The technology sector is in a cautious recovery, with AI emerging as a game changer. While enterprise adoption remains in the early stages, AI investments by hyperscalers are surging, driving demand for AI chips and memory. The PC and smartphone markets show modest improvements, but the impact of AI-enabled devices is on the horizon. For our views on the impacts of AI on the U.S. tech industry and on ratings of selected issuers, see "AI Will Gradually Reshape U.S. Tech Companies' Credit Quality", published April 8, 2024.

Cautious Enterprise Demand Amid Of AI Use Cases

In the first quarter of 2024, overall IT hardware spending was weak across storage, servers, and PCs, although we anticipate improvement as the year progresses. Enterprise spending is recovering as management teams have more confidence in the macroeconomic environment than they did a year ago. The exception is networking, which remains one of the last markets to undergo an inventory correction following COVID-19 pandemic-induced supply constraints. Despite lingering IT hardware weakness, demand has stabilized, and we expect a gradual recovery as the year advances.

AI and security have emerged as top priorities for enterprises. Despite initial spending on AI, overall adoption remains in the early planning and evaluation phase. Enterprises are cautiously exploring use cases for AI assistants and AI-capable PCs, aiming for tangible value from their investments. So while we expect enterprise spending on generative AI to emerge in the second half of 2024, it may have a more significant impact on enterprise IT budgets in 2025. The adoption of AI inferencing could boost on-premises and hybrid cloud spending. Cost and security concerns may prompt some customers to prefer these environments over the public cloud for certain workloads. We think Dell Inc. and Hewlett Packard Enterprise Co. are best positioned to benefit.

The PC cyclical recovery was weaker than expected in the first quarter, with shipments increasing only 1.5% year over year against an easy comparison from 2023. This brought PCs back to pre-pandemic shipments after two years of declines from peaks. We expect the PC recovery to continue throughout the year, catalyzed by the end of Windows 10 support in 2025, the need to replace PCs purchased at the beginning of the pandemic in 2020, and the introduction of new AI-enabled PCs in the fall.

In other enterprise spending segments, networking inventory remains an overhang. We expect sales to be muted over the next few quarters. Inventory should be more balanced exiting 2024. Service provider spending is challenging and has few catalysts for a rebound this year. Ericsson said that estimates for a global radio access network market decline of 4% seemed optimistic. Small and midsize business demand seems to be somewhat weaker than in enterprise. CDW LLC's revenue fell 5% year over year on project pushouts and elongated decision-making, partly due to AI planning.

Hyperscale Data Centers Ramp Up AI Investments

Capital expenditure (capex) in the market is surging, driven by accelerated investments in AI and a modest rebound in general purpose investment. We now expect U.S. hyperscale spending to increase in the mid-40% area, compared to our previous estimate of about 30% from last quarter.

Meta Platforms Inc. raised its full-year capex guidance for 2024 to a 34% increase at the midpoint, anticipating even higher investments in 2025 as part of a multiyear AI investment cycle. Microsoft Corp. has guided for a material quarter-over-quarter increase next quarter, while Google LLC expects quarterly spending for the rest of the year to be at or above the first quarter.

Strong revenue performance supports increased spending. Non-AI demand is improving as customers' optimization cycles wane. Customers are signing longer and larger deals, and AI proofs of concept are moving into production. Additionally, new workload growth and cloud migrations are contributing to the demand.

Amazon.com Inc.'s Amazon Web Services (AWS) reported 17% year-over-year revenue growth, up from 13% in the previous quarter. Non-AI demand was robust, and Amazon's overall operating margin exceeded 10% for the first time, indicating capacity for further investment from a companywide perspective. Microsoft Azure enjoyed 31% year-over-year revenue growth, up from 28% in the previous quarter. AI contributed 7 percentage points to growth, up from 6 points in the previous quarter. It guided for 30%-31% revenue growth in the next quarter citing broad-based demand for non-AI services. Google Cloud reported 28% year-over-year revenue growth, accelerating by 3 percentage points quarter over quarter.

AI chip availability is improving as Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC) ramps up investments in advanced packaging capacity for AI chips. Major customers previously had to wait almost a year for H100 chips, but lead times have fallen to a few months. NVIDIA Corp.'s Blackwell processors will start shipping in the second half of the year.

AI Semiconductor Strength And Mixed General Purpose Recovery

Total semiconductor sales increased 15% year over year in the first quarter, primarily driven by a near doubling of memory revenue due to a strong price recovery in both DRAM and NAND. Excluding memory, semiconductor sales increased in the low-single-digit percentage area. TSMC reduced its 2024 semiconductor growth outlook excluding memory, to 10% from over 10%, citing a slower recovery in PCs and smartphones; our forecast for this metric remains 8%. Demand for AI chips continued to be robust, with TSMC expecting AI server revenue to more than double to the low-teens percentage of its total revenue in 2024, with a 50% compounded annual growth rate to over 20% of revenue by 2028.

