Preface

 

When Microsoft® announced their reorganization into a Devices and Services company beginning with the current fiscal year it also resulted in significant changes to the way in which they report earnings.

 

Revenue is now separated into “Devices and Consumer” and “Commercial”, and reported in the following five segments:

 

Devices and Consumer (D&C)
HardwareXbox® and Xbox LIVE® Subscriptions and other hardware
LicensingWindows® OEM, Windows Phone®, Office® Consumer, IP Licensing
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

 

It has always been difficult to determine revenue from individual products unless MS specifically told us, but it is now even more difficult because revenue for some products is divided among more than one distribution channel. For example, Windows® revenue is now divided among D&C Licensing, D&C Other, and Commercial Licensing.

 

The document is structured in the following way:

  • Summary of the financial results for FY2014 Q3
  • Revenue and Operating Income for FY2014 Q3
  • Contributions per business segment
  • Microsoft’s® Volume Licensing Revenue Summary for FY2014, 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® had an excellent quarter, but that may not be reflected without looking beyond initial headlines. They reported flat revenue and a slight decline in net income for the third quarter of FY14, but still managed to beat Wall Street expectations. The software giant reported revenue of $20.40 billion, compared with $20.49 billion from the same quarter a year ago. Earnings per share were 68 cents, compared to 72 cents a year ago. Analysts were expecting EPS of 63 cents and revenue of $20.39 billion.

 

As is so often the case, particularly with Microsoft®, earnings need to be examined beyond just the reported numbers. In reality, MS appears to have had a respectable, if not impressive quarter, particularly amidst declining PC sales and increasing competition from tablets and other mobile devices. The official (reported) numbers reflect adjustments to net revenue related to last year’s Windows® Upgrade Offer, the Office® and Video Game Deferrals, and the European Commission fine. If we disregard those factors and look solely at the Q3 numbers, the report is actually quite impressive with revenue up 8% to $20.4 billion and gross margin up 3% to $14.5 billion, up 3%.

 

Revenue and Operating Income (FY14 3rd Quarter)

 

 

Three Months Ended March 31

($ in millions,except per share amounts)

2013 As Reported (GAAP)

Net revenue recognition for Windows Upgrade Offer, Office Deferral, and Video Game Deferra

European Commission Fine

2013 As Adjusted (Non-GAAP)

2014 As Reported (GAAP)

%Y/Y (GAAP)

%Y/Y (Non-GAAP)

Revenue

$20,489

($1,658)

 

    $18,831

$20,403

(0)%

8%

Gross Margin

$15,702

($1,658)

$14,044

$14,462

(8)%

3%

Operating Income

$7,612

($1,658)

$733

$6,687

$6,974

(8)%

4%

Diluted EPS

$0.72

($0.16)

$0.09

$0.65

$0.68

(6)%

5%

 

Contributions per Segment

 

In Millions

3rd_quarter_fy_2014_chart
 

A description of each segment and their financial performance as provided by MS appears below:

 

Devices and Consumer

 

(In millions,except percentages) 

Three Months Ended  March 31

 

Paercentage Change

 

 Nine Months Ended  March 31     

 

Paercentage Change

 

2014

 

2013

 

 

2014

 

2013

 

 
Revenue

Licensing

$

4,382

 

$

     4,352

 

 

1%

 

$

14,109

 

$

   14,733

 

 

(4)%

 

Hardware

 

1,973

 

 

1,402

 

 

41%

 

 

8,187

 

 

5,294

 

 

55%

 

Other

 

1,950

 

 

1,656

 

 

18%

 

 

5,378

 

 

5,055

 

 

6%

 

 

 

 

 

 

 

 

 

Total revenue

$

8,305

 

$

7,410

 

 

12%

 

$

27,674

 

$

25,082

 

 

10%

 

 

 

 

 

 

 

 

Gross Margin

 

 

 

Licensing

$

3,906

 

$

3,929

 

 

(1)%

 

$

12,809

 

$

13,163

 

 

(3)%

 

Hardware

 

258

 

 

393

 

 

(34)%

 

 

875

 

 

1,603

 

 

(45)%

 

Other

 

541

 

 

430

 

 

26%

 

 

1,324

 

 

1,678

 

 

(21)%

 

 

 

 

 

 

 

 

 

Total gross margin

$

4,705

 

$

4,752

 

 

(1)%

 

$

15,008

 

$

16,444

 

 

(9)%

 
  • 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.
  • D&C 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.
  • 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.

 

D&C Revenue increased $895 million (12%), but it’s important to note that this was primarily a result of increased hardware sales.

 

D&C Licensing revenue increased slightly, due to increased revenue from Consumer Office® and Consumer Windows®as well as increasing sales in Japan. Windows® OEM revenue increased 4%, reflecting a 19% increase in revenue from Windows® OEM Professional. This was partially offset by weakness in the consumer PC market.

