"Cloud Computing" is a new buzzword (or is it buzzwords?). Everybody is talking about it and most people don't understand it. I will try to review the current state of cloud computing from an investment perspective and possible future developments in the area.
IT expenses are huge in most companies. At least that's what any manager (with some exception) will tell you. To reduce those expenses, companies have adopted various business practices: cutting the number of personnel (usually with disastrous consequences later), appointing MBAs as IT department managers, buying software packages instead of in-house development (not a bad idea) and, of course, outsourcing (with the whole spectrum of results, from awful to great). In most cases, IT costs have ignored all heroic efforts of managers and have continued to grow. They continue to grow for two reasons: IT does more work every year and most of the efforts of managers are counterproductive- they actually increase costs instead of cutting them.
Looks like managers see cloud computing as a great new way to cut IT costs. They are both right and wrong. They are right because when implemented properly, cloud computing can cut costs and/or increase productivity. They are wrong because there is no such thing as a free lunch and correct implementation still costs a lot of time, effort, and money.
In the news, especially investment news, there are three different IT developments which are lumped together under name of "cloud computing". Below is a quick review of them.
Also called server farm, this is a new way of organizing computing infrastructure. Companies set up big server farms with thousands of individual servers. Servers belong to the company, although management might be outsourced. The biggest plus of internal clouds is the fact that all data is kept on company's own hardware. Usual features of such farms include: virtualization, automatic computer management and virtual networking. I am not going to explain all these terms, there are enough explanations on the Web. The first server farms, as far as I know, were used by Web oriented companies, such as Amazon.com (AMZN), Yahoo! (YHOO), Ebay (EBAY) and Google (GOOG).
But for investors, the most interesting companies are those which provide hardware and software solutions for internal clouds. The biggest of them are: Dell (DELL), HP (HPQ), IBM (IBM), Cisco (CSCO), EMC (EMC) in hardware; and in software, Microsoft (MSFT), VmWare (VMW), Oracle (ORCL) (which is also a hardware vendor after buying Sun Microsystems). There are also a lot of smaller players, but judging by the latest earning report from Brocade (BRCD), competition is stiff and prospects are not certain.
If the idea of storing data on somebody else's hardware doesn't scare you, the cloud itself can be outsourced. Currently, Amazon, Google, Microsoft, AT&T (T) and a lot of smaller companies provide this kind of service. I think that Amazon and Google have an advantage here, both because they are better at managing relationships and have better hardware/software combinations. Microsoft's policy of using exclusively the Windows operating system is a drag on performance, while Amazon's and Google's reliance on Linux is a plus. AT&T is at a disadvantage here as well, because its problems with customer service are not restricted to the mobile phones area.
The companies provide virtual machines to their customers, with the operating system of the customer's choice. But Linux is a better base for virtualization than Windows. Unfortunately for investors, external cloud doesn't look like a significant piece of business for any of these companies or any other big companies which might get into it. Possible candidates are IBM, Ebay, Yahoo!, Dell, HP, Oracle. Of specialized companies, I only found Rackspace Hosting (RAX) and Enomaly, which is not public (yet?). I don't know if specialized companies have any chance inside of the herd of elephants, but Rackspace is on my watch list.
Software As a Service
I don't really know why is it often called "cloud computing," it has nothing in common with the other two. These are suites of applications provided to businesses online, usually through web browser interface. True, companies providing applications might use internal or even external computer clouds, but the business model is completely different.
From my point of view, this is a very interesting development. There is only one problem for the companies here: data is kept on devices which belong to a different company. But in this case, companies don't need expensive IT departments to run the application. It's not a big help to big companies, which use hundreds of different applications, including a lot of custom built. But for a small company, which needs less than a dozen applications, this is a very interesting proposition. Current competitors in this area: Salesforce.com (CRM), Oracle ORCL), Rightnow Technologies (RNOW).
Salesforce.com is a leader, and any independent company is a possible acquisition target for Oracle and SAP (SAP). There is a possibility that Microsoft might get into this business, using acquisitions or internal developments, but so far I don't see any indication.
Of the above mentioned, software as a service is the most interesting investing area. I'm looking at Salesforce.com often, but the stratospheric P/E scares me every time. I might be wrong and the P/E might be justified. For internal clouds, software companies look like the best bet with VMW being the leader. I don't see any investing possibilities in the external clouds yet. I am long GOOG for different reasons and I think that AMZN is a great company, for other reasons as well.
Full disclosure: At the time of publication author had long positions in GOOG, VMW and BRCD and no positions in other stocks mentioned. Positions can change any time.