Preface

Microsoft® reports earnings in three operating segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing.

Microsoft

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, Q1

Revenue and Operating Income for FY2018, Q1

Contributions by Business Segment

Microsoft’s Volume Licensing Revenue Summary for FY2018, Q1

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 expectations by a wide margin during their first fiscal quarter.

Analysts were looking for top-line revenue of $23.56 billion, which the software giant exceeded, reporting $24.54 billion for the quarter (non-GAAP).  This represents a 12% year-over-year increase.  Perhaps even more impressive, adjusted EPS was $0.84, which beat expectations of $0.72.

Revenue in Productivity and Business was up 28% to $8.2 billion, largely due to a 42% increase in commercial Office 365 revenue.  Microsoft reports there are now 28 million Office 365 Consumer subscribers.

LinkedIn revenue contributed $1.1 billion during the quarter.

Intelligent Cloud revenue was $6.9 billion, up 14%.  Azure revenue was up 90% over last year, representing continued strength and growth in the cloud.

The More Personal Computing segment reported $9.4 billion.  This number was down 1% from the same period last year.  Microsoft attributed the decline to be largely due to declines in custom support agreements.

The company reported contracted, not billed revenue of $21.5 billion.  Contracted, not billed is primarily sales from volume licensing agreements which have been booked but not yet recorded.

Microsoft returned $4.8 billion to shareholders during the quarter in the form of dividends and share repurchases.

Revenue and Operating Income (FY18 1st Quarter)

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

Three Months Ended September 30

Productivity and Business

Revenue in Productivity and Business grew 28% to $8.2 billion as key products such as cloud services, Office 365™, and Dynamics™ all grew respectably.  Revenue from Office 365 commercial was up 42%.  Margins for Office 365 in the commercial sector also improved, as an increasing number of Volume Licensing customers moved from E1 to the higher priced E3.

Dynamics products and cloud services revenue was up 13%, thanks largely to increases in Dynamics 365 revenue growth of 69%.

On the consumer side, Microsoft reports that Office 365 now has approximately 28 million subscribers, with Office and cloud revenue increasing by an impressive 12%.

LinkedIn contributed revenue of $1.1 billion.

Intelligent Cloud

Revenue in the Intelligent Cloud segment rose 14% to $6.9 billion, led by server products and cloud services with an increase of 17%.

Azure™ revenue was up respectably once again, at 90%.

Enterprise Services revenue increased 1% with growth in Premiere Support Services, but offset by declines in custom support agreements.

More Personal Computing

Revenue in the More Personal Computing segment was relatively unchanged, at $9.4 billion.

Windows OEM revenue increased by 4% year over year, which is slightly ahead of the overall PC market.

Surface revenue increased by 12%, driven by sales of the new Surface Laptop.

Volume Licensing Revenue Summary (Q1, FY18)

The reporting segments make it difficult to isolate Volume Licensing revenue, although during the earnings call Microsoft did report that “Commercial bookings” were up 14% year-over-year.

The company continues to report 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 $21.5 billion in unearned revenue, which is up 19% 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.

On-Demand Cloud Compute Pricing

There is no question that Microsoft is relying upon cloud services to drive the future of the company, and the continued growth of Azure, Office 365 and related products suggest that they’re on the right track.  It’s important to note, however, that while the number of users and the amount they purchase continues to increase, compute pricing is becoming commoditized and market leaders such as AWS, Azure, and Google are engaged in a fierce pricing battle.  Increasing consumption is certainly outweighing price erosion, but Microsoft (and their competitors) must continue to develop products and services to set themselves apart from each other. Microsoft has a unique advantage in the enterprise space in that most of the potential customers have existing Volume Licensing agreements (EA, SL, etc.), so the relationships already exist for those who have yet to migrate to the cloud, but few will be willing to over-spend simply in the interest of preserving an existing relationship.

Vulnerability of Legacy Software

This topic comes up periodically, but the risk never goes away.  Individuals and organizations typically have a number of reasons for failing to use the most recent version of software.  Cost is obviously a common consideration, but product familiarity or support for other tools may also be a factor.  Unfortunately, older versions of applications (and Windows) don’t have the latest security protection and, depending upon how old they are, they may no longer even receive security updates.  Hackers and those with malicious intent typically target as many potential victims as possible, which means that in most cases, they attack the products with the most users.  Products such as Office and Windows certainly fall into that category.  A widespread or highly publicized breach would not only be detrimental the effected users, but if it’s discovered to have been introduced through a Microsoft product, it could impact Microsoft as well.

FY18 Predictions and Roadmap Information

Continually Enhancing Azure

This one is obvious, but notable because we are seeing an increasing number of organizations and individuals beginning to embrace the cloud for its security and data management capabilities.  The irony here is that these have been (and remain) the primary reasons many have refused to step out of their on-prem datacenters.  We have often argued that the security and procedures offered by a quality cloud service provider are probably much greater than even the most diligent on-prem facility. Today, we are seeing an increasing number of organizations who are accepting that, and also moving to the cloud so they can leverage tools and services they may not be able to or wish to deploy on-prem.  Geico™ insurance and Dun & Bradstreet™ recently announced that they selected Azure, largely because of the data management tools and support offered by Microsoft.  Bank of America™ is moving to Azure and Office 365, largely because of Microsoft’s Financial Services Compliance program.  These examples are consistent with our comments (above) regarding the need to continue to develop products and services to differentiate Microsoft from their competitors.

Azure Stack™

We have long maintained that Azure would become the dominant cloud service provider in the enterprise space.  This is largely because customers have existing licensing relationships with Microsoft for their on-prem datacenters.  Since it’s extremely rare for an organization to suddenly turn off their on-prem functionality and immediately move to an environment which is hosted entirely in the cloud, the interim model typically involves some sort of hybrid solution.  Historically, Azure offered certain tools and functionality exclusively in the cloud, which resulted in numerous inconsistencies between on-prem deployment and that in the Azure cloud.  Azure Stack is intended to reduce the inconsistencies by making more Azure functionality available in an organization’s own datacenter.  We believe Microsoft will continue to enhance Azure Stack and continue to gain market share among major cloud providers.

Product Releases

Azure Stack – Released

Dynamics™ 365 update – Fall, 2017

Dynamics 365 for Talent – Fall, 2017

Dynamics 365 for Retail – Fall, 2017

SharePoint Framework update – Released

SQL Server 2017 – Released

SQL Server on Linux – Released

Windows 10 Redstone 3 Creators Update – Released

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.