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STATE OF PLAY

A complete guide to Microsoft’s comeback

Ana Kova for Quartz
  • Dave Gershgorn
By Dave Gershgorn

Artificial intelligence reporter

Published Last updated This article is more than 2 years old.

In 1993, Satya Nadella—then a technical marketing manager—sat in front of a camera for a broadcast about how developers could use Microsoft server products.

The broadcast itself is a relic of its time: developers could call into a live hotline to inquire about Microsoft products (this was before customer support chatbots), Nadella chunked out code on a mechanical keyboard in front of an old CRT screen, and what we call servers today were still lovingly referred to as mainframes. The topic Nadella was talking about, wedged in the middle of the three-hour-long affair, was seemingly mundane: How to make custom inventory software using Excel and a local server.

Missing from the broadcast was any sign that Nadella would, 21 years later, become Microsoft’s CEO, or that the objective of this decades-old video—making it easy for companies to embed Microsoft into their most crucial processes—would become the bedrock of Microsoft’s success today.

Nadella is now five years into his tenure as the CEO of Microsoft, and his pitch is strikingly similar to what it was in 1993: Microsoft products make businesses more efficient. The difference is that instead of convincing people to use Microsoft software on their own computers like he once did, Nadella’s new mission is to get businesses to use Microsoft’s massive empire of data centers. This “cloud” is essentially a Microsoft-owned version of the server software that he started his career at Microsoft marketing.

You’ve been hearing Microsoft is “back,” and this is often attributed to the new culture ushered in by Nadella—one in which Microsoft loves open-source Windows competitor Linux (gasp), customers are business partners, and AI is the future. But that’s only part of the story. Nadella has also revitalized the company for the new era of tech, when “cloud” services matter more than software licenses. He has helped Microsoft fundamentally shift its business model, without sacrificing growth, to make the 43-year-old company bigger and more relevant than ever before.

A HISTORICAL INTERLUDE

Microsoft’s licensing problem

Before 2014, the year Nadella took the reins as CEO, Microsoft was mostly focused on the software that got loaded onto devices. It made that software and then sold licenses for consumers and enterprises to use it, which is how Microsoft’s operating system Windows got onto nearly every PC and how Microsoft Office became the standard for document, spreadsheet, and presentation creation. In 2013, Microsoft made nearly 80% of its revenue through licensing, according to financial filings.

Former Microsoft CEO Steve Ballmer tried to pivot the PC software company into mobile phones and tablets by acquiring Nokia in 2014. But by that point competitors had already established rich ecosystems of third-party apps, and in comparison, you could do very little on a Windows phone. It wasn’t just the Windows phone that failed, either: When it came to consumer technology in general, it seemed like Microsoft was coming apart at the seams. Remember the clunky Zune MP3 player? Or the much-maligned, bloated Windows Vista operating system?

REUTERS/Robert Sorbo
The Zune media player, may it rest in peace

As Microsoft was falling behind in mobile, its licensing business was also becoming dated amidst a rush of new Silicon Valley enterprise companies. Microsoft was still selling a Microsoft Office 2010 license for hundreds of dollars, and then not hearing from its customer until the software became functionally obsolete years later. But a new kind of business was gaining steam called SaaS, or software as a service, in which, instead of selling software one time for a set price, companies got their customers to pay on an ongoing basis. In many of these cases, software was run not on a company’s own servers, but in the provider’s cloud. Programs would keep working as long as users kept paying. The upfront revenue was less, but the SaaS provider’s goals were aligned with its clients, which meant more revenue over the long term.

With his background as the head of the company’s since-renamed server and tools division— where he oversaw the initial construction of Microsoft’s “cloud”—Nadella was put in a position to transition Microsoft to this recurring revenue business.


AP Photo/Rafiq Maqbool

How Satya Nadella changed Microsoft

Microsoft today is not a drastically different company than it was 10 years ago, in terms of the people working there. Microsoft executives are lifers at the company—the average c-suite executive at Microsoft has worked there for 21 years, according to financial filings.

