Microsoft Earnings, COVID, and You (Premium)

Microsoft’s earnings this week were greeted with cheers and a lot of celebratory backslapping, at least virtually, given social distancing. But what does the data really tell us about the firm’s consumer businesses?

Before diving in, I can say that the most interesting tidbit from earnings was this little quote from its FY20 (Q120) earning press release:

“COVID-19 had minimal net impact on the total company revenue.”

Um, what now?

Microsoft has spent the past two months frantically and incessantly communicating about COVID-19, and it has promoted its Microsoft 365 suite of solutions as the cure-all for our new work at home requirements and the suddenly sped-up “digital transformations” that companies around the world are experiencing. Its cloud infrastructure has wheezed and nearly collapsed under the weight of increased demand, a fact that Microsoft addresses only quietly, in community forum posts, and an issue that the market leader, Amazon, never seems to suffer from. And the firm is communicating … what here? Normalcy in a time of pandemic?

That’s a rather amazing marketing spin for a single sentence in a press release, and I assume it can be excused away by the fact that Microsoft’s overall business, at least from a revenue perspective, has remained on track when viewed from a high level, like outer space. But I think it’s more important and pertinent to note that Microsoft’s collective businesses have been put in a blender and thrashed beyond recognition, just like the rest of the global economy. And that what emerges on the other side of that most unwanted digital transformation is a very different mix of businesses and strategic priorities.

The most basic shift can be seen if you move a bit closer to the company, say from the stratosphere, from a place where you can observe its three top-level business units. For years now, I’ve been watching the relative financial performance of each to see when what Microsoft promotes—the cloud—actually surpasses what’s quietly been making most of the firm’s revenues during this time, which is a legacy product like on-premises servers, Windows, and Office.

That’s hard to do. Microsoft smartly and purposely mixed on-prem/legacy businesses with cloud businesses in each of those top-level units to hide the truth. On-prem servers are mixed in with Exchange. On-prem Office is mixed in with the Office bits in Office 365 and Microsoft 365. And so on.

But there is one part of Microsoft that provides a bit of insight in this regard: Its curiously named More Personal Computing business unit is where it lumps Windows, Surface, and Xbox. And while some of that is moving to the cloud, sort of, those parts are tiny. So most of the revenues in this business unit don’t come from the cloud. And there’s no good way to hide that.

And on that note, Microsoft’s top three business units each delivered roughly one-third of the firm’s revenues for several quarters in a row. The one exception was the fourth quarter (Microsoft’s fiscal second quarter), when More Personal Computing experienced a bit of a surge related to the support expiration of Windows 7 and the normal seasonality of the holidays.

But this past quarter, the first to include impact from COVID-19, and the first in the post-Windows 7 world, tells a different story. Microsoft’s two business units with large cloud-based components (and, yes, big traditional components, too) both surged upwards. And More Personal Computing fell (quarter over quarter; it barely grew year-over-year).

Specifically, Intelligent Cloud (Azure) was its biggest business, with $12.3 billion in revenues. Productivity and Business Processes (Microsoft 365) was a close second with $11.7 billion. And More Personal Computing held fast at $11 billion, where it’s been hovering for a while now.

Those numbers may seem only subtly different to you. And they are. But this is the start of the shift caused by COVID-19, and you’re not buying that, just look at the relative YOY growth rates to see what’s really happening. Intelligent Cloud grew by an incredible 27 percent YOY. Productivity and Business Processes surged by 15 percent. And More Personal Computing? In a quarter in which businesses should have been upgrading past Windows 7 en-masse and more and more people were working from home and presumably many needed new PCs, this business unit grew by just 3 percent.

So that’s the upper-level view. What I’m more concerned with is the next step down from there, the atmosphere, I guess. The mile-high view. At that level, we see the many businesses that exist within those business units. And things get tricky there, because this is the level at which Microsoft hides bad data and cherry-picks good data to publicize to shareholders and investors. We don’t get a complete picture at this level. How many units of Surface PCs that it sold, let alone the mix of models. How many Xbox consoles. That kind of data. You know, unless it’s exceptionally good news.

But that kind of revelation is in itself insightful. If Microsoft hid sales in the past and mentions a figure now, what does that really tell us? What were the numbers before? Are they artificially high now because we’re stuck at home? And will that growth, whatever it is, slow dramatically when this pandemic passes? We can only speculate.

