FY19 (Premium)

As you may have seen, Microsoft issued its fourth-quarter and full-year earnings for Fiscal Year 2019 last night. Let’s take a closer look.

The numbers:

For the quarter ending June 30, 2019—the fourth quarter of Microsoft’s Fiscal Year 2019—the software giant posted net income of $13.2 billion (up 49 percent year-over-year) on revenues of $33.7 billion (up 12 percent YOY).

For the full fiscal year (FY19), Microsoft posted net income of $39.2 billion (up 137 percent YOY) on revenues of $125.8 billion (up 14 percent).

While I don’t usually write about this, I’m always fascinated by how others cover Microsoft’s financials. There’s an interesting dynamic here where Microsoft, as always focuses on the positive and the buzz markets on which Wall Street is fixated, and others either toe the line or, occasionally, provide real insight. Unfortunately, the latter is less common than the former.

First, the line.

Microsoft shares hit record highs, powered by growing cloud sales, Reuters notes, highlighting everything that Wall Street wants to hear in a single headline: Shares surging and Microsoft’s cloud business success. “Since Chief Executive Satya Nadella took over in 2014, Microsoft has been shifting away from its Windows operating system software and toward cloud services, in which customers move their computing work to data centers managed by Microsoft,” the piece breathlessly notes, ignoring the fact that Microsoft began this transition fully 15 years earlier than that and has been steadily working towards a non-Windows future for almost 20 years now.

Business reporting may trend more boringly than, say, celebrity “news,” but it is no less resistant to highlighting invented controversies in order to drive clicks and views. For example, CNBC, that bastion of the click-bait headline (kidding) leads with, “Microsoft reports Q4 Intelligent Cloud revenue of $11.39B, up 19% YoY, with Azure revenue up 64% YoY, its lowest growth rate in at least four years,” as if that is in any way significant from a negative standpoint.

It is not. As I’ve noted repeatedly in the past, Microsoft Azure—which had once consistently seen heady growth rates north of 90 percent —had to slow down from a growth perspective as the business matured. And this has happened in recent quarters. In FY19 Q3, the Azure business grew by about 71 percent. This past quarter, it was 64 percent. Aside from the fact that no businesses can be accurately compared quarter-over-quarter—that’s why we measure change YOY—64 percent is incredible growth. It is a cause for celebration, not for concern.

Azure is also outperforming expectations as it cements its number two position in the market behind Amazon AWS, another cause for celebration. Analysts had expected Azure to deliver $11.02 billion in revenues in the quarter, but the figure came in at $11.39 billion. That partly explains why Microsoft shares surged after it released its financials. (Any why CNBC focusing on “the lowest growth rate in four years” is nonsense.)

If you’re looking for real insight about this part of Microsoft’s business, I can recommend my Windows Weekly cohost Mary Jo Foley, who predictably put this all in perspective.

“Some looking deeper into Microsoft’s earnings are wondering whether Microsoft’s Azure business is slowing because it is now ‘only’ up 64 percent, year-over-year, but steadily down, sequentially,” she writes, echoing my comments above. “Mike Spencer, General Manager of Investor Relations, said the lower Azure growth percentage is because of the law of large numbers, meaning the bigger Azure gets as an overall business, the slower it’s likely to grow, percentage-wise … It’s a different story on the Azure margins side, where things are improving noticeably, thanks to larger, multi-year contracts that Microsoft’s been signing of late.”

Right.

On the flip side, it’s equally fascinating to see others finally pick up on something I first reported last year, when Microsoft saw two straight quarters of heady growth in its money-losing Xbox business. At the time, I was apparently the only one who noticed that this growth came solely from the happenstance of Fortnite happening. Fortnite, as you may know, is not a Microsoft game, and it does not work exclusively on Xbox. And yet it was SO big that it actually made Xbox look artificially strong.

“[Microsoft’s] gaming [business] did great, but only because of a third-party game called Fortnite, which is not an Xbox exclusive,” I reported in early February in the wake of FY19 Q2 earnings report. “Microsoft’s hardware sales actually tanked in the quarter, falling 19 percent.”

Now, the rest of the world is catching on, presumably because the Fortnite phenomenon has died down (thanks, Apex Legends). So, Microsoft can no longer hide the fact that its Xbox business really doesn’t do all that well.

