Making Cloud Money Is Hard and Will Remain So
Cloud computing is the future of the technology marketplace. The services-led, recurring-revenue model is transforming earnings and profit streams. Capitalizing on the cloud opportunity isn’t easy for vendors or partners.
By Larry Walsh
Escaping the cloud is practically an impossibility. End users are increasing spending on private, hybrid, and public cloud resources. Yet vendors and solution providers alike are finding it more than challenging to make a profit in the cloud.
In its most recent earnings report, Microsoft conceded that cloud margins are shrinking as booked business for Azure, Office 365, and Dynamics Online continues to expand. It’s ironic, considering Microsoft is trending alongside IBM and Google in growing their cloud businesses faster than market. According to Light Reading’s Mitch Wagner, each of these companies’ cloud businesses are growing faster than 100 percent year over year. Yet, they’re facing profit pressures. The Microsoft disclosure prompted ChannelE2E’s Joe Panettieri to question whether this trend should concern partners trying to make the transition to the cloud.
The simple answer: Yes.
Vendors recognized the cloud trend and potential long before partners. Solution providers were happy making their money on managed and professional services, but vendors foresaw how cloud computing could disrupt the legacy hardware and software business models. As such, vendors continue to push partners to expand their cloud practices and generate more cloud sales.
Yet partners are facing the same cloud profitability problems as vendors, albeit for different reasons.
Vendors bear most of the cost of infrastructure, operations, maintenance, and innovation in the cloud model. As such, vendors offer partners slim margins on cloud services resale, even when street prices increase above list. On the average, partners earn margins of 11 percent to 20 percent on resold cloud services, according to research by The 2112 Group. Conversely, partners earn margins of 21 percent to 30 percent on managed services and 31 percent to 40 percent on professional services.
And therein lies the problem. The cloud simply isn’t as profitable as legacy products. And it has everything to do with the persistent engagement and recurring-revenue model associated with the cloud.
For vendors, cloud services require persistent engagement with customers, even when working through partners. Vendors have to build the cloud, service the customers in the cloud, and continuously innovate the cloud value proposition. That requires money, and that’s the reason vendors’ cloud margins are slim. While the law of recurring revenue says earnings will increase over time and costs are predictable, the reality is that cloud consumption isn’t always predictable, particularly when it comes to cost of sales. If the goal is capturing and retaining market share, it comes with a hefty cost in sales and marketing. And that leads to lower margins.
For partners, the cost and earnings equation is much different. Vendors may say partners can upcharge for the cloud services they resell and add managed services, but that’s not always realistic. Upcharging the cloud is nearly impossible given the pricing transparency; everyone knows what the cloud costs, so customers can pick and choose based on quality and expense. Managed cloud, a growing trend, has the potential of driving up partner cloud profits, but reaching into and managing clouds on behalf of customers is difficult, as few tools are available for effectively doing that across different platforms.
By comparison, channel-delivered managed services – also under commoditization pressure – have retained higher margins because they’re less dependent on maintaining infrastructure and applications. Managed services is about monitoring, administering, and maintaining equipment that’s already been purchased by customers. As a result, those services come with minimal costs associated with tools licenses and labor costs. Most of all, managed services profits are disconnected from underlying customer infrastructure.
And for vendors and partners, the cloud is proving that it’s not a one-to-one replacement of legacy revenue. While companies such as Microsoft, IBM, and Google are posting huge gains in cloud sales and revenue, they’re not replacing legacy revenue. In fact, IBM continues to post quarter-over-quarter earnings declines as hardware sales falter and cloud sales climb. Market analysts always point to the expanding cloud marketplace, as sales remain on track to top $200 billion annually by the end of the decade; however, these same analysts overlook the fact that overall IT spending is declining as the cloud cannibalizes legacy business.
Money can be made in cloud computing, as demonstrated by Amazon Web Services, Salesforce.com, and NetSuite – companies that are unencumbered by legacy products and business models. And eventually the cloud will become profitable for vendors and partners as well. But it’s going to take time for sales models, costs, and value propositions to equalize into a new normal.
Should vendors and partners worry about cloud profitability? A little. More so, they need to think about how to manage the change in operating models and economics to minimize the pain of change. And, they need to recognize that the value from cloud computing may not come from the service, but from the activities around the services – just as it had during the hardware and software eras.