Preface

One of the key tenets of negotiation is “knowledge is power”. Analyzing Microsoft’s® Quarterly Earnings Report for the third quarter of the Financial Year 2013 will provide valuable information as you prepare to negotiate your licensing agreement.

 The document is structured in the following way:

  1. A summary of the financial results for FY2013 Q3.
  2. Contributions per business segment
  3. Microsoft’s® Licensing Revenue Summary for FY2013, Q3.
  4. Risk Factors
  5. Predictions for the future as well as recent releases and new products that will be launched during 2013

Summary of the Financial Results

 Revenue and Operating Income (FY13 3rd Quarter)

Revenue for the quarter was $20.5 billion, up 18% from the same period a year ago. Operating income was $7.6 billion, up 19%. Earnings per share were 72 cents, up 20%. Net cash from operations was $9.67 billion, which is up less than 1% from the same period last year. Total operating income was $33.5 billion for the trailing year. These figures are in accordance with generally accepted accounting principles (GAAP), but deserve closer examination.

The reported GAAP figures include revenue deferrals resulting from the Windows® 8 Upgrade Offer, Office® 2013 Upgrade Offer, and Entertainment & Devices Video Game Deferral. These deferred revenues were partially offset by a $731 million fine paid to the European Commission for failing to promote multiple web browsers in the European Union, rather than solely Internet Explorer®. If we include these factors and were to report using Non-GAAP calculations the quarter would reflect $18.8 billion in revenue, $6.7 billion operating income, and 65 cents EPS.

 

Three Months Ended, March 31

Percentage Change

 

(In millions, except per share amounts and percentages)

Revenue

Operating income

Diluted EPS

Revenue

Operating income

Diluted EPS

2012 As reported (GAAP)

$17,407

$6,374

$0.60

 

 

 

2013 As reported (GAAP)

$20,489

$7,612

$0.72

18%

19%

20%

Net revenue recognition for Windows® Upgrade Offer, Office® Upgrade Offer and Pre-Sales, and Video Game Deferral

($1,658)

($1,658)

($0.16)

      

 

 

European Commission fine

$733

$0.09

      

 

 

2013 As adjusted (non-GAAP)

$18,831

$6,687

$0.65

8%

5%

8%

 

Contribution per Segment

 

In Millions

 

3rd_quarter_fy_2013_chart 

 

Windows® Division – The Windows® Division includes OS and related software, certain online services, and PC hardware products, including the Surface™ and Surface™ Pro. They reported $5.7 billion in revenue during the recent quarter, which is up 23% from a same period last year, but that included a $1.1 billion accounting deferral to recognize an upgrade promotion to Windows® 8. Excluding the impact of the accounting deferral, approximately 65% of the division’s revenue comes from OEMs who preinstall on hardware they sell. The remaining revenue comes from commercial and retail sales of Windows® , Surface™, PC hardware products (keyboards, mice, etc.), and online advertising.

 

The Windows® Division revenue increased from the same period a year ago, but that would not have occurred without the $1.1 billion Windows® Upgrade Offer. x86 PC sales are declining and there is nothing to suggest the trend will change. Microsoft® does not appear to have a good strategy for maintaining Windows® dominance as an operating system. This is not the result of a competitive force within the PC market but rather, that the PC is losing its dominance as the computing device of choice.

 

The primary deliverable for this division is Windows®, and the latest version is Windows® 8. There have been many reports to suggest that Windows® 8 is not selling as well as expected, and even MS seems to have become less vocal about celebrating its success.

 

As previously noted, approximately 65% of Windows® sales are preinstalled on new hardware (OEM). This means that if you buy a new PC it may come with Windows® 8 preinstalled whether you intended to “upgrade” or not. Additionally, many Volume Licensing customers are electing to exercise their Downgrade Rights, even if they obtain Windows® 8 on new hardware purchases. This doesn’t mean Windows® 8 isn’t a good product, but it doesn’t confirm that users are aggressively upgrading either. In the enterprise space, many companies will continue to standardize on Windows® 7 to ensure platform consistency except for devices that require touch enablement offered in Windows® 8. Perhaps the greatest reason people aren’t moving to Windows® 8 more quickly is because Windows® 7 isn’t broken. Many customers embraced Windows® 7 because they were dissatisfied with Vista or because of enhancements over XP. In contrast, Windows® 8 isn’t necessarily intended to be a replacement for Windows® 7 in the near term, but rather an OS to let Microsoft® compete in the Tablet space and with new touch-enabled devices.

 

The Server & Tools Business Division reported $5 billion in third quarter revenue, an 11% increase from the prior year period. Approximately 80% of Server & Tools revenue comes from product sales via Volume Licensing, OEM, and retail packaged product. The remainder comes from Enterprise Services. The fastest growing sellers for the division are SQL Server®, Windows® Server, and System Center®.

 

The Microsoft® Business Division reported $6.4 billion in third quarter revenue, an 8% increase from the same period last year. This is another report that deserves closer evaluation. During the quarter, MS® recognized $101 million of revenue related to the Office® 2013 Upgrade Offer, and $92 million related to Office pre-sales. These deferral recognitions compliment increased sales, but must be taken in context.

Business revenue increased $816 million or 6%, reflecting growth in multi-year volume licensing revenue and an 11% increase in Microsoft® Dynamics revenue. Consumer revenue decreased $1.1 billion or 32%, driven by the deferral related to the Office Upgrade Offer and the impact on revenue of a decline in the x86 PC market.