“Xbox sales disappoint,” the Verge reported, as if they hadn’t been doing so all along. “Microsoft’s Xbox hardware revenue declined a massive 48 percent, and Microsoft attributes this to a ‘decrease in the volume of consoles sold’.”

Right.

And this isn’t going to change, given that Microsoft recently delayed its next-generation Xbox One console by a year, mimicking Sony. One gets the feeling that Xbox executives were relieved that that happened, since they were poised to launch in late 2019 whether the new console was ready or not.

Moving past what others are reporting, I always find it interesting to examine what Microsoft chooses to discuss in the mountain of documentation it provides with each earnings announcement. And what it says, and is forced to respond to, during its post-earnings conference call with analysts and press, some of whom actually ask real questions.

A few highlights.

Starting with Windows, of course, and not just because this is my focus. As we move into the second half of 2019, we are of course approaching the January 2020 end of support date for Windows 7. I’ve said before that I don’t expect to see a massive spike in Windows license sales/revenues ahead of this transition, at least nothing like what Microsoft experienced when it belatedly put an end to Windows XP. So, I’m always interested to see whether what happens with Windows each quarter.

To date, it’s been a steady and consistent performer. And for those that wish to push the Wall Street line that the future is all about the cloud, it’s also a bit of an embarrassment because the business unit of which it is the primary contributor remains Microsoft’s biggest.

So what happened this past quarter?

First, one notable change: More Personal Computing, that business of which Windows is part, is for the first time ever not Microsoft’s largest business unit. It generated $11.3 billion in revenues in the quarter and 4 percent growth, ahead of Productivity and Business Services, which generated $11 billion in revenues and 14 percent growth. But behind Intelligent Cloud, with $11.4 billion in revenues and 19 percent growth.

Folks, this is an important milestone.

Not only has a Microsoft cloud-based business unit finally surpassed Windows, but that business is growing at almost 5 times the rate of More Personal Computing. And Productivity and Business Services, of which Office 365, another cloud-based business, is the primary contributor, is growing at almost 4 times that of MPC/Windows. So we just crossed a line where the marketing (“cloud is the future”) has become the reality (“cloud is now”).

That said, there’s no real bad news here. Windows has, after all, consistently performed during a several-year period in which the market it serves, for PCs, has fallen by one-third. The performance of Windows during this time is nothing short of miraculous. And it did so again in the most recent quarter. Somehow.

In FY19 Q4, Windows Pro revenues to PC makers grew by 14 percent, compared to 18 percent a year ago. Windows Home revenues to PC makers fell by 4 percent, compared to an 8 percent drop a year ago, so that’s actually an improvement.

Microsoft says it saw “continued pressure in the entry-level [PC] category,” which it blamed on a mythical Intel chipset shortage (“we’re making them as fast as we can!”) in past quarters but neglected to mention this time. But it also admitted to benefiting from an artificial 4 percentage points of revenue gains because PC makers ordered more components from China, and thus more Windows licenses, than they needed because they were afraid that the US/China trade war would lead to higher component prices. So they stuffed the channel with inventory no one wanted. Microsoft—and Windows—won again.

That’s cute. But two-thirds of Microsoft’s Windows revenues come from businesses, not from consumers. So how did that business do? Excellent, as it turns out. Microsoft reported that Windows licensing revenues to businesses grew by an astonishing 23 percent, compared to 13 percent a year ago.

That, presumably, is where we see the impact of the Windows 7 to 10 transition. Just 10 percentage points. Right?

No. See, the problem with an OS transition for Microsoft is that business customers moving from one version of Windows to another doesn’t boost the bottom line. Those Windows licensing revenues cover whatever supported versions of Windows its customers choose to deploy. Upgrading from one version of Windows to another doesn’t move the dial in the slightest.

For this reason, Microsoft is trying to shift as many customers as possible to Microsoft 365, an uber service that combines Windows, Office 365, and device management under a single umbrella and provides it with bigger per-user licensing revenues. In other words, Microsoft doesn’t benefit from its business customers transitioning from Windows 7 to Windows 10. But it would benefit from those who transitioned from Windows 7 to Microsoft 365.

So, how do we explain the 23 percent bump?

Microsoft says blandly that it’s from “an increase in multi-year agreements that carry higher in-quarter revenue recognition.” It has nothing to do with the Windows 7 transition.

