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Analysis of Microsoft’s® 4th Quarter FY 2018 Earnings Report from a Licensing Perspective

//Analysis of Microsoft’s® 4th 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.

New Microsoft Reporting Segments

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, Q4

Revenue and Operating Income for FY2018, Q4

Contributions by Business Segment

Microsoft’s Volume Licensing Revenue Summary for FY2018, 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 beat revenue and profit expectations once again during their fourth fiscal quarter, driven by an 89% increase in Azure revenue.  This propelled the stock to an all-time high of $108.

Analysts were looking for top-line revenue of 29.21 billion, which the software giant exceeded, reporting $30.09 billion for the quarter (non-GAAP).  This represents a 17.5% year-over-year increase.  Adjusted EPS was $1.13, which beat expectations of $1.08.

Revenue for the year was $110.4 billion, which is a 14% year-over-year increase.  Earnings for the year were $3.88 per share.

Revenue in Productivity and Business was up 13% to $9.7 billion, largely due to a 38% increase in commercial Office 365 revenue.  Microsoft reports there are now 31.4 million Office 365 Consumer subscribers.

LinkedIn revenue increased by $397 million, to $1.46 billion.

Intelligent Cloud revenue was $9.6 billion, up 23%.  Azure revenue was up 89% over last year, representing continued strength and growth in the cloud.

The More Personal Computing segment reported $10.8 billion.  This number was up 17% from the same period last year.

The company reported commercial unearned revenue of $29 billion, up 23%, driven by strong cloud billings.  Commercial unearned revenue is primarily sales from volume licensing agreements which have been booked but not yet recorded.

Microsoft returned $5.3 billion to shareholders during the quarter in the form of dividends and share repurchases.

 

Revenue and Operating Income (FY18 4th Quarter)

 

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

 June 30,

Twelve Months Ended

 June 30,

 2018 2017 2018 2017
Revenue:
   Product $17,159  $16,057 $64,497  $63,811
   Service and other 12,926  9,548 45,863  32,760
      Total revenue 30,085  25,605 110,360  96,571
Cost of revenue:
   Product 3,517  3,141 15,420  15,175
   Service and other 6,225  5,315 22,933  19,086
      Total cost of revenue 9,742  8,456 38,353  34,261
      Gross margin 20,343  17,149 72,007  62,310
Research and development 3,933  3,514 14,726  13,037
Sales and marketing 4,760  4,292 17,469  15,461
General and administrative 1,271  1,355 4,754  4,481
Restructuring0  3060  306
Operating income 10,379  7,682 35,058  29,025
Other income, net 301  276 1,416  876
Income before income taxes 10,680  7,958 36,474  29,901
Provision for (benefit from) income taxes 1,807 (111) 19,903 4,412
Net income $8,873 $8,069 $16,571 $25,489
Earnings per share:
   Basic $1.15 $1.05 $2.15 $3.29
   Diluted $1.14 $1.03 $2.13 $3.25
Weighted average shares outstanding:
   Basic7,6837,7157,7007,746
   Diluted7,7757,8067,7947,832
Cash dividends declared per common share $0.42   $0.39 $1.68  $1.56

 

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

 June 30,

 Twelve Months Ended

 June 30,

  
 2018 2017 2018 2017
Revenue    
Productivity and Business Processes $9,668   $8,548 $35,865  $29,870
Intelligent Cloud 9,606   7,82232,219  27,407
More Personal Computing 10,811   9,23542,276  39,294
  Total $30,085 $25,605$110,360 $96,571
    
Operating Income (Loss)    
Productivity and Business Processes $3,466   $2,891 $12,924   $11,389
Intelligent Cloud 3,901   2,911 11,524   9,127
More Personal Computing 3,012   2,186 10,610   8,815
Corporate and Other0  (306)0  (306)
  Total$10,379  $7,682$35,058 $29,025

 

Microsoft Q4 FY 2018 vs Q4 FY 2017

  

Productivity and Business

Revenue in Productivity and Business grew 13% to $9.7 billion as key products such as cloud services, Office 365™, and Dynamics™ all grew respectably.  Revenue from Office commercial was up 10%, driven by continued growth in Office 365 subscriptions.  LinkedIn revenue was up 37% to $1.46 billion.

Dynamics revenue was up 11%, thanks largely to increases in Dynamics 365 revenue.

On the consumer side, Microsoft reports that Office 365 now has approximately 31.4 million subscribers, with Office and cloud revenue increasing by an impressive 8%.

LinkedIn revenue grew 37% to $1.46 billion.

 

Intelligent Cloud

 

Revenue in the Intelligent Cloud segment rose 23% to $9.6 billion, led by Azure™, where revenue was up respectably yet again, at 89%.

Enterprise Services revenue increased 8%.

 

More Personal Computing

 

Revenue in the More Personal Computing segment was up 17% to $10.8 billion.

Windows OEM revenue increased by 7% year over year, driven by an 14% growth of OEM Pro, reflecting a strengthening commercial PC market.

Windows commercial products and cloud services increased 23%, largely due to an increase in multi-year agreements that have higher in-quarter revenue recognition.

