Is This Microsoft Corporation's Next $20 Billion Business?

Microsoft CEO Satya Nadella recently claimed that his company could generate $20 billion in annual cloud revenues by the end of fiscal 2018. By comparison, Microsoft generated $86.8 billion in annual revenues last year.

To hit that $20 billion target, Microsoft would have to more than triple its cloud revenue in just three years. Let's take a look at why Nadella believes that goal is achievable, and whether or not investors should believe him.

Microsoft CEO Satya Nadella. Source: Microsoft.

The path to $20 billionLet's first take a look at Microsoft's cloud growth over the past four quarters.

Source: Microsoft quarterly reports.

Annual growth, while robust, noticeably slowed down over the past four quarters. Part of that was due to currency impacts -- third quarter cloud revenues would have risen 111% on a constant currency basis.

Between the fourth quarter of 2014 and the third quarter of 2015, the cloud business' annual run rate rose 43% from $4.4 billion to $6.3 billion. If its annual run rate hits $7 billion by the end of fiscal 2015 and keeps growing 40% annually, it could reach $9.8 billion in 2016, $13.7 billion in 2017, and $19.2 billion in 2018. That math supports Nadella's forecast, but maintaining 40%+ annual growth is easier said than done.

Microsoft's cloud business is comprised of three main units: Office 365, Dynamics CRM, and Azure. Of those three, Office 365 generates the most revenue with its cloud-based productivity services. To introduce more users to Office 365 and OneDrive, Microsoft has been bundling free trials with new tablets and PCs.

Azure, its cloud computing platform, has a lot of growth potential in hosting websites, apps, and files, but it's still fairly small. Deutsche Bank estimates that the service only generates $500 million to $700 million in annual revenues.

Why Windows 10 mattersWindows 10, which will arrive as a free upgrade for certain customers in a few months, could also play a major role in boosting Microsoft's cloud revenue. Nadella claims that by 2018, 1 billion Windows devices will be on the market.

By comparison, IDC logged 308 millionPC and 230 million tablet shipments last year. Those numbers don't come anywhere close to 1 billion. To get to 1 billion devices, Microsoft must convince owners of older Windows PCs to upgrade to Windows 10.

It would then need to sell more Windows Phones, which accounted for less than 3% of the market in 2014. It can then upgrade all those devices -- from the low-end Lumia 430 to the high-end Lumia Icon -- to Windows 10. New versions of Windows 10 for IoT-ready board computers like the Raspberry Pi 2 and Qualcomm'sDragonBoard 410c could also extend Windows 10's reach beyond PCs, tablets, and phones.

Therefore, uniting all those devices with Windows 10 would reduce OS fragmentation and tether more users to Microsoft's cloud-based productivity apps and Azure.

Source: Microsoft.

The potential pitfallsMicrosoft's strategy seems sound, but IBM, Amazon, Google, and Salesforce.com'scloud-based businesses are all eyeing the same market.

Microsoft's Azure ML (machine learning), a platform which helps businesses identify trends and predict customer responses, already competes against IBM's Watson Analytics, Amazon ML, and Google's Prediction API. Amazon and Google also offer cloud-based storage solutions which directly compete against OneDrive. Google Drive's free productivity apps are a direct threat to Office 365. Microsoft's Dynamics CRM is also dwarfed by Salesforce's industry-standard CRM system.

When too many competitors enter the market, pricing wars begin. Between Oct. 2013 and Dec. 2014, Google and Microsoft cut their cost per GB or RAM (a common metric to measure cloud-based workloads) by 6% and 5%, respectively. Amazon's AWS reduced prices by 8%. If this trend continues, it could be tough for Microsoft to constantly maintain 40% growth.

Let's not get ahead of ourselves yetInvestors shouldn't forget that Microsoft still faces tough bottom line challenges in the near term. On average, analysts expect Microsoft's earnings to decline 8% year-over-year in fiscal 2015.

Reduced prices and free trials of Windows, Office 365, and Azure might tether more users to its ecosystem, but there's no guarantee that all of them can be monetized. Nonetheless, it's still a crucial step toward eliminating Microsoft's dependence on launching hit-or-miss OS upgrades every few years.

Growing cloud revenue is a promising way to offset those weaknesses, but it shouldn't be considered a magic bullet for all of Microsoft's problems. Too many tech giants are looking in the same direction, and pricing wars could throttle the unit's growth and prevent it from achieving an annual run rate of $20 billion by 2018.

The article Is This Microsoft Corporation's Next $20 Billion Business? originally appeared on Fool.com.

Leo Sun owns shares of Apple. The Motley Fool recommends Amazon.com, Apple, Google (A shares), Google (C shares), and Salesforce.com. The Motley Fool owns shares of Amazon.com, Apple, Google (A shares), Google (C shares), International Business Machines, and Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.