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Cloud Computing: Who Owns the Castles in the Sky?

The winners have emerged in the cloud market.

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Cloud computing has been a hot topic for years, but most companies are still in the early stages of adoption. As IT workloads shift to the public cloud over the next several years, opportunity abounds for infrastructure- and platform-as-a-service vendors, or IaaS and PaaS, respectively. However, as explored in a recent Technology Observer from Morningstar Research Services,1 only a handful of providers have the capital investments, research and development initiatives, and technical knowhow necessary to predominate.

To learn more about the best investments in this space, I spoke with lead author Rodney Nelson. Our conversation took place on Aug. 1 and has been edited for length and clarity.

Laura Lallos: Many of us are most familiar with software as a service, or SaaS. How do the platform and infrastructure as a service markets relate?

Rodney Nelson is an equity analyst with Morningstar Research Services specializing in enterprise software.

Rodney Nelson: The difference between SaaS and PaaS and IaaS is all about who is managing which part of the software and hardware stacks. With SaaS, a single vender, such as  Salesforce.com (CRM), manages the entire software stack, including the physical server, the database, the operating system, the middleware, the bins, the libraries, and the underlying code for the application itself.

With PaaS and IaaS, the customer has more ability to customize. With IaaS, the only thing that the cloud vendors do is manage the core compute and storage services. They have data centers spread across the globe of homogenous hardware that is providing on-demand compute and storage technologies for companies to build and run software on. The beauty of that is the customer only pays for the amount of compute and storage that it actually uses, whereas in an on-premise environment you have to pay for the cooling, the heating, and so on, 24/7/365.

With PaaS, the stack is a little bit more controlled by the vendor, who usually dictates which database technology and middleware components are used. It's a predefined set of tools that the customer uses to build a software application. An example is  Twilio (TWLO). They've developed their own programming language on top of a set of tools that allows a customer to build a communications application or build communications function into an existing application.

Lallos: You found that industry estimates for the shift to the cloud in PaaS and IaaS are probably too conservative.

Nelson: One of the more challenging things to predict in any industry is a secular trend or a new theme. I don't think many people predicted that  Apple (AAPL) would have such a rapid rise in the smartphone market and that the demise of  BlackBerry (BB) would be so quick. That's the perfect example of how difficult it is to project exponential growth in certain technologies.

But with the cloud, there's an increasing understanding that running on-premises infrastructure is a wholly inefficient way to conduct business. Within an on-premises data center, you're lucky to extract utilization rates above 10% to 15%. Within a cloud data center, utilization rates are up to 95%, so they can spread those costs over massive customer bases. That's a compelling reason for enterprises to move into a cloud environment. They don't necessarily want to spend less on technology; they want to spend smarter.

Our belief is that over the next five or 10 years, enterprises will migrate legacy technologies that run inefficiently, meaning they're only utilized part of the time or they're built on a very dated set of technologies. With the savings generated from that gain in efficiency, they can invest in more modern technologies like artificial intelligence, machine learning, the "Internet of Things," and edge computing. And all of those services are available in the public cloud. The public cloud vendors stand to gain a substantial share of the IT budget and tap into a portion where they never had a presence before.

Lallos: How long do you anticipate it will be before the migration is largely complete?

Nelson: It takes a very long time to migrate to the cloud in totality.  Netflix (NFLX) was a very early adopter, and it took them seven years to migrate their entire business from an on-premises mode to a public cloud model. That speaks volumes because Netflix is a business that hasn't been around very long and was already pretty modern, while some other enterprises have legacy technologies that date back 30 years. It's reasonable to assume that most enterprises will take between five and 10 years to get to a steady state where they are happy with the amount of assets they have in the public cloud.

Lallos: Is there anything that might disrupt this process?

Nelson: A few years ago, the most significant concerns were data integrity and security. When you have one customer in one partition and another customer in another partition on the same server, you could have data breaches if that ecosystem isn't managed carefully. Those risks have been mitigated, and the perception has changed as we've seen more companies undergo their own data breaches. Enterprises aren't the best managers of their own IT, and they can't spend at nearly the same rate as a public cloud vendor can on security. Moreover, public cloud vendors are managing a homogenous ecosystem, and they know it inside and out.

