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Cloud power

How to invest in tech's cash cow
Cloud power
  • Cloud stocks have led the market-wide digital transformation this year 
  • But investors can still get in on further growth

This year’s collective shift to remote working has accelerated several digital trends more quickly than even the most bullish tech evangelists could have hoped for. For Satya Nadella, chief executive of Microsoft (US:MSFT), the second quarter saw “two years’ worth of digital transformation in two months” for his company. Ever-greater numbers of ever-more connected individuals were already placing ever-greater demand on data storage long before the pandemic struck. Then, almost overnight, that demand leapt.

Common to a number of technology stocks that have soared this year has been the use of distributed computer systems, also known as 'the cloud'. Zoom (US:ZM) could not have coped with a sudden spike to as many as 300m daily users if it weren’t for the power of its cloud-based infrastructure, first supported by Amazon Web Services (AWS) and then Oracle (US:ORCL).

Even the typically tech-shy Warren Buffett got in on the action. His company, Berkshire Hathaway (US:BRK.B), put more than $570m (£427m) into Snowflake (US:SNOW), a cloud data warehousing company whose valuation soared from $33bn to over $70bn on its first day of trading. The initial public offering was also the largest ever for a software company.

On reflection, it is perhaps unsurprising that Snowflake brought Mr Buffett in from the tech tundra, given cloud businesses have a number of quality markers that tick his boxes: chunky margins, sticky customers and a rapidly growing market to aim at. Research firm Gartner expects revenues from the worldwide public cloud services market to hit $258bn this year, before rocketing 41 per cent to $364bn by 2022. 

And cloud businesses, when part of a larger technology company, often make for a good cash cow – allowing management to milk profits and invest elsewhere in the business. Take Amazon (US:AMZN), whose AWS division contributes almost three-fifths of the group’s total operating profit. Its retail business is complex and sluggish in comparison. 

 

 

Investors have cottoned on to the opportunity. The Bessemer Emerging Cloud Index, a collection of just over 50 smaller (and not-so-small) listed providers of cloud-based software, is up by more than 50 per cent since the start of 2020. Since the index was launched in August 2013, it is up almost 900 per cent.

 

 

 

 

Infrastructure: the building blocks 

The cloud may seem like an abstract concept, but it is actually made up of racks of physical computers, stored in massive data centres across the world. An early pioneer of the concept was Salesforce.com (US:CRM), which was one of the first software applications developed from scratch to run in the cloud. In 2002, Amazon quietly launched its AWS product, after it hit on the concept of renting out its excess computing power to businesses, and quickly became a leader in the cloud computing market as a result. A couple of years ago, chief executive Jeff Bezos admitted to Bloomberg that “a business miracle happened... we faced no like-minded competition for seven years”.

 

A breakdown of the IaaS market

Amazon Web Services, estimated 31 per cent market share

2006

Zoom uses mainly AWS for extra computing capacity, after a huge jump in video meetings 

Responsible for most of Amazon’s operating profit

Microsoft’s (MSFT) Azure, est. 20 per cent

2010

Enterprise favourite 

Missed growth estimates in Q2

Alphabet’s (US:GOOGL) Google Cloud, est. 6 per cent

2008

Growth slowing in latest quarter

Relatively small part of Google’s revenue, but leads the way in terms of cloud innovation in artificial intelligence

Alibaba (US:BABA), est. 5 per cent

2009

Source: Canalys

Lead provider in Asia

International expansion is a longshot for Alibaba cloud 

Big players in Asia also include Baidu (US:BIDU) and Tencent (HK:700). Chinese mobile network operator Huawei also has a cloud offering. 

 

Big Blue and Big Red 

It is not just the young tech kids on the block who dominate the market. Though they were slow off the mark, the IT sector old guard – ‘Big Blue’ IBM (US:IBM) and ‘Big Red’ Oracle (US:ORCL) – are players in the cloud, too. “It’s very difficult when you’re a company and a new, disruptive technology comes along,” says Nic Ziegelasch, head of equity research at Killik & Co. “For you to invest behind that disruptive technology means that you cannibalise parts of your existing business.” 

But Big Blue has recently announced plans to spin out its managed infrastructure services unit, which makes up around a quarter of its top line, into a freestanding company. According to chief executive Arvind Krishna, the move is designed to allow the company to invest more in the cloud and its artificial intelligence business.

IBM

  • Bought Red Hat in 2019 for $34bn
  • In Q2 this year cloud revenues were up by around a third.
  • The hybrid cloud market still presents growth opportunity for IBM, even if it is a little late

Oracle

  • Missed top-line estimates for Q1, struggling to cope with competition from AWS and Azure

Dell Technologies (US:DELL)

  • Stake in VMWare (US:VMW)
  • Still reliant on older generation technology and hardware 

 

The software

Market leaders have already established themselves in the IaaS market – for any of the big tech companies, buy and hold is a relatively safe strategy. Opportunities for higher rates of growth lie in cloud-based platforms and services. Most software now operates on a cloud-based SaaS model, which fattens up margins and generates a steady, reliable stream of income. Some of the hottest picks in the global technology sector incorporate this business model: take Adobe (US:ADBE) or Intuit (US:INTU), both of which boast returns on capital employed of more than 20 per cent. 

