THE CLOUD REVOLUTION
DEMOCRATISING COMPUTING POWER IN THE 21ST CENTURY
The cloud is the most important yet least understood trend in IT. With cloud services touching virtually
every aspect of our lives behind the scenes, you may find it surprising that companies have so far only
redirected a small fraction of their IT budgets to the cloud. We believe there is much more to come.
“You go back in time a hundred years, if you wanted to have electricity, you had to build your own little electric power plant, and a lot of factories did this. As soon as the electric-power grid came online, they dumped their electric-power generator, and they started buying power off the grid. Just makes more sense. And that’s what is starting to happen with infrastructure computing.”
Jeff Bezos, Amazon founder and chairman
IaaS
PaaS
SaaS
The cloud is a broad term that refers to the provision of IT services over the internet rather than over a personal device or on-premise hardware. For example, when a photo is saved in the cloud, it is not stored on the phone’s memory but externally in a public data centre.
SO WHAT EXACTLY IS "THE CLOUD"?
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THE FUTURE IS IN THE CLOUD
It took on-premise data bases and servers 40 years from when they were introduced in the early 1980s to reach full maturity. Following a similar trajectory, our best guess is that we are only in the sixth or seventh year of a multidecade transition to the cloud.
GROWTH OF THE CLOUD
Many companies operating in the cloud have high rates of growth and strong business models, but they tend to be expensive. Because platform services tend to be bundled together with infrastructure and/or software services, we will focus on the latter two.
OPPORTUNITIES IN THE CLOUD
INFRASTRUCTURE
SOFTWARE
Is this a replay of the bursting of the dotcom bubble? There are two main questions investors must now ask themselves: how will cloud demand normalise after the explosive growth in 2020 and 2021, and what is the right price to pay for investing in the cloud as we head into an atmosphere of higher rates?
CLEARER SKIES AHEAD?
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If there has been a slowdown in growth in cloud services, we believe signs of it would have emerged by now, and if it is still to come the underlying impetus for the cloud transition means any deceleration would be short-lived. Our analysis also suggests that share prices for the cloud infrastructure players may now reflect undue pessimism in future sales and earnings growth from these services.
We see a more mixed picture in software services, where growth for some vendors has certainly slowed as the world begins to emerge from the pandemic and analyst expectations may still be too high. But others that are more tapped into enterprise applications (i.e. for organisations rather than individuals), appear to be maintaining momentum.
The base layer is called Infrastructure as a Service (IaaS) which comprises the bare metal of the servers in data centres. The business model of IaaS is to rent out the computing and storage of those servers, on demand, at a very low price. The leading IaaS services are Amazon’s AWS, Microsoft’s Azure and Alphabet’s Google Cloud Platform, with Alibaba Cloud.
Prior to the recent sharp correction, many SaaS stocks were trading on eye-watering multiples that were difficult to justify, and they remain lofty compared to more mature peers in the technology sector. Three catalysts have contributed to a sudden bursting of this bubble.
COULD THE CLOUD GO FROM ‘BOOM’ TO ‘BURST’?
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Firstly, inflation has remained above expectations with the end of the pandemic now in sight and an expected series of interest-rate hikes has begun in the US and UK. That matters because higher rates make expected returns far out into the future less valuable today.
The second blow has come in recent quarterly earnings updates.
Many tech investors were forced to lower their projections after realising that growth enjoyed during the pandemic, amid a massive shift online in activities such as shopping and conducting meetings, was a one-time surge that in many cases pulled forward future demand.
Finally, high valuations attracted a wave of capital into new cloud start-ups, as evidenced by a surge in tech IPOs in 2020 and 2021. In this more competitive environment, losses deepened as companies vied to win market share by outspending each other on marketing and product development. With higher rates expected, and less money sloshing around, investors became less tolerant of companies burning capital.
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BENEFITS OF
THE CLOUD
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Cloud providers also have robust disaster recovery measures in place to protect businesses from IT hardware failure or natural disaster. Cloud centres are looked after by dedicated professionals and data and software can be recovered quickly and easily.
SaaS
IaaS
As companies around the world join an arms race to compete in the digital era, we see annual spending on cloud services growing nearly five times by 2030 to $1.3 trillion. We think cloud services can sustain similar levels of long-term growth to US ecommerce sales.
INFRASTRUCTURE AS A SERVICE (IaaS)
The middle layer, called Platform as a Service (PaaS), glues together the servers with the applications. This provides software tools for developers to build applications in the cloud such as inserting search functionality into an app, as well as software integrations and extensions. Using Microsoft as an example, its PaaS products are Visual Studio, GitHub, and Power Platform. IaaS and PaaS are normally bundled together.
PLATFORM AS A SERVICE (PaaS)
At the top of the pyramid is the application itself, Software as a Service (SaaS). For Microsoft that application could be Office or Dynamics. SaaS customers generally pay an annual subscription. The advantage for the customer is they get the latest version, while the vendor benefits from not having to support multiple versions and having more predictable revenue streams.
