How Network Effects Are Likely To Power The Cloud

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The recent posts about the economics of cloud computing between Nick Carr and Tim O’Reilly (here and here) and the panel at this week’s Web 2.0 have created a lot of buzz. The central question is of great consequence: will the emerging “cloud” operating system generate the monopoly rents and industry control that Microsoft enjoyed with Windows? For the sake of argument, let’s assume VMware is leading in private enterprise clouds and that for now Amazon leads public ones with Google, Yahoo, Rackspace, and Microsoft as contenders. It seems likely so far that Microsoft will have a significant advantage in private clouds, though not to the same extent as with Windows. Public clouds seem years further out, so they’re harder to handicap.

But at the center of the argument is whether dominance in either variety will come via Web 2.0 style “harnessing collective intelligence” or the more traditional “network effects.”  I believe we will see Microsoft emerge as a leader in private clouds in 3-5 years and it will be on account of the more traditional network effects.  Market share won’t accrue to the leader by virtue of capturing more information every time someone uses the cloud.  Instead, it will accumulate the way Windows steadily accumulated application and device support over time.

The two critical success factors in cloud computing: virtualizing the hardware and managing the software components

There are two key assets to leverage success in this market. VMware and Microsoft are likely to share self-reinforcing leadership to the first. That is the ability to make a sprawling and heterogeneous collection of servers, storage, and networking look like a single machine. Through automation interfaces, this capability dramatically changes the economics of administering data centers. The other key asset to leverage for success in this market is the ability to combine infrastructure and applications management. That is the critical requirement for turning an IT operation into a private cloud that can deliver rock solid online services.

Leveraging network effects to make the hardware infrastructure look like one big machine

As Tim explains, the cloud has multiple layers. But the bottom-facing utility layer sits on the hardware infrastructure and uses this generation’s equivalent of device drivers to make it look like a uniform pool of resources to the software above this layer. This is VMware’s strength by virtue of its lead in virtualization. Market share begets network effects at this layer in terms of device support, such as the widest range of storage devices and access to all their unique features. However, over time, it’s hard to imagine how Microsoft will fail to leverage its Windows Server and associated Hyper-V unit volume to achieve similar device coverage. So although the utility layer intrinsically has low value add, vendor concentration in private clouds will probably preserve prices and margins to some degree.

Leveraging network effects to deliver end to end application service management

In order to be able to deliver end to end online services, the upward-facing cloud software layer has to orchestrate and manage an untold number of application components, many from third parties, some from corporate developers. VMware has some leading-edge management technology that automatically wraps around applications (courtesy of the B-hive acquisition). But as long as commercial and corporate developers primarily target Windows as their application deployment platform, Windows will have a self-reinforcing advantage relative to VMware.

Microsoft’s self-reinforcing advantages are twofold, building on its leadership both as a deployment and development platform.

  1. First, since it accounts for roughly 80% of X86 server unit shipments, software developers of just about any stripe have to do at least some work to wrap Microsoft management tools around their applications.
  2. Second, because Microsoft is the leading provider of development tools on Windows, it will be able to capture even more management information about the subset of applications that use their tools. Even if both of these structural advantages haven’t yet been exploited by Microsoft, it’s hard to see that situation lasting as they roll out their Dynamic Systems Initiative.

VMware’s best potential for upside in this market is threefold.

  1. First, the extent to which commercial or corporate software developers use development platforms that are independent of Windows likely means neither company has an advantage in collecting management information. Examples of these platforms include J2EE, PHP, Ruby On Rails, Spring, and Hibernate. Some of these platforms don’t require any conventional operating system.
  2. Second, the extent to which VMware proliferates its platform ubiquitously, it may have more of an advantage in managing the infrastructure it sits on and the applications that sit on it.
  3. Third, virtualized environments make it possible to deploy applications in “appliances” that include all the bits required to run, including operating system, middleware, and multiple application components. Today, all these appliances are deployed using Linux because of Windows licensing restrictions. If appliances take off independent of Windows, that would help VMware tilt the platform competition in its favor.

Public clouds are likely to be more diverse, like a set of services, but with the core or anchor services having similar economics

Windows Azure has all the economic characteristics of a private cloud – masking the infrastructure, managing the application services – but with the margin-depressing overhead of tightly-integrated data centers. It will clearly have higher-level services like SQL Services, Exchange, and .NET, but it will be easy to integrate premise-based software as well as third-party services such as Salesforce.com’s Force.com or Google Adwords.  In other words, if Microsoft delivers on its promise, it will be an anchor platform at a higher value, higher margin layer than Amazon, but with bridges to other services.  Considering how it appears to build on Microsoft’s on-premise software tools and interfaces, it appears likely to have a leading market share.

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