Profit from cloud computing

So far, 'cloud computing' has not lived up to the hype – big business has stayed away because of security fears. But that's set to change. James McKeigue examines the sector and picks the three best stocks to buy now.

For more than a decade, technology experts have been predicting a computing revolution. They dreamed of computing power becoming commoditised delivered through a grid system that would allow providers to sell hardware and software just as a utility trades electricity. In the last few years, this dream has spread from Silicon Valley to Wall Street, where any firm specialising in 'cloud computing' the latest buzzword for the concept trades on sky-high valuations.

But despite the investment hype, cloud computing is still a long way from meeting the heady expectations of the late 1990s. While individuals and smaller firms have taken to various forms of cloud computing, most large firms have yet to be convinced, and experts in the field are still struggling to overcome several technical challenges. The good news for investors is that there are plenty of companies, still unnoticed by the market, who are set to benefit when cloud computing for big business goes mainstream.

What is cloud computing?

The chances are you already use cloud computing in some form on a daily basis. Email services, such as Microsoft's Hotmail, or social networking sites, such as Facebook, allow individual users to use their storage, processing power and software from any location. This is a type of 'public cloud', because it is open to anyone with access to the internet. As a result companies such as Facebook and Google have invested heavily in 'data farms' facilities that are capable of storing huge amounts of digital information.

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After individual users, the next group to embrace cloud computing were small- and medium-sized businesses. A lot of smaller firms have tapped in to the so-called 'public clouds' run by the likes of Amazon and These allow firms to buy computing resources in the same way they buy electricity. In other words, they only pay for what they use, and they can buy more or less at the flick of a switch. "Services like these have mainly appealed to start-up companies... Starting with a blank sheet of paper, designing a company's processes with no 'on-premise' systems can be highly appealing," as Richard Waters puts it in the FT.

Cloud computing means smaller firms don't have to shell out on servers powerful computers that form the backbone of most organisations' computer networks or storage space. And because their clients are all sharing hardware, the providers of these services can build huge facilities that are more cost-efficient.

The same economies of scale apply to software. and its peers produce standardised business software programs. One of the most common is a platform that firms can use to run their online customer service operations.

For small firms, renting these programs is much cheaper than buying them up front, or developing a tailor-made program themselves. As a result, smaller companies "gain from access to technologies they could never have afforded before", while the "bean counters" are kept happy by turning "technology capex [capital expenditure] into more manageable opex [operating expenditure]", says the FT's Philip Delves Broughton.

There are many other advantages. Cloud services are quick to set up, allowing businesses to be more flexible. So if a business is growing fast or has seasonal spikes, then cloud systems can cope with sharp increases in workload, without firms having to shell out on expensive extra hardware that may not always be needed. Cloud computing is not tied to a particular location, making it ideal for businesses with a mobile workforce. And most providers constantly update their technology, so that firms don't have to worry about replacing obsolete IT equipment.

Even the original idea of trading computing like a commodity has arrived well, sort of. At the end of 2009, Amazon launched a new pricing option that lets customers bid to use its unused computing capacity. Just as in commodity markets, the spot price is determined by supply and demand. However, this won't suit every company. When the spot price ie, the price other firms are willing to pay rises above your bid, your virtual machine will be turned off and given to a new user.

Why isn't it more widespread?

But despite these benefits, large companies, who form the bulk of IT spending, have been reluctant to use cloud computing. Aside from sales firms using e-commerce platforms, most large businesses have avoided 'enterprise cloud computing' (the buzzphrase for business cloud services). One reason is that companies who have already sunk large amounts of money into their IT systems have more to lose than a start-up.

Another is that fear of cybercrime has made companies wary of losing sensitive information. Cybercrime is nothing new, but a spate of recent high-profile attacks have brought it onto the agenda of most boardrooms. The European Union recently had to close its carbon trading scheme after discovering that hackers were manipulating prices, while Facebook founder, Mark Zuckerberg, recently had his Facebook profile hacked.

