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Analysis of Microsoft’s® 2nd Quarter FY 2018 Earnings Report from a Licensing Perspective

//Analysis of Microsoft’s® 2nd Quarter FY 2018 Earnings Report from a Licensing Perspective

Preface
 

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

 

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 FY2018, Q2
Revenue and Operating Income for FY2018, Q2
Contributions by Business Segment
Microsoft’s Volume Licensing Revenue Summary for FY2018, 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 revenue and profit expectations once again during their second fiscal quarter.

Analysts were looking for top-line revenue of $28.4 billion, which the software giant exceeded, reporting $28.9 billion for the quarter (non-GAAP). This represents a 12% year-over-year increase. Adjusted EPS was $0.96, which beat expectations of $0.87.

Revenue in Productivity and Business was up 24% to $9 billion, largely due to a 41% increase in commercial Office 365 revenue. Microsoft reports there are now 29.2 million Office 365 Consumer subscribers.

LinkedIn revenue contributed $1.3 billion during the quarter.

Intelligent Cloud revenue was $7.8 billion, up 15%. Azure revenue was up 98% over last year, representing continued strength and growth in the cloud.

The More Personal Computing segment reported $12.2 billion. This number was up 2% from the same period last year.

The company reported contracted, not billed revenue of $20.2 billion, up 18%. Contracted, not billed is primarily sales from volume licensing agreements which have been booked but not yet recorded.

Earnings results include a net charge of $13.8 billion related to the Tax Cuts and Jobs Act.

Microsoft returned $5 billion to shareholders during the quarter in the form of dividends and share repurchases.

Revenue and Operating Income (FY18 2nd Quarter)

 

INCOME STATEMENTS
(In millions, except per share amounts)(Unaudited)
Three Months Ended

 December 31,

Six Months Ended

 December 31,

 2017 2016 2017 2016
Revenue:
Product $17,926 $18,273 $32,224 $33,241
Service and other10,9927,55321,23214,513
Total revenue28,91825,82653,45647,754
Cost of revenue:
Product5,4985,3788,4788,959
Service and other5,5664,52310,8648,786
Total cost of revenue11,0649,90119,34217,745
Gross margin17,85415,92534,11430,009
Research and development3,5043,0627,0786,168
Sales and marketing4,5624,0798,3747,297
General and administrative1,1098792,2751,924
Operating income8,6797,90516,38714,620
Other income, net490117766229
Income before income taxes9,1698,02217,15314,849
Provision for income taxes15,4711,75516,8792,915
Net income (loss) $(6,302) $6,267 $274 $11,934
Earnings (loss) per share:
Basic $(0.82) $0.81 $0.04 $1.54
Diluted $(0.82) $0.80 $0.04 $1.52
Weighted average shares outstanding:
Basic7,7107,7557,7097,772
Diluted7,7107,8307,7997,853
Cash dividends declared per common share $0.42  $0.39 $0.84  $0.78

 

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

(In millions)(Unaudited)

 Three Months Ended

 December 31,

 Six Months Ended

 December 31,

  
 2017 2016 2017 2016
Revenue    
Productivity and Business Processes $8,953  $7,179 $17,191 $13,615
Intelligent Cloud7,795 6,75814,717 12,855
More Personal Computing12,170 11,88921,548 21,284
Total $28,918 $25,826 $53,456 $47,754
Operating Income    
Productivity and Business Processes $3,337  $3,053 $6,343  $5,958
Intelligent Cloud2,832 2,2914,969 4,068
More Personal Computing2,510 2,5615,075 4,594
Total $8,679  $7,905 $16,387 $14,620

 

Three Months Ended December 31

  

Productivity and Business
 

Revenue in Productivity and Business grew 25% to $9 billion as key products such as cloud services, Office 365™, and Dynamics™ all grew respectably. Revenue from Office 365 commercial was up 41%.

Dynamics products and cloud services revenue was up 10%, thanks largely to increases in Dynamics 365 revenue growth of 67%.

On the consumer side, Microsoft reports that Office 365 now has approximately 29.2 million subscribers, with Office and cloud revenue increasing by an impressive 12%.

LinkedIn contributed revenue of $1.3 billion.

Office commercial products revenue declined 16%, reflecting the migration to the cloud by many users.

Intelligent Cloud
 

Revenue in the Intelligent Cloud segment rose 15% to $7.8 billion, led by server products and cloud services with an increase of 18%.

Azure™ revenue was up respectably once again, at 98% with compute usage more than doubling.

Azure premium services revenue grew by triple digits for the fourteenth consecutive quarter.

