Quick Thoughts: MSFT – Moving Quickly to the Cloud
– MSFT’s 2QF15 beat on both the top and bottom lines. Adjusting for one-time items, EPS was $0.77 ahead of the $0.71 consensus, and sales of $26.47B edged expectations on 7.9% YoY growth.
– Businesses central to the “mobile first, cloud first” strategy – Office 365, Azure, Surface, and server products – performed very well in the quarter, and are positioned to continue the trajectory.
– Several traditional businesses – i.e. consumer Windows, Office packaged software, and Xbox – were weak, spooking some investors who took profits and sent the stock down 4% after hours
– MSFT is delivering strong growth while aggressively shifting to the cloud, navigating the decline of front-loaded SW sales, the end of the Windows upgrade cycle, and a challenging int’l market
Just a week after showcasing the impressive Windows 10, Microsoft delivered a respectable 2QF15 beat on both the top and bottom lines, evidence that CEO Satya Nadella’s “mobile first, cloud first” strategy is working. The $26.47B in reported revenue beat expectations of $26.27B, while $0.77 in adjusted EPS, after adding back one-time Nokia integration and IRS audit expenses, easily topped the $0.71 consensus. The quarter saw Microsoft navigate well through some short term headwinds that included the end of the Windows 8 upgrade cycle, a transition to the cloud subscription model with less upfront revenues than its traditional packaged software business, weak international demand from China, Japan, and Russia, and a challenging foreign exchange environment with a strong US dollar. With the commercial and consumer cloud segments up 45.7% and 30.0% respectively, along with a sixth consecutive quarter of triple digit growth for Azure, everything points to a successful transition to the cloud. Still, the unavoidable struggles of the company’s older businesses spooked investors who took the stock down 4% in after hours.
While overall sales were up a robust 7.9%, the company’s three largest reporting segments saw declines in the quarter. The Devices and Consumer Licensing segment took the biggest hit with revenue down -25% from $5.54B to $4.17B. This segment includes revenue reported for Windows Phone, Windows OEM revenue, and packaged Office software for consumers, all of which were weak. Windows Phone revenue took a $650M hit as the company’s commercial agreement with Nokia, the largest supplier of Windows handsets, terminated with Microsoft taking over the company’s handset business in 4FQ14. Next, Windows OEM revenue was down some 13%, as the company is seeing the tail end of device upgrades from users of the no longer supported Windows XP. Although the company announced last week that Windows 10 upgrades will be free for Windows 7 and 8 users, we don’t expect OEM licensing terms to change much and Microsoft will still collect fees from the likes of Dell, HP, Acer, and Lenovo as they sell new PCs preloaded with Windows. Users on even older versions of Windows, which still run on over 20% of PCs, are likely loaded on pre-2009 machines that are well below minimum requirements for Windows 10. This upgrade cycle may have tailed off, but Windows 10 could spell a new rush for PCs. Finally, the segment was also impacted by declines in sales of traditional Office software as consumers move to subscription based Office 365. (N.B. Office 365 revenues are reported in the “D&C Other” segment, which was up very strongly.) CFO Amy Hood also noted Japan was an area of weakness for the category.
Next, the Computing and Gaming hardware unit saw revenue down -11% from $4.47B to $4.0B as XBox revenue was down 20% on heavy discounting implemented to grow share leadership. Though the 6.6M XBox units shipped came in under the 7.4M units shipped last year, the figure this year include more XBox One units as the older Xbox 360 becomes obsolete. Also important to note, given the Xbox One platform is newer, margins are naturally lower as the device is still near the beginning of its product life cycle. Despite these YoY declines, the company took back share from Sony and seems to be executing well on its gaming strategy and will soon get an added boost as Windows 10 will offer tight integration with XBox. Also, Surface sales were a resounding success with revenue exceeding the $1B milestone, driven by the higher margin Surface Pro 3.
Turning to the enterprise, MSFT’s Commercial Licensing segment was down 2% as packaged Office licensing was down -13% driving the segment lower, while Server products were up 7% and Windows volume licensing was up 3% on annuity revenue growth. Corporate Office 365 revenues are not included in this segment and are instead allocated in the “Commercial Other” segment which saw growth of 45.7%. The annuity nature of the Server and Corporate Windows businesses stabilizes revenue and insulates the company from the downside risk of upgrade cycles. In the case of corporate Windows licenses structured as annuities, the free upgrade to Windows 10 doesn’t mean much on the corporate side as enterprises pay their license fees regularly.
Phone Hardware, which had no YoY revenue compare disclosed given the business was just acquired in 4FQ14, saw strength with more Lumia devices sold on both a sequential and YoY basis. However, the old Nokia business remains a significant maker of feature phones shipping nearly 40M handsets in the quarter and non-Lumia handsets will likely be wound down by MSFT as the company seeks to make affordable Windows-based smartphones targeting emerging markets. Still, with only two quarters of comps available, gross margins are all over the place with 2FQ15’s 14% coming in below the 18% of last quarter and well above the 2.7% during the 4FQ14 when the business was acquired. The Phone segment is an integral part of Nadella’s “mobile first, cloud first strategy” and given it won’t pursue an Apple or Samsung flagship phone strategy, we expect margins will stay low as the company sets its sights on markets where it can win.
In terms of guidance, the company’s 3FQ15 forecast is lower than this quarter given seasonality across businesses, but the company did allude to some headwinds that concern investors as of late: FX swings. For MSFT, this will represent a 4 point impact on both commercial and consumer business, and seems lower than expected given about half the company’s revenues come from abroad with significant exposure to Europe. The company, which also reports contracted but not billed revenue as “unearned revenues,” adjusts FX rates dynamically. CFO Amy Hood indicated during the call the level of these revenues is in line with expectations when adjusted for FX. Still, the 4 percentage points is a significant figure for a company that that has grown revenues at an average YoY pace of 8% since the onset of the financial crisis in 2007. The high end of next quarter’s guidance calls for topline growth of 4.9%, taking into account the FX environment.
While this FX headwind adds to Nadella’s challenges as he manages the transition from packaged software sales and OS upgrades, the pace of his company’s cloud transition and the excitement around its new initiatives point to long term success. Given the potential for Microsoft to increase its domination of enterprise IT and to establish a viable role in the consumer cloud, selling on this quarter’s results because traditional Office software and Windows upgrade sales are weak seems to be extraordinarily short-sighted.