Microsoft Earnings: Phone Hardware Write-down Impacts Profitability, While Shift To Cloud Dents Revenue Growth

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Microsoft (NASDAQ:MSFT) announced its earnings for Q4 FY15 on July 21st. (Fiscal year end with June.) [1] The company posted a 5% year-over-year decline in revenues to $22.18 billion. In our pre-earnings note, we noted that hardware sales and cloud services would boost revenues. In cloud, sales  of Microsoft’s commercial cloud, which includes Office 365, the Microsoft Azure platform, and Dynamics CRM, grew 88% year over year, achieving an annualized run sate of $8 billion. The company stated that it was on a strong trajectory towards its goal of $20 billion n CLoud revenues by fiscal year 2018. However, the devices and consumer revenue declined by 13% (10% in constant currency) to $8.7 billion due to decline in PC market that impacted Windows OEM sales following the XP end-of-support refresh cycle. However, the shift to hardware impacted overall margins of the company as non-GAAP operating profit declined by 3% year over year to $6.38 billion. Below, we review Microsoft’s Q4 FY 15 (Q2 CY2015) results by segment.

See our complete analysis of Microsoft here

Hardware Sales Improve

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In our earnings note published earlier, we stated that the device sales will drive revenue growth for Microsoft in Q4. Microsoft’s computing and gaming hardware revenues improved by 50% (in constant currency), primarily due to 117% improvement in Surface 3 revenues to $888 million. Furthermore, Xbox revenues grew by 27% due to strong growth in consoles, Xbox Live transactions and first party games.

Phone Division Dents Profitability And Revenue Growth

Microsoft acquired the Nokia Devices and services (NDS) unit in the fourth quarter of fiscal 2014. During the quarter, Microsoft announced that it was writing off $7.5 billion related to its Nokia acquisition. This impacted its operating profitability as the company reported $2.05 billion losses in the quarter. While the company sold over 8.4 million Lumia phones, average sales price declined, which translated into a 34% year-over-year decline in sales to $1.23 billion. Going ahead, we expect that Microsoft will focus on developing an ecosystem of devices for its Windows 10 instead of just selling more smartphones.

Windows OS Licensing Declines

While Microsoft reported that its consumer Windows licensing revenues declined by 22% and its OEM-Pro declined by 21%, Windows Commercial volume licensing revenue declined by 8%. 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. As both its existing and new OEM partners are bringing to market an expanded set of device offerings at lower price points and for Windows 10 offering, we expect sales to pick up.

Shift To Office 365 Impacts Licensed Office Revenue

While Office 365 subscriber base grew to 15.2 million, Office consumer products and services revenue declined due to the ongoing transition to Office 365. Additionally, commercial Office was soft, with growth of 1% in constant currency, as transactional revenue was impacted by the continued transition to Office 365 and the  decline in business PC sales. 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 Q4 FY15, server products and services revenue grew by 4% (9% in constant currency), driven primarily by growth in Microsoft SQL Server. Furthermore, adoption of the cloud-based Azure platform also increased, and Dynamic reported 6% growth in revenues, with the CRM installed base increasing by 2.5x during the quarter. As a result of these products, its cloud revenue run rate exceeded $8 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 also reported some encouraging signs as online search advertising revenue grew 21% and  Bing’s US search market share rose to 20.3% 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. The company expects that Bing will report profit in fiscal year 2016. 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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Notes:
  1. Earnings Release FY15 Q4, July 21 2015 []