Firms who are doing their utmost to guard their digital data are understandably reluctant to hand it over to a third party to store and process. Of course, cybercriminals can strike anywhere. But when data is stored in-house, firms have control over their own security measures from firewalls to 'white lists' of people with varying security clearances. When companies use cloud computing they give away control of those defences that's a big step if your firm's success depends on the data it owns. Cloud-computing fans counter that providers can spend more on collective security than an individual client could afford. But a recent survey by CIO Magazine and Price Waterhouse Coopers showed that security is still the main concern of potential cloud customers.

They may have good reason. Security firms have exposed flaws within various big players' cloud offerings, such as lax password controls. In some cases, the problems are down to the clients' policies as much as any fault on the behalf of the cloud provider, but it hardly reassures big potential clients. John Pescatore, a Gartner security analyst, compares the security of some cloud-based services to Microsoft's Windows software in 1999. "It's being widely used and nothing tremendously bad has happened yet. But it's just in the early stages of getting exposed to the internet, and you know bad things are coming," he told the FT.

Aside from specific attacks, some worry that cloud computing has structural security issues. Providers can offer storage and processing at low costs because they share machines between users, allocating greater or smaller chunks of machines as clients' demand changes. Yet experts admit there is a risk that data could be compromised if it was not deleted completely before that part of the machine was given to another customer. The most effective way to destroy data is to disrupt the disk's magnetic field, via a process known as degaussing, or to shred the optical disks. Yet large providers generally don't do this as the computers are in constant use.

This raises a host of worrying questions, says the Economist's Tech.view column. "What happens when data stored on a virtual machine gets compromised? Will the customer ever know? Will the provider take responsibility?" Given these doubts it's easy to understand why a company like Visa whose need to process varying amounts of data globally could benefit from the technology is implementing cloud computing very slowly.

It's a matter of time

But objections about security and technical issues are "merely delaying the inevitable", says Delves Broughton. "The basic ideas behind cloud computing seem irresistible: pooling resources to drive down cost and accelerate innovation and liberating people from the tether of physical software." In fact, the intransigence of big corporations so far is good news for investors. It means that there are still plenty of opportunities left to invest in enterprise cloud companies before the sector really takes off.

Gartner, an IT research specialist, estimates that the cloud-computing market will grow from $56bn now to more than $146bn by 2014. The bulk of this spending will be on 'enterprise'. Big corporate IT players such as IBM, Microsoft and Cisco have unveiled new products and strategies to tempt corporate clients onto the cloud. One solution is to offer walled-off cloud services, known as 'industry clouds'. This removes some of the security concerns, as a client has its own set of dedicated servers although it does raise costs. Another shift is that instead of asking customers to hand over their information, cloud providers offer specific services run from their data centres, which are then integrated into a client's existing IT set-up. This creates a hybrid of cloud and in-house IT.

Which firms are best placed?

So which of the familiar names is well-positioned in enterprise IT? Amazon and Google had a head start, as they began life as public cloud businesses. Microsoft had some exposure too, through its Hotmail service, but only began working on its business offering in 2005 when Microsoft's then chief technology officer, Ray Ozzie, warned that unless Microsoft responded to cloud computing, "our business, as we know it, is at risk". Now 90% of its engineers work in the area and last year it launched Azure a cloud computing system for businesses. So far these firms do not disclose their cloud-related revenues, although both have predicted that they will be worth billions of dollars within the decade.

Meanwhile, larger companies like IBM, Dell, Oracle and HP have spent billions buying firms with successful cloud-computing technologies. Analysts expect the consolidation to continue as large tech companies try to become "one-stop providers of products from computers to software to networking gear", says Bloomberg's Peter Burrows. The companies are cash rich and will take advantage of low borrowing costs to "pursue a vision of cloud computing which lets customers store their software in massive data centres, rather than in the computer room down the hall".

