Analysis of Microsoft’s® 3rd Quarter FY 2017 Earnings Report from a Licensing Perspective
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, Q3
Revenue and Operating Income for FY2017, Q3
Contributions by Business Segment
Microsoft’s Volume Licensing Revenue Summary for FY2017, Q3
Predictions for the future and products that have recently been released or will be launched during coming months
Summary of the Financial Results
For the first time since January, 2014, Microsoft missed revenue expectations. Analysts were looking for top-line revenue of $23.62 billion, which the software giant narrowly missed, reporting $23.56 billion (non-GAAP). Conversely, adjusted EPS was $0.73, which represents a 19% increase over the same period a year ago, and beating expectations by three cents.
Revenue in Productivity and Business was up 22% to $8 billion, largely due to a 45% increase in commercial Office 365 revenue. LinkedIn revenue contributed $975 million.
Intelligent Cloud revenue beat expectations, with $6.76 billion, up 11%, vs. $6.60. Azure revenue was up 93% over last year, representing continued strength and growth in the cloud.
The More Personal Computing segment reported $8.84 billion, which fell short of the expected $9.22 billion. This number was down 7% from the same period last year. Microsoft attributed the decline to be largely due to reduced phone revenue, although phone revenue never seemed to be much of a factor.
The company reported contracted, not billed revenue of $27.5 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 $4.6 billion to shareholders during the quarter in the form of dividends and share repurchases.
Revenue and Operating Income (FY17 3rd Quarter)
|Three Months Ended March 31,|
|($ in millions, except per share amounts)||Revenue||Operating Income||Net Income||Diluted Earnings per Share|
|2016 As Reported (GAAP)||$20,531||$5,283||$3,756||$0.47|
|Net Impact from Windows 10 Revenue Deferrals||1,625||1,625||1,282||0.16|
|2016 As Adjusted (non-GAAP)||$22,156||$6,908||$5,038||$0.63|
|2017 As Reported (GAAP)||$22,090||$5,594||$4,801||$0.61|
|Net Impact from Windows 10 Revenue Deferrals||1,467||1,467||914||0.12|
|2017 As Adjusted (non-GAAP)||$23,557||$7,061||$5,715||$0.73|
|Percentage Change Y/Y (GAAP)||8%||6%||28%||30%|
|Percentage Change Y/Y (non-GAAP)||6%||2%||13%||16%|
|Percentage Change Y/Y (non-GAAP) Constant Currency||7%||5%||16%||19%|
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|
|Nine Months Ended|
|Productivity and Business Processes||$7,958||$6,521||$21,998||$19,517|
|More Personal Computing||8,836||9,539||29,953||31,474|
|Corporate and Other||(1,467)||(1,625)||(5,324)||(4,616)|
|Operating income (loss)|
|Productivity and Business Processes||$2,783||$2,981||$9,159||$9,429|
|More Personal Computing||2,097||1,751||6,524||5,154|
|Corporate and Other||(1,467)||(1,625)||(5,324)||(4,616)|
|Total operating income||$5,594||$5,283||$16,996||$17,102|
Three Months Ended March 31
Productivity and Business
Revenue in Productivity and Business grew 22% to $8 billion as key products such as cloud services, Office 365™, and Dynamics™ all grew respectably. Revenue from Office commercial products and cloud services grew 7%, driven by a 45% increase in Office 365 Commercial revenue.
Dynamics products and cloud services revenue was up 10%, thanks largely to increases in Dynamics 365 revenue growth of 81%.
On the consumer side, Microsoft reports that Office 365 now has approximately 26.2 million subscribers, with Office and cloud revenue increasing by an impressive 15%.
LinkedIn contributed revenue of $975 million, with a gross margin of 59% during its first complete quarter since the acquisition was finalized.
Revenue in the Intelligent Cloud segment rose 11% to $6.8 billion, led by server products and cloud services with an increase of 15%. Azure™ revenue was up respectably once again, at 93%.
Enterprise Services revenue decreased 1% with declines in custom support agreements, although these were offset by Premiere Support Services and consulting.
More Personal Computing
Once again, revenue in the More Personal Computing segment was down, this time by 7%, to $8.8 billion. This was largely due to a 26% decline in Surface revenue. The declining Surface sales are likely due to the anticipation of a new Surface Pro, which is expected later this year.
Windows OEM revenue increased by 5% year over year, as did Windows commercial products and cloud services.
Volume Licensing Revenue Summary (Q2 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 12% 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 $20.4 billion in unearned revenue, which is up 9% year-over-year.
