Best Way to Play the Cloud

by: Dana Blankenhorn

Cloud computing is the most important change to the enterprise computing paradigms this century.

By virtualizing operating systems, running on data clusters and building scale into a single infrastructure, clouds let you run huge jobs fast, host big web services from a single stack and handle demand when everyone rushes to a service all at once.

The impact of the cloud was made self-evident by social networking sites like Facebook, Twitter and Groupon (NASDAQ:GRPN), which were able to use open source tools to quickly build scaled systems that clouds could host, resulting in hyper-growth. clouds in the end are an enabling technology, a tool like a hammer. The money comes from services built on them.

Clouds are also the first new product of the open source era. In theory this makes customer lock-in harder to achieve. In fact it does not. The effort required to switch between cloud platforms is enormous even if two clouds are completely compatible.

Clouds are so hot there is talk of building an ETF around them. For now, however, you still need to play them through individual stocks.

The closest thing to a "pure cloud play" available to investors has been VMWare (NYSE:VMW), a software company majority-owned by 30-year old data cluster company EMC. VMWare's open source bonafides may be subject to question, but "open source" no longer has the market power it once did and the company continues to make new offerings to the market, the most recent being vFabric5, which enables enterprise-scaled Java applications,

Over the last year the best performance among the cloud computing pack has been put in by Rackspace (NYSE:RAX), a hosting provider whose sponsorship of the Open Stack Infrastructure as a Service (IaaS) software offering has it up over 135% since last June. (NASDAQ:AMZN) has been another big cloud winner, the online merchant up almost 89%, as has (NYSE:CRM), whose Software as a Service platform helped define clouds and is up almost 72% in the last year.

The P/Es on all cloud players are quite rich – often north of 100. Which is why I think the best way to play the cloud may be Red Hat (NYSE:RHT). Their P/E is a relatively-reasonable 77, they have put all their growth chips on the cloud and they have powerful allies – an Open Virtualization Alliance headlined by IBM (NYSE:IBM), HP (NYSE:HPQ) and Intel (NASDAQ:INTC) built around the KVM "hypervisor" (a virtualization system) used by Red Hat's OpenShift. Red Hat is also the largest commercial Linux distributor. It success could make it the target of a very profitable takeover battle in the next few years.

Overall, however, it's important to remember that everyone is moving to the cloud. Microsoft's ambitions are all tied up in its Azure cloud. IBM talks about building private clouds. HP and Dell (NASDAQ:DELL) both have cloud ambitions, starting with the data cluster market led by EMC. Cloud computing will in time become enterprise computing and probably in less time than enterprise advocates think.

So if you're going to play the cloud, know what it's about. There is not much air up there, so image matters, reputation matters, alliance matters and even what tech journalists like me say may matter. And in the end the whole thing is going to fall to earth, one way or another.

But the computing earth these companies fall to will be changed. Which to me is what it's all about.

Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours. I covered this area extensively at ZDNet, saw there wasn't any good overview and wrote one.