For a brief shining moment last week, Microsoft Corp. (MSFT, Financial) surpassed its old rival Apple Inc. (AAPL, Financial) for the magic $1 trillion market cap prize.
Though the market position and business models of the two companies are vastly different today, Microsoft holds a lesson for Apple about the necessity of shifting the company’s business model away from a dominant market product that has been disproportionately responsible for most of its revenue growth, but whose sales are now declining.
Microsoft successfully redirected its efforts from relying solely on its Windows and Office suite of software — for years, its core products— and reinvented itself as one of the premier cloud services providers that is currently the only company giving Amazon (AMZN, Financial) and its AWS unit a run for the money.
The company’s evolution from an operating systems software company into a subscription-based cloud services provider is a compelling story.
Those who purchased stock in Microsoft in the early days when Bill Gates (Trades, Portfolio) was introducing his personal computer operating system that would eventually dominate the market, saw the price of the stock rise astronomically from 37 cents in 1987 to $45 in 2000. During this period of time, Microsoft was viewed as one of the hottest growth stocks on the market.
After 2000, Microsoft stock followed the predictable path of growth companies that had entered their mature stages. From 2000 through 2012, the stock price was mostly flat, trading in a narrow range, reflecting a company with a stable and reliable earnings history.
In 2013, things began to change. Newly hired CEO Satya Nadella made entry into cloud software services a focus of his strategic business plans for the company. Nadella’s gamble was hoping that cloud networking services would be able to drive most of Microsoft’s future growth. His high-risk strategy has paid off.
A review of the numbers tells the story.
In 2014, shortly after Nadella took the helm, Microsoft’s price-earnings ratio was approximately 14.3; today, it is 46.5. In January 2017, the company's price-earnings ratio was 22.47; Amazon's was 168.49. Today, Amazon's price-earnings ratio has dropped to 98.7, while Microsoft's has climbed to 46.5. The stock price followed a similar trajectory. In 2014, shares of Microsoft were selling for $38; today, the stock price is $112.
For the third quarter, Microsoft earned $1.12 per share on revenue of $29.08 billion — a 19% increase; analysts had expected 96 cents a share on $27.92 billion in revenue. Net income increased 34% to $8.82 billion. The company’s rapidly growing Azure cloud-computing business grew by 76%. A surprise component in the overall revenue growth picture was Microsoft’s gaming business, where sales jumped 44%.
As a measure of its phenomenal and heady growth rates in its cloud database services business, for the last 20 quarters, Microsoft has beaten analysts’ revenue estimates 19 times. It is clear that betting the farm on cloud computing has paid off. Revenue from the company’s Azure division has climbed more than 76% every quarter since it began reporting the growth in that unit separately beginning in 2015.
Even though its once-dominant Office suite of software products as well as its Windows OS are no longer the company’s bread and butter revenue leaders, while it proceeds to build its cloud services business, Microsoft has adopted a prudent and successful strategy of continuing to squeeze revenue out of these stable software and PC products.
For the third quarter, revenue in Microsoft’s PC-related business, including Xbox, increased 15% to $10.75 billion. The Office productivity suite grew a respectable 19% to $9.77 billion. These are remarkable numbers for a company whose lodestar product many analysts believed was in its death throes.
Additionally, Microsoft has positioned itself well for dominating cloud services offerings for the retail market. Many retailers, directly competing with Amazon, are reluctant, if not loathe, to use Amazon’s AWS services, as it simply provides them with a rope to hang themselves. Microsoft provides a viable alternative.
Microsoft provides those brick-and-mortar companies seeking to compete with Amazon on its own terms, a massive database of customers' shopping habits and preferences. Using Microsoft’s Azure cloud services will help level the playing field for retailers with limited customer data warehousing capabilities.
Walmart (WMT) recently agreed to use Microsoft’s cloud services technology to streamline its business operations and develop purchasing and sales data-sharing capabilities with its third-party vendors.
For Walmart, using Microsoft’s growing and established cloud computing services capabilities is the most cost-effective and expeditious manner to help it enter the online retailing business. Walmart will now have some of the same data-sharing capabilities that Amazon has long since enjoyed and upon which it has capitalized or leveraged to establish its massive internet-only retail presence.
As is evident from Microsoft’s increasing multiples, the market believes there is additional room for growth. Adding Walmart as a cloud services customer was a significant feather in the company's cap as it foretells a potential market that has enormous recurring revenue potential and will be in heavy demand in the years to come.
As it completes its remarkable transformation, Microsoft’s unbroken rapid rate of growth in its cloud services business indicates that, at some point, it will become a viable alternative to Amazon, currently its only principal competitor.
Disclosure: I have no positions in any of the securities referenced in this article.
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