Analysis: Microsoft Earnings (Premium)

Last night, Microsoft announced earnings for its second fiscal quarter, which ended on December 31, 2018. 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 usually provide a “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.com. But with Microsoft moving its earnings announcement from Thursday to Wednesday, I think it makes more sense for me to do this here, and in a non-humorous way.

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.

Windows

Microsoft noted that Windows revenues from PC bundles were “lower than expected,” and I’m interested to see that it parroted Intel’s line about the chipmaker somehow not being able to meet demand in what is a years-long down market.

“In Windows, the overall PC market was smaller than we expected primarily due to the timing of chip supply to our [PC maker] partners which constrained an otherwise healthy PC ecosystem and negatively impacted both [PC maker-based] Pro and Non-Pro revenue growth,” Microsoft CFO Amy Hood claimed. “Windows [PC maker] Pro revenue declined 2 percent, roughly in-line with the commercial PC market. [PC maker] non-Pro revenue declined 11 percent, below the market with continued pressure in the entry-level category.”

I’m sorry. “An otherwise healthy PC ecosystem”? Seriously?

As a recap, PC sales fell in 2017 for the seventh straight year. The last time PC makers sold fewer PCs than they did in 2018 was in 2006, when Windows Vista still had that factory fresh smell. And the PC industry today is only about one-third the size it was at its peak in 2011. This market is far from “healthy.” But it is arguably stabilizing, which is the most positive thing one can say about it: The past two years of shrinking sales were very tiny drop-offs. So maybe the worst is behind us.

But I am surprised to see Microsoft aping Intel’s line about not meeting demand, as if there was some wellspring of new PC sales to be had if only they could have made enough product. Intel first cracked open this little chestnut back in September, when it warned ahead of the holiday quarter we’re now discussing that it wouldn’t be able to meet the demand for PC chips thanks to the expected “modest growth” that was then happening in the PC market.

Again, that never happened: PC sales fell in 2018, again. But Intel’s warning is curious. It seemed to suggest, at the time, that it was over-emphasizing on expensive chips for premium and gaming PCs and that the additional demand for which it was unprepared was coming from customers wanting lower-end products.

I didn’t buy this excuse then. And I certainly don’t buy it now. And I’m not alone: During the post-earnings call Q&A, Hood was asked to explain, exactly, “inventory levels” explained the shortfall.

“Chip supply [will] remain constrained [in the current quarter],” she said, suggesting that Intel’s super-human efforts from last Fall still won’t bear fruit in the current quarter.”

Whatever. There is another Windows story that came up in the course of earnings, too: Windows 7 support is ending one year from now and Microsoft is pushing a narrative that Windows 10 upgrades are going strong. Without any data to back it up, of course.

“We know that the signals we get from especially our commercial customers is that there is a healthy demand for the value that exists in Windows 10,” Hood said in response to another question. “We’re seeing it in terms of deployments on new and existing devices. And the security and manageability value prop that comes with a modern device, and the experiences that employers want their employees to have and be able to take advantage of along with some of the end of support deadlines that we have talked about, there is still an opportunity for us to remain focused on and execute on through this calendar year. And I still feel quite good about that, including the signals we’re getting in the market.”

Those “signals”—which I assume are mostly about intent to upgrade—are kind of hard to see in the earnings data. Microsoft reported that Windows PC maker revenues for the Pro SKU declined 11 percent in the quarter. But “Windows commercial products and cloud services” revenue grew by 13 percent. A year earlier, both of those product offerings declined, by 5 and 4 percent, respectively. So perhaps we’re finally seeing the start of a Windows 7 upgrade “bump.”

Gaming

Overall gaming revenue was up 8 percent year-over-year, identical to the year-ago quarter. The big news? This was Microsoft’s largest gaming revenue quarter ever, albeit one that comes with an asterisk….

Xbox software and services jumped 31 percent, which is impressive, and well ahead of the 4 percent growth experienced last year. The caveat? That growth came largely from the “continued strength from a [single] third-party [game] title,” meaning Fornite. So we can’t attribute that one highlight to anything Microsoft did.

Xbox hardware revenues declined an alarming 19 percent; Microsoft blamed this on the fact that the year-ago quarter benefited from the Xbox One X launch. That said, Microsoft did not provide hardware growth figures a year ago, which is rather curious.

Xbox Live monthly active users jumped to 64 million. A year ago, it grew 7 percent to 59 million. “Xbox Game Pass subscribers and Mixer engagement also hit new all-time highs,” whatever that means. (Also, both are relatively new services, so these are low, if unstated, bars.)

Looking at gaming more generally, Microsoft spoke to the many investments its made to shore up this business. This includes the coming xCloud gaming service—an “expansive opportunity to transform how games are distributed, played and viewed”—plus its gaming studio acquisitions and the continued success of Minecraft. “xCloud will be in public trials later this year as we make progress on our ambition to build a world-class gaming platform spanning mobile, PC and console,” Satya Nadella said.

Surface

Surface revenue increased 39 percent year-over-year to nearly $1.9 billion. That is Surface’s biggest-ever quarter by and a big change from the year-ago quarter when Surface revenues grew just 1 percent thanks to higher average selling prices and lower sales volume.

I was looking for some evidence that certain Surface models made the difference, and got exactly what I expected: Microsoft’s decision to step back from the premium cliff and offer a low-cost Surface Go product while lowering prices on mainstream PCs like Surface Pro and Surface Laptop was what made the difference.

I feel that Surface is in a good place right now, despite the fact that PC hardware is, as Microsoft says, a “low-margin” business. And it’s good enough of a business that its success this past quarter was able to partially offset losses in Windows. Microsoft expects Surface to grow 20 percent this quarter, too.

Office 365, Microsoft 365

Microsoft’s transitioning of Office from on-premise software to a subscription-based service continues to be successful. Office 365 commercial revenues grew 34 percent, though we didn’t get a new active seats number. On the consumer side, we didn’t get a revenues figure, but the installed base grew to 33.3 million, up from 29.2 million a year ago. That’s not a huge jump, but then I don’t believe this figure ever improves dramatically. But Microsoft noted that a “sequential slowdown [in the Office 365 consumer installed base was] primarily due to changes made in how Office 365 is sold in Japan.”

Microsoft 365, which I view as a superset of Office 365, got a lot more traction in the post-earnings conference call, most likely because it can be viewed as a cloud subscription service that closely aligns with Microsoft’s positioning for the future. And there were a number of Microsoft 365 milestones that apply equally to Office 365.

First up, Microsoft Teams, which saw adoption jump to 420,000 organizations and 89 of the Fortune 100. Teams also came to First Line workers and saw some impressive changes in Education. Lots of big businesses are adopting Microsoft 365, too: For example, Walgreens will roll out the offering to 380,000 employees worldwide this year. (That one was a win for Azure as well.)

“The value proposition of Microsoft 365 transcends Windows and Office on Windows,” Mr. Nadella said. “We think about the relevance of our applications across all device sockets. We think about the security, identity management, information protection, and all that value across all device sockets.”