Microsoft’s bet on a future in the cloud


Just four years after Satya Nadella took over the helm at Microsoft, the US technology group looks set to report its strongest annual growth in more than a decade.

Microsoft’s results for the March quarter, which comfortably beat analysts’ expectations, showed that Nadella’s strategic shift, from a core focus on Windows to prioritising its cloud services, was the right move.

Commercial cloud revenue grew 58% year-on-year in the quarter to $6bn, with the gross profit margin improving by 6 percentage points to 57%. 

When Nadella was appointed to succeed Steve Ballmer as CEO in February 2014, Microsoft shares were trading at around $34, giving the group a market capitalisation of about $315bn, according to Thomson Reuters data. 

The share price has nearly tripled since then, trading at $94.25 on 2 May, giving Microsoft a market capitalisation of nearly $730bn. 

Of the 39 analysts polled by Thomson Reuters, 19 rate the stock a buy, an additional 13 believe it will continue to outperform the market, six rate it a hold, none an underperform and only one a sell.

Digging into the numbers, it is easy to see why the majority of analysts were so positive. Azure, its public cloud service that competes with Amazon Web Services, the leader in the global market, saw revenue growth of 93% in the quarter, with its premium offering reporting its 15th straight quarter of triple-digit growth, according to Goldman Sachs. 

These growth rates are likely to continue, Nadella said during the results conference call on 26 April, as “we’re still in the early innings of the cloud transition”. 

Customers tend to start with limited services on Azure, such as storage and infrastructure as a service, before buying higher-layer resources such as artificial intelligence (AI), he explained. 

Microsoft is also luring customers to Office 365, the cloud-based version of its work-productivity software. 

As part of its growth strategy for the cloud, it will open two data centres in South Africa this year, and has announced new data centres in Abu Dhabi, Dubai and Germany.

Missing the boat

It took just under two years on Nadella’s watch for the Microsoft share price to surpass its pre-dotcom crash levels, something Ballmer hadn’t managed to achieve in more than 14 years of running the business. 

In his 2017 book Hit Refresh: The Quest to Rediscover Microsoft’s Soul and Imagine a Better Future for Everyone, Nadella explains how the company, which is based in Redmond, outside Seattle in the US, lost its way. 

By 2008, when co-founder Bill Gates stepped down as chairman of the company, personal computer (PC) shipments were still the lifeblood of Microsoft. 

The group’s mission, after all, has been “a computer on every desk and in every home”. 

But after peaking in 2011, PC shipments began to shrink, with research company Gartner reporting the 14th consecutive quarter of declining PC shipments in March. (See graph below.)

At the same time, sales of Apple and Google smartphones and tablets were on the rise, producing revenues from search and online advertising that Microsoft hasn’t matched, Nadella writes.

One example of how Microsoft missed out on key consumer trends while fixated on its Windows and Office cash cows is the Zune, the music player it launched in 2006, about five years after Apple released its iPod. 

That it took five years for Microsoft to catch up is bad enough; what’s worse is that two months later, in January 2007, Apple announced the imminent arrival of the first iPhone. 

By the March quarter of 2012, sales of the iPhone alone outstripped Microsoft’s total quarterly revenues. The Zune was discontinued in 2011.

Microsoft also lost out on e-readers and tablets – it developed an e-reader in the late 1990s, when Bill Gates was still CEO, some years before Amazon launched the Kindle, and had a tablet before Apple launched the iPad, but these were never released. 

It also lost out on earnings from internet searches, where Google remains the undisputed leader in revenue and market share.

Ballmer’s efforts from 2012 to grow Microsoft by focusing on “devices and services” and to catch up with rivals, notably Apple, included the ill-fated acquisition of Nokia’s devices and services business for $7.2bn in 2013 – a deal that saw most of the 25 000 employees who joined Microsoft from the cellphone firm laid off by 2016. 

Microsoft eventually wrote off $7.6bn from the purchase.

Corporate culture

Microsoft’s corporate culture was widely seen as one of the major reasons why it fell behind its rivals during the Ballmer years. 

During his time, a “stack ranking” system was in place for employee reviews. 

In short, this meant that every business unit within Microsoft was forced to “rank” certain percentages of its employees as top, good, average, below average and poor performers. 

“Each employee had to prove to everyone that he or she knew it all and was the smartest person in the room,” Nadella writes. 

Instead of collaborating within and across teams, employees focused on outperforming their colleagues to score as high as possible in the six-monthly review.

Under Nadella, various initiatives have been launched to change Microsoft’s culture to one that fosters innovation across the organisation, ensures better collaboration across teams and removes the barriers that kill ideas, says Tim O’Brien, general manager, global communications at Microsoft. 

“It has changed from a know-it-all to a learn-it-all culture,” he told journalists during a media visit to Microsoft’s headquarters in March.

* “A lot of fear of making mistakes has been removed.”

Microsoft also has a new mission: “To empower every person and every organisation on the planet to achieve more.”

Performance

The results speak for themselves. Overall, Microsoft revenue increased by 16% to $26.8bn in the quarter. Achieving organic growth of over 10% in the quarter is a “big achievement” for a company of its size, Deutsche Bank’s Karl Keirstead said during the results conference call.

In the March quarter, the company reported across three key business divisions.

Its More Personal Computing section – which includes Windows, Xbox and other gaming products, Surface devices and search engine advertising revenue – was the biggest contributor to revenue, with $9.9bn of the $26.8bn. 

But it also recorded the slowest growth across the three divisions, with revenue increasing 13% year-on-year.

Second is Productivity and Business Processes, which include Office, professional networking service LinkedIn and Dynamics, Microsoft’s line of enterprise resource planning and customer relationship management software applications. 

This division contributed $9bn to overall revenue, reporting growth of 17% year-on-year. 

The Intelligent Cloud sector, which includes Microsoft’s server and cloud revenue, its cloud computing service Azure and Enterprise Mobility, reported growth of 17% year-on-year to $7.9bn. 

“Every organisation today needs cloud-based infrastructure and applications that can convert vast amounts of data into predictive and analytical power through the use of advanced analytics, machine learning and AI,” Nadella writes in his book.

Speaking during the conference call, Microsoft’s chief financial officer Amy Hood said revenue growth would continue to be driven by the transition to cloud services, and Microsoft would grow its investment in capital expenditure to meet this demand.

Microsoft’s focus is “on being a growth company, even at our scale”, Hood said.
 
*The author visited Microsoft’s head office in Redmond in the US as a guest of Microsoft.

This article originally appeared in the 10 May edition of finweek. Buy and download the magazine here, or sign up for our weekly newsletter here.

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