Microsoft Corporation (MSFT) reported encouraging second quarter 2015 results with earnings of 77 cents exceeding the Zacks Consensus Estimate of 70 cents. However, shares fell 4.3% in after-hours trading, as the company took down its full-year outlook.
Similar to Intel (INTC), which reported last week, Microsoft also saw weakness in the PC market, which the company however attributed to difficult comps as earlier quarters benefited from customers upgrading from XP due to withdrawal of support.
The company appears to be on track with its cloud-first mobile-first strategy, but its pain period seems to be far from over. That’s because Windows continues to struggle and Office attach (which remains largely related to Windows) is trending down. Management assures and we agree that this is also related to the Office 365 migration.
Microsoft also saw continued weakness in Asia (the important Chinese and Japanese markets), something that is expected to continue in the next quarter. Moreover, FX is expected to remain a negative due to strengthening of the dollar.
That said Microsoft’s services and technology are getting into a larger number of devices across the existing PC and mobile platforms, as well as emerging platforms like wearables and the Internet of Things (IoT). And this will continue to drive results in quarters to come.
Revenue
Revenue of $26.47 billion was up 14.1% sequentially and 8.0% from last year, better than the Zacks Consensus Estimate of $26.06 billion. Management said that the U.S. did better than expected and Europe was generally in line with expectations. However, the disappointment was related to China and Japan.
Devices & Consumer Segment
Following the acquisition of the Nokia Devices and Services (NDS) business that closed on Apr 25 2014, management changed the reporting structure to add a sub-segment called Phone Hardware to the Devices & Consumer (D&C) segment. They also renamed the D&C Hardware segment as Computing and Gaming Hardware.
Accordingly, D&C Licensing, Computing and Gaming Hardware, Phone Hardware and D&C Other revenue made up 16%, 15%, 9% and 9% of quarterly revenue, respectively taking the contribution of the Devices & Consumer segment to 49%.
D&C licensing revenue of $4.17 billion was within the guided range of $4.0-4.2 billion. This business still has a certain amount of seasonality so year-on-year comparisons are more meaningful. Additionally, lower-end devices continue to grow in the mix, leading to a near-term negative impact on revenue comparisons.
There are three buckets within this segment: Windows Phone, Windows OEM and Office Consumer; and declines across all three drove the 24.8% segment decline from last year.
The phone business was positively impacted by the recognition of $650 million in the year-ago quarter related to the termination of Microsoft’s commercial agreement with Nokia, so there was a 61% decline.
Both Windows OEM Pro and non-Pro revenue declined 13%. Lower priced devices to academic customers and the positive impact of XP end of support were the reasons for decline in Pro revenue. Mix was the main factor pulling down non-Pro revenue as Microsoft tried to increase penetration at the entry-level.
Office consumer was the most disappointing however with a 25% decline although it was partially on account of the transition to Office 365 (so just a temporary impact). The disappointing factor was weakness in Japan’s PC market, which typically has high Office attach rates.
Revenue from Computing and Gaming Hardware, which includes the Xbox and Surface platforms jumped 62.9% sequentially while declining 10.6% year over to $4.00 billion, higher than the guided $3.5-3.8 billion.
Surface devices generated $1.1 billion million (up from 908 million in the Sep 2014 quarter), driven by Surface Pro 3 and accessories.
The 20% year-over-year growth in Xbox platform revenue was helped by price concessions for Xbox One that also resulted in declines in Xbox 360.
The $2.28 billion contribution from Phone Hardware was better than guided and driven by lower-priced Lumia devices, which grew from 9.3 million units in the Sep 2014 quarter to 10.5 million units in the last quarter. But the shrinking non-Lumia feature phones continue to make up the bulk of sales. Management is in the process of rationalizing the product line, which along with the impact of the shrinking market is hurting segment sales.
D&C Other revenue jumped 34.7% sequentially and 30.0% year over year and was also better than guided. First-party games were up 79% year over year due to Minecraft, the latest Halo and Forza Horizon 2 with Xbox LIVE driving resale revenues up 42%. The increase in search advertising revenue was driven by both RPS and volumes with Bing market share continuing to rise. Office 365 subscribers grew to over 9 million representing a 30% increase during the quarter.
