The long-awaited "private cloud boom" is here.
New figures from Synergy Research Group show that servers and software for the construction of private and hybrid clouds are now a $60 billion market, and the business is growing at 20% per year.
No company has much more than one-eighth of this huge market but leadership has begun to emerge from two companies - Hewlett-Packard Enterprise (NYSE:HPE) and Cisco (NASDAQ:CSCO). Cisco is the lead in serving public clouds, HPE the leader in private, according to spokesman John Dinsdale. Each has about 12% of the market.
Figures for the fourth quarter show a big rise for IBM (NYSE:IBM), tying Dell, and Microsoft (NASDAQ:MSFT) with a 7% share as the software vendor of choice, but Dinsdale said that gain should be disregarded. "IBM always has a relatively huge fourth quarter," he told me. "You can pretty much guarantee that the IBM numbers will drop substantially again for the first quarter of this year."
One reason the market is so large is that even companies like Amazon.com (NASDAQ:AMZN), which build and install their own gear from parts, still use Original Design Manufacturers, or ODMs, for some of the work. The ODMs can bring in huge volumes of business, but they suffer from very low average selling prices and margins. Thus "private cloud now accounts for just over half the market, public cloud just under half," Dinsdale told me.
This is a big part of the problem for the old computer hands. Customers have scaled to the point where they don't need them. This crushes margins. Only a few companies, like Amazon and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), are large enough to use the ODM model, but now that it's established larger public cloud, players have a clear path to savings, and as they grow will use it.
For IBM, which both builds cloud gear and has its own cloud, obtained through the acquisition of Softlayer, this means it gets little benefit from its improved integration skills. It is simply getting squeezed out on both ends.
But Microsoft, which also runs a public cloud system called Azure, does not have this problem. Since it is supplying other clouds with software, not hardware, it does not sustain the same kind of costs as a supplier, while it benefits from the ODM model as both a builder and cloud owner. One thing I have written often here is that "hardware is software," meaning that while there remain chips, boards and racks, that's not where the profits are.
If I could draw one investment conclusion from the report, then, it is to buy Microsoft. It is not being drawn into the commodity margin spiral, it is maintaining a decent share in private cloud, and it is benefiting from public cloud economics. That might be why its price/earnings multiple is in the high 30s, while the P/Es of CSCO, HPE and IBM are in the low teens.
Disclosure: I am/we are long MSFT, AMZN, GOOGL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.