Can cloud computing withstand the heat?

For years, technology stocks soared as they reported outsized profits, fuelled by the pandemic that moved much of the world online. But a lot has changed this year, with trillions in market value wiped off the technology sector overall. Investors have abandoned once red-hot start-ups and even the big tech giants, typically regarded as stable investments, have faltered.

Much investor unease about tech stems from worries about its once-compelling promise of strong profit growth far out into the future. Higher interest rates erode the value of those distant profits. And many investors also started to expect spending on tech to fall back from its pandemic spike.

This has inevitably raised the spectre of the dot.com crash at the turn of the millennium when tech stocks went from boom to bust in a matter of weeks. But there are big differences between then and now. Twenty years ago, the tech sector was dominated by hardware manufacturers reliant on cyclical demand and profitless dot.com ventures. Borrowing was excessive and revenues were lumpy.

Fast forward to today and the giant cloud computing platforms generate recurring revenues, enjoy strong cash flows and have net cash on their balance sheets.

Modern businesses are data-intensive and are on a quest to replace manual processes with automated, computer-based ones, which is exactly what cloud technology delivers. As we explain in our InvestmentReport: The cloud revolution, cloud computing enables the mission-critical services that we all use every day.

Demand for cloud solutions is booming

Research firm Gartner recently reported that businesses may be planning to spend less on hardware (desktops, laptops and tablets) this year, but they intend to spend more on software applications running in the cloud. Gartner believes that cloud computing is one of the few areas where technology spending will be stronger in 2022 than last year.

The CEO of leading US enterprise software firm ServiceNow recently warned that “macroeconomic cross winds are blowing strong”, particularly in Europe. He went on to argue that many companies have no option but to digitise more of their operations to battle these cross winds and stay competitive.

Painfully high inflation, steeper borrowing costs and slowing economic growth all seem likely to ensure that demand for cloud-based technology infrastructure and software remains resilient. That’s because they facilitate flexible business operations and allow companies to pivot quickly to meet changing environments. They also provide the tools that can help businesses alleviate labour shortages, cut back operating costs and increase productivity, while also opening up new opportunities to grow.

All this suggests that cloud computing businesses are well placed to withstand tougher economic conditions and to continue to report strong revenue growth.

That said, soaring inflation and sharply higher interest rates will exert pressure on the multiples that investors are prepared to pay for cloud stocks. Hence, while the operational performance of the companies remains strong, this may not be reflected in near-term share price returns. But for long-term investors, we believe many cloud computing companies are trading at attractive valuations relative to their growth prospects and earnings power.