Why Microsoft’s Cloud Could Keep Growing

Microsoft's (NASDAQ:MSFT) cloud business may not post 70% revenue growth quarter after quarter anymore, but that's not to say high double-digit returns won't be the norm for years to come. Expansion in key markets including e-commerce and healthcare are positioning Microsoft for just that kind of future growth. 

Even before the COVID-19 pandemic spread, Microsoft's cloud business was booming as it slowly and methodically chipped away at rival Amazon's (NASDAQ:AMZN) Amazon Web Services lead. But amid the pandemic, with work-at-home the new norm, demand for its cloud services have been surging. 

Office 365 now has 258 million paid seats, while Teams, its collaboration platform has more than 75 million daily active users. Corporations are also seeking out the tech stock's cloud offering, with Azure usage increasing during the pandemic. 

Microsoft ended the fiscal third quarter with gross margins at 69%, up two percentage points year over year. Gross margins in Commercial Cloud jumped four percentage points to 67%, with improvements in Azure's margins driving the increase. Even as Microsoft aggressively competes for cloud business, its cost of doing business is narrowing as it builds a reputation in the market and operates more efficiently. 

Microsoft's gaining on Amazon 

Gross margins in cloud are lower than the overall company's margins because Microsoft is investing more in that segment of its business to narrow the gap between its own cloud operations and Amazon's.
Without a doubt, Microsoft is still a scrappy second-place player, with just 17.6% market share at the end of the fourth quarter. But its share of the market is growing -- up from 14.5% the year before -- which isn't the case for AWS. According to Canalys, Amazon's market share stood at 32.4% at the end of 2019, down from 33.24% in 2018.

Microsoft's also growing its cloud sales significantly faster than Amazon. AWS posted annual revenue growth of 33.2%, compared to 62.3% for Azure. Those rising sales may further accelerate if Microsoft can win new customers in high growth areas such as e-commerce and healthcare. 

E-commerce presents a particularly interesting opportunity for the tech stock. It's one of the few areas that is seeing growth as the pandemic decimates the economy. Look at eBay (NASDAQ:EBAY), which raised its revenue and earnings targets for the current second quarter this week, citing stronger-than-anticipated demand. The e-commerce company added about 6 million buyers in April and May. It's not alone. Shopify (NYSE:SHOP), the e-commerce platform company, blew past Wall Street forecasts for its first quarter on the strength of pandemic demand. 

Online shopping may ease a bit as stores begin to reopen, but in a post-COVID-19 world, e-commerce is going to be a mainstay. That's particularly true if cases of the COVID-19 disease increase in the fall or winter. 

Microsoft has another advantage in e-commerce: It's not competing against the customers it serves, whereas AWS is owned by the world's largest online retailer. Rivals looking to knock Amazon off its throne or even just compete may be reluctant to do business with AWS. A viable alternative -- say, offered by Microsoft -- may give those competitors a reason to switch. 

As it stands, AWS counts many specialty retailers as customers, including Brooks Brothers, Adidas, and Deckers Brands. Microsoft's cloud retail roster is growing to include Walgreens Boots, Gap, Walmart, and Kroger -- many of whom are broader-scale retailers in areas that directly compete with Amazon's ever-growing ambitions.

That leads us to Microsoft's recent deal with FedEx (NYSE:FDX). In May, the two companies announced that they were teaming up to leverage FedEx's logistics network and Microsoft's cloud to help retail and e-commerce customers better track and ship packages. That's a direct assault on Amazon, which has been building its own in-house logistics offering. 

The first service to come of the multiyear partnership between the two is FedEx Surround, which gives customers near-real-time analytics into shipping and tracking. Businesses will be able to track a package down to the zip code level. Microsoft and FedEx are going after any business with a supply chain, but especially businesses focused on fast shipping. And FedEx Surround is just the first of many offerings expected out of the partnership. 

Healthcare is a red-hot opportunity 

Outside of e-commerce, Microsoft is targeting another growing market: healthcare. Companies across the world are racing to come up with treatments and vaccines for COVID-19, and their pursuit requires much more computing power -- and thus, cloud services. Even beyond that, data is a critical part of healthcare advancements, and cloud services provide a way to crunch all of it. Microsoft recognizes that and has positioned itself as a partner during the pandemic and beyond.

It's also segmenting its cloud offerings to better focus on specific industries. In May, Microsoft rolled out Microsoft Cloud for Healthcare, aimed at helping healthcare organizations improve patient engagement, enhance collaboration between medical teams, and provide deeper insight into clinical data. The more it focuses on industry-specific cloud offerings, the better it will be able to serve different customer bases, differentiating itself from AWS. 

AWS may dominate the market today, but with Microsoft going after multiple growing industries, it could be a much more formidable rival in the years to come. Even if it remains in second place, Microsoft's cloud business will continue to be a strong growth driver, given its relatively low market penetration thus far. After all, Microsoft's cloud business has Wells Fargo Securities so giddy that it's predicting Microsoft will have a market capitalization of $2.2 trillion in two years' time.

Whether or not that rosy scenario plays out is anyone's guess. But Microsoft is positioning itself for more cloud growth by chasing e-commerce and healthcare businesses. Success there could fuel the continued rise of both its financial results and its share price.