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By Matthew Coffina, CFA and Grady Burkett, CFA | 03-18-2013 04:00 PM

Cloud May Have Silver Lining for Investors

Tech director Grady Burkett looks at the impact of cloud computing with StockInvestor editor Matt Coffina.

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm here today with Grady Burkett, who is the director of our technology team. We're going to talk about cloud computing and the impact of cloud computing on some of the holdings in the real-money Tortoise and Hare portfolios that are part of Morningstar StockInvestor.

Thanks for joining me, Grady.

Grady Burkett: Thanks for having me, Matt.

Coffina: Maybe just to start us off, could you review what is cloud computing, and where are we in the evolution of cloud computing when it comes to software as a service, platform as a service, and infrastructure as a service?

Burkett: Sure. It's a really broad concept, and it can be as simple as accessing your Google email account from your Web browser; that would be an example of a consumer-oriented service of cloud computing. On the enterprise side, it can be something as basic as a company renting compute and storage resources from an Amazon Web server, for instance. So, they do the same thing--go into a portal, self-select how much compute and storage resources they want for their particular application, and build off of that infrastructure that they don't have to buy in-house.

It could also move all the way up to software as a service, where a third-party provider, a software provider like a salesforce.com, actually delivers the software application remotely and the enterprise simply has to access that application through web browsers. The advantage to an enterprise, if you move all the way to software as a service solution, is they don't have to make the up-front capital investment and they don't have to manage the resources in-house.

In terms of where we are at, again, it really depends on what type of application you're looking deliver as a service. With infrastructure as a service, I think Amazon and AWS is kind of the classic example and the most well-known example, and it's also the leader in the market. R.J. Hottovy, who covers that name for us at Morningstar, estimates they generated a little less than $2 billion last year. But this is a fragmented market; traditional service providers play in here, companies like Amazon play in here, and then there are a host of niche providers in here. So, it's very early innings for all of this adoption.

Coffina: What I'm most interested in, really, is the impact on some of the companies that we hold in the Tortoise and Hare. So, let's start with the good news maybe. Google is a company that we think of as being well positioned for the cloud. Can you tell me some of the things that they're doing there and how they could take advantage?

Burkett: Google benefits from a bit of a virtuous cycle. So, by hosting the applications in their own data centers, they can push out frequent updates to their software applications. So, for instance, if they want to update the Chrome browser, they can provide that update very quickly and very frequently to the consumers. They could also customize the experience to the consumer, and so by knowing more about you through the browser, through the Android operating system, through the search tool, they can actually create a better user experience for you.

Now, they also monetize that more effectively, because they know more about you as a consumer, and so they can charge more to the advertisers for their specific services. So, you do have this virtuous cycle that Google benefits from and a lot of that just is rooted in the fact that they own the data in their data centers and host these applications in the cloud.

Coffina: I know you don't cover Baidu on the technology team. We have it actually on the consumer team, but I'll just mention that that's a company that has a very similar story. It's basically the Google of China, but similar dynamics when it comes to the cloud.

Now another company that we think is relatively well positioned for cloud computing is Oracle, a company that we think has a stable competitive advantage. It could be at risk of disruption from the cloud, but we think that they're handling this transition well. Can you tell me more about Oracle?

Burkett: Sure. Oracle is one of our favorite companies in the enterprise software space. Essentially, the way that Oracle is prepared for the cloud is over a multidecade process. Basically they've really, by going out and owning middleware, database, and application software, they really own the customer kind of soup to nuts, and migrating from Oracle's database or its application software is very, very difficult for a company to do. And so, it's important to keep in mind that all these traditional vendors, and Oracle specifically, recognize these trends well before you and I see these trends coming. And so Oracle has gone out and collected assets, acquired assets, or made investments in assets that will allow it to migrate its customers to the cloud.

So, if you look at Oracle's Fusion Applications software portfolio, that's all cloud-based software--it's financials, it's supply chain management, it's governance--and so basically they can provide the same suite of services that are on-premise now in the cloud. If you think about it as a customer, you're more likely to stick with Oracle's solution, a vendor that you trust, a vendor that you know how to operate their software and where your data is actually held, is actually accessed through their software, than you are to migrate to kind of an upstart. So, they're very well-positioned.

Coffina: Makes a lot of sense. Now another company that's affected by these trends is Cisco. We used to have a negative moat trend rating on Cisco, which meant that we thought the competitive advantage was weakening over time. We recently upgraded that to stable, so now we think the competitive position is staying the same over time. What's really changed for Cisco with respect to cloud computing?

