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Analysis of Microsoft’s® 1st Quarter FY 2016 Earnings Report from a Licensing Perspective

//Analysis of Microsoft’s® 1st Quarter FY 2016 Earnings Report from a Licensing Perspective

Preface

 

Microsoft® has once again changed the manner in which they report earnings. Beginning this quarter, the software giant is reporting in three operating segments: Productivity and Business Processes, and More Personal Computing.

 

new reporting segments 1QFY2016

Microsoft

 

The change is said to better 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 FY2016 Q1

Revenue and Operating Income for FY2016 Q1

Contributions by Business Segment

Microsoft’s Volume Licensing Revenue Summary for FY2016, Q1

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 many analysts by reporting better than expected earnings for the first quarter of their 2016 fiscal year. The software giant reported adjusted revenue of $21.66 billion, compared with $23.2 billion from the same quarter a year ago. Net income rose to 57 cents per share, compared to 54 cents a year ago.

 

The positive earnings per share is welcome news to investors but the declining top line revenue should not be overlooked. Microsoft has a changing business model in which they are entering new markets such as cloud computing and offering additional hardware products. The product pricing required to compete in these markets is not as high as Microsoft has enjoyed in the past and the margins are rarely as lucrative as the traditional software market.

 

 

Microsoft has reorganized their earnings from the same quarter a year ago to enable year-over-year comparison.

 

 

Revenue and Operating Income (FY16 1st Quarter)

 

  Three Months Ended September 30

 ($ in millions, except per share amounts)

Revenue

Operating Income

Net Income

Earnings per Share

 
2014 As Reported (GAAP)

$23,201

$5,844

$4,540

$0.54

 
  Integration and Restructuring Charges

1,140

909

0.11

 
2014 As Adjusted (non-GAAP)

$23,201

$6,984

$5,449

$0.65

 
2015 As Reported (GAAP)

$20,379

$5,793

$4,620

$0.57

 
  Net Impact from Windows 10 Revenue Deferrals

1,281

1,281

760

0.10

 
2015 As Adjusted (non-GAAP)

$21,660

$7,074

$5,380

$0.67

 
Percentage Change Y/Y (GAAP)

(12)%

(1)%

2%

6%

 
Percentage Change Y/Y (non-GAAP)

(7)%

1%

(1)%

3%

 
Percentage Change Y/Y (non-GAAP) Constant Currency

(2)%

11%

11%

15%

Contributions by Business Segment

      Three Months Ended September 30

 
($ in millions)

 

2014 As Reported (GAAP)

2015 As Reported (GAAP)

Constant Currency Impact

%Y/Y (GAAP)

% Y/Y Constant Currency (GAAP)

Productivity and Business Processes

 

$6,490

$6,306

$(437)

(3)%

4%

Intelligent Cloud

 

$5,475

$5,892

$(351)

8%

14%

More Personal Computing

 

$11,236

$9,381

$(371)

(17)%

(13)%

 

 1st_quarter_fy_2016_chart

In Millions

 

 

Productivity and Business

 

Revenue in Productivity and Business declined 3% to $6.3 billion although key products such as cloud services, Office 365™, and Dynamics CRM all grew respectably.

 

On the consumer side, Microsoft reports that Office 365 now has approximately 18.2 million subscribers, including 3 million new subscribers added during the recent quarter.

 

Intelligent Cloud

 

Revenue in the Intelligent Cloud segment rose 8% to $5.9 billion, led by server products and cloud services with an increase of 13%. Azure™ revenue more than doubled during the year as did the number of Enterprise Mobility customers. This growth is particularly important since Microsoft will rely heavily on cloud revenue in the future.

 

More Personal Computing

 

The results from this segment aren’t as impressive as the others, but certainly not surprising. Revenue declined 17% to $9.4 billion. Windows OEM revenue was down 6% and phone revenue was down 54%.

 

On the positive side, search advertising revenue was up 29% and the number of Xbox® Live monthly active users grew 28% to 39 million.

 

Volume Licensing Revenue Summary (Q1 FY16)

 

The new reporting segments make it difficult to isolate Volume Licensing revenue, although during the earnings call Microsoft did report that “Commercial bookings” were up 2%.

 

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 $23.5 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.

 

Windows 10

 

Last quarter we identified Windows 10 as a risk, primarily because there was so much riding on a successful release and market acceptance. Three months later, Microsoft claims there are 110 million users running Windows 10 and user feedback has been almost surprisingly positive. I say “almost surprisingly” because this release was so highly anticipated and promised so much that it often seemed destined to disappoint.  Fortunately, this doesn’t appear to have happened. Microsoft has been criticized for some privacy policies and slow upgrade servers and also for downloading the code to eligible devices without the users consent, but for the most part the OS appears to be meeting or exceeding expectations.

 

Corporate Customers may be Slow to Upgrade

 

The reported 110 million Windows 10 users is an impressive number, but we can’t forget that Microsoft is giving away Windows 10 to eligible (non-enterprise) customers. Hopefully, the positive reception thus far will motivate enterprise customers to upgrade sooner rather than later, but failing to do so presents a huge financial and strategic risk for Microsoft.

