Analysis: Microsoft Earnings (Premium)

On Wednesday, Microsoft announced earnings for its second quarter, which ended on December 31, 2017. Brad has already covered the news over on Petri. Here, I’d like to dive a bit deeper and analyze what the results mean for the software giant’s core businesses.

Note: As you may know, I normally provide my “morning after” overview of Microsoft’s quarterly earnings in Paul Thurrott’s Short Takes, an often-humorous set of blurbs that appears on Fridays on Petri. But doing so was just a matter of timing: With Microsoft normally issuing its earning announcements on a Thursday, it made sense to provide more depth the following morning. But as Brad recommended to me last night, moving this coverage to Thurrott.com and making it a Premium article makes more sense. That will allow me to continue with the usual frivolity in Short Takes on Friday.

Here, I will examine some, but not all, of Microsoft’s key businesses. The focus is on those products and services that I, and I think readers of this site, care about the most.

The basics

Microsoft posted net income of $8.7 billion on revenues of $28.9 billion in the quarter. These are significant and double-digit gains—10 percent and 12 percent, respectively—over the same quarter a year ago.

I find the earnings trends to be very interesting: In the same way that Microsoft’s stock price was stuck at the same general price point for about a decade, Microsoft’s quarterly earnings had reached a comfortable and perhaps too-predictable plateau of sorts, too. That is, the firm had been reporting low single-digit billions in net income and mid-$20 billions in revenues each quarter for several years now.

That’s starting to change, and in time I expect Microsoft’s earnings to settle in at a higher general range—$10 billion-ish in net income and $30 billion-ish in revenues—as its successful transformation continues.

This is impressive, given the ongoing narrative about Microsoft. This is a company that is transforming its own business to the cloud while it guides its corporate customers to do the same. Microsoft’s core strength, as I’ve pointed out before, is that it is uniquely situated to successful undertake both of these transformations, and to do so at the same time. None of its competitors have such a large corporate customer base, once largely using on-premises solutions, that they can transition to hybrid and cloud solutions on an ongoing basis. And none of its competitors can so successfully transition from the increasingly obsolete solutions of the past to more modern offerings, as Microsoft can (and is).

Tax hit

One of the more confusing aspects of Microsoft’s earnings this quarter—to me, at least—was that Microsoft actually recorded a net loss of $6.3 billion. This was the result of a $13.8 billion net charge that Microsoft said in its earnings release was “related to the Tax Cuts and Jobs Act (TCJA).”

This surprised me, but it shouldn’t have, as it was widely expected by economists and industry analysts: Back in early January, it became apparent that some of the biggest U.S.-based international corporations, including some of the bigger players in tech, would be able to repatriate billions in in profits that were being held internationally without taking a major tax hit. But in doing so, they would all need to pay an upfront tax billion that would ding each in one quarter.

Point being: Like Apple and other tech giants, Microsoft is now poised to bring back from many billions of dollars of profits to the United States and to do so at a much lower tax rate than was previously the case. This one-time tax hit greases the way for that milestone.

The cloud

For the past several years, we’ve all looked to news of Microsoft’s continued success in the cloud, and this is the one area where the software giant has acquiesced when it comes to disclosing more than just basic information during its earnings announcements.

Yes, the information is still vague and hard to compare over previous quarters. And yes, some of the metrics Microsoft uses—like its non-existent “commercial cloud” businesses, which is really an unknown collection of product offerings from three of its primary business segments—are fuzzy at best. But with analysts looking for any hint at success in the cloud, Microsoft has provided some of its best data.

And it goes like this. Commercial cloud revenue in the quarter was $5.3 billion, Microsoft says, a 56 percent gain year-over-year. (All comparisons henceforth will be YOY unless otherwise noted.) So commercial cloud revenue, which, again, is not really a business segment, now accounts for about 18 percent of Microsoft’s revenues overall. That is, perhaps, lower than one might expect, given the emphasis on this fantasy business. But when you look at the actual business segments that contribute to commercial cloud—Productivity and Business Processes (think Office 365) and Intelligent Cloud (think Azure), you see double-digit growth of 24 percent and 15 percent, respectively. This is that transformation again, but depicted financially.

As good, gross margins for commercial cloud are quite high, at 55 percent. This is an improvement of 7 percentage points over last year. And Microsoft noted that these improvements hit its most important commercial cloud businesses: Office 365, Azure, and Dynamics 365.

Commercial cloud also provides Microsoft with a way to spread revenues out more evenly over time, something it did routinely with its core businesses of the past, like Windows and Office. The firm noted that it saw unearned revenues of over $20 billion for its commercial businesses (which are pretty much all lumped into commercial cloud now, even though some of that is from on-premises solutions).

