Google Does Cloud: Should We Care?

| About: Alphabet Inc. (GOOG)
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At the I/O conference in June, Google (NASDAQ:GOOG) announced Compute Engine - an Infrastructure as a Service (IaaS) product that will provide companies with raw computing power by way of the internet.

Infrastructure as a Service has been one of the largest growth areas in technology. Companies are forgoing maintaining their own servers, and instead, paying firms like Amazon (NASDAQ:AMZN) and Rackspace (NYSE:RAX) to provide that server power.

By outsourcing their server technology, companies receive several benefits. For starters, companies can "scale" very quickly by renting server power. Because companies are renting the IaaS they can simply rent more servers to add capacity very quickly. If companies were not renting IaaS, they would have to physically buy and implement their own technology -- a slow and cumbersome process. Also, when companies physically buy servers, they must buy enough servers to maintain service during peak hours, meaning that the server power is wasted for most of the day. By having a flexible amount of server power, companies are able to pay only for the amount of server power they need.

Another benefit of the cloud is that, because the large IaaS providers have more favorable economies of scale and more expertise, they can theoretically provide IaaS services to a company more cheaply than it would cost for a company to run their own servers. Adoption of the cloud has increased as large companies become more comfortable with renting IaaS. In 2011, adoption of the cloud by multinationals was up 61% from the previous year.

By offering an IaaS Cloud service, Google is entering Amazon's domain. Amazon is the unquestioned leader in the cloud industry, and holds a commanding market share in the IaaS market that Google is targeting, as the chart below shows:

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Why would Google's IaaS product succeed when Amazon has thwarted all previous competitors? Although Amazon was the first to rent out its cloud service, Google has been touted as one of the pioneers of the use of cloud technology, and has been using it internally since 2008. Google clearly has the technical chops to challenge Amazon, but many obstacles still remain.

Reasons Google Will Succeed

1. Google's Allure: According to industry experts, Google has the third most valuable brand in the world. Although Google's reputation has been slightly tarnished by its failed forays into social, it is still considered the industry benchmark when it comes to computer engineering. Its reputation as an engineering whiz gives it instant credibility in the engineering-centric IaaS field. For years, companies have been attempting to emulate Google's infrastructure, so the ability to instantly tap and utilize that infrastructure through Compute Engine will certainly be appealing.

2. Google's High Adoption Rate: Maha Ibrahim, a venture capitalist at Canaan Partners, estimated that 98% of startups already use Gmail, Calendar or Google Documents. By providing these services so globally, Google already has a relationship with the potential customers of its IaaS service -- something that competitors like Rackpace do not have. It will be interesting to see if Google attempts to integrate its existing services with its Compute Engine offering.

3. Service/Performance: Amazon's cloud system has recently had several high profile outages, which have damaged its reputation as a reliable service provider. Google owns over a million servers, more than any of its competitors. This scale, and its dedication to operating excellence, should help Google incur less outages than companies such as Amazon. Uptime is one of the biggest factors in choosing an IaaS provider, and if Google provides more and better uptime than Amazon, then Google should enjoy a major competitive advantage.

4. It Might Be Cheaper: Google claims that its data center is so efficient that it can offer "up to 50% more computing for your money than other leading cloud providers." However, the CTO at Joyent, which offers cloud software for service providers, stated that Google's service was actually more expensive than the industry's going rate. Direct comparisons between IaaS providers are tricky, but global technology blog The Next Web (TNW) did an analysis and found that Google is charging industry average prices for "computing units" while offering a significant discount on RAM.

5. Encryption: Of the major cloud computing players, Google is currently offering the best encryption options. One of the biggest concerns companies have about the public cloud is the potential for data breaches. Google's encryption system could be a key selling point for executives who are skittish about putting valuable information into the cloud.

6. It Isn't An App Engine: Google's App Engine, a Platform as a Service, struggled to gain traction because developers were frustrated by Google's restrictions on programming languages and standards. Google has promised that Compute Engine will be much more flexible. This flexibility should ensure Google's ability to target a much larger market segment than it could with its App Engine.

Challenges Google's IaaS Offering May Face

1. Does Google care? Google has a reputation for ditching failed products such as Google Wave, Google Buzz, and Dodgeball. If Compute Engine is not an automatic success, will Google remain committed to offering the service? With other companies intensely concentrating on the cloud, Google needs to provide a significant amount of attention and resources to make Computer Engine successful. Companies will be hesitant to invest heavily until they are confident that Google views Compute Engine as a core product, not simply an interesting side project.

2. Compute Engine Is An Unknown: It will be difficult for Google to overcome Amazon's existing momentum and dominant presence in the IaaS space. Enterprise clients are notoriously resistant to change, and it will be a struggle to convince customers that Compute Engine is better than Amazon's proven products.

3. Linux: Google only offers Linux servers as part of Compute Engine, while Rackspace and Amazon offer Windows servers in addition to Linux servers. It is unlikely that Google will add Windows servers to its menu of offerings, because Compute Engine is based on Google's Linux-only infrastructure. Many companies use Microsoft's server technology, and attempting to adopt Google's Linux servers could cause compatibility hassles.

The Big Picture

So, what does Compute Engine mean for Google's stock price? In the short term, don't expect much. Amazon, the behemoth of the cloud industry, simply stashes the revenue derived from its cloud services under "other" in its10-K. The revenue that Google receives from Compute Engine will not materially affect Google's bottom line -- at least in the short term.

Google's move into IaaS is all about getting market share in an industry that is projected to grow at an incredible rate. Forrester forecasts that the global market for cloud computing will grow from $40.7 billion in 2011 to more than $241 billion in 2020. At those predicted levels, significant market share in the cloud industry could be a key driver of bottom line revenue -- even for a company of Google's size.

I do not expect Compute Engine to be a catalyst for Google in the near future, but I will keep a close eye on it to see if IaaS ultimately becomes an avenue for Google to diversify its revenue streams and drive growth.

Disclosure: I am long RAX.