 

Surface™ Book

 

Microsoft has once again risked alienating their OEMs by releasing a competing hardware product. The Surface Book is the company’s first laptop and while impressive, it is sure to upset some of their OEM customers. To be fair, we criticized them when they released the Surface Tablet and while many OEMs weren’t happy about it they didn’t stop working with Microsoft.

 

Perhaps the biggest criticism many early reviewers have is that they question the need for a detachable display on a high-end laptop but the consensus from most has been very positive.

 

 

Overall Strategy

We all seem to be focused on the cloud. Microsoft is betting heavily on cloud services and applications. Businesses and consumers weigh the benefits and risks of cloud computing, citing factors such as affordability, security, and convenience. In the end, the economic value of cloud computing will ultimately prevail. This is good news for users but service providers such as Microsoft must continue to generate profitable revenue. As we consider Microsoft, we’re watching to see how they will replace lost revenue from traditional products such as Windows and Office. The presumed answer is that it will come from the cloud with products such as Azure, Office 365, Dynamics, and others, but will that be enough to maintain the revenue we have grown to expect from Microsoft? The potential revenue from these products would appear to be less than that of desktop Office and Windows during past years. We can look to new revenue sources such as cloud hosting and The Surface and Surface Book, but hosting and cloud storage will likely become commoditized and the margins on Microsoft hardware (if any) are substantially less than that of software.

 

Microsoft reported better than expected earnings during the recent quarter, but let’s not forget that expectations were for earnings to be less than the same period a year ago.  That doesn’t make Microsoft a failure, nor does it mean they are losing their edge. It may simply mean that they are entering a market that simply doesn’t provide the lofty profits Microsoft has enjoyed in the past.

 

FY15 and FY16 Predictions and Roadmap Information

 

Microsoft in the Hardware Business

 

It would have been hard to imagine a few years ago, but Microsoft is becoming a very influential player in the hardware computing space. After a disappointing start with early Surface Tablets, the Surface Pro 4 appears to be redefining the standard for hybrid tablets and even tablets in general.  Also, the first generation Surface Book appears to be a serious contender (if not leader) in the high-end laptop market and its detachable display makes it a hybrid device as well.

 

Microsoft refuses to give up on the Windows Phone and only time will tell whether they will ever offer a smartphone that is compelling for many of us, but the Surface products and Xbox have given the company credibility in the hardware space. I expect Microsoft to continue to improve their Surface product line and perhaps introduce a lower-end Book at some point.

 

Losing Momentum

 

Perhaps this should be listed above as a Risk Factor, but it is also a Prediction for FY 2016. Microsoft has historically realized considerable attention and momentum surrounding major releases of Windows. This has been accompanied by updated applications and server products intended to take advantage of new functionality of the latest OS. Finally, version releases of Windows typically drove new PC spending.

 

The continuous updating of Windows 10 will eliminate this as this is said to be the final version of Windows. That is not to suggest that Windows 10 will be the final operating system from Microsoft, but we have no indication of a replacement OS in the foreseeable future. Of course Microsoft will continue to update their products but the public and enterprise focus may be reduced.

 

Greater separation between consumer and business pricing

 

We expect to see a continued separation between Microsoft’s consumer business and their enterprise business. Microsoft is doing whatever they can to gain traction in the consumer space. We expect to see continued incentives to attract consumers to Microsoft products across all platforms but it’s unlikely corporate customers will be permitted to take advantage of these incentives.

 

 

Product Releases

 

Dynamics CRM 2016 – Q4, 2015

Exchange 2016 – 2nd half, 2015

Office 2016 – Released

Office 2016 for Mac – 2nd half, 2015

Office for Windows 10 – Released

Power BI – Released

SharePoint Server 2013 SP1 Cumulative Updates – Monthly

SharePoint 2016 – Q2 2016

System Center 2016 – 2016

System Center Configuration Manager: Q4, 2015

Visual Studio 2015 – Released

Windows 10 – Released

 

Release schedules are subject to change

 

 

If your current Windows Server licenses include Software Assurance, it is important to comply with the transition requirements when renewing your agreements. If you provide a time-stamped report from a tool such as the Microsoft Assessment and Planning Toolkit (MAP) you will be able to transition to the actual number of processors in your server farm. This is more cost effective as the alternative is that Microsoft only converts current licenses as opposed to taking the physical server deployment into account. If you are running four and eight processor servers, the cost savings will be significant.

 

To ensure continued revenue, it is in Microsoft’s interest to encourage you to sign a multi-year licensing agreement. Before you do this, make sure signing the agreement makes economic sense. Microsoft concerns regarding maintaining revenue streams is also something you can leverage in order to gain the concessions you might require.

Understand the Road-map: Being aware of the product road-map not only allows you to plan more effectively and maximize your IT budgets, but it provides you with the knowledge necessary to effectively negotiate agreements that meet your business requirements. This is specifically relevant when it comes to online services.

 

There are a significant number of product launches over the next twelve to eighteen months. Becoming involved in Microsoft Technical Adoption Programs means you have access to high level resources, licensing discounts and business investment funding from Microsoft.

2016-11-17T11:14:10+00:00 Nov 2016|