Microsoft Earnings: Cloud Growth Shines Through As PC sales Play Spoil Sports

Microsoft (NASDAQ:MSFT) announced its earnings for Q2 FY16 on January 28th. (Fiscal years end with June.) ^[1] The company posted a 2% year-over-year decline  in revenues to $25.7 billion though 0n constant currency basis revenues grew 3%. In our pre-earnings note, we noted that cloud services would boost revenues. The commercial cloud annualized revenue run rate exceeded $9.4 billion, and the company is on course to achieve $20 billion in commercial cloud revenue by fiscal year 2018. Additionally, the company has doubled its cloud customer base over the past twelve months. 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 Q2 FY 16 (Q4 CY2015) results by segment.

See our complete analysis of Microsoft here

Office 365 Buoys Productivity Division Revenues

While Office 365 subscriber base grew to over 20 million, Office commercial and consumer products and services revenue declined by 1%  and 14%, respectively, respectively due to the ongoing transition to Office 365.  (On a constant surrency basis, these busiensses were down 8% and up 5%, respectively.)  Office 365 commercial revenue up by grew 70% in constant currency, while Office 365 commercial seats grew by 59%. 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 Q2 FY16, server products and cloud services revenue grew by 3% (10% 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 140% growth in its revenues. Combined, the intelligent cloud segment (Azure, Server products and enterprise services) delivered $6.3 billion in revenues during the quarter. Additionally, dynamic products and cloud services revenue grew by 11% in constant currency. We’re encouraged by the continual growth that this division posted.  Clearly, it is becoming an important driver for Microsoft’s value.

Shift In Phone Strategy Continues To Impact Hardware Revenue

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%. Industry wide, premium phones account for 20% of the revenue and 90% of the profitability. 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 changed its strategy in July 2015 and this has impacted its hardware revenues. The company reported that its devices revenue declined by 22% on a constant currency basis with a 49% 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 3% and its OEM Pro declined by 6%, Windows volume licensing revenue grew by 3% in constant currency. The declines are the result of slowdown in global PC industry.  Recent data from IDC indicates that PC shipments declined by 10.6% in Q4 2015. 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 partners in the last few months. Since both its existing and new OEM partners are bringing to market an expanded set of device offerings at lower price points for Windows 10, we expect license sales to increase while revenues decline.

We are in the process of updating our Microsoft model. At present, we have $47.13 price estimate for Microsoft, which is 23% below the current market price.

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1. Earnings Release FY16 Q2, January 28 2016 [↩]