July 17, 2016 12:31 p.m. ET
For Microsoft, shifting its business to the cloud has been the right decision—albeit an expensive one.
While now just one-third of the company’s revenues, Microsoft’s cloud business is the company’s primary driver of growth—and its stock price. The latter point was painfully clear in the company’s most recent quarterly report in April, when a small miss for the cloud business translated into a big selloff in the stock. The shares have recovered somewhat, but remain off about 4% from their level from before the report.
That may prevent another fall when the company reports fiscal fourth-quarter results Tuesday afternoon. But the cloud business will remain closely watched. Microsoft estimated year-over-year growth in the range of 3% to 6% for its Intelligent Cloud segment in the quarter. This will help offset continued declines in its personal-computing segment, which still accounts for more than 40% of the company’s total revenue.
But even if the cloud numbers are good, Tuesday’s results will provide a useful illustration of the challenges in transforming a $90 billion-a-year business. Microsoft is expected to post its first annual revenue drop in seven years, due mostly to the impact of currencies and the weakening PC business. And the results will also likely show a continued decline in the company’s gross margins, which have steadily slipped from 80% in fiscal 2010 to an expected 64% for the recently ended fiscal year
Several factors are driving the margin decline. One is Microsoft’s foray into building its own hardware, which includes its ill-fated smartphone efforts and—more successfully—its own brand of high-end Surface tablets and laptops. The Surface products have sold well, at least to a small niche of the market. But producing hardware is still expensive compared with bundling software onto devices made by others.
Building a huge cloud business is also expensive. Microsoft has spent about $7.5 billion over the past four quarters on capital expenditures, which went primarily to data centers and servers that power its cloud services. That is up 36% from the same period the year before.
Microsoft may have some of the deepest pockets in tech, but it is competing head-on in the cloud arms race with Amazon.com and Google. Both of those companies have topped Microsoft’s capital outlay over the past four quarters. Those competitive pressures won’t abate anytime soon. Walter Pritchard of Citi estimates that gross margins for Microsoft’s Intelligent Cloud segment will slip from 70% for the just-ended fiscal year to 66% by fiscal 2018.
This doesn’t mean Microsoft is moving in the wrong direction. Indeed, the cloud is ultimately the only way the company will keep its software properties relevant for the future. But getting there has a high cost, which investors should keep in mind.