A RULE BREAKERS SPECIAL REPORT

cloud compuTing

The 3 kings of

Motley Fool Rule Breakers

January 2012

the 3 Kings of Cloud Computing

Brought to you by David Gardner and tim Beyers

dmit it. Youve seen the footage of Microsoft (Nasdaq: MSFT) CEO Steve Ballmer sweatily invoking a crowd of software superstars. Developers! Developers! Developers! goes the chant. Seats empty, hands clap, and the assembled throng joins in what feels like a massive seance as if Ballmer is conjuring a powerful spirit wholl summon sharpedged bits and bytes for the coming soft-war.

Sound crazy? Perhaps, but its not far from the truth. Windows became what it is because developers saw fit to write code to support and extend it. Now theyre writing code for the Web. Techies call the process cloud computing. Motley Fool Rule Breakers calls it an opportunity for investors like you to make a lot of money, starting with the three companies youre about to read about. You see, some new ideas are bigger than any single company. Cloud computing a Motley Fool Rule Breakers favorite involves the movement, storage, and processing of the digital backbone behind many global businesses. Plug into an electrical outlet, and youre tapping into a vast network that matches supply and demand across the grid. Now think of doing that for any computing need, and thats cloud computing uniting processing power, storage, applications, and more via networks. Networked systems can be more effective, solving business problems in groups rather than individually, because several brains are better than one. The human genome project was managed by a team of experts and a massive, networked computer system. Cloud computing applies this model to everyday business applications. Weve chosen to invest in cloud computing my recommending several companies. Our favorite three are below. But when dealing with complex industries, it helps to look at the value chain all the steps that create value in a transaction. So before we share our favorite three cloud computing companies with you, lets walk through the various levels of the cloud computing industry.

1st Ripple: Apps

Think of the cloud experience: On one end of a data transaction sits a user like you at a computer, TV, or mobile device entering information into some form of browser. When this pebble drops, its ripples travel through some obvious and not-soobvious parts of the pond. Following where they go is a useful way to find new opportunities and potential threats. The first ring, then, is the application youre using. It could be a consumer app like OpenTable, a business app from Salesforce. com, or a productivity app like Googles Gmail. This is the most open end of the cloud, because theres no limit on the kinds of software someone might want to run.

Why Invest here? While many areas of cloud computing are open to commoditization, these are the programs consumers and businesses actually interact with and thus benefit from branding, habit, and loyalty. They offer a different kind of moat than most other parts of the cloud.

2nd Ripple: Tools

The next ripple is the tools that allow this data to be computed. The most obvious requirement is a browser, which needs to act like an operating system, but theres a lot more to handling the different kinds of data being processed and dispersed through different parts of the Web. Companies like Informatica essentially normalize data from different systems so they can communi2 Motley Fool Rule Breakers Special Report January 2012 rulebreakers.fool.com

cate with each other. Amazon.com can warehouse the data through its S3 service, and Rackspace hosts data and applications.

Why Invest here? Many companies in this space offer commodity services. But many of these businesses have an advantage in scale. Theres a reason Amazon took advantage of its huge retail scale to start hosting data and offering spare computing power. Even a company like VMware, which makes software rather than offering a commodity service, exists to make clients more cost-effective the kind of measurable benefit that can make tool providers visible businesses with premium pricing ability.

3rd Ripple: Transport

One ring further out is the movement of data around the Web. VMware makes sure high-demand data can quickly get where it needs to go, and companies like Acme Packet, Riverbed Technology, and F5 Networks, also play a role in moving data securely and efficiently.

Why Invest here? Its hard to predict the future, but the rise in demand for data throughput is a pretty safe bet. People will want more data, faster, for the next five, 10, 20 years and more. While theres a lot of cutthroat competition, transport is an area where a successful company can achieve extraordinary growth for a long time. If youre a patient investor who wants a company you can hold for a decade or more, consider this part of the cloud.

The Outer Edges: Overlooked Opportunities

As the ripples move further outward, they expand but become harder to read. What about the not-so-obvious beneficiaries of cloud computing? Infinera isnt a cloud company per se, but rising demand for more data transport favors its business. AT&T and Verizon could find themselves disrupted by cloud computing, but they could also ride it to success by becoming the de factor brokers of mobile data access. Likewise, American Tower controls a lot of mobile backbone infrastructure. There are even less obvious connections: As computing gets centralized into huge data centers, power management and even green energy come into play.

Why Invest here? Some opportunities simply get overlooked. For a long time, investors ignored Amazons role in cloud computing you essentially got that part of the business for free if you bought the stock. While the furthest ripple offers less certainty, you may find that investments you already like can bring you the benefits of cloud computing as hidden upside.

Our Top Cloud Ideas

Now that you have a good overview of the cloud industry as a whole, read on to discover our top three cloud computing companies, and why theyve earned this title.

Company snapshots
VMware (NYSE: VMW)
market Cap: $37.1 billion recent share price: $87.88 52-Week range: $74.04 - $111.43 p/e: 59.0 Caps rating: 3 out of 5 stars

Data as of January 12, 2012

Google (Nasdaq: GOOG)

market Cap: $203.9 billion recent share price: $629.64 52-Week range: $473.02- $670.25 p/e: 21.5 Caps rating: 4 out of 5 stars

Rackspace Hosting (NYSE: RAX)

market Cap: $5.7 billion recent share price: $43.19 52-Week range: $26.83 - $46.50 p/e: 91.9 Caps rating: 3 out of 5 stars

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Special Report January 2012

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VMware (NYSE: VMW)

