Preface

Microsoft reports revenue by “Devices and Consumer” and “Commercial” divisions, and reports in the following six segments:

 

Devices and Consumer (D&C)
HardwareComputing and Gaming Hardware
Licensing

Phone Hardware

Windows® OEM, Windows Phone®, Office Consumer, IP Licensing

Nokia devices

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

 

The document is structured in the following manner:

 

Summary of the Financial results for FY2015 Q3

Revenue and Operating Income for FY2015 Q3

Contributions by Business Segment

Microsoft’s Volume Licensing Revenue Summary for FY2015, 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 surprised many analysts by reporting better than expected earnings for the third quarter of their 2015 fiscal year, although expectations were rather conservative due to sluggish PC sales and conservative guidance from the company. The software giant reported revenue of $21.73 billion, compared with $20.4 billion from the same quarter a year ago. Diluted Earnings-Per-Share were 61 cents, compared to 68 cents a year ago. Analysts were expecting EPS of 51 cents and revenue of $21.06 billion. Investors appeared pleased as shares of Microsoft stock were up more than 10% the day after earnings were released.

 

Revenue and Operating Income (FY15 3rd Quarter)

 

Three Months Ended March 31

($ in millions, except per share amounts)

2014 As Reported (GAAP)

2015 As Reported (GAAP)

% Y/Y (GAAP)

2015 Impact of Noted Items

Revenue

$20,403

$21,729

6%

Gross Margin

$14,425

$14,568

1%

Operating Income

$6,974

$6,594

(5)%

$(190)

Diluted EPS

$0.68

$0.61

(10)%

$(0.01)

 

Contributions by Business Segment

 

In Millions

3rd_quarter_fy_2015_chart

 

 

SEGMENT REVENUE AND GROSS MARGIN

(In millions)(Unaudited)

 

Three Months Ended March 31

 

Nine Months Ended March 31

 

 

 

2015

 

2014

 

2015

 

2014

Revenue

 

 

 

 

 

Devices and Consumer Licensing

 $     3,476

 

 $  4,597

 

 $   11,736

 

 $14,625

Computing and Gaming Hardware

1,800

 

1,872

 

8,250

 

7,751

Phone Hardware

1,397

 

0

 

6,290

 

0

Devices and Consumer Other

2,280

 

1,824

 

6,525

 

5,252

Commercial Licensing

10,036

 

10,335

 

30,588

 

30,852

Commercial Other

2,760

 

1,902

 

7,760

 

5,284

Corporate and Other

(20)

 

(127)

 

251

 

(313)

  Total revenue

 $   21,729

 

 $20,403

 

 $   71,400

 

 $63,451

 

 

 

 

 

 

Gross Margin

 

 

 

 

 

Devices and Consumer Licensing

 $     3,210

 

 $  4,017

 

 $   10,904

 

 $12,918

Computing and Gaming Hardware

414

 

258

 

1,353

 

874

Phone Hardware

(4)

 

0

 

805

 

0

Devices and Consumer Other

566

 

391

 

1,428

 

1,102

Commercial Licensing

9,275

 

9,432

 

28,301

 

28,317

Commercial Other

1,144

 

475

 

2,849

 

1,164

Corporate and Other

(37)

 

(148)

 

190

 

(369)

  Total gross margin

 $   14,568

 

 $14,425

 

 $   45,830

 

 $44,006

 

  • 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.
  • Computing and Gaming 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.
  • Phone Hardware, comprising: Nokia devices
  • 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.

Overall Devices and Consumer revenue increased by 8% to $9 billion, due to increased revenue from Office 365 Consumer, which increased by 35% sequentially to 12.4 million. Revenue from Surface products increased 44% to $713 million.

Microsoft reported selling 8.6 million Lumia phones for a total of $1.4 billion. These gains were offset by declining OEM revenue.

 

Commercial

 

  • 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 5% to $12.8 billion, largely as a result of a 111% increase in commercial cloud revenue driven by Office 365, Azure, and Dynamics CRM Online.  Server products and services revenue increased 12% with premium versions of Windows Server, System Center Server, and SQL Server combined to grow by 25%.

 

Volume Licensing Revenue Summary (Q3 FY15)

 

Commercial Licensing revenue decreased 3% to $10.68 billion. This was primarily the result of decreased revenue from Commercial Office perpetual licenses as many users moved to Office 365. Server product revenue grew by 11%. Windows volume licensing revenue declined by 2% as declining transactional revenue was offset by annuity revenue growth.

 

Commercial cloud revenue increased by an impressive 106%, thanks to continued increases in Office 365, Azure, and Dynamics CRM Online. Commercial cloud revenue is now on an annualized revenue run rate of $6.3 billion.

 

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 $20.2 billion in unearned revenue, up 4% over last 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.

 

Mobile First, Cloud First

 

We have repeatedly applauded Satya Nadella’s “Mobile first, cloud first” strategy under which Microsoft has abandoned their traditional Windows-only strategy for most of their products. This newly found practice of being OS agnostic has certainly kept Microsoft relevant in the mobile computing space and we’re not suggesting that the strategy is a bad thing, but it is not without risk. The business challenge with offering traditionally profitable applications on competing operating systems is that MS now faces competition, and it’s often with very inexpensive or free products. Microsoft is doing well to penetrate competing platforms, largely due to the credibility of products such as Office, but they are literally giving it away in many cases.

 

We continue to believe that “Mobile first, cloud first” may be the best strategy Microsoft could have taken, and Microsoft is painfully aware that they must find new ways to generate revenue. With declining PC sales and mobile computing growing at an exponential rate, MS can no longer compete under a Windows-only strategy, but they must find some extremely large revenue sources if they hope to maintain the sales and profitability they have enjoyed in the past.

