Morningstar Magazine - October/November 2017 - 84

Investors

Meanwhile, Alibaba's advantage in China seems set.

Nelson: While Alibaba has assets internationally,
it's probably going to be a pretty big challenge
for them to win Western business because
of that association with China. That adds a lot
of red tape to dealing with the company.
But China is a massive market, and it is not even
remotely as far down the road of migrating
to the cloud, so there is much pent-up demand.
Alibaba's AliCloud is the Amazon Web
Services of China. It's already got more than 40%
market share, and it has the full support
of the state.

can't drive utilization high enough to generate
economies of scale.
In the U.S., the lowest-cost vendor, Google,
is a U.S. company, as are the most established
vendors, Microsoft and Amazon. So, it's
going to be really challenging for regional players
to have much of a presence. Overseas, because
of concerns about data sovereignty and local
regulations, there is more potential for regional
players to have nice small businesses. But
the bulk of this market is going to be consumed
by three or four companies.

The public cloud vendors stand to gain
a substantial share of the IT budget
and tap into a portion where they never had
a presence before.
Rodney Nelson

They will win some business internationally, from
Chinese firms that have international interests.
Winning European business and American
business is almost going to be impossible but the
Chinese market is large enough to support
a very high rate of growth and very durable returns
on invested capital.
Will there be niche roles for smaller players
in the future?

Nelson: It's going to be challenging. If you want
to manage the workloads of the largest enterprise
customers, you can't be a niche player. You
must have a global infrastructure to handle the
needs of a global multinational enterprise.
A regional cloud vendor can serve domestic or
regional companies, but it will be a challenge for
these vendors to invest intelligently in their
own business and not overreach and build out too
much data-center capacity such that they

84

Morningstar October/November 2017

Nelson: Coming into the year, there were some
great opportunities to get involved in technology
names, many of which had sold-off postelection. But valuations in general are now pretty
full because tech has been on a tear for most
of this year and most of these companies have
performed quite well.

Microsoft is trading in the low $70s, and our
fair value is $83 a share. That represents
a compelling opportunity to get into the public
cloud market, which is a nice growth component
alongside a business that's also got a very
stable set of products. Amazon is also compelling
at its current discount to our $1,200 fair value
estimate. We think Alibaba is closer to
fairly valued, because of the fervor for leading
technology companies in China.
With Google, you're really buying the advertising
business. That's still the biggest driver of
revenues and profits of the business, but you
do have some nice optionality with the
cloud business that could steer the business more
towards a bull case valuation.
From where we're sitting today, Microsoft and
Amazon look like the best opportunities, but we'd
happily invest in any of these companies if you get
the right discount to our fair value estimate. K

Do you anticipate M&A activity remaining busy
in this area?

Nelson: Yes, the four prime vendors-Amazon,
Microsoft, Google, and Alibaba-will continue
to snap up small shops. If you look at the
biggest deals or the highest frequency of deals
over the last five or 10 years, they're all in
the realm of cloud, machine learning, analytics,
Internet of Things, artificial intelligence. I
think that's where you're going to see the bulk
of M&A dollars occur, simply because those are
the markets that are the most untapped. I
do expect it to remain a vibrant M&A market,
though maybe the actual deal sizes might
not be as big for some of these smaller shops that
are more specialized.
For investors looking for an opportunity to
invest in the public cloud today, what do valuations
look like?

Laura Lallos is the managing editor of Morningstar magazine.
Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2017
