Thursday, June 23, 2016

Behind Microsoft's Shift to Cloud Technology (MSFT)

Few companies have enjoyed the long-term success of Microsoft Corporation (NASDAQ: MSFT). The company has been a leader in the software business for over four decades and has created one of the most iconic brands in technology. Microsoft shareholders have benefited from the company's success. The company's $409.1 billion market capitalization as of June 8, 2016, ranked it as the world's third most-valuable publicly traded company.

Despite its history of success, Microsoft faces serious challenges going forward. Disruptive technologies, such as cloud computing, challenge the company's traditional software business and ultimately may make it obsolete. How the company addresses and embraces the competition from cloud computing may determine its future.


Proactive Response

Microsoft understands that it must embrace cloud computing and transition the company for future growth. Chairman John Thompson asserted that the company's traditional software business may disappear in a few years. While he lauded efforts by chief executive officer (CEO), Satya Nadella, to increase the company's revenues from internet software and services, he also acknowledged that the transition must occur more quickly. Thompson mentioned increased spending on cloud technology and restructuring the company's sales force and partnerships as ways to address the problem. The company sees cloud computing not merely as an add-on to its existing services, but rather as a critical step in its transition.

An Analogy to Telecom

Thompson noted that fellow board member Chuck Noski, the former chief financial officer (CFO) of AT&T Inc. (NYSE: T), experienced firsthand the effects of failing to address competition from new technology. Noski witnessed the traditional wireline business at AT&T disappear as consumers switched to wireless devices. Thompson and Noski understand that Microsoft may face a similar fate with its on-premise software programs.

Late to the Game

Microsoft forecast $20 billion in annual sales of commercial cloud products in fiscal year 2018, and Nadella expects the company to meet this goal. However, Thompson expressed concern about the company's late entry into cloud computing. While Microsoft's Azure cloud computing platform posted 100% gains in quarterly sales, it contributed only $5.8 billion of the company's $93.6 billion in revenues in fiscal year 2015. Other cloud products such as Power BI and the enterprise mobile management service contribute an even smaller fraction of the company's overall revenues. The board is evaluating whether the company has invested enough in this area and how it might leverage its relationships with partners to deliver better cloud products.

Building Partnerships

Analyst Lydia Leong of Gartner Inc. (NYSE: IT) believes Microsoft can better leverage its Azure offerings by forming partnerships with consultants to install and manage its services. Leong noted that Microsoft lags Amazon Web Services in its knowledge about installing and servicing cloud products. Most Microsoft salespeople lack deep familiarity and experience with subscription-based deals. Unlike the one-time purchases of traditional software sales, cloud sales entail longer-term contracts. Matt McIlwain, managing director at Seattle's Madrona Venture Partners, believes that Microsoft's sales team still needs to transition more effectively to a subscription-based selling model.

Reliance on Traditional Model

Microsoft's quarterly report, which it released on April 21, 2016, demonstrated the long path the company faces in breaking into cloud computing. The company announced weakness in its traditional software business and noted that this weakness may persist in the future. The company needs to grow its cloud business more quickly to avoid more growth headaches.

The company's 2015 annual report also highlighted the costs of transitioning to cloud computing. Cloud computing is a lower-margin business than traditional software; the cost of building and running data centers to deliver the product erodes margins. Microsoft's gross margins dropped from 80% in fiscal year 2010 to 65% in fiscal year 2015.


In market share, Microsoft's Azure cloud service trails Amazon Web Services, the product offering of Inc. (NASDAQ: AMZN), but it leads product offerings by Alphabet Inc. (NASDAQ: GOOGL) and International Business Machines Corporation (NYSE: IBM). Microsoft also offers Office 365 cloud versions for email, spreadsheets and other software.

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