Preface

 

Microsoft® reports revenue by “Devices and Consumer” and “Commercial” divisions, and reports in the following six segments:

 

Devices and Consumer (D&C)
HardwareComputing and Gaming Hardware
Licensing

Phone

Hardware   

Windows® OEM, Windows Phone®, Office Consumer, IP Licensing

Nokia™ devices

OtherBing® and MSN®, Office 365™ Home Premium, 1st Party Video Games,

Marketplaces

Commercial
LicensingWindows® Enterprise, Server Products, Office Business, Dynamics,

Unified Communications

OtherEnterprise Services, Office 365™, Azure, Dynamics CRM Online


The document is structured in the following manner:

  • Summary of the Financial results for FY2015 Q2
  • Revenue and Operating Income for FY2015 Q2
  • Contributions by Business Segment
  • Microsoft’s Volume Licensing Revenue Summary for FY2015, Q2
  • 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 had a respectable second quarter as they met and slightly exceeded Wall Street’s expectations, although expectations were rather conservative due to sluggish PC sales and a strong US dollar. The software giant reported revenue of $26.5 billion, compared with $24.5 billion from the same quarter a year ago. Diluted Earnings-Per-Share were 71 cents, compared to 78 cents a year ago. Analysts were expecting EPS of 71 cents and revenue of $26.3 billion. Despite earnings being in line with expectations, investors were clearly disappointed as shares of Microsoft stock plunged approximately 10% on the news.

 

Revenue and Operating Income (FY15 2nd Quarter)

Three Months Ended December 31

($ in millions, except per share amounts)

Revenue

Gross Margin

Operating Income

Diluted EPS

2013 As Reported (GAAP)

$24,519

$16,197

$7,969

$0.78

2014 As Reported (GAAP)

$26,470

$16,334

$7,776

$0.71

%Y/Y (GAAP)

8%

1%

(2)%

(9)%

2014 Impact of Noted Items

$(243)

$(0.02)

 

Contributions by Business Segment

 

In Millions

 

2nd_quarter_fy_2015-1 

 

SEGMENT REVENUE AND GROSS MARGIN

(In millions)(Unaudited)

 

Three Months Ended December 31

 

Six Months Ended December 31

 

 

 

2014

 

2013

 

2014

 

2013

Revenue

 

 

 

 

 

Devices and Consumer Licensing

 $     4,167

 

 $  5,544

 

 $     8,260

 

 $10,028

Computing and Gaming Hardware

3,997

 

4,470

 

6,450

 

5,879

Phone Hardware

2,284

 

0

 

4,893

 

0

Devices and Consumer Other

2,436

 

1,874

 

4,245

 

3,428

Commercial Licensing

10,679

 

10,906

 

20,552

 

20,517

Commercial Other

2,593

 

1,780

 

5,000

 

3,382

Corporate and Other

314

 

(55)

 

271

 

(186)

  Total revenue

 $   26,470

 

 $24,519

 

 $   49,671

 

 $43,048

 

 

 

 

 

 

Gross Margin

 

 

 

 

 

Devices and Consumer Licensing

 $     3,876

 

 $  4,981

 

 $     7,694

 

 $  8,901

Computing and Gaming Hardware

460

 

411

 

939

 

616

Phone Hardware

331

 

0

 

809

 

0

Devices and Consumer Other

550

 

387

 

862

 

711

Commercial Licensing

9,926

 

10,080

 

19,026

 

18,885

Commercial Other

900

 

415

 

1,705

 

689

Corporate and Other

291

 

(77)

 

227

 

(221)

  Total gross margin

 $   16,334

 

 $16,197

 

 $   31,262

 

 $29,581

  • D&C Licensing, comprising: Windows, including all original equipment manufacturer (“OEM”) licensing (“Windows OEM”) and other non-volume licensing and academic volume licensing of the Windows operating system and related software (collectively, “Consumer Windows”); non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers (“Consumer Office”); Windows Phone, including related patent licensing; and certain other patent licensing revenue.
  • Computing and Gaming Hardware, comprising: the Xbox 360® gaming and entertainment console and accessories, second-party and third-party video games, and Xbox LIVE® subscriptions (“Xbox Platform”); Surface™; and Microsoft PC accessories.
  • Phone Hardware, comprising: Nokia™ devices
  • D&C Other, comprising: Resale, including Windows Store, Xbox LIVE transactions, and the Windows Phone Marketplace; search advertising; display advertising; Subscription, comprising Office 365 (“O365”) Home Premium; Studios, comprising first-party video games; our retail stores; and certain other consumer products and services not included in the categories above.

