Even if Microsoft beats on earnings today, the stock still might tank

Microsoft CEO Satya Nadella delivers a keynote address during the 2014 Microsoft Build developer conference on April 2, 2014 in San Francisco, California.
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Even if Microsoft reports fiscal first quarter earnings that beat analyst expectations, that might not be enough to prevent some investors from selling the stock if its cloud business results disappoint, said Pacific Crest analyst Brent Bracelin.

Analysts expect Microsoft to report earnings per share of 68 cents on revenue of $21.7 billion, according to estimates compiled by Thomson Reuters. If Microsoft's quarterly revenue delivers on that expectation, this would stop a revenue slide that dates back five quarters.

But the focus for investors on Thursday will be how effectively Microsoft CEO Satya Nadella is driving the technology giant towards a future of growth via its cloud-based software and services, Office 365 and Microsoft Azure. Microsoft's stock is trading up around 3.8 percent so far this year. The S&P 500 is up around 5 percent.

"We think of Office 365 and we think of Azure as really being the two most important growth drivers to the business," RBC Capital Markets' analyst Ross MacMillan.

For a preview of what could happen to Microsoft if fails to deliver on cloud, just look to IBM's stock this week, said Bracelin.

On Monday, IBM reported quarterly earnings per share and and revenue that beat analyst expectations, but the stock traded down following those results because investors were disappointed with margins declines in the company's cloud business.

"It isn't whether they slightly beat revenue, or slightly miss revenue, it's really about that cloud transition, because that's the future of these companies," he said.

Institutional investors are watching closely to see how well these tech dinosaurs are managing the transition to new lower-margin cloud-based businesses, which will impact their future earnings power, said Bracelin. Microsoft recognizes the need to bring visibility to this important segment of the business and last quarter revealed its commercial cloud margins for the first time, and announced it would continue to do so.

"It is important because these are large companies that historically had large installed bases and they historically had high margin profiles and so you are going from a legacy business that had high margins to a newer immature business that's growing fast," said Bracelin.

The average gross margin for Microsoft across all of its businesses was 64 percent last quarter, and investors have become accustomed to those sorts of returns. The problem is, the higher margin segments of the business are in decline, while the lower margin cloud segments are growing, and cannibalizing those older businesses putting further pressure on earnings results.

Investors are likely to become nervous if cloud computing gross margins do not at least match the 42 percent figure Microsoft reported last quarter, despite several quarters of consecutive margin declines in this segment of the business, said Bracelin.

Microsoft expects commercial cloud gross margins to improve for the year, said CFO Amy Hood said last quarter. That said, the trend over the past three quarters has been declining margins, as Microsoft invests in things like giant cloud data centers to serve a growing roster of multinational customers. In the past several months, Microsoft announced it had added Adobe and Boeing to its Azure cloud customer list.

Like rival and cloud leader Amazon, Microsoft has significantly invested in a large data center footprint to serve these enterprise giants which are also transitioning their businesses to become cloud-based operations.

"These are global entities, and so they need someone that has invested billions and billions of dollars in a data center footprint in specific countries that they might have operations," said Bracelin.

The December quarter is likely to mark an inflection point for commercial cloud gross margins — from that point on, margins should pivot to growth, said RBC's McMallan.

Pacific Crest is looking for Microsoft to report a $12.2 billion annual revenue run-rate for its commercial cloud business, which would equate to 49 percent year-over-year growth.