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Get Smart: Building Castles in the Clouds

Everyone probably recognises International Business Machines, or IBM (NYSE: IBM), as a software and mainframe giant in the information technology (IT) space.

The impression that IBM gives is that it’s a behemoth, but one that is staid and from the old guard of technology.

However, in a surprising twist, IBM announced that it is splitting itself into two public companies.

It’s a valiant effort by the world’s very first computing company to diversify away from its legacy business to focus on high-margin cloud computing.

IBM’s IT infrastructure services division is set to be spun off as a separate company by the end of 2021.

The IT giant’s move underscores investors’ love affair with all things cloud.

But before you think that this move represents puffery, here’s a look at what has transpired in this year alone.

Floating on clouds

There’s been a surprising number of technology IPOs this year that hinge on cloud-based solutions.

First off, there’s Asana (NYSE: ASAN), which went public at the end of last month.

The company offers a suite of cloud-based project management tools used by companies such as Uber (NYSE: UBER) and Spotify Technology (NYSE: SPOT), allowing teams to manage remote work and tasks more effectively.

Half a month earlier, cloud data warehouse vendor Snowflake (NYSE: SNOW) also listed its shares.

The company went public at US$120 per share and last closed at nearly double that at US$238, and is now labelled as the “hottest tech IPO of 2020”.

Not to be outdone, Chinese company Kingsoft Cloud (NASDAQ: KC) floated its shares on the NASDAQ in back May, pricing them at US$17 apiece and raising US$510 million.

Shares in the company last closed at US$31.42, up nearly 84% from their IPO price.

The promise of strong growth

Looking at the numbers above, you’d be forgiven for thinking that cloud companies are the only ones worth buying in this market.

With the COVID-19 pandemic still raging across the world, investors have elevated cloud companies to the status of market darlings.

As companies and individuals engage in telecommuting, digitalisation has become the new buzzword for 2020.

Software companies that provide services through the cloud have been warmly embraced as investors recognise their potential for strong growth powered by this new trend.

Not a bed of roses yet

But before you get all excited and sink your money into either Snowflake, Asana or some other hot cloud IPO, there are some sobering numbers to take note of.

Asana’s net loss in the three months ended 31 July jumped 57% year on year from US$15.6 million to US$41.1 million, and the company has yet to turn a profit.

Snowflake is not profitable either, incurring a net loss of US$348.5 million on revenue of US$264.7 million for 2019.

And Kingsoft Cloud booked a net loss of RMB 420.1 million for its second-quarter results.

Although these companies’ share prices have been on a tear, we can’t say the same for their business performance.

Until such time the trio demonstrates their ability to become consistently profitable, their shares may be supported by their promise of a better future rather than fundamentals.

Every cloud has a silver lining

Still, there’s hope out there.

And that hope brings us full circle back to IBM.

In July 2019, IBM acquired Red Hat, a company with hybrid cloud infrastructure offering cloud-native application development, for US$34 billion.

Unlike the trio above, Red Hat is profitable.

In its second-quarter 2019 earnings report, Red Hat disclosed that it had generated US$87 million of net income on revenue of US$823 million, proving that cloud companies can indeed be profitable.

But Red Hat brings more to IBM than just revenue and profits.

CEO Arvind Kirshna said that the acquisition of Red Hat was the impetus behind the company’s move to spin off its legacy business to focus on cloud computing.

In fact, Kirshna expects Red Hat to be the key to the next “enduring platform” for IBM.

If IBM succeeds, it will show that you can invest in cloud computing companies that promise a better future and earn a decent profit as well.

You don’t have to sacrifice the latter for the former.

Similarly, for investors, we may want to be as discerning in our choice of cloud companies.

And if you select the right cloud companies to invest in, you may be richly rewarded many years down the road.

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Disclaimer: Royston Yang does not own shares in any of the companies mentioned.