Microsoft's Cloud Should Keep Rising

By Dan Gallagher Features Dow Jones Newswires

Microsoft may be designing its own personal computers these days, but it has successfully convinced investors that it is past its dependence on them. Now comes the hard part.

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Over the past three years, Microsoft appears to have settled the existential crisis of being the company that ushered in the PC era but missed the mobile one. Microsoft's focus on building a large cloud platform to offer its software and services across any device or operating system has resonated with investors. Its stock is up nearly 90% since Satya Nadella took over as CEO in early 2014 to lead that push. The Nasdaq Composite is up about 51% in that time.

The addition of about $230 billion in market cap -- more than the total market value of about 97% of the companies in the S&P 500 -- means Microsoft's cloud now needs to deliver a big silver lining. Mr. Nadella is likely to focus heavily on the cloud come Wednesday, when he kicks off the company's annual Build conference that once served mainly as the showcase for the Windows operating system.

Two of Microsoft's three operating segments contain cloud-related businesses. The good news is those two segments are on track to comprise about 64% of total revenue for the fiscal year ending in June, compared with 54% two years prior. The bad news is Microsoft doesn't disclose enough information to tell just how well its cloud business is performing. Improving that would bolster the company's case for growth.

That is important because the cloud business is expensive to build and to operate and doesn't command the same profitability as Microsoft's past big businesses, such as Windows and Office. Adjusted operating margins have compressed to the low 30% range in the last three years, compared with an average of 37% for the five years prior. And Microsoft's growing efforts at hardware -- like the new Surface laptop introduced last week and a new supercharged Xbox coming this fall -- also weigh on its margins.

Microsoft has signaled that its margins are on pace to improve, and its capital spending is expected to moderate over the next year. It also needs to add more clarity to its cloud business. Walter Pritchard of Citigroup estimates Azure, the Microsoft cloud business that competes with Amazon's AWS, will hit about $3.5 billion in revenue for the fiscal year ending in June, compared with $1.8 billion the year before.

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That's still a lot smaller than AWS, which is projected to top $14 billion in revenue for the same period. But Azure's rapid growth rate is helping to close some of that gap.

At 22 times forward earnings, Microsoft is fetching its highest multiple in more than a decade. But is cheaper than Google-parent Alphabet and Amazon, making it a reasonable bet for a rising cloud.

(END) Dow Jones Newswires

May 07, 2017 17:04 ET (21:04 GMT)