Cloud Migration Remains A Secular Growth Story

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Includes: ADBE, AMZN, EQIX, GOOG, MSFT, NTNX, PANW, VMW
by: ClearBridge Investments
Summary

After aggressive spending in the last several years, hyperscale providers of cloud computing infrastructure are facing revenue headwinds as purchase decisions are delayed as capacity is being absorbed.

We believe the slowdown in cloud capex spending is a medium-term issue and that hyperscale providers will continue to grow their capacity and data centers in-line with workload migration at a measured pace (instead of the current temporary overbuild).

Enterprise workload migration to the cloud is undeniable and secular. We are in the very early days of migrating computing and storage needs to the cloud for cost and flexibility reasons.

By Peter Bourbeau and Margaret Vitrano

Amazon, Microsoft Continue to See Strong Cloud Results

The migration of corporate workloads and data storage from on-premise to the cloud is one of the most important and far-reaching trends in technology. That migration began to hit some speed bumps last year as Chinese providers of cloud services – known in the industry as hyperscale vendors – and U.S. data storage firms and chip suppliers to data centers began to report slowing capital spending on cloud infrastructure: the servers, software and related technologies that make the cloud work. Most industry watchers attribute the slowdown to a “digestion period” following aggressive cloud spending over the last several years, a trend further sparked by new U.S. tax rules allowing for immediate write-offs of capex.

A broad range of technology companies with business tied directly to the cloud will likely face tougher earnings comparisons in 2019 and could see near-term weakness in their results. The largest U.S. hyperscale providers, Amazon.com (AMZN) and Microsoft (MSFT), continue to grow significantly faster than aggregate enterprise tech spending. Revenue at Amazon’s AWS jumped 45% year-over-year in the fourth quarter and was a major driver of the company’s better than expected results. Amazon continues to make significant investment in its AWS sales and marketing efforts and cloud should continue to be a consistent source of growth for the company as it expands into other areas like advertising. At Microsoft, its Azure hybrid cloud solution saw a second consecutive quarter of 76% year-over-year growth in its fiscal second quarter and continues to be the fastest growing part of the company’s business. We believe the pace of Azure, which saw its gross margins expand from the mid 30s a year ago to over 50% in the latest quarter, will be key to determining the pace of Microsoft’s aggregate growth going forward.

Exhibit 1: Cloud a Growing Driver for Largest Platforms

Microsoft

Amazon.com

Total Revenue

$118,459

$141,366

Cloud Revenue

$30,400

$25,655

Trailing 12 month data as of Dec. 31, 2018. Source: ClearBridge Investments, company reports.

While not as high profile as its peers, Alphabet (GOOG) has also developed a significant cloud infrastructure that it includes in its Google Cloud Platform or GCP division. GCP revenue was up 102% year-over-year in the fourth quarter to $2.7 billion and the company is stepping up hiring in the division.

Data center REITs such as portfolio holding Equinix (EQIX) are also exposed to the capex cycles of hyperscale companies. While the company’s existing business is highly recurring in nature, a slowdown in demand from these providers could lead to a slowdown in cabinet and interconnection growth, as well as the potential for pricing pressure in the near term. Longer term, we believe the shift to hybrid-cloud IT infrastructures will continue to drive growth across the data center space, and the unique benefits of Equinix’s dense network of interconnections will keep the company’s growth rate within its long-term range of 8-12%.

Software Providers Crucial in Improving Cloud Efficiency

We continue to see tremendous opportunity in supporting cloud players in the software area. VMware (VMW) and Nutanix (NTNX) hold significant market share in a cloud solution called hyperconverged infrastructure (HCI) that enables storage, computing and networking to operate as a single platform. HCI increases the efficiency and scalability of data centers and its usage as a low-cost solution is expected to more than double in the next several years. Meanwhile, providers of software solutions that make the hybrid cloud fault tolerant and seamless, like VMware, are benefiting from partnerships with cloud providers AWS and IBM. Open source software provider Red Hat’s cloud capabilities were the primary motivation for its acquisition by IBM in the fourth quarter. Given that enterprise security is a board-level concern, Palo Alto Networks (PANW) continues to innovate and be a leader in the security space both on-premise and within the cloud. The company brought in a senior Google executive as CEO last year to accelerate that move to the cloud.

Finally, software-as-a-service (SaaS) providers, the original cloud companies, continue to thrive from subscription models for their software that result in consistent recurring revenues. Companies like Adobe (ADBE) and Microsoft (whose Commercial Cloud business, which includes its Office 365 subscription service, grew 47% in the fourth quarter) benefit from their SaaS models.

The cloud continues to offer cost, security and execution efficiencies over the on-premise computing model that will only be enhanced by technological innovation. However, the movement to the cloud is still discretionary. Slower global GDP, revenue and profit growth may delay mission critical applications moving off premises and to the cloud, impacting growth rates for the hyperscale providers. In addition, we acknowledge that valuations for many SaaS and infrastructure-as-a-service providers are still rich and could re-rate with a meaningful slowdown in spend. Nevertheless, while we believe the recent momentum of cloud spending may slow temporarily, the secular outlook for the cloud business model remains strong. As long-term growth investors, we expect to maintain meaningful exposure to cloud investments.

Peter Bourbeau co-manages the Large Cap Growth and All Cap Growth strategy products. Peter joined predecessor firm Shearson Asset Management in 1991, and has 27 years of investment industry experience.

Margaret Vitrano co-manages the Large Cap Growth and All Cap Growth strategies. Margaret has 22 years of investment industry experience and joined a ClearBridge predecessor organization in 1997.

Disclosure: I am/we are long ADBE, MSFT, AMZN, GOOG, EQIX, VMW, PANW, NTNX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The opinions and views expressed herein are of the Portfolio Managers listed as of the date shown, and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results, or investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information.