Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 127

The shift to the cloud

The enterprise technology industry is currently undergoing its most significant transition in two decades. Cloud computing has emerged as a compelling alternative to the traditional deployment of IT resources on premise, giving rise to new, multi-billion dollar cloud businesses, and disrupting incumbent IT vendors.

Major cloud applications

“It's not water vapor. It's a computer attached to a network.” Larry Ellison, Oracle CEO, 2009

For most people, interaction with cloud computing is done through the consumer cloud services that they access on a regular basis. Streaming cloud services like Spotify and Netflix have revolutionised consumers’ consumption of media, delivering a catalogue of music and video via the internet for a monthly subscription fee. Apple’s iCloud centralises the storage of photos, documents, contacts and other information on Apple’s servers, accessible from multiple connected devices. Similarly, Dropbox has transformed file storage by allowing users to store files on its servers rather than locally on their PCs or other devices.

Cloud computing is also having a dramatic impact on the way enterprises use technology. Traditionally, enterprises have purchased hardware and software licenses upfront, installing and managing equipment in on-premise data centres. However, cloud vendors have increasingly enabled IT resources to be hosted in third-party data centres, and delivered over the internet for a subscription fee. This model of IT is often referred to as ‘public’ cloud delivery, because enterprises typically share IT resources with many other enterprises, hosted in hyper-scale cloud data centres.

Sales automation software company Salesforce.com was among the first and most successful enterprise cloud computing companies, having grown rapidly since its creation in 1999. It was followed by Amazon, which launched Amazon Web Services (AWS) in 2006. AWS provides cloud computing and storage services, and is one of the largest and most dominant cloud vendors today, with $4.6 billion of cloud revenue in 2014. In aggregate, market research firm Gartner estimates that the public cloud computing market was worth over $150 billion in 2014, and expects it to double by 2019.

Benefits and adoption

Cloud computing confers a number of benefits:

  • It enables enterprises to benefit from the economies of scale achieved by their cloud vendors, often reducing the total cost of ownership of enterprise technology, and improving the quality of their IT.
  • Subscriptions for cloud services are typically billed on an ongoing basis, reducing significant upfront costs.
  • While on-premise hardware and software resources can be difficult and time-consuming to provision, enterprises are now able to provision cloud hardware and software with the click of a button.
  • As shown below, the cloud allows enterprises to adjust their cloud hardware and software capacity according to their needs, increasing the efficiency of their technology expenditure. This flexibility enables smaller firms to scale up and down quickly as required. For example, a promotional web article or video might prompt a spike in traffic to their website.

Source: Amazon

Cloud computing has so far been most readily adopted by smaller enterprises, which are likely to derive the most significant benefit from the scale and resource utilisation achieved by cloud vendors. In 2013, approximately 50% of Salesforce.com’s revenue was sourced from small and medium-sized businesses with fewer than 1,000 employees. Likewise, WorkDay, which sells payroll software in the cloud, has been focusing on mid-market customers in the United States. AWS has been extremely successful in attracting and supporting the growth of (former) start-ups, including Uber, Airbnb, Netflix, Spotify, Yelp, and Shazam.

Among large enterprises, cloud adoption has focused on discrete business processes and development and testing workloads. Large enterprises have typically few incentives to migrate mature, mission-critical processes to the cloud. This is the case for commonly-used custom airline reservation systems running on IBM mainframes, integrated Oracle financials applications, or SAP supply chain management products used by multinational companies. Large-scale migrations may be multi-billion dollar undertakings, and can involve material transition risk. Large enterprises can also be affected by regulatory considerations, data sovereignty or security concerns.

Example: implications for Microsoft

New cloud entrants threaten to disrupt the businesses of incumbent IT vendors. After achieving consumer success with its Gmail service, Google released ‘Apps for Work’, which delivers email, word processing, and spreadsheet functionality via the internet, in competition with Microsoft’s lucrative Office business. Concurrently, Amazon offered its customers the ability to initiate and migrate server workloads to the public cloud, and improved the ease with which they could implement alternatives to Microsoft’s software.

Microsoft has aggressively responded to these challenges, releasing the cloud-delivered Office 365 productivity suite and its Azure cloud platform. Cloud customer benefits include: mobile access to Microsoft software products, latest updates, and enhanced functionality, all with lower implementation and management costs. It is not surprising that Microsoft’s commercial cloud business grew by 88% in the fourth quarter of 2014, after posting seven consecutive quarters of triple-digit growth. It now has an annualised revenue run-rate in excess of $8 billion, making it the largest enterprise cloud vendor globally.

However, the shift from the sale of on-premise licenses to cloud subscriptions has materially affected Microsoft’s revenue and earnings in the short term. While it has traditionally recognised one-time on-premise sales upfront, cloud contracts are typically characterised by smaller, ongoing payments. It will take time for cumulative subscription revenue to exceed the value of cannibalised on-premise sales. Meanwhile, the cost of delivering cloud software is structurally higher than on-premise. Microsoft’s cloud earnings margins should, however, expand as its cloud business grows and it improves the utilisation of its data centres.

