Is Microsoft Becoming a Better Cloud Stock Than Amazon?

Amazon (AMZN -2.56%) and Microsoft (MSFT -1.27%) own two of the largest public cloud infrastructure platforms in the world. Amazon Web Services (AWS) leads the market, thanks to its first-mover advantage in the space, while Microsoft's Azure ranks second.

Amazon's leading position makes it a top cloud pick for many investors, but Microsoft has become a resilient competitor. Azure is growing at a much faster rate than AWS, and Microsoft's other big cloud services -- Office 365 and Dynamics CRM -- are also posting robust growth.

Let's examine both companies' cloud businesses to see if Microsoft, once considered a slow-growth tech stock, is actually a better cloud play than Amazon.

Image source: Getty Images.

Understanding the key differences

Amazon and Microsoft's cloud businesses can't be directly compared to each other in terms of revenue. All of Amazon's cloud revenues come from AWS, a public cloud platform service that lends out storage space and computing power to companies.

During the first quarter, Amazon's AWS revenue rose 41% annually to $7.7 billion, or 13% of its top line. The unit's operating income grew 58% to $2.2 billion, or half of Amazon's operating profits. The growth of AWS' higher-margin business traditionally offsets the lower margins of Amazon's marketplace businesses.

Microsoft's "commercial cloud" revenues rose 41% annually to $9.6 billion, or 31% of its top line, during the first quarter. That business initially seems larger than AWS, but only a portion of those revenues come from Azure, which directly competes against AWS in the cloud platform market.

The rest comes from public cloud software services like Office 365 and Dynamics, which target mainstream end users instead of developers and IT professionals. Microsoft discloses the annual growth rates of those services but doesn't reveal the actual sales figures -- which makes it difficult to draw direct comparisons between AWS and Azure.

Image source: Getty Images.

Will Azure catch up to AWS?

Nomura analyst Christopher Eberle recently estimated that Azure will generate $13.5 billion in revenues in fiscal 2019 (which ends on June 30). AWS generated $25.7 billion in revenues in 2018. If we compare the year-over-year growth rates of Azure and AWS over the past four quarters, we see that the former has much more momentum than the latter:

Year-over-year revenue growth. *Constant-currency terms. Source: Company quarterly reports.

Azure has two big advantages over AWS. First, Microsoft's leading market position in PC operating systems with Windows and productivity software with Office makes it easier to tether big enterprise customers to Azure. Second, brick-and-mortar retailers that compete against Amazon -- like Walmart, Walgreens, and Kroger -- often prefer to use Azure instead of AWS.

Yet Azure won't catch up to AWS anytime soon on revenue, even if it maintains its current growth rate. However, the robust growth rates of both platforms indicate that the market could become a duopoly -- which is bad news for smaller cloud players like Alphabet's Google.

Microsoft also noted that Azure's improving margins boosted its commercial cloud gross margin 5 percentage points annually to 63% during the third quarter -- so it isn't losing pricing power as it competes against AWS. Microsoft believes that new features for Azure, including services for Internet of Things devices and cybersecurity features, will boost its revenues per customer and widen its moat.

Microsoft's other cloud growth engines

Microsoft's cloud software services also make its cloud business more diversified than Amazon's. Office 365 has about 180 million users worldwide. Dynamics 365, which bundles together customer relationship management, sales, and marketing tools, continues to grow in the shadow of larger rivals like Salesforce (CRM -0.57%). Like Salesforce, Microsoft believes that the integration of new AI features will streamline those processes and help companies optimize their businesses.

Here's how Office 365 and Dynamics 365 fared over the past year:

Year-over-year revenue growth, constant currency. Source: Microsoft quarterly reports.

These cloud services are growing at a slower rate than Azure, but their growth rates should stabilize as enterprise spending picks up again.

But is Microsoft a "better" cloud stock than Amazon?

Microsoft became a juggernaut in the cloud market under CEO Satya Nadella, and its overall cloud business is larger than Amazon's. However, Amazon only focuses on the higher-growth cloud platform market instead of the slower-growth software services market, and its core marketplace business is growing at a faster rate than Microsoft's noncloud software and hardware units.

Microsoft and Amazon both own solid cloud businesses, but we can't consider one a "better" cloud stock than the other without examining their other businesses. I personally prefer Amazon for its stronger growth, but Microsoft is still a solid long-term investment with a well-diversified business.