- North American technology revenue was up a modest 2.6% year-over-year in the third quarter due to the start of recovery in the PC, smartphone, and memory markets, and slowing but still strong public cloud growth, but it was held back by cautious enterprise spending and a weakening industrial market.
- Public cloud growth is finding a bottom as a customer spending rationalization cycle is waning. S&P Global Ratings is cautiously optimistic about acceleration in 2024 as cloud migrations resume and artificial intelligence (AI) use cases expand, but a weakening economy could derail this view.
- AI spending among hyperscale data centers is crowding out spending on central processing units (CPUs), memory, hard disks, and networking. However, we expect hyperscale capital spending (capex) will improve for all areas in 2024 and the AI benefits will be shared more broadly.
- High interest rates and deteriorating service provider spending keeps non-investment grade ratings under pressure.
Per our third quarter corporate results roundup, third quarter revenue for the North American technology industry was up a modest 2.6% year-over-year because of cautious enterprise demand, inventory corrections, and a weakening industrial market. S&P Global Ratings forecasts 2023 global information technology (IT) spending growth at a meager 2.2% as IT budgets seem locked into levels set at the beginning of the year when recession risk was higher, likely reflecting fears of a downturn caused by high interest rates and geopolitical uncertainties. Nevertheless, the PC, smartphone, and memory markets are in early stages of recovery, and while public cloud growth is slowing, it remains very robust. AI continues to garner significant interest and investment, which has so far mostly helped NVIDIA Corp., but we expect the benefits to be more broadly dispersed in 2024 and 2025.
PCs And Smartphones Are Beginning A Recovery
The PC and smartphone markets are in the early stage of recovery following very weak conditions since the beginning of 2022 and the conclusion of an inventory correction. International Data Corp. (IDC) reported quarter-over-quarter unit growth resumed and the year-over-year comparison improved, with PC units only down 8% following double-digit declines over the last five quarters, and smartphone units flat. We expect further improvement next quarter with unit growth in both segments. While for full year 2023 we expect PC units to be down low double digits and smartphone units to be down 5%, we expect unit growth in 2024 and we expect plans to emerge for AI features in both products.
The China smartphone market appears to be bottoming, with Qorvo Inc. notching 8% growth in its cellular segment year-over-year and Qualcomm Inc. calling for handset revenue from Chinese smartphone makers to grow 35% quarter-over-quarter next quarter. Xiaomi Corp. returned to modest year-over-year growth after double-digit declines in five of the last six quarters, per IDC. Improvement should continue next quarter with new flagship models coming and replacement rates at historic lows as consumers have stretched old models.
PC units will return to pre-COVID levels near 260 million in 2023. We expect growth in 2024 helped by a refresh of units purchased during the beginning of the pandemic and a Windows refresh cycle, but unlikely to be anywhere near the post-COVID peak of around 350 million.
Broad Markets Showing Signs Of Weakness
The outlook in other markets is more grim. Enterprise spending has not benefitted as much as we would have expected given strong GDP figures and we expect this market to remain frugal until the 2024 budgeting cycle, which may also prove to be conservative. We see the consumer sentiment as mixed going into the holidays, weighed down by macroeconomic uncertainty and higher interest rates. Declining service provider capex budgets are hurting suppliers to the communications end market like CommScope Holding Co. Inc., Corning Inc., and TE Connectivity Ltd., although networking providers like Cisco Systems Inc. still have large backlogs built up due to prior supply constraints to support near-term sales. This market could be entering a multiyear cyclical retrenchment. The industrial market has been a solid growth driver for U.S. technology but is now succumbing to broad macroeconomic weakness. Only the automotive market is holding up supported by increasing content for electrification and computing power, although growth in this market is slowing from very strong levels.
AI To Be A Key Driver Of Cloud Growth
Cloud revenue growth is stabilizing as customer optimizations and consolidations moderate. After delivering growth of 28% last quarter, Microsoft Corp. is calling for growth in the 26% to 27% range next quarter, and the first half of 2024 could be at similar levels. Amazon Web Services (AWS) growth was 12%, the same as the prior quarter, and management commented that the pace of new deals picked up. We expect AWS growth in 2024 to accelerate from current low levels supported by AI demand.
AI is starting to become meaningful as it contributed 300 basis points to Microsoft Azure growth, and we expect it to be a key driver for all the cloud players in 2024 and beyond. AI investment continues to crowd out general purpose computing in 2023 as the providers draw down inventory they built up in 2022. We expect the inventory adjustment to finish in the first half of 2024 and for general purpose investment required to support strong customer demand to be a growth driver for CPU, networking, memory, and hard disk providers.
We expect U.S. hyperscale capex growth in the low-teens in 2023, down from the mid-20% area in 2022 on slower general purpose spending and inventory digestion. Spending on GPUs for AI workloads led by Microsoft has buoyed industry capex, but it has mostly benefited NVIDIA. We look for mid-teens growth in 2024 as general purpose spending comes back, which we believe represents roughly midcycle levels. Meta’s growth will resume after a consolidation year in 2023; its guidance calls for 16% growth at the midpoint. Microsoft's growth should moderate from breakneck levels in 2023 but remain strong. Alphabet Inc. signaled capex growth in 2024 and while we expect roughly double-digit levels, the company could be a source of upside as it seeks to defend its AI position against massive investments from Microsoft.
