Inside the Cloud Computing Conundrum

The bull market for growth stocks that perished last year had plenty of contributors. That stands to reason because said bull market last for a decade or more depending on the estimate.

Among those contributors were cloud computing stocks. Ah yes, the good old days. These aren’t the good old days. Cloud equities are growth stocks and the latter being out of favor is wreaking havoc on the former. For example, the BVP Nasdaq Emerging Cloud Index (EMCLOUD) is off 39% year-to-date, as of June 8.

Not surprisingly, that index and other cloud-related assets started weakening in November 2021 when the Federal Reserve initially said it would dial back its bond-buying program. Fast-forward to this year and in May, EMCLOUD touched levels it hadn’t seen in nearly three years.

Rising interest brought a perfect storm for cloud stocks. Many of these companies, particularly mid- and small-cap fare, aren’t profitable and investors don’t have tolerance for longer-dated cash flows in a rising rate environment. All that said, writing obituaries for cloud stocks today is likely to prove hasty.

Competing Views on Cloud Investing

As Christopher Gannatti, WisdomTree global head of research points out, there are two possible outcomes facing the cloud industry.

One potential outcome is corporate customers simply tiring of the subscriptions costs associated with cloud services and finding cost-effective alternatives. Obviously, that’s the negative outcome.  The other outcome is the exact opposite: Customers are excited about cloud computing, its evolution and will continue paying up for the privilege.

“While we are never able to view the future with certainty, the evidence that we can interpret today would tend to indicate that outcome #2 has a higher probability of becoming true,” says Gannatti. “One of the risks we monitor in cloud computing regards the biggest players shifting from engines of growth to something more like ‘utilities’—the concept being that everyone able to adopt cloud computing has done so, so the future growth stabilizes.”

He brings up another important point – one investors should not ignore. That is that many cloud companies are still rapidly growing. For example, Amazon Web Services recently reported revenue growth of 37%, $18.4 billion. Google Cloud’s revenue growth surged 44%. Microsoft’s Azure, the second-largest cloud company behind AWS, is growing at a rapid pace, too.

Adding to those impressive examples of top-line growth is the point that mergers and acquisitions activity in the space remains brisk.

“Google Cloud has announced its intention to buy Mandiant, a cybersecurity firm, for $5.4 billion. The rationale is to provide its cloud customers with more robust cybersecurity solutions at a time when this is at the forefront of many customers’ minds,” adds Gannatti.

Cloud Realities

One of the cloud realities in the current environment is that the stocks are flailing and timing when that trend will run its course is futile, though the aforementioned EMCLOUD is up almost 10% over the past month.

The other reality is that cloud computing is going to be around awhile and switching costs make it difficult for corporate to just drop the habit on a dime.

“The recent behavior of software-oriented cloud computing companies would tell us something different—adjustments are clearly still being made,” concludes Gannatti. “Our bottom line is this—these subscription-oriented businesses are still largely growing their revenues, even if that growth is nowhere near what would have been seen during the pandemic period in 2020. Those with a time horizon of the next few months may have an extremely uncertain outcome. Those with a time horizon in the range of 5, 7 or 10 years—as long as the cloud business model continues to find favor—may see this downdraft as an interesting opportunity.”