The UK’s IT sector is weedy compared with the US. Most domestic tech companies are too small to start infrastructure services, where so-called hyperscaling requires hefty investment budgets. There aren’t many pure-play cloud stocks on this side of the pond, but there are a few software companies with cloud offerings and compelling investment cases. Among them are Gamma Communications (GAMA), a unified communications as a service (‘UCaaS’) provider, and Aveva (AVV), an industrial software group that is using cloud technology to draw together oil and gas mining data. 

 

The warehouses 

As the data storage market developed and prices fell, added services started to emerge. This includes analysing the data that is being housed by the cloud – a technology that was pioneered in the late 1970s and early 1980s by Teradata (US:TDC). Now Snowflake is taking the market lead - when it listed earlier this summer, it hit the ground running with a market value that was already three-quarters the size of IBM’s. And despite the fact that it has yet to turn a profit, its net loss narrowed by 3 per cent to $171m in the six months to July, as revenues more than doubled. 

 

 

Does the cloud ever get stormy?

When Mr Nadella made his comments around Zip-file-like compression of digital transformation in March, the market swooned. 

But the comment, and similar sentiments echoed by other leaders in cloud computing, should give investors food for thought. There remains the risk that such accelerated transformation has simply brought forward two years’ worth of new business growth. As such, investors should rightly question how this expansion can be sustained. After Microsoft’s Azure missed expectations in the second quarter this year, Mr Nadella might have wondered if his initial boast missed the point – and whether he was observing a trend that could serve to depress Microsoft’s shares in the long run.

Ben Barringer, equity analyst at Quilter Cheviot, is not so sure. “I’m not so convinced that the genie goes back in the bottle when Covid is over,” he says. “Once you put things in the cloud you can start doing other things with it: artificial intelligence, or robotic process automation.” 

The need for robust security is even more crucial for cloud solutions because data is constantly flowing from one point to another. If not secured properly, that data is vulnerable to attack. This also plays a part in low cloud penetration in industries that handle sensitive data, for example finance or the public sector. 

Take big banks, which arguably have a reputation for being inflexible and resistant to change. They also have good reason to be cautious, given how many of them have been burned by cyber attacks and disastrous data breaches in the past.

These include Capital One (US:COF), which saw 100m of its customers’ data leaked in the summer of 2019. The perpetrator, Paige Thompson, had previously worked as a software engineer at AWS, which Capital One had used as its cloud infrastructure platform. A spokesperson for Amazon told CNBC in 2019 that Ms Thompson “gained access through a misconfiguration of the web application and not the underlying cloud-based infrastructure” and that the vulnerability was not cloud-specific.

 

Growth on the horizon 

While some companies fret about the cloud’s security implications, other industries are embracing the disruptive power it offers. Gaming is just one example. While Sony’s PS5 and Microsoft’s new Xbox hard consoles were launched earlier this month, a growing number of gamers are turning to streaming to play their video games. But that still relies on having a high-speed internet connection.  “The idea of playing Call of Duty and then having two second latency between pulling the trigger and a bullet coming out of the gun - that’s not going to do very well. For a lot of the world population that isn’t a viable option,” says William de Gale, portfolio manager of Bluebox global technology fund.

Meanwhile, for titans such as Amazon, Microsoft and Google, there are some concerns about the sustainability of the great run they have so far enjoyed. Though all beat consensus forecasts for the third quarter, guidance was mixed. While there is some uncertainty around potentially lower spending and the pace of the coronavirus pandemic, the cloud is going to be a reliable growth narrative for a while yet. 

 

 

Indeed, the rapid development of cloud technology increasingly overlaps with parallel progress of 5G in telecommunications. Google, Microsoft, Amazon and IBM have started to develop their positions in the public cloud as a way to capitalise on growing demand for 5G services. Research firm Mordor Intelligence expects the telecoms cloud market, valued at $22bn in 2019, to grow at 20 per cent a year on average until 2025.

Microsoft appears to be leading the charge here, having developed proprietary software to run telecoms networks. This year it acquired two specialist companies, Metaswitch and Affirmed Networks, which will pit the US giant against the likes of Nordic operators Nokia (HEL:NOKIA) and Ericsson (STO:ERIC-B), both of which have been hoovering up 5G market share in Europe as governments push back against China’s Huawei. 

Then again, investors might want to brace for some short-term volatility in cloud stocks’ shares once a Covid-19 vaccine is introduced. In apparent acknowledgement of the threat of a return to normalcy, shares in Alphabet, Amazon and Microsoft all wobbled by a few percentage points when Pfizer (US:PFE) told the world its candidate was 90 per cent effective this month. It’s also possible the digital transformation narrative is overdone and that the promise of a vaccine means the public and private sectors cutting or even skipping IT spending.

“If we see a recession because of poor performances from a macro perspective... that detracts from the pool of companies that can spend on IT,” adds Mr Barringer.

But companies simply cannot afford to fall behind in this next generation of technology, lest they get eaten up by their more digitally-agile competitors. While cloud-driven digital transformation is well under way, investors have not missed the boat. With some untapped sectors, rapidly evolving technologies and high-growth markets, the best time to invest in the cloud, if you haven’t already, is now.