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Analysis of Microsoft’s® 3rd Quarter FY 2016 Earnings Report from a Licensing Perspective

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Preface

This is the third 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, Q3

Revenue and Operating Income for FY2016, Q3

Contributions by Business Segment

Microsoft’s Volume Licensing Revenue Summary for FY2016, Q3

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 missed analyst’s expectations by reporting slightly less than expected earnings for the third quarter of their 2016 fiscal year. The software giant reported adjusted revenue of $22.07 billion (up from $21.73 billion a year earlier), or $0.62 per share (non-GAAP). This narrowly missed Wall Street expectations of $22.09 billion and $0.64 EPS.

 

Microsoft returned $6.4 billion to shareholders during the quarter in the form of dividends and share repurchases.

 

The company reported deferred revenue of $25 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 3% to $6.1 billion.

 

Revenue and Operating Income (FY16 3rd Quarter)

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

 

Three Months Ended March 31,

 ($ in millions, except per share amounts)

Revenue

Operating Income

Net Income

Earnings per Share

2015 As Reported (GAAP)

$21,729

$6,594

$4,985

$0.61

  Integration and Restructuring Charges

190

119

0.01

2015 As Adjusted (non-GAAP)

$21,729

$6,784

$5,104

$0.62

2016 As Reported (GAAP)

$20,531

$5,283

$3,756

$0.47

  Net Impact from Revenue Deferrals

1,545

1,545

1,217

0.15

2016 As Adjusted (non-GAAP)

$22,076

$6,828

$4,973

$0.62

Percentage Change Y/Y (GAAP)

(6)%

(20)%

(25)%

(23)%

Percentage Change Y/Y (non-GAAP)

2%

1%

(3)%

0%

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

5%

10%

6%

10%

  

Microsoft presents constant currency (CC) information where noted to provide a non-GAAP framework for assessing business performance while excluding foreign currency rate fluctuations.

 

Contributions by Business Segment

3rd_quarter_fy_2016_earning_report

3rd_quarter_fy_2016_chart

Productivity and Business

 

Revenue in Productivity and Business grew 1% to $6.5 billion as key products such as cloud services, Office 365™, and Dynamics CRM all grew respectably. Office commercial products and cloud services grew 7% in constant currency. Dynamics CRM Online seat additions have more than doubled year over year for the sixth consecutive quarter.

 

On the consumer side, Microsoft reports that Office 365 now has approximately 22.2 million subscribers.

 

Intelligent Cloud

 

Revenue in the Intelligent Cloud segment rose 5% (CC), led by server products and cloud services with an increase of 10%. Azure™ revenue was up 120% (CC) with usage of Azure compute and Azure SQL database more than doubling year-over-year.

 

The number of Enterprise Mobility customers more than doubled from the previous year, now exceeding 27,000. This growth is particularly important since Microsoft will rely heavily on cloud revenue in the future.

 

More Personal Computing

 

Somewhat surprisingly, revenue in the More Personal Computing segment increased 1% despite continuously declining Windows and Windows Phone revenue.

 

On the positive side, search advertising revenue was up 14% and Surface revenue increased by 61%. The number of Xbox® Live monthly active users grew 26% year over year to 46 million.

 

Video game revenue grew 11% as gamers have streamed more than ten million hours of gameplay from Xbox One to Windows 10 PCs.

Volume Licensing Revenue Summary (Q3 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 7%.

 

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.

 

Microsoft vs. DOJ

This isn’t necessarily a risk to Microsoft, but it has the potential to generate criticism in the eyes of many. Microsoft receives numerous orders to allow law enforcement to access users private data residing on Microsoft servers. Microsoft typically complies, but they are suing the DOJ for the right to notify the user when it occurs. The case will likely result in the typical “privacy vs. security” debate, which can be polarizing for some.

