reopening helps the smartphone market, new data center CPUs with higher core counts roll out requiring more memory, falling prices simulate increased memory content in some devices, and as the supply actions hasten the inventory digestion and ASPs firm up.

As a result of this intense downturn, over the last two quarters we downgraded Western Digital, revised our outlook on Micron to stable from positive, and revised our outlook on SK Hynix to stable from positive in November and to negative from stable in February.

Tech Layoffs: The Days Of Laundry Service And Massage Therapists Are Over

Lavish perks at tech companies are being slashed from laundry service at Meta to massage therapists at Google and companies are reducing headcount reversing a years-long hiring spree. However, we see tech as the exception, rather than the rule. The U.S. labor market remains tight with the last jobs report showing a whopping 517,000 jobs added in January with positive revisions to prior months, and wages, hours, labor force participation, and job openings all up. With tech companies placing more emphasis on profitability, we view their actions as credit enhancing. They are taking an opportunity to rationalize teams that may not fit with their strategies as they had expected after a more than 10-year run of hiring that accelerated in the post-COVID-19 years, right sizing for slower growth over the near term. The scope of many of these actions like Alphabet's and Microsoft's seems to cover headcount in the range of 5% of total, which we view as manageable. In our experience, the risk of disruption rises when cuts reach the midteens or higher.

We see these actions as defensive as well. We think the fact that Twitter's product survived cuts that have reportedly approached 70% of headcount, demonstrated a degree of bloat industrywide and put pressure on other management teams to deliver much more modest cuts in light of slowing growth. We also think they might be aimed at preempting activists. If mighty Salesforce can attract the likes of Elliott, others are surely targets. We think an increasing industrywide focus on efficiency will be beneficial for credit ratings at the margin.

Investment-Grade Companies Can Withstand A Mild Recession; Spec Grade Hardware And Highly Leveraged Ones Are At Risk

We believe most U.S. investment grade-rated tech companies have enough cushion within their ratings and solid business positions that are durable enough that their ratings can endure the mild recession we are expecting in the first half of 2023. Intel Corp. is the exception. We downgraded the company to 'A' due to company-specific factors including increased execution risk related to its turnaround and share losses to AMD, but also weakening end-market demand that is exacerbating the situation and which we expect to cause cash flow deficits of $7 billion to $8 billion in 2023 before dividends. Our negative outlook on the company reflects the risk that a recovery in 2024 might fail to materialize.

We are watching the speculative-grade category closely for signs of credit deterioration, particularly hardware companies with low product differentiation or those exposed to weak end markets, and slow-growing companies with stretched and variable-rate capital structures that might also be facing execution risk. Among the latter group are usually leveraged buyouts with 'B' and 'B-' ratings that make up 44% of rated U.S. tech companies. For example, we recently revised our outlook on education software provider Astra Acquisition Corp. (d/b/a Anthology) to negative because it is investing more than expected to turn around the products of its Blackboard acquisition. We also revised our outlook to negative on cyber security software provider Redstone Buyer LLC (d/b/a RSA) due to rising interest expense combined with weakening topline growth. We lowered our rating on ATM-maker Diebold Nixdorf Inc. to 'SD' (selective default) on Dec. 30, 2022, following a distressed exchange. We subsequently upgraded the company to 'CCC+' on Jan. 9, 2023, following its restructuring. Finally, we lowered our rating on Avaya Holdings Corp. to 'CC' upon its disclosure that it had been engaging with lenders around potential debt restructurings.

For a more comprehensive rundown of the companies we see as most at risk for negative actions, see "U.S. Tech Bracing For The Credit Storm: Ripples Now With A Chance Of Bigger Waves," published Dec. 6, 2022.