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Tech Stocks

Take Your Head Out of the Cloud

By Jason R. Koepke, on Dec. 28, 2016

Cloud technology has become a catch-all answer to almost any software or business challenge, to the point of being cliché. That’s nice if you’re creating a pitch deck, but if you’re investing your money, you need to crack open that cliché and understand what’s happening.

Most of the time we hear about the cloud, it’s treated as being monolithic—a way for all the online services to work. It covers a dizzying array of products and services: how we write and share documents (Office 365), share photos and see what others are doing (Instagram), send messages (Slack), email friends (Gmail) or watch movies (Netflix).

Cloud technology has become a catch-all answer to almost any software or business challenge, to the point of being cliché. That’s nice if you’re creating a pitch deck, but if you’re investing your money, you need to crack open that cliché and understand what’s happening.

Most of the time we hear about the cloud, it’s treated as being monolithic—a way for all the online services to work. It covers a dizzying array of products and services: how we write and share documents (Office 365), share photos and see what others are doing (Instagram), send messages (Slack), email friends (Gmail) or watch movies (Netflix).

The first wave of cloud providers focused on providing the “bare metal” that companies used to quickly establish a data center. Providing that infrastructure eliminated the mighty start-up costs associated with buying servers and hiring people to set up the racks, monitor the health of the servers, and maintain them.

But running large data centers filled with commodity hardware and the most basic of services also means low margins. Amazon.com (NSDQ: AMZN) got into the business, because it already had these data centers for its online retail operations and thought it could monetize the unused cycles of its servers by renting them to others. It worked.

Tech giants with their own unused servers sitting in various data centers realized the revenue possibilities and dove in. Given Amazon.com’s cutthroat pricing and the inherently low margins of renting out just the hardware and data center space, cloud providers wanted to move up the value chain (or up the stack, in industry parlance). It’s one thing to rent out servers with only the basics and quite another to make available the various operating systems, databases and platforms developers use in everything they build.

In doing so, cloud providers sought to differentiate themselves. Amazon AWS (the company’s cloud services unit) focused on low costs and constant new offerings. Microsoft Corp’s (NSDQ: MSFT) Azure established itself by making it easy for quickly transfer applications written for Windows to a cloud architecture and then built out the basic bare-metal offerings. And Alphabet’s (NSDQ: GOOG) Google Cloud used Google’s experience at running huge networks and products to make it easy for other companies to build their own complicated cloud systems.

Other companies are in the mix, but none rival these three.

Rackspace Hosting serves as a good example of how companies evolved and sought to establish their own market position. The company started as a basic webhost, before quickly transitioning to an infrastructure-as-a-service provider. Unable to compete against AWS pricing, Rackspace Hosting began offering hands-on support, giving companies the infrastructure and platforms they needed as well as ready-to-consult IT team.

Eight years after going public, it was taken out by a private-equity company and focused on being a managed cloud provider­­–an IT services company that supports other companies’ use of AWS, Azure, Compute and/or other options.

So far we’ve only looked at the public cloud–data centers built and managed by a third party. But there’s another world, and another differentiator.

What’s Old isn’t New

On the one hand, there’s the public cloud, where a company’s data is stored and computing run by a third-party company at another site. On the other hand, there’s the private cloud, which is the new name for a company buying, running, and using its own data centers with its own staff.

Don’t drink the Kool-Aid: Companies still do this, and they do it a lot. Analysts at JPMorgan & Chase (NYSE: JPM) estimate that only 5 percent of current data center spending is for the public cloud.

In the past, several cloud providers have tried to win the massive private cloud market by shoving their capabilities into other people’s data centers. This hasn’t worked too well, with Azure and Oracle’s Corp’s (NYSE: ORCL) now quietly hushed-away efforts being the most visible ones.

It’s not a surprise that cloud companies haven’t been able to establish a footprint in private data centers. Two of the three main reasons cloud computing has been so attractive don’t work in private data centers.

Investors shouldn’t overlook the excluded middle. Put most simply, companies can put some of their processing and storage needs in the cloud and keep some in their own data centers.

Most companies have pursued this hybrid approach. But many tech companies didn’t focus on this opportunity set because the growth opportunities—in sales, in new technologies, in new capabilities, and in share prices—focused on the public cloud.

In late 2013 and early 2014, industry insiders began to realize how well the two approaches could work and the benefits of each leveraged. Let the new hype cycle begin.

Fast-forward to 2016 and companies, even cutting edge Silicon Valley types, have realized that the hybrid cloud may be the smartest forward.

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