While we’re on More Personal Computing, I should address Microsoft’s Surface business, which gets far more press than it deserves. Don’t get me wrong: I love Surface, am, in fact, writing this post on a Surface Book 2 which I specifically chose over the other 30+ PCs I have available to me to use during my three-week home swap. But Surface is not a big business for Microsoft, nor is it a money-maker, and it most certainly doesn’t deserve the attention it gets each quarter.

The Surface business, we’re told, grew 14 percent by revenues, and Microsoft said this was driven by “strong growth in [its] commercial segment.” The business grew a bit from $1.185 billion in revenues a year ago to $1.35 billion a year ago. But the Microsoft quote suggests a cratering of Surface sales with consumers, driven in part by a massive average selling price (ASP) drop-off courtesy of the inexpensive Surface Go.

The problem, as I see it, is that Microsoft is just dabbling in PCs. And while I and many others may like Surface for whatever reasons, Microsoft doesn’t update these products frequently enough, nor does it adopt modern technology at an acceptable pace. Surface is a boutique PC business, and nothing more, and it will always be so unless Microsoft gets serious about leading the market. I just don’t see it happening.

But don’t take my word for it.

In its post-earnings conference call, all Microsoft could say about Surface was that it “expanded” its family of products this past fiscal year by introducing the Surface Go, an under-powered low-ball entry that was so uninteresting to the Surface team that they farmed out its design to a third party, and Surface Hub 2S, which I’ll point out has not even been released yet. So that’s all that Microsoft did to expand Surface in its entire fiscal year. A cheap Surface it didn’t even design and an expensive Surface Hub it didn’t even release.

Worse, Microsoft expects Surface revenue to decline in the current quarter, driven by the fact that its stable of products just keeps getting older and older. It didn’t say this, but we know the next new Surface PCs won’t appear until this fall—next quarter or later—and that when they do appear, they will replace products that are two years old.

Finally, let’s look at Office 365.

I’ve always viewed this product line as the poster child for Microsoft’s transition to the cloud, and with the Productivity and Business Processes business—seriously, could this company have worse business unit names?—now Microsoft’s biggest, that opinion has become fact. So, how is Office 365 doing?

Great, as you’d expect.

Office Commercial revenues overall were up 14 percent in the quarter, but Office 365 Commercial, specifically, was up an amazing 31 percent thanks to an incredible 23 percent jump in Office 365 Commercial seat (“user”) growth and an increase in revenue per user (which indicates that businesses are paying for more higher-end Office 365 SKUs.)

On the consumer side, Office 365 grew 6 percent YOY by revenues and the Office 365 Consumer subscriber base hit 34.8 million users. It was 31.4 million a year ago.

And then there’s Microsoft 365, which is correctly seen as a superset to, and perhaps the future replacement of, Office 365. Microsoft has been largely quiet about this business—the component parts of which each come from different business units—in its quarterly revenue reports, at least from a hard numbers perspective.

And so it was again this quarter, when we learned that Microsoft Teams now has 13 million daily active users and 19 million weekly active users; previously, Microsoft only discussed how many organizations had adopted Teams, making comparisons with the past impossible. We also learned that several multinational corporations—L’Oreal, Walgreens, BASF were singled out—have adopted premium Microsoft 365 offerings. And vaguely that Microsoft 365 is doing well in education.

Microsoft, as it turns out, is a big, healthy, and diverse company. And while it’s convenient to focus on certain parts of the business to generate headlines or drive the story in a particular direction, what I see here can be expressed most easily by a quick glance and its top-level business units. You’ll recall that I noted above that Intelligent Cloud had, for the first time, surpassed More Personal Computing to become Microsoft’s biggest business unit by revenue. And that both Intelligent Cloud and Productivity and Business Processes were growing much more quickly than More Personal Computing, suggesting that next quarter, for the first time, More Personal Computing cloud slump into third place.

That’s all true.

But this quarter, this one slice of time in a continuum, is fascinating to me because now, for the first and probably only time, all three of Microsoft’s business units are roughly the same size. Intelligent Cloud, More Personal Computing, and Productivity and Business Processes delivered $11.4, $11.3, and $11 billion in revenues, respectively. Microsoft, temporarily, is in complete balance.

And that, I think, is the real story of this quarter, this past fiscal year, and of Microsoft in general. It is poised to both succeed in the high growth markets of the future and to withstand the inevitable contraction of its legacy businesses. And no matter what you think of its overall strategy or of the decisions it makes, this is a company that is sanely, logically, and well run.