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Microsoft’s® 2nd Quarter FY 2017 Earnings Report from a Licensing Perspective

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Preface

Microsoft® reports earnings in three operating segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing.

 

Microsoft

This segmentation is said to align reporting with CEO Satya Nadella’s vision for the company.

 

This document is structured in the following manner:

 

Summary of the Financial results for FY2017, Q2

Revenue and Operating Income for FY2017, Q2

Contributions by Business Segment

Microsoft’s Volume Licensing Revenue Summary for FY2017, Q2

Risk Factors

Predictions for the future and products that have recently been released or will be launched during coming months

 

Summary of the Financial Results

Microsoft surprised analyst’s once again, by reporting better than expected earnings for the second quarter of their 2017 fiscal year.  The software giant reported revenue of $26 billion after adjusting for the LinkedIn® acquisition and Windows® 10 deferrals, or $0.83 per share (non-GAAP).  This exceeded Wall Street expectations of $25.3 billion and $0.79 EPS.

 

Azure™ revenue was up 93% with usage of Azure compute more than doubling year-over-year.

Revenue from the Intelligent Cloud business was up 8% to $6.9 billion.

Microsoft reports that Office 365™ now has approximately 24.9 million subscribers, with Consumer Office and cloud revenue increasing by an impressive 22%.

The company reported contracted, not billed revenue of $28 billion.  Contracted, not billed is primarily sales from volume licensing agreements which have been booked but not yet recorded.  This is a positive indication of future business, suggesting that momentum continues to grow.

Microsoft returned $6.5 billion to shareholders during the quarter in the form of dividends and share repurchases.

 

Revenue and Operating Income (FY17 2nd Quarter)

Three Months Ended December 31,
 ($ in millions, except per share amounts) Revenue Operating Income Net Income Diluted Earnings per Share
2015 As Reported (GAAP) $23,796 $6,026 $5,018 $0.62
  Net Impact from Windows 10 Revenue Deferrals 1,710 1,710 1,128 0.14
2015 As Adjusted for Windows 10 Revenue Deferrals (non-GAAP) $25,506 $7,736 $6,146 $0.76
2016 As Reported (GAAP) $24,090 $6,177 $5,200 $0.66
  Net Impact from Windows 10 Revenue Deferrals 1,976 1,976 1,315 0.17
2016 As Adjusted for Windows 10 Revenue Deferrals (non-GAAP) $26,066 $8,153 $6,515 $0.83
Percentage Change Y/Y (GAAP) 1% 3% 4% 6%
Percentage Change Y/Y (non-GAAP) 2% 5% 6% 9%
Percentage Change Y/Y (non-GAAP) Constant Currency 4% 8% 10% 13%

 

Microsoft is providing the following table to help investors compare results for the second quarter of fiscal year 2017 to the guidance previously provided for the quarter, which excluded LinkedIn.

Three Months Ended December 31,
 ($ in millions, except per share amounts) Revenue Operating Income Net Income Diluted Earnings per Share
2015 As Adjusted for Windows 10 Revenue Deferrals (non-GAAP) from Table Above $25,506 $7,736 $6,146 $0.76
2016 As Adjusted for Windows 10 Revenue Deferrals (non-GAAP) from Table Above $26,066 $8,153 $6,515 $0.83
  LinkedIn Results Including Amortization of Acquired Intangible Assets 228 (201) (100) (0.01)
2016 As Further Adjusted for Windows 10 Revenue Deferrals, Excluding LinkedIn Results (non-GAAP) $25,838 $8,354 $6,615 $0.84
Percentage Change Y/Y Excluding LinkedIn Results (non-GAAP) 1% 8% 8% 11%
Percentage Change Y/Y Excluding LinkedIn Results (non-GAAP) Constant Currency 3% 11% 12% 15%

 

 

Unless otherwise noted, the numbers presented herein do not consider constant currency (CC) calculations which are used to provide a non-GAAP framework for assessing business performance while excluding foreign currency rate fluctuations.

