• A top Microsoft official has reported that Windows 10 has been enjoying strong adoption.
• Future Windows 10 upgrades will be offered via the cloud.
• This will give Microsoft an excellent opportunity to cross-sell its existing cloud offerings.

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Microsoft’s (NASDASQ:MSFT) corporate VP Yusuf Mehdi disclosed a few days ago via a tweetsorm that more than 75 million devices are already running Windows 10, about a month after the release of the OS. Windows 10 has already managed to garner 5.2% OS market share, a feat that a free upgrade from Windows 8 to Windows 8.1 took a full seven months to match. So it’s quite clear that the popularity of the new OS is not just because it’s a freebie but rather due to a superior design and positive user sentiment.

Microsoft stock has lately been gaining on another big piece of Windows 10 news after Intel (NASDAQ:INTC) launched its much awaited 6^th generation Skylake Core Processor. Skylake will power the full range of PCs from large Xeon workstations to entry-level laptops. Skylake has been hailed as a ‘‘once in a decade experience’’ that will offer groundbreaking speed, unparalleled graphics performance, and long battery life especially when used with Windows 10. So that’s another big reason why Windows 10 could continue seeing strong adoption.

So what does all this mean for Microsoft?

Good Times for Microsoft’s Cloud

Once users manually install their first copy of Windows 10, Microsoft will start offering upgrades via its cloud. The company has said that Windows 10 will be the last Windows OS, meaning upgrades will be offered on a continuing basis. This is a good thing for Microsoft’s bottom line since the company has been spending huge chunks of money supporting older operating systems. Having a single unified OS will greatly cut on these costs.

There is a possibility that Microsoft will charge for future Windows 10 upgrades. The company said during its latest investor presentation that Windows 10 would realize about 50% more revenue over a single upgrade cycle compared to older Windows operating systems.

Source: Microsoft

It’s not yet clear whether Microsoft will continue reporting Windows 10 revenue under the Windows segment or will report it under the cloud segment. But either way Microsoft’s cloud should get a significant boost from offering Windows 10 through the cloud. A huge install base for the OS will give Microsoft a good chance to cross-sell its numerous cloud services including OneDrive, Office 365, Skype, Xbox Live Gold, Xbox Music Pass, and MSN. Microsoft’s cloud sales are already on a $6 billion-plus annual run rate and growing in triple digits. But the cloud still contributes less than 10% of the company’s revenue, so there’s still plenty of room to run.

Higher Valuation

Although strong adoption of Windows 10 has already started providing a boost to Microsoft stocks, the real gains will be over the next 2-3 years. For one, the new OS is not very likely to make a large impact on Microsoft’s top line during the first 12 months after its release. Microsoft’s Windows products revenue (about 10% of revenue) declined by a large 22% during the last quarter. The new OS will only be sold to enterprise customers, which probably make around half of Windows revenue base.

Secondly, history shows that Microsoft’s latest OSes, including the wildly popular Windows XP OS, were accompanied by large double-digit declines in PC sales. This is due to increasing reluctance by many users to shift to a new OSes unless they feel compelled to do so, which delays the upgrade cycle. Despite Microsoft’s continuing transitioning to the cloud, many investors still draw a close corollary between the company’s performance and PCs sales, and large declines in PC sales usually impinge on Microsoft’s stock performance.

Source: Microsoft PE Ratio Vs Adobe PE Ratio by Amigobulls

But the future for Microsoft looks bright. A successful transition to a cloud-based and subscription model will bode well for Microsoft stock, as evidenced by Adobe’s (NASDAQ:ADBE) cloud transition. Investors have given Adobe’s shares a much higher multiple than its historical average after the company successfully shifted its services to a cloud-based model. Adobe shares currently trade at a PE ratio of 105, compared to around 25 average in 2013 due to the company’s success in moving into a cloud-based revenue model. Microsoft shares trade at a very modest 14 times expected fiscal 2016 earnings. Even a modest rise to 18-20 times earnings would represent a healthy 29%-42% stock gains.