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.

Beginning this quarter, revenue will be 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 will be 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:

  1. A summary of the financial results for FY2014 Q1.
  2. Contributions per business segment
  3. Microsoft’s® Licensing Revenue Summary for FY2014, Q1.
  4. Risk Factors
  5. Predictions for the future as well as recent releases and new products that will be launched during coming months

 

Summary of the Financial Results

 

Revenue and Operating Income (FY14 1st Quarter)

Revenue for the quarter was up 16% to $18.53 billion, compared to $16.01 billion a year ago. Net income was $5.24 billion, representing a 17% increase over the $4.47 billion last year. Diluted earnings per share were 62 cents, compared to 0.53 a year ago.

 

(In millions, except per share amounts) (Unaudited)
Three Months Ended September 30,

2013

2012

Revenue$

18,529

  $

  16,008

Cost of revenue 

5,114

  

4,168

Gross margin 

13,415

  

11,840

Operating expenses:

 

 

Research and development 

2,767

  

2,460

Sales and marketing 

3,304

  

2,945

General and administrative 

1,010

  

1,127

Total operating expenses 

7,081

  

6,532

 

Operating income 

6,334

  

5,308

Other income 

74

  

226

Income before income taxes 

6,408

  

5,534

Provision for income taxes 

1,164

  

1,068

 

Net income$

5,244

  $

4,466

 

 

Earnings per share:

 

 

Basic$

0.63

  $

0.53

Diluted$

0.62

  $

0.53

 
Weighted average shares outstanding:

 

 

Basic 

8,339

  

8,396

Diluted 

8,434

  

8,494

 
Cash dividends declared per common share$

0.28

  $

0.23

Contribution per Segment

 

In Millions

 

1st_quarter_fy_2014

 

Comparison With Past Reporting

Since Microsoft® modified the manner in which they report revenue per segment, it is impossible to precisely compare the current quarterly results with that of a year ago based upon previous SEC Filings. To enable comparison, Microsoft®has “recast certain prior period amounts to conform to the way <they> internally manage and monitor segment performance during the current fiscal year”.

 

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

 

Devices and Consumer

 

(In millions,except percentages)

Three Months Ende September 30,

Percentage Change 

2013

2012

Revenue
Licensing$

4,343

$

  4,678

    (7)%

Hardware 

1,485

  

1,084

37%

Other 

1,635

  

1,400

17%

 

 

Total revenue$

7,463

  $

7,162

4%

Gross Margin
Licensing$

3,925

$

4,103

(4)%

Hardware 

206

  

448

(54)%

Other 

352

  

362

(3)%

 

 

Total gross margin$

4,483

  $

4,913

(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.

 

Commercial

 

(In millions, except percentages)

Three Months Ended September 30,

Percentage Change

2013

2012

Revenue
Licensing$

9,594

  $

8,945

        7%

Other 

1,603

  

1,248

28%

 

 

Total revenue$

11,197

  $

  10,193

10%

 

 

Gross Margin

 

 

Licensing$

8,801

  $

8,183

8%

Other 

275

  

105

162%

 

 

Total gross margin$

9,076

  $

8,288

10%

 

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.

 

Volume Licensing Revenue Summary (Q1 FY14)

 

Enterprise demand for products and services drove strong multi-year commitments resulting in $9.59 billion in revenue for the quarter, and multi-year licensing revenue growth of 7% over the previous year. They reported unearned revenue of $20.1 billion, up 14% 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 $20.1 billion as noted above which has been contracted but not billed.

 

Microsoft® is projecting revenue of $10.7 to $10.9 billion for Commercial Licensing during the second fiscal quarter, so the increasing revenue trend is expected to continue.

 

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 will provide you with leverage when negotiating your agreement.

 

1.  Windows® 8.1: Last quarter we identified Windows® 8.1 as a “Risk Factor”. The stated concern was that Windows® 8 is not intended to immediately replace Windows® 7. Questionable product positioning, combined with reports of disappointing sales has resulted in many claims that Windows® 8 is a failure. In reality, we don’t know how well this latest version of Windows® may be performing relative to confidential internal projections, but the public perception is very real and a serious problem for Microsoft®. MS® attempted to address this with the highly anticipated update to Version 8.1 which was made available at no additional charge to all Windows® 8 licensees. Unfortunately, Windows® 8.1 has been plagued with numerous problems. The problems were so bad that Microsoft® pulled the RT update from the Windows® Store just 48 hours after it was released when it didn’t even work properly on their own Surface™ Tablets!

 

Windows® and Office® have traditionally been the flagship products for Microsoft®, and the perceived “failure” of Windows® 8 has created a serious credibility problem for the company. This would be a problem in just about any scenario for MS®, but it is compounded as commercial customers and consumers are relying more heavily on tablets and other devices that do not run on Windows®. The PC market will continue to decline and Microsoft’s® attempted entry into the tablet space has failed miserably thus far.

 

2.  Steve Ballmer: While many will consider Steve Ballmer’s imminent retirement to be a good thing for Microsoft®, it still creates uncertainty as we don’t yet know who will replace him or how effective that person will be. The corporate culture at Microsoft® is unlike most companies. They rarely operate in a “top down” manner, and decision making is often decentralized. One may argue that this has not been effective during recent years and perhaps the practice needs to change, but doing so will create internal turmoil at a time when MS® needs to focus on damage control surrounding Windows® 8 and on their migration to being a Devices and Services company.

 

3.  Bill Gates: It has been widely publicized that three large shareholders are campaigning to have Bill step down from his role as Chairman. As with Ballmer, whether Bill’s departure would be positive or not is uncertain, but it would certainly create turmoil.

