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Analysis of Microsoft’s® 1st Quarter FY 2019 Earnings Report from a Licensing Perspective

//Analysis of Microsoft’s® 1st Quarter FY 2019 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 FY2019, Q1

Revenue and Operating Income for FY2019, Q1

Contributions by Business Segment

Microsoft’s Volume Licensing Revenue Summary for FY2019, 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 beat revenue and profit expectations yet again during their first fiscal quarter, driven by a 76% increase in Azure revenue.

Analysts were looking for top-line revenue of 24.54 billion, which the software giant exceeded, reporting $29.1 billion for the quarter (non-GAAP).  This represents a 19% year-over-year increase.  Adjusted EPS was $1.14, which beat expectations of $0.96.

Revenue in Productivity and Business was up 19% to $9.8 billion, largely due to a 36% increase in commercial Office 365 revenue.  Microsoft reports there are now 32.5 million Office 365 Consumer subscribers.

LinkedIn revenue increased 33%, fueled by a 34% growth in LinkedIn sessions.

Intelligent Cloud revenue was $8.6 billion, up 24%.  Azure revenue was up 76% over last year, representing continued strength and growth in the cloud.

The More Personal Computing segment reported $10.7 billion.  This number was up 15% from the same period last year.

The company reported commercial unearned revenue of $30.2 billion.  While they typically offer a comparison to the same quarter a year ago, they elected not to this time because the LinkedIn acquisition prevents an accurate comparison.  Commercial unearned revenue is primarily sales from volume licensing agreements which have been booked but not yet recorded.

Microsoft returned $6.1 billion to shareholders during the quarter in the form of dividends and share repurchases, representing a 27% over the same quarter a year ago.

 

Revenue and Operating Income (FY19 1st Quarter)

 

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

 September 30,

 2018 2017
Revenue:
Product $17,299  $14,298
Service and other11,785 10,240
Total revenue29,084 24,538
Cost of revenue:
Product3,649 2,980
Service and other6,256 5,298
Total cost of revenue9,905 8,278
Gross margin19,179 16,260
Research and development3,977 3,574
Sales and marketing4,098 3,812
General and administrative1,149 1,166
Operating income9,955 7,708
Other income, net266 276
Income before income taxes10,221 7,984
Provision for income taxes1,397 1,408
Net income $8,824  $6,576
Earnings per share:
Basic $1.15  $0.85
Diluted $1.14  $0.84
Weighted average shares outstanding:
Basic7,673 7,708
Diluted7,766 7,799
Cash dividends declared per common share $0.46   $0.42
 

 

 

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 September 30,
20182017
Revenue
Productivity and Business Processes  $9,771  $8,238
Intelligent Cloud    8,567    6,922
More Personal Computing  10,746    9,378
  Total$29,084$24,538
Operating Income
Productivity and Business Processes$3,881$3,006
Intelligent Cloud  2,931  2,137
More Personal Computing  3,143  2,565
  Total$9,955$7,708

 

 

 

Productivity and Business

Revenue in Productivity and Business grew 19% to $9.8 billion as key products such as cloud services, Office 365™, and Dynamics™ all grew respectably.  Revenue from Office commercial was up 36%, driven by continued growth in Office 365 subscriptions.  LinkedIn revenue was up 33%.

Dynamics products and cloud services revenue were up 20%, thanks largely to a 51% increase in Dynamics 365 revenue.

On the consumer side, Microsoft reports that Office 365 now has approximately 32.5 million subscribers, with Office and cloud revenue increasing by an impressive 16%.

LinkedIn revenue grew 33%.

Intelligent Cloud

 

Revenue in the Intelligent Cloud segment rose 24% to $8.6 billion, led by Azure™, where revenue was up respectably yet again, at 76%.

Enterprise Services revenue increased 6%.

 

More Personal Computing

 

Revenue in the More Personal Computing segment was up 15% to $10.7 billion.

Windows OEM revenue increased by 3% year over year, driven by an 8% growth of OEM Pro, reflecting a strengthening commercial PC market.

Windows commercial products and cloud services increased 12%, largely due to an increase in multi-year agreements that have higher in-quarter revenue recognition.

Surface revenue increased by 14%.

 

Volume Licensing Revenue Summary (Q41, FY19)

 

The company reports 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 $30.2 billion in commercial 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.

