Microsoft (NASDAQ:MSFT) is a strong player in the cloud computing business, even if it currently is a distant second in terms of market share. The public cloud market is going to reach 241 billion in revenue by 2020 according to Forrester Research. Microsoft's growth and current market position will allow it to use the cloud to significantly add to its top and bottom lines.
Microsoft Growth Factors
Source: Synergy Research Group
Microsoft had an incredible 154% YoY market share growth according to a report by Synergy Research Group, giving it 8% of the total cloud market. By comparison Amazon (NASDAQ:AMZN) had 67% year over year growth, giving it 27% of the market.
Even if Microsoft would simply maintain its market share, it would be making around 19 billion dollars in revenue from cloud computing (if Forrester Research is accurate) by 2020. Microsoft's total revenue for 2013 was 83.35 billion. While Microsoft does not generally disclose its exact cloud sales per year, it did do so last year; on April 29, 2013 the finance chief of the server and tools unit revealed that Microsoft had reached 1 billion in annual sales for Azure. Given Microsoft's 154% growth, it has probably reached at least 2 billion in annual sales by now. If you subtract the 2 billion from its current revenue, and add back the 2020 projected cloud revenue, you get 100 billion in annual revenue by 2020. Microsoft's P/S is 3.92 currently, which would give it a market cap of 392 billion. That's a 19% increase from Microsoft's current market cap of 329 billion. Microsoft has other things up its sleeve than just cloud though, with organic growth from other Microsoft initiatives such as its push into the Internet of things likely to push revenue and earnings higher. Additionally, shareholders will be rewarded through things such as share buybacks and dividends as well. Most importantly though, Microsoft will probably continue to grow its cloud market share due to a variety of factors.
Microsoft has an advantage in enterprise due to the relationships it has built up over the years with businesses, especially when compared to other legacy vendors. A survey was undertaken in 2013, by Everest Group and Cloud Connect, which showed that Azure has three times the number of PaaS (platform as a service) and IaaS (infrastructure as a service) users as other legacy vendors.
Speaking of legacy vendors, IBM was a notable exception to the recent round of price cuts undertaken by Amazon, Microsoft and Google (NASDAQ:GOOGL). Microsoft and IBM are both well-known tech blue chips, and have been around longer than both Amazon and Google, which has allowed them to build up a reputation of trustworthiness. People and businesses are more and more concerned about guarding their privacy and data, which means they are likely to turn to Microsoft now, due to IBM's comparatively high prices.
Microsoft has also made its cloud services a part of many of its services, which can easily be seen in Office 365. Growing cloud computing market share is likely part of the reason they released Office for iPad, as it will draw more people into the Microsoft ecosystem, which will lead to more people paying for cloud services such as OneDrive. This will let Microsoft draw further market share, with an incredible 27 million people having already downloaded Office for iPad. Another factor worth mentioning is that the cloud business thrived when Nadella headed it, making it likely that Microsoft's cloud business will continue to thrive.
One of the biggest risks is that cloud computing is increasingly becoming commoditized, as evidenced by the price war between Microsoft, Amazon, and Google. This would lead to very slim margins.
Historically Amazon has operated on slim margins and high volume, allowing them to beat competitors. However Microsoft has very deep pockets, especially when compared to Amazon ($87.67 billion compared to Amazon's $8.67 billion), giving them a financial advantage. It also has an operating cash flow of 28.62 billion compared to Amazon's 5.34 billion, which will allow it to invest more heavily than Amazon and withstand price cuts. Microsoft was able to cut prices even farther than Amazon did in some cloud categories in the latest round, with storage prices falling about 55% and computing prices falling about 30%. Additionally Amazon is spending money on a great deal of other things such as fulfillment centers, developing a smartphone, and acquiring content for Amazon Instant Video. Most importantly, Amazon investors are starting to get impatient for profits, with Amazon's stock trading below both its 50 and 200 day moving average. Conversely, Microsoft has beaten expectations for the past few quarters and been rewarded for it, with its stock trading near 52-week highs.
I think these factors should prevent the cloud business from being commoditized from Amazon's efforts. However if Amazon does drive the margins significantly down, then Microsoft can still out-compete Amazon on margins here, due to its resources. I don't think Amazon will drive margins down though, due to this new investor focus on profits. It's a rather unusual situation for Amazon, as investors have not really cared about profits for a long time. Microsoft can also invest more than Amazon in making its cloud presence bigger and better, which would allow them to charge higher prices.
Google was actually the one to begin the latest price war, and is very cash-rich, with an excellent and growing cash flow. This makes the possibility of Google driving down margins a very real threat. However Google isn't known for being a low margin company, evidenced by its current operating margin of 23.52%. It would be out of character for Google to drive down prices permanently. That's why I feel this is a promotional price cut, and will not last forever. Additionally, Microsoft is more trusted than Google. There has been a great deal of criticism levied on both Google and Microsoft following the NSA revelations, but Google has weathered the brunt of it, simply due to the fact that they have more of your data. This would make businesses leery of trusting Google to provide them with cloud services.
While Microsoft probably isn't going to become #1 in terms of cloud business market share anytime soon, I believe they will be able to gain significant market share by 2020, mostly at the expense of IBM, Amazon, and Google. They won't be that distant of a number two anymore, perhaps reaching as much as 15-20% of the cloud computing market. This would result in 36 billion - 48 billion dollars being added to Microsoft's top line. This should result in at least a few billion being added to Microsoft's bottom line. Combined with earnings growth from Microsoft's other products and inorganic growth from share buybacks, Microsoft looks like a strong buy.
Disclosure: I am long MSFT, GOOGL. 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.