Nadella has a similar story. He started at the company in 1992 as a marketing manager, and quickly moved his way up the ladder, earning a series of VP roles until being promoted to president of the company’s server and tools division in 2009.

Insiders say that Nadella’s actions in the server and tools role and as chief executive were very different. The department wasn’t exactly known as a leader: One part of Microsoft’s cloud business called Azure, which competes directly with Amazon Web Services (AWS), would follow the release of a new AWS feature with a similar one of its own. A standing question when Nadella took over was whether Microsoft would keep chasing the tails of its competitors, or differentiate itself in some way. The result was stark. After being chosen as CEO to succeed Ballmer, Nadella took a holistic look at the way the company operated and realized that the biggest barrier to getting ahead of competitors was the company culture.

The 130,000 people who worked for him just weren’t functioning as a cohesive unit. Bureaucracy, suspicion, and short-sighted quarterly goals reigned supreme.

Part of achieving this culture change was through a messaging campaign, like talking about Microsoft’s approach to competition in a drastically different way. Here’s an example from just this month, when he said at Davos:

“We have new competition, whether it’s an Amazon or a Google or an Alibaba. But the interesting thing is I don’t primary come at this from a zero-sum competition perspective. I think that Microsoft has a unique identity. Even the companies that I name, in our case it’s about building technology so that others can build more technology and trust technology, and I think that’s a pretty unique attribute of what we do, and I want to reinforce that every day.”

Structural changes have been made, too. For years, the research and development team had to convince a product team to put forward one of their ideas for it to considered for a product launch. But the product teams were focused on how fast something could grow and earn revenue, says James Staten, who has covered Microsoft for Forrester Research on and off for more than 10 years, and briefly worked for Microsoft. Nadella changed the system so R&D could directly pitch new products, and changed the product teams’ performance indicators to focus more on long-term growth, drastically rebalancing the power dynamics in the company.

Nadella has also restructured the company around the cloud, grouping the main engineering divisions into Experiences & Devices and Cloud & AI. A former product marketing manager suggests that Satya’s high-level decisions, like trimming products that weren’t working and focusing on the cloud, changed the environment of the company. “[Microsoft] was so big and going in such a wrong direction,” the former employee told Quartz. “I don’t think anyone thought there was even a chance it could be saved.”

COMPUTE POWER

Enter Microsoft’s cloud

But it was Nadella’s focus on the cloud that proved to be crucial in saving Microsoft.

Microsoft’s cloud is a host of data centers with functionally unlimited computer power. It is how the company powers its existing subscription services, and it gives it a blank canvas upon which to build and scale new cloud tools to service an entire industry on day one.

Most companies use Microsoft’s cloud in two ways. The first is by building their own software to run on Azure, Microsoft’s name for pretty much any product offering that is used by a developer.

With Azure, companies can essentially “rent” those things they used to have to hire engineers and build data centers to do. A simple swipe of a credit card gives them everything from data storage to cybersecurity to the ability to run AI applications and host websites. Renting computing power in this way allows a small company to have an entire server infrastructure.

The second way that companies use Microsoft’s cloud is by buying a subscription to a Microsoft product, like Office 365 (a suite that includes programs like Microsoft Word, PowerPoint, Excel, and OneNote) and using the cloud to store files generated by those programs. Dynamics 365, Microsoft’s ever-expanding suite of business tools for processes like customer relationship management and accounting, takes advantage of the cloud by running proprietary analytics algorithms on enormous databases that companies amass for manufacturers or ecommerce sites.

When Microsoft (read: Ballmer) was focused on licensing software, it fought tooth and nail to keep the Windows operating system as the dominant platform. Microsoft Office or Dynamics only ran on Windows, which meant that every Windows operating system sold was an opportunity to sell more licenses.

