Infrastructure as a Service: The Race Won’t Go All the Way to the Bottom

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Infrastructure as a Service: The Race Won’t Go All the Way to the Bottom

The stakes for public cloud operators (IaaS) are huge. Annual global spending on enterprise data centers – hardware, infrastructure software, staffing, facilities, etc. – is more than $1.2T. We expect most of this will migrate to the cloud over the next 2 decades, due to the compelling economic advantages of web-scale distributed data centers, with cloud operators hosting both SaaS and customized applications. The costs and performance of IaaS are highly levered by scale and technical sophistication, factors that will force all but the biggest and best from the market with time. Currently, the 3 best positioned players – AMZN, MSFT, and GOOG – are engaged in a price war, temporarily sapping industry growth and maybe driving all 3 into losses. However, the real casualties of this war will be smaller IaaS operators, who will be uncompetitive without massive consumer cloud franchises to drive scale and sophistication. Meanwhile, we do not expect a “race to the bottom” amongst AMZN, MSFT and GOOG. Rather, as the market concentrates into their hands, we believe natural points of differentiation for each of them will allow lucrative value added services atop commodity processing and storage services. All three should be profitable long-term, with sales growing into $10s of billions before decade end. However, given a slightly richer data center cost structure and the lack of a high margin core business to cover for any losses, we are concerned that AWS will be a burden to AMZN in the near term, as it works to re-establish the confidence of investors.

Global spending on data center infrastructure is huge. Infrastructure-as-a-Service (IaaS) solutions compete directly for data processing jobs that would otherwise be run in-house. Globally, we estimate that enterprises spend more than $1.2T annually in building and operating their own data centers, including the costs of hardware, infrastructure software, facilities, maintenance, user support, and management. Long term, we believe that all but the most latency sensitive workloads will be addressable by cloud-based IaaS operations, even those currently constrained by regulation and security concerns.

Modern web-scale distributed data centers have compelling advantages. Public cloud distributed data center platforms have huge cost and performance advantages vs. private data centers based on several factors: 1) Use of commodity components vs. value-added configured systems; 2) Minimal non-productive costs; 3) Much higher utilization; 4) Superior system availability and recovery;5) Very low personnel costs; 6) Flexibility, scalability, power and convenience; 7) Substantial economies of scale. For example, we estimate that the all-in costs of running computing workloads in the biggest and most sophisticated IaaS data centers may be as little as 10% of those for a typical enterprise IT operation, while offering the advantages of nearly limitless scalability, global access, and world class support.

AMZN, MSFT and GOOG very well positioned vs. would-be rivals. These three IaaS competitors lever enormous scale, institutional skills, data center R&D and operational experience from their massive consumer cloud franchises into their commercial IaaS platforms. This has given them big head starts, with significant cost and performance advantages over traditional enterprise IT players looking to move into IaaS. Moreover, AMZN, MSFT and GOOG continue to make massive CAPEX and R&D investments in their data center infrastructures, setting fast moving targets far out ahead of potential rivals, such as IBM, RACK, CRM, VMW, HP, ORCL, VZ and others.

Aggressive pricing will drive IaaS adoption and concentrate share. AMZN, well known for its punishing pricing vs. retail rivals, got a taste of its own medicine earlier this year when GOOG cut its computing and storage prices by roughly 32% and 68%. Both MSFT and AMZN quickly responded with price cuts of their own, with AMZN getting punished by investors after reporting 2Q14 “other” revenues (N.B. largely comprised of AWS) down QoQ and delivering a much wider loss than had been promised. Despite this short term revenue hit, these step function price reductions should greatly accelerate adoption of hosting by enterprises and facilitate more compelling SaaS offerings by 3rd parties running on IaaS infrastructures. We expect that this incremental growth will be captured primarily by AMZN, GOOG and MSFT, and that the ongoing share shifts will be apparent in coming quarters.

Traditional IT spending will suffer. The aggressive IaaS pricing is hastening enterprise adoption of cloud hosting and removing barriers for SaaS applications vendors. Conversely, we expect it to negatively affect sales of data center hardware and software, which have already been decelerating. This will compound the suffering of traditional vendors, who will see dying sales in their core products even as they struggle to compete in the IaaS market. While many these companies are pressing the idea of a “hybrid” cloud, hoping to preserve lucrative proprietary software solutions and premium priced “value added” hosting, we believe that this is a transitory opportunity that will quickly erode as tools for managing workloads (such as “containers”) improve and as barriers to cloud adoption (regulation, security/privacy concerns, etc.) recede. In the long run, we believe it will put the viability of venerable IT names, such as IBM, HPQ, ORCL, VMW and others, at serious risk.

No “race for the bottom” – the big 3 will be huge and profitable long term. As the market concentrates and grows, we believe AMZN, MSFT and GOOG will all reach $10’s of billions in annual IaaS sales by 2020, with $100’s of billions realistic within 20 years. While we anticipate much of the volumes to be in commodity processing and storage services, we expect the price rivalry to ease somewhat as the market matures and weak hands exit. Moreover, we believe that there will be substantial demand for differentiated, value-added services atop simple hosting that will afford each of the big 3 opportunities for attractive margins playing to their disparate strengths.

AMZN will be challenged in the near term. MSFT and GOOG have high margin core businesses that can absorb the costs of losses in their small but fast growing IaaS operations. AMZN will be much more challenged. Not only is AWS considerably larger than its rivals, but AMZN’s core businesses compete with razor thin margins while the company invests heavily in their future growth. Losses in AWS are more than noticeable on the bottom line and will serve to undermine the company as it seeks to re-establish the confidence of its investor base, since we do not expect CEO Jeff Bezos to cede IaaS market share to his rivals without a fight.

For our full research notes, please visit our published research site.

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