Microsoft's (MSFT -2.45%) cloud business is booming, as work-at-home becomes the new normal amid the COVID-19 pandemic. At the same time, the rest of its operations are being hurt by the same forces driving demand for its cloud services. It's unclear which will win out, or even whether the increased usage for cloud services will cushion some of the blow from the pandemic. Investors will want answers to that question when Microsoft reports third-quarter earnings this week.
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1. How bad is the hit to the PC unit?
Microsoft already warned investors that the pandemic would hurt its PC unit this quarter. But it only withdrew its target for its More Personal Computing segment, leaving the rest of its businesses alone.
That spooked investors, but the stock quickly recovered thanks to the tech stock's cloud business; as the company's most likely growth driver now and into the future, it typically draws the bulk of investors' attention. Its Azure cloud alone has posted high double-digit growth for more than eight quarters in a row. But Microsoft's More Personal Computing Segment, at the center of the warning, is also important, accounting for 36% of the company's total revenue. In the second quarter, the unit posted revenue of $13.2 billion, up roughly 2% year over year.
More Personal Computing includes Windows, Surface devices, and gaming including Xbox. Microsoft had originally expected it to bring in revenue between $10.75 billion and $11.15 billion but withdrew that target without offering a new one. We'll soon know just how badly this segment suffered in the most recent quarter, but it's more important to figure out how long that pain will last -- and what Microsoft is doing to counter it.
Even as Microsoft tries to move more customers to the cloud, it still gets a healthy chunk of its revenue from selling licenses for its Windows operating system to computer makers. This business isn't a huge growth driver, expanding sales in the high single digits each quarter for the last 18 months -- but the pandemic may change that, at least in the short term.
Work-at-home mandates across the world are requiring companies to shell out money for new computers, printers, and other office equipment. That may drive an uptick in orders for PCs -- and thus, Windows 10 licenses -- in the near term. But after that initial spike, companies will likely have less need to purchase more hardware. And a one-time surge won't reverse the global PC market's slow but steady state of decline.
Microsoft is trying to counter that shrinking market by getting consumers to purchase its software on a subscription basis. It's newly rebranded Microsoft 365 offering, including Office and other cloud-provided services, already has more than 38 million subscribers. To further entice consumers, it just launched monthly subscription plans for families and individuals. Rather than trying to get customers to buy new software and operating systems every few years, Microsoft now hopes they'll pay a smaller but more consistent amount every month. If Microsoft is successful in getting consumers to pay monthly for its productivity software, it means even more recurring revenue for the company. Any color Microsoft has on subscriptions could allay concerns about a decline in PC demand amid the pandemic and beyond.
How product development for Surface and gaming are faring will also be of importance. Microsoft is still expected to roll out new Surface devices this spring despite the pandemic, and the new Xbox Series X game console is still expected in time for the 2020 holiday season. If Microsoft delays that and misses the busiest shopping season of the year, it could be worrisome for the overall performance of that business segment.
2. Is cloud growth sustainable for years to come?
One of the reasons Microsoft's stock is up so far this year, despite the COVID-19 pandemic, is its cloud business. Demand had been strong prior to the virus outbreak, but now it's skyrocketing. With everyone working at home, usage for its collaboration software and its videoconferencing platform have been climbing.
At first blush, the usage is impressive, but will that growth still be there a year from now? What about two, three, or five years out? If work-at-home is the new normal, does that mean demand continues unabated for the years to come?
Outside of its software in the cloud, Microsoft is waging a cutthroat battle with Amazon (AMZN -1.65%) to win corporate cloud customers at a time when that particular business is seeing a slowdown. After two consecutive years of more than 70% growth for Azure, July saw that revenue expansion decline to 60%.
Microsoft may be able to provide upside, however, if it inked more deals with new cloud customers during the pandemic. These contracts last several years, boding well for Microsoft over the long term. During the pandemic, it's already inked a multiyear deal with the NBA, , a five-year cloud contract with Coca-Cola (KO 0.31%), and an expansion of its partnership with Adaptive Biotechnologies (ADPT 0.39%) to focus on COVID-19 research. With rivals like Amazon breathing down its neck, Microsoft's cloud margins may suffer, something investors should pay attention to.
When it comes to the COVID-19 pandemic, uncertainty is the only certainty. Nobody knows how long it will last, or what economic impact it will have. Microsoft doesn't have a crystal ball, but it can and should offer up insight into where it's been and where it's going. That tale may be a positive one, with cloud cushioning the blow from the PC weakness. Or it may be one in which the pandemic is too steep to easily overcome. But given that Microsoft has $134 billion in cash and short-term investments, and a still-growing cloud business, it's looking more like a safe haven than a highly exposed tech stock. If cloud demand is able to offset the blow from the pandemic, and Microsoft paints a picture of a stronger company emerging once the virus is contained, it could remain a compelling investment during the pandemic and beyond.