 

Declining Dominance in Enterprise Markets

 

We haven’t seen specific statistics to validate this, but logic would suggest that as more companies migrate to the cloud, their need for some of Microsoft’s biggest enterprise products such as Windows Server, SQL Server, Exchange, and others may eventually be outsourced to web hosting companies as well. Additionally, as Windows becomes less relied upon or even relevant, the door is open for other companies to compete by offering similar functionality. Although Windows still enjoys a 91% market share on the desktop, the desktop has become increasingly irrelevant and PC sales continue to decline with no sign of meaningful rebound.

 

Data Security and User Confidence

 

Many companies and consumers remain hesitant to entrust their sensitive data to the cloud but eventually the economics of cloud computing usually prevail. People have many reasons for their (wise) caution, but data security always seems to top the list. It seems unlikely that many companies (and certainly consumers) could hope to match the maintenance and security offered by major cloud service providers but ironically, knowing how much sensitive data resides in the cloud is exactly what makes it a target. No one wants to rob an empty bank.

 

Major security breaches are widely publicized and can result in untold financial and credibility losses. We rarely hear whether security breaches occur to internal data centers or hosted facilities, but the threat exists and if Microsoft, AWS, or any major host becomes subject to a major breach it could be detrimental to their business.

 

Windows 10

 

We can’t omit Windows 10 from our list of risks for Microsoft but ironically, it appears to be growing less significant. That’s not a result of Windows being less important to Microsoft but rather, because it is becoming less important to the market.

 

Microsoft needs a major win with Windows 10. The decision to make MS apps available on competing operating systems lessens the risk to Microsoft if Windows 10 fails to live up to expectations, as Mobile first, cloud first removes the all-or-nothing reliance upon Windows, but Microsoft cannot afford another Windows stumble. If successful, the latest version of Windows promises to be a technical and usability breakthrough, which Microsoft desperately needs. Perhaps more importantly, people equate Windows with Microsoft and a disappointing Windows 10 would be the third perceived failure in the past four versions. There was a time when Microsoft could dictate sales and terms based upon their unmatched industry reputation. They already face new competition today and if Windows 10 disappoints they may find themselves facing an insurmountable battle to compete in the market as we know it today.

 

FY15 and FY16 Predictions and Roadmap Information

 

Internet of Things

 

We keep mentioning Microsoft’s need to fill the revenue void that is being created by declining Windows and Office sales. Some of this will occur as Microsoft makes their products available on multiple operating systems, and also as the company transforms itself into more of a services company with offerings such as cloud hosting.  There is also an emerging market opportunity which Microsoft will likely pursue aggressively. The Internet of Things (IoT) is being touted by many as the next big thing, and the projected numbers are staggering. As we continue to find value in various “smart” devices which are connected to the internet, Cisco® is predicting that there will be 50 billion “things” connected to the internet by 2020, and IDC estimates that the resulting revenue will exceed $7 trillion by that time. Microsoft has already announced that Azure and Windows 10 will support IoT and they will release a free version of Windows 10 designed specifically for small device builders this summer. Microsoft has partnered with companies such as Intel®, Qualcomm®, and the Raspberry Pi Foundation to enable board makers to run IoT devices with Windows 10.

 

It is unclear how Microsoft may monetize the IoT, but there are a number of possible scenarios. They could charge a royalty per device or possibly implement a pay-per-click model. The IoT could also become the way for Microsoft to finally become a significant player in tracking user activity and resulting Business Intelligence activity.

 

Selling an Ecosystem

 

Another strategy Microsoft is employing is much more subtle than entering new markets or adding new products. Microsoft has traditionally been very good when it comes to creating a consistent user experience among their products. A Windows user, for example, finds the experience with MS Office very familiar as it closely emulates that of Windows. This practice works well within the Microsoft product line but MS knows they have to continue to recruit new users. Their strategy is to give away software such as Office for Android devices, for example, get them hooked, then figure out which users may be willing to pay for subscriptions to that which they have grown to like.  The consistent user experience may also lead users to other MS products which are not offered for free.

 

Microsoft is also trying to get better at integrating their products. The new digital assistant Cortana®, which will ship as part of Windows 10, uses Bing as its search engine. Of course there is nothing surprising about Windows users being defaulted to use Cortana and subsequently Bing, but MS has announced that Cortana will eventually be offered as a standalone product for iOS and Android. If successful as a standalone product, Cortana users will then become Bing users by default, rather than Google as is so often the case today (Bing is already the search engine for Siri).

 

Subscriptions and Azure

 

We can also expect a continued push to subscriptions and all things related to Azure and cloud hosting. Many (most?) companies are reluctant to abandon their onsite datacenter and make an immediate jump to cloud computing, but the benefits of doing so eventually cannot be ignored. Since Microsoft has existing agreements with most companies, we can expect an increased push for hybrid solutions such as StorSimple® as a means to retain MS customers and gradually move them to a MS-hosted cloud.

 

Product Releases

 

Dynamics CRM – Q2, 2015

Exchange 2016 – 2nd half, 2015

Office 2016 – 2nd half, 2015

Office 2016 for Mac – 2nd half, 2015

Office for Windows 10 – Fall, 2015

Power BI – 2nd half, 2015

SharePoint Server 2013 SP1 Cumulative Updates – Monthly

SharePoint 2016 – Q2, 2016

Skype for Business (aka Lync Server) – Released

System Center – 2016

Visual Studio 2015 – Summer, 2015

Windows 10 – Summer, 2015 – July?

 

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 (MAP) 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