But I’ve been speculating about Microsoft’s revenues for decades, and I’ve been trying to analyze how things are really going with the products and services that I—and, I suspect, you—care about most. You know, the Microsoft solutions that impact us. People. Individuals. Consumers. Whatever name you wish to use. So let’s see what the firm really said. And, where necessary, speculate.

Windows

Microsoft executives uttered the word “Windows” directly fewer than 10 times in the post-earnings conference call, and it was almost an afterthought. That’s rather incredible given the timing; again, the end of support for Windows 7 which should be driving upgrades and the stay-at-home orders which should have triggered more PC sales.

Here’s what they did say.

“Windows 10 now has more than 1 billion monthly active devices, up 30 percent year-over-year, and we are seeing demand for Windows 10 PCs – from small screens to large screens to dual-screens.”

That first bit is a fact, but it’s also not news and is unchanged from the figure Microsoft provided a month ago. That last bit is … nonsense? Microsoft says it is seeing demand for Windows 10 PCs with dual screens? Then why did it delay its only dual-screen PC, Surface Neo? And why is it switching the focus of Windows 10X, which supposedly only targeted dual-screen PCs, to traditional single-screen PCs?

“Let me take a moment to discuss the impact of COVID-19 on the quarter,” CFO Amy Hood said, specifically mentioning the market I care about most. “We saw increased demand from work, play, and learn from home scenarios, benefitting Windows OEM [PC maker sales], Surface, Office consumer, and Gaming.” The firm also noted that “better than expected Windows OEM, Surface, and Gaming revenue more than offset lower than expected Search revenue” in the quarter, helping drive More Personal Computing’s $11 billion in revenues.

Windows commercial products and cloud services grew 17 percent in the quarter. But I had to turn to the slide deck accompanying the earnings release to get more information.

And there, we see that Windows non-Pro revenues from PC makers selling to consumers fell by 10 percent. Windows Pro revenues from PC makers, which presumably covers both businesses and individuals, was up just 5 percent. These are not great numbers given the market conditions. Both should have been up dramatically.

Microsoft credited demand from work-from-home for the Pro results. And it claimed that supply chain restraints and “continued pressure in the entry-level category”—i.e. Chromebook and iPad—were the reason for non-Pro’s declines. Not good.

Surface

Though it delivered nearly $2 billion in revenues for the first time in the previous (holiday) quarter, Surface under-performed last time around, leading me to believe that its latest PCs—Surface Pro 7, Pro X, and Laptop 3—were not selling well. This quarter, Surface revenues were flat with the year-ago quarter, and there were no compelling new products last year, so this isn’t great news.

Surface came up even less than Windows in the conference call, but that makes sense. It’s a tiny business. But it was only mentioned once by itself, when Hood said, in a long list of product expectations, that “continued strong demand should drive revenue growth in the low-teens” in the current quarter. That as it.

Looking at the slides, Surface likewise gets little mention. Revenue was up 1 percent, i.e. was flat, “driven by increased demand from remote work and learn scenarios [but ] partially offset by supply chain constraints in China.” Those constraints are gone, and Microsoft should announce at least two new Surface PCs any day now. So that may explain the revenue growth expectations for the current quarter. I am surprised they were so specific.

Is Surface … healthy? It’s hard to say. I feel like the fall 2019 lineup was strong and that two of those models, the Pro 7 and Laptop 3, were mainstream PCs that should sell well. But only the Pro 7 appears to have done so. We need new AdDuplex data, as Microsoft will never tell us.

Xbox

Xbox is in a precarious position right now: There was no new console last year, and console sales were already running on fumes. And last quarter was a bloodbath as a result, despite being the holiday quarter: Xbox revenues were down 11 percent overall.

This quarter wasn’t much better despite all the stay-at-home requirements: Overall Xbox revenues were up just 2 percent YOY. But if you look at the (non-COVID) year-ago quarter, you’ll see something interesting: Xbox revenues back then jumped by 12 percent YOY. So much for this quarter’s successes.

Microsoft mentioned Xbox just a single time in its conference call, but it mentioned gaming about as many times as it mentioned Windows. This, I feel, is because the future of Xbox/gaming aligns with the cloud future that Microsoft is now promoting to Wall Street. And there was a lot of future talk in this part of the call.

“People everywhere are turning to gaming to sustain human connection while practicing social distancing,” Microsoft CEO Satya Nadella said during a lengthy introductory discussion. “We saw all-time record engagement this quarter, with nearly 90 million active users of Xbox Live, led by strength on and off console. Xbox Game Pass has more than 10 million subscribers, and we are seeing increased monetization of in-game content and services. And our Project xCloud gaming service now has hundreds of thousands of users in preview across 7 countries, with 8 more launching in the coming weeks.”