Another challenge for multinational organizations is the constraints surrounding data sovereignty internationally. In Europe, every country seemingly has its own set of regulations about how data needs to be handled and where it needs to be stored. It may need to live in a physical data center within the boundaries of that country.

For public cloud vendors that want to handle the workloads of multinational customers, it is crucial to have assets distributed globally as well. It's not enough to just build out thousands of data centers in the United States because if you get a customer that has interests outside of the U.S., you wouldn't be able to serve that customer from a performance perspective and/or a regulatory perspective.

That's why we've established  Amazon.com (AMZN) and  Microsoft (MSFT) as the big winners in this market today and going forward. They've cleared the hurdle of making really large ramp-ups in capital intensity and capital investment in these businesses, and they have the most distributed network of public cloud services globally. That in and of itself is a huge stepping stone to winning deals. Beyond that, the premium services they already provide around themes like Internet of Things, machine learning, and artificial intelligence deepen their expertise, and ultimately allow them to win more deals. It's sort of a virtuous cycle. They've gotten past that initial capital outlay, and now they can focus on those services that are going to attract customers that want to drive their own businesses forward.

Lallos: It sounds like size and scale are essential to developing and maintaining a competitive edge.

Nelson: Absolutely. By our estimation, this market could be worth hundreds of billions of dollars in very short order in terms of addressable market opportunity. But to address that market, you must outlay tens of billions of dollars to build out that global infrastructure. If you're already behind the eight ball, if you're an  Oracle (ORCL) or an  International Business Machines (IBM) () and you haven't made the requisite investments, you're already very far behind.

The leaders aren't stopping their rate of investment in these businesses. Data-center buildouts are beginning to slow at Amazon and Microsoft, but we're still seeing heavy investment on the R&D side, leading to even deeper product portfolios that are increasingly difficult to replicate. And as more data flows through these services, they become smarter and faster. It's kind of an arms race.

First and foremost, that level of capital intensity and that global scale affords the biggest players a cost advantage, because they can lower prices as they attract more customers and pass on those economies of scale without degrading their own margins. Then, there's an intangible asset component to these businesses as well that comes from having experience managing hyperscale cloud data centers, which we would certainly attribute to Amazon and Microsoft and increasingly to  Alphabet (GOOGL) and  Alibaba (BABA).

Then it ties back into that premium services portfolio, offerings around the Internet of Things, artificial intelligence, machine learning--the things that are driving incremental investments at enterprises. Those two things are really the building blocks for a competitive advantage and ultimately an economic moat in this market.

Longer term, as the cloud market matures, there's going to be some level of switching costs for customers. It's going to be very difficult to replicate an ecosystem at a different vendor. Amazon and Microsoft each have their own areas of expertise. For Microsoft, it's a deep and inherent knowledge of Windows-based applications, of which there are millions out there. That creates a natural landing place for a lot of those workloads in Microsoft Azure. Amazon has the deepest and broadest product portfolio of any of the cloud vendors.

Lallos: You noted that Google has made an extraordinary capital investment. Do you see it catching up?

Nelson: We expect the cloud to be a small component of Google's broader business, because its search and advertising business is so massive. Any amount of capital investment that Google makes into a particular product or service is going to have a very difficult time moving the needle of the broader business, because that advertising business is still growing very rapidly.

Where Google can be a player in this market is with its inherent expertise at data analytics and artificial intelligence. These drive that core search and advertising business. Being able to manipulate and parse through data and ultimately make decisions based on that data is a core component of any marketing campaign. As they expose some of their AI technologies to their own customers and unlock some of the frameworks that they utilize in their own business, it will attract a lot of customers to their cloud business.

Google hired Diane Greene, who was a co-founder of VMware, whose server virtualization technology enabled the cloud market to come to fruition. She not only has a very deep understanding of the underlying technology, but she also has the experience of dealing with enterprise customers. She was a savvy hire, and she's done a lot of things to bring a more formal atmosphere to Google's cloud business, but it is still several steps behind both Amazon and Microsoft.