But the move to the cloud offered the opportunity for Microsoft to think differently about who its customers could be. Nadella’s open culture also contributed, leveraging partnerships to sell software subscriptions rather than making customers bow to Microsoft’s computing empire. And since data storage and computing could now be done on Microsoft servers, rather than on a local machine, it began to matter less what operating system your customer was running. A license to use a piece of software on a computer made less sense, because suddenly the software was available on every kind computer—as long as that computer could connect to the internet.

Microsoft’s new cloud focus has been responsible for growth across the company’s products. It has changed Microsoft from a company that earns revenue from a one-time purchase into one based on subscription- or usage-based recurring revenue—and not just for office products. Microsoft is a much more diverse company than it was 10 years ago. The recurring revenue model—made possible by the cloud—applies across much of its operations, whether it’s video games or powering an ecommerce site’s infrastructure. The company still sells licensed business tools and operating systems, but it sells so few of them that in earnings reports they’re now line items under bigger umbrellas. Cloud generates nearly one-third of the company’s revenue.


THE STRUCTURES OF INFRASTRUCTURE

A 2012 video tour of Microsoft’s data centers.

Between renting computing infrastructure and supporting its own growing suite of cloud tools, Microsoft needed to invest in the data centers that actually do all the work. The investment started in earnest in 2010, when the company first released “Windows Azure,” later renamed simply Azure.

At the time, Microsoft’s data centers were almost exclusively in the US, covering about three geographic areas still serviced today, though in a more much robust manner, says Michael Spencer, general manager of investor relations. That’s expanded to 54 regions across the world in 2019. The need for new infrastructure is so great that instead of building data centers from the ground up, Microsoft has now started leasing space from other companies’ data centers to save construction time and stand up these server farms more quickly, Spencer said.


THE LONG VIEW

Microsoft’s cloud strategy

Microsoft’s transition to the cloud wasn’t perfect. The biggest mistake was arguably that it didn’t come soon enough. The cloud-based enterprise software company Salesforce, founded in 1999, became a fierce competitor to Microsoft’s business tools by focusing on cloud-based software from day one. Every dollar that Salesforce earns is a reminder that Microsoft could have been better in the Ballmer era.

In terms of Azure, Microsoft has also been characterized as playing second-fiddle to Amazon Web Services. Amazon started AWS in 2006, years before Microsoft. Though Microsoft has been reticent about revealing exactly how much Azure earns, avoiding comparisons to Amazon’s rival service, Amazon clearly has more customers. All of Microsoft’s commercial cloud revenue, though—a figure that includes not just Azure but also Office and Dynamics—outstrips Amazon’s, which begs the question of which is more important, a large stable of customers like Amazon, or a smaller cloud plus your own cloud businesses to grow, like Microsoft’s Office, Dynamics, and various analytics platforms?

Despite its mistakes in timing, Microsoft’s approach to the cloud has been strategic. Here are three ways in which it has earned an edge:

1. Hitching a ride on its customers’ growth

For the companies that rely on Microsoft’s cloud to power their ecommerce sites, like Walmart-owned Jet, airline Iberia Express, and jewelry company Pandora, Microsoft charges customers based on consumption, meaning that customers pay for how much computing power their processes use in Microsoft’s data centers, as well as how many developers are using the services. As Microsoft’s clients grow and use more computing power, Microsoft automatically makes more money.

This is a huge shift from Microsoft’s past pricing structure, in which a sales rep would need to have contact with a company in order to assess its needs, draw up a licensing contract and then repeat the process a few years later. Now, instead, a company can buy as much cloud infrastructure as it needs without talking to anyone at Microsoft.

Microsoft has also found another way to grow with its customers. As these customers build software for their own businesses, Microsoft approaches a small percentage to partner with and build versions of the customers’ software that can be sold on its Azure Marketplace. It’s like any other software that a company can buy, except it’s often tailored to the needs of a specific industry, and naturally, it runs on Azure. For example, Microsoft and Kroger turned the grocer’s cloud retail software into a product that Kroger is now co-selling with Microsoft to other retailers. In this approach, the customer, who has now become a business partner too, can diversify its revenue, while Microsoft benefits from increased consumption of Azure, since every new customer of that co-sold IP is using Azure as well.

