Quick Thoughts: MSFT – Not Your Father’s Microsoft

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–          MSFT’s 1QFY15 were stellar – 11% YoY organic sales growth, strength in both devices/consumer and commercial businesses, and a solid EPS beat.

–          MSFT is killing it in the cloud – commercial sales up 128% YoY, likely to a $5B+ annual run rate. Commercial Windows and Server both delivered double digit growth

–          Consumer was a surprise. Xbox sales doubled YoY. Surface Pro 3 is selling at 2X the pace of Pro 2. Office 365 up 25% QoQ. Even Nokia was surprisingly strong.

–          Margins are down, but the fruits of MSFT’s significant restructuring are yet to be felt. 2015 should yield significant earnings acceleration.

Microsoft delivered another extraordinary quarter under CEO Satya Nadella showing the “mobile-first and cloud-first” strategy articulated in July is working. Top line revenue was up 25% to $23.2B, and backing out Nokia, the organic growth was a still impressive 11%. The top line figure handily beat consensus expectations of $22.0B and the bottom line was a solid beat of $0.54 in EPS against $0.49 expected. The company’s restructuring expenses also came in at the lower end of guidance with some $1.14B in write offs related to the Nokia handset business. With other traditional enterprise IT players struggling to adapt their businesses for new cloud and mobile opportunities, Microsoft has shown it’s successfully making the transition.

As a result of new reporting segments introduced last year, the separation between the consumer and enterprise businesses are more distinct and understanding the company’s positioning for new opportunities is clearer. Weak areas of the business continue to be old PC-paradigm products like Windows and Office, which are now booked across several reporting segments, as well as Windows Phone, which weighed heavily in the YoY decline of the D&C licensing segment. While Windows OEM revenues were down 2%, negatively impacting the Devices and Consumer licensing segment, Windows volume licensing, which is reflected in the Commercial licensing segment, was up about 10%. Similarly, declining packaged Office sales put pressure on both consumer and commercial licensing categories as Office 365 revenues are now booked in the “Other” categories of both the consumer and commercial segments. The D&C licensing category was also hit by declining Windows Phone revenue on a mix of lower royalty devices. Taking a page from the Android playbook, the company dropped royalty fees in April for devices with screen sizes under 9-inches. The result was a 46% decline in Windows Phone royalties and a D&C licensing segment that was down almost 9% YoY.

With few exceptions, the company displayed extraordinary growth rates across its other segments. The Computing and Gaming Hardware segment saw the fastest growth and was up 74% on blow out sales of Surface tablets and XBox consoles. Once laughable Surface revenue is up to a respectable $908M suggesting the company shipped over 1 million tablets in the quarter. XBox One availability in 28 new markets drove sales of 2.4M units, double the number that shipped last year and last quarter. The growth in XBox gives credence to the importance of gaming at Microsoft despite Nadella’s July memo reiterating the company’s core focus on productivity. Analysts who have called for Microsoft to spin out Xbox will be disappointed – it remains Microsoft’s major play for the home and Xbox Live is a considerable scale driver for the company’s distributed cloud data center infrastructure. Nadella doubled down on gaming last month, taking out Minecraft maker Mojang in a deal expected to close in November. Mojang will be accretive almost immediately and add more users to the MSFT ecosystem as well as giving it access to other platforms. Unlike his predecessor, Nadella is open to having Microsoft products run on a number of platforms whether they be productivity tools or games.

The next fastest growing segment was Commercial other – which includes cloud based offerings like Azure and the commercial version of Office 365 – up 50% to $2.4B in the quarter. On their own, the cloud based products were up 128%,  even in a highly competitive IaaS environment with both Google and Amazon aggressively cutting prices for their cloud services. For Microsoft, its cloud infrastructure has become a critical part of the business driving commercial offerings like Office 365 and Azure, but also consumer elements like XBox, Bing, and Consumer Office 365 subscriptions. The latter two are booked in the D&C other category, which saw respectable 16.4% growth with over 1.4M new Office 365 subs in the quarter. Bing revenue was up 23%, as its US share grew to 19.4% of search.

Finally, the all new phone business acquired from Nokia last quarter is showing signs of life despite taking the write down and some 12,000 job cuts. The unit saw modest growth driven by European sales where it was able to gain share on lower priced devices. Microsoft sold 9.3M Lumia phones giving it some $2.6B in revenue versus $1.98B the previous quarter. The low end strategy seems to be working. Microsoft won’t get involved head to head to head battles with Apple and Google that it knows it can’t win. With Office availability on iOS and Android as well as Mojang soon to be acquired, platform agnostic apps are an integral part of the company’s strategy for mobile in developed markets.

All in all, well played Mr. Nadella, well played.

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

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