When investors first realised that data storage and software were moving to the cloud, many became excited about the prospect of investing in data centres. However, the far more exciting opportunities, in my view, are created by the ways cloud computing can change existing businesses and make them more profitable.
Put simply, cloud computing has reduced reliance on in-house hardware and software, but increased reliance on the connection between users and their data. Data-centres themselves are a fairly low-margin business, requiring extensive capital expenditure. If a company can't sell its rack space quickly, the return on investment is going to be very poor, as large scale squeezes margins.
I therefore consider Vocus Communications Limited (ASX: VOC) to be my most conventional cloud play. Vocus owns a network of fibre optic cables connecting the central business districts of Australia with their own data centres and the rest of the world. The company rents individual strands of those cables to certain companies, guaranteeing ultra-secure, ultra-reliable, ultra-fast connections between clients, their business critical data, and the rest of the world.
The company's competitive advantage is in its fibre network, which is rivalled by few. Data centre space is sold to fibre customers, and visa-versa. When I reported the results, I concluded that, Vocus was "a reasonable long-term investment at the current price of $3.77." Shares now trade around $4.40. The window for achieving attractive long-term returns in Vocus is closing fast. It's also on the verge of shedding its small-cap status. However, I'm not ready to sell at current prices. Indeed, were the share price to drop back to under $3.50, I'd probably consider buying more shares.
Vocus currently comprises over 10% of my share portfolio, making it my second-largest holding. The company's days of continuously increasing capital expenditure are behind it and it should now begin generating increasing amounts of free cashflow. My plan is to hold at least some of my shares until Vocus is spinning off a generous dividend. I expect the stock to yield a dividend less than half a percent in FY 2014, based on the current share price, but I can't envisage the dividend payment going backwards any time soon.
A potentially more attractive option at current prices is accounting software company Reckon Limited (ASX: RKN). To invest in Reckon is undoubtedly contrarian. The elephant in the room for Reckon shareholders is Xero FPO NZ (ASX: XRO). Xero has undoubtedly the best cloud-based accounting software and is fast gaining market share. I think it's fait accompli that Xero will achieve scale and profitability eventually, although I'm not sure that justifies the company's $5 billion market capitalisation.
In comparison, Reckon's cloud offering, Reckon One, is a work in progress. The dominance of Xero in this space partially explains Reckon's depressed share price. Xero has 100,000 registered businesses using its platform in Australia (and gaining fast), whereas Reckon has 600,000 registered users. Revenue from Reckon's Business Division, which competes with Xero, was $58 million in FY 2013. Reckon also supplies business management software to accountants. This segment is smaller, with revenue of $29 million in FY 2013. A reduction in revenue of over 5% in either segment would indicate that Reckon's revenue is not as sticky as shareholders hope. On the other hand, an increase in revenue would demonstrate that the threat from new competition is overplayed, and that Reckon is available at a good price.
The share price for Reckon is quite attractive, at less than 10 times operating cashflow. At the moment, the company is having to invest considerable sums in getting its Reckon One cloud offering up to scratch. If Reckon can maintain market share in its business division while it transitions customers to the cloud, it will have a solid base for growth. It might take a few years, but if the company can actually find a way to grow profits, shareholders are likely to reap substantial rewards. Reckon shareholders have to believe the company can compete with Xero, Intuit and MYOB.
I consider increased competition from a well-funded rival, Xero, to be a nasty headwind. Having said that, Reckon ticks a lot of boxes, with CEO Clive Rabie and Director Ian Ferrier both stepping in to buy shares recently. Although the Reckon One software is probably inferior to Xero's software, it is a lot less expensive. Furthermore, Reckon is currently in the process of improving its software – if it can 'catch-up' to Xero, it seems unlikely small businesses would ignore Reckon's more attractive pricing.
With a tiny capitalisation of just $21 million, Global Health Limited (ASX: GLH) is in a vaguely similar business to Xero and Reckon. Instead of providing business management software to accountants, the company provides electronic patient record systems to hospitals and mental health practices.
By far the most important offering is the Mastercare Mental Health Electronic Medical Record System, a cloud platform sold mostly to psychologists and psychiatrists in Australia. Unlike Reckon, the company does not face serious competition, and unlike Xero, it is actually turning a profit. Of course, the addressable market is much smaller for Global Health. I have sold some of my Global Health shares at 70c, but it remains my largest holding, and not unreasonably priced either.
Foolish takeaway
The advent of cloud computing has impacted these companies in different ways. For Vocus, the switch to the cloud is an essential driver of demand, and is responsible for the splendiferous growth in revenues (and share price) over the last 12 months. For Reckon, the shift has provided an opportunity for a competitor to make some serious inroads, and depressed the company's share price. However, Reckon may well be able to use its existing customer relationships to remain a player in its industry while its cloud offering catches up. Finally, cloud computing has allowed Global Health to cut operational costs, and transition away from providing boutique software to become a provider of software as a service. As with rising demand for healthcare, I believe the switch to cloud computing is one of the important meta-trends of this decade.
