The cloud hosting space is saturated with Fortune 100 companies looking to up their investment in what is already an overly-invested industry. With the likes of Amazon (Web Services), Microsoft (Azure), HP and IBM (Softlayer) already providing cloud services, it means two things now that Google (Compute Engine) has jumped into the deep end of the pool: lower prices and a willingness to move downstream for customers.
Given the capital-intensive aspect of this business, what is the ROI of this business? I would have stipulated that it is close to breakeven. ProfitBricks, a German based provider of cloud hosting, produced the graph below highlighting the profit margin in cloud hosting. They report that the price erosion since 2006 has happened more slowly than technology efficiencies (as measured by Moore’s Law), resulting in profit margins staying the same or increasing depending on where you are in the hosting lifecycle.
Amazon Web Services (AWS) is the market leader in cloud hosting. They approached the cloud hosting space with significant resources, a service that matched off with the consumer’s requirements, and extremely competitive pricing. Netflix is their biggest customer (experiencing double-digit growth) and they rely on AWS because they can scale as Netflix grows; Amazon is constantly innovating; and the price is very competitive. And if it isn’t competitive today, it will be in two weeks time. Ultimately, it was the pricing pressure vis-a-vis their competitors which allowed AWS to capture a significant portion of the cloud hosting market in a very short period of time.
After reviewing some of the technicals above, why would you fund a startup focused on cloud hosting? Digital Ocean has the answer to that question. They believe the small business and developer customers are underserved because a majority of the cloud hosting resources are focused on the enterprise customers. They might be right, to a certain extent — today. In the future, the crowded cloud hosting enterprise market will ultimately force the big market makers to smaller markets so that they can generate revenues and maintain top-line earnings for their shareholders. It will be interesting to watch if the Digital Ocean bet has legs to stand on or will be washed away in the cloud hosting storm.