 

More Free Software

 

We often find ourselves making some sort of reference to free or declining software prices or the need for continued monetization of Microsoft products as they compete in the cloud and on non-Microsoft platforms and devices. Perhaps the most notable example is the free upgrade to Windows 10 for non-enterprise users, but there have been others.

 

Microsoft recently announced two new editions of SQL Server, which they refer to as SQL Server Express. SQL Server Express is free to developers, primarily as a means to attract developers to an environment in which they can build web and mobile apps for multiple data types which will be used by paying customers. We view this as a positive strategy, but it is still another example of Microsoft reducing their pricing.

 

Another example of free or reduced cost software is intended to lure customers away from Oracle. Beginning with SQL Server 2016, Microsoft is offering free licensing and training to existing Oracle customers. Those accepting the offer will be required to pay for Software Assurance and there are other cost implications that make it far from a truly free offer, but it is a largely unprecedented move on the part of Microsoft.

 

The strategy of making Microsoft products available on competing platforms appears successful to date, but it’s important to note that Microsoft now faces competition from products that are frequently less expensive.

 

Forcing Businesses to Use Windows 10

 

Business PC users had been largely exempt from the nagware and automatic downloading of Windows 10 most other users have experienced since its release in July, but beginning in January, Microsoft subjected domain-joined business PCs to the same practice. Additionally, business users who receive updates via Windows Update are now receiving the Get Windows 10 (GWX) icon on their taskbar. Neither practice is forcing the user to upgrade but the increasing pressure is an annoyance to many.

 

While the nagware and background downloads may be annoying, they aren’t forcing business users to upgrade. There is another, subtler action in play, however. Beginning July 17, 2017, the next chipsets from Intel® (Skylake), Qualcomm® (8996), and AMD® (Bristol Ridge) will only be supported on Windows 10. This means that devices running the latest chipsets on any version of Windows except Windows 10 will no longer receive security and software updates after July of next year.

 

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 perpetual Office licenses. 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.

 

FY16 Predictions and Roadmap Information

 

Microsoft will reach their goal of 1 Billion

 

When Windows 10 was released last year Microsoft made a bold prediction that it would be installed on more than a billion devices within the first few years. While the company was rarely consistent in the messaging, there were a number of instances in which they stated that the “few” would be three. If we consider the number of currently installed systems which Microsoft reports to be 270 million, and assume that upgrades to even a small percentage of those currently running version 7 or 8, Microsoft will be well on their way to their goal. Add to that, the estimated 951 million new PCs expected to ship between 2015 and 2017, most of which will come pre-installed with Windows 10, and the goal seems very attainable, if not conservative.

 

Of course having a billion installed copies of Windows is an impressive number, but it’s not as important as it would have been with previous versions. As Microsoft continues to make their applications and tools available on competing operating systems, the specific OS becomes less important.

 

Conversations as a Platform

 

Satya Nadella unveiled plans to closely integrate human speech with machine intelligence and data, which he refers to as “Conversations as a Platform”. It has also been described as tying Azure™, Office 365, and Windows with communication tools such as Skype®, Cortana®, HoloLens and Windows Ink.

 

A central element of this technology is an increasing reliance upon internet bots. Bots will serve as the new apps responsible for learning broad context data about people, places and things as well as personal data and preferences about the user.

 

It all sounds very conceptual at this point, but Nadella believes this will eventually be as significant as the birth in the Web, or graphical user interface (GUI).

 

Windows 10 Anniversary Update (Redstone)

 

The next significant update to Windows 10 is expected sometime this summer. The free update will add Windows Hello and Windows Ink, as well as improvements to Cortana.

 

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 – Released

Dynamics GP 2016 – May 1, 2016

Exchange 2016 – Released

SharePoint Server 2016 – May, 2016

SQL Server 2016 – Q2, 2016

System Center 2016 – Q3 2016

Windows 10 “Redstone” – Summer, 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.

2016-12-26T13:09:12+00:00 Nov 2016|