More than a decade after taking a leap of faith, cloud vendors prove profit possibilities
For vendors such as Microsoft (Nasdaq: MSFT), Oracle (NYSE: ORCL) and SAP (NYSE: SAP), offering cloud solutions required them to leave the safe and profitable confines of their traditional software businesses, where they were confident in the business models and drove consistent double-digit operating margins. Even for born-on-the-cloud companies such as Salesforce (NYSE: CRM) and Workday (Nasdaq: WDAY), the lack of short-term profit required them to adjust funding requirements and sell this new business model to potential investors. All vendors that chose to participate in the nascent market had to take on the cloud financial risk without a clear picture of when or how their businesses would reach sustainability and profit.
More than a decade after the initial cloud transition, nine of the leading providers in the space, which come from a variety of business backgrounds, are proving out the benefits of cloud business models. It has taken adjustments to almost every major category of financial and operational strategy, but profitability has improved significantly and is gradually approaching the levels seen with traditional software businesses. In summary, the state of cloud profitability has never been stronger.
Gross profit gets little attention but delivered most of the improvement to cloud profit
The direct costs of delivering a solution — and their inverse, gross profit — get little attention in the cloud business model discussion. Although shifts in sales and marketing strategy may be more attention-grabbing, gross profit and cost of goods sold have made the bigger impact to overall cloud profitability. As shown in Figure 2, the “big nine” cloud vendors have increased cloud gross margin by 5 basis points over the last three years. At 65%, cloud gross margin is still lower than the traditional software gross margin of close to 85%, but it has improved significantly for the cloud businesses. The improvements have been driven by a variety of factors, most notably:
- Increased scale of data centers: For IaaS vendors that own and operate core data center locations and infrastructure, their growing scale has led to greater cost-effectiveness. The cost of IT infrastructure has gone down, and automation allows vendors to operate data centers more efficiently. Additionally, there is a greater availability of third-party services such as colocation, which allows cloud providers to cost-effectively scale to new regions and expand capacity.
- Professional services cost declines: As vendors across all cloud service types initially rolled out their services, most of the professional service needs were met by the providing vendor out of necessity. However, as these platforms and services have scaled, the level of third-party skills has expanded, shifting a lot of responsibility and opportunity for service engagements away from the cloud vendors. The result has been a shifting of professional service opportunity to the partner ecosystem, allowing cloud providers to focus on the higher-margin cloud solutions.
- Declining acquisition-related costs: Acquisitions played a large role in the establishment of cloud computing leaders. IBM (NYSE: IBM) buying SoftLayer, Oracle purchasing NetSuite and SAP buying SuccessFactors are just three examples of the purchases that have shaped the market over the past decade. Many costs of those purchases are borne out in the acquiring organization’s cost of goods sold. As the scale of cloud businesses has grown following the large acquisitions, the overall gross margin has rebounded.