Microsoft's thriving cloud business set to offset chip shortage headwinds

Microsoft Corp. is expected to report continued double-digit revenue growth for the September quarter on the strength of its cloud business, which analysts predict will offset any slowdown in the company's hardware sales as a global chip shortage drags on.

Supply-chain disruptions related to the critical computing component used in everything from laptops to cars are weighing on manufacturing around the globe, and Microsoft confirmed that its new 2-in-1 tablet computer, the Surface Pro 8, is no exception.

"With such high interest and the same component shortages facing the entire consumer electronics industry, we currently see demand outpacing supply," a Microsoft spokesperson told S&P Global Market Intelligence. "Microsoft is committed to working closely with our industry partners to catch up and again provide customers the full breadth of options we offer with Surface."

Offsetting Microsoft's device sales headwinds are booming cloud sales, fueled by a pandemic-driven shift to remote work that accelerated companies' digital migration plans across the globe.

A cloudy future

Microsoft's Azure cloud-computing product provided the backbone of growth for the company through its fiscal year 2021, and analysts expect that trend to continue. The company's Intelligent Cloud segment, which includes a variety of server products and cloud services, reported revenue of $17.38 billion in the June quarter, up about 30% year over year. That marked an acceleration of the 27% year over year growth reported in the March 2020 quarter, which marked the start of the pandemic when many companies began shifting employees to remote work.

"We are seeing deal sizes continue to increase markedly as enterprise-wide digital transformation shifts are accelerating with CIOs [chief information officers] all focused on readying their respective enterprises for a cloud driven architecture," Wedbush analyst Daniel Ives wrote in a research note predicting that Microsoft would report a "Picasso-like masterpiece quarter" for its September period.

Ives reiterated his "outperform" rating on Microsoft's stock and upped his target price to $375 from $350 on expectations that the company will "handily exceed Street estimates" for its fiscal first quarter.

Microsoft is expected to report about $44 billion in consolidated revenue for the September period, according to S&P Capital IQ consensus estimates.

Ives estimates that only about 35% of Microsoft's Windows operating systems and Office 365 customers have transitioned to the cloud, indicating growth tailwinds that could last a few years.

Jean Atelsek, an analyst working across the cloud transformation team and digital economics unit of 451 Research, said Microsoft's reach with enterprise Office 365 customers allows it opportunities to incentivize the transition to cloud services.

"Microsoft can bundle in credits for Office 365 and Windows licenses to sweeten the pot for companies seeking basic cloud compute and storage services to replace IT infrastructure that they no longer want to manage in their own datacenters," Atelsek said.

Software development platform GitHub, which Microsoft purchased in 2018, is also luring customers.

"Developers have a growing influence in selecting platforms for digital transformation, and Azure's development tools have therefore become more important in attracting organizations to Microsoft," Atelsek said.

The new Surface

Microsoft's Surface revenue declined 20% year over year in its fiscal fourth quarter ended in June, which the company attributed to supply chain constraints. But Eric Smith, director of connected computing devices at research firm Strategy Analytics, said a slow upgrade cycle could also be weighing on Surface sales.

"Surface shipment growth has been stagnant over the last several quarters as their flagship Surface Pro 7 has been around for two years and there hasn't been an update to any of its tablets since May 2020," Smith said. "Microsoft is highly dependent on fresh product to drive replacement sales, so this has hurt the company since Q4 2020."

The tablet's latest model, the Surface Pro 8, brings performance and mobility updates that Smith said could drive sales — if the company can get the devices into customers' hands.

"We expect this [Surface Pro 8] to be big a hit, but the question remains whether Microsoft, as one of the smaller players in the market, can secure adequate component supplies ahead of the holiday season," Smith said.

In a dour sign for the state of the electronics supply chain, Apple Inc.'s new iPhone 13, released last month, is encountering chip shortages as well.

Gaming growth slows

Microsoft's gaming revenue has been growing amid the pandemic, boosted by sales of the Xbox Series X and S consoles that launched in November 2020. However, the company has struggled to keep up with demand for the devices amid pandemic-related supply chain woes, and the chip shortage is expected to weigh heavily on the availability of the consoles in the coming months.

"We're working as fast as possible with our manufacturing and retail partners to expedite production and shipping to keep up with unprecedented demand for our new Xbox consoles," a Microsoft spokesperson told S&P Global Market Intelligence.

On the software side of gaming, Microsoft's Game Pass subscription and cloud-streaming service contributed to the company's 11% growth in overall gaming revenue in the June quarter, but subscriber growth is slowing faster than expected.

In a recent SEC filing, Microsoft disclosed that the Game Pass subscriber base grew by about 37% year over year in its fiscal year ended in June, compared to the company's goal of about 48%. That compares to growth of about 86% year over year in fiscal 2020.

Neil Barbour, an analyst at Kagan, a media research group within S&P Global Market Intelligence, said Microsoft's decision to delay the next installment of its flagship Halo title impacted Game Pass' growth.

"Game Pass was supposed to have Halo Infinite to grow on in 2020, but instead had to settle for a slate of legacy titles it inherited after acquiring Zenimax," Barbour said. "The service's core value proposition is in granting access Microsoft-published games at the same time they hit retail, but Microsoft won't be able to test the power of that message until it delivers a blockbuster or two."

Microsoft will have a clearer picture on Game Pass' subscriber growth potential after some of those big titles start launching on the service, starting with Halo Infinite in December, Barbour said.

Overall, the company's More Personal Computing segment, which includes both Surface devices and gaming-related revenue, reported $14.09 billion in revenue in the June 2021 period, up 9.1% year over year.