Microsoft cloud revenues and investments

Two recent reports attracted my attention. First, at Microsoft’s Worldwide Partner Conference, Steve Ballmer noted that Microsoft runs more than one million servers in its datacenters. Second, Microsoft CFO Amy Hood said that Office 365 revenues are now running at $1.5 billion annually.

Both figures are impressive but as always, the devil is in the detail. James Hamilton, ex-Microsoft and now an Amazon VP, took a look at the server number and calculated that the cost of putting this hardware in place is in the order of $4.25 billion, of which between $1.45 and $2 billion is the capital cost for the million servers, plus or minus a few hundred million dollars, depending on the exact configuration of the servers and whatever discount Microsoft managed to extract from the vendors. Throw in networking, storage, operations, and other costs and the economics of putting these massive multi-tenant cloud infrastructures come into view.

The exact annual running cost of the Microsoft datacenters is not clear, but obviously keeping a million servers going consumes a lot of power and cooling, not to mention the operations (people) and support costs. In addition, build-out costs continue to add resources to deal with customers who want to use the new services plus you have the costs of managing the migrations. Then we have to factor in ongoing software development to create and upgrade services like Office 365 and Windows Azure. In addition, there’s the ongoing investment such as the $500m reported by the Sunday Times (July 21) for a new datacenter in Dublin that is required to provide extra space to allow for growth in customers. In short, this is a very expensive business indeed.

Scale is important when you’re selling mailboxes at $6 a month. The $1.5 billion number looks big but it’s not clear how much of it is due to Office 365 cloud services and how much is down to the new Office 365 subscriptions covering the traditional Office desktop applications. Just for kicks, let’s say that $1 billion of it is revenue for cloud services and that an “average” cloud consumer pays $10/month. This means that Office 365 might have about 8.3 million paying customers at this month. The number of actual users is probably higher because Office 365 also supports Microsoft employees . It might be lower too, if the average revenue per user is more than $10/month like the $15/month that Microsoft charges for Office 365 Midsize Business in the U.S.

Azure also delivers some revenue. Bloomberg reported that the Azure and associated programs had passed the $1 billion annual sales landmark in April 2013. Between Office 365 and Azure, Microsoft might therefore be seeing cloud services revenue just north of $2 billion annually.

Put another way, even though the hype is definitely flowing with “the service”, the number of actual paying customers is not particularly high when compared to the number who use on-premises Windows or even those who use Google’s services, all of which are cloud-based. For example, the Radicati group estimated the number of Exchange users at 360 million in 2011, 76% of which were classic on-premises deployments with the remainder spread across cloud and other managed services (many other companies offer hosted Exchange to compete with Office 365).

Microsoft’s latest financial results tell us that cloud services are not currently producing sufficient revenue to realize a return on the investment that Microsoft has made to date to create and run their datacenters. It will be interesting to see how quickly Microsoft can persuade customers to move from on-premises to cloud services to allow them to balance income with expenses. Cloud adoption is accelerating but these numbers prove that a very large transition must happen before profits can accumulate.

Of course, I am not a professional analyst and this interpretation is based on a small number of articles that have attracted my attention. I wouldn’t go and take a punt on Microsoft stock based on this analysis!

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