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Bottom Is In Sight For U.S. Tech Earnings, With A Modest Rebound Expected For The Second Half Of 2023


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Bottom Is In Sight For U.S. Tech Earnings, With A Modest Rebound Expected For The Second Half Of 2023

The weakening macroeconomic environment and the annual information technology (IT) budgeting cycle led to a weak first quarter for U.S. tech companies, roughly in line with our expectations. We still believe in a second-half rebound, but it will be more modest than we expected last quarter given incremental weakness in the PC and smartphone segments. Memory is the weakest part of the market given its exposure to falling mobile, PC, and data center markets; their products face the most severe inventory corrections that we don't expect to ease until the second half of the year.

For more information on our first-quarter expectations, see "U.S. Tech Earnings: Austerity Everywhere All At Once", published on RatingsDirect on Feb. 9, 2023.

First Quarter Was Slow With Stronger Signs Of A Trough In The Second

In our first look at 2023 IT budgets in action, company metrics behaved as expected with a slow first quarter. However, second-quarter guidance displays more incremental weakness than we anticipated and the second-half rebound we forecast last quarter will likely be more modest than previously expected. In the first quarter companies faced continued inventory corrections and weak demand in smartphones, PCs, data center spending, and industrial markets. The automotive market remained strong, but we see signs of softening in the second half of the year as companies work through backlogs they built up because of supply constraints at the same time as demand weakens through the year. Value-added reseller CDW Corp.'s weak earnings preannouncement and sharply lowered IT spending expectations suggest that IT spending might be under severe pressure. However, we believe this indicates weakness among small- to midsize businesses that will be more impaired by tightening credit from regional banks than large enterprises. Microsoft Corp. delivered a strong report with constructive comments about waning cloud optimization and good bookings trends, indicating to us that large enterprise demand is in better shape. We believe currency headwinds will likely moderate through the rest of the year given that the U.S. dollar has weakened since the second half of last year.

Semiconductor revenue (excluding memory) declined 9%, in line with our expectations. The industry is in the midst of an earnings recession on weakening IT spending and elevated inventories. We expect inventories will approach normal levels midyear, give or take a couple months and depending on the market, and that improving demand for PCs and smartphones will support a modest second-half rebound. For a more detailed explanation of our view on the inventory correction, see "Excess Inventory Is The First Roadblock To Tech Recovery", published March 31, 2023.

Memory Will Recover But Still Far From Normal

The outlook didn't get any worse this last quarter, and there are signs of healing in the quarters to come, but "back to normal" is probably a couple years off. Memory revenue was down approximately 60% year over year in the quarter, with units down about 20% and pricing down 40%. Smartphone and PC end-user demand remained weak. While end demand in data center markets was much better, customers in this segment drew down component inventory (i.e., inventory digestion). Importantly, the market leader Samsung Electronics Co. Ltd. joined its competitors in cutting production to hasten alignment of supply and demand. Samsung is a potent rival because it is a conglomerate--it can fall back on other profit centers and outlast its peers through a downcycle. Samsung notably did not join the others in cutting capital expenditure (capex), indicating it still intends to leverage the situation to enhance its technological position and gain market share.

We expect a sharp bit recovery next quarter off a very low base on higher content in smartphones and PCs. We forecast production cuts will lead to firmer pricing in the second half as demand returns after inventory digestion ends. New server platforms coming in the second half of the year will catalyze data center chip demand, and we expect a better outlook for smartphone and PC markets then. However, as demand improves, memory suppliers will want to unwind their recent production cuts, which could hinder profitability. We believe this will lead to only a partial rebound and the market will need another year for demand to catch up to supply. We don't expect profitability to normalize until 2025.

Public Cloud Optimization Cycle Is Waning

Optimization of cloud spending by customers is causing a sharp slowdown among service providers, with year-over-year growth decelerating 4%-7%. While we expect similar deceleration next quarter, growth will remain robust, with Microsoft Azure and Google Cloud Platform above 20% and Amazon Web Services near 10%. Microsoft said the opportunity for optimization has almost been fully captured and new workloads are coming back. Public cloud remains a top enterprise spending priority and artificial intelligence (AI) will be a new growth vector. We expect the optimization cycle to last for another quarter or two before growth rates reaccelerate.