This strategy is paying off big time: Microsoft says co-selling has generated $8 billion since July 2017 when the program started.

2. Taking advantage of “flexible” data centers

At its heart, a data center is a host of connected computers. These computers are immensely fast and have petabytes (thousands of terabytes) of storage.

When customers pay to run on Microsoft’s cloud, they are putting their files in Microsoft’s data centers, and their programs run using that same compute power. But there is more compute power in that data center than just Microsoft’s Azure customers might need to run their cloud programs. So Microsoft can power its own cloud on the same computers, meaning calls from Skype (which Microsoft owns) and enterprise Office cloud files and transactions on customers’ ecommerce sites are all being processed simultaneously.

Microsoft’s future is predicated on building data centers to use itself and sell to others. The company is situating all of its products around cloud- and subscription-based models, with Azure at its center.

3. Being first to the “hybrid cloud”

A reasonable person would assume that using a cloud service and having on-premise servers could be mutually exclusive. But Microsoft was first to build a “hybrid cloud,” which involves software that a company can put on its own servers that allow them to basically mimic the Microsoft cloud. If that company needs more computing power or space for a task—like an ecommerce company during a peak shopping season—Microsoft’s cloud automatically picks up the slack.

For example, a national government will typically have some data that can’t leave its servers for regulatory reasons. The hybrid cloud would allow the government to have one cohesive “cloud” that acts as a unified database, but the data that need to stay on its own servers do, while the rest goes to Microsoft’s data centers.

This is a huge advantage for Microsoft, given its existing relationships with legacy businesses restricted by regulation or other limiting factors, according to Staten, the Forrester analyst. He says that while 95% of the companies Forrester surveyed were interested in moving to the cloud, almost none of them wanted to move its entire company onto the cloud. Since Microsoft was a first mover to this arena, Staten says that even a year is a huge head start in front of AWS, a fierce competitor in the cloud that later released its own hybrid cloud solution.


DEJARGONIZER

Here’s a quick run-down of how Microsoft talks about its cloud business, because it does so often and in a lot of different ways.

  • Intelligent cloud: This is how Microsoft reports its cloud services revenue to investors. It includes Azure, the database software SQL Server, licensing of its operating system, Windows Server, subscriptions and licenses for the developer tools it calls Visual Studio, and enterprise support and consulting services.
  • Commercial cloud: This is a bundle of cloud services pitched at businesses, including Azure, but also Office 365 Commercial and Dynamics 365, as well as other cloud products that Microsoft doesn’t go into specifically. This category is a good way to track Microsoft’s migration of its business tools to the cloud.
  • Azure: This is the most specific of the ways that Microsoft references the cloud, but it is still not one discrete product. Azure can be as simple as using compute on Microsoft’s cloud, but it can also be the use of AI tools sold by Microsoft as an API. The latter means developers can call on Microsoft’s AI software in their applications without having to build the AI themselves, for instance in an application that uses AI to turn audio of speech into text.

AI FOR ONE, AI FOR ALL

Microsoft’s AI strategy

Along with Microsoft’s cloud, Microsoft’s continued investment in AI has proved a boon across product categories.

AI accounts for a large part of Microsoft’s R&D spend, according to financial filings. One of Microsoft’s three engineering groups has AI research in the name—and it is regularly cited in company filings as an investment priority, especially in recruiting talent.

AI flows into Microsoft’s top line in a few ways. Most directly, it can be sold as an API, which means a developer could use a short line of code to run one of Microsoft’s AI algorithms, rather than having to build it themselves. These are usually basic AI applications, like image recognition or speech-to-text. More value can be added by each developer to these applications in situations like image recognition, where developers can use their own datasets to augment Microsoft’s, making it more tailored to the intended use case. That’s not possible to do without the cloud’s virtually unlimited computing power, because these AI processes take more power than would be possible on a user’s smartphone, laptop, or even desktop computer.