Enterprise Services revenue increased 5% with growth in Premiere Support Services.

More Personal Computing

 

Revenue in the More Personal Computing segment was up 2% to $12.2 billion.

Windows OEM revenue increased by 4% year over year, driven by an 11% growth of OEM Pro. This is slightly ahead of the commercial PC market.

Windows commercial products and cloud services decreased 4%, but this decline is attributed to comparison with a particularly large deal the previous year.

Surface revenue increased by 1%.

Volume Licensing Revenue Summary (Q2, FY18)

 

The reporting segments make it difficult to isolate Volume Licensing revenue, although 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 $20.2 billion in commercial unearned revenue, which is up 18% year-over-year.

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.

 

Security Vulnerabilities

 

Azure, Office 365 and the rest of Microsoft’s cloud services are clearly doing very well and the momentum continues to grow. Microsoft could obviously make some strategic or execution errors, and we know they will make some, but their internal business plan appears to be working well. Unfortunately, they continue to face external threats which may be beyond their control. Microsoft and AWS may have the most sophisticated security and privacy protection anywhere, but nothing is ever 100% secure. If Microsoft or even another large cloud provider were to suffer a major security breach, the damage and publicity could severely impact the positive momentum they’re enjoying today.

Similarly, if they were to experience a significant exploitation of one of their primary products, such as Windows, the market perception could be devastating. Satya Nadella has been incredibly successful in terms of changing the public perception of Microsoft, but if external or internal events create a negative impact of their customers, the public perception will quickly change.

Changing User Trends
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Beginning sometime during 2016, more users are reportedly accessing the internet from mobile devices than from traditional PCs. This trend will continue, forcing Microsoft to compete in the mobile market while losing the dominance they once enjoyed in the OS market. It’s clear that Microsoft won’t be able to significantly erode Android or Apple’s dominance in this space, so Microsoft is shifting their focus to cloud services and other products. They are obviously doing well in the cloud and elsewhere, but they face competition and are less capable of influencing user behavior than in the past.

FY18 Predictions and Roadmap Information

 

Always Connected Personal Computers (ACPC)

 

There hasn’t been a lot of fanfare around it (yet), but HP, Acer and Lenovo are preparing to release thin, light, LTE enabled laptops running Windows on Qualcomm’s Snapdragon™ ARM® processor. This has the potential to be huge for Microsoft, as these devices will not only run all Win32 applications, but they claim battery life may exceed twenty hours of active use and up to thirty days on standby! Combine that with always-connected cellular capability, and the ACPC may finally make Windows a viable competitor in the mobility market.

The amount of data used while connected via 4g, and the cost of data plans will likely be a key factor in the success of ACPCs, but these new devices may prove particularly useful for many.

 Microsoft Stream

 

Microsoft has repeatedly stated their desire to make meetings and conferencing more productive. Skype for Business has been the company’s primary business meeting service, but as Microsoft continues to enhance Teams, which will eventually replace Skype for Business, it appears increasingly likely that they will add video functionality to the mix. Microsoft Stream has been referred to as “YouTube for Business”. Stream is replacing Office 365 Video. While Stream doesn’t include all functionality of O365 Video, it does add valuable tools such as searchable speech-to-text transcription, face detection in videos, and linked timestamps.

Cloud Solution Provider (CSP)

 

Some have speculated that the Cloud Solution Provider licensing model will eventually replace the Enterprise Agreement. Promoting the CSP is consistent with Microsoft’s desire to move everyone to the cloud, and there have been signs that they are tightening the qualification criteria for an EA. Whereas an EA was previously only available to organizations with at least 250 users or devices, that threshold has been increased to 500. Despite the complexity of the Volume Licensing model, Microsoft would like to simplify it as much as they can for as many customers as they can. The EA is intended for their largest enterprise customers who often have complex needs which don’t fit into a largely generic agreement. We’re not suggesting that the CSP can’t be negotiated, but it seems likely that while the qualification criteria for an EA may become more restrictive, the EA will probably remain for the foreseeable future.

Product Releases

 

 Azure Stack Build 1711 – Released

Dynamics™ 365 update – Spring, 2018

Dynamics 365 for Talent – Spring, 2018

Dynamics 365 for Retail – Spring, 2018

Dynamics SL 2018 – First half, 2018

Microsoft Teams – Released

Office 2019 – Second half, 2018

SharePoint Framework update – Released

Windows 10 “Redstone 4” – Spring, 2018

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.

 

2018-02-05T11:22:54+00:00Feb 2018|