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Analysis of Microsoft’s® 2nd Quarter FY 2016 Earnings Report from a Licensing Perspective

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Preface

 

This is the second quarter since Microsoft changed the manner in which they report earnings. The software giant is now reporting in three operating segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing.

 

segments_q2_2016

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, Q2

Revenue and Operating Income for FY2016, Q2

Contributions by Business Segment

Microsoft’s Volume Licensing Revenue Summary for FY2016, 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 beat the street again by reporting better than expected earnings for the second quarter of their 2016 fiscal year. The software giant reported adjusted revenue of $25.7 billion, or $0.78 per share (non-GAAP). This exceeded Wall Street expectations of $25.26 billion and $0.71 EPS.

 

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

 

The company reported deferred revenue of $25 billion, exceeding expectations of $23.6 billion. Deferred revenue 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.

 

We continue to focus on Microsoft’s cloud business as that is the likely replacement to offset losses resulting from declining PC sales. Revenue from the Intelligent Cloud business was up 5% to $6.34 billion, which also exceeded expectations of $6.29 billion.

 

Revenue and Operating Income (FY16 2nd Quarter)

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

 

Three Months Ended December 31,

 ($ in millions, except per share amounts)

Revenue

Operating Income

Net Income

Earnings per Share

 
2014 As Reported (GAAP)

$26,470

$7,776

$5,863

$0.71

 
  Net Impact from Revenue Deferrals

(326)

(326)

(248)

(0.03)

 
  Integration and Restructuring Charges

243

175

0.02

 
2014 As Adjusted (non-GAAP)

$26,144

$7,693

$5,790

$0.70

 
2015 As Reported (GAAP)

$23,796

$6,026

$4,998

$0.62

 
  Net Impact from Revenue Deferrals

1,897

1,897

1,277

0.16

 
2015 As Adjusted (non-GAAP)

$25,693

$7,923

$6,275

$0.78

 
Percentage Change Y/Y (GAAP)

(10)%

(23)%

(15)%

(13)%

 
Percentage Change Y/Y (non-GAAP)

(2)%

3%

8%

11%

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

3%

13%

20%

23%

 

 

Contributions by Business Segment

 

Three Months Ended December 31,

 

Six Months Ended December 31,

 

 

 

2015

 

2014

 

2015

 

2014

Revenue

 

 

 

 

 

Productivity and Business Processes

 $     6,690

 

 $  6,822

 

 $   12,990

 

 $13,312

Intelligent Cloud

6,343

 

6,041

 

12,232

 

11,516

More Personal Computing

12,660

 

13,282

 

22,114

 

24,548

Corporate and Other

(1,897)

 

325

 

(3,161)

 

295

  Total revenue

 $   23,796

 

 $26,470

 

 $   44,175

 

 $49,671

 

 

 

 

 

 

Operating Income (Loss)

 

 

 

 

 

Productivity and Business Processes

 $     3,305

 

 $  3,587

 

 $     6,460

 

 $  6,988

Intelligent Cloud

2,580

 

2,600

 

4,977

 

4,705

More Personal Computing

2,038

 

1,506

 

3,542

 

3,014

Corporate and Other

(1,897)

 

83

 

(3,160)

 

(1,087)

  Total operating income

 $     6,026

 

 $  7,776

 

 $   11,819

 

 $13,620

2nd_quarter_fy_2016_chart

Productivity and Business

 

Revenue in Productivity and Business declined 2% to $6.7 billion although key products such as cloud services, Office 365™, and Dynamics CRM all grew respectably. Office commercial products and cloud services grew 5% in constant currency, fueled by an almost 70% increase in Office 365 revenue. Dynamics CRM Online seat additions have more than doubled year over year for the fifth consecutive quarter.

 

On the consumer side, Microsoft reports that Office 365 now has approximately 20.6 million subscribers.

 

Intelligent Cloud

 

Revenue in the Intelligent Cloud segment rose 5% to $6.3 billion, led by server products and cloud services with an increase of 10%. Azure™ revenue was up 140% with revenue from Azure premium services growing almost 3x year over year.

 

Microsoft reported that more than one third of Fortune 500 companies have chosen MS Enterprise Mobility Solutions.

 

This growth is particularly important since Microsoft will rely heavily on cloud revenue in the future.

 

More Personal Computing

 

Not surprisingly, revenue in the More Personal Computing segment declined 5% to $12.7 billion. Windows OEM revenue was down 5% in constant currency, although that figure still outperforms the PC market. Phone revenue was down 49%.

 

On the positive side, search advertising revenue (excluding traffic acquisition costs) was up 21% and Surface revenue increased by 29%. The number of Xbox® Live monthly active users grew 30% year over year to 48 million.

 

Volume Licensing Revenue Summary (Q2 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 12%.

 

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 $25 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.

