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Microsoft's Azure makes it the ‘cloud king,’ analyst says

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Piper Sandler Cloud Software Analyst Brent Bracelin joins Yahoo Finance Live to discuss Microsoft revenues, its cloud business, and better-than-expected earnings.

Video transcript

BRAD SMITH: Welcome back to Yahoo Finance Live, everyone. Taking a look at shares of Microsoft here on the day, as we've got big news for big tech. Microsoft reporting its fiscal Q2 earnings, beating analyst revenue expectations by almost a billion dollars. The tech giant also announced its cloud services Azure revenue. That jumped 46%. That's down a bit from its 50% jump in Q1.

For more on this, we welcome in Piper Sandler equity research analyst Brent Bracelin joining us today. Brent, let's dive right into this because you actually believe that Microsoft Azure could double within three years. So where do you believe the business could continue to drive increased adoption leading up to an en route to reaching $80 billion, is the number that you've got?

BRENT BRACELIN: Yeah, I mean, so if you think about the opportunity in cloud, we see an incremental trillion dollars of revenue. The overall enterprise stack is about $2 trillion. If you take the 100 largest cloud players, we're about $290 billion. So that puts cloud penetration at about 15%, with Microsoft being the cloud king here. They have about 28% market share. That's the highest market share out of all the cloud vendors. But there's still a long runway to help these large enterprises transform their models, digitize their businesses, and really run more and more of their applications on Microsoft itself.

And so, yes, the crown jewel for Microsoft is Azure. It's 20% of the business. But as you cross over that $40 billion threshold this quarter, you can see that as it becomes a bigger part of the Microsoft business, grows from $40 to $80 billion, that's going to change the growth trajectory of the business. Most importantly is that not only is Azure changing the growth trajectory of Microsoft's business overall with that mix shift to Azure, but it's also driving incremental profitability. This is a company that generated 43% operating margins, even with all of the investments they're making in the cloud.

AKIKO FUJITA: Brent, even with that said, investors initially yesterday, when those numbers came out, weren't exactly wowed. And we're talking about Azure with, as we're showing, 46% revenue growth, and yet, the expectation seemed to be that things would go even higher. Essentially, Microsoft just matched the expectations that were out there. And I wonder what you think this says about just how jittery the tech trade is. Microsoft shares didn't actually bounce back until we heard from CFO Amy Hood, who said, look, the demand is still really strong.

BRENT BRACELIN: Yeah, I mean, listen, there's hypersensitivity to the cloud group. Right now, this is a group that's down about 50% since from the highs in November. We're down 20%. The whole 100, cloud 100, it's down 20% year to date. So a lot of concern around the sustainability of cloud growth. That's why there's hypersensitivity when Azure downticked from 48% FX adjusted growth last quarter, 46% growth this quarter, there was some initial reaction and concern that that may be the beginning of a slowdown.

Microsoft clarified they actually think Azure is going to reaccelerate. More importantly, leading indicators for the cloud business, their CapEx spend accelerated, their bookings accelerated. So there are other inputs that people didn't see initially that did give people confidence that, hey, this cloud transition is still very, very strong. Demand signals are very strong across the whole entire stack of Microsoft products.

BRAD SMITH: We're also, on the screen here, taking a look at Xbox content and services revenue. That was up by about 10%. And it was going to be noteworthy what the executives had to say about this most recent blockbuster acquisition of Activision Blizzard. Of course, it still needs to get through in entirety.

However, as of right now, are you impressed by what the company has been signaling around what they're intending to do, how immediately accretive it could be in the future, and what type of contribution that it can make to margins in the future, too? Because it's margins from the cloud business that allows them to continue to make some very large strategic acquisitions such as this.

BRENT BRACELIN: It's interesting. Most people give Microsoft a lot of credit for their commercial cloud business. That's the growth engine of the business. But Microsoft still has a pretty impressive consumer business. It's small. I look at Activision Blizzard as really a strategy around consumer and driving share gain opportunities beyond just cloud, but also now on the consumer side. That's a big content. Microsoft's generating close to $70 billion a year in free cash flow, so essentially able to pay for the entire acquisition of Activision Blizzard with one year of cash flow.

So I think it's a better use of cash than Microsoft sitting on $120 billion of cash today. And I do think it's a really strategic asset as you think about them getting into the content side on the consumer space, particularly as you think about different ways to monetize the content that Activision Blizzard King have, be it in gaming today or the new Metaverse market. So content skiing, they're getting in that consumer space. And I'm certainly constructive on the combination here.

AKIKO FUJITA: And Brett, you've got a price target of $352 a share. We're right under that about $300. What do you think is the biggest risk right now for the company? I mean, you know, now that we're seeing investors sort of digest the numbers with the commentary got on the call, certainly the outlook is positive. But what's the biggest thing that could potentially derail that?

BRENT BRACELIN: You know, listen, there's lots of things to be worried about as we think about external factors. But ultimately, we believe as you think out beyond some of the external factors, even going back to 2004 to 2006, this concern around FOMC rate hikes, the FOMC raised rates 17 times from 1 and 1/4 to 5 and 1/4 between 2004 and 2006. And guess what companies and stocks did really well? High growth, high tech names.

So, listen, I think there are a lot of concerns. There's a lot of issues about Microsoft. There's a large cap was up over 50% last year into basically November before the sell-off. And so I think we're going through kind of this fundamental, growing into the multiple. Valuation is still a big risk. But as we think about large cap software names, Microsoft is one of the best names in our coverage list here that has very durable growth, irrespective of some of these external factors that are certainly going to weigh in valuation.

AKIKO FUJITA: Brent Bracelin, Piper Sandler equity research analyst, cloud software and analytics, good to get your insight today. Appreciate you stopping by.

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