When Microsoft reported earnings last week, an all around beat, it proudly showed off huge 127% revenue growth in its hugely important cloud business, in which it competes head-to-head with cloud juggernaut Amazon Web Services.
But buried in that growth was a detail that Wall Street didn’t much like, which sent the stock tumbling. It’s now down about 8% since that earnings report.
The problem: Gross margin profitability on Microsoft’s cloud is expected to decline throughout the rest of its fiscal year (two more quarters), management warned.
Deutsche Bank’s Karl Keirstead wrote in a research note Thursday, “Fast-growing Azure is hugely unprofitable compared to the +29% operating margins posted by AWS in 4Q15.”
So Deutsche Bank met with Microsoft to try and find out why and came away so satisfied with the reason, Keirstead reiterated his “buy” rating and a target price of $65. That’s pretty bullish given that the stock is trading at just above $50 now and has never been as high as $65 (if you adjust for splits).
Microsoft is still offering deep discounts to its enterprise customers to convince them to try its cloud, instead of Amazon’s or others.
“MSFT is pricing aggressively to drive adoption and MSFT likely looks at Azure as a means to secure enterprise relationships and help drive Office 365 migrations. If this is a key reason behind the GM decline, we can live with it,” he writes.
Meanwhile, Microsoft is growing overall profits by tightly managing costs.
Keirstead also points out that all the other traditional software vendors competing with cloud companies are doing the same thing — facing margin pressure and offering all kinds of discounts to try and get their customers to try their cloud versions.
As we’ve previously reported, with enterprise software companies, it’s a little more complicated than just offering discounts to try the cloud.
In Microsoft’s case, the company has been known to tack on Azure credits to an enterprise software contract in a way that doesn’t cost their customer any more money. That technique does work, but is a little bit risky. Some companies take the discounts on the other products, and then ignore Azure.
So Microsoft has been increasingly pressured to report actual cloud consumption stats, not just the growth of its revenue under contract, to give more insight into all of this.
In fact, former CEO Steve Ballmer, who is now Microsoft’s largest single shareholder, wants the company to do that one better and report actual cloud revenue numbers. Microsoft reported “intelligent cloud” revenue of $6.3% last quarter, but the name of that unit is a little misleading. That unit bundles Azure together with Microsoft’s traditional not-cloud server software, such as Windows Server and its database SQL Server.
Disclosure: Jeff Bezos is an investor in Business Insider through hispersonal investment company Bezos Expeditions.
Business Insider Emails & Alerts
Site highlights each day to your inbox.