Quick Thoughts: It’s Not Your Father’s Microsoft

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–          MSFT handily beat the 2QF14 consensus, delivering topline of $24.52B versus expectations of $23.68B and EPS of $0.78 versus $0.68, with strength across the board

–          Earlier, Nokia posted a sequential decline in Lumia WP8 smartphones, likely emblematic of shorting industry product cycles – still those sales were up 83% YoY, a good sign for MSFT.

–          Although AMZN remains the undisputed cloud king, MSFT is also a big winner, with enterprise sales of Office 365, Azure and Dynamics CRM all up more than 100% YoY.

–          Devices delivered surprisingly strong performance with XBox selling 7.4M units in the quarter and Surface more than doubling revenue sequentially

It was an excellent holiday quarter and a second straight beat for Microsoft, as the strategy and reorganization set in motion by departing CEO Steve Ballmer is beginning to show signs of bearing fruit. Though Mister Softy reported its lowest gross margins since its 1986 IPO, largely on the cost of launching and selling lower margin hardware like the XBox One and Surface, its reported numbers for device sales were heartening. Of course, earlier in the day Nokia’s device business, soon to be absorbed into Microsoft, reported somewhat disappointing numbers. Microsoft will live with the deterioration of Nokia’s dead-end feature phone business, but the slight sequential decline in Windows Phone powered Lumia smartphones is a sober reminder of shortening product life cycles in the face of fierce competition. Still, the YoY Lumia growth was a still robust 83% and the cavalry is on the way, with a new round of Nokia product releases expected for spring.

With a strong device strategy bolstered by its enterprise relationships, Microsoft would appear well on track. As the company now is committed to reporting performance along new segmentation, gone are old segmentation restatements reflecting segments like “Windows Division,” “Server and Tools,” and the “Microsoft Business Division.” The company instead restated some of its financials from last year to conform to the new standard which separates the business between consumer, device, and commercial segments. Though the new segments make it easier to isolate enterprise versus consumer performance, Microsoft is taking a page from Amazon’s playbook divulging less detail and from the looks of it, investors don’t mind with the stock up over 300 basis points after hours. The commercial divisions delivered 10% overall YoY growth, despite the weak PC market and an uncertain IT spending environment.

Fiscal 2Q 2014, as Microsoft reports calendar 4Q 2013, is the first time that the company’s margins dipped below 70% since its IPO. The culprit is Microsoft’s new Devices and Consumer Segment which saw gross margin erode over 1500 basis points from last year with new product launches including the XBox One and new Surface 2 line of tablets increasing COGS. The Device and Consumer Licensing segment is also a catch all that includes Windows revenue for both enterprise and consumer as well as Office consumer revenue. Not surprisingly, consumer Windows revenue was down 20% and Office consumer revenue was down 24% as the company shifts to offering the software via its Office 365 platform, where it added 1.5M new consumer subscribers in the quarter. Windows professional revenue though was up 12% and seems to be offsetting the consumer declines. With support for Windows XP ending on April 8 of this year and the OS maintaining a 28% share of the OS market as of December 2013, we anticipate the platform to perform well as consumers and enterprises upgrade out of the obsolete platform.

Despite the margin hit to Devices, the investment is paying off. The XBox One is off to a strong start selling 3.9M consoles in the last 6 weeks of the quarter and the title of best selling console in the US for December according to NPD group. The Surface business more than doubled from $400M to $893M, now making up 7.5% of the Device and Consumer business, though there was no indication from Redmond on how many units sold. With a likely ASP above $500 factoring in discounted Surface 1 units as well as higher capacity Surface 2 and Surface 2 Pros, we suspect it sold between 1.2-1.8M units. Microsoft also appears to be careful to avoid another write down on Surface as channel checks suggest most configurations of the Surface 2 and Surface 2 Pro continue to be sold out even a month after the end of the holiday shopping season. The careful inventory management could be a double edged sword as consumers considering Surface devices opt for other tablets.

Going forward, I expect the soon to be acquired Nokia assets to be grouped into this category and make up over 42% of the expanded Device and Consumer Hardware category revenue. The sequential sales decline of Lumia handsets disclosed earlier today came as a shock, especially in the holiday quarter and contradicts third party data such as Kantar’s November 2013 European smartphone shares. But it shouldn’t be surprising since the last sub 5” Lumia smartphone handset to hit the market was released in July and the current lineup is now well out-speced by offerings released by Apple, Google’s Motorola, and others since September. Though Nokia did release a line of phablets and tablets, which were revealed in October, some such as the Lumia 1320 have yet to be made available.  The lesson from today’s earlier Nokia earnings results is that sales follow product launches and Microsoft will have to keep Lumia line specs fresh and narrow the window from announcement to availability. As Microsoft’s product mix shifts to devices, investors can expect sub 70% margins are here to stay.

Helping the mix is enterprise cloud, which continues to grow at a fast clip and has maintained margins north of 82%. Overall, the commercial business grew 10% YoY with all reported products including Windows, Office, and Hyper-V showing growth. While Microsoft doesn’t detail revenue from cloud services like Azure, its cloud revenue was up 107% with users for each of its major cloud services including Office 365, Azure, and Dynamic CRM up over 100%. Mister Softy is in the upper echelon of commercial cloud players, jousting with Google behind market leader Amazon Web Services. Microsoft has a potent advantage in its large existing enterprise sales force and client base. Some 70% of the Fortune 500 is signed on to use a Microsoft cloud service, a number that will certainly continue to grow. As AWS, Google, and Microsoft continue to engage price wars, Azure is an easy service to bundle with its existing enterprise offerings and has a potent value proposition.

I’ve been a vocal champion for Microsoft, picking it as one of my top 5 TMT stocks for 2014. This quarter is ample evidence of the company’s promise. The Windows platform now has traction in mobile and remains the horse to beat in the enterprise. 3QF14 brings two big milestones – completing the Nokia device acquisition and announcing a new CEO. With the business in such good health, I’m confident that these events will be further steps to bringing investor sentiment the rest of the way around.

For our full research notes, please visit our published research site.

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