Originally sent to VIXCONTANGO subscribers on November 20th, 2015
2016 will be the year when the Cloud Economy enters the lexicon of American investors and Americans in general. While much is being made about the Gig economy as unicorn darling Uber transforms the taxi and logistical delivery businesses, a much bigger transformation is underway in the American economy.
After 20 years of employment as a software developer, I finally launched my own business this year. And I am not alone – at least 6-7 of my former colleagues have done the same. Some are launching video game streaming business, some online wine-rating business, others online lingerie stores, on and on. All of these are not unicorn startups that will change the world, but solid small businesses that provide services that thousands or tens or hundreds of thousands can use. The reason why this is happening is because we all can finally do it without breaking the bank. The empowering capabilities of the Microsoft Azure Cloud, Amazon Web Services, the Google Cloud and other open-source computing tools are something I cannot emphasize enough. VIXCONTANGO utilizes a system architecture of distributed caching, low-latency messaging and multi-layered software design that was formerly possible only inside Fortune 500 corporations who could shell out the tens of millions necessary for a global distributed cache server cluster or messaging bus or various other servers. If somebody wanted to start a company in 2010, they had to shell out millions just to buy computers. Now, it costs $100 per month on Azure to have a complete set of web and database servers, a distributed cache and a messaging bus right from the start! Pay as you go – only for what you use! The barriers to entry to creating complex online/mobile businesses have been dramatically lowered and mobile app/cloud adoption is thus in its infancy. The most recent market measures for Azure or AWS pins them at the Salesforce market cap of $60 billion. Let’s do some napkin math here. There are 35 million (17 million .Net and 18 million C/C++) Microsoft developers – if all of them spend $1000/year (less than $100/month or what most pay for cable) on Azure running a side business – that is $35 billion in annual revenue! This does not include the mass migration to the cloud of corporate America which is an avalanche that will bury corporate IT departments in 2016. Even the most bullish current estimates for the cloud businesses are wildly underestimating the size these business will have eventually. I project Microsoft Azure and Amazon Web Services to reach at least a $200 billion valuation each over the next decade.
The end result of the great migration to the Cloud Economy is a nationwide set of online and mobile savvy businesses that have very high profit margins and as result deserve higher P/E multiples both on the private and public markets. If you compare the profitability of a physical lingerie store before vs an online one now – the profit margin expansion I am talking about will become apparent. Before you had to rent a store, remodel it, hire workers, keep moving merchandise around, all for the opportunity to sell to a limited number of people who walk through the door in that specific neighborhood. So hundreds of thousands spent on startup costs and years spent before breaking even. Eventually tiny margin. Now, you build a website, hook up to a few various service providers for tens of dollars per month– you’re up and running and the entire population of the world can be your customer. My former colleague is sitting at home, doing a mini version of an Amazon warehouse, packing, boxing, selling at 90% margin. She makes far more money than she did before, right from her Little House in the Cloud. There is a reason why Facebook is so highly valued – they have 95% margin – once they have built the basic product, money just comes through the door and costs are minuscule in comparison. While not every developer will turn a company into Facebook, there will be a proliferation of high margin small and medium sized mobile/online businesses in the years to come. Most of them be will be operated from inside people’s houses or garages. In fact, it will not be uncommon to have small 20 person companies like Snapchat reaching hundreds of millions of users and making tens of millions in revenue. Large corporations will change as well. For example, Walmart and Macy’s will de-emphasize physical locations and try to be more like online retailers like Bonobos and Banana Republic (well Banana is a real retailer but they are very web savvy). I still shop for clothes but I buy them off emails sent to me by Banana Republic and I buy entire ensembles. I don’t have to go to the store and think how to match clothes. I haven’t been to Macy’s in years. As such it is very important to disregard Macy’s and Walmart’s struggles and understand that they are part of a secular retail shopping trend towards mobile and online shopping. The end result of this mobile/online transformation in retail but not only there is an increase in profit margins across the business spectrum in the US. And higher profit margins ultimately mean higher P/E multiples. Having worked at private equity – the valuation rules are simple – the higher the margin, the more repeatable the revenue, the higher the P/E multiple. So look for the mobile/cloud economy to get bigger not because it is cool but because it is more profitable.
You can expect more of what you saw this year in technology. More migration towards the leaders of the cloud, struggles and consolidation in traditional tech companies like Intel as they lose their box customers but overall a steady increase in profitability in the sector as 5-10 companies dominate sales and earnings and valuations and make up for the carnage in the rest. I expect a 10-15% in the Nasdaq and a 20% run in the Russell 2000.