Cloud Computing: Who Owns the Castles in the Sky? (II)

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.

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.

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.

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.

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 below our fair value. 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 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.

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