Giant tech companies aren’t immune to earnings disappointments, as the recent turmoil in Facebook’s stock has demonstrated. But while certain FAANG fundamentals may be challenged, some of the best-known names in U.S. tech are dominating one of the world’s largest addressable markets: cloud-based software services.
Getting our heads in the cloud
Barely 10 years old, the cloud ranks among some of the newer internet-driven investment themes, including the Internet of Things and big data’s intersection with financial technology. But for all the brevity of its existence, the cloud has been hailed as representing a new paradigm that may govern more than just internet technologies—it’s a platform of platforms for reshaping how consumers consume and how companies operate.
In terms of business model transformation, we think of the cloud as a force of automation that is also anti-hardware. Offering operational efficiency, the cloud gives companies an easy way of reducing costs in two dimensions: It helps them reduce tech support headcount and relocate data storage, analysis, and security outside the four walls of the traditional company. On average, we estimate that outsourcing tech and tech support to the cloud translates into a 30% operating cost savings versus keeping these functions entirely in-house.
How big is the opportunity?
Cloud-based services can lend efficiencies—and most importantly in our digital era, data security—to companies in virtually any sector. Think of how banks need impregnable data security that’s been battle-tested and able to support high levels of consumer engagement. The cloud provides what are increasingly considered the best available options. Or think of how a small business may need bigger computing power than it could reasonably purchase on its own; again, the cloud offers cost-effective solutions. And consider how disparate groups collaborating on projects in government—including the 2020 U.S. Census—education, and industry research could benefit from more powerful ways of sharing and processing raw data into actionable information. All of these operations can find their most urgent business and organizational needs met through the cloud.
Given the breadth and depth of the appeal of cloud services, it’s not surprising that this represents an enormous opportunity. We estimate that cloud-related software services represent a $1 trillion addressable market. And we see three big U.S. tech companies already riding the crest of this wave: Amazon (through Amazon Web Services), Alphabet (through Google Web Services), and Microsoft. This group includes two of the FAANGs—Facebook, Amazon, Apple, Netflix, and Google—and the remaining companies in this set of tech giants will be eager to turn cloud-based technologies to their advantage.
What does the cloud mean for investors?
As a sector, information technology has hit its share of snags in the first half of 2018, including issues around data privacy, social media’s intersection with geopolitical tensions, and sporadic disappointments with earnings results. But the profit-generation potential of cloud-based software services could be the new frontier for many big tech companies. As Apple’s recent positive earnings results demonstrated, cloud-based storage and software services are the fastest-growing component of its business, just as the company has crossed the threshold of $1 trillion in market capitalization.
To get an idea of how meaningful this market may be for the big three tech companies (Amazon, Alphabet, and Microsoft) on the cutting edge of cloud-based services, consider that to date there’s only about $60 billion in outsourced revenues; however, we believe this is a $1 trillion addressable market, which means there’s a very low market penetration. In addition, the operating margin for this business is quite high—on the order of 25%. Obviously, this translates into a huge opportunity for meaningful growth.
An investment theme that's here to stay
The cloud, as companies across sectors and market caps are rapidly demonstrating, is at the center of the digital revolution in which we’re all enveloped. As the sum total of software and services that run on servers located remotely to your location, it’s available to everyone, everywhere—from C-suite executives to kindergarten classrooms. Any company that currently keeps electronic storage and technology support on-site is a potential consumer for cloud-based services. And the trend is clear: Companies are accelerating the transition of their storage and tech support beyond the four walls of their physical locations. That makes for a terrific growth theme for equity investors, and one we’re taking advantage of in how we position our U.S. portfolios.
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