Successful Cloud Transition Earns Microsoft Stock A Major Upgrade

  • Success in its cloud transition has earned Microsoft stock a notable upgrade from an erstwhile Microsoft bear on Wall Street.
  • The success of Microsoft products such as Office 365 has also contributed to the upgrade.
  • Can Microsoft maintain its impressive cloud momentum?

Microsoft (NASDAQ:MSFT) bear Heather Bellini of Goldman Sachs has finally done a mea culpa and upgraded Microsoft stock to Neutral after staying on the sidelines and keeping the stock at Sell even as Microsoft stock went on a three-year rally. Miss Bellini has remained an adamant Microsoft bear even as the stock more than doubled over the past 3 years.

Microsoft Stock 3-Year Returns


Source: CNN Money

Bellini has changed her stance on Microsoft stock and hiked her stock target by $12 to $57 saying:

"We were wrong, we are increasing our out year non-GAAP EPS estimates, driven primarily by faster gross margin expansion in Office 365 and Azure. While we still believe EPS consensus for FY17 and FY18 are too high, given the ongoing successful transition to the cloud we do not see the multiple coming under pressure."

Bellini added that she sees several possible catalysts in 2016 that could continue pushing Microsoft stock higher including a successful cloud transition, EPS growth, gross profit dollar growth despite contracting margins, accelerating dividend growth, and diminishing headwinds related to Office 365 transition and weak PC sales.

Microsoft certainly seems to have a lot going for it. While all the catalysts that Bellini mentioned can play a part in helping Microsoft stock continue making good gains in 2016, I believe that a successful cloud transition is the biggest pillar upon which the stock trades.

Microsoft’s Cloud Growth: Short-term pain, long-term gain

Microsoft is not the only old-line software company that is attempting to transition from an on-premise software model to a cloud subscription model. Oracle (NYSE:ORCL) is facing pretty much the same situation as Microsoft as it tries to wean its enterprise customer from on-premise software. Looking at the earnings report by the two companies, one thing jumps at you: overall revenue has been on a decline even as their cloud revenues keeps growing.

During Microsoft’s last quarter, overall revenue declined 6.5% Y/Y to $21.7B. Microsoft no longer breaks out its cloud revenue figures, but said that Office 365 revenue was up 70% while Azure revenue had grown more than 100%.

The story was pretty much the same for Oracle whose revenue fell 6.3% Y/Y to $9B while cloud revenue increased 26% Y/Y to $694M.

That is the price that these companies have to pay as they transition to a subscription-based revenue model. In the past, Microsoft would sell its Windows OS licenses for a large one-time fee and recognize all the revenue upfront. Microsoft now mostly gives away new Windows copies, while selling to some customers on a monthly subscription basis. By foregoing a licensing fee and instead charging a monthly subscription fee, a company’s top line is bound to suffer in the near-term. But over the long-term, the company might be able to recognize several times the revenue it would have received from selling perpetual software licenses.

Microsoft’s cloud (commercial cloud revenue), is estimated to be on a $8B+ annual run rate compared to ~$2.8B for Oracle’s cloud. The big difference between the cloud transitions by the two companies is that Microsoft’s cloud is growing in triple-digits, much faster than Oracle’s which is growing in the mid-20%. Microsoft’s cloud growth rate is in fact the fastest for all public clouds. Microsoft CEO Satya Nadella recently said that Microsoft’s cloud revenue will exceed $20B by 2018. That is the biggest reason why Microsoft’s cloud transition is being hailed as a success while Oracle’s is not.

Microsoft’s phenomenal cloud growth is being fueled by a number of factors including the fact that the company owns Windows OS, an overwhelmingly dominant OS with more than 90% market share; and Microsoft cloud’s vendor agnostic stance that lets even rival clouds easily shift workloads between the platforms. Microsoft is considered the market leader in hybrid clouds, which is the direction that most enterprise clouds are taking. Additionally, Microsoft’s cloud has lately been getting into new services such as machine learning and IoT (Internet of Things) earlier than cloud market leader, $AMZ AWS thus giving the cloud plenty of momentum.

The big question investors have been asking is whether Microsoft can maintain its impressive cloud momentum. The short answer is: Yes. Microsoft appears to have done the right thing by offering Windows 10 for free to most consumers. By first building a huge cloud userbase, it will now have a good chance to cross-sell its numerous cloud services to these consumers. With Windows 10 momentum building up rapidly, Microsoft’s cloud growth in the next 2-3 years seems assured.

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