Microsoft Corporation Takes A Breather In The Cloud "Race To Zero"

Microsoft (MSFT -1.84%) recently announced that it would stop offering unlimited cloud storage on OneDrive for its Office 365 Home, Personal, and University subscribers. Starting in early 2016, those storage limits will be capped at 1TB. The company will also replace its 100GB and 200GB storage options with a 50GB plan for $1.99 a month, and reduce its free storage option from 15GB to 5GB. It will also drop its free 15GB "camera roll" for smartphone users. However, Microsoft didn't change unlimited storage options for enterprise users.

OneDrive's mobile app. Source: Microsoft.

Microsoft's abrupt move sparked a fierce backlash online, with an online petition for Microsoft to reconsider its decision attracting over 5,500 signatures as of this writing. While the decision clearly upset customers, it was probably necessary to keep costs under control while focusing on growth in the enterprise market.

To understand that decision, we should discuss the "race to zero" in the cloud storage market, and why promises of unlimited storage could be hard to keep.

The "race to zero"
The "race to zero" refers to the plunging prices of cloud-based storage, which occurred due to plunging costs of hard drive storage and intense competition between companies like Amazon (AMZN -1.14%), Microsoft, and Alphabet's (GOOG 0.37%) (GOOGL 0.35%) Google. Between 1995 and 2014, the average price for a GB of storage plunged from $1,120 to $0.03. Faster Internet speeds and the proliferation of mobile devices facilitated the rise of cloud-based services. To tether more users to their growing ecosystems, companies handed out free cloud storage like candy.

Last March, Google dramatically undercut its rivals by slashing prices on its cloud storage, on-demand computing, and data analysis services, which triggered an aggressive price war across the cloud market. Microsoft's recent retreat from that war now makes it a less lucrative option than competing services from Box (BOX 0.84%), Amazon, and Google.

Prices for standard consumer plans. Sources: Company websites, CNET.

Declining prices and rising demand for more storage has forced these companies to either reduce the amount of storage or slash prices. Microsoft chose to do the former, but Amazon opted for the latter by reducing its cloud service prices almost 50 times over the past nine years. Microsoft's discontinuation of unlimited storage for university students also weakens its position against Google, which started giving away unlimited cloud storage to students last year.

Google Apps for Education. Source: Google.

Why Microsoft made the right move
Microsoft's reductions in OneDrive storage might seem counterproductive, but taking a break from the "race to zero" is actually a smart move. Back in April, CEO Satya Nadella claimed that Microsoft could generate $20 billion in annual cloud service revenues by the end of fiscal 2018. That's more than double the annual cloud run rate of $8.2 billion it reported last quarter.

Offering free storage plans to mainstream consumers won't help Microsoft achieve that goal. Meanwhile, unlimited storage subscriptions will generate revenues, but most of those revenues could be "empty calories" which will be wiped out by server costs. Considering that Microsoft's net income slipped nearly 2% annually last quarter, it's wise to reduce expenses and focus on more profitable markets. For Microsoft, that's the enterprise market, which is more likely to pay for additional cloud services, like Azure and Dynamics CRM, than mainstream consumers.

Google is willing to take losses on cloud services because it's more interested in expanding its ecosystem than generating profits. That growth tethers more users to its ecosystem, who will then provide the company with more data for targeted ads. As for Amazon, most of its AWS (Amazon Web Services) unit serves paying enterprise customers instead of mainstream consumers. Since Amazon doesn't offer any free cloud storage services to non-members, the "race to zero" mainly refers to price reductions at its IaaS (infrastructure as a service) and PaaS (platform as a service) platforms.

The road ahead
Microsoft has noticed that matching Google's prices is an unsustainable strategy, and that it's smarter to concentrate on the enterprise market instead. Microsoft also appears to be following Amazon's strategy of relying more on cloud platforms (IaaS/PaaS) like Azure than mainstream SaaS (software as a service) solutions like Office 365. That strategy is paying off -- as I noted in a previous article, Amazon and Microsoft are both generating much higher cloud service revenues than Google.

For now, consumers might be upset with Microsoft's decision, but it was the right move at the right time. Remaining in the "race to zero" could prevent Microsoft from reaching its goal of $20 billion in cloud revenues on time.