Cloud computing floats heading for trouble?

Businesses in growing industries are attractive, but without barriers to entry, it means little for investors. 

When Michael Jackson’s Thriller topped the charts in 1983, National Audio Company, Inc. competed in the large, growing industry of audio cassette manufacturing. As CDs overtook cassette tapes in the early 90’s, most cassette manufacturers made the ‘logical’ decision to convert to CD, shifting their capital from a declining industry to a growing one.  

That is everyone except National Audio Company. Instead of converting to CD, National Audio bought out its competitors to eventually become the last man standing in the audio cassette industry. By the time Taylor Swift’s 1989 album topped the charts in 2015, National Audio was producing the most audio cassettes in its history, as a near monopoly supported by an emerging retro market of nostalgic consumers. 

This counterintuitive example highlights how low industry growth does not necessarily translate to low returns for its participants. As competitors exited cassettes in search of high growth in CDs, National Audio’s market share improved along with its pricing power. This suggests that industry structure might be more important than industry growth. National Audio’s dominant position is also likely to remain uncontested. Can you imagine a company marketing an IPO on the basis that it wanted to enter the cassette industry? 

Growing industries intuitively seem like a better bet, but the prospect of high returns attracts new entrants and eventually fiercer competition. An investor’s search for good businesses should not stop with fast growing industries but extend to fast growers protected by high barriers to entry. The operating system industry experienced rapid growth in the 80s and 90s, but it was Microsoft’s ability to ward off new entrants that made Bill Gates a billionaire. 

A current fast grower is cloud computing, widely expected to have years of high growth ahead as more people use IT services via the internet. IDC estimates that the private cloud will grow at 38.1% p.a. across the Asian Pacific region.  

Unsurprisingly, this statistic features prominently in the presentations of ASX cloud pure-plays Rhype (ASX:RHP) and Bulletproof (ASX:BPF), resellers of Microsoft’s and Amazon’s cloud technology. What CEO wouldn’t want to alert prospective shareholders to the fact their market is growing at nearly 40% a year? 

What the company prospectus won’t tell you is how such high growth rates attract additional supply, especially in an industry like this where barriers to entry are low. Even Dickerdata (ASX:DDR) went from hardware reseller to Rhype competitor when it signed to resell Microsoft’s cloud solutions in June. 

Rhype and Bulletproof may have the wind of industry growth in their sails, but their eventual returns will be determined by their ability to defend against a plethora of new entrants.  

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