These economies of scale will drive down the cost of cloud services and turn storage into a commodity. This should drive further consolidation, as smaller players will find it hard to compete. But it should also encourage specialisation as firms find profitable niches within the sector. One major theme will be carbon emissions. Data centres now consume more than 0.5% of the world's electricity and produce almost as much carbon dioxide as Argentina. As a result, it is becoming a serious PR issue for companies such as Google, with its "don't be evil" motto. Iceland is planning to use its untapped renewable energy potential to become a centre for 'zero-free emission data centres', and green storage will become a big theme as cloud computing takes off. We look at the best ways to invest below.

The three best stocks to buy now

The companies that have profited most from cloud computing so far have been the 'software-as-a-service' (Saas) providers. These have focused on areas that big companies are willing to outsource to the cloud. A leading example is, whose programs help companies keep track of sales online. Unfortunately the success of most Saas providers is already in the price trades on a p/e of 115. Sure, it's a growing industry but this is expensive by any measure.

A cheaper way to invest in business cloud software is through Microsoft (Nasdaq: MSFT). Once the darling of the Nasdaq, the software giant has fallen out of favour with investors. Sales of traditional desktop PCs are predicted to fall in the coming years, and many feel that Microsoft is 'behind the curve' on smartphones and tablet computers. But while Microsoft might have taken its time to move into enterprise cloud computing, it now has a serious offering Azure. As Gene Mark notes in Forbes, Microsoft has a "history of getting into the market late and then crushing its competitors" remember the Lotus operating system or Netscape internet browser? Azure has picked up 31,000 customers in its first year. Analysts expect that number to grow quickly as owners of traditional Microsoft business applications switch to the cloud. Importantly, Microsoft already has a foothold in most offices. "The battle won't be won over products and features and cool apps and gizmos" it is about trust. "Whatever people say about Microsoft, we know them and for the most part we trust them." Better yet, its dull reputation means Microsoft trades on just ten times earnings.

A less obvious way to play cloud computing is via companies that build power infrastructure for data centres. A recent EU study showed that servers' energy use rose by 60% between 2006 and 2011. Energy is now the major operating cost for data centres, and a combination of new emissions regulations and rising energy prices will encourage cloud providers to pay for energy-efficient applications. Better yet, it doesn't matter which cloud provider, platform or technology becomes dominant a good power management company offers a cheap 'nuts and bolts' play on the sector that should benefit regardless.

One such stock is Power-One (Nasdaq: PWER), which makes converters for the renewable energy, communication and computing industry. Its products allow cloud providers to take power from the mains and adapt it for their needs for example, converting AC power to the DC needed in data centres. Power-One's gadgets can improve the efficiency of a computer's power delivery and reduce the energy it consumes when it is inactive. Its products are also used for communication and data transfer, so it will benefit as more firms store their data offsite. Telecom networks and computing account for almost 50% of net sales, with renewable energy and industrials making up the rest. The share price fell 22% recently after cutbacks in the renewable energy sector and the slashing of 'feed-in' tariffs in Europe particularly hit its sales outlook. But the shares now trade on a forward p/e of 6.7. Dougherty and Co. analyst Joe Maxa sees this as a "buying opportunity".

Another firm that will benefit from the growth in cloud networks is digital communication specialist Cisco (Nasdaq: CSCO). The company sells the routers and switches used to sort and transport data. Demand for its products and services is strong. For example, Cisco's United Computer Systems offering doubled its number of customers in the fourth quarter of 2010. Group sales were up 11% in 2010 as Cisco benefited from the convergence between networking, servers, storage and software being caused by cloud computing. As well as supporting other companies' clouds, Cisco is developing its own Saas offering. Like Microsoft, Cisco has a strong corporate customer base it currently supplies 80% of America's Fortune 500 and looks good value on a forward p/e of 12.1.

James McKeigue

James graduated from Keele University with a BA (Hons) in English literature and history, and has a certificate in journalism from the NCTJ. James has worked as a freelance journalist in various Latin American countries.He also had a spell at ITV, as welll as wring for Television Business International and covering the European equity markets for the London bureau. James has travelled extensively in emerging markets, reporting for international energy magazines such as Oil and Gas Investor, and institutional publications such as the Commonwealth Business Environment Report. He is currently the managing editor of LatAm INVESTOR, the UK's only Latin American finance magazine.