Warryn Robertson

In a world of low growth, macro economic uncertainty and high equity market valuations we consider that at present the number of investment opportunities, even for a global equity investor are incredibly scarce. We do however see pockets of value, with the IT sector being one example. In recent times, the established IT global powerhouses have been out of favour, with the market fearing that cloud computing will erode their economic moats. Yet, in most cases, we believe their competitive position and revenue opportunities will actually be enhanced.

The Cloud

Cloud computing is the practice of using a network of remote servers hosted in offsite data centres to store, manage, and process data via the internet, rather than on a local server or a personal computer.

Rather than owning a license that is upgraded infrequently, customers effectively rent the software for an annual or monthly fee. The value proposition to enterprise customers is primarily the cost savings and flexibility that can be achieved through the replacement of on-site servers, IT staff, and ongoing maintenance costs with off-site cloud hosting. Importantly, that will typically enable the software vendor to charge more for their cloud-based product, whilst still saving their customers money.

Since cloud-based software (often called “software as a service”) is sold by subscription rather than periodic license renewals, over time the total revenue generated by customers is increased by effectively compressing traditional renewal cycles of 3–5 years into much shorter periods. Customers can no longer defer upgrades—non-renewal means no more software.

In addition, software as a service will likely reduce piracy over time; potentially expand the user base due to the lower upfront costs for smaller customers; enable more frequent customer engagement; and substantially increase the proportion of recurring revenues, reducing earnings volatility.

It is true that the transition to the cloud may give new entrants a foot in the door in some market niches, however overall we see the revenue upside far outweighing any market share losses for the incumbent software vendors, who have vast installed customer bases, strong brands, and proven technology.

In our Lazard Global Equity Franchise Fund, we currently hold a number of IT stocks that we believe could benefit from the transition to the cloud, including:

1 - Alphabet (Google) – Continues to find top line growth across its business channels.

2 – Microsoft – Believes that its value of gross profit per customer could rise 1.2x–1.8x in the cloud.

3 – Oracle - Indicated lifetime revenues per customer could be at least 2x–3x a license-based model.

4 – SAP - Estimated to generate 40%–60% more revenue in the cloud.

5 – Intuit - Expects its Quickbook Online product to generate 50% more revenue via the cloud.

In many respects, we think the transition to cloud computing represents an opportunity for long-term value-oriented investors. We think the move to the cloud will take many years, requiring investors to thoroughly research the risks and opportunities and it may hurt earnings in the short-term, weakening share prices providing long-term investors with an investment opportunity.

As at 31 October 2015

Article contributed by Lazard Asset Management: (VIEW LINK)


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