Burkett: The big-picture trend for any IT infrastructure supplier is that you do have some customer consolidation, and so going back to Google owning its data centers--Google is a much more powerful customer than a traditional enterprise in terms of how it can negotiate with its suppliers. And so we saw that trend, and that trend is still in place.

What concerns us with Cisco, in 2009 when we initiated with a negative moat trend on that company, is that management seemed to have dropped the ball a little bit in terms of navigating these threats and had moved into some markets that really weren't adjacent. And over the last three or four years, we've seen management kind of realign its strategy, focus on its enterprise customers, and it's really stabilized its position in enterprise. We haven't seen any market deterioration. It's also started to create solutions to offset some of these pressures that we're seeing from these cloud service providers.

So, in our view right now that warrants a stable trend for Cisco. We are seeing a flow-through in the financials, the gross margin has been stable, the operating margins have expanded, cash flows have come up.

We think that ultimately some of the pressures contained within these hyperscale cloud service providers, and we are not convinced that this is going to bleed through to traditional enterprises, simply because traditional enterprises, it's not inherited in their business model to program their networks and do some of the same things that a Google or an Amazon would do.

Coffina: And one more name from the Tortoise. This is probably the one that I'm most worried about: Microsoft, a company that we think has a negative moat trend, again indicating a deteriorating competitive position. What's your current take on Microsoft, again with respect to the threat from the cloud?

Burkett: Right. A lot of our concern with Microsoft is again getting back to software as a service and applications delivered through the Web browser. So to the extent that the operating system is marginalized and Microsoft's Windows operating system is marginalized, that obviously poses a competitive threat.

Now, if we look at the Windows business itself, it's about $22 billion of revenue across about a $90 billion revenue run rate. So it's very significant to the company. But more importantly, Microsoft also delivers its Office primarily right now on top of its Windows operating systems, so its Office products, Excel, Word, et cetera.

So, these are definitely negative headwinds; we see companies like Apple and Google to be able to capitalize on providing a better mobile experience and that could potentially disrupt Microsoft's position in the market. But I think you also have to look at Microsoft. The negative trend is in place. But this is a multidecade cycle, not a couple of years. So I wouldn't expect a turnaround and see Microsoft's business deteriorate quickly in the next few years, but certainly it's a long-term headwind for that particular company.

Coffina: And we actually think Microsoft is one of the cheaper names in tech despite the negative moat trend.

Burkett: And that's one way to think about these negative moat trends, is if you have a situation where the market is overly fearful of some of these trends and you have a company that generally has very, very high switching costs--so if you look at Microsoft, its servers and tools business, its office productivity tools business, these are products that are pretty sticky. So if you get a situation where the market is overly fearful and is dismissing a company's competitive advantages with the customer switching costs, it can create opportunity.

Coffina: Lastly, are there any companies that we didn't talk about today that you think are particularly well positioned for the cloud or look particularly undervalued within this general area?

Burkett: Yes, there are a couple ways to look at this. I mean, first of all, from an undervalued perspective, and if you can extend the cloud to just mobile, we can look at Apple. I think that's a great example of a company that right now is trading at about $450 per share, which to us suggests that the market expects free cash flows to decline fairly substantially over the next 10 years. And we think it's unlikely--the markets are still growing, Apple still has the opportunity to pick up market share. Now there may be lower price points, lower ASPs, lower gross margin involved, but the gross profit should continue to grow. And so, when you've got a company that's trading at single-digit multiple of forward earnings, excluding cash, you've got a lot of fear around their competitive position and you still have a very strong competitive position, a company that can still generate switching costs for its products, we think that creates a compelling opportunity.

More specific to the cloud, you can look at some of the systems integrators and the consultants that address some of this migration to the cloud. The cloud migration is a multistage process. It's from on-premise to hybrid, where you have a mix of both, to a public cloud, and the consultants help customers make this migration. So, Accenture is a name. It doesn't really look that attractively valued to us right now, but it definitely is one of the better-positioned IT service providers to benefit from this trend.

Finally, I would mention Check Point as a name. So, network security, obviously, as you migrate more data to the cloud, you require more network infrastructure security, and we're seeing a lot of this surface in the public domain right now, with concerns over network security. Check Point again--it's trading at a single-digit multiple of free cash flow, pure-play network security firm, 10% share of the market, and we think that's a name to consider.

Coffina: Great. Well, this has been very informative. Thank you very much, Grady, and I hope to talk to you again soon.

Burkett: Thanks, Matt.

Coffina: For Morningstar StockInvestor, I'm Matt Coffina.

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