SOFTWARE AS A SERVICE (SaaS)
As spending on the cloud increases, it will be hard to avoid paying some of those dollars to one of them. However, none of the big three are pure plays on cloud infrastructure, and only Amazon and Microsoft have profitable IaaS operations. As a result, investors in these companies must also take a view on the prospects of their other divisions.
INFRASTRUCTURE AS A SERVICE (IaaS)
When looking for cloud-related investment opportunities, we think it makes sense to start with the base layer of the cloud, the infrastructure. The top three providers – Amazon, Alphabet, and Microsoft – control 80% of this market (outside of China). As spending on the cloud increases,
it will be hard to avoid paying some of those dollars to one of them. However, none of them are pure plays on cloud infrastructure,
and only Amazon and Microsoft have profitable IaaS operations.
IaaS
Users can get up and running on cloud software in minutes without having to pay a large upfront license fee or manage a lengthy implementation process. For example, companies were able to adopt Slack, a provider of workflow automation and communications services, or Zoom across their organisations at lightning speed at the start of the pandemic.
The cloud enables infinite storage and access to massive computing power at the click of a button. Personal devices like our phones and laptops have limited memory – they can only save so many books, albums, photos and videos. Consumers can access all this data as needed, as long as they have an internet connection.
This can be most clearly seen in ecommerce, where companies using cloud-based services are harvesting data from their websites to gain better insights into their customers. According to Steve Vamos, CEO of Xero, “In simple terms, technology won’t just collect information – it’ll learn from what it stores…Consider tasks like bank reconciliation: systems can learn how to completely automate this infuriating job, freeing up your time.”
SOFTWARE AS SERVICE (SaaS)
The total cloud software market is about $150 billion and grew an estimated 28% in 2020. Although this pandemic-influenced rate of growth is unlikely to be repeated, we believe cloud software spending should continue to grow at a healthy clip for the next 5-10 years. But gaining exposure to that growth is more complicated: in contrast to the big four in cloud infrastructure, the cloud software market is much more fragmented, with the top 10 players only having a 30% share.
Companies can take advantage of the processing power in public data centres to deploy next generation services like AI, data analytics, and voice recognition at a fraction of the cost of deploying the same functions on-premise. Cloud software also has more rapid innovation cycles as updates are automatic.
SaaS
By subscribing to cloud services, businesses can use a “shared responsibility model” to help provide security. Cloud providers protect the cloud’s physical servers and ensure security patches are updated as needed. To most companies, this is an enormous security upgrade considering that the major cloud providers employ teams of experts and adopt the latest security technologies.
The cloud enables work to be done on projects remotely and simultaneously. For instance, an auto manufacturer could have multiple designers working on different aspects of a car. If the design software is cloud based, they can all make modifications to the design regardless of time, location, or device. Office employees can access their files and applications from any location, allowing for more seamless working.
Investors face much more choice than for infrastructure services, because software is a more specialised area, with many industry specific solutions, and scale is less of a barrier. Compared to IaaS companies, software vendors have simpler business models, lower regulatory risk and they require less capital investment.
Our conviction that the future is in the cloud remains unshaken. The path of growth to get there may not be as steep as investors priced in six months ago, and we could be in for a bumpy ride before growth reaccelerates. Investors must tread carefully, and in our view favour companies that are clear winners in their categories, with competitive advantages and plenty of growth ahead. And some of these companies are starting to look cheap for the first time in years.
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e.g. Microsoft Azure, AWS, GCP
e.g. Microsoft Visual Studio, GitHuB,
Power Platform
e.g. Microsoft Office and Dynamics
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The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.
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Measuring performance
The technology sector's outperformance has mainly been driven by earnings;
in the dotcom bubble, prices and earnings moved in opposite directions
Source: Factset, EVR-ISI Research
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In this webinar, our speakers Liz Savage, co-chief investment officer, Ben Derber, equity analyst and Chris Handley, IT strategy and change director, demystified the technology, its applications, and benefits through real world examples.
28 June at 12:30 - 13:15
WEBINAR: THE CLOUD - HARNESSING THE POWER OF THE INTERNET
Publlic cloud % of profit
Alibaba 2022E 1%
Alphabet 2022E -5%
Amazon 2022E 46%
Microsoft 2022E 22%
28.0%
41.0%
20.0%
6.0%
5.0%
Amazon
Microsoft
Alphabet
Alibaba
Other
Salesforce.com
Microsoft
SAP
Oracle
Google
Other
7.8%
4.0%
3.7%
3.0%
74.0%
7.0%
Swipe the graph to the left to reveal more
Swipe the graph to the left to reveal more
Source: Piper Sandler, Rathbones
Source: Gartner
Source: Gartner
Source: Factset. *Enterprise value is the measure of a company's total value, including equity and debt.
Source: US Department of Commerce
Source: Factset, EVR-ISI Research
Source: Factset, EVR-ISI Research
Source: Piper Sandler, Rathbones
Source: Gartner
Source: Factset. *Enterprise value is the measure of a company's total value, including equity and debt
Source: US Department of Commerce
Source: US Department of Commerce
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