There's still a fairly sizable gap from a revenue perspective between Amazon and Microsoft, but there's also a sizable gap between Microsoft and Google and the rest of the field. Considering that Microsoft is growing 100% year over year in its cloud business, and Amazon is still growing at a very high rate on a much larger base, it's likely that those firms will be able to maintain their leads. So now it's really a matter of who is going to be that third player in mature Western markets. Given their prowess in AI and machine learning, we think Google is going to have the most success.

Lallos: Meanwhile, Alibaba's advantage in China seems set.

Nelson: While Alibaba has assets internationally, it's probably going to be a pretty big challenge for them to win Western business because of that association with China. That adds a lot of red tape to dealing with the company. But China is a massive market, and it is not even remotely as far down the road of migrating to the cloud, so there is much pent-up demand. Alibaba's AliCloud is the Amazon Web Services of China. It's already got more than 40% market share, and it has the full support of the state.

They will win some business internationally, from Chinese firms that have international interests. Winning European business and American business is almost going to be impossible but the Chinese market is large enough to support a very high rate of growth and very durable returns on invested capital.

Lallos: Will there be niche roles for smaller players in the future?

Nelson: It's going to be challenging. If you want to manage the workloads of the largest enterprise customers, you can't be a niche player. You must have a global infrastructure to handle the needs of a global multinational enterprise. A regional cloud vendor can serve domestic or regional companies, but it will be a challenge for these vendors to invest intelligently in their own business and not overreach and build out too much data-center capacity such that they can't drive utilization high enough to generate economies of scale.

In the U.S., the lowest-cost vendor, Google, is a U.S. company, as are the most established vendors, Microsoft and Amazon. So, it's going to be really challenging for regional players to have much of a presence. Overseas, because of concerns about data sovereignty and local regulations, there is more potential for regional players to have nice small businesses. But the bulk of this market is going to be consumed by three or four companies.

Lallos: Do you anticipate M&A activity remaining busy in this area?

Nelson: Yes, the four prime vendors--Amazon, Microsoft, Google, and Alibaba--will continue to snap up small shops. If you look at the biggest deals or the highest frequency of deals over the last five or 10 years, they're all in the realm of cloud, machine learning, analytics, Internet of Things, artificial intelligence. I think that's where you're going to see the bulk of M&A dollars occur, simply because those are the markets that are the most untapped. I do expect it to remain a vibrant M&A market, though maybe the actual deal sizes might not be as big for some of these smaller shops that are more specialized.

Lallos: For investors looking for an opportunity to invest in the public cloud today, what do valuations look like?

Nelson: Coming into the year, there were some great opportunities to get involved in technology names, many of which had sold-off postelection. But valuations in general are now pretty full because tech has been on a tear for most of this year and most of these companies have performed quite well.

Microsoft is trading in the low $70s, and our fair value is $83 a share. That represents a compelling opportunity to get into the public cloud market, which is a nice growth component alongside a business that's also got a very stable set of products. Amazon is also compelling at its current discount to our $1,200 fair value estimate. We think Alibaba is closer to fairly valued, because of the fervor for leading technology companies in China.

With Google, you're really buying the advertising business. That's still the biggest driver of revenues and profits of the business, but you do have some nice optionality with the cloud business that could steer the business more towards a bull case valuation.

From where we're sitting today, Microsoft and Amazon look like the best opportunities, but we'd happily invest in any of these companies if you get the right discount to our fair value estimate.

1 Nelson, R., Lange, A., Mogharabi, A., Hottovy, RJ, Sun, M., Narayan, H. 2017. "Castles in the Sky: Identifying Moats, Winners, and Losers in the Burgeoning Public Cloud Market." Technology Observer. June.

Laura Lallos has a position in the following securities mentioned above: AAPL, AMZN, GOOGL, MSFT. Find out about Morningstar’s editorial policies.