 

4.  Changing Customer Actions: We have addressed this in the past but Microsoft’s® inability to penetrate the tablet and smartphone space is resulting in a serious threat to the company. Ironically, MS® is losing their operating system market to Google® in large part because Google® is employing the same business model that made Windows®successful for so many years. Just as Microsoft® allowed multiple OEMs to license Windows®, Google® allows anyone to license Android™. Unfortunately, even if MS® could penetrate the mobile space, Android™ is Open Source so MS®would have to compete with a free operating system. Even Apple®, which is notorious for charging their customers at every opportunity, is now offering their updated operating system OS X® Mavericks and productivity suite iWork® at no charge to qualifying customers. Microsoft® can’t afford to give away Windows® and they don’t have the advertising infrastructure to compete with that of Google® or the hardware offerings of Apple® to offset the cost of a free OS.

 

5.  Windows® RT and The Surface™ Tablet: Microsoft’s® attempt to enter the tablet market has been questioned by many from the beginning. They alienated their OEM customers when MS® elected to release the MS-branded Surface™. Microsoft® had to reduce the price of the original Surface™ by $150 to stimulate sales, resulting in a $900 million write-off during Q4FY13. In our Q4FY13 Earnings Analysis we suggested that “After fewer than ten months, it may be time to declare The Surface™ and Windows® RT a failure”. Apparently Microsoft® disagrees, as they now offer two new Surface™ models; the Surface™ 2 and the Surface™ 2 Pro, in addition to the original. Of course these were in development long before the $900 million write-off and the even more recent embarrassment surrounding the release of Windows® RT 8.1, but it’s hard to imagine the Surface™ 2 offering the much needed entry into the mobile space.

 

FY14 Predictions and Roadmap Information

 

Under most circumstances, “Predictions and Roadmap Information” is about upcoming products, but Microsoft® is at a pivotal stage with respect to the future of the company. We expect them to continue to release and update the usual products, and increase emphasis on those residing in or impacted by the cloud. The bigger question is whether MS®can leverage their market presence and resources to remain a dominant force as the market evolves away from their traditional business model.

 

The preceding list of risk factors weighs heavily on our expectations for the coming year. At a macro level, Microsoft’s®traditional business of perpetually licensed locally resident software is being at least partially replaced by cloud based, often subscription licensed software and tools. The reorganization to a “Devices and Services” company is intended to address this, but it’s going to take much more than a company reorg to dominate or even compete in this evolving market. It would be premature to read too much into individual events, but it is important to note that MS appears to be on track with significant updates to SQL Server®, Windows Server®, System Server, Dynamics®, and Visual Studio®. On the other hand, initial impressions and execution of Windows® 8.1 have been disappointing, at best.

 

With the notable exception of Windows® 8.1, the reorg appears to be progressing as planned and we have witnessed no major release schedule slippages. It will be critical to minimize slippages if they want to succeed with their shortened (one year) release cycles.

 

Microsoft® is well positioned to leverage cloud computing as they have industry leading tools and datacenters. They also benefit from existing relationships with Volume Licensing customers, consumers, OEMs, and others around the world. They will certainly leverage these assets, but the decentralization of hardware resulting from BYOD (Bring your Own Device) cannot be ignored. The overwhelming majority of BYOD devices generate little or no revenue for MS®until they connect to a corporate network employing MS® products. In the case of BYOD to a corporate network, Microsoft® realizes revenue from Device CALs, but that will never replace the traditional Windows® revenue they enjoyed in the past. This is among the reasons MS® continues to invest in the Surface™ Tablet and smartphone handsets.

 

Part of Microsoft’s® strategy with respect to tablets is to make Office only available on the MS® Surface™ and other (OEM) RT devices. They appear to be relaxing this position a bit as they recently released a Remote Desktop app for iOS and Android™ users. Office® is still only available as a resident app on RT devices, but with Remote Desktop mobile users can now access and control Office running on a Windows® PC from their tablet or smartphone. This will likely be embraced by consumers, but it will result in minimal incremental revenue for MS® since the Remote Desktop app is free and it assumes the customer has already purchased Office for the PC. It will be interesting to see how this effects plans to release a touch enabled version of Office for resident use on non-RT devices. On one hand, it would likely generate significant revenue for MS®, but it would also remove one of the few competitive advantages offered by RT devices, thereby decreasing the likelihood of Microsoft® penetrating the mobility space with their own hardware.

 

Many market dynamics are beyond the control of Microsoft®, but the strategy with which they address them will be largely influenced by executive management. We already know that Steve Ballmer will retire soon and Bill Gates future as Chairman is being challenged. It may be time for a new CEO, but to lose Bill’s knowledge and insight at such a pivotal time could be devastating. Then again, maybe it’s time for a change.

 

It would be wise to pay attention to Microsoft’s® actions during the coming months, particularly if you are entering into or renewing a VL Agreement. Microsoft® and their partners will always attempt to maximize their revenue, but if they experience increased competitive threats or declining sales they may be motivated to work a bit harder to keep (or earn) your business.

 

If there is one thing we can predict for the coming year, it’s that Microsoft® will continue to face significant challenges. It will be interesting to see how they react.

 

Product Releases

 

Cortana® – Q1 2014

Dynamics® CRM – 10/31/13

Dynamics® NAV 2013 R2 – Released

Lync® Server 2013 – Released

NetBreeze “Subra” – Q1 2014

SQL Server® 2012 RTM Cumulative Update 10 – Released

SQL Server® 2014 – Preview CTP2 currently available for download

System Center® 2012 R2 – Released

Visual Studio® 2013 – 11/13/13 (RC currently available for download)

Windows® 8.1 – Released

Windows® Phone 8 “Apollo” – 2014

Windows® Server 2012 R2 – Released

 

Reminder – Support for Windows® XP and Office® 2003 ends April 8, 2014

 

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’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