Amazon and Microsoft have expanded their market share and strengthened their dominance of cloud computing in much the same way that mainframe manufacturers came to rule their sector 50 years ago. The two companies in the most recent quarter boosted earnings and increased profits from the sale of computing power and data storage via the Internet by stepping up sales of sophisticated software, data analytics and services. Their gains—part of a trend that has accelerated in recent years—come at the expense of IBM, Oracle, HP Enterprise and other rivals that are struggling to shift to the cloud after decades of tailoring services to customers’ in-house data centers. The expansion by Amazon and Microsoft up the “technology stack” into all stages of enterprise cloud computing resembles the vertical integration that mainframe computer makers achieved in the 1960s. Back then, companies such as IBM, Burroughs and Honeywell controlled the entire computing supply chain—manufacturing mainframe hardware components, writing operating systems and application software, and providing services. Their “end-to-end solutions” locked in customers, prompting the purchase of entire product lines. Today, Amazon and Microsoft are using the cloud to stake out the competitive advantages from vertical integration. Like their mainframe predecessors, they are fueling profitability by locking in customers to an expanding product line. The companies’ recent quarterly results show how they aim to lead the ascent into new, more profitable areas in the cloud such as big data analytics and artificial intelligence (AI). “Once enterprise customers choose one of our cloud services, they continue to adopt more services,’’ Microsoft CEO Satya Nadella said in an Oct. 20 call with analysts. More than 60% of Fortune 500 companies use at least three of Microsoft’s cloud products, a 20-percentage-point increase in just 12 months, Nadella said. "The companies aim to lead the ascent into new, more profitable areas in the cloud such as big data analytics and artificial intelligence." Amazon and Microsoft are hardly alone in riding a boom in on-demand, Internet-based computing. Another cloud pioneer, salesforce.com, built an infrastructure housing software that enables companies to track all their contacts with customers— from sales, to marketing, to support. Amazon and Microsoft are each building on their core strengths, with Amazon deploying its expertise in managing large-scale data centers as a top online retailer. Microsoft, which for years has sold software and servers to companies for use on site, is building its own data centers to offer customers those same capabilities in the cloud. Demand is rising for Amazon Web Services (AWS) and Azure—Microsoft’s cloud business—as companies seize on the savings, efficiency and flexibility from cloud computing. Companies can immediately ramp up or reduce computing power based on their needs while shutting down costly in-house data centers. Also, they can be confident of using the newest version of software. AWS says it can slash a company’s information technology expense during a three-year period by 60%. Global spending on cloud computing will more than double to $141 billion by 2019, according to International Data Corp. (IDC).1 The advance into the cloud by AWS and Azure has been especially challenging to HP Enterprise, Dell EMC, NetApp and other makers of servers and storage that companies install in house. Hardware and on-site workloads become obsolete when a company replaces its own data centers with cloud services from AWS or Azure. That shift will probably persist— spending on public cloud infrastructure, including servers and storage, will grow at a compound annual rate of 15% during the next five years, while non-cloud information technology spending will annually fall 1.8%, according to IDC.2 Up the Stack Amazon and Microsoft are locking in customers to an expanding product line in cloud computing, staking out the competitive advantages from vertical integration. The companies aim to lead the ascent into new, more profitable fields of on-demand Internet computing, including big data analytics and artificial intelligence. Microsoft’s recent quarterly results reflect how the shift from on-site data centers is accelerating. While sales of its PC software shrunk, revenue from the cloud business surged, with gross profit margins jumping to 49% from 42% during the second quarter. The higher profitability stems from Microsoft’s success in building on the foundation of its servers and storage to sell more sophisticated and profitable cloud-based services. Microsoft aims to further expand its premium services on the cloud by deploying AI and riding the explosive growth in the “Internet of Things,” in which businesses and consumers connect objects ranging from heating systems to jet engines for real-time monitoring and measuring. “AI will be infused into everything we do,” Nadella said. By 2020, the number of connected things will increase to 21 billion from 4.9 billion in 2015, according to Gartner.3 The oceans of data will need processing, storage and analysis. Like Azure, AWS soared during the most recent quarter and remains one of Amazon’s biggest sources of profit. The operating profit margin for AWS rose to 31.6% from 25% in the third quarter of 2015 in part because of its rapid pace of innovation, according to Amazon spokesman Darin Manney. AWS this year has already added more functions and services in the cloud than in 2015, when it deployed more than 700 new features, Manney said in an Oct. 27 call with analysts. Although cloud computing is still in an early stage of hypergrowth, we believe AWS and Azure should heed the decline of mainframe manufacturers, whose lock-in of customers weakened when advances such as client-server computing spurred innovation, cut costs and increased flexibility. While leading growth into the cloud in the years ahead, AWS and Azure would do well to keep in mind how the makers of “big iron” frittered away the advantages from vertical integration with their inflexible, oligopolistic approach to customers. 1. IDC, Worldwide Semiannual Public Cloud Services Spending Guide, January 2016. 2. IDC Press Release, Expected Recovery in Hyperscale Service Provider Spending Will Lead to Another Year of Strong Growth for Cloud IT Infrastructure, October 5, 2016. 3. Gartner, Gartner Says 6.4 Billion Connected “Things” Will Be in Use in 2016, Up 30 Percent From 2015. November 10, 2015. www.gartner.com/newsroom/id/3165317 The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. 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