Microsoft: On Cloud 9? – Seeking Alpha

by Catherine Leona

Microsoft’s (NASDAQ: MSFT) cloud service, Azure, not only wants to bring more agility and speed to your work and daily life, it also aims to embed intelligence into it — whether adding new layers of analysis to your business presentation or comparing your golf grip and swing performance with that of PGA professionals.

While many cloud services promise to make information management more flexible and snappier, smarter cloud services are behind Microsoft’s current growth story. Cloud market revenues grew 25% to $148 billion in 2016.

Microsoft’s transition from its “mobile first” strategy into the era of “intelligent cloud and intelligent edge” is revealing a mixed reality for its legacy and new cloud product lines.

Fading and Glowing Businesses

The realigned Intelligent Cloud division has grown to close to one-third of company revenues in less than three years.

Over the same three-year period, operating margins have been squeezed below 25 percent. On the revenue side, the More Personal Computing division has several struggling product lines. Revenue growth for the overall business has slowed in the third quarter of 2017 to $8.84 billion, down 7% from a year ago. Surface sales dropped 26% to $831 million in the third quarter 2017. The death of the Windows phone is another drag on sales.

Microsoft officially became agnostic with the July announcement it is providing minimal support for the Windows phone. The software giant’s narrowing focus is making sure its cloud service runs smoothly on your mobile device, whether it is powered by Windows, Android, IOS, or Linux. Hardware is hurting Microsoft.

Overall operating efficiency improvements have helped offset declining revenues in the More Personal Computing group. But Microsoft is finding being the smartest kid on the cloud server block is expensive. While company operating expenses have registered double digital declines in each quarter of 2017, the Intelligent Cloud Computing division has registered low double digit increases. CEO Satya Nadella says the increase of 11% in the third quarter reflects rising cloud engineering and developer costs.

Smartest Kid on the Cloud

The Azure business unit is quickly signing up Fortune 500 companies seeking highly customized cloud services with real-time data visualization, advanced analytics and deep integration. The competition to develop differentiated cloud enterprise strategies that “listen, learn and predict” is intense and includes Amazon (NASDAQ; AMZN), Google (NASDAQ: GOOGL, GOOG), IBM (NYSE: IBM) and Oracle (NASDAQ: ORCL).

Amazon Web Services has 50 percent of the market versus 19 percent for Azure, but with companies with more than 500 employees, Microsoft has a 66 percent market share. Among the market leaders in cloud computing, Microsoft competes directly with Amazon’s AZW in cloud infrastructure services and Salesforce (NYSE:CRM) Enterprise in SaaS cloud services.

Being the cloud favorite with large companies seeking intelligent, responsive and actionable data solutions and differentiation is keeping the technology behemoth on its toes. Cloud service providers should not plan on passing these costs on. Lowering the costs of cloud services is a priority of businesses according to the RightScale 2017 State of the Cloud Report’s survey of over 1,000 technology professionals.

Microsoft’s R&D/sales ratio, typically in the 13-14 percent range, has jumped to 14.5 this year. The cloud player is applying a more open and flexible approach to research and development, which should help to trim costs. Last year, its cognitive toolkit was made open source to entice developers to tinker with its neural network tools in speech recognition, facial recognition and other areas. Application development in Hololens – the tool that could project your Skype caller into the room beside you — is also open source.

Is Microsoft Still a Software Company?

Microsoft still looks and acts like a software company. As proof, Microsoft Windows desktop users officially passed the 100 million user mark in 3Q 2017. The question is worth asking because it affects how the company accounts for revenue and is valued by the market.

Only three years ago, Microsoft’s online business was a modest 4 percent of revenues. Today, the re-aligned Intelligent Cloud Business has grown to comprise 30 percent of revenues. Productivity and Business Processes, powered by two key cloud applications, Office 365 and Dynamics CRM, is also edging in on revenue share from More Personal Computing.

But even the accountants are having trouble deciding whether cloud services should be treated like software for revenue recognition purposes. The good news is US revenue recognition practices are harmonizing with international standards. Software and cloud services revenue is more likely to be recognized at the time the product and/or service changes ownership. The bad news is Microsoft and other software companies could revise revenues downwards as they adjust to this new world in 2018. Microsoft plans to start reporting under the new regime this year, so the transition should be smooth.

Watch Those Expenses

Much to the chagrin of its former CEO and biggest shareholder, Steve Balmer, Microsoft is reporting the revenue run rate for its cloud services business which, impressively, has increased by $1 billion in each of the last three quarters. The run rate projects annual sales based on the sales performance of one quarter. Revenues tripled for the Azure platform in 2016.

As long as Microsoft keeps providing smarter cloud solutions, it is well positioned to capture more high end business. Its server business is also benefitting, although cloud services demand is growing three times faster than cloud infrastructure hardware and software. Apparently, the run-rate is also being applied to legacy cloud software. Current CEO Satya Nutella reports Office 365 and Dynamics 365 are on track to achieve $20 billion in commercial cloud annualized revenue run rate in fiscal year 2018. Remember to also look for the actual sales volume and profit margin numbers.

Assuming Microsoft can right size its cost structure, it is well positioned to capitalize on the growing software market. This could help drive Microsoft’s next leg up. At 22 times forward earnings, Microsoft is still a good deal. It’s expected to grow earnings at nearly 10% annually for the next half decade and still pays out a decent 2.2% dividend yield. That earnings growth could move higher as Microsoft appears to be getting more serious with investing in growing its cloud and high margin services business.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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