Please ensure Javascript is enabled for purposes of website accessibility

3 Things to Know About Microsoft's Hottest Growth Engine

By Leo Sun - Oct 27, 2019 at 12:02PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Azure’s margins are still expanding as it grows at a faster rate than AWS.

Microsoft's (MSFT 1.29%) stock recently popped after the tech giant's first-quarter numbers easily beat analysts' expectations. Its revenue rose 14% annually to $33.1 billion, topping estimates by $860 million and marking an acceleration from its 12% growth in the fourth quarter. Its EPS increased 21% to $1.38, beating expectations by 14 cents.

Microsoft attributed most of that growth to its commercial cloud business, which grew its revenue 36% annually to $11.6 billion and accounted for 35% of its top line. That business' core growth engine is Azure, the world's second largest cloud infrastructure platform after Amazon (AMZN 4.03%) Web Services (AWS). Let's discuss three key facts Microsoft disclosed about the closely watched division during its quarterly report.

A cloud logo on a computer chip.

Image source: Getty Images.

1. It's growing at a faster rate than AWS

Microsoft's Azure revenue rose 63% annually in constant currency terms during the first quarter (59% as reported). This marked a deceleration from its previous quarters, but it was milder than its drop between the third and fourth quarters of last year:

Azure

Q1 2019

Q2 2019

Q3 2019

Q4 2019

Q1 2020

YOY revenue

76%

76%

75%

68%

63%

YOY = Year-over-year. *Constant currency terms. Source: Quarterly reports.

Microsoft doesn't disclose Azure's exact revenue, but Nomura analyst Christopher Eberle estimates that it generated $13.5 billion in revenue in fiscal 2019. AWS generated $25.7 billion in revenue for Amazon last year, but the unit posted just 35% annual sales growth last quarter.

Azure continues to gain ground against AWS for two main reasons: Microsoft bundles its services with its other market-leading software products (like Windows, Dynamics, and Office 365), and it attracts big enterprise customers -- especially retailers -- which don't want to feed Amazon's most profitable business.

2. Its margins are expanding

The gross margin of Microsoft's entire commercial cloud unit -- which includes Office 365, Dynamics 365, Azure, and other related services -- grew four percentage points annually to 66%. During the conference call, CFO Amy Hood noted that within that business, a "significant improvement in Azure gross margin offset a sales mix shift to Azure." In other words, Azure's gross margin remains lower than that of its other cloud services, but it's improving as its scale increases.

Hood noted that within the Intelligent Cloud segment, which generated $10.8 billion in revenue during the quarter, a "material improvement in Azure gross margin was partially offset by a growing mix of Azure IaaS (infrastructure-as-a-service) and PaaS (platform-as-a-service) revenue," which "slightly" boosted the unit's total gross margin.

This means that Azure's core IaaS/Paas platform, which competes against AWS and other rivals, still generates lower margins than the add-on services it cross-sells to enterprise customers. But that still marked a significant improvement from the fourth quarter, when Hood noted that the Intelligent Cloud unit's gross margin stayed "flat year-over-year" as Azure's lower IaaS/PaaS margin and higher add-on service margins canceled each other out.

3. More services, more customers

One of Azure's biggest add-on services is Azure AI, which offers a suite of AI tools for analytics, automation, and other services. Microsoft claims that Azure AI now serves over 20,000 customers, and that more than 85% of the Fortune 100 used those tools over the past 12 months.

Microsoft noted that the healthcare sector is a key growth market for Azure AI. Novartis uses the tools to develop new treatments, while Humana deploys them to build personalized healthcare solutions for over ten million members.

A visualization of network connections across a city.

Image source: Getty Images.

Another add-on service is Azure Sphere, a Linux-based OS that links Internet of Things (IoT) devices on the "edge" of traditional networks to Azure. Starbucks, for example, connects its coffee machines to Sphere to identify potential maintenance problems before they occur.

Hood noted that all those add-on services contributed to Azure's "material growth in the number of $10 million plus contracts" during the first quarter.

Azure means a lot to Microsoft

Azure remains the underdog in the cloud platform race, but it's still growing at a faster clip than AWS, with plenty of irons in the fire. Investors shouldn't fret over its gradual deceleration, since its margins are still expanding as its ecosystem grows and locks in more customers.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Microsoft Corporation Stock Quote
Microsoft Corporation
MSFT
$265.90 (1.29%) $3.38
Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$2,221.55 (4.03%) $86.05

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
332%
 
S&P 500 Returns
118%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/27/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.