Analog segment revenue declined year over year for the fifth consecutive quarter, down in the mid-single-digit percentage area in the first quarter, as inventory continues to be worked down. However, we expect a gradual recovery in the second half of the year. Microcontrollers declined more sharply, in the mid-teens percentage area, the second consecutive quarter of contraction. Microchip Technology Inc.'s microcontroller revenue in particular plunged 46% year over year last quarter, with guidance pointing to another quarter of correction of a similar magnitude. We anticipate the recovery will begin toward the end of 2024, as the recent shortages were more severe than for analog, leading to a more pronounced correction.

Weak demand in the industrial and automotive markets affect both the analog and microcontroller markets. The industrial market is undergoing a cyclical downturn, with tepid demand and ongoing inventory correction, which we expect to bottom out in the first half of 2024. We anticipate the automotive market will take longer to recover since it entered its correction later, possibly extending through the year, but the bottom should be shallower due to increasing semiconductor content. NXP Semiconductors N.V.'s automotive segment declined only 1% year over year in the first quarter. TSMC expects automotive revenue to decline in 2024. We anticipate a soft landing.

Conversely, hyperscalers' AI investment remains robust with NVIDIA the main beneficiary ahead of Advanced Micro Devices Inc. (AMD), Broadcom Corp., and memory makers Samsung Electronics Co. Ltd., SK Hynix Inc., and Micron Technology Inc. AMD's data center revenue increased 80% year over year in the first quarter, helped by strong demand for graphics processing units (GPU), AI accelerators, and central processing units (CPU). Intel Corp.'s data center revenue only rose 5% in the first quarter because it is a laggard in AI chips. Still, guidance points to over $500 million of AI accelerator revenue in the second half and a pipeline of $2 billion.

The PC market expanded in the first quarter, albeit against an easy comparison. Intel's PC revenue increased 31% year over year, fueled by inventory restocking on a very easy comparison. For 2024, we expect PC unit sales to increase in the 2%-4% range. We expect a gradual recovery in the smartphone market, with an anticipated 3% unit growth in 2024. But 4G to 5G upgrades in China and emerging markets and the increasing prevalence of AI features contribute to increasing content, so semiconductor revenue from the mobile end market should outperform units. The gaming cycle remains weak, with Microsoft's Xbox hardware revenue declining 30% year over year and AMD's gaming segment contracting 48%.

Supply conditions are in good shape outside of AI chips. Lead times are short, reducing visibility. Pushouts, cancellations, and double ordering are moderating. TSMC's advanced packaging capacity bottleneck is still restricting AI chip availability. The situation is easing as capacity is set to more than double in 2024, although it will still not keep up with demand.

Memory Prices Ride Explosive Growth

Prices increased in the memory semiconductor market in the first quarter, driven by robust demand for high-bandwidth memory (HBM) used in AI applications, which is a DRAM product, and supply-side dynamics in the NAND market. This helped Samsung's semiconductor business swing back to profitability after four consecutive quarters of losses. Samsung's memory revenue nearly doubled year over year, while SK Hynix reported a staggering 144% increase in revenue. We expect double-digit quarter-over-quarter price increases next quarter as well.

The strong rebound in pricing came about because of industry curtailment of capex amid excess capacity and an inventory glut last year. Production cuts have sustained into 2024, but the players could bring back some of this capacity to capture more share as pricing strengthens further. Capex in the memory segment remains disciplined, with higher investments likely directed toward HBM production to meet robust demand. SK Hynix is investing nearly $15 billion in South Korea to expand a DRAM facility, but the first phase of construction will not be completed until the end of 2025, so there will be limited impact to supply from this investment over the next few quarters.

The strong demand for HBM drives DRAM capex while NAND capex remains low. Within DRAM, the players are shifting resources to HBM, which tightens supply for general purpose DRAM. As a result, we expect prices for both to remain firm. Demand for AI memory is staggering. Micron stated that its HBM3e supply is sold out for 2024 and most of its 2025 supply has already been allocated. SK Hynix made similar comments, while Samsung expects its HBM bit production to triple in 2024 and at least double in 2025.

The demand for NAND-based enterprise solid-state drives for AI applications is also increasing due to their faster read/write times, lower power consumption, and space efficiency, as well as the need for larger training data sets. Samsung expects to expand this business more than 80% in 2024.

Major Semiconductor Players Awarded Billions In CHIPS Act Funding

Micron Technology has secured up to $6.1 billion in funding from the Creating Helpful Incentives to Produce Semiconductors (CHIPS) and Science Act to establish three new facilities. This funding is part of its planned investment of up to $125 billion over the next 20 years, $50 billion by 2030. CHIPS funding will go toward two of the four facilities planned in New York, while the third will be in Boise, Idaho, next to Micron's research facility. All three will focus on DRAM production, and the agreements are still subject to due diligence. The U.S. government expects the projects to create 20,000 direct construction and manufacturing jobs.

