Microsoft Earnings Preview: Cloud Revenue To Increase, OS Revenue To Falter

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Microsoft (NASDAQ:MSFT) is set to announce its Q2 FY 2016 earnings on Thursday, January 28th.  ((Microsoft Q2 Earnings Announcement)) (Fiscal years end with June.) While the company continues to build a cache of hardware devices around its Windows 10 in order to establish its ecosystem, it continues to struggle to sell these devices. 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. Recently, it launched PowerApps with the aim to disrupt enterprise mobile App Development market. Through these launches, Microsoft aims to line up its businesses with the changing landscape in technology, especially in enterprise software segment, that is geared towards mobile devices and the cloud. Therefore, during this earnings announcement, we will continue to monitor its growth in cloud services, and expect it to report growth across its verticals. Furthermore, we continue to monitor the progress of its revenue growth from productivity (Office) and operating systems divisions, which will give us a fair indication of  adoption of its software by Original Equipment Manufacturers (OEM) and end-users.

See our complete analysis of Microsoft here

Cloud Revenues To Boost Topline Across Productivity And Server Divisions

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Microsoft continues to build its portfolio of cloud services that will help it to adapt the ever changing IT landscape, facilitated by improvement in hardware and advent of mobile devices.  Microsoft’s small and medium business clients are price sensitive, and therefore, are trying to cut their upfront cost by subscribing to cloud services, which can be scaled up depending on the needs of the company. In the previous quarter, the company reported $8.9 billion revenue run rate for its cloud services ($6.3 billion in previous quarter), which includes Dynamic CRM, Office 365 and Azure sales.

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 $2 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 nearly ~23% of its total value. The strong adoption of cloud-based Azure platform continues to drive growth at the server division. 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. [1] 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 for these services in Q2 as well.

Windows OS Sales To Slide In The Quarter

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). However, it is giving away its Windows 10 to users of Windows 7 and 8 for free. As a result, the Windows 10 installed base has increased to 110 million. [2] This might not help the company to reverse the negative outlook on OS division. Recent data from IDC indicates that PC shipments declined by 10.6% in Q4 2015.  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 Q2. Overall, we expect revenues for Windows OS division to slide for the quarter.

Hardware Sales To Impact Margins

While Microsoft’s premium offerings such as Surface Pro have failed to enthuse users, its smartphones have not fared well either. 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.

We have $47.13 price estimate for Microsoft, which is 10% below the current market price.

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Notes:
  1. Reference from Microsoft cloud site []
  2. Windows 10 officially installed on over 110 million devices, with over 1.25 billion visits to the Windows Store, October 6 2015 []