Morningstar Magazine - October/November 2017 - 83

Is there anything that might disrupt this process?

Nelson: A few years ago, the most significant
concerns were data integrity and security.
When you have one customer in one partition and
another customer in another partition on the
same server, you could have data breaches if that
ecosystem isn't managed carefully. Those
risks have been mitigated, and the perception has
changed as we've seen more companies undergo
their own data breaches. Enterprises aren't
the best managers of their own IT, and they can't
spend at nearly the same rate as a public
cloud vendor can on security. Moreover, public
cloud vendors are managing a homogenous
ecosystem, and they know it inside and out.

Another challenge for multinational organizations
is the constraints surrounding data sovereignty
internationally. In Europe, every country seemingly
has its own set of regulations about how data
needs to be handled and where it needs to be
stored. It may need to live in a physical data center
within the boundaries of that country.
For public cloud vendors that want to handle
the workloads of multinational customers,
it is crucial to have assets distributed globally
as well. It's not enough to just build out
thousands of data centers in the United States
because if you get a customer that has interests
outside of the U.S., you wouldn't be able
to serve that customer from a performance
perspective and/or a regulatory perspective.
That's why we've established Amazon.com AMZN
and Microsoft MSFT as the big winners in this
market today and going forward. They've cleared
the hurdle of making really large ramp-ups
in capital intensity and capital investment in these
businesses, and they have the most distributed
network of public cloud services globally.
That in and of itself is a huge stepping stone to
winning deals. Beyond that, the premium services
they already provide around themes like
Internet of Things, machine learning, and artificial
intelligence deepen their expertise, and
ultimately allow them to win more deals. It's sort
of a virtuous cycle. They've gotten past that initial
capital outlay, and now they can focus on those
services that are going to attract customers
that want to drive their own businesses forward.

It sounds like size and scale are essential to developing
and maintaining a competitive edge.

Nelson: Absolutely. By our estimation, this market
could be worth hundreds of billions of dollars
in very short order in terms of addressable market
opportunity. But to address that market, you
must outlay tens of billions of dollars to build out
that global infrastructure. If you're already
behind the eight ball, if you're an Oracle ORCL
or an IBM IBM and you haven't made the requisite
investments, you're already very far behind.

The leaders aren't stopping their rate of investment
in these businesses. Data-center buildouts
are beginning to slow at Amazon and Microsoft,
but we're still seeing heavy investment on the
R&D side, leading to even deeper product
portfolios that are increasingly difficult to replicate.
And as more data flows through these services,
they become smarter and faster. It's kind of an
arms race.
First and foremost, that level of capital intensity
and that global scale affords the biggest
players a cost advantage, because they can lower
prices as they attract more customers and pass on
those economies of scale without degrading
their own margins. Then, there's an intangible
asset component to these businesses as
well that comes from having experience managing
hyperscale cloud data centers, which we
would certainly attribute to Amazon and Microsoft
and increasingly to Alphabet GOOG and
Alibaba BABA.
Then it ties back into that premium services
portfolio, offerings around the Internet of Things,
artificial intelligence, machine learning-the
things that are driving incremental investments at
enterprises. Those two things are really the
building blocks for a competitive advantage and
ultimately an economic moat in this market.
Longer term, as the cloud market matures,
there's going to be some level of switching costs
for customers. It's going to be very difficult
to replicate an ecosystem at a different vendor.
Amazon and Microsoft each have their own
areas of expertise. For Microsoft, it's a deep and
inherent knowledge of Windows-based
applications, of which there are millions out there.

That creates a natural landing place for a lot
of those workloads in Microsoft Azure.
Amazon has the deepest and broadest product
portfolio of any of the cloud vendors.
You noted that Google has made an extraordinary
capital investment. Do you see it catching up?

Nelson: We expect the cloud to be a small
component of Google's broader business, because
its search and advertising business is so
massive. Any amount of capital investment that
Google makes into a particular product or service
is going to have a very difficult time moving
the needle of the broader business, because that
advertising business is still growing very rapidly.

Where Google can be a player in this market
is with its inherent expertise at data analytics and
artificial intelligence. These drive that core
search and advertising business. Being able to
manipulate and parse through data and ultimately
make decisions based on that data is a core
component of any marketing campaign. As they
expose some of their AI technologies to their own
customers and unlock some of the frameworks
that they utilize in their own business, it will attract
a lot of customers to their cloud business.
Google hired Diane Greene, who was a co-founder
of VMware, whose server virtualization technology
enabled the cloud market to come to fruition.
She not only has a very deep understanding of the
underlying technology, but she also has the
experience of dealing with enterprise customers.
She was a savvy hire, and she's done a lot
of things to bring a more formal atmosphere to
Google's cloud business, but it is still several steps
behind both Amazon and Microsoft.
There's still a fairly sizable gap from a revenue
perspective between Amazon and Microsoft, but
there's also a sizable gap between Microsoft
and Google and the rest of the field. Considering
that Microsoft is growing 100% year over year
in its cloud business, and Amazon is still growing
at a very high rate on a much larger base, it's
likely that those firms will be able to maintain their
leads. So now it's really a matter of who is going
to be that third player in mature Western markets.
Given their prowess in AI and machine learning,
we think Google is going to have the most success.

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