Samsung will receive up to $6.4 billion for its location in Texas. The investment will include a second factory, advanced chip packaging, and research and development facilities, totaling roughly $45 billion. The government expects the project to create 17,000 construction jobs and 4,500 manufacturing jobs, with operations starting in 2026 and 2027. Samsung's advanced chip packaging facility will focus on 3D packaging for HBM used in AI applications, as well as 2.5D packaging that combines logic and memory into a single package for AI. According to U.S. Commerce Secretary Gina Raimondo, the country is on track to produce 20% of global advanced semiconductor logic chips by 2030.

TSMC will receive up to $6.6 billion for its Arizona project, which involves the construction of a complex factory in Phoenix. TSMC plans to invest more than $65 billion in total and add a third chip factory to the site, where it will manufacture leading edge 2-nanometer chips. However, TSMC has faced delays in its production timelines due to a shortage of skilled workers and has pushed back the start of mass production to 2025.

These announcements follow our previous coverage of CHIPS Act funding for Intel and GlobalFoundries, "CHIPS Act Funding To Intel Sparks Revival For U.S. Semiconductor Manufacturing," published on March 27, 2024.

iPhone At A Crossroads As Market Anticipates AI Features

Global smartphone shipments increased 7.8% year over year in the first quarter, according to IDC, but Apple Inc.'s shipments declined 10%. This allowed Samsung to regain the top spot. Samsung has performed stronger than in recent quarters with the release of its AI-enabled Galaxy S24. Chinese brands have also integrated AI features into their smartphones. iPhone revenue declined 10% in the first quarter, marking the biggest drop since 2020, indicating that Apple customers may be holding back in anticipation of new AI features.

In China, Apple's unit sales dropped sharply, 19% (according to Counterpoint Research), falling to third place behind Vivo S.A. and Honor. Huawei secured the fourth position with unit shipments increasing 70% as it rolled out 5G capable phones using its own technology, bouncing back from restrictions on its access to U.S. 5G chips. The quarter was the most competitive in the Chinese smartphone market ever, with only 3 percentage points of share separating the first and sixth players and significant promotions for Lunar New Year.

Chinese rivals offer broader portfolios that include low- and midrange phones, which bodes well for the macroeconomic weakness. Despite concerns about Huawei's resurgence, Apple's iPhone revenue increased in mainland China, the company said during its earnings call, offering a different perspective than third-party unit sales estimates. Two iPhone 15 models were the top sellers in Chinese urban areas, pointing to Apple's still-strong presence in the high-end segment.

The lack of a transformational iPhone model and lengthening replacement cycles weigh on Apple's results. AI presents an opportunity to get consumers excited about the product again. When Apple rolls out an AI-enabled iPhone, it could set up a strong upgrade cycle globally.

Credit Trends Improve To Start 2024 After A Challenging 2023

We took several negative rating actions in the first quarter, but an increasing mix of positive actions reflect a stabilizing macroeconomic environment. Weak service provider demand led us to downgrade Casa Systems Inc. to 'D' after it filed for Chapter 11 bankruptcy protection. We downgraded Lumentum Holdings Inc. for the second time in 12 months, and we revised the outlooks for Corning Inc. and MaxLinear Inc. to negative from stable.

Notably, we downgraded Atlas Midco Inc. (Alveria) to 'D' due to a distressed exchange caused by higher interest rates, restructuring costs, and revenue declines. This could be a precursor to more distressed exchanges for a handful of companies in the 'CCC' rating category as they continue to face pressure from high rates and weak performance.

Increased acquisition activity provoked us to revise our outlooks on HPE and Juniper Networks Inc. to negative from stable. Their deal could put downward pressure on ratings pending more details about the financing plan. We placed the rating on Viavi Solutions Inc. on CreditWatch with negative implications pending its acquisition of Spirent Communications. Conversely, we placed the rating on Snap One Holdings Corp. on CreditWatch positive pending its deal to be acquired by higher-rated Resideo Technologies Inc.

We took seven positive actions, including an upgrade of NVIDIA and revising the outlooks on AMD, and Cadence Design Systems Inc. to positive. They all benefit from solid demand trends in the semiconductor industry for AI and general purpose applications. Upgrades of Uber Technologies Inc., Motorola Solutions Inc., and Elastic N.V. reflect good performance due to idiosyncratic factors in their respective industries. Notably, our 'BB+' rating on Uber has a positive outlook and could enter investment grade over the next several quarters if its strong performance continues.

Other notable outlook revisions to negative were on companies with weak operating performance or significant interest burdens, including Xerox Holdings Corp., Polaris Parent LLC (Solera), VeriFone Systems Inc., and Synaptics Inc.

We could take more positive actions through the rest of 2024. These might be driven by recovering end markets emerging from inventory drawdowns in 2023 or companies adjusting to support higher interest burdens by cutting operating costs. However, we expect negative actions on companies facing secular business declines or still-high interest burdens, some of which may be compounded by upcoming maturities that lead to either payment defaults or distressed transactions.