CLOU: Expect Rain With So Many New Cloud Companies

Summary

• Cloud computing companies have dominated the recent technology rally as the stay-at-home lifestyle brings greater e-commerce revenue.
• SaaS, PaaS, and other "acronym firms" have extremely high valuations today, with the Global X Cloud Computing ETF trading at a weighted-average P/E of nearly 100X.
• There is no doubt the cloud computing industry will grow by double digits over the coming years, but growth does not necessarily mean profit growth.
• Problematically, many firms in CLOU compete with each other and competition can be extreme with non-physical firms that lack significant moats.
• The firms in CLOU appear to be in a bubble that recently went through a classic "blow-off top" which means their long-term peak may now be in.
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(Pexels) - Is the sun setting for Cloud Computing stocks?

Technology stocks have dominated market performance over most of 2020. Many firms such as Apple (AAPL), Google (GOOG) (GOOGL), and Microsoft (MSFT) are up 30-50% YTD despite it being an abysmal year for the global economy. However, it is actually the newer cloud computing firms that have seen the most significant gains. This includes Software-as-a-Service, Platform-as-a-Service, and Infrastructure-as-a-Service firms, as well as server and data REITs.

The Global X Cloud Computing ETF (NASDAQ:CLOU) invests in this subindustry and has seen a significant increase, rising 35% this year and 60% from its March trough. See below compared to the popular Technology Select Sector SPDR ETF (XLK):

Data by YCharts

The ETF has seen significant investor inflows in recent months, with its AUM doubling since May despite a slowdown to its appreciation. Let's take a closer look at this ETF and its holdings to gauge whether or not investors are buying the "Next Apple"'s or are riding the last wave of a technology bubble.

A Look at CLOU's Holdings and Valuation

The bulk of CLOU's holdings are software, with application software making up 58% of holdings and systems software 13%. This includes companies such as Zoom (ZM), Netflix (NFLX), and Coupa Software (COUP). The other major category is internet services which include the likes of Shopify (SHOP) and Zscaler (ZS).

Nearly all of the companies in CLOU have had very high momentum this year. This is particularly true for the top ten holdings in the ETF, about half of which have doubled or more this year. The performance of these ten firms is shown below:

Data by YCharts

With such strong performance across so many holdings in the ETF, it is no surprise many investors are flocking to it. Much of this is because consumers are switching from in-store shopping to online shopping. This benefits not only firms like Amazon (AMZN) and Shopify but also online payment processing companies, firms e-commerce companies use to manage customer relationships and companies that are paid to store data in the cloud. Indeed, most of these firms saw substantial increases in revenue in Q2. See below:

Data by YCharts

It is no doubt that these are high growth companies that are in industries that will likely see growing demand over the coming years. That said, investors may be overlooking a few key factors. Chiefly, CLOU trades at a weighted-average P/E of 98X and 82X on a forward basis. Remember, AAPL has never traded even close to such a high P/E valuation since 2007 when it first invented the iPhone.

Sure, some analysts can justify such valuations by assuming an Apple-like growth curve, but the fact of the matter is that these stocks are extremely expensive. Most have low debt and high growth, but these are bubble-like valuations that are akin to those of the 2000s technology bubble. Most importantly, we must consider if these growth estimates will truly pan out due to growing competition.

Separating Industry Growth Vs. Profit Growth

There is no doubt that cloud computing is the future and that e-commerce and other internet-centric industries will continue to mature and become a dominant aspect of the economy. The cloud computing/SaaS (and other acronyms) industry will likely grow by double digits for many years to come. However, as investors, we need corporate profits to grow in order to generate a high return. This requires companies to have strong margins and a wide moat.

It is very popular today for analysts and investors to look at a company in an emerging industry like cloud computing and deem it the "next Apple/Amazon". However, there are a few key facts that separated those firms from competition. First, Apple has almost always made a considerable profit margin on its products even while inventing new ones. This is less true for Amazon, but Amazon has benefited significantly from creating a near-monopoly on the e-commerce industry via "network effects" and its fulfillment infrastructure. Apple has relied on network effects to grow its iPhone business as well as the fact it was the first major company to develop touch-screen smartphones.

Most importantly, Apple, Amazon, Microsoft, Google, and similar technology giants have large physical presences that make it very difficult for competition to impact their margins.

So, what moat does a company like Zoom Video or similar have? Zoom has many larger competitors and, while it is a popular platform, lacks a monopolistic moat that it would need in order to generate a large profit margin. The same can be said for most of the firms in CLOU. Problematically, most lack physical presence and are subject to growing competition. For example, if Twilio (TWLO) (CLOU's largest holding) were to raise prices on its video or messaging services, then it would not be hard for new competition to undercut the company and take market share.

Importantly, many firms within CLOU are competing with each other. For example, Paycom (PAYC) and Paylocity (PCTY) offer almost the exact same services and have seen margin contraction this year due to that competition. The same is true for perhaps most of the firms in CLOU.

Looking Forward

Overall, I believe investors are better off avoiding CLOU and most of the firms within it. They have had stellar performance lately due to COVID's positive impact on revenue, but irrational exuberance appears to be dominating this industry. The simple truth about most internet companies is that competition is nearly infinite and most of the software sold through these services can be replicated by other firms and lead to price-warring.

While the industry is growing, price competition will likely be low, but as it matures over the coming years, I believe many will be forced to cut prices in order to compete with others such that profit margins are near-zero.

Now, if you were to go through the ETF, I am sure there are a few companies that have both high growth potential and a wide moat from competitors. However, the majority of the companies in the ETF have irrationally high valuations that do not account for growing competition.

CLOU is the only ETF I've seen to have a negative SEC yield. The fund's dividend yield is around 21 bps, but it has a higher expense ratio of 68 bps, meaning its net yield is negative. This is a testament to the extreme valuation of its holdings, particularly considering it owns a few REITs that pay their profits in dividends.

Technically speaking, CLOU may even be a short opportunity. CLOU's short borrowing fee is on the high-end today at 15%, but I firmly believe it is headed (at least) 40-60% lower in the long-run in order to bring its valuation to a more reasonable level. We saw the fund see significant declines during the March crash and now it is far higher than it was before the crash. I believe the recent rally was a classic "blow-off top" that comes at the end of a speculative bubble.

As you can see below, CLOU's momentum has now faded and it has begun to underperform the S&P 500, meaning the bubble may have reached its peak.

Data by YCharts

CLOU can certainly see more speculative gains, but I am willing to bet against it using tight stop losses at the past double/triple peak of $23. Personally, I am short a few of the fund's constituents in order to avoid the high borrowing fee which includes Salesforce (CRM), Shopify, and Netflix. Obviously, these have been dangerous stocks to short, so tight stops losses are necessary, but as the speculative "blow-off top"/"hockey-stick" rally fades, I believe they have much more downside risk than upside potential.

Disclosure: I am/we are short NFLX, AAPL, CRM, SHOP. 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.