- Microsoft has reduced pricing on Azure to remain competitive with Amazon.
- It's worth mentioning that both companies will sustain improvements to operating margins.
- However, Microsoft offers a safe alternative in a world where hardware faces cyclical headwinds.
- Therefore, Microsoft remains the safest of the high-beta technology group, and should be bought on dips.
If I had to label one company that could be a thorn in the side of Amazon (NASDAQ:AMZN) AWS it would be Microsoft (NASDAQ:MSFT) Azure, and while both companies are aggressive with reducing pricing on cloud instances, I find it highly probable that both companies will sustain gross margin gains in infrastructure cloud. Furthermore, it’s worth mentioning that Microsoft has recently slashed pricing on Azure to remain price competitive, and while investors aren’t exactly certain on the long-term pricing/margin dynamics of hyper scale cloud providers, it seems fairly probable that both companies will improve profitability while reducing pricing across Linux and Windows Server instances.
This puts a lot of pressure on conventional IT companies like IBM (NYSE:IBM) and Oracle (NYSE:ORCL) who are struggling to transition clients to the cloud due to the competitive pricing dynamics of hyper-scale cloud vendors. I anticipate that more and more companies will transition over to Windows Azure and Amazon Web Services despite vendor lock-ins. Of course, this will take time as many enterprise IT departments will need to migrate workloads to the cloud, and some will need to remain on premise. However, the cost savings in hybrid instances also creates a compelling argument for moving over to AWS, Azure, Google Cloud, etc.
According to a recent blog post from Microsoft, pricing was reduced by 10% on Windows Server instances, and 14% on Linux instances. The efforts to remain competitive on both Windows and Linux based servers is noteworthy, however, it does little to change the underlying investment thesis for Amazon investors.
This is because AWS has reduced pricing by 87.3%, 83.8% and 22.8% in 2013, 2014 and 2015 respectively, according to Credit Suisse. AWS is projected to reduce pricing by 20% in FY’16 and FY’17 respectively, which implies that Amazon will sustain a competitive price advantage. Furthermore, the reduction in price will still accompany an improvement to AWS operating profit margins, which Credit Suisse estimates to be around 26.1% and 29.8% respectively for FY’16 and FY’17. As such, Amazon will sustain its pricing advantage while improving margins.
Microsoft seems poised to ramp profitability a little quicker. However, Amazon’s margins have remained depressed for quite a while, so an incremental improvement to profitability in the case of Amazon will be far more material to shareholders as opposed to Microsoft. While retail margins are expected to improve, there’s a low ceiling to retail margins, which is why Microsoft’s business model tends to appeal to a broader group of investors.
It’s just simpler to deal with a company that has an established pattern of earnings, and when considering the majority of Microsoft’s business will transition to an annually recurring revenue model there’s a lot of visibility to long-term CAGR assumptions. The buy side feels a lot safer with old tech companies that aren’t dependent on hardware for revenue, which explains Microsoft’s premium when compared to Apple and BlackBerry. While I do acknowledge that there are risks to Microsoft’s valuation, the safety in fundamentals helps justify the premium it currently trades at in relation to other software companies.
Microsoft stock has recovered in response to a broader market rally. But even during the market correction, MSFT was resilient among tech names. In other words, investors should see every pullback as an opportunity to accumulate Microsoft stock as the company’s beta risk is low when compared to peers within its space. Furthermore, I could see additional upside to the stock following a series of earnings/sales beats as expectations have moderated in response to a weak PC environment. I believe Intel’s guidance on PC sales was conservative in response to Chinese macro risks. However, the PC market is long overdue for a major refresh due to the aging PC installed base. Therefore, PCs could become a catalyst in the long term.
Microsoft’s strength in the enterprise masks the weakness in its consumer PC business. So even without PC recovery, the company is on track to meet consensus sales/earnings estimates. So there’s very little expectation risk over the next 12-months. In other words, Microsoft stock seems like a reasonable investment in a sea of companies facing cyclicality, therefore, I continue to reiterate my buy recommendation on Microsoft stock.