 

 

Contributions by Business Segment

SEGMENT REVENUE AND OPERATING INCOME (LOSS)
(In millions)(Unaudited)
Three Months Ended

December 31,

Six Months Ended

December 31,

2016 2015 2016 2015
Revenue
Productivity and Business Processes  $7,382  $6,690  $14,040  $12,996
Intelligent Cloud 6,861 6,343 13,243 12,235
More Personal Computing 11,823 12,473 21,117 21,935
Corporate and Other (1,976) (1,710) (3,857) (2,991)
Total revenue  $24,090  $23,796  $44,543  $44,175
Operating income (loss)
Productivity and Business Processes  $3,256  $3,292  $6,376  $6,448
Intelligent Cloud 2,398 2,568 4,456 4,959
More Personal Computing 2,499 1,876 4,427 3,403
Corporate and Other (1,976) (1,710) (3,857) (2,991)
Total operating income  $6,177  $6,026  $11,402  $11,819

 

Three Months Ended December 31

 

 

Productivity and Business

 

Revenue in Productivity and Business grew 10% to $7.4 billion as key products such as cloud services, Office 365™, and Dynamics™ all grew respectably.  Revenue from Office commercial products and cloud services grew 5%, driven by a 47% increase in Office 365 Commercial revenue.  The number of Office 365 Commercial seats grew by 37%.

Dynamics products and cloud services revenue was up 7%, thanks largely to increases in Dynamics 365 revenue growth.

On the consumer side, Microsoft reports that Office 365 now has approximately 24.9 million subscribers, with Office and cloud revenue increasing by an impressive 22%.

LinkedIn contributed revenue of $228 million, beginning when the acquisition was formally complete on December 8, 2016.

Microsoft reported that the number of monthly active devices running Office on iOS™ or Android™ more than doubled year-over-year to more than 65 million.

 

Intelligent Cloud

 Revenue in the Intelligent Cloud segment rose 8% to $6.9 billion, led by server products and cloud services with an increase of 12%.  Azure™ revenue was up 93% with usage of Azure compute more than doubling year-over-year.

Enterprise Services revenue decreased 4% with declines in custom support agreements, although these were offset by Premiere Support Services and consulting.

 

More Personal Computing

Once again, revenue in the More Personal Computing segment was down, this time by 5%, to $11.8 billion.  This was primarily due to declines in phone and gaming revenue.

Windows OEM revenue increased by 5% year over year, as did Windows commercial products and cloud services.

 

Volume Licensing Revenue Summary (Q2 FY17)

The reporting segments make it difficult to isolate Volume Licensing revenue, although during the earnings call Microsoft did report that “Commercial bookings” were up 7% year-over-year.

The company continues to report unearned revenue from Volume Licensing programs.  Unearned revenue represents customer billings for multi-year licensing arrangements paid either at inception of the agreement or annually at the beginning of each billing coverage period, often referred to as “Contracted not billed”.  Also included in unearned revenue are payments for post-delivery support and consulting services to be performed in the future.  Microsoft currently reports $21.1 billion in unearned revenue.

 

Risk Factors

 We consider the risks facing Microsoft when we analyze the Financial Year.  For more information on identified risks, refer to the “Management’s Discussion and Analysis of Financial Conditions and Results of Operations” and “Risk Factors” sections of Microsoft SEC filings.  These can be obtained at http://www.Microsoft.com/investor/.

For the sake of this document, we would like to highlight significant risks for Microsoft.  Understanding these risks may provide you with leverage when negotiating your agreement.

 

LinkedIn™

It may be somewhat premature to cite LinkedIn as a risk, since Microsoft only recently completed the $26 billion acquisition, but the announcement was made seven months ago and we have seen very little in terms of product integration or specific plans.  In a positive note, Microsoft recently announced that LinkedIn engineering executive Kevin Scott has been named CTO, reporting to Satya Nadella.  Kevin has also worked at Google™ and AdMob™.

The lack of announcements from Microsoft has led to a great deal of speculation about how LinkedIn will integrate and merge with Microsoft products.  It’s a logical partnership, as LinkedIn is clearly the dominant professional network, but they face increasing competition from Google’s Facebook for Business.  Some may argue that LinkedIn has stagnated recently, but if they can integrate well with products such as Outlook® and Office, as well as Sales Navigator, Dynamics, and other Microsoft products, the result should be significant improvements across the board.  We may never be able to calculate whether Microsoft realizes $26 billion in value, as any acquisition of that size carries a degree of risk.  It will be interesting to watch.

