Transition to the Cloud: Do-or-Die Time For Laggards

Cloud computing may be the most compelling and, thus, perhaps the most lucrative technology theme over the rest of this decade. Global enterprise spending on cloud computing, which excludes consumer purchases, is expected to be $235 billion in 2017 — triple the $78 billion spent in 2011.¹ In this context, what is cloud computing and what factors are important to investors?

Although its definition varies, we define cloud computing as any subscription-based or pay-per-use service that — in real time, over the Internet — extends your technology infrastructure and capabilities. It includes Infrastructure as a Service (IaaS), Platform as a Service (PaaS), and Software as a Service (SaaS).

IaaS firms provide virtualized hardware, primarily storage and servers. Gartner, a leading information technology research company, reports that worldwide IaaS revenues were $9 billion last year and projects them to be $24 billion in 2016. Amazon.com epitomizes this market with its Amazon Web Services (AWS) unit producing $1.3 billion in sales last quarter, up 40% versus the same period a year ago.

With PaaS, a similar service delivery model, customers rent virtualized servers and services in order to run their applications or to develop and test new ones. Software developers most often use this service. Gartner predicts that the global PaaS market will be $2 billion this year and $3 billion in 2016. Google competes in this space with its Google App Engine.

Global enterprise spending on cloud computing is expected to rise to $235 billion.

SaaS offers customers access to software applications over the Internet. Customers rent the software, typically on a monthly basis, rather than buy it up front. The service provider hosts applications, whereas in the prior delivery model they had been installed on customers' computers. Gartner pegs this worldwide market at $24 billion in 2014 and sees it growing to $33 billion in 2016. Analysts expect leading SaaS firm Salesforce.com to increase sales more than 30% this fiscal year to over $5 billion.

To capture this investment theme, investors must determine which of the incumbent technology companies will be made obsolete by the cloud and which ones will survive the transition and perhaps even thrive as a result. One of the best examples of the latter is Adobe Systems, which Saturna held at the end of November in the Amana Growth (4.14%) and Sextant Growth Funds (2.18%).

Founded in 1982, Adobe is a dinosaur, at least from a technologist's perspective. It has offered its Creative Suite of products, including Photoshop, InDesign, Dreamweaver, and Premiere, since 2003 as software to be purchased and installed on customers' premises. However, in May 2013 the firm moved these products to the Creative Cloud. Now a Photoshop customer can only update that software in the cloud.

Adobe's CEO Shantanu Narayen forced this drastic business model change. In Silicon Valley if you do not quickly cannibalize yourself, a competitor — sometimes another incumbent, but more likely a start-up company — will do it for you. Narayen showed courage in embracing the cloud because the financial implications for any firm, particularly in the first year of this transition, are scary. Why? Because analysts often gauge a firm's sales and profits on a quarterly basis versus the same period a year ago, and they generally want to see an increase. Nothing chills analysts — technology investors in particular — more than significant year-over-year declines in reported revenues and earnings per share.

Unfortunately, that often appears to be the case when a firm such as Adobe switches its product delivery model from one where revenue is recognized up front (when the software is sold) to an SaaS model where the revenue stream is divided into smaller monthly payments (when the software is rented). Adobe made it through the perilous first year of its transition to SaaS while most of its peers still cling to the old paradigm or have just begun the switch. Gladly, Adobe's shares returned 27% over the twelve months ended November 18, versus 15% for the S&P 500. In technology, it is almost always good to be first.

For better or worse, sometimes there's no scarier roller coaster than the technology sector. Products go in and out of favor at a rapid pace while making or breaking companies and enriching or busting their investors. It's not practical to avoid the ride altogether, especially when growth is among your investment objectives. Identifying and acting upon the longer-term trends can help alleviate the white-knuckle effect.

Saturna's analysts continue to scrutinize incumbent technology companies to determine which will become meaningful cloud computing beneficiaries. We also keep a watchful eye on emerging firms that establish promising track records as potential cloud investments.

Security weightings are shown as a percentage of a Fund's total net assets. Amana Income, Amana Developing World, Idaho Tax-Exempt, Sextant Bond Income, Sextant Core, Sextant Global High Income, Sextant International, and Sextant Short-Term Bond Funds did not own any securities of the companies mentioned.

Footnote

¹ Enterprise Cloud Spending to Soar to New Heights in Quest to Drive Greater Business Success. IHS Press Release, April 3, 2014. http://press.ihs.com/press-release/design-supply-chain/enterprise-cloud-spending-soar-new-heights-quest-drive-greater-bus

Copyright 2014 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 8 · No. 10

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