Waddell & Reed Market Perspective – September 2011
The Waddell & Reed Advisor Funds investment team is taking a closer look at cloud computing, which is attracting an increasing amount of attention and investment dollars. With its arrival on the scene, we are clearly seeing another major shift in how companies and individuals utilize technology. Simply put, the world is looking for cost-effective ways to achieve mobility and ubiquitous computing – the ability to seamlessly access the information they want and need, any time, and in any place.
Cloud computing is about “real time on the fly” through data centers to provide the kind of metered bandwidth that users need and that is clearly becoming important as the world moves beyond mobile devices and electronic mail. At the end of the day, it’s about on-demand, self- service capabilities for any number of applications— e-mail, voice, music, video, photographs, and others — in a timely and reliable but very measurable and cost-effective manner. And the cloud? It’s anything and everything that’s stored on the Internet instead of on a computer’s hard drive.
One of the greatest things about cloud computing is the level of security it provides. The cloud backs up data so that if a user’s home computer breaks down, he or she can still access digital files no matter where they are. Because cloud computing stores an individual’s digital files on remote computer servers instead of on his or her own hardware, the user has less need for individual storage and the expenses associated with it.
A software perspective
The “cloud” is basically a new delivery model that expands the market for software consumption by making software more affordable and enhances the capabilities of the solutions themselves. In the past, an enterprise information technology department would buy all the pieces to deliver a piece of software. This would involve purchasing hardware and infrastructure software, finally the software itself, and then hiring people to manage the solution on site, which would demand a certain level of expertise and would incur a lot of upfront costs. With cloud computing, “software as a service” (SAAS) allows a user to simply subscribe to a service that is delivered over the Internet. In this scenario, a customer pays a recurring fee on a per-user basis, so upfront costs are lower and costs scale as usage increases/decreases in terms of number of users.
Three things are enabling cloud computing solutions to become widely available: The exponential decline of hardware prices, better connectivity and increased hardware utilization via virtualization software. VMware is one example of how investors can capitalize on the cloud computing trend. This is a software company that makes virtualization software, which saves enterprise customers money in the form of lower hardware costs (better hardware utilization). VMware also enables SaaS companies to deliver their solutions economically over the Internet. The savings again comes in the form of lower hardware costs associated with hosting the software. SAAS also provides traditional software vendors a better way of delivering their solutions. Consider Intuit, which we would normally think of as a seller of QuickBooks or Turbo Tax in the form of “on-premise” software. A customer would typically purchase QuickBooks from a retail outlet, install it and hopefully get it to work. But now, Intuit is moving these customers online, where they will simply create a user name and password, in order to access the software and consumer it online. This allows Intuit to expand its margins by not having to pay retailers a fee to sell the software and enables it to drive sales through its existing customer base. Intuit now owns its customers’ data and can observe how customers are using the software in real time, which enables Intuit to iterate and improve the solutions with more rapidity and to better understand what additional solutions their customers might be interested in buying.
The ability of cloud computing to expand the market for software usage is why we are excited about the software industry and SAAS, in particular. But it’s also affecting industries outside of software. Consider retailer Williams Sonoma, which purchased software from a company that was recently acquired by a firm called Salesforce. com. Salesforce.com provides applications for sales and customer service, a platform for building and running business applications and also offers an enterprise collaboration application. Its products are significant because it’s becoming important for retailers to understand what people are saying about their products over the Internet, on Facebook and other social media. Via the cloud, Salesforce.com enables Williams Sonoma to monitor the Internet and retrieve all mentions of Williams Sonoma, so it can spot problems and fix them early or identify customer trends the company can pursue in profitable ways.
Networking, telecommunications
Networking is an important area in cloud computing, but it doesn’t get as much attention as software. With networking, we’re seeing many more devices, bigger data centers and a greater number of data points between the devices and the places where information and applications are stored. What’s become clear is that we need bigger, better networks, with bigger, faster pipes to aggregate data from homes and businesses. Optical transport and higher-level technology transport methodologies are making those pipes faster. What’s been significant in the past five years is that from an investment perspective, we’re making the networks smarter. We now have load downs that prevent over stressing one data center while another is idle. Prioritization of traffic is basically identifying what is most important and sending it first.
