Seeking Alpha

Microsoft Or Amazon To Benefit From The $10 Billion JEDI Cloud Contract

Includes: AMZN, MSFT
by: David Zanoni

The Department of Defense is set to choose Microsoft or Amazon for the JEDI Cloud contract.

The contract is worth $10 billion.

Regardless of who gets the contract, both companies are poised to benefit from their cloud businesses.

JEDI Contract: DoD Seeking a Large Reliable Cloud Vendor

Despite the JEDI name, this has nothing to do with Yoda or Star Wars. The U.S. Department of Defense [DoD] is in the process of choosing a cloud vendor. They narrowed down the search to either Microsoft (MSFT) or Amazon (AMZN). This contract is known as JEDI, which stands for the Joint Enterprise Defense Infrastructure contract. The decision on the contract winner could come as soon as mid-July.

The JEDI contract is worth $10 billion over 10 years. So, it can provide a good recurring revenue boost for either company. The important thing for Microsoft and Amazon is not just the potential for getting this contract, but the idea that they are among the top cloud vendors in this space and likely to get ongoing business from various sources.

The JEDI project has been designed to speed the flow of data and analysis to the military, specifically combat troops. The CIO of the Joint Chiefs of Staff, Lt. General Bradford Shwedo, stated recently that this project is needed immediately. Here is his quote:

Delaying implementation of the JEDI Cloud will negatively impact our efforts to plan, fight, and win in communications compromised environments, and will negatively impact our efforts to improve force readiness and hampers our critical efforts in AI. This position has been forwarded and is supported by all of the U.S. Combatant Commands. Our adversaries are employing these technologies; our war fighters need this capability now"

Urgency in Getting the JEDI Project Secured

The CIO's quote clearly states the urgency in getting this deal done soon. The United States always needs to be on the cutting edge of technology to help protect our freedom and the safety of our citizens.

The DoD is clear that they want one cloud vendor, so the JEDI contract will be winner take all.

The cloud business is important for both companies. Amazon's AWS cloud business is the large driver of the company's profitability. AWS only accounts for 11% of Amazon's total revenue, but a whopping 59% of their operating income based on 2018 annual data. Microsoft's Intelligent Cloud segment is also lucrative for the company - it comprised 29% of Microsoft's total revenue and 33% of operating income in 2018.

Once the outcome of the contract is announced, the stock of the winner could bounce higher on the news, while the loser's stock could take a dip. The dip could create a good buying opportunity for the loser. Both companies are likely to remain successful and outperform the broader market over the long-term as a result of their above average revenue and earnings growth.

Large Market for the Cloud

The global cloud market size is expected to grow from $272 billion in 2018 to $623 billion by 2023. This represents a compound annual growth rate [CAGR] of 18%.

The benefits for companies to implement cloud systems is to eliminate the need for hardware and software to run data centers, which provides significant cost savings. Other benefits of cloud systems are that they are reliable, fast, productive, continually updated, and can be scaled up on a global basis. They can also be scaled up and down based on business needs.

So, it is a no-brainer for businesses to move to the cloud. This shift will help drive growth not only for Amazon and Microsoft, but also for other major players in this space: Google (GOOG), Oracle (ORCL), IBM (IBM), VMWare (VMW), and Alibaba (BABA).

Cisco Global Cloud Forecast

The chart above provides Cisco's global forecast through 2021 for the growth in the percent share of hyperscale data center servers. The figures embedded in the blue bars show the growth in the number of hyperscale data centers which is expected to reach 628 by 2021.

While typical data centers support hundreds of physical servers, hyperscale data centers support thousands of physical servers and millions of virtual machines. Amazon is the largest hyperscale provider. The next largest providers are Microsoft, Google, and IBM.

There are only a total of 24 providers that qualify to offer hyperscale cloud services. That includes Infrastructure as a Service [IaaS], Software as a Service [SaaS], internet, search, social media, and e-commerce payment processing companies. This growth is likely to help drive strong growth for these cloud providers.

Global Cloud Service Revenue Forecast

The table above shows the projected revenue growth for each sub-category of cloud services according to Gartner. The strong growth and large market size leaves plenty of room for multiple companies to benefit in the cloud space.

Amazon and Microsoft's Fundamentals

Here's how Amazon and Microsoft stack up according to some key fundamentals:

Amazon Microsoft
Forward PE 53 27
PEG 1.38 2.01
ROE 30% 40%
ROIC 9.6% 14.7%
Expected Revenue Growth for 2019 18% 13%
Expected Revenue Growth for 2020 18% 11%
Expected EPS Growth for 2019 36% 13%
Expected EPS Growth for 2020 40% 11%

Source: Seeking Alpha, MorningStar, Yahoo Finance

The forward PE ratios for these companies are above average, but that is a result of their above average revenue and earnings growth. The market tends to drive their stock prices higher for that high growth.

That's why I tend to like to use the PEG ratio for above average growth stocks. PEG ratios below one would be considered a bargain valuation. However, the growth stocks that I cover typically trade with PEG ratios between one and two. That reflects a fair valuation level.

The PEG ratios shown here are based on 5 years' worth of future earnings growth. So, with the PEG ratios between one and two, the stocks could continue to rise at an above average pace as long as the bull market remains intact. Of course, pullbacks on large investor profit taking can take place anytime along the way.

The return on equity is stellar for both companies. However, I like to see a higher return on invested capital. ROIC levels above 15% are typically attractive. However, we could let Amazon and Microsoft slide because they can make up that return on their high sales volume/growth and still achieve strong earnings growth.

Long-Term Amazon and Microsoft Investment Outlook

Either company could be awarded with the JEDI contract. Regardless of who gets the contract, both companies are still poised for above average growth. The growth in the cloud industry will help drive the cloud businesses of both companies and other companies in the cloud space.

Look for an overreaction sell-off for the stock of the company that doesn't get the contract. That could create a good buying opportunity.

Given that we are in the late stages of this bull market and economic activity such as existing home sales and new vehicle sales are showing signs of slowing down, we could be getting closer to a recession within the next year or two. A recession would likely create a great buying opportunity for these stocks. Growth stocks like Amazon and Microsoft typically drop significantly during recessions.

Minus a recession, which would likely slow down or delay the amount of cloud projects, Amazon and Microsoft are poised for strong above average growth in the cloud space over the next five years. So, if a recession occurs in this time frame, the businesses and stocks of these companies could recover nicely during the economic expansion phase that follows as cloud projects ramp up again.

If we look out five years from now, the stocks of Amazon and Microsoft have a good chance of outperforming the S&P 500 (SPY) as a result of their above average revenue and earnings growth driven by cloud business growth.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: This article was originally written for Kirk Spano's Margin of Safety Investing service. Subscribers had an early look at the article.

Additional disclosure: The article is for informational purposes only (not a solicitation to buy or sell stocks). David is not a registered investment adviser. Kirk Spano is an RIA. Investors should do their own research or consult a financial adviser to determine what investments are appropriate for their individual situation. This article expresses my opinions and I cannot guarantee that the information/results will be accurate. Investing in stocks involves risk and could result in losses.