 

Windows 7

Microsoft has taken unprecedented measures to convince users to upgrade to Windows 10.  Most would agree that the latest version of Windows is their best operating system to date, but there are still countless users who are happy with Windows 7 and are in no hurry to upgrade.  Enterprise customers have until January 13, 2020, at which time extended support will end for Windows 7, but Microsoft is already warning of security risks which exist within Windows 7.  It’s easy to accuse Microsoft of using this as yet another ploy to get people to move to Windows 10, but with a reported 48% of the market still running Windows 7, the consequences could be severe if the aging OS is compromised.

 

Surface Phone

Microsoft has not formally announced that they are making another attempt in the smartphone business, but Satya Nadella has confirmed that they are working on the “ultimate mobile device”.  This has led to speculation about as many as three versions of a phone, and even screen size and chipset predictions.  Some are predicting a release date sometime during the first half of 2017, although it seems somewhat unlikely to be happening that soon since no verifiable facts have been announced (or leaked).  Whether it happens during the coming months or not, most seem to agree that there is indeed a new phone in the works.  When we consider Microsoft’s dismal track record in the already saturated smartphone space, if they attempt to reenter the market, they had better offer something very special.

 

  FY17 Predictions and Roadmap Information

 

Surface® Phone

We’re skeptical about the likelihood of success if Microsoft releases another phone, but nevertheless, it seems almost inevitable.  The internal goal may not be to significantly penetrate the smartphone market, but rather, to complete the Surface product line, which would then include the Surface Book, Tablet and Phone.  We question the value of offering a phone, as it seems slightly contradictory to the company’s strategy of making their software available on competing devices and platforms.  While the Surface Tablet and Book deliver excellent quality and are in many ways, superior to their competition, each are tools in a relatively specific market that runs on Microsoft Windows.  Conversely, a smartphone is a personal, commoditized device in a market that is largely indifferent when it comes to the operating system.

 

LinkedIn

We identified LinkedIn as a risk, largely because it was such an expensive acquisition, but we fully expect to see it integrated into other Microsoft products.  We have already seen changes to the look and feel of LinkedIn as a standalone platform, but a refreshed look and feel will likely be only the beginning.  It’s difficult to predict how significant early integrations will be, but they will almost certainly become more robust in the future.  LinkedIn functionality may be largely an add-on to existing products today, whereas it will be built in to the core products in future versions.  Also, Microsoft will probably discover new ways to leverage the possibilities of such a far-reaching platform.

 

Azure

We will continue to see Microsoft pushing the cloud, both as a complete hosting service as well as in hybrid solutions.  An increasing number of organizations are beginning to trust cloud providers, and Microsoft is making it very appealing to get them to make the move.  Rarely do organizations suddenly abandon their on-prem datacenters, so they start with a hybrid solution in which they retain certain functionality and data onsite, while using the cloud for short term needs or less mission-critical demands.  As on-prem hardware is retired or compute needs increase, they rely more heavily on cloud service providers.

 

Artificial Intelligence and Machine Learning

The increasing emergence if the Internet of Things (IoT) will continue to generate incredible amounts of data.  One of the challenges will be to navigate the data and identify which is useful, but even when this has been accomplished, data, without purpose, is meaningless.  Microsoft is investing heavily in AI, machine learning, and data analytics, and they will continue to do so.

 

Product Releases

Azure Stack – Mid-2017

BizTalk® Server 2016 – Released

Dynamics™ CRM 2016 update – Released

Dynamics GP 2016 update – May 1, 2017

Dynamics NAV 2017 – Released

Windows 10 Redstone Creators Update – Spring, 2017

 

Release schedules are subject to change

 

As Microsoft continues to fill the revenue void left by traditional perpetual license and software sales, they have increased their software licensing audit activity.  Microsoft typically demands some sort of audit on most of their Volume Licensing customers at least once every three years.  It’s a good business for Microsoft as the cost of the audit is typically paid by the customer (unless the customer proves that they are almost 100% compliant).  By exercising their audit rights, Microsoft forces organizations to verify their compliance and purchase any additional licenses necessary to become fully compliant.  It’s typically much more cost effective to confirm compliance before being audited.

 

2017-02-14T15:59:59+00:00 Jan 2017|