3 Reasons Microsoft Is Not Done Growing

Software giant Microsoft is essentially the landlord of technology: Much of the world’s tech depends on its systems for a place to live and work. While Microsoft is a long-standing blue-chip stock, it also has quite a few exciting prospects for growth investors.

Despite the company’s 19% revenue growth and 44% net income growth in the third quarter of fiscal year 2021, the stock has fallen about 5% since it reported those results in late April. Looking to the company’s future prospects, this short-term dip shouldn’t stop you from considering Microsoft for your portfolio.

Azure gaining on AWS

In 2019, Microsoft won a contract with the U.S. Defense Department to provide services to the Pentagon through its cloud computing business, Azure. Microsoft beat out Amazon‘s AWS for the $10 billion deal, signaling that Azure is gaining on AWS as a market leader in the space.

AWS still claims most of the market share in cloud computing, but Azure’s revenue is growing faster year over year at 50% than AWS’s at 32%. Azure’s growth can be attributed to its strong competitive advantages over AWS on pricing, and its integration with Microsoft 365, with special cost savings such as three years of free security upgrades for companies already using Windows Server or SQL Server. Over 95% of Fortune 500 companies now use Azure — a dominant and growing position that Microsoft surely owes to the decades of trust built upon major American corporations relying on Windows Servers and operating systems.

Growth in the Azure segment is great news for Microsoft’s profitability because the company’s cloud sales are high-margin compared to its overall business. While Microsoft reported its commercial cloud gross margin at 70% as of its third-quarter earnings report (up 3% year over year), the company does not reveal its margins specific to Azure.  It does, however, specify that Azure’s margins are improving steadily as the segment grows.

Gaming going digital

Microsoft’s successful release of the Xbox Series X and Xbox Series S in late 2020 helped bring the company’s gaming revenue to 9% of its total revenue.  Hardware sales alone don’t tell the whole story, though.

Microsoft’s Xbox Game Pass is like a Netflix for Xbox, allowing gamers unlimited downloads from an extensive digital library of popular games for a monthly fee. The service has reportedly attracted over 23 million subscribers, up 5 million since this January. Sony does not offer a service for its competitor console PlayStation that matches Xbox’s Game Pass in terms of access to a broad selection of new, exclusive games.

This competitive edge is important because Microsoft’s growth in the gaming industry will likely be largely digital and subscription-based. In the third quarter, Xbox content and services revenue (i.e., not including hardware sales) increased 34% year-over-year as its Game Pass became the industry darling. This focus on digital growth is sure to increase margins — both Microsoft and Sony sell their physical consoles at a loss with the long-term strategy of securing loyal customers and recurring revenue through digital offerings.

The better Microsoft’s digital gaming offerings get, the less likely loyal Xbox users are to switch teams and pay their valuable recurring subscriptions to PlayStation or elsewhere. The network effects in the gaming space are powerful — friends are more likely to play games together if they all use a service like Game Pass, and the social aspect of modern gaming cannot be overstated.

Office moving to the cloud

The Microsoft 365 (previously called Office 365) software subscription suite enjoys a virtual monopoly in the office productivity software space, with nearly 90% of the market share. Microsoft 365 includes traditional Office products like Word, Excel, and Outlook as well as newly popular products like Teams, the free business communication platform. Teams has doubled its daily active users year-over-year to 145 million as of the third quarter.

A key point in the office productivity business segment is Microsoft’s wide competitive moat. Switching costs, which include factors like time lost retraining a workforce on new software, translate to a significant competitive advantage for Microsoft. Additionally, although Teams is a free product, it contributes to Microsoft’s competitive moat by introducing users to the Microsoft 365 software suite, which makes up about 22% of the company’s total revenue with higher margins than its traditional software sales, and encouraging paid upgrades for additional storage, security, and collaboration among other Microsoft apps. These factors work together to help Microsoft “land and expand” new paying, long-term customers through Teams.

And that’s not all

Beyond these three business segments, Microsoft has a promising future with LinkedIn, its ubiquitous yet largely unmonetized professional social network. Revenue from Microsoft’s Dynamics 365, which provides enterprise resource planning (ERP) and customer relationship management software, increased 45% year over year in the third quarter and has become a significant profit driver for the company. The stock has been cheaper in the past in terms of P/E ratio, but its current ratio of 34 is well worth it for the company’s growth prospects, competitive moat, and massive market share.

Amazon is pursuing a lawsuit to protest the Defense Department’s selection of Microsoft’s bid over its own, claiming that political intervention lost AWS the contract. If Amazon wins that lawsuit, it could throw a short-term wrench in Azure’s relationship with the DoD. With that said, Microsoft has a more recent $22 billion government contract in the works to provide augmented-reality headsets to the Army, and the lost $10 billion in DoD revenue would not have a large impact on Microsoft’s top line, representing only about 6% of the company’s trailing 12-month revenue. Investors considering getting in on Microsoft should  nonetheless keep an eye on Azure’s continued traction in the cloud computing space, especially relative to AWS.