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Analysis of Microsoft’s® 4th Quarter FY 2016 Earnings Report from a Licensing Perspective

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Preface

Microsoft® reports earnings in three operating segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing.

segments_q2_2016

Microsoft

 

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 FY2016, Q4

Revenue and Operating Income for FY2016, Q4

Contributions by Business Segment

Microsoft’s Volume Licensing Revenue Summary for FY2016, 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 surprised analyst’s by reporting better than expected earnings for the final quarter of their 2016 fiscal year. The software giant reported adjusted revenue of $22.64 billion (up from $22.18 billion a year earlier), or $0.69 per share (non-GAAP). This exceeded Wall Street expectations of $22.14 billion and $0.58 EPS.

 

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

 

The company reported contracted, not billed revenue of $25.5 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.

 

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 7% to $6.7 billion.

 

Revenue and Operating Income (FY16 4th Quarter)

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

 

2016_q4_1

 

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

 
 
 2016_q4_2

2016_q4_3

Productivity and Business

 

Revenue in Productivity and Business grew 5% to $7 billion as key products such as cloud services, Office 365™, and Dynamics CRM all grew respectably. Office commercial products and cloud services grew 5%, driven by a 54% increase in Office 365 commercial revenue growth. Dynamics CRM Online seat additions have increased by 2.5x year-over-year. This marks the seventh consecutive quarter in which Dynamics CRM Online doubled.

 

On the consumer side, Microsoft reports that Office 365 now has approximately 23.1 million subscribers, with revenue increasing by 19%.

 

Intelligent Cloud

 

Revenue in the Intelligent Cloud segment rose 7% to $6.7 billion, led by server products and cloud services with an increase of 5%. Azure™ revenue was up 102% with usage of Azure compute and Azure SQL database more than doubling year-over-year.

 

The number of Enterprise Mobility customers almost doubled from the previous year, now exceeding 33,000 as the installed user base grew nearly 2.5x. This growth is particularly important since Microsoft will rely heavily on cloud revenue in the future.

 

More Personal Computing

 

Not surprisingly, revenue in the More Personal Computing segment was down 4%, primarily due to the continuously declining Windows and Windows Phone revenue.

 

On the positive side, search advertising revenue (excluding traffic acquisition costs) was up 16% and Surface revenue increased by 9%. The number of Xbox® Live monthly active users grew 33% year over year to 49 million.

 

Volume Licensing Revenue Summary (Q4 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 3%.

 

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 $24.6 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.

 

LinkedIn™

 

Microsoft’s $26.2 billion cash acquisition of LinkedIn is the largest in Microsoft’s history.  Much has been said and speculated about their plans for the business-oriented social networking company, and there are some obvious synergies between the two companies, but it remains to be seen whether they will ever realize enough benefit to justify the lofty price.

 

The predictions are complicated because LinkedIn doesn’t generate a great deal of directly measurable revenue, and certainly not enough to justify $26.2 billion. The greater value will presumably be the way in which Microsoft can merge LinkedIn’s data and functionality with products such as their CRM tools, Cortana, Windows, Office and others. CEO Satya Nadella has suggested possibilities such as CRM and an “intelligent newsfeed”, but even he hasn’t offered a particularly convincing strategy.

 

Another interesting factor is that Microsoft claims that LinkedIn will operate as a “fully independent entity within Microsoft”. In a memo to employees, LinkedIn CEO Jeff Weiner stated that they should expect mostly “business as usual”. It’s unlikely that Microsoft can merge significant data and functionality if LinkedIn continues to operate as they have in the past.

 

End of Support

 

All Microsoft products eventually reach the end of their support cycle, but Microsoft is using this as a means of motivating users to upgrade to newer or different versions. For example, earlier this year they stopped providing security updates for Internet Explorer versions lower than IE 11. They also stopped supporting Windows 8 in January (mainstream support for Windows 8.1 will continue until 1/9/2018).