 

Volume Licensing Revenue Summary (Q3 FY13)

 

Enterprise demand for products and services drove strong multi-year commitments resulting in multi-year licensing revenue growth of 16% over the previous year and an unearned revenue balance of $17.9 billion, a 17% increase over the same period year ago.

 

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 $17.9 billion as noted above which has been contracted but not billed.

 

Risk Factors

 

We consider the risks facing Microsoft® when we analyze the Financial Year. For more information on the 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 will provide you with leverage when negotiating your agreement.

 

 

1.  Declining PC Sales:  International Data Corporation® (IDC) recently reported a 13.9% decline in first quarter PC shipments compared to the same period a year earlier. This has to be very concerning for Microsoft®. Their business model has always been to license and sell products that would run on PCs from multiple OEMs.  It didn’t matter to Microsoft® which OEMs were most successful as MS® received revenue from all of them. The strategy was that by developing an OS and products that would run on everyone’s hardware they would create a standard technology platform and MS® would make money from everyone. That strategy has served them well for 30+ years, but it did so because of a reasonably stable PC market. The concern today is that the “decline” in PC sales may be better described as a “migration” to something else. People are still buying computers, but they are now in the form of tablets and smartphones where Microsoft® is years behind the competition.

 

2.  Adoption of Windows® 8 and Office® 2013: For the third consecutive quarter, I consider this to be among the greatest risks facing Microsoft® today. Although dominant on PCs and Laptops, Microsoft® has very little presence when it comes to mobile devices, specifically tablets. Windows® 8 and Office® 2013 have taken significant steps into that arena but neither have been widely embraced to date. Perhaps the biggest reason for the slow adoption is that their predecessors, Windows® 7 and Office® 2010, continue to meet the needs of most customers. The compelling reason to upgrade is to take advantage of the touch screen capabilities offered with the latest versions, but most traditional Office users don’t need touch functionality today, nor do they have the hardware to support it.

 

There has been much debate about whether MS® should release a version of Office® for iOS, Android™, and Symbian® devices. Office is the global standard productivity suite on the PC, but maintaining that dominance requires the PC to remain the dominant computing device, which is clearly at risk. A “mobile” edition of Office® probably wouldn’t require the full functionality of the PC edition, as mobile users would be less likely to use their devices for intense content creation, but they would certainly benefit from the ability to read and edit content. That said, an increasing number of tablet users have external keyboards and/or displays so tablets are the sole computing device for many and that trend is likely to continue.

 

3.  Can Microsoft® remain relevant?: This may seem odd when discussing one of the top ten publically traded companies in the world, but Microsoft® is in a sector that is constantly changing and they no longer demonstrate the innovation and dominance they did in the past. With more than 100,000 employees (including contractors), they are not as agile as they once were and with a stagnating stock price and shareholder scrutiny it’s not as easy to attract and retain the top talent they once did.

 

Microsoft’s® dominance in the enterprise sector remains their strength, but the increased power of portable devices such as tablets and smartphones are blurring the line between corporate and consumer use. Since Apple® and Google® (Android™) are the dominant players in the consumer space, this means Microsoft® has to either accommodate them or defeat them. Defeating Apple® or Google® in the tablet and smartphone markets seems unlikely, so MS® will have no choice other than to find a way to allow their devices into the enterprise ecosystem.

  

FY13/14 Predictions and Roadmap Information

 

This is a pivotal time for Microsoft®. They are fortunate (wise?) to have diversity in their product line, as evidenced by this and recent quarterly earnings, but the landscape is rapidly changing. Technologies developed by Microsoft® literally changed the world and enabled computing devices and functionality which revolutionized the way in which we conduct business, communication, entertainment, personal productivity, research, and so much more. One may argue that software was the catalyst for this revolution, but it relied upon hardware. With time and technology, hardware has become much more powerful and portable, thereby enabling mobility unlike anything we experienced in the past. The need for software has not faded, but device manufacturers have more options for software today than ever before. Microsoft® is obviously aware of this and will likely seek a balance between maximizing traditional revenues and risk losing business to competition which has not been a factor in the past. We will also likely see an increased emphasis on revenue generation from devices such as non-Windows® tablets and smartphones as they access MS® licensed assets, and increased efforts to ensure VL compliance.

 

Many industry analysts expect Windows® 8 adoption to be extremely slow in the enterprise space.

The general expectation is that CIOs will continue to invest in cloud solutions to deliver productivity and scalability to their business.

 

Microsoft® is expecting continued low double digit growth in licensing revenue in the Microsoft® Business Division, and they will aggressively negotiate to achieve those goals.

 

MS® has invested heavily in virtualization and improving their market share against Cisco® and VMware® is key to their strategy.

 

Product Releases

 

BizTalk® Server 2013 – Released

Dynamics® CRM – Mid 2013

Dynamics® ERP – Mid 2013

Exchange® Server 2013 – Released

Lync® Server 2013 – Q2 2013

Microsoft® Desktop Optimization Pack (MDOP) – Released

Office® 365 – Released (Open VL only)

Office® 2013 – Released

SharePoint® 2013 – Released

Windows® 8 “Blue” – Q3 2013

Windows® Embedded 8 – Released

 

Release schedules 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® 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®.

For Further information, please contact Emerset.

Nov 2016