Azure Likely To Outgrow Amazon Web Services Making Microsoft A Buy

Summary

• Expect Microsoft Azure to outgrow the current industry leader, Amazon Web Services, for the near-term (three-to-five years) and gain share.
• Expect  Microsoft to grow at least 10% for the near-term driven by Azure, Commercial Cloud, LinkedIn, and Github.
• Expect Microsoft to continue its dominance with its Dynamics and Office applications due to hybrid cloud offerings, despite inroads by Google.
• Best positioned large cap growthname in the industry whose valuation is not as stretched as other growth names.
• With reasonable valuation andconservative estimates, we expect Microsoft to beat and likely guide inline toahead of estimates. Therefore we see Microsoft as a compelling buy.

Microsoft (MSFT), a reasonably valued software company and one of the best large cap names, is a buy in our opinion. Microsoft should be a core holding in any growth portfolio, given that revenue continues to grow at least 10% for the next three to five years. Despite up 33% year to date and up 52% during the last 12 months, we expect the stock to continue higher, driven by growth of Azure Cloud Services and other Cloud properties (Dynamics, Linkedin, Github, etc). A majority of Microsoft Small Medium Businesses ((SMB)) and enterprise customers are just beginning their journey migrating to cloud and we expect this cloud journey to drive Azure revenue growth. Over the next three-to-five years, we expect Azure to grow faster than Amazon (AMZN) Web Services (AWS), the current market leader (with over 63% share), and to take share. We also believe that Google will have a tough time making inroads into Microsoft’s core install base of SMBs and large enterprises, given the sustained investments needed in sales and marketing and convincing customers to accept Google (GOOG) Cloud Products.

Drivers of Growth

Our Microsoft buy thesis is mainly driven by our belief that Azure will outgrow Amazon Web Services for next several years. We expect the majority of Microsoft’s on-prem customers to choose Azure over Amazon, driving Azure growth over the next few years. Microsoft software stack is a business standard. A majority of businesses worldwide have standardized on the Microsoft software stack – i.e. products that are Windows based and written for Windows using Microsoft technologies such as .Net, SharePoint, Active Directory, Exchange, Office, SQL Server, and Dynamics. Applications written using Microsoft stack will likely move to Azure, given that no other cloud vendor has an advantage running the stack in the cloud better than Microsoft.

Microsoft is making it easy for its on-prem customers to move their applications to Azure by engaging with them through its partner channels. The partners are working with Microsoft’s customers by providing training and support in moving applications to cloud. The common refrain that we hear from many of Microsoft’s customers and its partners is that “who can support Microsoft applications better than Microsoft”. Therefore, we believe Azure will receive a lion share of these legacy workloads when compared to other public cloud vendors such as Amazon and Google.

Given the aforementioned reasons, we expect Microsoft to continue outgrow Amazon for the next three-to-five years growing, its market share from about 26% in 2019 to an estimated 39% in 2025. Microsoft Azure is expected to grow revenues from about $14.5 billion to about $70.1 billion by 2025 while AWS is expected to grow from about $35.0 billion to about $85.5 billion. Please find our proprietary public cloud model forecast below:

Source: Author's analysis based on IDC and Gartner data

Other drivers of Microsoft revenue

Microsoft continues to be the dominant PC operating system, despite major inroads by Apple. While Apple sold 18.4 million macs during 2019, total PCs shipped were about 262.2 million units. A majority of the PC’s are shipped with Windows OS. Most businesses have standardized on Windows, but still some companies are allowing employees to BYOD (Bring Your Own Device) to work. Despite this, we believe Windows will be the dominant PC operating system for the foreseeable future, especially in the business setting.

The commercial cloud business, consisting of Office365 for business, Linkedin, Dynamics, and other properties, should continue to grow roughly 40%, driven mainly by the Office365 and Dynamics move to cloud. In addition, we expect Microsoft to continue to dominate on-prem offerings of Office, Dynamics ERP, and CRM applications.

With Linkedin, gaming, and Github contributing to the growth of the franchise, we expect overall Microsoft to continue generate revenue growth of at least 10% for the next three-to-five years driven by the above mentioned product franchises. Net-net, Microsoft should generate revenue growth, margin expansion, and a steady stream of cash flows, to make it one of the best mega cap stocks to own.

How is Azure positioned relative to Amazon AWS

In our opinion, Microsoft is playing to its strengths by and closing competitive gaps in its products and services. Microsoft was singularly focused on getting its customers to move to Azure from the day one. Hence, its focus was on makings its Azure platform best for Windows applications. We believe this focus on its windows customers is about to bear plenty of fruit. Since Microsoft has customers in every single country in the world, its Cloud service is available in 58 regions and 162 availability zones. Despite being late by 4 years in offering public cloud, Microsoft already boasts revenues of about $14 billion, when compared to Amazon which has about $35 billion. The  The following chart illustrates the relative strengths of the top three cloud providers.