In 2023, we expect U.S. hyperscale capex to fall to about 10% this year from about 25% last year. This is better than the last trough in 2019 and 2020, when average annual spending growth was in the low-single-digit percent area. Microsoft said capex will show material sequential growth through the year, Alphabet Inc. increased its capex guidance saying it would be higher in 2023 compared with 2022, and Meta reaffirmed its prior guidance for $30 billion-$33 billion (compared with $32 billion last year). However, some spending is rotating to support AI workloads. In our view, this means providers of graphics processing units (GPUs) for AI training and networking to support higher data throughput will outperform components to support non-AI workloads like central processing units (CPUs), hard disk drives (HDDs), and memory. For example, in March, U.S. hyperscale spending was up a healthy 19%, but HDD maker Seagate Technology Holdings PLC's revenue was down 34%, illustrating the depths of the inventory correction. In contrast, revenue from cloud networking provider Arista Networks Inc. increased 54%. We lowered our rating on Seagate based on our weaker outlook for cloud spending on HDDs (see "Research Update: Seagate Technology Holdings PLC Downgraded To 'BB' On Deeper Hyperscale Inventory Correction; Outlook Stable", published April 26, 2023).

PC Inventory Has Corrected But Remains High After Very Weak Units Last Quarter

Inventories of PCs and components have fallen over the last two quarters, but unit sales declined 29% year over year according to International Data Corp. (IDC), keeping inventories high. By comparison, Advanced Micro Devices Inc.'s client segment was down 65% and Intel's was down 38% as the companies undershipped end demand and pricing softened. We believe the inventory correction will conclude in the second quarter as component sales catch up to final unit sales, setting up a better second half. We also see a second-half recovery as the macroeconomic environment stabilizes, schools upgrade aging Chromebooks, and businesses adopt Windows 11. We now expect units for 2023 to be down more than our prior estimate of 10%, reaching pre-pandemic levels.

Apple's New Models And Modest China Rebound Will Lead Second-Half Smartphone Stabilization

Smartphone units decreased 15% year over year, the seventh straight quarter of declines according to IDC. Even though tight COVID-19 restrictions eased, the decline of Chinese original equipment manufacturers outpaced the total again due to weak reception of new Android phone releases, casting doubt on the strong second-half rebound we previously expected. Nonetheless, we think a modest rebound is likely given a very weak second half in 2022. Apple Inc. fared better, only down 2%, helped by pent up demand in China following the factory shutdown in late 2022. We believe the high end of the market is more resilient against economic weakness than the low- to mid-range segments. Inventory remains elevated but is much closer to normal levels than two quarters ago, partly due to heavy promotional activity. We now believe global smartphone units will decline in the mid-single-digit percent area in 2023, revised from our last forecast for 1% growth.

A Shallow Recession Would Hinder Speculative-Grade Companies More Than Investment-Grade Firms

Our base-case forecast calls for modest declines in U.S. real GDP in the second and third quarters of 2023, which we expect will weigh on operating results for most U.S. tech companies. We also see indications that demand slowed in April due to the ongoing regional banking challenges. Large enterprises seem to be mostly unaffected but small to midsize businesses and companies that serve them will probably be more strained. Software companies' revenue growth is slowing and their margins are under pressure. However, ratings on those companies are less at risk than those on hardware and semiconductor companies because they benefit from high recurring subscription revenue and more flexibility in their cost bases to adjust to periods of lower demand. Private equity-owned software companies are an exception because of their highly leveraged capital structures.

We don't see a trend of negative rating actions for investment-grade tech companies in response to these conditions given their solid business positions and cushion within our ratings. We believe there are higher chances of negative actions among speculative-grade companies, particularly in the 'B' category, because they have a lower margin for error due to highly leveraged capital structures. They are also more exposed to higher interest rates because of a higher preponderance of floating rate debt. Three examples of recent negative actions include Cornerstone OnDemand, Intermedia, and Imperva. We view these companies' business positions relatively favorably, but a challenging macroeconomic environment weighing on revenues and higher rates have resulted in our forecast for negative cash flow in 2023. We believe this will likely be a common theme for U.S. tech companies rated in the 'B' category as we move through 2023. See our recent report, "Tighter Credit Conditions May Be Next Shoe To Drop For Speculative-Grade Tech Companies", published April 3, 2023, for our view of the U.S. tech speculative-grade landscape and which companies are most exposed to a recession.

This report does not constitute a rating action.

Primary Credit Analyst:Christian Frank, San Francisco + 1 (415) 371 5069;
Secondary Contact:David T Tsui, CFA, CPA, San Francisco + 1 415-371-5063;

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