How You Can Avoid Amazon's Cloud Dominance

Dana is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The dominance of Amazon.com in the public cloud, highlighted by the CIA's decision to award a $600 million, 10-year contract to the company, has caused huge problems for alternatives to the company's infrastructure, especially OpenStack.

The assumption was that, while Amazon would grab early adopters and start-ups eager to develop quick-and-dirty applications, systems like OpenStack would win the “private cloud,” because it's open source infrastructure enterprises can control.

This assumption is under continuous challenge, and the question is, how should investors play the cloud while best avoiding the problem?

Rackspace Getting Killed

Rackspace (NYSE: RAX) was the original corporate sponsor of OpenStack, and remained the second-leading vendor of cloud vendors last year, according to Talkin Cloud. But it's expected to tumble down those rankings, which will be announced later this week, due to Amazon's dominance.

Rackspace provides OpenStack services and support. The company was, until recently, the largest supplier of OpenStack “committers,” people with power to change the code. But that has not translated in the market. 

Since the start of the year Rackspace has lost 37% of its value, but still trades at a sky-high Price/Earnings multiple of nearly 61. The reason for that is that its financials have been falling along with its stock. The March quarter saw revenues grow only $10 million over the previous quarter, to $362 million, and margins fall under 10%, with net income reported at $27.26 million.

The balance sheet still appears solid, but the fact is it's not moving forward, as that of a high-growth company should. The company continues to hold $3 in cash for every $1 in long-term debt, but assets actually fell quarter-to-quarter, to $418 million. Operating cash flow for the quarter, meanwhile, fell sharply, and while that matches the pattern of 2012 investors will be poring over the second-quarter report, due early next month, for signs of further deterioration.

RedHat for OpenStack Fans

This has caused many investors who believe in OpenStack to move toward Red Hat (NYSE: RHT).

The Raleigh-based software company now has more OpenStack committers than Rackspace, and its business model is not built around the infrastructure services that Rackspace is built. Instead RedHat produces open source software, and licenses support for it. For the year so far RedHat is down 4%, against Rackspace's 37%.

RedHat's newest play in the OpenStack arena is OpenShift, a Platform as a Service or PaaS that rides on top of the OpenStack infrastructure, enabling enterprises to port applications previously written on Red Hat Enterprise Linux and JBOSS middleware to private OpenStack clouds.

RedHat's growth, however, has slowed markedly, with the March quarter revenues of $363 million just $15 million ahead of the previous quarter. Margins, however, remained firm, with the company bringing $1 in each $10 down to the bottom line. The balance sheet shows no debt, but the cash position has not grown in over a year. Operational cash flow for its second quarter, which ended in May, fell, but investments more than made up for it and cash flow was positive overall.

RedHat was battered, however, recently by word that IBM (IBM), its chief ally and (some say) its silent partner, would be supporting a different platform, the Pivotal Initiative's Cloud Foundry, instead of OpenShift going forward. An IBM executive I talked to insisted this was no rejection of RedHat, that Cloud Foundry is open source just as RedHat's products are, but that Cloud Foundry is more flexible, supporting more programming languages and application sets, than OpenShift is.

Not everyone is as optimistic about RedHat's long-term prospects as I am, it should be noted JP Morgan recently gave the stock the equivalent of a “sell” rating  with a price target $10 below its current market price.

IBM the best choice

In addition to Amazon, cloud was hurt badly by the so-called NSA “scandal” this year, in which it was revealed that the nation's security services are using cloud just as consumer companies are, to identify prospects and trends. The difference here is scale – the NSA considers each of you a customer, and thus all your web cache and phone records as fair game.

This has made cloud a dirty word with some enterprises, according to the Cloud Review. There are increasing reports of cloud projects failing due to the normal factors – inertia, lack of motivation, poor success metrics, etc.

No company is better positioned to handle all this than IBM (NYSE: IBM). The company is doing less well than other members of the Dow 30, up only 6%, but unlike most cloud companies it sports a hefty dividend of 95 cents/share, yielding nearly 2%.

IBM's mainframe monopoly and its control of many other Dow and government accounts give it wiggle room, however. It is now able to pick up falling cloud stocks at good prices, as with its recent acquisition of SoftLayer. The company's results remain a model of consistency, and margins are actually on the rise under CEO Ginny Rometty.

Go back five years with IBM and you see a company whose dividend has nearly doubled, and whose stock has doubled since the bottom of the last recession in 2009.

My Foolish bottom line

Any new technology is going to have its speculative rises and sudden falls. Cloud is no exception.

The importance of cloud cannot be underestimated, and any portfolio without some exposure to it is going to be hurt. Cloud is rapidly becoming the enterprise infrastructure of choice, and while the move to private cloud has been delayed by Amazon's aggressive price-cutting, there are no indications that it won't move forward in time.

For that reason conservative portfolios need to have some IBM in them, for strength. The stock's momentum has slowed this year, making it a relative bargain at a market-matching P/E of 14.

For those who are more speculative, now may be a good time to look into Red Hat. The company remains a steady mover, it has lots of enterprise customers, and it may be over-sold in comparison with other cloud stocks. I wouldn't touch Rackspace with a barge pole, however – they're directly in the sites of Amazon.com and looking poorly.  

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Dana Blankenhorn owns shares of International Business Machines.. The Motley Fool recommends Rackspace Hosting. The Motley Fool owns shares of International Business Machines.. 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!

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