Source: Amazon, Google and Microsoft websites

The following Gartner magic quadrant image shows that Microsoft already is close to Amazon in terms of completeness of vision. We also believe Microsoft’s ability to execute is also improving under the leadership of CEO Satya Nadella.

Source: Gartner

Microsoft Competitors

Microsoft has formidable competitors on every front. In PCs, it competes with Apple. In the Office segment, it competes with Google G-suite. In most categories, Microsoft is either the share leader or the 2^nd largest player. The following chart illustrates Microsoft’s competitors in various product segments.

Source: Author and Microsoft

Valuation

On the valuation front, Microsoft is still relatively inexpensive when compared to other high growth names. Microsoft is trading at 8.2x on EV/sales basis when compared to other names in the software peer group. We believe that Microsoft deserves a premium multiple given that the company reports numbers on a GAAP basis, when compared to many other growth names in software such as Vmware and Splunk that report GAAP and non-GAAP numbers. Microsoft is also highly profitable, produces plenty of cash, and dominates in multiple market segments. With its large installed base of products and services and its dominant position in Windows productivity, operating systems and business applications, Microsoft deserves a premium multiple, in our view.

Source: Author based on Thomson Reuters Data

Source: Author based on Thomson Reuters Data

Risks of owning Microsoft

Since a large part of our buy thesis is based on the belief that Azure will continue to drive growth for Microsoft, we believe significant risks exist, if the competitors such as Amazon and Google begin competing on price. Amazon is known to be particularly aggressive on price. Any price competition will lower revenue and operating margins for the company, leading to a potential stock sell-off.

A significant portion of Microsoft revenue is derived from the sales of PCs. In times of macro uncertainty, as that occurred during the great financial crisis in 2008/2009, PC shipments declined, impacting Windows revenue. Similarly, server shipments could also decline during the times of turmoil, impacting Windows server revenue.

Azure has a history of outages. Since 2018, Azure service has gone down multiple times, impacting customers that depend on its service. Azure Active Directory has been the source of problems before and could likely be a source of problems in the future. Any extended outage of services could lead to payment penalties and a loss of confidence in the service, leading to customers choosing alternate service providers.

Given the uncertainty surrounding Covid-19 and the accompanying spending environment, Microsoft is highly levered to the global IT spending. If for any reason IT spending slows, we expect Microsoft revenue could also slow.

Execution is always a major risk for most companies that have a fairly large base of perpetual revenue streams. Microsoft's quarters are usually back-end loaded - i.e., a significant portion of the business closes during the last two-to-three weeks of the quarter. Any deal slippage for any reason during the last weeks of the quarter could impact revenue and earnings, leading to a stock sell-off.

Microsoft is aggressively building out capabilities to augment its Artificial Intelligence and Internet of Things ((IoT)) services. If the adoption of services is slower than expected, revenue and EPS could be impacted.

Microsoft is at a major risk of a catastrophic breach in Azure. Microsoft and its applications have been a major target for number of years. If hackers breach Azure or any other components of Microsoft stack, we believe customers and investors would lose confidence in Microsoft’s capabilities. This could lead to a slowdown in the cloud business, in addition to penalties that the company would need to pay to regulators.

Finally, the company continues to acquire businesses at a rapid clip. Any challenges to integrating the acquired companies into its stack could lead to product launch delays. Delays in product launches could hurt revenue which could lead to a sell-off of the stock.

Why Buy Microsoft

In our opinion, Microsoft is one of the best positioned large cap technology stocks that has marched back into relevancy with its cloud and SaaS/subscription offerings. Microsoft has number of growth drivers with Azure being the biggest. The company is now one of the top public cloud vendors, despite coming to the public cloud 4 years later than the industry leader Amazon. Our buy thesis mainly rests on the premise that the Microsoft Azure cloud business will outgrow the current industry leader Amazon for the next three-to-five years, aided by Commercial Cloud Business (mainly consisting of O365 and Dynamics franchises), providing revenue growth, cash flow, and expanding margins.

Given that a majority of Microsoft’s customers have yet to transition to cloud and are in early innings of the digital transformation, we are highly confident a majority of them will choose Microsoft over its rivals Google and Amazon. The refrain we keep hearing, “who can have better infrastructure than Microsoft to support Microsoft applications”? Microsoft is considered a trusted partner by many of its SMB customers and it has deep relationships with them. These small medium businesses are serviced by an army of Microsoft partners and it is incredibly difficult for Amazon or Google to replicate the partner network quickly and economically. Hence, we are highly confident that a majority of SMB customers will remain with Microsoft and will use Azure driving growth for years to come.

Other franchises such as Office (both commercial and consumer) and Windows (consumer and server) should hold up fairly well and drive subscription/cloud growth for the company. Similarly, we expect Dynamics (Power BI, SQL Server and other associated properties) and Linkedin to contribute to the growth. Microsoft has a history of beating estimates and guiding inline to ahead of estimates. Anytime, that the company provides an opportunity to own the stock at a cheaper price, investors should take advantage of it. We would be owners of Microsoft for a long term horizon.