 

Continued Monetization of the Cloud

 

Microsoft has enjoyed great success with Azure, Office 365 and their cloud computing platform but it’s important to note that this growth is a relatively new market for the company and has become a necessary revenue stream to offset declining sales of Windows and on-premises Office. The challenge is that as cloud based storage and services become increasingly commoditized, prices are declining. A recent report suggests that public cloud pricing fell 66% during the past two years and the trend is likely to continue. Price wars between Microsoft, AWS, Google and others will continue to apply downward pressure. We expect this to be partially offset as an increasing number of organizations and individual users migrate to the cloud but Microsoft will have to find revenue from other products and services if they want to overcome the current trends.

 

Aggressive Pressure to Upgrade to Windows 10

 

Windows 10 has been a success to date by most accounts and fortunately, it has proven to be a very good operating system, but Microsoft is alienating many users with their pressure to upgrade. Issues such as constant “offers” to upgrade and consuming resources by automatically downloading the code onto users’ devices has become a major annoyance to many and has resulted in some people refusing to install if only out of defiance.

 

Microsoft recently announced a change to the support duration for some Windows 7 and 8 users. The published support lifecycle states that support for Windows 7 will continue until 2020 and Windows 8 will be supported until 2023 but in a surprising move, Microsoft has backed off that promise for some. Users whose devices have the latest processor from Intel, AMD or Qualcomm will no longer receive most software or security updates after July 17, 2017 and will be forced to move to Windows 10 if they wish to receive the same support they have today. Microsoft defends the practice, claiming that going forward they will be able to focus on deeper integration between Windows and the silicon, resulting in improved performance and security, but changing the rules part way through the previously promised support lifecycle is not going to go over well, particularly in organizations with sizeable investments in newer hardware.

 

In another attempt to motivate users to upgrade, Microsoft recently announced that they will impose the annoying GWX (Get Windows 10) messages on domain-joined business PCs which had previously been exempt.

 

Microsoft apparently believes that their user base is so entrenched in the Windows platform that these tactics aren’t enough to alienate users to a point of going elsewhere but using forceful or even annoying tactics to motivate users is rarely a good practice.

 

FY16 Predictions and Roadmap Information

 

Internet of Things (IoT)

 

The Internet of Things continues to gain momentum and attention. Some of the projected numbers being tossed around are astronomical and unlikely to ever materialize, but regardless of the eventual numbers, the IoT is here to stay and growing rapidly.

 

The IoT is so vast that people’s expectations and understanding of the concept vary dramatically. In a relatively simple form, it refers to multiple devices connected by the internet with the ability to capture and report their activity. The resulting data can be used to communicate success or failure, trends, equipment failure or pending failure, load balancing, automation, medical activity, and so on. In some cases the entity supporting the connected device may be able to receive notification of a problem and transmit a fix before a failure occurs. The list of possibilities seems almost endless.

 

Many believe that communication protocol and platform standardization are the most important keys to the IoT but while critical, these are only some of the hurdles to be addressed. Whenever a device is connected to the internet it becomes vulnerable to security and privacy encroachments as well as malicious activity. Finally, with all of the data being captured, those gathering the information will need tools to analyze the data and take appropriate action.

 

Microsoft is investing heavily in the IoT as they are supporting it in Windows 10 and also on Raspberry Pi. There is also an IoT Suite for Azure.

 

Continued Cross-platform Offerings

 

Microsoft will continue to make their products available on competing operating platforms such as iOS and Android. A recent example is Microsoft News Pro, which is a news application for Apple’s iOS devices. We view this particular app as being somewhat of a desperate attempt to get another MS product into the iTunes library, rather than something expected to be widely successful. Apple users in particular are fiercely loyal and News Pro doesn’t appear significantly different from Apple’s News application which comes built into iOS 9.

 

Just because we question the future of News Pro doesn’t mean we disagree with Microsoft’s strategy of penetrating competing platforms. Some products, such as Office, which has already been released for Apple and Android devices have been hugely successful and continue to enhance Microsoft’s presence on non-Windows devices.

 

Updates to Enterprise Products

 

As shown on the list below, we expect major releases to most enterprise products. This will be partially to leverage and enable the functionality of Windows 10 and is also consistent with the more frequent update schedules Microsoft announced last year.

 Product Releases

 

Azure Stack – Q4, 2016

BizTalk Server 2016 – Q4, 2016

Dynamics CRM 2016 – Released

Dynamics AX – Q1, 2016

Dynamics GP 2016 – 1st Half, 2016

Exchange 2016 – Released

SharePoint Server 2016 – Q1, 2016

SQL Server 2016 – Q2, 2016

System Center 2016 – Q3 2016

Windows 10 “Redstone” – Q3, 2016

Windows Server 2016 – Q3, 2016

 

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.

2016-11-17T11:15:56+00:00 Nov 2016|