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Analysis of Microsoft’s® 4th Quarter FY 2017 Earnings Report from a Licensing Perspective

//Analysis of Microsoft’s® 4th Quarter FY 2017 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 FY2017, Q4

Revenue and Operating Income for FY2017, Q4

Contributions by Business Segment

Microsoft’s Volume Licensing Revenue Summary for FY2017, Q4

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 narrowly missed revenue expectations during their third fiscal quarter, but they more than made up for it by crushing expectations in the forth.

Analysts were looking for top-line revenue of $24.3 billion, which the software giant exceeded, reporting $24.7 billion for the quarter (non-GAAP).  This represents a 13% year-over-year increase.  Perhaps even more impressive, adjusted EPS was $0.98, which beat expectations of $0.71.

Revenue in Productivity and Business was up 21% to $8.4 billion, largely due to a 13% increase in consumer Office 365 revenue.  Microsoft reports there are now 27 million Office 365 Consumer subscribers.

LinkedIn revenue contributed $1.1 billion during the quarter.

Intelligent Cloud revenue beat expectations, with $7.4 billion, up 11%, vs. $7.3.  Azure revenue was up 97% over last year, representing continued strength and growth in the cloud.

The More Personal Computing segment reported $8.8 billion.  This number was down 2% from the same period last year.  Microsoft attributed the decline to be largely due to reduced Surface and phone revenue, although phone revenue never seemed to be much of a factor.

The company reported contracted, not billed revenue of $31.5 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 $4.6 billion to shareholders during the quarter in the form of dividends and share repurchases.

 

Revenue and Operating Income (FY17 4th Quarter)

 

Three Months Ended June 30,
 ($ in millions, except per share amounts)RevenueOperating IncomeNet IncomeDiluted Earnings per Share
2016 As Reported (GAAP)$20,614$3,080$3,122$0.39
  Net Impact from Windows 10 Revenue Deferrals2,0272,0271,4660.19
  Impairment and Restructuring Expenses1,1108950.11
2016 As Adjusted (non-GAAP)$22,641$6,217$5,483$0.69
2017 As Reported (GAAP)$23,317$5,330$6,513$0.83
  Net Impact from Windows 10 Revenue Deferrals1,3831,3839090.12
  Impairment and Restructuring Expenses3062430.03
2017 As Adjusted (non-GAAP)$24,700$7,019$7,665$0.98
Percentage Change Y/Y (GAAP)13%73%109%112%
Percentage Change Y/Y (non-GAAP)9%13%40%42%
Percentage Change Y/Y (non-GAAP) Constant Currency10%16%42%43%

 

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

              June 30,

Twelve Months Ended

            June 30,

  
 2017 2016 2017 2016
Revenue    
Productivity and Business Processes $8,446   $6,970 $30,444   $26,487
Intelligent Cloud7,434  6,71127,440  25,042
More Personal Computing8,820  8,96038,773  40,434
Corporate and Other(1,383) (2,027)(6,707) (6,643)
Total revenue $23,317     $20,614 $89,950     $85,320
    
Operating income (loss)    
Productivity and Business Processes $2,754     $2,989 $11,913     $12,418
Intelligent Cloud2,501  2,1809,138  9,315
More Personal Computing1,764  1,0488,288  6,202
Corporate and Other(1,689) (3,137)(7,013) (7,753)
  Total operating income $5,330     $3,080 $22,326     $20,182

 

 

Three Months Ended June 30

 

Productivity and Business

 

Revenue in Productivity and Business grew 21% to $8.4 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 43% increase in Office 365 Commercial revenue.

Dynamics products and cloud services revenue was up 7%, thanks largely to increases in Dynamics 365 revenue growth of 74%.

On the consumer side, Microsoft reports that Office 365 now has approximately 27 million subscribers, with Office and cloud revenue increasing by an impressive 13%.

LinkedIn contributed revenue of $1.1 billion.

 

Intelligent Cloud

 Revenue in the Intelligent Cloud segment rose 11% to $7.4 billion, led by server products and cloud services with an increase of 15%.  Azure™ revenue was up respectably once again, at 97%.

Enterprise Services revenue decreased 3% with declines in custom support agreements, although these were offset by Premiere Support Services.

 

More Personal Computing

Once again, revenue in the More Personal Computing segment was down, this time by 2%, to $8.8 billion.  This was largely due to decline in phone revenue, as they were still shipping phones during the comparable quarter last year.

Windows OEM revenue increased by 1% year over year, which is slightly ahead of the overall PC market.

 

 Volume Licensing Revenue Summary (Q4 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 30% 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 $27.8 billion in unearned revenue, which is up 13% 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.

