Microsoft Earnings: Cloud Fillips Revenue Even As OS Sales Decline

Microsoft (NASDAQ:MSFT) announced its earnings for Q1 FY16 on October 22^nd. (Fiscal years end with June.) ^[1] The company posted a 12% year-over-year decline in revenues to $20.38 billion. In our pre-earnings note, we noted that cloud services would boost revenues. Commercial cloud annualized revenue run rate exceeded $8.2 billion, and the company is on course to achieve $20 billion by fiscal year 2018. However, the free give away of Windows 10 to Windows 7 and Windows 8 users impacted the top line, which was further subdued due to decline in sales of phones. Below, we review Microsoft’s Q1 FY 16 (Q3 CY2015) results by segment.

See our complete analysis of Microsoft here

Shift To Office 365 Impacts Revenues

While Office 365 subscriber base grew to 18 million, Office consumer products and services revenue declined due to the ongoing transition to Office 365. Commercial cloud revenue grew by 5% ( in constant currency) with Office 365 commercial revenue up by 70% in constant currency, while commercial product revenue declined by 2% 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 Q1 FY16, server products and cloud services revenue grew by 6% and 13% respectively in constant currency, driven primarily by growth in Microsoft SQL Server. Furthermore, adoption of the cloud-based Azure platform also increased as the company reported 135% growth in its revenues. Combined, the intelligent cloud segment (Azure, Server products and enterprise services) delivered $5.9 billion in revenues during the quarter. Additionally, dynamic products and cloud services revenue grew by 12% in constant currency. As a result of these products, the company’s cloud revenue run rate exceeded $8.2 billion. We’re encouraged by the continual growth that this division posted, and it is becoming an important driver for Microsoft’s value.

Shift In Phone Strategy Dents Revenue

Microsoft acquired the Nokia Devices and services (NDS) unit in the fourth quarter of fiscal 2014. Most of Microsoft’s smartphones target the sub $200 segment and are mostly sold in emerging markets that are expected to witness more growth in smartphone adoption. However, these phones have very low margins (8-10%) and tend to erode profitability. Meanwhile, the premium segment, which is led by Apple’s iPhone, has a gross profit margin of over 40%. These premium phones account for 20% of the revenue and 90% of the profitability of the smartphone industry.  Considering this, it made sense for Microsoft to ditch its efforts to manufacture and sell cheap smarphones, and instead focus on selling premium quality phones at higher price points.  As a result, the company reported that its devices revenue declined by 40% (in constant currency) with 54% decline in phone revenue. 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 Windows OEM non- Pro licensing revenues declined by 4% and its OEM Pro declined by 7%, Windows volume licensing revenue grew by 4% in constant currency. The declines are the result of slowdown in global PC industry. 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. ^[2]  However, the company was able to buck this trend as license sales declined at a slower pace due to launch of new devices by its OEM partner in the last few months. 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.

Online Service Division (OSD)

The online services division also reported some encouraging signs as online search advertising revenue grew 29% to over $1 billion, and Bing’s US search market share rose to 20.7% 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 updating our Microsoft model. At present, we have $44.12 price estimate for Microsoft, which is 20% below the current market price.

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1. Earnings Release FY16 Q1, October 22 2015 [↩]
2. 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 [↩]