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.
Cross Platform Windows
CEO Satya Nadella continues to push for a single version of Windows that will run on all devices (PC, mobile, etc.). He has been promoting this idea to varying degrees since becoming CEO, and probably before. It’s an interesting idea, and if successfully executed, could finally give Microsoft a meaningful presence in the mobile OS space, but even a non-technical observer can see some of the risks and challenges. We’re not betting against Microsoft at this point, but since multiple devices often run on differing processors and other hardware components, it seems like a challenge to fully exploit the capabilities of one without compromising to accommodate the other(s). Regardless, Nadella has promoted the idea as recently as last week, so we expect to see some degree of activity in this area in the future.
Declining Profit Margins
It’s hard to look at Microsoft and be concerned about their financial status, particularly since they have $9 billion in free cash flow (up 11%), and to be fair, this topic isn’t as much about concern, as it is about preserving shareholder confidence and loyalty. While top-line revenue continues to grow, and long term Volume Licensing receivables remain strong, bottom-line profitability is declining. It’s unlikely that this will ever become an operational concern, but Microsoft is doing whatever they can to preserve their traditionally lofty margins, which often results in price increases, customer audits, and less favorable discounting.
Customer Resistance to Cloud Computing
Microsoft continues to gain market share in the cloud, both with subscription based software such as Office 365, and with hosting and other Azure services. While we anticipate this momentum to continue, Microsoft is becoming increasingly unwilling to accommodate the desires of organizations who have so far, refused to move to the cloud. This may not be a risk at first glance, but Microsoft has enjoyed a well-deserved turnaround in public (and customer) perception since Satya Nadella took over. As is so often the case, customers will continue to use Microsoft products and services when they must, but if Microsoft does too much to alienate them, customers will look elsewhere when given an opportunity.
FY17 Predictions and Roadmap Information
LinkedIn and Dynamics 365
Microsoft made its first major announcement about how the newly acquired LinkedIn will fit into the Microsoft ecosystem. Beginning in July, they plan to integrate data from LinkedIn’s Sales Navigator into Microsoft’s CRM and ERP offering, Dynamics 365. They also plan to use data from LinkedIn in their upcoming (July) HR application, Dynamics 365 for Talent, as well as Dynamics 365 for Retail, which is also expected in July.
It’s rather difficult to visualize how these integrations will work, and there is nothing inherently “risky” about any of them, but any time you’re dealing with a $26 billion acquisition, the cost of failure could be very high. LinkedIn is reportedly used by more than 500 million users in 200 countries, so the amount of raw data is huge if Microsoft can find an effective way to use it.
We expect Microsoft to continue with their ongoing updates to Windows, which typically include both feature and functionality enhancements. The Creators Update was recently released, and we expect another significant update, Redstone 3, sometime during the fall.
We will continue to see Microsoft pushing the cloud, both as a complete hosting service as well as in hybrid solutions. An increasing number of organizations are beginning to trust cloud providers, and Microsoft is making it very appealing to get them to make the move. Rarely do organizations suddenly abandon their existing on-prem datacenters, so they start with a hybrid solution in which they retain certain functionality and data onsite, while using the cloud for short term needs or less mission-critical demands.
Despite Microsoft’s desire to move everyone to the cloud, they are not abandoning on-prem customers. They recently released Azure Stack, which allows users to deploy Azure either exclusively on-prem, or in a hybrid environment. Unfortunately, organizations using Azure Stack must by new hardware to do so, making it less appealing than if they could use their existing hardware, but at least Microsoft is offering an opportunity to use Azure tools and functionality in house. This may be little more than a “seeding” strategy, intended to get users hooked on Azure so they will eventually move to the cloud, but regardless, it’s a small step toward accommodating continued on-prem customers.
Surface Pro 5
While we have seen no official release date for the next Surface tablet, it was previously rumored to release at alongside the Windows 10 Creators Update (Redstone 2), which obviously didn’t happen. Still, we expect it within the coming months, if not weeks.
Azure Stack – Mid-2017
Dynamics™ CRM update – July, 2017
Dynamics 365 for Talent – July, 2017
Dynamics 365 for Retail – July, 2017
Dynamics GP 2016 update – May 1, 2017
Microsoft Teams – Released
SharePoint Framework update – Q2, 2017
SQL Server 2017 – Mid-2017
SQL Server on Linux – Mid-2017
Visual Studio 2017 – Released
Windows 10 Redstone 2 Creators Update – Released
Windows 10 Redstone 3 Creators Update – Fall, 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.