Microsoft Shrinking Margins Loom on Cloud Push

By Dina Bass - Dec 19, 2011 12:01 PM GMT+0700

Microsoft Corp. (MSFT)’s push into cloud computing will help the company compete with Google Inc. (GOOG), Apple Inc. (AAPL) and Salesforce.com Inc. (CRM) It also will hurt profit margins.

The company’s cloud software lets corporate customers pay a subscription to do things like manage spreadsheets and corporate websites with software stored and run on Microsoft’s servers. The new services also help users view TV shows and edit photos on the Web.

While that may be great news for customers, the cost of storing software in Microsoft’s own data centers, combined with other expenses, means the company may miss profit estimates for fiscal 2012, said Heather Bellini, an analyst at Goldman Sachs Group Inc. It also means the good old days of outsized margins for the software giant may be a thing of the past, said Jason Maynard, an analyst at Wells Fargo (WFC) Securities.

“Nothing will ever be as high as the old model,” said Maynard, who’s based in San Francisco.

Profit margins, which shrank to a 22-year low in 2011, are set to fall further. Gross margins, or the percentage of sales left after production costs, will narrow 1.6 points to 76 percent in fiscal 2012, the average estimate of analysts compiled by Bloomberg. That’s after a 2.4-point drop in 2011.

The challenge to Microsoft’s margins stems from decisions Chief Executive Officer Steve Ballmer has made in recent years to invest in new businesses, such as adding content for Xbox and acquiring Skype Technologies SA for $8.5 billion.

Rising Costs

The pressure will persist beyond this year as more customers switch to cloud computing, which involves hosting software on Microsoft’s servers and delivered it over the Internet. That shifts the cost of storing and operating those programs to Microsoft.

Microsoft traditionally sold packaged software that, once developed, costs little to manufacture and distribute. In moving more business to the cloud, the world’s largest software maker must take on the costs of running data centers. These expenses include powering, cooling, housing and maintaining servers that run the programs for clients.

Mark Moerdler, an analyst at Sanford C. Bernstein & Co., estimates that cloud-related costs will range from 15 percent to 25 percent of revenue. That’s about 10 percent more than selling standard packaged software, he said.

Goldman Sachs’s Bellini said analysts may not be taking into account a large enough increase in cost of goods sold for the fiscal year ending in June, which could cause Microsoft to miss profit predictions. Even Bellini, who lowered her projection for gross margins and trimmed 9 cents from her overall profit estimate, said she may not have cut enough.

Microsoft declined to comment for this story.

Growth Challenges

Margin pressure is making some investors leery of Microsoft stock, and may weigh on the shares in coming months, said Walter Price, who manages the $3 billion Allianz RCM Technology Fund at RCM Capital Management in San Francisco.

The shares, which gained 1.7 percent to $26 on Dec. 16, have declined 6.8 percent this year before today.

Microsoft was already facing a challenging year for profit growth. The European debt crisis and a sluggish economic recovery have prompted government and financial customers to pare spending, while the PC industry is reeling from flooding in Thailand that has slashed production of hard drives.

Companies will boost spending on software and computers at a slower rate next year than 2011, according to Gartner Inc., which said it may cut its forecast even further at the end of the quarter. Hewlett-Packard Co. (HPQ), the largest computer maker, last month said it’s started to see businesses curb spending.

Xbox Content Fees

Microsoft’s product cycles also point to a year of slower growth in its flagship Windows and Office software businesses, according to Rick Sherlund, an analyst at Nomura Holdings Inc. The two divisions will expand more slowly this year as customers wait for an update to the Windows operating system, which Sherlund expects in October. Microsoft is likely to follow that with a touch-enabled version of Office productivity software, he said.

At the same time, costs are rising across businesses. Microsoft’s Xbox game consoles, which are selling well, are more expensive to manufacture than software, and the company is paying more licensing fees for content to run on the Xbox Live service.

The addition of Skype, increased demand for consulting services in the server business, and costs of Microsoft’s search partnership with Yahoo! Inc. are also adding to the jump in expenses.

Need for Scale

Including the impact of Skype, operating expenses for the year will be as much as $29.2 billion, up from a previous forecast of $28.6 billion, Microsoft said in October.

Reining in cloud computing costs will be key, and that will depend on how efficient Microsoft can become at running its massive data centers. The company will need to attract large numbers of cloud customers to get the services running at scale. And it will have to remain vigilant on data-center energy and cooling costs, said Sanford C. Bernstein’s Moerdler.

“They should be able to be pretty efficient and they should be able to generate net more revenue so the margin will go down, but earnings per share will go up,” he said. That’s in line with Microsoft’s own forecasts since starting its move to the cloud.

To contact the reporter on this story: Dina Bass in Seattle at dbass2@bloomberg.net.

To contact the editor responsible for this story: Tom Giles at tgiles5@bloomberg.net.