 

Commercial

 

(In millions, except percentages)

Three Months Ended  March 31 

 

Paercentage Change

 

Nine Months Ended  March 31  

 

Paercentage Change

 

2014

 

2013

 

 

2014

 

2013

 

 
Revenue

Licensing

$

10,323

 

$

9,979

 

 

3%

 

$

30,805

 

$

29,059

 

 

6%

 

Other

 

1,902

 

 

1,449

 

 

31%

 

 

5,285

 

 

4,086

 

 

29%

 

 

 

 

 

 

 

 

 

Total revenue

$

12,225

 

$

   11,428

 

 

7%

 

$

36,090

 

$

   33,145

 

 

9%

 
       

Gross Margin

 

 

 

Licensing

$

9,430

 

$

9,085

 

 

4%

 

$

28,308

 

$

26,594

 

 

6%

 

Other

 

475

 

 

264

 

 

80%

 

 

1,165

 

 

585

 

 

99%

 

 

 

 

 

 

 

 

 

Total gross margin

$

9,905

 

$

9,349

 

 

6%

 

$

29,473

 

$

27,179

 

 

8%

 

 

  • 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 by $797 million (7%) as a result of increasing cloud business and on-premise licenses. Commercial Office® and Commercial Office 365™ revenue and gross margins each grew by 6%.

 

Volume Licensing Revenue Summary (Q3 FY14)

 

Enterprise demand for products and services drove strong multi-year commitments resulting in $10.3 billion in revenue for the quarter, an increase of 3% over the previous year. This increase may be largely attributed to momentum and emphasis upon cloud services as Commercial Cloud revenue more than doubled again this quarter. Server product revenue increased by 10%, while Office Commercial revenue grew by 6%. Lync®, SharePoint®, and Exchange grew by double digits collectively.

 

Commercial Licensing revenue was up 3% to $10.32 billion. Contributing to that was SQL Server® revenue which gained more than 15%. Windows® volume licensing revenue was up 11%. MS claims that approximately 90% of all enterprise desktops globally are now running Windows® 7 or Windows® 8. “Commercial Other” grew 31% during the quarter as Cloud Services grew 101%, Office 365™ more than doubled, and Azure increased by more than 150%. Commercial gross margin improved by 6%.

 

The current reported unearned revenue of $19.5 billion is up 9% after adjustments.

 

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 $19.5 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 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.

 

1.  Competitive Pressure in The Cloud: In our analysis of Microsoft’s® second quarter of FY14 we identified competition in the cloud as perhaps their greatest risk, stating that As corporate customers and consumers alike migrate to the cloud either by means of BYOD or corporate owned thin clients, Microsoft® will be forced to compete in arenas which will likely severely erode their ability to maintain their dominance”. While this remains perhaps their greatest risk, the severity may have been reduced on March 27th when new CEO Satya Nadella introduced the company’s “Cloud First, Mobile First” strategy. Whereas Microsoft® has traditionally attempted to leverage their dominance in certain markets as a means to compete, they appear to have accepted the fact that they are not a dominant player in the cloud and have adjusted their strategy accordingly. Mr. Nadella announced that MS will make their products accessible from the cloud on all devices, specifically naming those running Windows®, iOS, and Android™ operating systems. This announcement came as MS introduced Office 365™ for the iPad®, which has been the most popular application at the App Store since it was introduced. We view this strategy as very wise, as the availability of Office® on Apple® and Google® devices has the potential to severely impact competitive offerings from Apple® (iWork®) and Google® (Google Apps™). It’s important to note, however, that the ability to read and display Office files on the iPad®, iPhone®, and presumably future products is offered free of charge so there is no revenue to MS in these cases. Microsoft® will only realize additional revenue when the user wants to create or edit Office files (Word® documents, Excel® spreadsheets, and/or PowerPoint® presentations), at which time they must purchase an Office 365™ subscription. If the user buys Office 365™ at the Apple® App Store, MS will reportedly share 30% of the subscription with Apple®. Finally, we can’t forget that MS is being forced to succumb to pricing pressures as evidenced by the recent introduction of Office 365™ Personal, which is intended for individual users with no more than one PC or Mac® and one tablet. Office 365™ Personal is available for $6.99 per month or $69.99 annually. We continue to identify this as a risk because while expanding the availability of Office® to more devices will almost certainly ensure its continued dominance for the foreseeable future, not all users will have to pay for access and those who do may not provide the comfortable margins MS has grown to expect.

 

2.  The Surface™ Tablet: Microsoft® reported that revenue from Surface™ tablets grew by more than 50% during the recent quarter, but it must be noted that the formal announcement and availability of Office 365™ for the iPad®took place just four days before the end of the quarter. Offering Office® on non-Windows® devices may be a wise strategy, but it may also be detrimental to the already disappointing sales of the Surface™. The original strategy was to make Office® available only on Surface™ and other tablets running Windows® RT, and that may have been the reason they sold as many as they did.  We have questioned the wisdom of MS offering a Microsoft® labeled tablet from the beginning as it directly competed against some of their OEM customers. If the Surface™ fails, MS will have damaged their OEM relationships and have nothing to show for it.

