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Putting a price on the transition to the cloud

Pity the business technology company. While investors have rewarded internet retailers like Amazon with its razor thin margins, consumer cloud services like Twitter which has yet to make a profit , and SaaS startups like Salesforce with sky high valuations, traditional enterprise technology companies are struggling to win over Wall Street.

The challenge for enterprise technology companies that are trying to manage the transition from traditional software license sales to the cloud subscription model is particularly acute because their corporate customers are embracing the cloud computing model faster than almost anyone had expected.

This accelerating trend is apparent in the third quarter numbers from enterprise IT suppliers including IBM, Oracle and SAP and highlights the growing importance of how these and other suppliers are perceived to be navigating the transition to the cloud.

For example IBM’s shares fell sharply after the company reported disappointing third quarter earnings including a $1 billion shortfall in consensus revenue and lowered its 2014 earnings target.

While IBM cited sales softness in September as one issue, the much bigger issue is what the company identified as “the unprecedented pace of change in our industry” – a statement that analysts took to be at least partially a reference to cloud services adoption.

Among investors and analysts, IBM is seen as being particularly exposed to the changes underway in enterprise tech because most of its revenues are tied to an old and increasingly outdated business model while its cloud-based revenues – which are running at an annualized rate of a little over $3 billion – make up a negligible three per cent of the total.

Similarly, Oracle’s recent earnings results were below estimates for both revenues ($8.6 billion from $8.77 billion) and earnings-per-share ($0.62 from $0.64). But although licenses for software and hardware sales declined, bookings for cloud sales increased 54 per cent.

The story behind the headline numbers at SAP is also one of transition. SAP missed its Q3 revenue estimates (while posting in-line EPS), and reported a 3 per cent year-on-year   drop in traditional software license revenue.

But much more importantly, cloud revenues grew by 41 per cent in the latest quarter and now represent more than a third of license software sales.  SAP now has more than 44 million cloud applications subscribers and an annualized cloud run rate of $1.7 billion.

This shift has profound implications for the shape of SAP’s business in the longer term and for the way investors view enterprise software suppliers.  Cloud-based subscription revenues are recognized over an extended period rather than software sales which boost the top line immediately. So, $100 million of cloud revenue in any one quarter is equivalent to roughly $250 million in software sales.

This reduction in upfront revenues puts pressure on margins in the short term, but should result in higher profitability in the long term due to the greater efficiency and the more recurring nature of the cloud model.

Ultimately this means investors will need to reassess their portfolios and place a premium on those companies that have coherent cloud strategies and the agility to adapt quickly to a rapidly changing market.

At the same time, they may begin to question whether the sky high multiples and triple digit market caps commanded by companies like Amazon, Facebook and most recently Alibaba are really justified.

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      Author's profile photo Former Member
      Former Member

      Excellent analysis, Paul.