Stock in focus

Microsoft

Michael Bray, Research Analyst
Andrew Rees, Illustration

Price$151.38

52 week high-low$152.50—$93.96

Net yield1.2%

Hist / pros per30.3—28.1

Equity market cap$1,154,849

More than just the creator of the Windows operating system and Excel, Microsoft sells a range of software, hardware and IT services across an array of computing devices. Customers are primarily enterprises although Microsoft does have a consumer offering in markets such as gaming and laptops/tablets.

Following numerous failed pivots into the consumer device segment (e.g. Nokia acquisition / Windows phone), Microsoft has now developed a clear growth strategy based upon cloud computing. Cloud computing (The Cloud) marks a dramatic evolution in the ICT industry, effectively allowing the streaming of computing power from data centres to, and the collection of data from, any internet connected device. Depending on The Cloud service, this means there is a limited need for enterprises to house on-premise (on-prem) ICT infrastructure (e.g. servers) and hire less ICT personnel.

The advantages of The Cloud include cost-savings and enhanced security, but perhaps most importantly it provides enterprises of all sizes with almost unlimited ICT resources. This enables enterprises to digitise more of their workflows and receive more real time data, allowing them to make their business models more innovative and efficient. Microsoft’s cloud partnership with the US grocer Kroger is a good example. Together they have developed cloud backed “digital shelves” that can show ads, price dynamically, help reduce food waste and make personalised suggestions to customers. Another use is in oil rig maintenance. Internet- connected sensors, backed by Microsoft’s cloud platform, transmit real-time data which can alert engineers to earlier signs of rig failure and help avoid the potential revenue loss.

This technological change is known as ‘digital transformation’ and underpins many secular ICT trends such as cyber security, artificial intelligence and the internet-of-things. The structural need for more computing power, driven in large part by The Cloud, has meant that ICT costs are increasingly moving from being an overhead cost for enterprises to a cost of doing business. As a result, the $2.5T global ICT market is expected to nearly double over the next decade.

Microsoft is expected to take a big share of this increased spend. Microsoft’s cloud platform, Azure, is the largest globally by revenues and by data centres, possessing more than Amazon and Google combined. The Cloud accounts for c.30% of Microsoft’s $126B of revenue, has driven over 80% of Microsoft’s revenue growth over the past three years and is expected to drive the majority of growth moving forward. Management are forecasting a healthy low double-digit growth in total company revenue and operating pro t for the foreseeable future.

The Cloud accounts for c.30% of Microsoft’s $126B of revenue.

Cloud growth for Microsoft does however differ by model. Microsoft is one of the few providers of all three cloud models: Infrastructure-as-a-Service (IaaS), the cloud alternative for physical server and datacentre infrastructure; Platform-as-a-Service (PaaS), which includes IaaS services, as well as resources which support the life cycle of an application, such as Excel (i.e. the building, managing, updating and deploying); and Software-as-a-Service (SaaS), which includes IaaS and PaaS services, but also allows for applications (not just the support software) like Excel, to effectively be rented and streamed from Microsoft’s data centres.

SaaS is Microsoft’s slowest growing cloud model but is still performing well. It primarily centres on Office 365, its cloud version of its Office suite of applications, Outlook, Excel, and PowerPoint etc, which grew +30% in FY19.

The biggest cloud prize for Microsoft lay within IaaS and PaaS where the bulk of enterprises’ digital transformations are captured. Microsoft’s IaaS and PaaS sales are primarily recorded under its Azure product line, the Azure platform itself does however power all cloud services. Azure grew +72% in FY19 and is Microsoft’s fastest growing segment.

Microsoft is the no.2 player (c.22% market share) in the IaaS and PaaS cloud market, behind Amazon (c.47%) which has had a several year head start, but has been able to catch up quickly over the last few years. This is in large part due to Microsoft’s on-prem software presence which it has built up in enterprises over the past few decades; c.70% of the world’s on-prem server workloads run on Microsoft software. Microsoft’s strategy has been to leverage this vast installed base of on-prem server customers by migrating them over to the cloud for no additional cost. This initial move is from on-prem to IaaS. Once Microsoft has customers on The Cloud with IaaS, the monetisation comes from selling higher margin PaaS services, such as security, operating systems, database and data analytics (e.g. artificial intelligence) software. Microsoft say that this process is still within its infancy as many businesses have only just started their digital transformation journeys.

Despite the positive backdrop for Microsoft, there are some headwinds that face the business. Some basic IaaS cloud services, such as storage, are likely to become more commoditised over time, causing a race to the bottom in terms of pricing which would impact the business. Additionally, a big chunk of Microsoft’s business (16% of revenues) is still accounted for by Windows software, of which some is cloud-based with the rest bundled with PC manufacturer sales. PC sales remain highly cyclical and are dependent on product cycles and the wider macro environment. Perhaps the biggest threat to the business comes from technological change to distributed computing. The cloud is the established model for distributed computing currently, but this could change with the onset of quantum computing.

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