 

3.  Windows® 8.1: We cannot remove Windows® 8.x from our list of Risk Factors. MS released version 8.1 on April 8 as expected, and while it offers some much needed improvements, particularly for desktop and laptop users without touch-enabled devices, Windows® 8 is still an awkward compromise between a tablet OS and a PC OS. Many (most?) users appear to continue to use Windows® 7 if they don’t need touch functionality as those who have tried Windows®8 have reported widespread criticism. Microsoft® is aggressively working to address the problems and there is another rumored update expected this summer, but public perception is extremely important to Microsoft® and many users fear another OS disappointment as was the case with Windows Vista®. Many OEMs are still selling new PCs running Windows® 7. While this is not prohibited by Microsoft®, the company strongly prefers to have their OEMs selling the most recent OS.

 

4.  Public Perception: Admittedly, citing public perception as a risk factor is somewhat subjective and intangible, but Microsoft® is more conscious of it than most companies and they are currently in the spotlight in some highly visible areas. With an estimated 25% of PC users still using Windows® XP, Microsoft® has been criticized for ending support and security updates. To be fair, XP is twelve years old and outdated by many standards and we have known the retirement date for many years but still, many are critical of Microsoft’s® refusal to further extend support. There are many reasons some are reluctant to upgrade, and the poor reception to Windows® 8 is high on the list. Some will also cite the Surface™ and seemingly slow adoption of Windows® Mobile as additional signs that the company may be faltering.

 

On the positive side, MS has a new CEO who has hit the ground running and achieved some significant wins during his short time in office. Earnings are up, they have announced a new strategy which will expand their markets, the stock price has risen sharply during recent months, and they are delivering on their promise to reduce the time between product updates. We submit that the positives outweigh the negatives, but if you happen to be negotiating with MS and have an opportunity to leverage any of the negatives you may find Microsoft® to be more accommodating than many companies.

 

5.  Google Chrome™ OS: Much has been said about the way tablets have taken  market share away from Windows®based PCs, but there is another trend which has Microsoft® concerned. Low cost netbooks and laptops running Chrome™ OS continue to gain in popularity and during recent months we have even seen desktops running Chrome™ from Samsung® and Asus®. Only 1% of 2013 global PC sales were running Chrome™, but the trend is concerning and nearly all major PC manufacturers now offer at least one Chromebook™. HP introduced three models in the past year. The reason is simple: Chromebooks™ typically cost about half as much as a similar PC running Windows®. The Windows® PC is usually capable of running more resident software, but since so many users rely upon cloud computing this isn’t a major complaint. Google doesn’t charge a royalty for Chrome™ so it seems very unlikely MS will ever be able to compete on price.

 

6.  Next Generation Volume Licensing (NGVL): We identified this as a risk during our Q2 analysis and Microsoft®has been virtually silent on the subject since that time. NGVL is said to be a replacement for the current Volume Licensing program and promises to streamline and simplify the process of acquiring and managing MS software. Last fall we were told to expect a phased rollout in the US beginning the end of 2013 but MS has shared very little on the subject since that time. We know it is coming, but we’re disappointed it appears to be taking longer than expected.

 

FY14 Predictions and Roadmap Information

 

Microsoft® earnings were a pleasant surprise again this quarter as they met or exceeded many expectations. MS appears to have a sound strategy and they are well positioned to capitalize on their current and future investment in the cloud. In the commercial arena, specifically software licensing, Microsoft® continues to grow at a very respectable pace. As users continue to embrace cloud computing, whether based on-premises or in an external datacenter, Microsoft® should realize continuous revenue and growth from their server products and Device CALs. For SaaS offerings which are not running on company owned servers such as Office 365™, MS appears well positioned for continued growth. The “Cloud First, Mobile First” strategy which involves offering MS products on devices running on operating systems in addition to Windows® will significantly increase market opportunities for MS and may provide ways to capture more of the consumer market. While MS has dominated the enterprise space for years, their reputation in the SMB space remains less than favorable. This is largely the result of the typically high price of their products, but if they (MS) succumb to pricing pressure, which they must do to compete in the cloud, they may be able to improve their position with SMBs as well.

 

Unfortunately, as we have discussed here and elsewhere, the inevitable move to the cloud will often result in competition with products which are much less expensive than Microsoft® has been able to sell in the past. We anticipate continued success in the commercial markets, particularly with products that enable distributed computing and BYOD but if Microsoft® is to become a dominant player in the cloud they will have to relinquish the large margins they have enjoyed in the past.

 

Product Releases

 

Cortana® – Released

Dynamics® AX R3 – April, 2014

Dynamics® CRM “Leo” – Mid-2014

Dynamics® GP 2015 – Q4, 2014

Exchange Server® 2013 SP1 – Released

Lync® Server 2014 – Q2, 2014

“Mohoro” Desktop as a Service – Late 2014

NetBreeze “Subra” – Q2 2014

Office® 2013 SP1 – Released

Office® for iPad® – Released

Power BI for Office 365™ – Released

SharePoint® Server 2013 SP1 – Released

SQL Server® 2012 SP2 – Q4, 2014

SQL Server® 2014 – Released

Visual Studio® 2013 Update 2 – Spring, 2014

Windows® 8.1 Update 2 – August, 2014

Windows Server® 2012 R2 – Released

Windows “Threshold” – April, 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