The Coming Cloud Stock Shakeout
Dana is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The recent fall in the price of Rackspace (NYSE: RAX) – from the mid-$70s to the mid-$50s – was just a preview.
The public cloud shakeout is coming.
In the face of falling earnings Rackspace continues cutting prices, locked in a death struggle with Amazon (NASDAQ: AMZN), Google (NASDAQ: GOOG) and Microsoft (NASDAQ: MSFT) for public cloud services.
All four companies are growing expenses, despite stagnant top lines, because they fear other companies entering the market – everyone from the old PC companies like Dell to the old telcos like AT&T to the old web hosts, the space that Rackspace left.
They are right to fear this, because all these companies, and doubtless more, are building out their hosting capacity as fast as ever they can.
I have been covering technology revolutions full-time for 30 years, and have followed the cloud market intensively since before it began. I have learned to track technology industry patterns, which always repeat, and I have been tracking those patterns within this market. I'm confident things will proceed as they have in the past, in other areas. I call these patterns "clues," not because they're infallible but because they deliver clear indications of what is likely to happen.
So how should you play this?
Amazon is the Leader
Amazon.com is one of those companies you're always told to buy on weakness, but the weakness never seems to come.
Cloud is a big reason for this. Amazon doesn't break out its cloud revenues from its commerce revenues. Stock buyers are left with estimates from uber-bulls like Macquarie Research, which recently insisted that Amazon Web Services would be worth $19 billion if it were spun out.
Two problems with that. First, you can't spin it out because it is dependent on its parent for capital, and could not thrive as a stand-alone company. Second, that still leaves $98 billion in market cap unaccounted for, for a retailing company with a total of $61 billion in revenues (including cloud). Most retailers are worth a fraction of their sales, not multiples of it.
Any way you look at it, Amazon.com is overvalued. A great company, but overvalued.
The cloud shakeout is going to make this apparent to everyone, but it's important to note that the impact will mainly be to make Amazon affordable, not unattractive. This is the company you want to own.
Microsoft is a Problem
If you think Amazon is opaque about its cloud operations, it has absolutely nothing on Microsoft, with its Azure cloud.
While Amazon is at least selling its infrastructure, Microsoft is using Azure as the center of hope for its entire operation. So Xbox services run on Azure. Office 365 and its other software-as-a-service operations run on Azure. It's virtually impossible to break out Azure revenues as something separate and apart from Microsoft's other operations – they rise or fall together.
Too many of them are falling. While some operations, like Windows licensing and Office, continue generating revenue and profit for the same reason companies like Oracle do it – client lock-in – new operations of all sorts are slowly moving toward cloud, meaning away from Microsoft.
I think you want to avoid Microsoft. The argument will be made, when the weakness in cloud infrastructure revenues becomes apparent, that the company is buttressed by its other operations in the cloud. But this is a story Microsoft bulls have been selling for many years, and it still hasn't come true.
At best, you can hold Microsoft for the dividend. Just don't expect the cloud to open new vistas of profit for you.
Google is Your Best Bet
Google is a little like Amazon.com, in that it's overpriced relative to its performance. And its continuing cloud price war with Amazon.com is going to hit its next few quarters in the revenue.
The hope of the bulls is that all this will get hidden by search engine revenues, by gains at YouTube, and by commerce, not to mention Android and Chrome hardware. But the hardware is a giveaway, the YouTube and commerce programs are unproven. This is a company that lives on advertising.
But Google is the company you most want to own in this space, and there's a simple reason for that.
Google has invested very heavily over the last decade in order to make its cloud infrastructure the best, and the cheapest, in the industry. It has more than succeeded. That's why it offers so many free services, often without advertising. It owns its own fiber, its data centers are built for cash and written off very quickly, and nearly all incremental revenue drops to the bottom line.
This assures that Google can survive any price war. While other companies, even Amazon, need to measure revenues against costs, Google just doesn't. It's letting Amazon lead the price war, responding rather than acting first, but it's more like a poker player that is letting its opponent raise the pot than a company that has to fight to respond.
For the Rest, a Struggle
I started this analysis with Rackspace and I'm going to finish there. I think it's going to struggle to survive. I think it's going to be taken out, at some point, by a stronger player. Not at current prices, but at a substantial discount to them, as the damage done by the cloud price war becomes apparent to everyone.
But however bad things may appear at Rackspace, there will be plenty of buyers from among those companies that are going to do worse. A phone company, or a computer company, could easily take Rackspace out, at a substantial premium over its soon-to-be-depressed price, as a lifeline, as a way to survive and keep its own customer base on board.
I don't know who that will be, and I don't know when, but that's the way these things generally work out, when you have a secular change like this, a slightly-open door only a few players can get through.
DanaFBlankenhorn owns shares of Google and Microsoft. The Motley Fool recommends Amazon.com, Google, and Rackspace Hosting. The Motley Fool owns shares of Amazon.com, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!