Microsoft (NASDAQ:MSFT) reportedly has agreed to acquire Israeli cloud security company Adallom, which was founded three years ago, for about $320 million.

Adallom develops a technology that protects an application or data as it sits on a remote server. Remote access is handled by Adallom's command and control mechanism, which logs and reports any suspicious activity. This layer compartmentalizes and protects cloud-based data for enterprise customers. The start-up has raised $49.5 million to date, including a $30 million investment from Hewlett-Packard.

The acquisition of Adallom would complement Microsoft's other recent purchases in the cloud, enterprise, and security markets. Last November, it acquired another Israeli firm, Aorato, which specializes in enterprise security and machine learning. It also acquired analytics firms Equivio, Revolution Analytics, and Datazen Software to beef up its big data capabilities.

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Adallom's cloud security platform. Source: Adallom

Why does the cloud matter to Microsoft?
Back in April, Microsoft CEO Satya Nadella claimed his company could generate $20 billion in annual cloud revenues by the end of fiscal 2018. That was a bold claim, considering Microsoft would need to more than triple its annual cloud revenue within three years to meet that goal.

Microsoft's cloud business mainly consists of three parts -- Office 365, its Salesforce competitor Dynamics CRM, and its cloud-computing platform Azure, which is a hybrid PaaS (platform as a service) and IaaS (infrastructure as a service) platform. PaaS enables developers to write and launch apps directly from cloud-based servers. IaaS allows customers to "outsource" computing services, like storage and processing power, to virtual data centers.

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Microsoft CEO Satya Nadella. Source: Microsoft

In the third quarter of fiscal 2015, Microsoft reported that its total cloud revenues rose 106% annually and had an annual run rate of $6.3 billion. Most of that revenue came from Office 365 and Dynamics CRM. Microsoft doesn't break down its cloud revenues by service, but Deutsche Bank estimates Azure only generates between $500 million and $700 million in annual revenue.

But Azure could grow substantially over the next three years. Research firm Gartner estimates that the global IaaS market will be worth $16.5 billion this year, then grow at a compound annual growth rate (CAGR) of 29.1% until 2019. The PaaS market, worth $4.1 billion this year, is expected to grow at a CAGR of 65% until 2018. To capitalize on that growth in both markets, Microsoft is enhancing Azure with top-tier security features, which could include Adallom's platform.

Why does cloud security matter?
The growth of cloud-based services lets businesses spend less on on-site hardware and cut substantial costs on real estate and utilities. But remotely stored applications and data can be vulnerable to data breaches.

That fear has fueled the growth of cloud security players like Adallom. According to Transparency Market Research, the global cloud security market was worth $4.5 billion last year, but could grow at a CAGR of 12.8% and hit $12 billion by 2022. Much of that growth will be fueled by small and medium businesses relying more on IaaS, the relaxation of BYOD (bring your own device) policies, and the increased usage of subscription-based SaaS (software as a service) platforms like Office 365.

Last year, lapses in security dominated headlines. Adobe lost 152 million records, eBay was hit for 145 million records, and a breach at JPMorgan Chase exposed 76 million records. Those big breaches are convincing companies to boost their IT security budgets and move their data to cloud or hybrid-cloud installations that compartmentalize their data.

The upcoming market consolidation
Microsoft isn't the only tech giant investing in cloud security. Networking giant Cisco recently acquired cyber security firm OpenDNS for $635 million. Chip designer ARM Holdings acquired Dutch security firm Offspark in February, and is currently in talks to buy Israeli mobile security firm Sansa Security. Google scooped up various cybersecurity firms over the past three years, including VirusTotal, SlickLogin, and Impermium.

The Internet of Things (IoT) -- which links everyday objects like appliances, wearables, and cars to each other and the cloud -- will be another critical factor in that consolidation. As more IoT devices get tethered to the cloud, the possibility of hacks rises considerably, encouraging tech giants like Microsoft to consolidate the cyber security market with additional acquisitions. Looking ahead, investors should expect Microsoft to continue buying up cloud, security, and analytics firms in its quest to generate $20 billion in annual cloud revenues by 2018.

 

Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Adobe Systems, Cisco Systems, eBay, Gartner, Google (A shares), Google (C shares), and Salesforce.com. The Motley Fool owns shares of eBay, Google (A shares), and Google (C shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.