What bubble? Legacy tech gets shut out

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In the technology world, no question comes up more frequently these days than "Are we in a bubble?" And while it's not up to us at CNBC to answer that question, we do sometimes happen upon little nuggetsdata, anecdotes, tweets and the occasional wild partythat can possibly help others make their own assessments. When we do, we'll share them in a little column we're calling: "Bubble watch?"

Lost in all the chatter about the inflating tech bubble is an important detail: Most of technology's most notable names aren't participating. For the incumbents selling into the enterprise, the picture is downright bleak.

It's the flip side to the story that has the Silicon Valley's venture community giddy. The growth of cloud, big data and mobile have converged to quickly lift enterprise computing start-ups like Cloudera, Pure Storage, Nutanix and DocuSign to billion-dollar plus valuations and Box to an upcoming initial public offering. Information technology departments and corporate data centers are being redesigned and rebuilt, inviting a whole new set of vendors into the mix.

"There's a tsunami of forces that are all intersecting at roughly the same time and creating a massive set of platform shifts," said Roger Lee, a general partner at Battery Ventures, which invests in business software start-ups. These "trends are terribly damaging to the tech behemoths."

For evidence, look no further than the latest batch of quarterly earnings. In the second quarter, only two of the 10 biggest publicly traded U.S. enterprise technology companies by revenue (Microsoft and VMware) reported year-over-year sales growth that topped 10 percent. Sales actually shrank at three companies (IBM, Computer Sciences and Cisco).

In terms of shareholder returns, five of the 10 (IBM, Oracle, Cisco, EMC and VMware) have trailed the S&P 500 over the past two years, while people betting on the 30-member Dow Jones industrial average over that stretch have done almost as well as investors in the S&P 500 tech index.

That's a stark contrast to the dot-com bubble of the 1990s, when most of the incumbents soared along with the Internet darlings, before everything came crashing down. This time, as venture investing in software start-ups reaches its highest level since 2000, the big news out of Microsoft and Cisco is about layoffs. Hewlett-Packard aspires to grow at the meager rate of gross domestic product, IBM is talking about transforming its business and Intel is struggling not to get shut out of mobile.

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Even as Oracle says it's "firmly into the transition to the cloud," sales from cloud-related software and infrastructure in the quarter accounted for less than 5 percent of its total software and cloud business. The company has spent billions of dollars to get into the cloud, snapping up businesses including Eloqua, Taleo and RightNow Technologies, but Larry Ellison's company hasn't topped 4 percent revenue growth in any period since 2011.

With cloud computing, software is no longer delivered in packages to sit on individual servers, but is instead available in browsers and on mobile devices, without being tied to a single machine. Sellers of proprietary hardware are rapidly wilting (see Dell), as vendors buy cheap boxes from Asian manufacturers and make money by providing unique services on top. Even if big companies can make the shift, they typically have to accept reduced economic control in the process, because they're competing in a new subscription economy with emerging companies that lack the legacy baggage. Techies call this a classic innovator's dilemma, citing Clayton Christensen's seminal book with that title from 1997.

"The whole business design makes it very hard," said Matt Holleran, a general partner at Cloud Apps Capital Partners, an early stage venture firm that backs business software start-ups. Big companies are "the most threatened in terms of revenue and profit by the new model."

Another challenge for the incumbents is that their shareholders—the owners—aren't necessarily looking for growth. As companies build up cash from old business lines but struggle to find new markets, investor preference tends to shift toward returning dollars to shareholders and away from throwing money at new projects.

Of the 10 biggest enterprise technology companies, only VMware (majority owned by EMC) doesn't pay a dividend. All of them buy back stock as a way to reduce the number of shares outstanding, thus improving earnings per share (EPS).

Fast-growing companies, meanwhile, are encouraged to reinvest their cash into research and development. In Silicon Valley, where top engineers are chasing the next big thing and the riches that may follow, the talent war favors the upstarts and their willingness to take risks.

Larry Augustin, chief executive officer of SugarCRM, sees his business software company benefiting from all the belt-tightening of competitors such as Oracle and Germany's SAP. Across the board, the tech giants were forced to reel in their investments after the dot-com crash, and when the time came to seek out the next growth opportunities, newer entrants got there first, he said.

Top 10 U.S. enterprise tech companies by sales, Q2 2014

Company
Q2 Sales (in blns)
Q2 Sales Growth (yoy)
Hewlett-Packard $27.70 2.0%
IBM $24.40 2.3%
Microsoft $23.40 18.0%
Intel $13.80 8.0%
Cisco $12.40 -0.5%
Oracle $11.30 3.4%
EMC $5.90 4.8%
Computer Sciences $3.20 -7.0%
ADP $3.10 9.4%
VMWare $1.50 17.0%
U.S. VC funding in software (Q2) $6.06 167.0% (yoy increase)
Source: FactSet and NVCA

"Everyone hunkered down, and the big tech companies spent 10 years optimizing for efficiency and EPS," said Augustin, whose Cupertino, California-based company provides customer relationship management software that's used by over 1.5 million people. "Now we're in the growth phase and they're struggling to transition."

As head of a venture-backed company without a publicly traded stock, Augustin also acknowledges that he only has "four shareholders to please."

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Still, big companies with profit to spare do have advantages. If and when the Federal Reserve raises rates, taking away much of the cheap money that's been fueling the economy, capital will likely get more expensive. That's a potentially scary scenario for many high-growth, money-losing start-ups that have been heavily financed during this extended period of low rates and Fed stimulus.

Large companies burned by the previous bubble have seen that movie before and are better positioned this time to deal with a downturn. But given the choice, they'd surely prefer not to be mere spectators, watching as smaller competitors pull their customers up to the cloud.

By CNBC's Ari Levy.