Microsoft's ongoing transition to the cloud, has been very well executed by new senior leadership, most notably Satya Nadella and Amy Hood. The company has been successfully transitioning its Office installed base to Office 365, is the number two leader in cloud services behind Amazon Web Services, and has shown strong operating expense discipline and capital allocation. We continue to believe Azure?s positive momentum will continue, the transition to Office 365 will lead to an uplift in revenue and gross profit, and new leadership has executed well.
Azure users typically start with IaaS as an entry point, whether it's Microsoft or non-Microsoft workloads. The easiest workloads to start out with are existing Hyper-V or VMware workloads, as customers can see additional efficiency benefits from hosting them in the cloud (beyond virtualization). Customers then branch out to use Azure for Microsoft workloads and PaaS services, such as Active Directory, or Microsoft?s Enterprise Mobility Suite (Office usage also drives both services). Given the higher value add associated with PaaS, gross margins for these offerings are higher than IaaS workloads.
In addition, as Azure scales, it should see significant margin expansion as long as price wars between vendors such as AWS and Google remain controlled. Currently, Azure has negative gross margins. In fact, since we believe Azure has the ability to have a higher PaaS mix versus AWS over the long run, this should enable Azure to have a higher gross margin profile than the current market leader. Our view of a higher PaaS mix over time is the result of Microsoft already owning and having vast installed bases of key PaaS products such as SQL Server, Active Directory, Exchange, etc.