It is Magellan’s view that in the longer-term, Microsoft is likely to benefit significantly from growth in its cloud business. Cloud delivery increases the addressable market for Microsoft’s products by allowing enterprises to access, deploy, and manage its software products more easily and cost effectively. Microsoft considers that the lifetime value of transactional Office customers increases 1.2-1.8x when they migrate to the use of Office 365. Cloud delivery may also allow Microsoft to launch new, innovative products that were previously not feasible on-premise, such as machine-learning software leveraging Microsoft’s hyper-scale data centre network. Cloud delivery of Office could also reduce piracy over time.

While the upfront price of Microsoft’s cloud products is lower than its on-premise products, the cumulative total price of its cloud products over time is likely higher. This dynamic is particularly apparent with respect to consumer Office 365. Office 365 has a subscription price of $100 per annum, a large discount to the circa $180 upfront price on-premise. However, customers have historically only upgraded their on-premise Office licenses every five to seven years, implying an equivalent price of $26-36 per annum on-premise. As shown below, the short-term headwind of lower upfront revenue is dwarfed by an indicative longer-term benefit from the shift to cloud subscriptions.

Shift to the cloud affects many businesses

The shift to the cloud has had a significant impact on the enterprise IT industry, and presents challenges and opportunities for incumbent vendors. As they transition, many inherently stable software companies may experience short-term earnings and stock price volatility well in excess of any change in their underlying value. Such volatility may potentially present attractive investment opportunities for long-term investors.

 

Michael Poulsen is an Investment Analyst covering the Information Technology sector at Magellan Asset Management Limited. This material has been prepared by Magellan Asset Management Limited for general information purposes only and must not be construed as investment advice. It does not take into account your investment objectives, financial situation or particular needs.

 

2 Comments
SMSF Trustee
September 21, 2015

I thought like you, Hamish, when I first heard of the cloud. But the reality is that it's no different to having all your data on your own computer or server and being connected to the internet. You have to have security built in to prevent your data being accessed by unauthorised users and damaged or lost. Data stored on the cloud isn't in some open storeroom for anyone to wander in and take what they like. It's encrypted for your system's access only.

Most businesses access the cloud via vendors providing particular applications. The vendor stores the data on the cloud, but builds security around it and wears the financial responsibility for breaches. Larger businesses are able to use different vendors for different services to reduce the risk of a breach of any one application making a critical difference to their customers and employees.

The cost savings are significant, both in terms of computer hardware and IT staff resources.

As for the data on your phone that's not being stored on the cloud now. Good luck getting it back if your phone's hardware breaks down or you damage it in some way. The cloud is much safer.

Hamish
September 20, 2015

The ‘cloud’ is scary – the thing that leaks and/or loses confidential data supposedly kept secure from everybody from the CIA to Sony to the IRS. The other day I realised that certain categories of data on my phone was being automatically uploaded to the cloud every day – luckily I canned that ASAP.

 

Leave a Comment:

RELATED ARTICLES

Cloud computing is an unheralded success

Cybercrime response may slow internet

The silver lining really is in the cloud

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

Latest Updates

Investing

Designing a life, with money to spare

Are you living your life by default or by design? It strikes me that many people are doing the former and living according to others’ expectations of them, leading to poor choices including with their finances.

Investment strategies

A closer look at defensive assets for turbulent times

After the recent market slump, it's a good time to brush up on the defensive asset classes – what they are, why hold them, and how they can both deliver on your goals and increase the reliability of your desired outcomes.

Financial planning

Are lifetime income streams the answer or just the easy way out?

Lately, there's been a push by Government for lifetime income streams as a solution to retirement income challenges. We run the numbers on these products to see whether they deliver on what they promise.

Shares

Is it time to buy the Big Four banks?

The stellar run of the major ASX banks last year left many investors scratching their heads. After a recent share price pullback, has value emerged in these banks, or is it best to steer clear of them?

Investment strategies

The useful role that subordinated debt can play in your portfolio

If you’re struggling to replace the hybrid exposure in your portfolio, you’re not alone. Subordinated debt is an option, and here is a guide on what it is and how it can fit into your investment mix.

Shares

Europe is back and small caps there offer significant opportunities

Trump’s moves on tariffs, defence, and Ukraine, have awoken European Governments after a decade of lethargy. European small cap manager, Alantra Asset Management, says it could herald a new era for the continent.

Shares

Lessons from the rise and fall of founder-led companies

Founder-led companies often attract investors due to leaders' personal stakes and long-term vision. But founder presence alone does not guarantee success, and the challenge is to identify which ones will succeed in the long term.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.