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 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 Q2.
  2. Contributions per business segment
  3. Microsoft’s® Volume Licensing Revenue Summary for FY2014, Q2.
  4. Risk Factors
  5. Predictions for the future as well as new products that will be launched during coming months

 

Summary of the Financial Results

Microsoft® soundly beat earnings estimates, reporting record revenue of $24.52 billion which represents $0.78 EPS vs. analyst’s expectations of $0.68. Much of this may be attributed to the seven million Xbox® gaming consoles sold during the quarter but surprisingly, overall profits rose by a respectable 3%. This is surprising because while Xbox® sales contributed greatly to overall revenue, the consoles themselves generate little or no margin. Of course the associated games are very profitable, but many analysts have been expecting declining margins and perhaps declining revenues as a result of diminishing PC sales and reduced Windows® revenue.

 

Revenue and Operating Income (FY14 2nd Quarter)

Revenue for the quarter was up 11% to $24.52 billion, compared to $21.46 billion a year ago. Net income was $6.56 billion, representing a 3% increase over the $6.38 billion last year. Diluted earnings per share were 78 cents, compared to 0.76 a year ago.

 

Three Months Ended December 31

($in millions,except per

share

amounts)

2012

As Reported

(GAAP)

Revenue deferred

for Windows Upgrade Offer, Office Deferral,

and Video Game Deferral

Revenue recognized

for Windows 8

Pre-sales

2012 As Adjusted (Non GAAP)

2013 As Reported (GAAP)

%Y/Y

(GAAP)

%Y/Y

(Non

GAAP)

Revenue

$21,456

$1,329

($783)

    $22,002

$24,519

14%

11%

Operating Income

$7,771

$1,329

($783)

$8,317

$7,969

3%

(4)%

EPS

$0.76

$0.13

($0.08)

$0.81

$0.78

3%

(4)%

Contribution per Segment

 

In Millions

 

2nd_quarter_fy_2014, wAAACwAAAAAAQABAEACAkQBADs=, ELF report, Microsoft EA renewal, Microsoft SAM, Microsoft savings

 

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 Ended December 31 Percentage Change
20132012
Revenue
Licensing$10,888  $10,135        7%
Other 1,780  1,38928%

 

 

Total revenue$12,668  $  11,52410%

 

 

Gross Margin

 

 

Licensing$10,077  $9,3268%
Other 415  216115%

 

 

Total gross margin$10,492  $9,54210%

• 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 (Q2 FY14)

 

Enterprise demand for products and services drove strong multi-year commitments resulting in $10.9 billion in revenue for the quarter, and a slight multi-year licensing revenue decline of 2% over the previous year. This decline was the result of GAAP accounting calculations to reflect revenue that was recognized related to the Windows® 8 and Office®2013 Upgrade Offers during the same quarter a year ago. The current reported unearned revenue of $19.5 billion is up 12% 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.

 

Microsoft® doesn’t disclose sales figures for individual products, but they offer valuable insights into which segments are selling best. During the recent quarter, server product revenue was up 12% while Office Commercial was up 10%. System Center, Hyper-V®, and SQL Server® Premium all had respectable gains. Even Windows®volume licensing was up ten percent, although much of that may be attributed to the end of support for Windows®XP which has forced many VL customers to upgrade.

 

Two other noteworthy statistics are that Commercial Cloud services revenue grew by 107% and Office® 365, Azure customers, and Dynamics CRM net new adds all grew by more than 100%. These are reported as “Commercial Other” and the category only represents $1.78 billion, but the trend is clear.

 

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.  Competitive Pressure in The Cloud:  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. We explore this more deeply in a separate article Cloud Computing Implications for MS. To summarize, Microsoft® doesn’t enjoy dominance in the cloud with their traditional mainstream products Windows® and Office®, and since much of the market is rapidly moving to cloud computing MS® will be faced with increasing competition from lower priced alternatives.

 

2.  Next Generation Volume Licensing (NGVL):  Microsoft® Volume Licensing customers, partners, critics, and competitors have complained about the complexity of Volume Licensing since its inception. Microsoft® is preparing to unveil a comprehensive change to the VL program. They have revealed very few details to date, but NGVL is believed to be a replacement to the existing VL program, intended to simplify Volume Licensing. We identify this as a Risk Factor because any major changes to a program that generates about $40 billion from Microsoft’s® largest and most strategic customers carries a significant degree of risk.

 

Whether NGVL truly simplifies Volume Licensing remains to be seen, but even if it does as promised, the result will still be a complex process. Microsoft® is promising a consolidated agreement structure with the introduction of a single “Microsoft® Products and Services Agreement”. The MPSA is intended to simplify purchasing and will encompass on-premises, cloud based, and hybrid scenarios. NGVL will also introduce new web-based tools for purchasing and managing VL assets. The Next Generation Volume Licensing has been in development for years and has been in testing with a number of customers and channel partners for approximately a year. Microsoft® plans a phased rollout but has not publically released the schedule.

 

3.  Windows®8.1: We continue to watch Windows® 8.1. We’re expecting an update to Version 8.1 in April which will likely be referred to as Windows® 8.1 Update 1. Expectations are for improvements to the user experience for devices that are not touch enabled but running the Metro UI.

 

It is interesting to note than 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.  Windows® RT and The Surface™ Tablet:  Among the highlights of this Earnings Report is a surprising increase in sales of Surface™ Tablets. To keep it in perspective, these sales are compared to the previous quarter rather than the same quarter a year ago, and the most recent quarter included the Holiday season, but comparative sales more than doubled. Just as with Windows® 8, sales of the Surface™ may provide insight into Microsoft’s®ability to penetrate the tablet market using their own hardware. We identify this as a risk because while the recent sales are encouraging, Windows® RT is a key element in Microsoft’s® mobility strategy and it has not been well received to date.

 

FY14 Predictions and Roadmap Information

Microsoft® earnings were a pleasant surprise this quarter as they met or exceeded expectations in just about every category. They had a huge quarter in the hardware space which speaks well to their ability to diversify from their traditional business of selling software. Xbox® is not only a hardware product, but also a consumer product, which is also encouraging. 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 from their server products and Device CALs. 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, but watch for erosion of price and market share in the consumer space as products such as Office 365®compete with Google Apps™ and others.

 

Product Releases

 

Cortana® – Q1 2014

Dynamics® AX R3 – April, 2014

Dynamics® CRM “Leo” – Mid-2014

Exchange Server® 2013 SP1 – April, 2014

Lync® Server 2014 – Q2, 2014

“Mohoro” Desktop as a Service – Late 2014

NetBreeze “Subra” – Q2 2014

Office® 2013 SP1 – Q2, 2014

Power BI for Office® 365 – Q1, 2014

SharePoint® Server 2013 SP1 – April, 2014

SQL Server® 2014 – Q1, 2014

Visual Studio® 2013 Update 2 – Spring, 2014

Windows® 8.1 Update 1 – April, 2014

 

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®.

Aug 2016