Microsoft Earnings Preview: Cloud First Strategy To Boost Revenues, Mobile First To Erode Profitability

Microsoft (NASDAQ:MSFT) is set to announce its Q1 FY 2016 earnings on Thursday, October 22^nd.  ((Microsoft Q1 Earnings Announcement)) (Fiscal years end with June.) Microsoft is focusing on building a cache of hardware devices around its newly launched Windows 10. This was evident from the recent launch of smartphones, a hybrid laptop, and other devices. ^[1] The company is also focusing on the cloud business that comprises a developing ecosystem of cross-device applications and value added services. Microsoft has re-stated its commitment to developing a comprehensive suite of software that extensively uses cloud technology, and is easily deployable on mobile devices. The aim is to line up Microsoft’s businesses with the changing landscape in technology, especially in enterprise software segment. ^[2]  Therefore, during this earnings announcement, we will continue to monitor its growth in cloud services, and expect it to report growth across its verticals. Additionally, we expect the company to lay out more details for its “mobile first strategy” going forward. In particular, we will continue to closely monitor the impact of increasing hardware sales on Microsoft’s margins. Furthermore, we continue to monitor the progress of its revenue growth from productivity (Office) and operating systems division as they are closely tied to the adoption by Original Equipment Manufacturers (OEM) for their new devices.

See our complete analysis of Microsoft here

Cloud Revenues To Boost Topline Across Productivity And Server Divisions

Over the past few years, changes in the IT landscape, facilitated by improvement in hardware and advent of mobile devices, have encouraged Microsoft to extend its services into the cloud domain. One such factor is 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. Other factors include the declining demand of PCs and servers that lowers demand for its software. 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 47% of our estimated value. In the previous quarter, the company reported 90% growth in its cloud revenues, which includes both Office 365 and Azure sales. 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 believe that these steps will augur well for the company and help it in maintaining its market share in the future.

In the upcoming earnings announcement, we expect Microsoft to report increases  in both subscribers and the revenue run rate for Office 365. We anticipate that Office 365 will attain a greater than $1.8 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 21% 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.com to boost its portfolio of services.  The Microsoft’s vision of cloud services allows customers to offer not only standalone applications, but also to interact seamlessly with Microsoft infrastructure and on-site applications such as Hyper- V, Windows Server and System Center, as well as other SaaS offerings. Over the past few years it has invested close to $15 billion to build its cloud infrastructure. ^[3] The company said that Microsoft’s cloud computing business (which includes revenues from Azure, Office 365 and Dynamic CRM online) is on track to generate over $20 billion in revenues by FY 2018.

In its fourth quarter earnings (for FY15), the company announced that it annualized commercial cloud run-rate surpassed $8 billion. Furthermore, according to Gartner research, Microsoft Azure is a a leader in public cloud market and ranks second behind Amazon Web Services in its Magic Quadrant. ^[4] We believe that the cloud-based Azure platform and Dynamic CRM 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. Therefore, we believe the company will report good growth in revenues in this quarter as well.

Hardware Sales To Impact Margins

Most of Microsoft’s hardware, except for X-Box, was targeted at the emerging countries. However, these devices have very low margins (8-10%) and tend to erode profitability. Microsoft’s premium offerings such as Surface Pro have failed to enthuse users. As a result, in the past it had to take write downs on its hardware and scale back operations of sub $200 segment phones. Despite these measures, any increase in hardware sales will erode profitability as it has lower margins compared to margins for its software business.

Windows OS Sales To Slide In The Quarter, But Ancillary Sales To Boost Topline

The Windows Operating System (OS) is Microsoft’s third largest division and makes up around 10% of its stock value, by our estimates. Microsoft still generates most of its revenues and cash from sale of perpetual license of their Operating system (Windows), Productivity suite (Office) and (to enterprise clients) SQL server. However, it is giving away its Windows 10 to existing users of Windows 7 and 8 for free. As a result, the Windows 10 installed base has increased to 110 million. ^[5] This might not help the company to reverse the negative outlook on OS division. Recent data from IDC indicates that PC shipments declined by 10.8% in Q3 2015 as clients deferred buying new PCs in anticipation of Windows 10, which will be launched at the end of this month. ^[6] While we expect new PC shipments will help Microsoft post some growth in license sales during the quarter, disappointing PC sales might have dented revenue growth in fiscal Q1. Overall, we expect revenues for Windows OS division to slide for the quarter.

However, giving away Windows 10 for free has enabled the company to sell more apps on its app store. Windows marketing chief Yusuf Mehdi tweeted that Microsoft’s store has witnessed six times more downloads per device than the previous version of Windows (i.e. Windows 8). Moreover, Xbox One users streamed 122 years’ worth of gameplay to Windows 10 PCs during the last four weeks. We believe that Microsoft is set to become the third platform behind Google’s Android OS and Apple’s iOS on the back of user installs. This can incentivize app development and create a sustainable and profitable ecosystem for developers and users to thrive in. This would not only improve user experience but also boost Microsoft’s topline in the future. In this earnings announcement we expect the company to report higher revenues for X-Box  in game sales.

We have $44.12 price estimate for Microsoft, which is 7% below the current market price.

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More Trefis Research

1. Read Why Microsoft Launched New Smartphones And Laptop? [↩]
2. Read Microsoft’s Azure To Boost Cloud Revenues In The Coming Years [↩]
3. Reference from Microsoft cloud site [↩]
4. Microsoft Named a Leader in Gartner’s Public Cloud Storage Services for Second Consecutive Year, June 26^th 2015 [↩]
5. Windows 10 officially installed on over 110 million devices, with over 1.25 billion visits to the Windows Store, October 6 2015 [↩]
6. PC Shipments Remain Depressed By Volatile Currencies, Inventory, and OS Transition in the Third Quarter, Although 2016 Should Fare Better, According to IDC, October 08 2015 [↩]