Microsoft (NASDAQ:MSFT) announced its earnings for Q2 FY13 and posted encouraging Windows growth. The quarter was a solid one on all fronts as total revenues increased to $21.5 billion during the quarter, 3% higher than the $20.9 billion the company posted during the same period last year. However, operating income fell year-over-year, but we aren’t too concerned about that yet because the key product for Microsoft’s future, Windows 8, has sold over 60 million licenses to date. 
In our pre-earnings article we noted that we wanted to see solid Windows 8 sales during the quarter since it would be key for Microsoft’s ecosystem going forward. We think that the 60 million licenses sold since Windows 8’s release leaves the company in good stead and has set a solid platform for growth going forward. However, we still think that the next few quarters are extremely important for Microsoft as the adoption of Windows 8 by a wider audience will strengthen its ecosystem and allow the firm to cross-sell other products. Overall, we are encouraged by the 24% year-over-year growth in revenues that the Windows division posted and think that Microsoft will be extremely competitive against Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL) going forward.
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Windows Division Shines Despite Concerns
During Q2 FY13, Microsoft’s revenues from its Windows division increased to $5.88 billion, an increase of 24% from the $4.7 billion it posted during the same period in FY2012. The large increase in revenues was driven by sales of Windows 8 and the Surface tablet. What is encouraging is the fact that OEM revenues grew 17% since these make up approximately 65% of total revenues for the division.
We have argued that the Windows 8 platform is the key to Microsoft’s future and this strong showing sets the company up for growth across all of its segments. Microsoft’s goal with Windows 8 has been to integrate the experience across devices, and the solid early adoption gives the company a strong base. We will be closely watching revenues form this division because if Microsoft can continue to grow here, it could be a catalyst for the company’s stock price.
Server & Tools is Another Catalyst for Growth
Microsoft’s Windows Server division has been one of its fastest growing divisions in the recent past. Again during the quarter, revenue from server and tools grew 9% during Q2 FY 13 driven by SQL server and Windows Server growth. This growth in revenues shows that enterprises are continuing to adopt the Windows ecosystem, which will again help the company cross-sell its Windows 8 products. We believe that this is the case because if a company uses the Exchange server, it is likely to prefer that its employees use other Microsoft products such as the Windows 8 PC’s, the Windows Phone and the Surface tablet. Therefore we think that as Windows Server continues to grow, it will drive PC and phone sales and help keep Microsoft’s overall business in good health. Going forward, we will be closely watching Windows Server sales as this division also has the potential to become a large cash cow like the Office and Windows divisions.
Bing Posts Another Gain In Market Share
The Online Services Division continued to negatively impact Microsoft’s overall profitability, posting an operating loss of $283 million. However, this division did report some encouraging signs as online advertising revenue again grew by 15% due to an increase in search revenues. Bing also posted an increase in US search market share as the metric increase by 120 basis points year-over-year to 16%. We do think that the Windows 8 ecosystem will help the company continue to gain market share in the search engine space, but any surprises to the upside are not expected to increase the company’s value substantially.
Lower Xbox Revenue Slightly Offset by Increasing Windows Phone Sales
Microsoft’s Entertainment and Devices division again posted a substantial decline in revenue of 10%, mostly due to lower Xbox 360 sales. However, what is encouraging was that declining Xbox sales were partially offset by an increase in Windows Phone sales which are important in getting new users on the Microsoft ecosystem.
Overall, these results were more or less in line with our expectations since we think that Xbox sales will decline until the new version of the Xbox is released, probably in 2013. A bit of a surprise though was the fact that the division’s operating income increased by15% (despite a 10% decline in revenues), primarily because of lower Xbox sales, partially offset by the payments made to Nokia for their usage of the Windows Phone OS.
We are currently in the process of updating our Microsoft model. At present we currently have a $41 price estimate for Microsoft, which is approximately 50% above its current market price.