 

Overall Devices and Consumer revenue increased by 8% to $12.9 billion, due to increased revenue from Office 365 Home and Personal and sales of the Surface Pro 3 ($1.1 billion, up 24%). Xbox console sales totaled 6.6 million units.

 

Devices and Consumer Licensing declined across the board as Windows Phone revenue was down 61% as a result of accounting recognition upon closure of the Nokia acquisition. Windows OEM revenue was down 13%, and Office Consumer declined 25% as users migrated to Office 365.

 

Microsoft reported that Office 365 now has more than 9.2 million non-commercial subscribers, representing a 30% growth over the previous quarter.

 

Commercial

 

•  Commercial Licensing, comprising: server products, including Windows Server, Microsoft SQL Server, Visual Studio, and System Center; Windows Embedded; volume licensing of the Windows operating system, excluding academic (“Commercial Windows”); Microsoft Office for business, including Office, Exchange, SharePoint, and Lync (“Commercial Office”); Client Access Licenses, which provide access rights to certain server products (“CAL”); Microsoft Dynamics business solutions, excluding Dynamics CRM Online; and Skype.

•  Commercial Other, comprising: Enterprise Services, including Premier product support services and Microsoft Consulting Services; Cloud Services, comprising O365, excluding O365 Home Premium (“Commercial O365”), other Microsoft Office online offerings, Dynamics CRM Online, and Windows Azure; and certain other commercial products and online services not included in the categories above.

 

Commercial revenue increased 5% to $13.3 billion, largely as a result of a 114% increase in commercial cloud revenue driven by Office 365, Azure, and Dynamics CRM. Server products and services revenue increased 9% with double digit growth for SQL Server and System Center.

 

Volume Licensing Revenue Summary (Q2 FY15)

 

Commercial Licensing revenue decreased 2% to $10.68 billion. This was primarily the result of decreased revenue from Commercial Office perpetual licenses as many users moved to Office 365. Server product revenue grew by 11%. Somewhat surprisingly, Windows volume licensing revenue grew by 3% as declining transactional revenue was offset by annuity revenue growth.

 

Commercial Other revenue increased $2.59 billion, or an impressive 46%, thanks to continued increases in Commercial Cloud revenue.

 

Unearned revenue from Volume Licensing programs 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. Also included in unearned revenue are payments for post-delivery support and consulting services to be performed in the future. Microsoft currently reports $21.2 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.

 

Windows® 10

We are learning more about the next version of Microsoft’s Windows operating system. Microsoft has a lot riding on Windows 10, both from a functional perspective and also in terms of rebuilding their credibility and public image. Their image was severely tarnished by the poor performance of Windows Vista, but there was a time when that was considered an isolated incident. Vista was not the first disappointing OS from Microsoft (remember Bob and ME?), but since Vista was touted as an enterprise product the disappointing performance was more noticeable than most. Windows 7 was a major improvement, but Windows 8 is considered worse than Vista by many, leading customers to question what may be coming next.

 

Windows 10 is expected to be released during the second half of 2015 and it promises to be the most ambitious and complex version to date. Windows 10 will include new features such as Cortana®, the new personal digital assistant, and Sparta, which is a completely redesigned browser. This latest version of Windows will also include scaled down Office functionality with touch enabled editions of Word, Excel®, PowerPoint®, OneNote®, and Outlook®. Microsoft is also promising unprecedented security features and a suite of utilities for managing photos, videos, music, maps, messaging, mail, and calendars. These new additions and others would be difficult under any circumstances, but perhaps the most noteworthy aspect of Windows 10 is that it promises to work across all devices, including desktop and laptop PCs as well as tablets and mobile devices and the user is expected to be able to seamlessly migrate from one device to another with little or no change in their experience or interface. The new tools and the multi-device functionality are difficult to implement on their own, and the combination of both raises the challenge exponentially. Early reviews have been quite positive, but skeptics question whether Windows 10 can meet expectations.