Within this, beyond just specialization in niches, there are real-time issues to address, such as noise and video. Incorporating all of these can be an unpleasant experience. There are companies, such as Acme Packet, that specialize in session delivery network solutions. Acme Packet has a session border control, which is a service delivery architecture encompassing many different product categories. In effect, it opens up the pipe, keeps it open and everything goes through prioritized and already pre-cleared from the security standpoint once the session has been established.
Another topic is scale. Most of what is happening today on the cutting edge of networking has to do with server virtualization and efforts to get more utilization in storage and the computer part of the network. The idea is to take all of the individuals who want to have their traffic switched, aggregate in mass and still provide everyone with the control they need to get more optimization out of the switching layer. A few companies are already pursuing this. Juniper, which provides high-speed, reliable switching routers, is working on something it calls QFabric, which has an open standard called Open Forum. A number of other companies are working on virtualization, the most prominent being Hewlett-Packard.
The final topic with respect to scale is, importantly, storage. With the price of memory dropping, it’s pretty inexpensive for a user to keep a lock on his device, but there are some situations in which a user wants to keep information in the cloud for quick accessibility. The frequency of use may not be so high and the type of device may not be consistent. There’s a lot going on in this area as well. The best example we can point to is the Human Genome Project. Studying massive amounts of information from each individual human gene, trying to find commonalities, creates the need to go across the data base and storage elements to figure it out. Within storage, a company like NetApp has storage tuned to work best in a virtualized environment.
Data mining for retailers is another compelling need, and Starbucks serves as a good example. It has a program that allows the company to see what people are buying, what trends are developing, and it has helped the company improve the customer experience.
Hardware storage, semiconductors and related components
The nuts and bolts of the underlying semi conductors and pieces of hardware enable a lot of cloud computing. All of these pieces work together, and that’s how the cloud touches every part of technology and flows pervasively into other industries. From the hardware and semiconductor standpoint within the need for real-time computing, we’re seeing more investments in the next-generation data centers. Google, Facebook and Apple are already doing it, and it’s driving a lot of spending.
Being able to push massive amounts of data through the network relies on semiconductors produced by companies such as Broadcom. Underlying the microprocessors, there’s Intel. On the small-cap side, there’s NetLogic — the point being that there are lots of different semi-conductor firms that have benefited at different touch points, whether it’s the network or inside the data center or certain particular configurations that enable pieces of software.
NetApp and several other semi-conductor companies are logical investments that you can see that are most directly impacted by the cloud. And there are other key beneficiaries, such as Apple’s bandwidth capability due to the proliferation of the devices and the interconnection of its Internet Operating System (IOS). We’ve watched it invest heavily in a data center in North Carolina for a long time. We all know the frustration with having several Apple devices that are not synched. To get music here, there or anywhere, now you’re going to be able to synch all those devices wirelessly, which is a big deal here as well as in the emerging markets.
With respect to emerging markets, we think about how and where technology is evolving, what the next generation of devices might be and where the growth will take place. For example, hearing aid devices could constitute just one application. If you consider the adaption of PCs, WiFi and connectivity are key. That’s where the cloud comes in — the ability to access that bandwidth, and then to access photos, music and other applications from just about any device.
Health care and other arenas
The cloud is changing delivery models in many other industries, including health care. In that arena, we can look to Cerner, a health care software company that touches hospitals, doctors and others in the health care realm. Hospitals typically invest locally in their information technology infrastructure. So, rather than making that enormous spend locally, they’re able to tap into resources because of the bandwidth capabilities and higher power in the data center. By doing that, they have much better access, a more cost-effective solution and an ability to ultimately provide better care for their patients as well.
Cerner is taking in all that data and not only using the interaction with the doctors and administrators at various hospitals, but is also lower to run a more efficient data center, which ultimate results in lower costs for the hospital. Consider medical records, the probability of doctors sitting at home on their PCs with the ability to do video conferencing with patients, or a doctor who goes on vacation and learns she has a patient in the emergency room. She can immediately access a patient’s records and immediately admit the patient to the hospital or call in a prescription.
A bright and cloudy future
Clearly, a tremendous amount of information already lives online, in places ranging from Facebook and other social networks, to emails services and gaming applications. But the tremendous potential of a full online existence remains unfulfilled. The market for cloud computer services and software is expected to grow more than 27 percent annually over the next five years, reaching $73 billion by 2015, according to International Data Corp. It estimates that by 2015, software-oriented cloud services will account for roughly three-quarters of all spending on public cloud services. With projections like that, we’re looking for — and increasingly finding— an abundance of compelling investment opportunities that cross technology and sectors.
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