Windows 10 logo. Source: Microsoft.
Microsoft (MSFT 2.51%) increasingly depends on its many cloud services, including Office 365 and Azure. These products, while united by their dependence on Microsoft's data centers, exist independently and serve different needs.
Yet the success of one may help fuel the others. On Microsoft's most recent earnings call, management highlighted a seemingly unlikely set of network effects -- ones that could ultimately benefit Microsoft shareholders.
The importance of the cloud
Historically, the bulk of Microsoft's business was generated by the sale of software licenses: Demand for copies of Windows and Office generated most of Microsoft's revenue over the last three decades. But more and more, Microsoft is shifting its focus to the cloud. Windows and Office remain vitally important, but for long-term investors, Microsoft's emergence as a cloud computing giant is more substantial. Microsoft sells cloud services to consumers (Office 365, Xbox Live), but its enterprise offerings are more significant. In recent quarters, it's offered investors insight into the health of its commercial cloud business through a single metric.
Microsoft's commercial cloud annualized revenue run rate is a figure that represents the amount of annual sales Microsoft's various enterprise cloud services could collectively generate were they to sustain their current demand over the course of a year. Over the last three years, it's soared from about $1 billion to over $9.4 billion. That rapid growth is expected to continue -- Microsoft's management sees the figure topping $20 billion by its fiscal year 2018.
Office 365 driving Azure and vice-versa
Microsoft's enterprise cloud services compete in several different segments. Office 365 (the cloud-based alternative to its popular Office productivity suite) competes with other spreadsheet, presentation, and text editors, Azure competes with Amazon Web Services (AWS), and Dynamics CRM competes with Salesforce. At first glance, these products appear disjointed -- what does a spreadsheet editor like Excel have to do with a cloud computing platform like Azure? But although they serve different needs, they work well together.
On Microsoft's earnings call in January, CEO Satya Nadella noted an interesting trend Microsoft was seeing with its customers.
We see that Azure customers who also purchase Office 365 consume eight times more Azure than other customers. More than 70% of the Fortune 500 have at least two different Microsoft cloud offerings, up 13 points year-over-year.
Later in the call, Nadella added additional color.
...we also see network effects between -- if you are using Office 365, you want to extend the data in Office 365 by building applications that join it with some other data inside of our data link service in Azure. Obviously Azure becomes the natural choice for such application development. And we are increasingly seeing that. That's really our strategy. Our strategy is not to complete in these constituent parts independently with different competitors. It is to bring one architecture and really drive the value for our customers because of that.
In other words, Office 365 and Azure complement one another, and firms that use one have a natural incentive to rely on both. Cloud apps that run on Azure can pull data from Office 365; Office 365 apps can be beamed to any device using Azure. In this way, Microsoft has an advantage over its cloud competitors, as it can leverage its multiple offerings to sell a more complete solution.
Azure revenue rose 140% on a constant-currency basis last quarter; revenue from commercial Office 365 subscriptions rose 70%. Those are exciting figures, and as Microsoft's customers increasingly rely on the company for several different cloud services, it appears it will hit its $20 billion target.