 

This may not be significant for most users, but for organizations using legacy tools that may not run on the latest version or would be cost prohibitive or disruptive to upgrade, the implications can be severe. In many cases, organizations can’t simply continue to use the unsupported software as it may result in a violation of their legal obligation to protect the data or privacy of their customers, since Microsoft is no longer offering security updates.

 

Windows 10

 

Citing Windows 10 in itself isn’t considered a risk, as it has proven to be arguably Microsoft’s best OS to date, despite the well-deserved criticism Microsoft has received for their tactics to get users to upgrade. The risk is that in spite of all the positive attributes of Windows 10, the harassing nagware and questionable motivational tactics endured by those who have yet to upgrade is severely tarnishing Microsoft’s reputation.

 

Another factor that may cast a shadow over Windows 10 is that they are not likely to reach the 1 billion devices by mid-2018 as they so famously predicted. Microsoft blames this at least in part on the lack of Windows Phone sales, which were predicted to contribute at least 50 million handsets per year.

 

Microsoft has also stated that they will not extend the free upgrade offer past July 29, as some have suggested. In reality, this may be somewhat meaningless since eligible users who haven’t upgraded by now, may not do it even if the deadline were to be extended.

 

Changing Business Model

 

As Microsoft moves from being a traditional software provider to a company providing software as a service, they are challenged to maintain their earnings as traditional revenue streams such as perpetual Office and Windows are replaced by subscriptions and services such as Office 365 and Azure. The surprisingly positive earnings reported during the past quarter is certainly encouraging, but since they fell short of expectations during the previous quarter, we have yet to witness a significantly positive trend.

 

FY17 Predictions and Roadmap Information

 

Azure

 

As Microsoft transitions from a traditional software provider to a services company, we will see continued attempts to lure customers to the cloud. This will be evident in numerous ways, including special promotions, product and service bundling, and pricing incentives. We are also seeing significant resistance to negotiating on the part of Microsoft when customers wish to purchase or revert to traditional, on-prem perpetual licenses.

 

With respect to Azure and the overall cloud market, we expect Microsoft to continue to gain market share. While they may never catch AWS, we’re seeing an increasing number of organizations embrace the cloud, whether in whole or with a hybrid model. There are a number of factors contributing to this. As cloud computing matures, people are becoming more trusting in the reliability and security of cloud computing.  Whereas many were reluctant to entrust a third party in the past, major cloud service providers are proving that they are often not only safe, but in many cases, they are more diligent in their security and data management than even the most advanced on-prem datacenters.

 

Microsoft will continue to leverage their existing relationships with enterprise customers in ways that competitors such as AWS and Google can’t compete. It’s also quite likely that many of the smaller providers will be unable to compete with the major players and will be forced out of the market.

 

Increasing Software Audits

 

As Microsoft continues to fill the revenue void left by traditional perpetual license and software sales, we expect them to increase 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 they prove that they are almost 100% compliant). By exercising their audit rights, they force organizations to verify their compliance and purchase any additional licenses necessary to become fully compliant.

 

Conversations as a Platform

 

Last quarter, 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.

 

Last month, Microsoft bought Wand Labs, a chat application for iOS. Wand was formed in 2013 as a technology to enable access to third party services by using natural language capabilities.

 

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.

 

We don’t know when we will see this technology in product form, but it is clear that Microsoft is serious about the concept.

 

Windows 10 Anniversary Update (Redstone)

 

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

 

 

Product Releases

 

Azure Stack – Mid-2017

BizTalk Server 2016 – Q4, 2016

Dynamics CRM 2016 – Released – Next update: Q3, 2016

Dynamics GP 2016 – 2nd half 2016

SharePoint Server 2016 – Released

SQL Server 2016 – Released

System Center 2016 – September, 2016

Windows 10 “Redstone” – August, 2016

Windows Server 2016 – September, 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|