(Bloomberg) -- Board members at Microsoft are grappling with a growing concern: that the company’s traditional software business, which makes up the majority of its sales, could evaporate in a matter of years -- and Chairman John Thompson is pushing for a more aggressive shift into newer cloud-based products.
Thompson said he and the board are pleased with a push by CEO Satya Nadella to make more money from software and services delivered over the internet, but want it to move much faster. They’re considering ideas like increasing spending, overhauling the sales force and managing partnerships differently to step up the pace.
The cloud growth isn’t merely nice to have -- it’s critical against the backdrop of declining demand for what’s known as on-premise software programs, the more traditional approach that involves installing software on a company’s own computers and networks. No one knows exactly how quickly sales of those legacy offerings will drop off, Thompson said, but it’s "inevitable that part of our business will be under continued pressure."
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The board members’ concern was born from experience. Thompson recounts how fellow director Chuck Noski, a former chief financial officer of AT&T, watched the telecom carrier’s traditional wireline business evaporate in just three years as the world shifted to mobile. Now, Noski and Thompson are asking whether something similar could happen to Microsoft.
"What’s the likelihood that could happen with on-prem versus cloud? That in three years, we look up and it’s gone?" Thompson said in an interview, snapping his fingers to make the point.
Small, but Growing
Nadella has said the company is on track to make its forecast for $20 billion in annualized sales from commercial cloud products in fiscal 2018. Still, Thompson said, the cloud business could be even further along, and the software maker should have started its push much earlier. Commercial cloud services revenue has posted impressive growth rates -- with Azure product sales rising more than 100 percent quarterly -- but the total business contributed just $5.8 billion of Microsoft’s $93.6 billion in sales in the latest fiscal year.
Thompson praised the technology behind smaller cloud products, such as Power BI tools for business analysis and data visualization and the enterprise mobile management service, which delivers apps and data to various corporate devices. But the latter, for example, brings in $300 million a year -- just a sliver of overall annual revenue, which will soon top $100 billion, Thompson said.
The board is examining whether Microsoft has invested enough in its complete cloud lineup, Thompson said. It’s not just about developing better cloud technology -- it’s a question of how the company sells those products and its strategy for recruiting partners to resell Microsoft’s services and build their own offerings on top of them. Persuading partners to develop compatible applications is a strong point for cloud market leader Amazon, he said.
Thompson declined to be specific about what the company might change in sales and partnerships, but he said the company may need to “re-imagine” those organizations. "The question is, should it be more?" he said. "If you believe we need to run harder, run faster, be less risk-averse as a mantra, the question is how much more do you do."
Analysts say Microsoft should seek to develop a deeper bench of partners making software for Azure and consultants to install and manage those services for customers who need the help. Microsoft is working on this, but is behind Amazon Web Services, said Lydia Leong, an analyst at Gartner.
"They are nowhere near at the same level of sophistication, and the Microsoft partners are mostly new to the Azure ecosystem, so they don’t know it as well," she said. "If you’re a customer and you want to migrate to AWS, you have this massive army that can help you."
In the sales force, Microsoft’s representatives need more experience in cloud deals -- which are generally subscription-based rather than one-time purchases -- and how they differ from traditional software contracts, said Matt McIlwain, managing director at Seattle’s Madrona Venture Partners. "They haven’t made enough of a transition to a cloud-based selling motion," he said. "It’s still a work in progress."
Microsoft declined to comment on the company’s cloud strategy or any changes to sales and partnerships for this story, and director Noski couldn’t be reached for comment.
The company’s dependence on demand for traditional software was painfully apparent in its most recent quarterly report, when revenue was weighed down by weakness in its transactional business, or one-time purchases of software that customers store and run on their own PCs and networks. Chief Financial Officer Amy Hood in April said that lackluster transactional sales were likely to continue.
Microsoft’s two biggest cloud businesses are the Azure web-based service, which trails top provider Amazon but leads Google and IBM, and the Office 365 cloud versions of e-mail, collaboration software, word-processing and spreadsheet software. Microsoft’s key on-premise products include Windows Server and traditional versions of Office and the SQL database server.
Slumps like last quarter’s hurt even more amid the company’s shift to the cloud, which has brought a lot of changes to its financial reporting. For cloud deals, revenue is recognized over the term of the deal rather than providing an up-front boost. They’re also lower-margin businesses, squeezed by the cost of building and maintaining data centers to deliver the services. Microsoft’s gross margin dropped from 80 percent in fiscal 2010 to 65 percent in the year that ended June 30, 2015.
"This business growing incredibly well, but the gross margin of that is substantially lower than their core products of the olden days," said Anurag Rana, an analyst at Bloomberg Intelligence. "How low do they go?"
It’s jarring for some investors, but the other option is worse, said Thompson.
"That’s a very different model for Microsoft and one our investors are going to have to suck it up and embrace, because the alternative is don’t embrace the cloud and you wake up one day and you look just like -- guess who?" Thompson doesn’t finish the sentence, but makes it clear he’s referring to IBM, the company where he spent more than 27 years, which he says is "not relevant anymore." IBM declined to comment.
The pressure is good for Microsoft, Thompson said -- pressure tends to result in change.
"You can re-imagine things when you’re stressed. It’s a lot easier to do it when you’re stressed because you feel compelled to do something," Thompson said. "I see a lot of stress at Microsoft."