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Analysis of Microsoft’s® 3rd Quarter FY 2018 Earnings Report from a Licensing Perspective

//Analysis of Microsoft’s® 3rd 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, Q3

Revenue and Operating Income for FY2018, Q3

Contributions by Business Segment

Microsoft’s Volume Licensing Revenue Summary for FY2018, 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 beat revenue and profit expectations once again during their third fiscal quarter.

Analysts were looking for top-line revenue of $25.77 billion, which the software giant exceeded, reporting $26.8 billion for the quarter (non-GAAP).  This represents a 16% year-over-year increase.  Adjusted EPS was $0.95, which beat expectations of $0.85.

Revenue in Productivity and Business was up 17% to $9 billion, largely due to a 42% increase in commercial Office 365 revenue.  Microsoft reports there are now 30.6 million Office 365 Consumer subscribers.

LinkedIn revenue contributed $1.3 billion during the quarter.

Intelligent Cloud revenue was $7.9 billion, up 17%.  Azure revenue was up 93% over last year, representing continued strength and growth in the cloud.

The More Personal Computing segment reported $9.9 billion.  This number was up 13% from the same period last year.

The company reported commercial unearned revenue of $20 billion, up 20%.  Commercial unearned revenue is primarily sales from volume licensing agreements which have been booked but not yet recorded.

Microsoft returned $6.3 billion to shareholders during the quarter in the form of dividends and share repurchases.

 

Revenue and Operating Income (FY18 3rd Quarter)

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

 March 31,

Nine Months Ended

 March 31,

 2018 2017 2018 2017
Revenue:
Product $15,114 $14,513 $47,338 $47,754
Service and other11,7058,69932,93723,212
Total revenue26,81923,21280,27570,966
Cost of revenue:
Product3,4253,07511,90312,034
Service and other5,8444,98516,70813,771
Total cost of revenue9,2698,06028,61125,805
Gross margin17,55015,15251,66445,161
Research and development3,7153,35510,7939,523
Sales and marketing4,3353,87212,70911,169
General and administrative1,2081,2023,4833,126
Operating income8,2926,72324,67921,343
Other income, net3493711,115600
Income before income taxes8,6417,09425,79421,943
Provision for income taxes1,2171,60818,0964,523
Net income $7,424 $5,486 $7,698 $17,420
Earnings per share:
Basic $0.96 $0.71 $1.00 $2.25
Diluted $0.95 $0.70 $0.99 $2.22
Weighted average shares outstanding:
Basic7,6987,7257,7067,756
Diluted7,7947,8137,7987,840
Cash dividends declared per common share $0.42  $0.39 $1.26  $1.17

 

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

 March 31,

 Nine Months Ended

 March 31,

  
 2018 2017 2018 2017
Revenue    
Productivity and Business Processes $9,006  $7,707 $26,197  $21,322
Intelligent Cloud7,896 6,73022,613 19,585
More Personal Computing9,917 8,77531,465 30,059
Total $26,819  $23,212 $80,275  $70,966
Operating Income    
Productivity and Business Processes $3,115  $2,540 $9,458  $8,498
Intelligent Cloud2,654 2,1487,623 6,216
More Personal Computing2,523 2,0357,598 6,629
Total $8,292  $6,723 $24,679  $21,343

 

 Productivity and Business

 

Revenue in Productivity and Business grew 17% to $9 billion as key products such as cloud services, Office 365™, and Dynamics™ all grew respectably.  Revenue from Office 365 commercial was up 42%, with more than 135 million active monthly users.

Dynamics products and cloud services revenue was up 17%, thanks largely to increases in Dynamics 365 revenue growth of 65%.

On the consumer side, Microsoft reports that Office 365 now has approximately 30.6 million subscribers, with Office and cloud revenue increasing by an impressive 12%.

LinkedIn revenue grew 37% to $1.3 billion.

 

Intelligent Cloud

Revenue in the Intelligent Cloud segment rose 17% to $7.9 billion, led by server products and cloud services with an increase of 20%.

Azure™ revenue was up respectably yet again, at 93%.

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

Enterprise Services revenue increased 8%.

 

More Personal Computing

Revenue in the More Personal Computing segment was up 13% to $9.9 billion.

Windows OEM revenue increased by 4% year over year, driven by an 11% growth of OEM Pro, reflecting a strengthening commercial PC market.

Windows commercial products and cloud services increased 21%, largely due to an increase in multi-year agreements that have higher in-quarter revenue recognition.