Looking forward, Microsoft says you can expect more growth, too.

“We expect year-over-year improvement in overall commercial cloud gross margin as Azure margin improvement continues to offset an increasing mix of Azure revenue,” Microsoft CFO Amy Hood said during the post-earnings conference call with analysts.

Put simply, Microsoft provided exactly what Wall Street wanted to hear, and if you scan any news stories about this quarter’s results, you will see some version of “Microsoft’s bet on cloud computing is paying off.” And, as The New York Times put it, “Microsoft is now widely considered the number two cloud provider after Amazon.” We can only guess because neither Microsoft nor Amazon provides data that is directly comparable.

Office 365

Office 365 is the core component of Microsoft’s Productivity and Business Processes operating segment, which, unlike commercial cloud, is a real business unit. It is also the poster child for the software giant’s transformation to the cloud, since Office was its biggest on-premises business.

Office 365 comes in both commercial and consumer versions. And as you might expect, the former is much bigger than the latter, and from both revenues and usage/active seats perspectives. In many quarters, Microsoft only provides part of the story—a new figure for Office 365 commercial or consumer—which makes charting the progress here a bit fragmented. But this quarter, it was a little bit more forthcoming.

On the commercial side, Office 365 revenue was up an astonishing 41 percent. This growth was driven by a 30 percent growth in Office 365 commercial seats (e.g. new users) and by a growth in revenue per user. My guess on that latter bit is that Microsoft is seeing existing customers opting into more premium tiers, including Microsoft 365 (which one might logically describe as part of the Office 365 family).

What Microsoft didn’t provide was a new number for Office 365 commercial seats. After its first fiscal quarter that ended in October 2017, the company said that it had 120 million active seats. And that was up from 100 million in April 2017. If growth hadn’t changed during the interim—and it probably went up—then we’re looking at about 130 million active seats today.

For consumers, Office (overall; not just 365) revenue increased 12 percent, and Microsoft credited both existing customers who resubscribe and new subscribers for that growth. The Office 365 consumer user base is now 29.2 million, up from 24 million a year earlier.

In the past, I questioned whether these numbers were good. After all, 155 million-ish active users pale in comparison to the 1.5 billion that Microsoft previously claimed for its traditional Office offerings. But over time, I’ve come to understand that the real value in today’s customer base is much higher: Where Office 365 subscribers represent a source of continued and ongoing income, the Office users of the past rarely upgraded. And were, in fact, often the source of a single, one-time payment. It won’t take too many years before Microsoft’s Office 365 business surpasses its old-fashioned predecessor from a financial perspective. And I expect Microsoft to eventually kill off its traditional Office offerings as well.

Windows

Each quarter, I examine the PC market share numbers from Gartner and IDC in the hope of seeing some trend to reverse the years-long declines. So far, that hasn’t happened, and by the end of 2016, we had marked six straight years—24 quarters—of decline.

But PC market share isn’t the only way to gauge the health of the industry. Each quarter, Microsoft reports revenue growth figures for Windows license sales to PC makers. And these numbers do not always line up with what we’re seeing from actual PC sales. That is, if PC sales decline by x percent in a given quarter, it’s reasonable to assume that Microsoft’s Windows revenues to PC makers will likewise decline by x percent-ish too.

In this past quarter, PC sales declined by 1.5 percent worldwide. Microsoft’s Windows licensing to PC makers, which is split between commercial and consumer PCs, saw varying results. Revenues from commercial PCs grew 11 percent, which is rather incredible. And revenues from consumer PCs fell by 5 percent. Which is depressing.

The math doesn’t really work out here, and there’s no way to rectify it. About two-thirds of Windows revenues, overall, come from businesses. But those are split between volume licensing (which I assume is the majority) and PC sales. (All consumer Windows revenues come from PC sales.) So that 11 percent gain is likely on a relatively small number of units.

Bolstering that, Microsoft reported something called “Windows commercial products and cloud services revenues,” which were down 4 percent YOY. That name/description seems new to me, in that I don’t recall seeing it before. And I originally assumed that it was related to Microsoft 365. But I’m told that this is really tied to volume licensing, the majority of Microsoft’s commercial Windows revenues. And that the drop was only because an unnamed customer (the UK government, I suspect) suddenly purchased some ungodly number of Windows licenses in the year-ago quarter. Normally, this number is flat or experiences small growth.

Anyway, there’s not much more to say about Windows beyond the fact that commercial sales are picking up.

