Microsoft flying high on wings of Cloud business

After following a new direction, changing their business model and successfully monetising their Cloud service, Microsoft’s share price has increased to record levels and is predicted to climb even higher by a number of Wall Street analysts

Over the last few years Microsoft (MSFT) has dramatically changed direction as a company to generate new sources of revenue. By doing so it altered consumer perception of the brand and impressed a number of Wall Street analysts. They are eagerly awaiting the company’s quarterly earnings report  (October 26) which they hope will confirm their selection as their top large cap pick.

Under CEO Satya Nadella the company is now well-placed to enjoy a period of sustained growth. It enjoys growing revenue from its Cloud offering (on target to reach $20 billion annually by 2018). Additionally, there are increased revenues from new ventures as well as revitalization of revenue from its existing portfolio of products.

Former CEO Steve Ballmer took the decision to move into Cloud services and turn Office into a subscription based product. However, when Nadella took over in February 2014, he undertook some drastic changes. He ditched many of the business practices used when the company dominated the marketplace with its Windows operating system.

Smartphones undermined Microsoft’s market

When Microsoft lead the PC market it sold copies of Office (Word, Excel, PowerPoint etc.) to run on them. But then smartphones ate away at its market by giving users computing power in the palm of their hands. This shift also created a perception that the PC giant was now behind the curve.

By selling Office on subscription, Microsoft has switched from a one-off $300 payment to a recurring ($70) revenue. When combined with its Cloud services, which are also sold on a monthly subscription, Microsoft now enjoys impressive perpetual revenue.

The perception of Microsoft as a lumbering dinosaur facing extinction at the hands of Apple et al. has faded as it has weaned itself off its dependency on the shrinking Windows market.

Microsoft has also expanded its range of projects to include HoloLens (which undercuts by half the price of Facebook’s Oculus Rift) and LinkedIn (which gives it a significant presence in social media) to re-stake its claim as a brand that will power the future.

Focus on apps to access PC products on smartphones

Microsoft has been quick to realise that its attempts in the smartphone market were failures. However, instead of mirroring its behaviour with PCs, it downsized its mobile business and focused on launching more apps. These apps allow PC users to access Office, Outlook, OneDrive and other services on smartphones which maintained their relevance.

Morgan Stanley’s Keith Weiss was so impressed he predicted in June that Microsoft’s shares could rise to $102. This represented a 46% increase from the price at that time. His prediction is playing out with Microsoft shares currently trading at an all-time high.

Credit Suisse analysts, who made the company its top large cap pick, said:  “Our outperform thesis on Microsoft is centered on what we view as strong cash flow growth and earnings power potential over the next few years, at least, driven by significant commercial Cloud growth and higher Cloud gross margins over time.”

However, not every cloud in Microsoft’s view comes with a silver lining. Last week the US Supreme Court agreed to hear a case on digital privacy which pits the federal government against Microsoft in a battle over emails held overseas.

Microsoft blocks government warrant

Back in 2013 US prosecutors demanded Microsoft hand over emails linked to a drug-trafficking case. Microsoft handed over the files stored on US servers but sued to block the warrant for those held in Ireland.

Microsoft warned that if they were forced to do so, foreign governments could force American companies to turn over evidence stored in the US.

Russia haven’t sat on their hands waiting for the Supreme Court to make a decision. Last month Moscow’s city government dropped Microsoft’s Outlook in favour of Russian-made software.  This program will quickly expand to all of Moscow’s 600,000 municipal employees.

The message from Moscow’s head of IT, Sergey Kalugin, was unequivocal: “Russia-developed software is not inferior to foreign software, but it’s much cheaper and, most importantly, provides reliable data protection.”

The worry for Microsoft is not about losing Moscow or even Russia as a territory, but the possibility that this is the first domino falling among other foreign countries who fear that software created by a US firm provides an access point to the US government to potentially sensitive data.

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