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Clouds Move Higher: Investing in Cloud Companies

Investor and financial analyst Sergey Grigoryan, looking back to 2020, shares his findings and forecasts in the field of cloud technologies and investments in cloud companies.
Investing in Cloud Companies
Investing in Cloud Companies
The dynamics of broad market indices
The dynamics of broad market indices
The main principles of cloud companies
The main principles of cloud companies
The golden age of clouds is  beginning
The golden age of clouds is beginning
Clouds Move Higher: Investing in Cloud Companies
Clouds Move Higher: Investing in Cloud Companies
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Sergey Grigoryan, FCE Team Member, financial and investment expert, shared his views and analysis of the cloud market over the past year. The past year has been a unique year for technology and technology investment. Sergey tells what happened and what to expect from cloud companies next.
The outcome for 2020
Last year was marked by many shocks and turmoil, and it was not only about a forced shift in lifestyle for the vast majority of the world's population. Most of the people felt deterioration both in their private lives and in business.

One area of activity that has benefited from the pandemic and its associated constraints is the cloud-based IT companies offering their users remote solutions based on their hardware and software. It applies both to B2C companies of the entertainment industry - streaming video services, games, betting, etc. - and to B2B companies providing corporate clients with an alternative to traditional office work such as cloud platforms for collaboration, video conferencing, cybersecurity, etc.

Unlike the companies of the "old economy," this segment quickly gained popularity and attracted investors. The following graph shows the comparative dynamics in 2020 of the "broad market" indices and one of the popular ETFs (stock exchange funds) investing in a basket of cloud companies.



At the end of 2020, the S&P-500 broad stock market index, a traditional barometer of the stock market, rose by more than 16%. It is about two times higher than the historical average annual yield of the index. However, the Nasdaq-100 index was well ahead, being "overweighted" in favor of companies of the technology and biotechnology sectors. The result of the free from the old economy companies and the banks - the main losers of the global lockdown - part of the market almost three times (!) exceeded the S&P-500.

But even the abnormally high results of the Nasdaq-100 do not compare with the fantastic profitability figures shown by the shares of companies operating in the cloud services segment. Some grew 4-5 times in a year, but even the average result shown by a basket of cloud companies (ETF exchange fund: WCLD) was almost 111% since the beginning of the year. This growth came against the backdrop of ever-increasing investor interest and investor demand. The size of the WCLD fund has grown from $0.4 billion to $1.3 billion over the past 12 months (according to etfdb.com).

Why cloud services became popular among users and investors
The main reasons are:

- cost reduction

Migrating to the cloud saves virtually every company a lot. Instead of spending lots of funds buying expensive hardware equipment, then setting it up and instructing employees, and building its infrastructure, it is reasonable to outsource all this to the external provider and concentrate entirely on the company's main activities. It is crucial for young companies and start-ups, which typically lack working capital. Although, even large companies could feel the economic impact of shifting some functions to the cloud during the pandemic era.

- flexibility and scalability

One of the main advantages of cloud platforms is the fine customization of the services and data used by the company, and therefore the possibility to pay only for services the company uses. There is no longer a necessity to keep in reserve unnecessary server capacity and space. It is enough to add the required virtual capacities depending on the tasks and to do it very quickly.

- compliance with "green" principles

The use of cloud services significantly reduces the need for the company's offices, workspaces, and equipment. The traditional working model requires resources for heating, lighting, communication, etc. When working in the cloud, energy efficiency, among other things, is greatly improved, which is an essential factor for the environment.

- ease of use

To start using a cloud service, only a computer and a credit card are enough. Online learning platforms accelerate the process of training users, while the ability to work remotely is vital during a pandemic.

- predictability of cash flows

It is the reason why cloud companies have become so fond of investors. They are mainly available as subscription services, which allows forecasting of the cash flow in each period. When companies of the old economy suffer a rapid decline in revenues, this fact becomes a major advantage.
The dynamics of broad market indices
The dynamics of broad market indices
The main principles of cloud companies
The main principles of cloud companies
The golden age of clouds is  beginning
The golden age of clouds is beginning
Know your cloud: Types of cloud companies
There are three main principles on which cloud companies operate:

- Infrastructure-like-service (IaaS)

This type of company provides its customers with basic data center services, including server and communications capacity. Clients receive a scalable virtual machine that can be configured and used to meet their current needs. It increases flexibility, but the sources of the incoming data and applications to interact with it remain on the client-side.

The most well-known solutions on the market are provided by IT giants: AWS (Amazon), Azure (Microsoft), GCT (Alphabet), Alibaba Cloud (Alibaba, for the Chinese market).

- Platform-like-service (PaaS)

In addition to infrastructure, this type of cloud company provides its customers with the right amount of time to run in their operating environment. It allows them to create, use, and distribute their applications and programs without significant equipment costs.

Additionally, there are more specialized companies in this niche, such as Twilio or Salesforce.

- Software-like-service (SaaS)

SaaS is the most common type of cloud companies. It allows its customers to use software without buying it, using a subscription. The most common example is Microsoft Office365, but there are more customized services. For instance, Netflix clients receive on-demand videos from the cloud, Zoom clients receive cloud-based video conferences, Slack clients receive remote collaborative project work, and Crowdstrike clients receive сybersecurity tools.
How to evaluate a cloud company
Companies operating in the cloud services segment tend to be fast-growing. Most of them remain unprofitable, so traditional valuation methods and metrics apply only to a limited extent. The main criteria for evaluating such companies for comparative analysis include:

- Price-to-Sales ratio—Market capitalization/sales ratio

For the average stock market, this ratio hovers around 1.5. For cloud companies, it can be 5 or higher. For the "hottest" organizations, the ratio can be as high as 40-50, in which case, investors need to see how robust the sales growth is to justify this high score before investing in their shares.

- The Rule of 40

The long-term ability of the company to make money is based on two things: revenue (sales) growth and profitability (margin) growth. To recognize the attractiveness of a cloud company, investors must put together two numbers: annual sales growth (in %) and "net profit margin" (%). If the amount is more than 40, then such a company is considered interesting for investment. For example, if the company's sales grew by 30% over the year and it operates with a margin of 15%, the sum of 45 makes it at least worthy of further analysis.

- Total Addressable Market and Market Share

The long-term growth and profitability potential depends on the size of the market and the company's part. It is perhaps the most difficult element of the assessment. It is not always possible to precisely determine the potential size of the market, especially when the company operates in a new niche. However, this criterion is also widely used by investors, although it implies some "creativity."
Forecasts and prospects
The global trend towards digitization did not begin recently, but the pandemic situation certainly accelerated the process. It is unlikely that after the threat of the Covid-19 has disappeared, this trend will reverse. On the contrary, by exploring the benefits of cloud services, companies and individuals will begin to apply them more broadly. The bills for IT infrastructure and applications will become such routine as water and electricity bills.

Ark Investment Management, one of the most advanced investors in innovative companies, estimates that the cloud industry will grow with a CAGR of 21% over the next 10 years and reach $730 billion by 2030. Wider application of IT solutions will generally lead to higher productivity, and cloud companies, owing to their unique characteristics (easy start-up and subscription-based regular revenues), are likely to capture a significant slice of this big technology pie.

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Big investment themes take years and even decades to go from idea to mass application. Cloud companies appeared about 10 years ago, attracting the attention and demand of users and investors in a short period. With more and more businesses applying digital solutions, there is a strong chance that the golden age of clouds is just beginning.


Sources: Ark Invest, Catana Capital, EurekaHedge
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