Memory Demand Returning; Production Cuts Help Inventories And Pricing
The memory market began the long road to recovery in the third quarter. Year-over-year revenue declines moderated significantly with DRAM down 25% and NAND down 5%, according to Semiconductor Industry Association data. Sequentially, DRAM grew 17% and NAND fell 4% but against a tough comparable period last quarter. Volume strongly grew quarter-over-quarter in both segments, while DRAM pricing was incrementally positive and NAND pricing fell modestly. Next quarter, we expect revenue to be up around 10% with DRAM performing better than NAND on both volume and pricing. In 2024, we expect pricing to continue recovery as the industry maintains supply discipline in order to return margins to sustainable levels, with low- to mid-teens bit growth in NAND and mid-single digit growth in DRAM. Conditions will gradually improve through the year, but we believe midcycle conditions won't materialize until 2025.
Smartphone and PC inventories have stabilized, but are still high in the data center market and we expect it will take another two or three quarters to normalize, but this market will be a key demand driver for high-margin high-bandwidth DRAM for AI applications in 2024 and for memory to support growth in general purpose workloads. Samsung commented that it has received more inquiries for strategic purchases due to awareness that memory is reaching a bottom.
In the middle of 2023, suppliers implemented production cuts to hasten the inventory correction; the benefits started to materialize in the third quarter and we expect more to come in the fourth and in 2024. Currently NAND inventory is higher so we expect to see progress on margins sooner in DRAM. A key watchpoint will be whether industry players can maintain discipline long enough to complete the inventory adjustment, or whether they will succumb to the temptation to bring back idled capacity early to take market share, which would prolong the time to achieve midcycle margins. Capex decisions are less flexible than production ones and they determine long-term supply. Signs are encouraging, with the players planning for only modest capex growth in 2024 from very low 2023 levels, and for spending support technology migrations more than capacity expansion.
Semiconductors Are A Mixed Bag
Taken as a whole, the semiconductor market continued a second quarter of sequential revenue recovery, and we expect the trend to continue next quarter when it will return to year-over-year growth for the first time since June 2022. This owes to memory recovering from deeply depressed levels, insatiable appetites for GPUs to support AI workloads, and the stabilization of inventory in the PC market. Cutting against these trends are the analog and microcontroller segments. Analog has been weak since the start of the year while microcontrollers have enjoyed a strong run for the last 12 quarters but will likely fall next quarter, as suggested by poor guidance from Microchip Technology Inc. and others. Both segments were supported by significant demand and supply constraints in the post-COVID era, but as supply has improved and lead times shortened customers have moderated their inventory. The very broad and macroeconomically sensitive industrial market is also starting to waiver. Pricing so far is stable but pressure could emerge in weaker markets like industrial over the next few quarters. While hyperscale data center customers have driven significant demand for GPUs, it has come at the expense of general purpose compute in 2023, but we expect that to improve in 2024 as they must build capacity to support strong demand from their customers. We expect the aforementioned trends emerging in the fourth quarter to continue in 2024, with memory driving most of the industry's revenue growth.
In the AI space, GPU demand so far has been driven by the need to train AI models. That demand will remain robust in 2024, but we expect spending for inferencing (applying AI models to specific cases) to emerge more prominently next year. This should open space for more players besides NVIDIA to win, as has been the case in 2023. Intel Corp. and Advanced Micro Devices Inc. should see more demand for CPUs, GPUs, and FPGAs. High-bandwidth DRAM and networking should benefit more. Custom AI chips could gain more traction, helping Broadcom Inc. and Marvell Technology Inc.
Finally, the U.S. recently updated rules covering the export of advanced chips and semiconductor equipment for the manufacturing of such chips to China. It aims to limit China's high-performance computing capabilities, particularly for AI. We believe supply-chain bifurcation and tit-for-tat measures could continue. Read more in our recent FAQ on the matter.
Higher Interest Rates And Weak Communications Market Pressure Speculative-Grade Ratings
Cash interest payments for the trailing four quarters are up 20% across corporate ratings globally according to our third quarter corporate results roundup, and 28% for the non-investment-grade space. EBITDA cash interest coverage is down to almost 5x from nearly 7x a year ago, and non-investment-grade cash interest to total debt is up to 5% compared to 4% in the first quarter of 2022, indicating more scope for further increases as they refinance into a higher rate environment. We are seeing similar trends in U.S. tech. Leveraged buyouts (LBO) are particularly at risk given their very high leverage and mostly unhedged floating rate capital structures. While we didn't have many rating actions based on interest rates last quarter, there were several the quarter before, and we continue to scrutinize LBO earnings for signs of unsustainable capital structures as each new quarter comes in.
Weak demand from communications service providers due to tightening capex budgets, a shift past the peak of the 5G investment cycle, and inventory digestion provoked several rating actions including our downgrade of Lumentum Holdings Inc. in July, our outlook revision on CommScope Holding Co. Inc. in September and placement of the rating on CreditWatch in October (following its negative earnings pre-announcement), and our outlook revision on Coherent Corp. in October. We also placed our ratings on Western Digital Corp. on CreditWatch pending full operating metrics and business strategy for its hard disk business after the spin-off of its memory business, and the going-forward capital structure. In addition, we downgraded Atlas Midco Inc. (Alvaria) to CCC+/Stable/-- due to weak performance and higher interest rates, a case we expected to see more of over the last three months. We had more negative actions during the prior quarter, which may suggest companies are adjusting their cost structures to muddle through the higher rate environment.
Finally, we took a number of positive actions including upgrading Uber Technologies Inc. and Genesys Cloud Services Holdings II LLC, and favorable outlook revisions for Banff Parent Inc. (BMC), and Red IntermediateCo LLC (Virgin Pulse), all non-investment grade. This is a surprising number given macroeconomic uncertainty and higher interest rates, and demonstrates the durability of many U.S. software and services businesses.
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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