Cloud computing has been among the fastest growing segments of the technology industry, driven by the ever expanding universe of new apps and websites. But many of these companies now trade with price-earnings multiples higher than 50x at a time when the industry is becoming increasingly commoditized. So, where are these stocks headed?
According to TickerSpy's index, the sector has jumped 20.4% over the past month (16.1% better than the S&P 500) and 87% since the beginning of 2008 (87.8% better than the S&P 500). Meanwhile, the sector now trades with an average price-earnings multiple of 58.8x, compared to just 22.86x for the S&P 500.
Stocks in this index include:
- Akamai Technologies Inc. (AKAM)
- Equinix Inc. (EQIX)
- InterNAP Network Services (INAP)
- InterXion Holding NV (INXN)
- Limelight Networks Inc. (LLNW)
- Level 3 Communications Inc. (LVLT)
- Rackspace Hosting Inc. (RAX)
- 21Vianet Group Inc. (VNET)
Do Growth Rates Justify the Multiple?
Earnings multiples are often a factor of historical or anticipated growth rates. Simply put, high growth companies trade at higher multiples, since their future earnings justify a higher current price. The problem often arises when historically high-growth industries begin to slow, but maintain their high multiples, which can lead to sharp declines.
Let's begin by looking at current growth rates for the four largest players:
Data taken from MorningStar using TTM where indicated.
From this chart, we can see that the growth rates are attractive, but the price-earnings to growth (PEG) ratios are overvalued at over 3.0x on average. The next step is looking to see if this valuation can be justified by looking at projected industry growth rates, and discounting that by the risks faced by the sector over the same time frame.
According to Forrester Research, the cloud computing market is expected to increase from $41 billion in 2011 to $241 billion in 2020. Similarly, Gartner predicts that the market will see revenues of $148.8 billion by 2014, which is even higher than Forrester's estimates. The hosting subsector of this market is expected to be equally as large.
Rack Space's Lanham Napier noted in a conference call that, "the opportunity ahead of us is massive and we've only just begun to tap the market … we believe that the cloud computing era represents one of the biggest marketing opportunities in all technology."
But there are also some key risks. Namely, the rapid growth in the industry has encouraged a lot of competition that has hurt margins. For instance, RAX's margins on its cloud-computing platform are sharply lower than its managed hosting. And this trend is likely to continue if the market continues to see the massive growth predicted by analysts.
There's little doubt that the sector is growing, but is it growing enough? Even with a CAGR of around 60% (as some analysts project), the P/E multiples seen in many of these companies seem to indicate even higher expectations, if we assume that a PEG of 1.0x is a fair valuation. In this case, investors may want to tread cautiously with some names in the space.
Opportunities in the Space
One of the best ways to play the cloud computing and hosting sector may be pairs trading, given the uncertainty surrounding its growth. Investors may want to consider buying companies with more reasonable PEG ratios, while simultaneously short selling those with lofty PEG ratios. As a result, industry dynamics are hedged out and the trade becomes a play on valuations.
Those long in these stocks may also want to consider hedging their bets using put options or by selling covered call options (the better choice, in my opinion). The income from covered calls can be used to help create a cushion in the event that the industry moves backwards. But this could be a while, as the market remains very bullish.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.