Originally recommended in our June 2008 issue. The numbers below have been updated. VMware helped popularize virtualization technology. Think of a server as a closet for storing data. VMware makes it so that your clothes arent kept in heaps but organized into labeled containers, each with everything youll need for the day ahead. Digitally speaking, this means that VMware takes a block of computing resources processing power, storage, and applications data and divides it into distinct, usable chunks. This process, interestingly, can lead to both greater security and efficiency. Why? IT experts often spread out and duplicate data across systems to protect servers from viruses and crashes. The result is that these servers are underused companies pay a lot for all this capacity, then use only 5% or 10% of it. VMware alters the equation by transforming a network into a pool of computing resources. Or, keeping with our theme, a cloud. What makes VMware special is how simple its software is to use. One example: Hypervisor, a toolkit for creating pools of computing power that can be accessed directly in servers from IBM (NYSE: IBM), Dell (Nasdaq: DELL), and HewlettPackard (NYSE: HPQ), among others. Simplicity breeds growth. VMware has grown its revenue at a compounded annual growth rate (CAGR) of 26% over the past three years. Net profit has grown at a CAGR of 36%. Returns on equity and invested capital key determinants of management excellence are also strong. This companys stock may be hitting new highs, but its potential remains undeniable.

And the Big G has other advantages when it comes to cloud computing: Infrastructure: Google reportedly has somewhere around 1,000,000 servers that leverage open-source software. Better still, thanks to its iconic search engine, these machines are designed to work cohesively. Partnerships: Companies hoping to profit from the shift to cloud computing are teaming up with Google. Salesforce. com has joined the Google Apps initiative, and IBM is working with Google on cloud computing for university research. Experience: Google Apps isnt about to replace Microsoft Office. But with over 40 million users of its online software, Google is gaining valuable experience delivering cloud computing services that others lack and that makes App Engine all the more useful. Microsoft just-announced plan for selling hosted online services such as email, Web meetings, and collaboration is a move in the right direction for the company, ComputerWorld columnist Preston Gralla wrote recently. But its not yet nearly good enough to fend off Google. Microsoft is going to have to deliver more, or it could ultimately face the loss of massive amounts of revenue. Ballmer is right: Its all about the developers. When it comes to cloud computing, its Google not Microsoft that is winning them over. Thats the sort of rebel you run with, Fool.

Rackspace Hosting (NYSE: RAX)

Originally recommended in our April 2010 issue. The numbers below have been updated. Pat Condon is one of the three founders of Rackspace Hosting (NYSE: RAX), but he never really wanted to be in the hosting business. He wanted to be in the coding business. It was 1998, and everyone wanted to be a coder which meant that no one was figuring out how to host all the code that was migrating to the Web. Rackspace transformed that need into a business opportunity. Fast-forward to today: The dot-bomb days are over, but the cloud computing era has begun, creating a new opportunity for hosting providers like Rackspace, now over 110,000 cloud computing customers strong, to handle the software and services that deliver data to hundreds of millions of users around the world. Hosting is a competitive business because these companies create nothing new. Rather, Rackspace takes software from others, installs it on systems in one of its eight data centers, and then ensures that it works as advertised. If that sounds terrifyingly replicable, it is. IBM, AT&T, Switch & Data Facilities, Amazon.com, and many others
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Google (Nasdaq: GOOG)

Originally recommended in our June 2008 issue. The numbers below have been updated. The cloud computing company that has been thus far ignored: Google (Nasdaq: GOOG). Its digital advertising business is thriving. Total revenue was up 30% over the past 12 months. In spite of this, weve seen a modestly-rising stock price shares of Google are up just 21% since Rule Breakers first recommended it in June of 2008. But thats the Google of today. Its the promise of a richer tomorrow that has ensnared developers. As a group, they appear to love App Engine, which is a platform for creating software for the cloud. More than 4 million businesses are already working with it. And thousands more sign up every day.

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Special Report January 2012

offer some form of hosting. Rackspace isnt the largest, either: Both Big Blue and Ma Bell employ far more servers, switches, load balancers, and storage. But Rackspace is unique for what it guarantees perfection. If a customers application goes down, at any time, for any reason, Rackspace will refund the fees. No other hoster is crazy enough to claim that. But Rackspace is driven by the mission to be one of the worlds great service companies, and it places reputation and reliability first, right down to copyrighting the catchphrase Fanatical Support. Refunds have been small and outpaced by revenue growth. Crazy has turned out to be a completely sane if Rule Breaking business decision. And the numbers bear this out. Revenue grew to $957 million in the past twelve months, while cash from operations grew to $312 million. And analysts still expect the company to grow 37% annually over the next five years a number we think it could easily exceed. Of course, Rackspace isnt Google, and the risk with this company is that IBM, AT&T, or any of the other big data center operators could decide to get a lot more focused on hosting and undercut Rackspaces already-thin margins. Management seems to know this all too well and thus the obsessive focus on customer service. If that service record became tarnished, wed think about selling. But even if Rackers continue to rule and the stock soars, venture investors Sequoia and Norwest could start dumping shares and sink an otherwise good growth story. Also, with debt and years of capital expenditures still ahead of it, Rackspace could significantly dilute existing shareholders for the sake of growth capital. Im willing to accept this risk; were in hypergrowth times when it comes to cloud computing. But if growth slows to the point that Rackspace fails to produce excess cash from operations, wed recommend changing course The bottom line: Rackspace is more than a dot-com survivor; its also one of the great growth stories of the past decade. Now its entering a fresh phase of growth fueled by the demand for cloud computing services. You can bet Rackspace will attack this opportunity with its signature fanaticism, and if it succeeds, as I believe it will, multibagger returns will follow. David Gardner owns shares of Microsoft, Nintendo, and Apple. Tim Beyers owns shares of Apple, Google, and IBM. The Fool owns shares of Apple, Google, IBM, and Microsoft.

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Special Report January 2012

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