Growth-oriented investors in the tech sector love cloud computing companies. The market is expanding as more companies migrate their infrastructure onto cloud platforms, replace their on-premise software with cloud-based services, and expand their cloud infrastructure to support the surging usage of cloud-based storage, streaming media, and apps.
Cloud stocks are also well-insulated from macro headwinds like the trade war and COVID-19. In fact, the ongoing pandemic is actually generating tailwinds for some cloud computing companies as more people stay at home and access cloud-based services.
That's why the Global X Cloud Computing ETF (CLOU 6.00%), which owns some of the market's top cloud stocks, rallied about 60% this year as the Nasdaq rose less than 30%. That's an impressive return, but investors shouldn't ignore one glaring problem with many high-growth cloud stocks: a lack of stable profits.
Why is it hard for cloud companies to make a profit?
Cloud companies are split into three categories: infrastructure as a service (IaaS), platform as a service (PaaS), and software as a service (SaaS). IaaS platforms loan out storage and computing power to companies, PaaS platforms allow developers to create and run software in the cloud, and SaaS platforms provide software services to enterprise and consumer users.
Larger cloud platforms -- like Amazon (AMZN 4.46%) Web Services (AWS), Microsoft Azure, and Alibaba Cloud -- bundle together various IaaS, PaaS, and SaaS products. But it costs a lot of money to run those data centers, develop new services, and court new customers with sales teams. Intense competition also prevents many cloud platform companies from raising their prices to offset those costs.
Only AWS, which surpasses its peers in both market share and economies of scale, has reported consistent profits in the cloud platform market. Microsoft only discloses Azure's revenue growth rate, while Alibaba Cloud remains unprofitable.
Spotting the profitable players
Smaller companies that only focus on one of the three cloud sectors also struggle with those headwinds. Twilio (TWLO 7.15%), which processes calls, text messages, videos, and more through its PaaS platform for mobile apps, grew its revenue 51% year-over-year to $766 million, but its net loss widened from $129 million to $195 million.
Snowflake (SNOW 4.64%), which stores and processes data for companies on its SaaS platform, grew its revenue 133% year-over-year to $242 million in the first half of fiscal 2021, but its net loss only narrowed slightly from $177 million to $171 million.
Yet there are still a few high-growth cloud companies that are firmly profitable. salesforce.com (CRM 5.65%), the market leader in the cloud-based customer relationship management (CRM) space, generates consistent profits and posted a record-high operating margin last quarter.
Another profitable cloud player is Veeva Systems (VEEV 4.34%), which helps life science companies maintain customer relationships, track clinical trials and regulations, and analyze their data. Salesforce, like AWS, leverages its market-leading position and economies of scale to stay profitable. Veeva, which runs its services on Salesforce's platform, leverages its first-mover's advantage in the life sciences market to lock in companies and retain its pricing power.
But does the market care about profits?
For now, the market doesn't seem to care too much about Twilio or Snowflake's lack of profits. Twilio's stock has rallied about 200% this year, while Snowflake's stock has roughly doubled since its IPO last month.
Cloud companies also often report their earnings in non-GAAP terms, which exclude stock-based expenses and other hefty expenses, which can create illusions of narrower losses or slim profits when they're still burning cash. These companies also frequently launch secondary stock offerings to raise more cash, which dilutes the value of their existing shares.
But generally speaking, growth-oriented investors don't focus too much on a company's profits until its revenue growth decelerates. Therefore, as long as Twilio, Snowflake, and other similar cloud companies continue generating double-digit or triple-digit revenue growth, investors will stick with them in hopes that economies of scale will gradually kick in and start generating profits -- as they did for AWS and Salesforce.
But if these companies run out of room to grow before becoming profitable, their stocks could quickly crumble under the weight of their valuations -- which have already priced in years or decades of unimpeded growth.