Commercial Segment
Commercial Licensing revenues grew 8.2% from the previous quarter but fell 2.1% from year-ago levels and were below expectations. The decline from last year was the combined impact of a 13% decline in Office Commercial that was partially offset by a 7% increase in server products and a 3% increase in Windows volume licensing.
Office Commercial was impacted by lower transactional revenue due to the XP refresh, transition to Office 365 and weakness in China and Japan.
Transactional revenue was also down in the server business, but continued strength in SQL Server, Windows Server and System Center more than offset the impact.
Commercial Other revenues saw extremely strong growth of 7.7% and 45.7% from the previous and year-ago quarters, respectively and were within the guided range. Commercial Cloud services grew 114% from last year, the main driver of the increase. Office 365, Azure and Dynamics CRM Online dove results. Enterprise mobility workloads increased.
Operating Results
Microsoft’s gross margin of 61.7% was down 263 basis points (bps) sequentially and down 451 bps from the year-ago quarter. A number of factors impacted the gross margin in the last quarter.
The higher mix of hardware and price discounts were the main reasons for the weak gross margin. But Microsoft is selling a more services and games, and it will also seeing greater scale in its cloud business, which could be positives for gross margins going forward.
Operating expenses of $8.32 billion were up 4.7% sequentially and more or less consistent with last year. As a percentage of sales however, there were declines in all expense lines except S&M, which increased 23 bps. COGS was also higher. As a result, the operating margin expanded just 19 bps sequentially while shrinking 221 bps year over year to 30.3%.
The company generated net income of $6.43 billion, or a 13.1% net income margin compared to $5.68 billion, or 24.5% in the previous quarter and $6.56 billion, or 26.7% in the year-ago quarter. Reported earnings including restructuring charges of $243 million and one-time tax adjustments came to 71 cents, up from 54 cents and 78 cents in the previous and year-ago quarters, respectively.
Balance Sheet
Inventories fell 34.6%, with inventory turns sliding from 10.5X to 19.7X. Days sales outstanding (DSOs) went from 51 to 56.
Microsoft ended with a cash and short term investments balance of $90.25 billion, up $1.06 billion during the quarter. The net cash position was around $61.90 billion ($7.55 a share), down from $65.47 billion ($7.95 a share) at the beginning of the quarter. In the last quarter, the company generated $4.34 billion in cash flow from operations, spent $2.15 billion to repurchase shares, $2.55 billion to pay dividends, $1.49 billion to purchase capital assets and $2.79 billion on acquisitions.
Guidance
Management said that FX would have a negative 4-point impact on revenue growth in the third quarter of 2015. For the quarter, Microsoft expects D&C Licensing revenue of $3.4-3.6 billion, Computing and Gaming Hardware revenue of $1.5-1.7 billion, Phone Hardware revenue of $1.4-1.5 billion, D&C Other revenue of around $2.0 billion, Commercial licensing revenue of $9.7-9.9 billion and Commercial Other revenue of $2.6-2.7 billion. China, Japan and Russia are expected to remain weak in the next quarter. Microsoft expects COGS of $7.1-7.4 billion and opex of $8.2-8.4 billion. Capex will increase sequentially.
Full year revenue is expected to increase 4-5% to $33.2-33.6 billion and full-year year tax rate 22-24% (previous 20-22%). Management expects additional restructuring charges of $200 million in the next two quarters and integration charges of $100 million a quarter.
Recommendation
Microsoft’s second quarter is a clear indication of the improvement in its focus areas: cloud and mobile.
While it may be too soon to comment, Microsoft does appear to be delivering on its cloud-first mobile-first strategy. In the last quarter, the company saw very strong triple digit growth in its cloud services. It has also been leveraging the popularity of Office to drive penetration on Apple and Google devices. At the same time, it is doing all it can to drive Surface sales.
The hit to margins is not such a big negative considering the fact that it now has a more sizeable hardware business. Particularly since the business model is in transition. That said, the company is still not making money on its Surface devices although it could break even this year. In the meantime, it is sparing no expense to succeed.
Microsoft shares carry a Zacks Rank #3 (Hold). Better-ranked software technology stocks to consider at this time are Cadence Design (CDNS) and Jive Software (JIVE), both of which carry a Zacks Rank #2 (Buy).
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