A few comments on that.

I suspect that Xbox Live is driven primarily by console, not PC or mobile (“off console”) but would love to see a breakdown there, especially over time.

90 million Xbox Live subscribers seems high, but that’s Gold plus unpaid subscribers (i.e. Microsoft account holders who have signed-in to Xbox Live). I’m curious how much the paid subscriber numbers have grown. (I believe the Gold subscriber-based was in the 50s before.)

The Xbox Game Pass number is new and, I think, the first time they’ve ever discussed a specific feature. This tells me that roughly 20 percent of the Xbox Live Gold subscriber-based has upsized. That’s a good number. But it could be temporary too. How many of those are temporary 3-month subscriptions aimed at getting people through the pandemic?

Project xCloud is in preview and generates no revenues for Microsoft. That user base is tiny right now.

Later, Microsoft notes that gaming revenue declined by 1 percent, but was somehow “driven by higher user engagement than expected.” In other words, the revenue decline would have been much worse if it weren’t for COVID. “Xbox content and services revenue increased 2 percent,” which, again, is a big drop from last year, but Microsoft cited “strong growth in GamePass subscribers and Minecraft.”

I’m most confused by Hood’s revenue predictions for this quarter.

“[In] Gaming, we expect revenue growth in the high-teens with continued strong user engagement across the platform.” I wonder if they spread out Game Pass revenues over the course of the subscription time. Or if this just indicates that the stay-at-home orders will continue to drive revenues in gaming for the short-term.

The slides don’t provide any additional data.

Microsoft 365 for consumer

Microsoft 365/Office 365 falls under Microsoft’s Productivity and Business Processes business unit, but the vast majority of its revenues and usage, and of Microsoft’s attention, goes to the commercial (business) side. There’s very little here that is specific to consumer.

That said, there is one very specific number here, too, which I like: There are 39.6 million Office 365 (now Microsoft 365) consumer subscribers, and quarter-over-quarter jump of 2.4 million subscribers over the 37.2 million reported in the previous sequential quarter, “because of increased demand from remote work and learn scenarios.” That’s 6 percent growth, and I suspect it will be as strong or stronger in the current quarter as working from home continues. (Commercial will benefit even more, yes.)

(A year ago, the Office 365 consumer subscriber base was 33.3 million.)

Office 365 and Microsoft 365 were mentioned many times in the conference call. But with regard to consumers, there was no additional information. Microsoft did mention that it was “bringing Teams to consumers for the first time so they can stay connected with family and friends,” but that won’t happen for many months.

What it all means

Microsoft touted a lot of big consumer numbers, as we reported earlier. But when I look at the data provided by the company, I don’t see much to celebrate. Windows should have been stronger, given what’s happening, so it will be interesting to see if those China-based issues being resolved turns this quarter into more of a success. Surface just seems stuck in a rut, but Surface Go 2 is on the way and its predecessor inexplicably sold pretty well (for Surface), so maybe we’ll see a bump there; whatever, the current lineup is underperforming. Xbox is falling badly, even with COVID, and it needs a services injection as soon as possible; I doubt that the Xbox Series X will provide more than just a temporary bump and it certainly won’t make inroads on PlayStation. And Office/Microsoft 365 consumer is perhaps the one bright spot, though it remains tiny compared to the commercial side of that business.

Yes, Microsoft is a juggernaut. But it is a juggernaut with businesses, not individuals, and one that continues to hide where it really earns revenues so that it can keep Wall Street happy while it continues to sell the future as it tries to move past its legacy, on-premises businesses.

The good news? Its consumer lineups are pretty solid: Despite the competitive pressures from Chromebook, iPad, and mobile generally, Windows is still the best productivity platform. Surface is an excellent premium brand with high-quality PCs. Xbox is the most gamer-centric platform there is, and the expansion to the cloud and to heterogeneous devices only expands that truth. And Office/Microsoft 365 is a no-brainer for anyone—individuals and families alike—that need to get real work done.

More to the point, Microsoft’s successes in commercial markets mean that we never really need to worry about the firm “abandoning” consumer. Windows, Surface, and Microsoft 365 serve both camps ably, and there’s no real overhead to Microsoft doing that. And Xbox is a big bet that has the backing of Microsoft’s CEO. These businesses aren’t going anywhere, whatever the numbers this quarter or in the near future.