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Staying on top of the cloud

Highly valued: Salesforce, whose chairman and CEO is Marc Benioff, is trading at a sky-high valuation

For those willing to brave the often treacherous world of technology investing, knowledge of rapidly changing trends is essential. Clearly, winners can quickly become losers in this fast-paced sector of the market where innovation is the key to gaining an upper hand. But that avenue is always open to competition and fortunes can quickly reverse. Because innovation is a two-edged sword, longer-term market leadership status ultimately belongs to those enterprises most able to adapt to a perpetually shifting landscape.

A key trend surfacing in recent years is the paradigm shift away from the “personal computer-server” model of information processing and towards the “device-cloud” platform.

The old world concept of consumers being tethered to bulky desktop computers with data stored on a local hard drive or loaded on a nearby server has been gradually giving away to more mobile solutions. The new paradigm is represented by a mobile consumer surfing the web and executing apps on a powerful smart phone or tablet. The large amounts of data generated by these applications are often not stored on the device itself but in the “cloud”, the term used to describe massive arrays of open storage systems run by dedicated “hosting companies”, typically located far away from the end user.

The trend towards cloud computing is sweeping and has been pushing even the most entrenched tech leaders to rethink their strategies. Satya Nadella, Microsoft’s latest CEO, has been actively attempting to reposition the company away from its roots as a PC operating system provider. While the old line tech company still promotes its stalwart Windows applications, the new executive has been aggressively moving towards the cloud. Nadella recently announced a fresh vision — moving from a “Windows first” strategy to a “cloud first, mobile first” strategy. By making applications and services available across different (non-Windows) platforms, Microsoft hopes to tie users to its new cloud services despite already having lost precious ground in the fight for market share in mobile device operating systems.

Leading cloud services company Salesforce.com (symbol CRM) trades at a stock market valuation many analysts consider lofty. At today’s price, investors are willing to pay 136 times this year’s earnings for CRM shares, or about 7.5 times the level afforded the average publicly traded company. Nevertheless, CRM’s share price jumped even further this month on rumours that Microsoft might buy the company at an even greater price.

Why should a company trade at such a premium? In the case of Salesforce, it is due to the company’s rapid growth attained by delivering a superior customer relationship management (CRM) service software platform based in the cloud. Salesforce provides a software solution which reduces companies’ costs by supporting a common hardware, networking and software platform saving customers from having to make the major capital investments needed to initiate and support these systems on site.

The profitability of cloud computing was further highlighted earlier this month when online retailing giant, Amazon.com Inc released its latest quarterly earnings report. Last year, Amazon stock substantially underperformed the market as investors became frustrated with the company’s apparent inability to monetise its massive sales volumes. Growth without profitability had been its downfall. However, the stock has quickly recovered its underperformance and then some in recent weeks after allowing investors greater insight into its prosperous cloud offering, Amazon Web Services (AWS).

Amazon.com’s first-quarter financial report showed the results of AWS broken out separately for the first time. It turns out AWS is the fastest-growing business within the company with revenue rising 49 per cent over last year’s tally, to a total of $1.57 billion. These results suggest the division could generate over $6 billion this year up from $4.6 billion of revenue in 2014 according to industry analysts. Revenue is expected to continue growing sharply in the years to come.

Amazon began building its cloud data storage systems to manage the vast amounts of customer and product data it requires to be the top online retailer. However, what began as a necessity has evolved into a very lucrative side business. According to Gartner statistics, Amazon Web Services currently possesses four times the computing capacity in use than the next 14 largest providers combined.

Investment research firm Morningstar agrees with the notion of cloud being an important trend believing “technology companies that provide scalable and flexible solutions that are cross-platform and support multiple internet-connected devices have the highest likelihood of success.” Old tech companies such as IBM, Oracle and Intel have struggled to grow in recent years largely due to the trend away from personal computing. But with varying degrees of success, many of these mature companies have been able to staunch the decline and even grow modestly by embracing the new paradigm.

Just as noteworthy as the growth of the cloud has been the exponential growth of mobile devices. Smart phones and tablets have taken off in a big way, evolving into items of necessity for a large part of the world population. Smartphones reached a total of 1.3 billion units last year, up 26% over the prior year and are expected to grow to 1.9 billion units by 2018, according to International Data Corporation (IDC).

Apple Inc has perhaps been the most successful company to reinvent itself from an old line PC maker to a new paradigm leader. From its origins as a niche technology company several years ago, Apple has managed to become the largest publicly traded company by market capitalisation, handsomely rewarding investors along the way. In its latest quarter, Apple sold 61.2 million iPhones in the three months ended March 28, up 40 per cent from the year-earlier period. Many of those sales came in emerging markets, including a 72 per cent gain in the number of phones sold in China.

The ongoing paradigm change in the technology sector has established a new slate of winners and losers. Leading mobile device makers, semiconductor companies and software developers should have a place in investment portfolios looking for growth.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.