Cloud computing is all the rage! In case you are not sure what “cloud computing” is, it is having another company manage your data and applications. For example, instead of having a spreadsheet program on your desktop PC along with spreadsheet files, with cloud computing, the code and all of your data reside on a server somewhere, accessible via any device hooked up to the web.
It has been popular with small start up companies, but even the internet “giant” Netflix has joined the party – Amazon may be a competitor in the retail side of the business, but Amazon now manages Netflix’s data (see NY Times, 4/19/10). And Amazon is by no means the only provider of these services – they are in good company with the likes of Microsoft and Google.
While lots of people talk about how cool cloud computing is, there is very little discussion regarding whether anybody will make a lot of money out of it. Maybe this is because while it could grow to be a huge revenue business, it is likely to remain a rather unprofitable one. Why? There are several reasons.
Let’s start with the comparison set. What other business sells “business process services”? … why of course, contract manufacturers (Foxconn, Flextronics, Jabil Circuits, etc.). Instead of making your latest mobile/cell/smart phone, have somebody else do it for you. There is a profitable transaction here because the contract manufacturer pools the demands across many clients. Consequently, the contract manufacturer experiences less volatility in demand than any one of the clients. It follows that the contract manufacturer can operate its assets with a higher utilization while providing at least as good service. In other words, the contract manufacturer can do something that the clients cannot do as well, hence they can charge a “premium” for this service. However, the gross margin of contract manufacturers are generally in the 5-10% range – those are rather thin gross margins indeed. In other words, if cloud computing is like contract manufacturing, then there is reason to believe the cloud computing firms will have small margins as well.
Now consider the fundamentals of this business. Selling cloud computing means you are dealing with highly price sensitive customers (Netflix will negotiate more aggressively than Sally’s Organic Honey) and you are selling a product that arguably is a commodity – is one server better than another server? Put another way, it is unlikely, like the contract manufacturers, that the cloud computing providers will have any brand equity. Finally, when you are competing against the likes of Amazon, Microsoft and Google, you shouldn’t expect the competition to be gentile.
So why are companies jumping into the cloud computing space? Well, for one, it will be big business on the revenue side. Contract manufacturers need to find a set of clients that have similar manufacturing needs. This means that you can serve Nokia and Apple, but it is unlikely that you can also serve CitiBank, DuPont and Ryder Trucking with the same manufacturing equipment and labor. In other words, while the market for a particular kind of manufacturing is “limited”, the market for computing services must be orders of magnitude larger due to the fact that every business uses computers and data processing. And, while the margins are not likely to be large, they will be positive because these companies are creating value. Hence, a small percentage of a very large revenue number cannot be ignored. Nevertheless, the return on invested capital for this business will not create eye popping numbers like Google’s ad business.