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What You Should Know About Investing in Cloud Computing

- By Sangara Narayanan

The growth of cloud computing has huge implications for the top vendors of the segment - Amazon (AMZN), Microsoft (MSFT), IBM (IBM), Alphabet's Google (GOOG)(GOOGL) and Oracle (ORCL). The industry has seen a massive amount of growth over the last few years, and there are several indications that the current growth rate may continue for some time before it starts levelling out.

For starters, the infrastructure-as-a-service (IaaS) segment - the bedrock of cloud computing - was estimated to be worth $22 billion in 2016, showing growth of 38% compared to the previous year. Also in 2016, worldwide data center expenses alone were $173 billion, which means the third-party management infrastructure has plenty of room to expand before it can enter a more mature phase of growth.

Secondly, according to Cisco Global Cloud Index, public cloud traffic to data centers is expected to increase by a compound annual growth rate of 30% until 2020, while IDC expects 27% CAGR for the IaaS segment over the next several years.

Next, Amazon and Microsoft both reported their annual cloud revenue run-rates for the most recent quarter were in excess of $14 billion, while IBM said it made $13.67 billion from cloud during 2016. Google and Oracle have a long way to go before they can catch up with the leaders of the segment, but there is still a tremendous growth opportunity for both companies - even a decade after Amazon entrenched itself into the IaaS market.

Lastly, the entire cloud computing segment - from IaaS to SaaS - is still a high-margin business. Amazon Web Services' operating margin surpassed 30% in the most recent quarter. Meanwhile, Microsoft reported a massive 45% operating margin (first-half 2017) from its Productivity and Business Processes segment, which houses its SaaS products such as Office 365 and Dynamics 365. Intelligent Cloud, which contains Microsoft's IaaS services, posted 33.65% operating margin, similar to what Amazon Web Services reported.

From all this evidence, it is clear that the cloud infrastructure market is not only growing, but it is an extremely profitable one to be in.

RightScale, a cloud management solutions company, recently conducted a survey that found several underlying trends that will shape the industry's near-term future as well as the earnings of the top three cloud service providers. Here are the salient points:

  • Private cloud adoption fell from 77% to 72%, bringing hybrid cloud adoption down from 71% to 67% year over year.
  • 85% of enterprises have a multicloud strategy, up from 82% in 2016.
  • 95% of organizations surveyed are running applications or experimenting with infrastructure-as-a-service.

In short, private cloud adoption, where companies own their IT infrastructure, is coming down, while 95% of the companies surveyed are running some form of cloud application.

That means most businesses around the world are already trying cloud, but have yet to move fully into it, which we know from the fact that 72% of companies are still on private clouds.

Vendor lock-in is also a threat many companies think about when moving to the cloud because they do not want to be stuck with a single provider.

Case in point, Snap Inc.'s recent IPO filing showed the company has a multicloud strategy, utilizing the services of Google's cloud platform and Amazon Web Services.

The multicloud strategy - where you use more than one cloud service or provider - has already become mainstream, and businesses around the world typically use this approach to avoid being dependent on a single provider.

Considering the current size of IT infrastructure spending worldwide, and the fact the multicloud model is here to stay, all the top vendors in the segment - and their bottom lines - stand to benefit over the next several years.

Investor takeaways

A few key points from this discussion should be noted by investors looking to put money into cloud companies.

  • The size of the cloud computing market, as well as its growth potential, are both big enough to accommodate several large service providers.
  • 95% of the world's businesses are experimenting with cloud-related services, which means a lot of them will be moving more workloads, implying further growth for top providers.
  • The multicloud model gives ample room for competing vendors to exist in the market.
  • High margin levels indicate the overall health of the segment.

These points should help investors better decide their level of exposure to the cloud industry. Right now, there are at least five deep-pocketed companies in this segment, and all of them have the potential to go to the next level. It is merely a matter of time before their combined efforts bring cloud into mainstream enterprise usage.

Disclosure: I have no positions in the stocks mentioned above and no intention to initiate a position in the next 72 hours.

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This article first appeared on GuruFocus.