The data center virtualization cycle that drove enterprise spending over the past decade has peaked. IT managers are now looking to a future where many of their applications will be handled by web-scale distributed cloud data centers with dramatic cost and performance advantages over privately run operations. Still, the obstacles remain daunting – e.g. security concerns, conversion costs, management complexity – and enterprises are proceeding cautiously. The result is a fallow period in IT spending – investment in client-server era data center hardware and software is slowing, but cloud-related spending has yet to hit the knee of its growth curve. The circumstances are reminiscent of the late ‘80’s/early ‘90’s when sales of the mainframes and minis that had dominated the previous era began to give way to client-server architecture. Then, as now, overall IT spending was sluggish and analysts projected a long slow adoption curve for the new approach. Now, as then, projections of the shift to new architectural paradigm are overly conservative. As such, we remain long-term bearish on enterprise data center systems and software – e.g. configured servers, RAID storage, networking gear, infrastructure software and traditional applications – even though some of these areas are still delivering growth. We believe patient investors will be well rewarded by a focus on large distributed data center operators, Software as a service applications, IT consulting, and commodity components, such as disk drives.
Enterprise data center IT spending has turned south. 1Q13 sales by companies in the enterprise IT segment were generally poor, continuing a trend of disappointments stretching back more than 2 years. The contagion that had been apparent in PC sales has spread to the data center, first in declining sales of server systems, then to sharp decelerations in infrastructure software, storage systems, enterprise networking, and IT services. While some of these categories are still seeing YoY growth, the downward trajectory is now well established. As a result, 1Q13 saw widespread disappointments amongst data-center oriented companies.
Cloud spending continues to grow. Enterprise spending on cloud services is growing rapidly from a relatively small base. Hosting entities like Amazon Web Services, Microsoft Azure and Rackspace suggest 20%+ annual growth, while SaaS companies, like Salesforce.com, Workday and Netsuite, are delivering better than 30% growth. CAPEX by web-scale data center operators Google, Amazon, Microsoft and Facebook, was up 42% YoY in 1Q13, focused on commodity hardware, such as server chips and disk drives, for their self-designed architectures.
The trend is consistent with shifting IT manager priorities. Over the last three years, Gartner’s CIO survey has seen a dramatic change in priorities, with longstanding key issue virtualization dropping out of the top 5, echoing earlier drops for ERP applications and security. Meanwhile, cloud computing has risen to the top, along with mobile computing and business intelligence/big data – all issues tied to the emerging new paradigm.
Paradigm shift puts overall IT spending in temporary stasis. CIOs are betwixt and between, certain that the future will see many, if not most, enterprise applications served from the cloud, but uncertain how best to get there. In this environment, spending on “old paradigm” data center technologies is cut aggressively, but investment in moving to the cloud proceeds cautiously. This is reminiscent of the transition from the mainframe/mini era to PC/client-server architecture, which saw weak IT spending in ’89-’92 eventually give way to the bounty of the ‘90’s. Then, as now, the deadwood needed to be cleared before the growing companies driving the new architecture could take the tech sector along with their growth.
Spending on “old paradigm” data center technology will NOT recover. While there may be some ebb and flow in spending on server systems, infrastructure software and traditional applications, these technologies appear to have begun their decline phase. Spending on storage systems is growing to cope with the extraordinary generation of data, but the profound cost advantages of cloud-based storage will win out and throw this segment into decline sooner rather than later. Networking would appear more robust, based on Cisco’s F3Q13 results, but progress on open source SDN alternatives to proprietary systems solutions and the eventual shift of workloads to the cloud could render the current surge in demand temporary. We note that the overall data center systems spending decline will be gradual – the advantages of the cloud are minimal for applications that are purely local and finite in scale, such as shop floor control systems, and inertia is a powerful force. IBM still sells more than $4B per year in mainframe technology nearly 50 years after the introduction of the first System360 systems. Still, core businesses for tech stalwarts such as HP, Dell, EMC, Cisco, Oracle, SAP, IBM, and others will face irreversible long-term decline.
Spending on “new paradigm” cloud infrastructure and applications will accelerate. We believe the market for Infrastructure-as-a-Service hosting and Software-as-a-Service applications will accelerate well ahead of expectations. We believe hosting will be dominated by scale players, with Amazon, Microsoft and Google best positioned in the US. SaaS applications will be a more open market, with the best players focusing on best-in-class apps and leveraging the scale infrastructure available from IaaS hosts. The processing and storage demands on the web-scale operators will continue apace, requiring massive CAPEX focused on commodity components, such as server chips, solid state storage and disk drives. Enterprises, maintaining hybrid IT operations and balancing multiple cloud vendors, will lean on IT consultants to build the new competencies needed to navigate the new paradigm. Companies expected to prosper in this era include MSFT, AMZN, GOOG, N, WDAY, CRM, ACN, RAX, RHAT, CTRX, STX, WDC, AMCC, and FIO.
For our full research notes, please visit our published research site.