Surface revenue increased by 25%.

 

Volume Licensing Revenue Summary (Q4, FY18)

 

The reporting segments make it difficult to isolate Volume Licensing revenue, although Microsoft did report that “Commercial bookings” were up 18% year-over-year, driven largely by customer commitment to commercial cloud.

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 $29 billion in commercial unearned revenue, which is up 23% 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.

 

Facial Recognition and AI

 

One of the many challenges faced by Microsoft and other cutting-edge tech companies is that as technology advances, the results often exceed that which may be appropriate for existing laws or even that which is considered socially acceptable.  During our Q3 FY18 Earnings Analysis, we considered the legal implications of a potential US Supreme Court ruling which could require US based companies to disclose user data which is stored on servers located outside the US.  It’s an example of a relatively new technology which probably didn’t exist or certainly wasn’t widely used when the current laws were written.

Today, Microsoft and others, are facing another challenge which could also have major legal implications.  The improving reliability of facial recognition has made it a critical factor for many public and private sector organizations and individuals.  We can use it for seemingly mundane tasks such as unlocking a smartphone, which doesn’t seem to have a lot of privacy concerns since the user is aware that they are using the technology.  The possibilities for facial recognition seems almost endless, however, particularly when enhanced by artificial intelligence (AI).  Consider the potential benefit to being about to scan a crowded airport or robbery scene, for example, to locate suspected criminals, or evaluating a crowd after a terror attack.  Many (most?) would agree that the end justifies the means, particularly in extreme cases, but there are many applications for facial recognition that are not extreme but will very likely employ the technology.

As is typically the case, privacy and other laws vary by country, but in the US and many other regions, an individual’s right to privacy is demanded by individuals and highly protected by laws.  Microsoft is heavily invested in AI, facial recognition, the IoT and other technologies that can combine to leverage these new market opportunities, but protecting personal privacy is a primary tenet of Microsoft’s core values.

Facial recognition is not going away.  It will continue to evolve as software reliability and scanning devices improve, but it will not be without challenges or setbacks.  One of the core challenges will be that of scanning and capturing an individual’s presence without their consent.

We expect Microsoft to proceed cautiously, and possibly lobby for some degree of legislation or protection, but just as with offshore servers, it’s unclear how much enforcement US lawmakers may be able to mandate outside of the US.

 

FY19 Predictions and Roadmap Information

 

 Office 2019

 

We would be remiss if we failed to acknowledge the pending update of the most widely used productivity software suite available.  Office 2019 is expected sometime during the coming months, as Microsoft has simply advised us that it will be released during the “second half of 2018”.  Office 2019 is the perpetual license counterpart to Office 365, which is a subscription product.  While there are some subtle differences between the two, the primary differences are the way we buy them and the way they are updated.  As previously noted, Office 2019 has a perpetual license; meaning that the user buys it now and has the right to use it indefinitely.  By contrast, O365 is a subscription, for which the user has a pay-as-you-go model, with the option to pay monthly or annually.  O365 use rights end when the user stops paying, whereas the license to use Office 2019 never ends.

The second major difference between the two is that O365 continuously receives feature updates in addition to maintenance and security updates.  Office 2019 customers receive maintenance and security updates, but no new features or functionality.

 

Microsoft Phone Rumor

 

There is a rumor on the street which, presumably originated at Windows Latest, stating that Microsoft is working on a Microsoft-branded Android based smartphone.  Even the article suggests that the source may be mistaken, and we’re going to jump on that bandwagon.

There has long been speculation about some sort of “phone” functionality as part of their Surface line, and it’s quite possible that’s where the latest rumor started.  The latest member of the Surface family of products, the Surface Go, will be available on August 2.  While not included in the first release, The GO promises to offer LTE functionality, hopefully later this year.  It has been more than a year since Microsoft CEO Satya Nadella said “I’m sure we’ll make more phones, but they will not look like phones that are there today.”  That quote lead to a great deal of speculation, and we haven’t seen anything new to date.

There has also been speculation about “Andromeda”, which is the code name for a Surface device that is intended to further merge PC and smartphone functionality.

It’s conceivable that the Surface GO could have some for of telephony app, or that Andromeda may materialize at some point, but we question the likelihood of a dedicated Microsoft-branded smartphone.

Frankly, we question the wisdom of Microsoft producing a smartphone or phone-like device.  Their original business model was one in which Microsoft wrote the software and licensed it to hardware manufacturers (OEMs) so they could produce the (expensive) devices.  The smartphone market is already saturated.  Microsoft would have to offer something truly revolutionary to compete.

 

Product Releases

 

Dynamics™ 365 update – October, 2018

Exchange Server 2019 Preview – Q3, 2018

Exchange Server 2019 – Q4, 2018

Office 2019  – Q4, 2018

SharePoint Server 2019 – Q4, 2018

Skype for Business Server 2019 – 2nd Half 2018

Teams – Continuous updates

Windows 10 “Redstone 4” – Released

Windows 10 “Redstone 5” – Fall, 2018

 

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.

2018-07-23T13:17:23+00:00Jul 2018|