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Blue Skies Ahead for Microsoft's Azure

We see a massive market opportunity for the undervalued company.

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We think the market opportunity for IaaS and PaaS numbers in the hundreds of billions, as large public cloud vendors will consolidate IT spending that was once allocated to disparate vendors around a small handful of strategic providers. We view Microsoft as one of those strategic providers, and we believe its Azure offering will grow at a 31% compound annual rate over the next 10 years, eventually contributing north of 35% of total revenue by the end of our explicit forecast period compared with an estimated 9% in fiscal 2018.

We also view the opportunity around Office 365 as one of the most important long-term growth stories for the company. Office 365 is now larger than the legacy Office business, and we expect Microsoft to enjoy the natural uplift in lifetime customer value that comes with a migration to a high-retention subscription model. We think the company provides a better value to consumers across applications and storage, reflected in its 30 million-plus consumer subscribers.

Microsoft remains one of the highest-quality operators in enterprise software today, and we believe the business is starting to pick up steam as it works through declines in its legacy businesses. Shareholders can also reap the benefits of a robust capital-return program that has returned more than $70 billion to shareholders in the past three years by way of dividends and share repurchases.

Opportunity and Responsibility CEO Satya Nadella's keynote address at Build centered on two themes: opportunity and responsibility. Microsoft's opportunity in the cloud remains massive and arguably as large as any major technology company when considering Azure and Office 365, which remain the key drivers of our long-term thesis for the company. More than 90% of the Fortune 500 have begun consuming services under the Azure umbrella, but Microsoft continues to innovate at a rapid pace. The company released 130 new services in the past year, with an additional 70 set to be released at this year's Build conference. We believe this constant stream of innovation will support not only general Azure adoption but higher-value premium services that will ultimately work to lift customer switching costs in Azure and lift Commercial Cloud gross margins.

With respect to responsibility, Nadella highlighted the need to empower users and organizations as the sole arbiters of control over proprietary data. Although Microsoft is not a neutral player when it comes to data monetization, it can probably use recent data scandals as further ammunition to encourage enterprise migrations into its highly securitized, hyperscale data centers.

Nadella’s comments were undoubtedly fueled by major privacy breaches at companies such as Facebook and heightened scrutiny around companies, such as Alphabet GOOG, that are actively engaged in data monetization. Microsoft’s data security strategy in the cloud has three core pillars: rights to privacy, cybersecurity, and ethical deployment of artificial intelligence. The company has instituted policies and controls around all three of these themes as it builds and markets new services for Azure and its broader business, evidenced by the hundreds of engineers Microsoft employs for compliance certification and preparation for regulatory adoption, such as the European Union’s General Data Protection Regulation. Microsoft’s efforts on this front also led to this year’s passage of the Cloud Act, data privacy legislation that was borne out of a 2013 lawsuit levied by the U.S. government. All in, we continue to view security and data integrity as a reason for, not against, migrating to the cloud, and we are encouraged by Microsoft’s continued efforts on these fronts.

Microsoft continues to deliver robust innovation and scale within Azure, resulting in more than 50 Azure regions globally and more than 70 certifications, putting the company on level ground with Amazon Web Services. Perhaps the most encouraging developments at Build were the progress made on newer services such as Azure Stack and Azure Cosmos DB. Both of these services were center stage at Build last year, and their rate of adoption appears to be surging. We continue to view Azure Stack as an important differentiator for Microsoft, because it addresses hybrid cloud customers. We heard several examples of customers across numerous industry verticals leveraging Azure Stack for hybrid cloud deployments, including companies such as Schlumberger, which is pushing cloud services developed in Azure Public Cloud out to its private cloud operations on oil rigs via Azure Stack.

Nadella disclosed during Microsoft’s fiscal third-quarter conference call that Cosmos DB had exceeded a $100 million annualized run rate, and while Microsoft rivals Amazon (DynamoDB) and Google (Cloud Spanner) offer globally scaled, highly available database solutions, we view Cosmos DB as another service that will lower the barriers to cloud adoption for Microsoft’s existing large enterprise customers, particularly given the number of connectors Microsoft makes available for migrating data into Cosmos DB. Further, Cosmos DB has risen the most in popularity among these three offerings in the past year, according to DB-Engines. We also view these services as a blow to Oracle ORCL, which lacks a viable answer to services such as Cosmos DB, given its subscale public cloud offering. Oracle continues to hold the top two positions in database popularity, according to DB-Engines, but these solutions (Oracle Database and MySQL) have seen their respective index scores fall 5% and 9% in the past year.

Finally, we continue to hear strong development initiatives around Azure IoT. Microsoft announced a number of partnerships and developer kits at Build, including a computer-vision-enabled camera from Qualcomm that can run Azure cloud services at the edge and a developer kit release for DJI’s commercial drones. While these might signal potential consumer-oriented uses down the road, the bulk of the demos we saw at Build revolved around commercial uses such as productivity or intelligent maintenance, which we think better aligns with Microsoft’s core competencies. At the very least, we think greater entrance into intelligent devices for Microsoft will come more from the software development angle and hardware partnerships, such as Cortana-enabled smart speakers from vendors such as Harman Kardon. The company did showcase tighter integration between Cortana and Amazon’s Alexa, which could help drive Microsoft’s artificial intelligence prowess, but Cortana’s contributions remain closely tied to business functions, while Alexa’s capabilities focus more closely on consumer processes.

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