AI advances also seed new features in Windows, Office, Dynamics, and in the data centers themselves. Cortana, Microsoft’s virtual personal assistant, turns speech to text and gauges the intent of questions using AI, and can privately scan emails to remind you of promises made in the text. Microsoft Office’s Word has grammar correction powered by AI, and Dynamics uses machine learning to generate insights for each individual customer.

An example of this cross-pollination is while Microsoft sells facial recognition as an API on Azure, similar algorithms power a Windows feature that uses a laptop’s front-facing camera to recognize who’s opening it, and automatically unlock that user’s profile.

MORE THAN A SUM OF PARTS

The Microsoft Ecosystem

The cloud is just one line-item in Microsoft’s revenue sheet, but it has helped establish an ecosystem of interlocking parts that together give Microsoft a suite of products difficult for any competitor to replicate exactly.

The best-known Microsoft products, including Windows, Xbox, and the Surface line of computers are all growing alongside the cloud business that powers them. They actually make up the largest revenue segment for the company, thanks to the inclusion of Windows, which remains a dominant, but slow-growth business.

While Windows only grew 5% over Microsoft’s 2018 fiscal year to $19.4 billion, it still accounted for nearly $1 billion in new revenue. Gaming revenue grew into a $10 billion business, buoyed by its online marketplace and services sales.

Microsoft is also a regular competitor for government contracts, especially for the US Department of Defense (DoD). The company earned $427 million in 2018 from US government contracts, according to government spending databases. That number might seem small relative to Microsoft’s other businesses, but it has been growing year by year, and is expected to increase following Microsoft’s signing of a new five-year, $1.76 billion contract with the DoD this January. One example of Microsoft’s defense activity is a $30 million check for the development of software for the US Marine Corps, to help commanders measure combat readiness using a sophisticated template. In other words, task management for killing.

Acquisitions have played a vital part in Nadella’s growth strategy, too. But his acquisitions have stayed within the bounds of Microsoft’s strengths in entertainment, business, and cloud computing, rather than making up for weaknesses or taking it into businesses it wants to enter. The company’s biggest acquisitions still operate as independent companies. Mojang, a gaming company, played to Microsoft’s gaming chops with Xbox, but also education and mixed reality platforms. Microsoft crucially owns Minecraft, a game where players can collaboratively build worlds of massive scale, which is enormously popular with kids and teens. Having said that, Fortnite has vastly overtaken Minecraft in popularity over the past year.

Many of Microsoft’s products are more robust thanks to the cloud. Xbox comes with Xbox Live, a cloud-powered service that allows Xbox players to play and communicate with others online. Its move toward becoming platform-agnostic allowed a greater presence in mobile. Microsoft Office can now run on an iPad, one of Nadella’s first announcements as CEO. Other Microsoft hardware products integrate directly into Microsoft’s cloud products and subscriptions. If you have a Surface computer, for instance, Office and OneNote are native apps to the Windows operating system, so of course you’ll subscribe for $70 per year.

Microsoft has expanded the scope of it business tools in recent years, adding Microsoft Teams—an in-office chat tool—and LinkedIn to the more established Office, Dynamics, and Skype for Business. That means that Microsoft can sell everything a company might need for intra-office operations, and then lock that company into paying for it every year by virtue of the company infrastructure being built on top of integrated Microsoft products.

This strategy of owning the entire field of business tools and uniting it under one subscription means Microsoft is squeezing more revenue per user, a boon for capturing more revenue from existing customers, as well as making more money from new subscribers. That has helped contribute to double-digit growth year after year in Office and Dynamics, according to company filings.

All of these products and services work in concert to either draw customers further into the company’s ecosystem (an art that competitor Apple has mastered), or spin up more cloud revenue over time. In a world where hardware is cheap, it’s not just who can sell the most phones anymore that wins, but who has the most computing power, and can do the most with it. And nowadays, that’s looking a lot like Microsoft.

Check back later this week for more about what Ballmer got right, a timeline of how Microsoft’s cast of competitors have changed throughout the years, and more.