Cash in on Cloud Computing

Even though many investors remain murky about what "the cloud" really is, they know that stocks tied to cloud computing deserve close inspection. This hot corner of the technology market is drawing attention thanks to media buzz and promising long-term prospects. A recent pullback in share prices adds to the intrigue.

Put simply, the cloud is the Internet. Cloud computing refers to the ability to run applications and access data online using any device equipped with Web-browsing capabilities, be it a desktop, laptop, tablet or smart phone. If you use Gmail, a service from Google (symbol (GOOG), or Google Docs, then you’ve already been introduced to the cloud.

For businesses, cloud computing means moving their networks onto the Internet. The switch can ultimately lower IT costs because companies won’t have to buy and maintain as much equipment and software. And because cloud-computing services can be shared, businesses pay only for what they need when they need it. Freed-up dollars can be invested elsewhere.

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Philip Tasho, co-manager of the Aston/Tamro Small Cap Fund (ATASX), expects cloud computing eventually to surpass on-premises computing. But the change won’t happen overnight. Jim Yin, an analyst at Standard & Poor’s, says it could take up to two decades before cloud computing is fully adopted.

The companies on the leading edge of cloud computing are positioned to benefit from a years-long transition. We take a look at three below. All of these stocks have had strong runs over the past five years but have seen their share prices take hits in recent weeks.

EMC (EMC)

As data is relocated from internal servers to the cloud, and as digital documents, pictures and videos gain in popularity, the demand for electronic storage grows. Enter EMC, the world’s largest data-storage-systems supplier for companies and governments.

EMC is currently the leader in storage, holding 26% of the market. The company is expected to keep gaining ground, thanks to new products and continuing demand for its data-backup services. And EMC recently acquired Isilon, a network-storage company. Isilon and Atmos, a big data-storage provider that EMC also owns, are projected to generate $1 billion in annual sales by next year. EMC’s 2011 sales are expected to top $20 billion.

Aside from storage, EMC has a security division, called RSA, and owns 80% of virtualization-software provider VMware (VNW). Virtualization software is a central piece of the infrastructure of cloud computing that reduces network complexity and enables on-demand access to services. VMware holds more than 85% of the virtualization-software market by sales, and it accounts for 17% of EMC’s revenues (storage and security account for 75% of EMC’s sales). EMC expects total sales (including VMWare’s contributions) to grow at an annualized rate of 13% or more through 2014.

Shares of EMC, at $23.34, are down more than 75% from their 2000 high, yet still carry a market capitalization of $48 billion (all prices and related data are as of August 15). The stock trades at 16 times estimated 2011 earnings of $1.50 per share, but may be cheaper than the price-earnings ratio suggests. At VMware’s $94.68 share price, EMC’s 80% stake is worth $32 billion, or $15.52 per EMC share. Subtract that figure from EMC’s stock price and the shares trade for less than 8 times projected earnings. Shares of EMC were up 24% over the past year (compared with 14% for Standard & Poor’s 500-stock index).

NetApp (NTAP)

Like EMC, NetApp helps companies store digital information. Although it often finds itself in the shadow of its bigger data-storage rival, NetApp is a sizable force that should continue to benefit as companies adopt virtualization software.

Credit Suisse analyst Deepak Sitaraman says NetApp’s share of the network-storage market should reach 18% in 2015, up from 10% in 2010. Sales for the fiscal year that ended in April were $5.1 billion, and analysts project a jump, to $6.7 billion, in the current fiscal year. NetApp’s earnings are expected to grow 19% per year over the next three to five years.

NetApp has been seeking acquisitions to juice its long-term growth. Its latest purchase, Engenio, allows NetApp to better provide storage for high-bandwidth items, such as video, digital surveillance and high-performance computing (think genomic sequencing). Sitaraman thinks Engenio will add 12 cents a share to NetApp’s earnings for the current fiscal year and 14 cents for the fiscal year that ends April 2013.

At $44.31, NetApp trades at 17 times earnings projections of $2.54 for the fiscal year that ends next April and has a market cap of $16 billion. Its stock, trading 27% below its 52-week high, is up 16% over the past year.

F5 Networks (FFIV)

F5 makes networking products that help companies manage Internet traffic to and from servers and network devices. And because F5’s products reduce the cost of managing networks and increase the efficiency of the flow of data, they are increasingly in demand as more companies move toward virtual networks. F5 serves the rapidly growing cloud-computing and mobile-applications markets.

Key to F5’s success is its leading position in the $1 billion market for Layer 4 - Layer 7 server switches, which help direct network and Internet traffic within groups of servers. F5 could add to its 50% share of the market at the expense of networking rival Cisco Systems (CSCO), which is in the midst of layoffs and a reorganization.

F5 is also rolling out new products that should prop up already solid earnings. The company, which has a $6.8 billion market cap, has a strong balance sheet and sports a high gross profit margin of 83% (gross profit margin is calculated by subtracting the cost of goods sold from revenues, then dividing by revenues). Earnings are projected to grow 23% per year for the next three to five years.

Worries about sales growth led to a recent selloff in the stock after F5 reported results for its fiscal third quarter, which ended in June. Revenues from Europe and the U.S. were less than expected. At $83.65, F5 trades at 22 times projected earnings for 2011 of $3.72. The stock, which is 42% below its 52-week high, broke even over the past year.

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