Microsoft Earnings: Focus On Hardware Boosts Revenues, Lowers Profitability

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Microsoft (NASDAQ:MSFT) announced its earnings for Q3 FY15 on April 23rd. (Fiscal years end with June)  The company posted a 6.5% year-over-year growth in revenues to $21.73 billion, which also includes $1.4 billion revenues from Nokia’s phone division. In our pre-earnings note, we noted that hardware sales and cloud services would boost revenues. While the devices and consumer revenue increased by 8% to $8.95 billion due to phone sales, Microsoft reported 106% growth (111% in constant currency)  in commercial cloud services, which includes Office 365, the Microsoft Azure platform, and Dynamics CRM. The annualized revenue run rate of commercial cloud stands at $6.3 billion. However, the shift to hardware impacted overall margins of the company as operating profit declined by 5% yesr over year to $6.6 billion. Below, we review Microsoft’s Q1 FY 15 results by segment.

See our complete analysis of Microsoft here

Hardware Sales Decline

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In our earnings note published earlier, we stated that the device sales will drive revenue growth for Microsoft in Q3. Microsoft’s hardware revenues declined by 4%, primarily due to an expect decrease of Xbox-One sales as it approaches the anniversary of its launch. Nearly offsetting the decrease were sales of tablets; Surface revenues grew by 44% (53% in constant currency) over the prior year to $713 million.

Phone Division Boosts Revenues

Microsoft acquired the Nokia Devices and services (NDS) unit in the fourth quarter of fiscal 2014. During the quarter, Microsoft sold 8.6 million Lumia phones and over 24.7 million non-Lumia phones, which translated into $1.4 billion sales.  Going ahead, we expect this division to do well  and Microsoft to report higher sales. However, since the company is focusing on selling Lumia at lower price points, and in emerging markets, the profitability declined and the company reported a slight loss of $4 million.

Windows OS Licensing – A mixed bag

While Microsoft reported that its consumer Windows licensing revenues declined by 22%  and its OEM-Pro declined by 19%, while Windows Commercial volume licensing revenue grew by 2%. The declines are the result of the wind down of the transition from Windows XP.  As the one-time benefit of the Windows XP end-of-life PC refresh cycle tailed off, revenues from Windows consumer licensing declined to pre-Windows XP end of support levels. Furthermore, as both its existing and new OEM partners are bringing to market an expanded set of device offerings at lower price points, Windows OEM non-Pro revenue declined 26%. Going forward, as the company gears to launch Windows 10 later this year, we expect sales to pick up.

Shift To Office 365 Impacts Licensed Office Revenue

While Office 365 subscriber base grew to 12.4 million, Office consumer products and services revenue declined 41% due to the ongoing transition to Office 365. Additionally, commercial Office declined by 16% as transactional revenue was impacted by the continued transition to Office 365 and decline in business PC following the XP refresh cycle. As the subscription model sets in, revenues for this division are expected to grow, and become more recurring and predictable going forward.

Server & Cloud Witness Another Quarter Of Strong Adoption

Microsoft’s Windows Server division is one of the fastest growing divisions of Microsoft. During Q3 FY15, server products and services revenue grew by 10%, driven primarily by 25% growth in Microsoft SQL Server. Furthermore, adoption of the cloud-based Azure platform also increased, and Dynamic CRM is a business in excess of $2 billion. As a result of these products, its cloud revenue run rate exceeded $6.3 billion. We’re encouraged by the continual growth that this division posted, and it is becoming an important driver for Microsoft’s value.

Online Service Division (OSD)

The online services division did report some encouraging signs as online search advertising revenue grew 22% as Bing’s US search market share rose to 20% during the quarter. Furthermore, search advertising revenue improved due to increased revenue per search resulting from ongoing improvements in ad products and higher search volumes. We forecast Bing’s global market share to increase steadily throughout our forecast period but any surprises to the upside are not expected to increase the company’s value substantially.

We are in the process of restructuring and updating our Microsoft model. At present, we have $44.46 price estimate for Microsoft, which is inline with the current market price.

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