It's Only the Early Innings for Cloud Computing

You may think that most companies would have moved all their business processes to the cloud by now, especially with so many studies showing how much cheaper and more efficient cloud computing technology can be. In reality, though, the majority of enterprises are still using clunky servers stored on-site or software once installed off a CD-ROM. In a recent white paper, Morningstar estimated that just 20% to 25% of virtualized infrastructure is running in a public cloud environment.

That's likely to change. All three main types of cloud computing markets--software as a service (programs people use), infrastructure as a service (virtual server space), and platform as a service (a virtual environment where companies can test their own apps and programs)--are expected to grow exponentially over the next few years.

"There was a lot of hype around cloud computing a couple of years ago, but we're still early," says Margaret Vitrano, who co-manages

The software market will jump the most, growing from $39 billion in 2016 to an estimated $110 billion in 2020, but infrastructure and platform should soar as well, from $38 billion to $70 billion and $13 billion to $30 billion, respectively, according to estimates from ClearBridge Investments.

This kind of growth should have investors salivating.

"We think the single most important trend in technology remains the ongoing shift toward cloud computing, which is having ramifications for dozens of stocks across our coverage," noted Morningstar analyst Brian Colello in his quarterly outlook.

Indeed, many stocks have seen their prices climb thanks to their cloud efforts. The ISE Cloud Computing Index is up 35% since January as of this writing, compared with the S&P 500's 8.5% gain. As more companies adopt this technology, investors are likely to see even greater gains.

Slow to Adopt

As familiar as people are with cloud computing today--most consumers use some sort of cloud program, such as email or online file storage--enterprises have taken their time with adoption, says Walter Price, comanager of the Bronze-rated

Many companies had been worried about security and whether they should store sensitive information on third-party servers. Plus, switching from expensive on-premises technology, like a server located in a company's office or software that has been installed directly on a computer, is a slow process.

"Trillions have been invested in existing infrastructure," says Price. "That investment has to be depreciated and companies have to think about how they're going to transition to a more on-demand or subscription-based cost stream. Like all revolutions, it takes time for people to agree that it's ready for prime time, but once it's ready it starts to move faster than expected."

Rodney Nelson, a Morningstar analyst who covers several cloud companies, says that it could take a decade for larger companies to shift their business processes to the cloud.

"We're talking about massive shifts of technology," he says. "This is a story that's going to play out over the next 15 years."

Cheaper and More Efficient Make no mistake, though, cloud computing is the future, says Nelson. The cost benefit to companies is too attractive to pass up. Rather than buying software for thousands of dollars that only some employees might use, companies can pay an annual fee based on the number of people who actually use a program. That fee covers software updates and technical support--things that companies used to have pay additional fees for.

The same goes for storage space. In the past, companies would build internal servers that were often not used to their full capacity. Now, companies can buy server space from a third-party vendor and use only what they need. If they want more space, they can easily add to what they have. Again, maintenance and upgrades are included in the price.

"Companies are increasingly realizing that operating on-premises IT infrastructure is inefficient," wrote Nelson in a recent white paper. "They're turning to cloud ... computing to streamline their processes and drive product and service innovation. We believe public cloud is a strategic shift that all companies will eventually embrace to varying degrees."

Profits Ramping Up Just as it has taken companies a while to embrace the cloud, it has also taken a while for cloud computing companies to generate profits. For the last several years, cloud operations have been focused on building products that are better than the non-cloud offerings on the market, and that has meant sinking millions into research and development, says Price.

Even when these companies started selling their cloud capabilities, revenues were low--people paying $50 a month for a subscription isn't the same as getting them to pay thousands of dollars up-front for a product. Now, though, those monthly subscription fees are adding up. Cloud companies are investing less in R&D, and the clients that have embraced the cloud are buying more services every year.

"It took a lot longer for these companies to get profitable off a subscription revenue base, but now they're on the other side of the mountain," says Price. "Their cost for renewal is much lower, and they now have superior features to the on-premises product. The model's only going to get more profitable over time."

Pick Your Spots Investing in this sector may seem like a no-brainer, but not every cloud enterprise will come out a winner. There are so many cloud companies out there, especially on the software side, that not all will succeed.

"It's like the PC era years ago," says Price. "The growth of the industry looked wonderful, but really only five or 10 companies associated with the PC generated most of the wealth for investors. That will be true in the cloud as well."

At the moment, Nelson sees the most value in infrastructure as a service companies, with

by about 37% year-over-year in the first six months of 2017, and it accounts for most of the company's overall profits.

The two do face some competition, mainly from

"Amazon and Microsoft have already outlaid tens of billions in investments," says Nelson. "They're the only two firms that have done that so far."

Amazon and Microsoft are also developing the most value-added services, such as machine learning, server-less computing, and artificial intelligence capabilities, and that will make them even more powerful going forward. It's one reason why the companies both have wide moats assigned to them, says Nelson. Both are also trading in 4-star range as of this writing, which suggests that the shares are undervalued relative to Morningstar's estimate of their fair value.

On the software side, a few companies look promising, such as customer relationship management programs

Nelson also likes

"When Adobe made the transition from boxed software that cost several thousands of dollars to a subscription offering, it was an immediate negative for their earnings," she says. "But over the long term it's been positive in terms of earnings power. It's helped them open up to the consumer market that would have never paid for its software."

While investors do have to be picky, it's hard to go wrong with the bigger, more promising names as the cloud is only growing form here.

"We like the whole sector," says Price. "And we're only in the second or third inning."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.