“OEM Pro revenue reflects a stronger than anticipated commercial PC market bolstered by improved macro conditions and continued healthy enterprise Windows 10 deployments,” the firm notes. “We benefited as well from a higher mix of premium licenses and the timing of license purchases.”

Surface

With Microsoft’s Phone business now spiraling under the drain in a pipe somewhere—inexplicably, the firm noted that “Phone revenue was immaterial and declined by $204 million” in the quarter—we naturally turn to Microsoft’s other hardware businesses to see whether there is any sign of life.

And here is where the company’s lack of transparency really hurts. There are no hard numbers of Surface or Xbox, and there haven’t been for years.

Let’s start with Surface.

Surface appears to be struggling, however: Revenues were up only 1 percent, and Microsoft reported that it sold fewer units overall but that the average price point was higher.

Let me be clear about that: Microsoft sold fewer Surface PCs in the previous quarter than it did in the same quarter a year ago.

That is not good news: In the preceding year, Microsoft released four major new devices—Surface Laptop, Surface Pro (2017), Surface Book 2, and Surface Pro with LTE—each of which hits at the heart of product lineup. In the year-ago quarter, Microsoft released two niche products, Surface Studio and Surface Book with Performance Base. And yet, it still sold fewer devices a year later.

I had expected Surface Laptop to emerge as the best-selling Surface device, replacing Surface Pro. There is no evidence of that happening, nor any evidence that this addition has done anything to improve Surface sales overall. I am surprised by this.

Looking ahead, Microsoft said that it expects Surface revenue to continue increasing due to “continued launch momentum from the latest Surface Pro, Book, and Laptop.” But it also expects Surface unit sales to “decline sequentially, consistent with holiday seasonality.” That’s not as terrible as it sounds, as this is a measure of quarter-over-quarter sales; obviously, the firm would sell more in a holiday quarter. But it provided no guidance on YOY unit sales, which is worrying. And I think we’re going to see another decline.

Xbox

Microsoft launched Xbox One X in the quarter, and it was a smash success by any measure. As I noted a few weeks ago, Xbox One beat the Sony PlayStation 4 (all version) over the holidays from a unit sales perspective, and Microsoft previously cited early record sales of the Xbox One X in particular.

“Xbox One X was the top-selling premium console this holiday in the U.S.,” the company revealed. “We grew gamer engagement again this quarter with 59 million monthly active Xbox Live members, record usage of our Xbox Live services, record viewers of our new streaming service, Mixer, and record Minecraft users.”

But Microsoft continues to offer squishy numbers to prove that its Xbox strategy is working. And the firm has not provided unit sales figures in about four years. So we don’t have much to work with here.

Gaming revenue overall—which includes hardware, software, and services—was up 8 percent, and Microsoft credited “Xbox hardware revenue growth from the Xbox One X launch.” To be clear, this is not the same as “selling more consoles”: At $500 a pop, the Xbox One X is significantly more expensive than the Xbox One S. So it is likely, since Microsoft did not state otherwise, that the firm actually sold fewer Xbox consoles in the quarter than it did a year ago. In other worse, the situation we see in Surface is being repeated here too.

Xbox software and services revenue rose 4 percent, which is an interesting indication of the overall health of the installed base. Here, Microsoft vaguely notes the lack of “AAA title launches” in the quarter (a negative) offset partially by an improvement in digital distribution (which I assume means both games, which lowers margins, and services like Xbox Live Gold and Xbox Game Pass).

The near-time future doesn’t offer much relief, either.

“In Gaming, we expect revenue growth similar to last quarter but with a revenue mix shift to software and services and continued year-over-year growth of our Xbox Live user base,” the company said, I believe referring to quarter-over-quarter expectations, not YOY.

A few other notes

The extensive documentation that Microsoft provides with its earnings releases is worth pouring over, and I’ve always paid particular attention to its 10-Q filing with the SEC: This provides a more comprehensive look at Microsoft’s various businesses, and in the past, it provided some hard data that the firm didn’t discuss elsewhere.

This quarter, the details in the 10-Q are a bit less compelling than usual. For example, phones.

We learn that Microsoft is embroiled in various patent lawsuits tied to Nokia’s former phone business and that, in at least one case, the companies are trying to settle. As with previous quarters, Microsoft has derived some financial relief by not having to advertise its phones. (Windows advertising costs also declined in the quarter, which is kind of curious.)

Microsoft has never provided Surface unit sales numbers, but my sources tell me it is south of 10 million units per year (and is apparently dropping now). But the 10-Q notes that Surface revenue increased $126 million in the quarter. Given the 1 percent gain, total revenues were thus over a billion dollars. I’m surprised they didn’t mention this.