 

Data Security

Microsoft has identified data security as one of their primary sales and corporate objectives.  This may seem somewhat obvious, but the implications of a widespread or particularly damaging security breach or malware attack could be devastating.  The company’s top priority is to move new and existing customers to Azure and Office 365.  Millions of organizations rely upon and trust Azure today, but a major concern many continue to express is one of data security in the cloud.  The Azure cloud is probably much safer than most on-prem datacenters, but the hesitation to abandon traditional thinking remains for many.  If Azure, or another major cloud service provider such as AWS, were to suffer a significant attack, the concerns of many would be confirmed, which could dramatically impact Microsoft’s sales and reputation.

 

Fragmented Windows Installed Base

One of the arguments Microsoft used when they announced Windows 10 and the plan for continuous updates was that they wanted a single version of the OS, rather than multiple versions as has been the case in the past (XP, Vista, 7, 8.1).  The idea sounds good, and when most organizations and individuals are finally running Windows 10, the result should be much better than before, but Microsoft will still face challenges that will result in multiple “versions” of Windows 10.  For example, Intel™ recently stopped supporting “Clover Trail” Atom™-based chips, which were being sold in devices as recently as 2014.  Three years may be an eternity for technology, but there are many individuals and organizations that don’t upgrade that frequently.  Since Intel will no longer provide firmware or driver support, impacted devices will be unable to leverage some features of the Windows 10 Creators Update.  Fortunately, Microsoft will continue to provide security updates to impacted customers, but they will be stuck with the Anniversary Update indefinitely.  User frustration is compounded because they don’t learn of the incompatibility until after downloading the Creators Update (3GB), at which time they receive the message: “Windows 10 is no longer supported on this PC”.  They are also instructed to “Uninstall this app”, which is misleading since they can still use the existing version of Windows 10.

It’s conceivable that we’ll face similar situations in the future, which will result in market fragmentation within Windows 10.

 

FY18 Predictions and Roadmap Information

Increased Motivation to Sell the Cloud

When Microsoft announced the widely-expected reorganization of their Sales and Marketing teams earlier this month, they also said they will shift their sales strategy from one of selling specific products to one of selling multi-product solutions.  At the surface, this sounds like a way to sell additional products, and potentially, bundles which may contain products users may not want, but will be forced to pay for as part of a solution.  This may certainly occur, but Microsoft claims to be responding to customer feedback requesting less emphasis on licensing, and more emphasis on consumption, usage and deployment.

We have witnessed countless occasions where Microsoft was reluctant to negotiate terms for on-prem/perpetual licenses, as they attempt to motivate customers to the cloud.  Microsoft sales professionals and executives are compensated based upon Azure usage and consumed revenue.  This will result in increased emphasis on cloud computing and services.

There is a growing number of enterprise customers claiming to prefer Azure over rivals such as AWS, Google and IBM, and some are even predicting that Azure will soon surpass AWS for market leadership.  While this seemed all but impossible a few years ago, Microsoft has repeatedly reported nearly doubling Azure revenue with every earnings release, and this quarter was no exception at 97%.

Chris Weber, Microsoft CVP Commercial Growth, prioritizes Azure, followed by Office 365, Windows 10, and data security as the top priorities for sales.  We expect this to continue throughout FY18 and beyond.

 

Enterprise Feedback

Microsoft periodically solicits input from several of their key enterprise customers.  It’s unlikely that Microsoft would disclose topics they don’t plan to act upon, but they have acknowledged the following four topics:

  1. Stop selling licensing; focus on making customers successful through consumption, usage, and deployment.
  2. Be more industry relevant – Focus on the customer’s specific vertical or industry.
  3. Help customers get to the cloud – More technical assistance requested from MS.
  4. Working with MS is too complex.

The recently announced reorg tries addressing some of these.  The Sales organization will now be divided into two primary groups, Enterprise and Small, Medium and Corporate (SMC).  They have divided the Enterprise group into six verticals: education, financial services, government, healthcare, manufacturing and retail.  They also claim to be increasing their efforts to provide technical assistance for organizations moving to the cloud.  Since cloud adoption is the top priority for Microsoft, we expect them to follow through, although it’s too soon to predict exactly what that may entail.

 

Product Releases

 Azure Stack – September, 2017

Dynamics™ 365 update – Summer, 2017

Dynamics 365 for Talent – July, 2017

Dynamics 365 for Retail – July, 2017

SharePoint Framework update – Released

SQL Server 2017 – Mid-2017

SQL Server on Linux – Mid-2017

Windows 10 Redstone 3 Creators Update – September, 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.

 

2017-07-23T16:11:31+00:00 Jul 2017|