Cloud Computing

Tech's Old Guard Is Fighting Back, By Making Profits

Software giants Microsoft and SAP have gone to the cloud to stay relevant -- and profitable -- as the structure of business software shifts to a more nimble model.

Tech companies that make business software are never going to match the glamour of their consumer counterparts. Facebook's Mark Zuckerberg is a household name, but many would be hard-pressed to identify the bosses of SAP or Oracle even if we use their products every day. (See footnote if you're interested )

For investors, though, dull doesn't have to be unattractive. As second-quarter results at SAP and Microsoft show, the old guard is doing alright despite a generational shift in how businesses buy and use technology.

Cloud computing, which uses networks of internet-hosted remote servers to run technology tasks (rather than doing so locally), is forcing SAP, Oracle, Microsoft and others to overhaul products and business models. It's given birth to fast-growing upstarts such as Salesforce.com, Workday, and Amazon Web Services, which offer less cumbersome subscription-based systems.

SAP and Microsoft began adjusting a while ago. SAP believes its sales of cloud-based software will be bigger than traditional products by 2018. It's had 13 consecutive quarters of more than 30 percent growth from cloud services, excluding M&A effects.

Microsoft sales in its cloud division rose 6.6 percent to $6.7 billion in the quarter. Revenue from Azure, the Microsoft platform that sells data-center computing power and services, has doubled in two consecutive quarters.

Nomura estimates that the cloud will account for about 30 percent of Microsoft sales by mid-to-late 2018 from just 5 percent in early 2015. CEO Satya Nadella (recognize him?) deserves credit for starting to fix Microsoft after predecessor Steve Balmer's missteps, including the value-destroying buy of Nokia's mobile phone business.

Of course, it's early days in the cloud era. The old guard must still prove they can cut costs to protect margins, while being nimble enough to ward off those new rivals. Cloud services, sold by monthly subscription, are often less profitable than on-premise software.

For SAP, the shift doesn't mean it can ignore traditional products entirely. Investors are closely tracking adoption of its new S/4 Hana suite, a complex set of products sold mostly to big companies.

Growth-obsessed investors favor Salesforce and its upstart kin since they were created exclusively to provide cloud computing services. Salesforce trades on 72 times expected earnings over the next 12 months, showing the faith people have in that growth. Yet while sales have quadrupled in five years to hit almost $7 billion, it didn't make a profit over the period. Nor does it pay dividends. Boring old SAP (with a more modest P/E of 18 times), Microsoft and Oracle do. That's a bonus in a low-interest rate world where yield is scarce. It might be time to brush up on those names.

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