SOURCE: Here's The 'Dirty Little Secret' Of Microsoft's Cloud Business

There's a huge change gong on in the tech industry that will create a whole new crop of winners and losers: cloud computing.

Microsoft CEO Satya Nadella recently declared that Microsoft was already in with the winners. "We absolutely caught the trend ... it's no longer up for debate, whether we get the cloud," he said.

One reason he gave to back up his claim: Microsoft's cloud business is on track to be a $4.5 billion business.

But sources tell Business Insider that this $4.5 billion number isn't as straightforward as it seems.

The Dirty Secret

The $4-billion-mark is a major milestone for cloud computing companies. Pure cloud company Salesforce.com just hit over $4 billion in revenues in its last fiscal year and expects to hit $5.3 billion at the end of its current fiscal year. It took it 15 years and a major acquisition, marketing automation company Exact Target.

Cloud market leader Amazon is aon track to generate over $4 billion in revenue this year, too. Amazon doesn't release its cloud revenues, but its "other" segment, which includes its cloud Amazon Web Services, had $1.4 billion in revenues, most of which come from AWS.

But our sources say that Microsoft is getting to that number by giving away cloud services for free or at a steep discount as part of bigger enterprise contracts, even to customers who aren't yet using those cloud services.

As one former Microsoft employee told Business Insider, "What Microsoft is doing is claiming a certain percentage of their Enterprise Agreements - these are renewals of their big licensing agreements - as cloud revenue. They bundle the 'rights' to use Azure or Office 365 as part of their overall agreement. The dirty secret is that very few customers are actually taking Microsoft up on using Azure in any meaningful way."

In other words, when an enterprise signs a new contract to buy software like Windows, Microsoft's database and Microsoft Office, the salesperson may toss in free (or almost free) access to Microsoft's cloud Azure (which includes a cloud version of the database) and Microsoft's online version of Office, Office 365.

Microsoft then assigns a percentage of that contract as cloud revenue.

It's a little like giving you a free toaster when you sign up for a checking account, then claiming toaster sales are going crazy.

Giving It Away For Free

Cynthia Farren has seen this sort of contract negotiation tactic happen first hand.

Farren is a consultant who makes her living helping enterprise navigate Microsoft's complex software licensing agreements. (In geek speak, she's a "software asset management consultant." Software license agreements from companies like IBM, SAP, Oracle, and Microsoft are so tricky and expensive there's a whole industry of consultants that helps companies negotiate them.)

"Since early in the days of Microsoft's venture into cloud computing we have often heard of and seen examples of cloud services getting added to customer's Enterprise Agreements at heavily discounted rates or an overall discount making the addition of the cloud services have a net zero dollar impact on the agreement," Farren tells Business Insider.

She adds: "I have also heard some Microsoft sales folks go so far as to boast that all of the EAs [enterprise agreements] they manage have some cloud services on them but have also explained that not all of them have implemented those services yet."

To decode that a little: she's saying that some Microsoft salespeople claim that all of their customers have access to Microsoft's cloud, even when they aren't using it yet.

The Tactic is Working

There's a brilliance to this: Build it and they will come.

If it costs the enterprise nothing to have access to Azure or Office 365, they'll try it out, and hopefully like it enough to pay full price during the next contract negotiation.

"In all fairness, I have seen an increase in the number of customers actually moving to Office 365, Azure, and Dynamics Online," Farren says. Microsoft has used similar tactics in the past, such as including licenses to less-popular server products in a bundle with licenses to products that had higher demand. Eventually, companies would come around and start using the products they've already partly paid for.

On the other hand, Farren says she's "jaded" when she hears Microsoft report the number of cloud users or its revenue numbers.

"What I would really like to know is how many of their total number of users have ever been activated. I'd really like to see a more transparent way of reporting the numbers (such as active users, etc)," she says.

Not The Whole Battle

While getting existing Microsoft customers to try Microsoft's cloud is huge, it's not the whole battle. Microsoft also needs to win over new customers.

"Most of the hot new companies don't use Microsoft," the former employee tells us. "These are the most important companies for growth of the cloud. Amazon and Google dominate share in these new high growth companies."

The other danger to the plan is profit margins. For the next few years, and maybe decades, Microsoft will have to invest billions into its cloud infrastructure to support cloud customers and engage in a price war with Amazon and Google. Unlike before, Microsoft can't just hand over the software to the customer and be done with it.

"You have to remember that in the past Microsoft has had gross margins in the 90% range for Office and Windows. There is no way to sustain that type of monopoly pricing in cloud when competing against Amazon and Google," our source says.

Microsoft won't need ridiculously high margins if it captures a growing slice of the growing cloud computing pie. It will make money aplenty from that.

The cloud computing is going nuts right now, growing at around 30% a year and is expected to generate $121 billion next year, predicts market research firm Markets and Markets,

And Now For The Good News

Profit margins will eventually be sorted out for Microsoft, and all the cloud vendors.

Even if enterprises pay less for each service, over time they'll be buying a lot of cloud services, including some premium high-margin services.

Fancy new features that you can only get from the cloud versions of Microsoft software will convince more companies to try Microsoft's cloud, according to a new report from Forrester Research on Thursday.

"Under Nadella's mandate, commercial product development teams are focused on driving innovation into the cloud versions of its properties first (on-premises [software] second). And its sales engines are all rewarded for pushing as much cloud into each enterprise license agreement as possible," Forrester says.

Forrester boldly predicts that, "Microsoft will make more profit from cloud than from [traditional] on-premises [software]." And it thinks this will happen in 2015.

But, as our sources point out, first Microsoft needs to get companies to pay for these cloud services, not just try them out for free.

We reached out to Microsoft on this story. We will update when we hear back.