 

Targeted Advertising using LinkedIn Data

 

Microsoft recently enabled “profile targeting” for their advertisers that leverages LinkedIn data for search campaigns in the US.  The announcement was made on the Bing Ads blog and is now available for current Bing Ads marketers.  Microsoft claims that accessible data will not include information such as a person’s name or address, but Microsoft is touting this as a way for advertisers to capture professional data, including company name, job function and industry.  LinkedIn is a business and employment related service, that contains professional information which many users probably won’t want used for targeted marketing purposes.  With more than 575 million members globally, the advertising revenue for Microsoft is significant, but they will likely alienate some of their members.

 

Artificial Intelligence (AI)

 

Microsoft is investing heavily in Artificial Intelligence (AI).  There are obviously more accurate and detailed descriptions of AI, but I think of it as decisions or actions made by devices using data captured by devices.  It wouldn’t be fair to assume that these decisions or actions are unmonitored or unchecked, but the sheer volume of data and speed with which devices can analyze and react make it easy to see why AI has and will continue to be such a major component in our lives, both now and in the future.  The Internet of Things (IoT) plays a key role in AI, as devices connected to the internet are needed to capture the data which AI will use to make decisions and act accordingly.

To be widely successful, Artificial Intelligence will rely upon multiple devices, data, and standards from multiple sources.  There will be circumstances in which data integrity, security, privacy and decisions made by AI will be compromised, possibly due to poor data or policies, poor algorithms, equipment failures, or a multitude of reasons.  While proponents will admit the risks, they also consider the benefits to outweigh the risks.  Microsoft obviously believes this, but they also acknowledge the risks.  After their Q4FY 2018 Earnings Release, Microsoft warned investors about the possibility of “brand or reputational harm” that could arise from the use of certain AI technologies.  Negative news travels quickly, particularly with the help of social media.  As is so often the case, headlines grab attention and many readers fail to objectively research or validate the facts.  In the case of an AI failure, it’s very possible (likely?) that well-known contributors such as Microsoft will be blamed, even if the errors occurred elsewhere.  There are also social, political or ethical issues which may arise from AI solutions which could negatively impact Microsoft.

 

FY19 Predictions and Roadmap Information

 

Microsoft as an OEM!

 

It would have seemed unheard of years ago, but the software giant is developing a meaningful presence in the hardware market. Many industry insiders, including myself, were skeptical when Microsoft released the Surface RT in 2012.  Branding a computing device was a major deviation from their traditional business model, and it was perceived as a threat to Microsoft OEMs whose software royalties had been a major portion of Microsoft revenue for many years.  Ironically, the Surface RT was deemed a failure by many, but that was due to the somewhat crippled version of Windows (RT), rather than the hardware itself.  Microsoft persevered and replaced the RT with Surface models that run full versions of Windows.  Today, the Surface product family includes the relatively entry-level Surface Go, the Surface Laptop 2, Surface Pro 6, Surface Book 2, and soon, the Surface Studio 2.  The hardware in these devices rival, if not surpass that of similar offerings from Apple, which typically enjoy a reputation for elegance and performance.  Gartner recently reported that Microsoft has become the fifth largest PC vendor by unit shipments in the US.  There is nothing to suggest that Microsoft will ever be a dominant player in the PC market, but the growth of the Surface product line is yet another indication of Microsoft’s ability to reinvent itself in response to changing market opportunities.  We expect Microsoft to continue to invest in Surface and accessories such as the upcoming noise-cancelling Surface Headphones.

 

Office 2019

 

On September 24, 2018, Microsoft announced the general availability of Office 2019 for Windows and Mac.  Office 2019 is the latest version of Office for on-prem users who do not use the cloud-based Office 365.  Office 2019 includes many features and enhancements which have been made available to Office 365 customers during the past three years, but since perpetual Office doesn’t receive those updates, they are incorporated into the on-prem updates.  There has been speculation that Microsoft may no longer update the popular on-prem productivity suite, but the company has confirmed at least one more update in the future.

 

Product Releases

 

BizTalk Server – 1st Half 2019

Dynamics™ 365 update – Released

Exchange Server 2019 – Q4, 2018

Microsoft 365 – Released

Microsoft 365 Security – Released

Office 2019  – Released

SharePoint Server 2019 – October, 2018

Skype for Business Server 2019 – 2nd Half 2018

Teams – Continuous updates

Windows 10 “Redstone 5” – Released

 

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.

 

2018-10-25T11:54:16+00:00Oct 2018|