Your Best Stock Investment in the "Cloud" Is Right Here

By: Money_Morning

Michael E. Lewitt writes: Last week, investors drove up the market valuations of both Amazon.com Inc. (Nasdaq: AMZN) and Microsoft Corp. (Nasdaq: MSFT) by tens of billions of dollars based on excitement over the companies' "cloud computing" hosting businesses.

For both companies, cloud revenues and growth were the catalyst of the big moves.

Indeed, both featured screaming improvements in what are critical segments in their business models….

Amazon Stock Is Rewarded for the Wrong Reasons

But that's where the similarities end. Savvy investors looking for the best long-term investment would be wise to dig deeper into the both company's quarterly results.

Once we do that, the decision on which stock to buy is an easy one.

Amazon's stock price rise came after it disclosed the first financial details about its cloud service Amazon Web Services (AWS), which offers hosting services to Internet startups, video streaming companies like Netflix Inc. (Nasdaq: NFLX), and the Central Intelligence Agency.

AWS's revenues for the first quarter of 2015 were $1.57 billion and its operating income was $265 million, which immediately placed this business segment among the e-commerce giant's most promising businesses from a profitability standpoint.

How do we know that?

Because once again the rest of the company lost money! In fact, Amazon reported a net loss of $57 million for the quarter on $22.7 billion of revenue.

AWS is a wonderful enabler for entrepreneurs that are able to start new businesses and pay very little for hosting services. Fifteen years ago, the system was not designed to handle the voracious appetite for bandwidth that video streaming and the thousands of new Internet-based businesses consume.

In fact, fifteen years ago the cloud did not exist. But today entrepreneurs can capitalize on low-cost storage of their data to build multibillion dollar businesses.

According to John Dinsdale, chief analyst and research director at Synergy Research Group, there are six companies that have annual cloud revenue run rates in excess of $5 billion: Amazon, International Business Machines Corp. (NYSE: IBM), Microsoft, Hewlett-Packard Co. (NYSE: HPQ), Cisco Systems Inc. (Nasdaq: CSCO), and Salesforce.com Inc. (NYSE: CRM).

Each of these can claim leadership in a different part of the cloud, although AWS is the current leader in cloud infrastructure services. With the market growing by almost 50% a year, there is enormous potential for all of these companies to grow their revenues.

The big question, however, is whether they can earn enough of a profit to move the needle on their stock prices in a business where price competition is intense and margins will come under enormous pressure.

The answer for Amazon stock is still very much up in the air.

AWS's results showed that Amazon earned an operating margin of 19.6%, far lower than the 70% to 90% margins that some technology aficionados were touting before the actual results were released.

Furthermore, this operating margin is actually overstated because it excludes stock-based compensation and likely other charges that are buried in Amazon's financials. Rackspace Hosting Inc. (NYSE: RAX), which is a pure cloud hosting company, generates operating margins in the low teens, so Amazon is doing roughly the same.

But if Amazon's history is any indication, profitability is not its endgame. If Amazon has proved anything, it is willing to pay any price to gain dominance in any business. And that price usually spells the destruction of profit margins for competitors and the obliteration of traditional business models.

There is little reason why Amazon should change its spots – it has been rewarded by the stock market with a huge valuation, and the more money it spends and loses, the more investors seem to clamor for its stock. Year to date, Amazon is up an astounding 39% – but two-thirds of that move came before the disclosure of AWS's results.

The Cloud Pays Dividends for Microsoft Shareholders

Microsoft's growing cloud business is running at about $6.3 billion in annual revenues and contributed to the company's 6% year-on-year revenue growth. Most Wall Street analysts were unimpressed with the company's first-quarter earnings despite the impressive performance of its cloud business and Goldman Sachs even reiterated its "sell" rating on the stock.

However, this did not deter investors, who bid up the software giant's stock after the AWS news by 10%, adding $37 billion in market capitalization. Microsoft is twice as large as Amazon – $400 billion market cap vs. $200 billion market cap – so it should take a much larger cloud business at Microsoft to move the needle than at Amazon.

Yet both stocks moved by roughly the same amount in terms of market cap after AWS's results were disclosed. Clearly investors are using something other than logic to guide their actions…

At both companies, it takes enormous leaps of faith (or leaps of something) to justify such large stock moves based on what we learned about AWS.

First, investors had to extrapolate AWS's first-quarter numbers to a full year ($6 billion in revenue and $1 billion in operating profit before stock option and other expenses); second, they had to extrapolate that growth out several years in a business that is already featuring vicious price competition and epitomizes creative destruction.

This is the kind of exponential thinking that got investors in trouble during the dot-com crash 15 years ago.

There is already intense price competition occurring in the cloud computer space. Amazon has been cutting prices like mad and will likely continue doing so. Having already destroyed margins in the retail business, there is no reason to think it will act any differently in this business.

If history is any guide, Amazon can be expected to sacrifice profits to expand its cloud business. Its goal is to be the no. 1 provider of cloud infrastructure services, not to be the most profitable provider of those services. Such a goal would be consistent with its approach to every other business it has entered.

Amazon is like a Rorschach test for investors – some see a business that will someday be able to turn on the profits spigot and earn billions. Others (like me) see a business that requires enormous capital investments without generating significant profits on any reasonable time frame.

Still others could argue that Amazon is creating a wholly new business model for our digital age in which value is measured not based on profits but on other metrics.

Before getting any further carried away, investors should stop and catch their breath. At infinity-times earnings and without a dividend, Amazon stock is grossly overvalued and should be avoided.

Microsoft stock, however, is trading at mid-teens multiple (net of cash) and pays a 3% dividend and is more reasonably priced. The company will continue to grow its cloud business as well as the rest of its very profitable operations that generate enormous amounts of cash.

Source :http://moneymorning.com/2015/05/01/your-best-investment-in-the-cloud-is-right-here/

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