Many companies operating in the cloud have high rates of growth and strong business models. One key drawback is that they are expensive, with share prices trading at much higher multiples of their sales and earnings than the average for the overall stock market.
With a few notable exceptions, most cloud-related businesses have low or negative profit margins as they invest heavily in expansion. Because platform services tend to be bundled together with infrastructure and/or software services, we will focus on the latter two.
Firm foundations
When looking for cloud–related investment opportunities, we think it makes sense to start with the base layer of the cloud, the infrastructure.
The big four infrastructure as a service (IaaS) providers — Amazon, Microsoft, Alphabet and Alibaba — provide this foundation that cloud applications are built on. As spending on the cloud increases, it will be hard to avoid paying some of those dollars to one of these four vendors.
The top three IaaS vendors control 80% of the market outside of China. One of the reasons is that they were able to leverage their huge data centre capacity, which they needed to service their core businesses, by effectively renting it to third parties. Without this pre-existing infrastructure, it probably wouldn’t be economical to build a public cloud business from the ground up.
In addition, once a customer commits to one infrastructure provider, it’s tricky to switch to another. They all have unique programs and applications and companies do not have the resources to engage with more than a few cloud vendors.
Vendors also have economies of scale to keep prices low and are continuously investing in value-added services, such as machine learning and voice recognition, that are bundled together with their core services. For these reasons, AWS earns an estimated post-tax return of 25% on the capital it invests in its public cloud business.
Some important caveats for investors: none of the big four are 100% pure plays on cloud infrastructure, and only Amazon and Microsoft have profitable IaaS operations.
The leading public cloud providers have diverse operations, which means they derive between roughly 10% and 25% of revenue from their infrastructure business. As a result, investors in these companies must also take a view on the prospects of their other divisions, which for Amazon is ecommerce, for Alphabet is primarily Search and YouTube, and for Microsoft is a wide array of businesses, including Office and Windows software, gaming and LinkedIn.
Over time, we believe the public cloud will generate an increasing proportion of their sales growth and profits. Investors in major cloud providers also incur higher regulatory and antitrust risk as their dominant positions attract government scrutiny.
All told, we see IaaS as a relatively low-risk way of gaining exposure to the growth in cloud demand as the market is more consolidated and the bulk of cloud software and services end up running over this established infrastructure.
Software: A fragmented cloud
We believe cloud software spending should continue to grow at a healthy clip for the next five to 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.
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.
The software as a service (SaaS) market is undergoing a Cambrian explosion in the number and type of applications being created and consumed. According to SaaS platform provider Blissfully, the number of unique applications used per company grew 30% to 137 in 2019 versus 2018.
This trend accelerated in the pandemic, with ever more cloud software solutions being adopted to address specific pain points across industries and functions, particularly software development, marketing and sales, and product development.
In the on-premise world, businesses tended to buy software from a single mega vendor as it was expensive to install and integrate multiple independent applications.
In cloud computing, companies can now buy best-of-breed solutions targeting specific workflows at the click of a button. Examples include workplace collaboration (Slack), document signing (DocuSign) or video conferencing (Zoom), which are pre-integrated with core applications like email and are hosted and managed by the vendor.
The rise of ‘freemium’ — giving away the lowest tier product for free — has been another factor driving adoption and helps explain how software companies like Zoom have been able to post such meteoric growth rates during the pandemic.
The cloud enables the freemium model to exist because distribution costs are low, and with gross margins often around 90%, the software can be offered at or close to zero. That drives huge global adoption and means that even a small percentage of paying users can generate billions of dollars in revenue. From the customers’ perspective, they gain access to a multitude of free software products, so it’s a win-win situation.
Cloud software providers tend to have more dependable, recurring cashflows relative to legacy software vendors because of their subscription-based business models. They have also had higher growth rates, in line with the trend of increased spending on cloud software from a low base.
For these reasons, SaaS companies tend to command higher prices than legacy software businesses relative to their earnings.
Risks to be aware of when investing in cloud software providers are that most are still unprofitable, the market may be saturated with similar services, and it’s often unclear who the long-term winners will be for cutting-edge solutions.
Ben Derber is an equities analyst at Rathbones. The views expressed above should not be taken as investment advice.