Quick Thoughts: Mister Softy’s blow out quarter and business as usual at Amazon


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Quick Thoughts: Mister Softy’s blow out quarter and business as usual at Amazon

–          MSFT blew out earnings amidst a sweeping reorganization; It’s difficult to compare growth across segments, but growth is growth and more to come with new products like XBox One

–          Microsoft’s enterprise biz grew 10%+ with Azure and Office 365 as long term elements for a sustainable future

–          As always, AMZN is a black box reporting little detail into its real margins which have been obscured by investments in the future and another EPS loss

–          AMZN continues to march on the path to dominating retail, intrinsic margins could be closer to 10% by the end of decade when investment potential is realized

Microsoft delivered its first earnings report since its sweeping July reorganization that abolished the familiar org map that included the “Windows” and “Servers and Tools” divisions in favor of a new structure emphasizing functionality and a cleaner reporting segmentation to better reflect exposure to consumer and enterprise markets. It delivered an EPS of $0.62 beating estimates by 15% and beat the topline with $18.53B in quarterly revenue versus the $17.78B consensus estimate, indicating something is working in Redmond. Amazon delivered the same old quarter reporting 23.8% of topline growth beating expectations of 21.3% growth and an inline EPS loss of -$0.09. Amazon was cryptic as usual on operating metrics touting millions of new Prime members. Investors cheered both earnings reports sending MSFT up over 6% and AMZN up over 8% in after hours.

Microsoft, which has had a string of announcements since the end of Q2 that included a reorg, the planned departure of Steve Ballmer, the acquisition of Nokia’s handset business, and new products like Windows 8.1, the Surface 2, and new Lumia phones and a tablet, demonstrated it’s not sitting idle. First, on the enterprise side, Mister Softy just handily delivered an “I told you so” to the naysayers proving its enterprise strategy is working. With the cleaner reporting segmentation, enterprise software sales are now reported under Commercial Licensing and the Azure cloud business is under Commercial Other, and grew 7.3% and 28.4% YoY respectively. Commercial Licensing, which includes all on premises enterprise software sales such as Windows, Office, SQL Server, Exchange, etc, now makes up the bulk of Mister Softy’s revenue at 51.8%. The Commercial Other segment largely includes cloud software and services like Azure, Office 365, and Dynamic CRM. Microsoft’s Azure infrastructure cloud service, which was disclosed to have grown 108% YoY is nipping at the heels of Amazon’s AWS as the dominant cloud infrastructure platform with a run rate in excess of $1B versus Amazon’s $3B+. According to Gartner, Infrastructure as a Service (IaaS) is expected to grow at a 37.4% CAGR through 2017 and represents the fastest growing opportunity in the cloud. Combined, Microsoft’s enterprise business grew 10%. We expect momentum to continue into the next several quarters.

On to the consumer and device side with the new Devices and Consumer (“D&C”) business, which grew 4% overall. The licensing segment, which includes Windows consumer, Office packaged software for consumers, Windows Phone, and patent licenses, reported a -7.2% YoY decline largely driven by double digit declines in Windows OEM revenue in the face of a better than expected decline in PC sales. To alleviate confusion, a portion of Windows Pro OEM revenue falls into the D&C Licensing segment. While Consumer Windows and Office software showed double digit declines, the magnitude of category decline was offset by increased Windows Phone revenue. According to recent surveys by Kantar WorldPanel, Windows Phone is gaining share in key European markets like the UK, Germany, and France. It’s been a long slog, but the phones are getting better and Microsoft has the wherewithal to invest its way into markets. Remember XBox? It took 6 years for Mister Softy to make a profit on the console business. Armed with Nokia, we expect to see Microsoft in the phone game as a compelling third platform to the delight of carriers around the world.

Once Nokia is fully absorbed into Microsoft, Lumia sales will likely be reported under the D&C Hardware segment which now includes the XBox, Surface, and PC accessories. Despite anticipation over a new updated XBox console and refreshed Surface products, the segment delivered 37% YoY growth, largely because the Surface business was still nascent last year and marketing efforts have resulted in doubling Surface sales over the previous quarter. We expect this category to show significant growth next quarter given the holidays and new product portfolio. Microsoft itself guided to a $3.8B-4.1B range for the category.

Finally the D&C other business, which is now comprised of advertising, Windows Phone Marketplace, Office 365, retail, in-house video games also showed strong performance over the previous year with 16.8% YoY growth and a positive margin. Reconciling for the category it seems Microsoft added the Bing business to a portion of the entertainment and devices category reflecting a profitable segment. Bing itself has slowly been narrowing losses with share growth in the US and increasing ad revenue while much of the upside contribution comes from growing Office 365 subscriptions. The underlying SaaS business model of Office 365 takes away version upgrade risks and instead provides steady cash flows. For Microsoft, the task is now to grow and retain the consumer Office 365 subscriber base. All in all it was a great quarter for the company breaking old fiefdoms and adopting a smart corporate strategy that aligns the company on addressing new opportunities in mobile and the cloud while mitigating risks from a shrinking PC market.

For Amazon, it was another quarter of impressive topline growth at 23.8% YoY with an on target earnings loss of -$0.09 attributing some of the shortfall to a foreign exchange hit. Despite the loss, Amazon again showed it can get to new record highs without caring for earnings. With the company revealing little operational detail in its earnings release and subsequent call, the story is much the same as in previous quarters: Jeff Bezos gets a free pass from Wall Street for high topline growth over low or negative margins resulting from reinvestment in the business.

First, what we know and what was revealed. Amazon added Prime subs by the millions in the quarter, but the magnitude we don’t know. Given conservative estimates of 10-15M Prime members over the past year, even growing the customer base by a 2M clip over a quarter would be substantial. Amazon is banking that its Prime value proposition of free shipping and free streaming is compelling enough that it leads to more customers buying products on Amazon. As a result, the company absorbs a portion of shipping costs to the tune of 4.7% of sales this quarter. For most retailers 4.7% is a lot of precious margin to be giving up on a freebie. Wal-mart eeks out an operating margin only 110 basis points higher and high volume retailers are generally in the low single digits. For Amazon, net shipping expenses are a necessary cost item to allow it a competitive advantage over rivals.

Jeff Bezos also loves to spend on infrastructure. It’s necessary for growth and also ensuring its ambitions of achieving same day delivery, flawless AWS services, and the hearts and minds of consumers. This past quarter saw Capex at its second highest quarterly level in the history of the company at over $1B with a run rate of $4.59B for the year. It spent just over $2B in Capex in Q4 2012. This Capex spend is used to fund the tech infrastructure, AWS, and fulfillment center investment. But compared to other tech companies, Amazon’s capex as a % of sales is in line with the likes of Google at 6.3%. It’s also close to Target, which spent 6.25% of sales on Capex in FY 2012.  Then again, Amazon’s most appropriate retail comparable, Wal-Mart, spent 3.0% on Capex in FY 2012.

Amazon though isn’t just buying buildings and hardware, it’s investing strategically to create the most efficient and advanced retail distribution operation the world has ever seen. It didn’t become the most beloved retailer among American consumers because it simply offered the lowest prices. Its infrastructure is largely to thank for its recognition by the American Customer Satisfaction Index as the highest rated retailer amongst all retailers, both on-line and brick-and-mortar, with a score of 86 out of 100. It’s “mayday” function that allows Kindle users access to technical support has an average response time of 11 seconds. Customer service experiences are largely hassle free and new innovations like same day delivery and groceries in key markets are making life easier for consumers.  The company isn’t missing a beat as it continues on the path to becoming the dominant global retailer.

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

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