A tale of two Microsofts

It was the best of times, it was the “not so great” of times...

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Microsoft

Microsoft released its latest quarterly earnings, and they were very telling about what’s happening in the market in general, and with Microsoft’s business in particular.

Overall, Microsoft continues on a tear, with a stand out quarter. And its efforts in accelerating its cloud business (“the best of times”) are doing very well. Microsoft has a major lead in enterprise cloud with its Azure offerings. Azure grew 97 percent year over year, the majority of which was from enterprises deploying their corporate apps on the platform. The relative ease of moving from a corporate on-premises infrastructure consisting of Windows-based servers into the Azure cloud, as well as the hybrid cloud enabling Azure Stack, make deployment decisions relatively easy. While AWS and Google, along with others like SAP and Oracle, are pushing their own cloud solutions and making some headway, the enterprise continues to be a sweet spot for Microsoft and Azure.

However, Windows (“the not so great of times”) continues to be a troubling area for Microsoft as the slowdown in PC sales, and Microsoft’s lack of any meaningful share of the tablet, and zero share of the phone market, means this stagnant market will continue to be a non-growth area, although Microsoft was able to improve its margins somewhat. And even though Surface has obtained many good reviews, its sales were down (likely due to imminent refresh), and still represents a pretty small portion of overall revenues. But there is a huge base of Windows users that Microsoft can tap into. I expect Microsoft to gradually find a way to switch Windows from a model of one transaction per device when sold to a recurring revenue stream, much as it has with commercial customers in productivity suites like Office. Longer term, that should significantly boost Windows revenues, but this may take 3 to 4 years before it’s realized.

Is Microsoft’s strategy working?

Over the past few years, Satya Nadella has implemented a major strategy shift for Microsoft. Its gains in cloud at the same time that Windows is stagnant, means that its new course seems well aligned with market dynamics. I expect Microsoft to continue to grow its cloud-based businesses and to solidify its position as the premier supplier to commercial and enterprise customers. That’s not to say that it will abandon the consumer, as its grown its base of Office in that market to 27 million users, and continues its strong position in gaming with Xbox, particularly online. But the growth (and margins) will continue to revolve around businesses.

Investing where the biggest bang for the buck is

Microsoft’s latest quarter continues to show why its making so many moves into the cloud, with nearly two-thirds of its revenues and most of its growth coming in this segment. Yes the market is going there, particularly the commercial segment. But it’s also true that the realignment is having major benefit to Microsoft’s operations as well.

The Productivity and Business Process segment ($8.4 billion) where Office 365, Dynamics 365, etc. reside is now about equal to the More Personal Computing segment ($8.8 billion) where Windows and Xbox reside. Yet one segment is growing (Productivity segment up 21 percent) and one is stagnant (More Personal segment down 2 percent). But that’s not the whole story. If we look at the income contributions, the Productivity segment is running at 32 percent while More is running at 20 percent. And while the Intelligent Cloud Segment where Azure resides is a little smaller than the other two at $7.4 billion, it grew at 11 percent and its profit contributions are 34 percent. It’s clear that Microsoft’s major investments in converting transactional purchases (e.g., Office installed on a PC) to cloud-based recurring revenues (e.g., Office 365, apps on Azure) is showing how Microsoft has effectively tapped into a major transition in the market, and to its benefit. I expect this transition in enterprise to continue unabated for several more years.

Bottom line

Many thought that as Windows slowly died, so would Microsoft. Satya Nadela has done a great job of turning the SS Microsoft from its previous course and is now sailing fairly smoothly into the cloud. His strategy is working and it’s likely that within the enterprise market which is so critical to Microsoft, they will continue to rack up wins against Google which has had a tough time getting much play for its productivity suite outside of SMB, and also against AWS which seems more focused on big web-based consumer-focused businesses like banking. Microsoft is now really more Microcloud!

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