Microsoft CEO Satya Nadella addresses shareholders during Microsoft Shareholders Meeting in December 2014 in Bellevue, Washington. The meeting was the first for Nadella as CEO. (Photo by Stephen Brashear/Getty Images)

Microsoft CEO Satya Nadella addresses shareholders during Microsoft Shareholders Meeting in December 2014 in Bellevue, Washington. The meeting was the first for Nadella as CEO. (Photo by Stephen Brashear/Getty Images)

The Billions in Data Center Spending behind Cloud Revenue Growth

The downside of having a thriving cloud services business is the enormous amount of money a company needs to spend on data center infrastructure to support it. And the faster it grows, the more money it needs to spend.

Every quarter, cloud giants Amazon, Microsoft, IBM, and Google collectively spend billions of dollars on servers and other hardware for their cloud services and data centers around the world to house all that gear, and the quarter that ended September 30 was no different.

It’s difficult to distill the exact amounts companies spend on data centers. They are not required to disclose those numbers and usually lump them in with other capital expenditures. Cloud service providers do, however, consistently say that data center spend represents the biggest portion of their capital expenditures.

Microsoft, for example, spent $1.5 billion in the last quarter to support demand growth for its cloud services, Amy Hood, the company’s CFO, said on the earnings call with analysts Thursday. Google’s capital expenditures for the quarter were about $2.4 billion, spent primarily on production equipment, data center construction, and facilities.

On Amazon’s earnings call, also on Thursday, Phil Hardin, director of investment relations at Amazon, said data center expenses that go into expanding or establishing cloud regions are “really lumpy,” meaning it requires spending big sums in short periods of time to deploy new data center infrastructure to support the rapidly growing and highly profitable Amazon Web Services business.

Own or Rent? Both

All major cloud providers also use commercial data center services to varying degrees to expand their reach beyond the big “web-scale” facilities they build around the world. IBM does it more than the others. SoftLayer, for example, is a major customer of Digital Realty Trust, a primarily wholesale data center provider.

But the others use “third-party” data center capacity too, be it multi-megawatt wholesale facilities or small footprints in network-rich retail colocation data centers.

One leased data center site AWS has disclosed publicly is a Corporate Office Properties Trust facility in Ashburn, Virginia. To extend cloud infrastructure to China, both IBM and Microsoft have partnered with Chinese data center provider 21Vianet to take their services to that market.

Making the Margins Work

In addition to lease and the capital expense of building data centers, there’s also the operational expense of powering and operating them, and all those costs obviously have direct impact on profit margins.

“Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved,” Microsoft said in its earnings documents filed with the SEC.

Despite the costs, AWS has managed to improve its margin dramatically from one year ago, going from about 8 percent in Q3 2014 to 25 percent in the last quarter.

Microsoft’s cloud margin is also a positive story. The company’s gross margins dropped substantially last quarter from deferred Windows 10 revenue and from lower margins from personal computing, productivity, and business processes products, but a higher gross margin from the Intelligent Cloud segment, which includes Azure, server products, and enterprise mobility, somewhat helped offset the overall margin drop.

Public Cloud is Only Part of the Picture

Even though Microsoft’s public cloud infrastructure services revenue is growing, taken alone it still pales in comparison to Amazon’s (as does IBM’s and Google’s). AWS made $3.2 billion in revenue and $420 million in profit in the last quarter.

Microsoft and IBM, however, due to their long legacy selling on-premise solutions to enterprises, have strong hybrid cloud strategies that yield substantially higher revenues than their public cloud services by themselves.

Asked by an analyst whether Microsoft Azure was eating into the company’s on-prem business, Hood said it wasn’t. “I do expect both to grow,” she said.

Microsoft doesn’t think of Azure “in isolation,” the company’s CEO Satya Nadella said on the call Thursday. It views its on-premise data center software, such as its ubiquitous server products, as extension of the cloud as a whole. It combines with Azure into a distributed hybrid cloud.

“Azure revenue and compute usage more than doubled year over year,” Nadella said. The company doesn’t break out revenue from Azure alone, but the Intelligent Cloud segment raked in $5.9 billion in the last quarter, an 8 percent improvement that hardly represents a doubling of revenue and is indicative of the size of Azure’s portion of the whole Intelligent Cloud pie. Again, Intelligent Cloud includes Azure, server products, and enterprise mobility.

Microsoft’s other source of cloud revenue, Office 365 (the version for businesses), is part of another revenue bucket called Productivity and Business Processes. While the bucket as a whole declined 3 percent, to $6.3 billion, Office 365 revenue was up 70 percent.

IBM’s strategy also relies on hybrid cloud to a great extent. The company didn’t break out its cloud services revenue for the quarter, but it did report a 12-month revenue run rate for public cloud, which was $4.5 billion – up from $3.1 billion a year ago. The annual run rate for all of IBM’s cloud services, including public, private, and hybrid, was $9.4 billion.

IBM’s cloud services include SoftLayer Infrastructure-as-a-Service, private cloud on-prem and off-prem, as well as Platform-as-a-Service called Bluemix, through which developers can use the company’s data analytics services, including Watson, its cognitive computing technology. In late September, the company furthered its hybrid-cloud play by introducing Bluemix Local, an on-prem version of the PaaS.

A Sport for Heavyweights

Because the capital and operational expenses required to run cloud services are so high, public cloud has proven to be an extremely tough business to compete in as a provider. The cloud giants enjoy economies of scale smaller players cannot access, which means smaller players cannot compete on price or geographic reach – an increasingly important factor in the market.

Unless you are a smaller player that can successfully occupy a specialized niche, cloud, and especially public cloud, has become a sport for heavyweights only.

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About the Author

San Francisco-based business and technology journalist. Editor in chief at Data Center Knowledge, covering the global data center industry.

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