Cloud Is The Star Of Microsoft's Q1

Microsoft released first-quarter financials Thursday that showed the growth, and more importantly, the profitability that investors were rooting for in the software giant's all-important cloud business.

CEO Satya Nadella, during the Redmond, Washington-based company's fiscal year 2017 Q1 earnings call, shared commercial cloud margins of 49 percent—up 7 percent from the previous quarter.

That metric, offered for the first time in a quarterly earnings report, allayed concerns of declining profitability in a vital growth sector, sending shares up more than five percent, to above $57, in after-hours trading.

[Related: 8 Major Products Unveiled At Microsoft Ignite 2016]

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On $22.3 billion in non-GAAP revenue, Microsoft grew its overall business by 3 percent, with gross margins flat and operating income declining by a hair. Earnings per share of 76 cents beat Wall Street's expectations of 68 cents.

Microsoft Azure revenue grew by 116 percent year-over-year, with the usage of its compute services more than doubling from the year-ago quarter.

But Microsoft thinks of its cloud business as a comprehensive offering that spans beyond the Azure public cloud, Nadella said, telling investors hybrid capabilities are a major differentiator from rivals.

"We really have a view of distributed computing that's more expansive than just our hyper-scale cloud," Nadella said. That includes on-premises operating systems like Windows Server 2016 and SQL Server 2016, which are essentially "the edge of our hyper-scale cloud."

Azure also can't be separated from Office 365 and Dynamics 365, software-as-a-service offerings hosted on Azure infrastructure which are essential elements of a highly integrated commercial cloud business, he told investors.

Nadella said Microsoft's cloud differentiates itself not only with its hybrid capabilities and SaaS extensions, but the services it delivers that enable customers to build out their digital capabilities.

"Our goal is not to just sell commodity services, but to use commodity services as a bootstrap for higher-level services," Nadella told investors.

Investors should think of the unique architecture that enables those integrated products as the primary driver of the higher margins that pleased them, Nadella said.

Despite quarterly fluctuations, over a long-enough period, Nadella said, margin improvements will continue as a result of that architecture.

Nadella also said the software giant has been busy integrating artificial intelligence (AI) capabilities across its entire stack, and the technology will be "infused in everything we do."

That means applying machine learning and natural language processing to familiar Office products like Word, Excel, PowerPoint and Outlook.

AI is also being implemented into security features like Office365 Threat Intelligence.

Microsoft projects a $13 billion annualized run rate on its commercial cloud, which keeps the company on track to meet a self-imposed goal of $20 billion in revenue by 2018. (By comparison, Amazon Web Services (AWS) is on track to surpass $10 billion in salesthis year.)

Another unique quality of Microsoft's business is its embrace of open-source technologies like Linux. Microsoft is "supporting the widest range of platforms, frameworks and tools," Nadella said.

Microsoft's CEO also praised the Windows 10 refresh cycle, saying more than 400 million active devices are currently running the latest operating system.

Sales of the Surface tablet have also been strong, he said, thanks to the company "reaching more customers of all sizes with the support of our channel partners."

Nadella told investors the new HoloLens virtual reality headset would be expanding into more markets.

A development community is emerging around the product, he said, and enterprise customers are embracing HoloLens to "create new mixed reality experiences for customers."