Microsoft Earnings Preview: Hardware And Cloud Sales In Focus

Microsoft (NASDAQ:MSFT) is set to announce its Q2 FY 2015 earnings on Monday, January 26th.  (Fiscal years end with June.)  Microsoft is transitioning from a software company that sold perpetual licenses for its Operating System (Windows OS) and productivity software to a cloud-based business that comprises a developing ecosystem of devices and value-added services. The aim is to assure that Microsoft’s businesses accommodate the major changes underway in computing, including Big Data, mobility and the cloud. For this quarter, we continue to monitor its hardware and cloud service, and expect it to report growth in all three of these verticals. In particular, we will continue to closely monitor its revenue growth from mobile devices (Windows Phone OS) and operating systems division.

See our complete analysis of Microsoft here

Smartphone Sales To Boost Hardware Sales

Microsoft is increasingly pursuing its devices and services strategy to reduce its reliance on PCs and expand its footprint in the mobile hardware domain with the recent launch of two new cheaper variants of Smartphone targeted at emerging markets. ^[1]  In Q4 2014 (June ending quarter), it launched Surface Pro 3 to boost its ecosystem and cater to the high end of the tablet market. In this earnings announcement, we will closely monitor Microsoft’s tablet unit sales and revenue numbers for its devices and consumer hardware segment. This would give us a fair indication of how these devices have fared and whether its devices are gaining traction among users.

Cloud Products To Drive Revenue Growth

Currently, Microsoft generates $96 billion revenues annually according to our estimate. Most of its revenue stems from the sale of perpetual software licenses ofr products such as Windows OS, Windows Office and (to enterprise clients) SQL server. However, over the past few years a host of factors have forced Microsoft to extend its services in the cloud domain. While declining demand of PCs and servers that lowers demand for its software is one such factor, other factors include price sensitivity of clients that want to cut down their costs and only pay for services that are rendered, based on the scale of operations. As a result, Microsoft has adopted cloud-first strategy to bolster its revenue in the coming years.

Its Office 365 offering continues to bolster revenues for the Windows Office division, which makes up ~40% of our estimated value. In the previous quarter, the company reported 147% growth in its cloud revenues, which includes both Office 365 and Azure sales. The company continues to support the adoption of its cloud services through a host of initiatives. We believe that these steps will augur well for the company and help it in maintaining its market share in the future.

In Q1 2015, Microsoft reported that Office 365 had over 7.1 million subscribers and the revenue from this cloud offering in the quarter more than doubled year over year. As subscription model for office sets in, revenues for this division will be recurring and thus more predictable going forward. Currently, we estimate that the company has close to 93% share in productivity software market. In the upcoming earnings announcement, we expect Microsoft to report increase in subscribers and revenue run rate for Office 365 as its clients adopt the feature-rich, cloud-based Office software. We anticipate that Office 365 will attain a greater than $1.7 billion annual revenue run rate as its clients adopt the feature-rich, cloud-based Office software.

Microsoft’s Windows server division is the second largest business unit, making up over 24% of its total value. The strong adoption of cloud-based Azure platform continues to drive growth at the server division as the company continues to form partnerships with companies such as Salesforce to boost its portfolio of services. During the Q1FY15 results, Microsoft CEO Satya Nadella said that Microsoft’s cloud computing business (which includes revenues from Azure, Office 365 and Dynamic CRM online) is on track to generate $4.4 billion in revenue this fiscal year (i.e., FY 2015, as fiscal years end in June), if sales keep up the way they’ve been going. We believe that the Azure platform will be a key growth driver for Microsoft going forward, as companies around the world are looking to lower costs by adopting cloud-based services. ^[2]

Additionally, many Microsoft customers depend on SQL servers for mission critical and business intelligence needs, specifically in the big data analytics domain. The company can leverage the popularity of its SQL server and Azure platform to sell its recently launched Business Intelligence tools. We expect the server division revenues to get a boost due to the bundling of these services.  Accordingly, we believe the company will report good growth in revenues in this quarter as well.

PC Sales To Affect Windows OS Sales

The Windows Operating System (OS) is Microsoft’s third largest division and makes up around 10% of its stock value, by our estimates. Recently, this division has reported growth in revenues, primarily due to Microsoft’s termination of support for Windows XP, which is forcing laggards to upgrade from this popular OS. Last week, Microsoft announced the end of mainstream support for its Windows 7 operating system. Additionally, recent data from Gartner indicates that PC shipment grew for the first time in the last two year in Q4 2014. ^[3] We expect new PC shipments, together with the existing installed base of Windows PCs, will help Microsoft post growth in license sales during the quarter. In this earnings announcement, we will continue to pay close attention to the numbers of licenses of Windows sold in both desktop and mobile verticals. We also note that an update Microsoft’s next OS, Windows 10, is pending as we go to our virtual press and plan to discuss it soon.

Bing Revenues In Focus

The Online Services Division has negatively impacted Microsoft’s overall profitability as it continues to post operating losses. However, due to rise in Bing’s penetration, the division’s revenues have increased by 40% year-over-year in Q1. Furthermore, its market share in the search market industry in the U.S. increased by 1.4 percentage points in November 2014 to 19.6%. ^[4]. We expect this trend to positively impact revenues, and the company to report growth in revenues and profitability from Bing in this earnings announcement.

We have $44.46 price estimate for Microsoft, which is inline with its current market price.

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1. Read more about it here [↩]
2. Read more about it here [↩]
3. Gartner Says Worldwide PC Shipments Grew 1 Percent in Fourth Quarter of 2014, January 12 2015 [↩]
4. comScore November 2014 data [↩]