Surface revenue increased by 32%, although the major increase is largely due to product lifecycle timing during the comparable quarter last year.

 

Volume Licensing Revenue Summary (Q3, FY18)

The reporting segments make it difficult to isolate Volume Licensing revenue, although Microsoft did report that “Commercial bookings” were up 26% year-over-year, driven largely by customer commitment to commercial cloud.

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 billion in commercial unearned revenue, which is up 20% 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.

 

Legal Challenges

The computing revolution we have witnessed during the past few decades has dramatically changed the way we work, communicate, find and store information.  It has helped create countless breakthroughs in healthcare, sciences, technology, entertainment and even personal efficiency.  While most of these advances have been widely beneficial, there are ways in which the governing laws around the world have been tested as never before.  Microsoft has been the subject (often Defendant) of many high-profile cases, including governmental disputes alleging anti-trust and unfair trade practices, and also private disputes over patent and copyright disputes, predatory marketing and business practices, and many others.

While many of these cases had industry-wide or international implications, few have had the potential to set the global precedent of the current United States v. Microsoft Corporation, where the US Supreme Court will decide whether a digital communications provider will be required to turn over user data when the information is stored on servers outside of the US.  The implications go far beyond US privacy laws, which can have polarizing volitivity by themselves.  If Microsoft and others are required to relinquish data stored offshore, it introduces potential violations of international laws and agreements with other countries, who are not bound by US law.  On the earnings call, Satya Nadella stated that “We recognize that privacy is a fundamental human right, and we have consistently acted accordingly”.

It’s hard to predict exactly what will happen if the Court rules against Microsoft, but at some level we need to consider the impact it may have on Microsoft’s (and others) plans for cloud computing.  Data security has been perhaps the greatest barrier to many organizations embracing the cloud, but that concern is finally diminishing for many.  If privacy is now at risk, whether email records, personal information or potentially trade secrets, organizations will have a new reason to resist the cloud and may be more likely to retain their data on-prem.

 

FY18 Predictions and Roadmap Information

Decreased Discounting

 

We all know that Microsoft is trying to motivate their customers to move to the cloud.  Part of the way they do this is to offer attractive pricing for cloud services such as Office 365 and Azure to customers who are still using products on-premises.  They don’t offer similar discounts for on-prem products, so when Microsoft gets aggressive enough in their pricing, many customers eventually acquiesce.  From a pricing perspective, that’s beneficial during the term of the current agreement, but when it comes time for renewal, Microsoft has already accomplished their goal, so they refuse to renew at such deep discounts.  Most customers assume they will realize similar discounts upon renewal, and they’re surprised when it doesn’t happen.  Some of them threaten to reduce their reliance upon Microsoft by buying competing products, but Microsoft knows how disruptive that can be to most organizations, so they rarely take the threat seriously.

There is nothing to indicate that this practice will change.  If you haven’t yet moved to the cloud, it’s wise to leverage the aggressive pricing while you can, but don’t expect it to continue upon renewal.

 

Fewer Audits for Azure Customers?

I’m not ready to make this a prediction at this point, but I’m beginning to wonder if Microsoft may attempt to entice organizations to move all their computing to the Azure cloud, in exchange for assurance that Microsoft won’t audit them, or at least change the way they monitor compliance.  This wouldn’t be an altruistic offering on the part of Microsoft, because by hosting computing on Azure servers, Microsoft could, with permission of the customer, monitor the way in which software is accessed and used.  This wouldn’t eliminate the need for customers to maintain compliance, but since most organizations want to be compliant, they may find it interesting to allow Microsoft to monitor them in exchange for the risk of an unexpected audit.  Microsoft could use this as a competitive advantage against AWS and other cloud service providers, as they would only offer it to Azure customers.

 

 Product Releases

Dynamics™ 365 update* – Released

Dynamics 365 for Talent* – Released

Dynamics 365 for Marketing* – Released

Dynamics 365 for Sales* – Released

Dynamics 365 for Retail* – Released

Exchange Server 2019 Preview – Q2, 2018

Exchange Server 2019 – Q4, 2018

Office 2019 Preview – Q2, 2018

Office 2019  – Q4, 2018

SharePoint Server 2019 Preview – Q2, 2018

SharePoint Server 2019 – Q4, 2018

Windows 10 “Redstone 4” – May 8, 2018

Windows 10 “Redstone 5” – Fall, 2018

Windows Admin Center (Honolulu) – Released

 

* Expect a model restructuring/rename for Dynamics 365 Products

 

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.

 

2018-07-23T13:18:59+00:00Apr 2018|