I am sure many investors have come across the term “cloud computing” by now. It may sound highly technical, but I will try my best in this article to cut through the jargon and present an investment thesis on the cloud computing business model.
So, what is cloud computing in simple terms?
Cloud computing basically refers to shared computing resources, which could refer to software, analytics, storage, databases, etc. Shared, primarily because service providers (think Amazon, Microsoft, Salesforce) will manage these resources and companies can then access them on a pay-to-go or subscription basis. The chosen service provider becomes a one-stop shop for their clients.
A decade ago, companies would spend large capital costs buying hardware and software, as well as to set up on-site data centers. In cloud computing, the service provider takes on these costs, thus allowing companies to save large amounts of costs. These cloud computing service providers have the expertise to upgrade the required software and to ensure that the networks remain secure, allowing companies to focus their time and resources on other areas.
Essentially, companies can choose the types of services (software, data storage, analytics etc.) they require, and only pay for those. The payments are recurring, via a subscription model.
Subscription business models provide a key source of recurring income for cloud computing service providers
A subscription business model leads to a steady source of recurring income. Think of Netflix’s (NFLX) business model, where viewers at home can gain access to a suite of movies and films, or at an inexpensive subscription fee that is paid monthly. The nature of this stream of revenue is more smooth and stable, compared to “lumpy” revenue derived from sales of hardware or products.
Also, cloud computing service providers essentially become one-stop shops for their corporate clients, which means companies may rely on the service provider for a wide range of products or services – such as network security, software, analytics platforms etc. This makes the relationship more sticky and more difficult to break away from.
During economic downturns, corporate clients may cut back on spending on hardware or tangible products. How do they cut back on the very backbone of which their business is run? Cutting back on the internal circuit of a corporation (e.g. data storage, network security, software) is likely more fatal than cutting back on hiring or products spending for example.
I would like to share an excerpt from a McKinsey interview with Mark Garrett, the Chief Financial Officer of Adobe (ADBE), a company which made the transition from selling products to web-based software and cloud services:
“During the downturn in 2008 and 2009, our revenue and stock price suffered more than that of most software companies, because other companies had high recurring revenue. Our recurring revenue for the prior fiscal year was about 5 percent annually. We had virtually no financial buffer.”
Now, looking at the cloud computing market, this market is growing rapidly at an expected CAGR of 19% from 2015 to 2020
In 2020, the market size is expected to be worth $162 billion. This, compared to 2015, when the market was worth only $67 billion. The cloud computing market is expected to expand by about 2.5x in 5 years.
The below chart shows that the cloud computing services market share is largely a two-horse race between Amazon Web Services (AMZN) and Microsoft Azure (MSFT), with AWS controlling close to a third of market share.
Currently, Amazon Web Services makes up a small fraction of the company’s overall revenues at an estimated 9%, and I believe there is significant growth potential in this segment.
The global cloud computing market is expected to grow to $162 billion in 2020, and Amazon currently dominates this market with a third of the market share. Assuming Amazon manages to grow its market share conservatively to 45% in 2020 after further consolidation within the industry, this could represent about $70 billion of revenue from the cloud computing segment alone.
To put things into perspective, the company’s revenue in FY 18 was $232 billion. $70 billion is almost a third of its current revenue!
Source: Visual Capitalist
Amazon Price Chart
Amazon is currently trading about 4% below its all-time highs, and I firmly believe it will notch up new record highs. This is a stock with multiple levers of growth, one of them being cloud computing services, which has incredible potential. The revenue stream from cloud computing services is also highly regular and sticky, which will likely provide a defensive moat for the company during an economic downturn.
Amazon Web Services currently dominates the cloud computing industry with close to a third of market share. I believe there will be further consolidation in this space, with Amazon’s scale and expertise likely to see it enhance its leadership position. If so, using my aforementioned conservative calculations, revenues from AWS will likely increase as a proportion to the company’s overall revenue.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.