 

Shifting Revenue Stream 

As reported in this earnings release and others, Microsoft’s cloud revenue (primarily Office 365, Azure, and Dynamics CRM Online) is growing nicely, but these gains are offset by declining revenue elsewhere. The move to the cloud and associated competitive pressure is forcing Microsoft to dramatically cut prices on some of their traditionally more profitable products. Perpetual licenses for Office are being replaced by Office 365 subscriptions. This results in a predictable recurring revenue stream, but competition from Google Apps™ and Apple iWork™ has driven O365 subscription prices lower than desired.  Perhaps more concerning is the announcement made last week that Windows 7, 8.1, and Windows Phone users will be able to upgrade to Windows 10 at no charge during the first year after its release. Microsoft hasn’t traditionally made a tremendous amount of money on Windows upgrades, but the precedent is very concerning. Additionally, they are no longer charging OEMs a Windows royalty for devices nine inches and smaller.

 

Microsoft’s strategy of making more of their products available on multiple platforms appears wise in many respects, but they are often competing with free or extremely inexpensive products. The original strategy for Office had been to enable read-only functionality on Apple™ and Android™ mobile devices and require an Office 365 subscription for editing, but last year the editing restrictions on the free versions were removed. Microsoft can’t continue to buy market share by giving away their products.

Office 2016

Microsoft announced that we can expect the next version of their immensely successful Office suite sometime during the second half of 2015, but they have shared very few details. Traditionally, any major update to MS Office has been highly anticipated from both a revenue and functionality perspective, but this one has us anxious for different reasons. The need for a powerful office productivity suite isn’t going away, but MS Office has offered more functionality than many users have needed for a very long time. We don’t yet know whether Office 2016 will offer identical functionality if incorporated into Office 365 or if the perpetual licensed edition may be different in some way. Microsoft has suggested that Office 2016 will be optimized for keyboard and mouse users, but that would seem somewhat contrary to their recent attempts to standardize applications across multiple platforms and minimize the number of editions or versions available. Another concern is with the margin erosions we just discussed. Office has traditionally been hugely profitable for Microsoft, but if it has to compete with other, less robust tools from Microsoft such as the universal apps which will be included with Windows 10, the potential market size for the full-featured Office suite may be much smaller than in the past.

 

FY15 Predictions and Roadmap Information

 

As Microsoft continues to deviate from their traditional business model in which they supported almost exclusively the Windows platform they must find new ways to differentiate themselves from their competitors. The “Cloud first, mobile first” mantra is a refreshing change and it has created a number of new markets for Microsoft, but these are often markets with less demanding users than Microsoft has catered to in the past. Less demanding users are less likely to pay the premium prices for products as robust as MS Office, for example, particularly when Microsoft themselves are offering less expensive alternatives.

 

Microsoft has to find new ways to monetize their business. One way they will do this will be a continued emphasis on subscription based licensing models. Another will be by entering new markets such as cloud computing which has already proven to be extremely lucrative. They will also look for new ways to maximize revenue received from their existing customers. One example of this may be an even greater emphasis on auditing Volume Licensing (VL) customers. Their practice to date has been to mandate a compliance review from each of their VL customers approximately once every three years. This can take the form of a “self-assessment” in which the customer performs an inventory of all installed MS software and compares that with their license entitlements. Microsoft may also require an onsite audit, which will be performed by an independent third party selected by Microsoft. In either case, the customer will be required to pay for the audit if a discrepancy of greater than 5% is discovered and purchase licenses (often without discounts) necessary to make them compliant. The applicable terms in a VL Agreement state that “If there is no unlicensed use, Microsoft will not undertake another verification of the same customer for at least one year”. In the end, the cost to Microsoft for exercising their audit rights is minimal, while the potential return can be significant. It’s quite possible they may increase the frequency of audits if they find that doing so reveals enough instances of non-compliance.

 

We can also expect a continued push to subscriptions and all things related to Azure and cloud hosting. Many companies are reluctant to abandon their onsite datacenter and make an immediate jump to cloud computing, but the benefits of doing so eventually cannot be ignored. Since Microsoft has existing agreements with most companies, we can expect an increased push for hybrid solutions such as StorSimple® as a means to retain MS customers and gradually move them to a MS-hosted cloud.

 

Product Releases

 

Azure RemoteApp (Mohoro) – Released

Dynamics GP 2015 – Released

Lync Server 2014 – 1st Half, 2015

Office 2016 – 2nd Half 2015

Office 2016 for Mac – 2nd Half, 2015

Office for Android™ – Released

SharePoint Server 2013 SP1 Cumulative Updates – Monthly

Visual Studio 2013 Update 4 – Released

Windows 10 – 2nd half, 2015

 

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 (MAPS) 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.

Nov 2016