Office And Servers Lift Microsoft As PC Slump Hits Windows

Microsoft (NASDAQ:MSFT) announced its earnings for Q3 FY13 and posted encouraging growth in Microsoft Office division. The quarter was a solid one on most fronts as total revenues increased to $18.8 billion during the quarter, 8% higher than the $17.04 billion the company posted during the same period last year. Operating income increased 5% to $6.7 billion year-over-year. ^[1]

In our pre-earnings article we noted that the Windows OS division would be negatively impacted due to weak PC shipment number for Q1CY13.  Microsoft felt the heat from declining PC sales as its Windows division revenues were flat y-o-y at $4.61 billion, excluding Windows deferral of $1.09 billion. While OEM Windows revenues were in line with the declines in the PC market, non-OEM revenues, which includes the sales of Surface tablet and commercial sale of Windows were up 40% and offset the decline in OEM sales. However, we are encouraged by the adoption of Office 365 which now has a revenue run rate of $1 billion. We expect Office will continue to drive revenue growth at Microsoft going forward.

Check out our complete analysis of Microsoft

Cloud Based Office 365 Bolster Revenues

During Q3FY13, Microsoft’s revenues from its business division increased to $6.13 billion, an increase of 10% from the same period in FY2012. The increase in revenue was driven by 16% increase in multi-year licensing agreements and sales momentum in Office 365, which reported revenue run rate of over $1 billion.

Microsoft’s biggest revenue driver is its Office productivity suite and makes up almost 40% of its stock value according to our estimates.

The adoption of Office 365 and Office 2013 is critical for Microsoft’s growth in the coming year, and this result indicates that Microsoft’s move towards cloud based Office software suite is gaining traction. As companies across various industries look to cut costs by using cloud based system, the adoption of cloud based Office 2013 and Office 365 will be critical  for Microsoft to maintain its market share in the future. We expect Microsoft to maintain its market share at 92% over our forecast period as clients continue to  adopt the feature-rich, cloud-compatible Office 2013.

Server & Tools Continues To Shine

Microsoft’s Windows Server division is the second largest business unit, making up around 22% of its total value. It is also one of the fastest growing divisions of Microsoft in the recent past. During Q3FY13, revenue from server and tools grew 11% driven by SQL server and Windows Server growth. Many Microsoft customers depend on SQL servers for mission critical and business intelligence needs, specifically in the big data analytics domain. As a result, Microsoft’ SQL server revenue grew by 16% outpacing the market.

This growth in revenues shows that enterprises are continuing to adopt the Windows ecosystem, which will again help the company cross-sell its Windows OS 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 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 cash cow like the Office and Windows divisions.

Windows Division Suffers As PC Sales declined

Windows Operating System is Microsoft’s third largest division and makes up around 15% of its stock value by our estimates. During Q3 FY13, Microsoft’s revenues from its Windows division was flat at $5.7 billion. For Q1 CY13, IDC reported a 14% y-o-y decline in PC shipments and OEM revenues declined in line with the PC market. However, non-OEM revenues increased by 40% and offset the decline in OEM revenues as Microsoft reported a double digit increase in license volumes.

We will be closely watching revenues from this division as we expect PC sales to stabilize in the coming quarters, and if Microsoft can continue to maintain its market share, it could be a catalyst for the company’s stock price.

Bing Posts Another Gain In Market Share

The Online Services Division continued to negatively impact Microsoft’s overall profitability, posting an operating loss of $218 million. However, this division did report 15% growth in online advertising revenue due to significant rate improvement in search. Bing also posted an increase in US search market share as the metric increase by 160 basis points year-over-year to 16.9%. We think that the Windows OS 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 increase in revenue of 56%, mostly due to lower Xbox sales which increased by 55%. Xbox 360 platform revenue increased $641 million, primarily due to the recognition of $380 million of revenue related to the Video Game Deferral and higher Xbox LIVE revenue. Additionally, Windows Phone sales continued to gain traction  as revenues increased to $259 million.

The division’s operating income also increased primarily due to revenue growth, which was offset in part by the higher cost of revenue as well as research and development expenses.

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 40% above its current market price.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. 10-Q, SEC [↩]