- Microsoft has posted mixed FQ3 results with in-line revenue but lower-than-expected earnings.
- Microsoft's cloud is growing slower than expectations while its hardware division is ailing due to weak console and phone sales.
- The two segments could, however, improve in the coming quarters.
Microsoft (NASDAQ:MSFT) has posted mixed FQ3 results and issued a weak FQ4 guidance during its latest earnings call. Microsoft reported non-GAAP revenue of $22.1B, up 1.7% Y/Y and in-line with the Wall Street consensus but non-GAAP EPS of $0.62 came in $0.02 below analysts' estimates.
Net profit for the quarter dropped 25% Y/Y to $3.76B. Microsoft blamed a higher-than-expected tax expense due to a changing geographic mix for the earnings shortfall. Microsoft had guided for non-GAAP tax rate of 20% but actual tax rate for the quarter was 24% resulting in a $0.04 EPS hit. This implies that Microsoft's earnings would have topped estimates had tax rates remained within the predicted range.
On a GAAP basis, Microsoft's revenue came in at $20.5B, down 5.5% compared to a year ago. Microsoft blamed the lackluster non-GAAP revenue on the multiyear PC market slump and currency headwinds.
Microsoft's segment performance was mixed with the pivotal cloud posting slower-than-expected growth while its PC division performed better than the market. Meanwhile, Microsoft announced that commercial cloud annualized revenue run rate had exceeded $10B, up from $9.4B in the previous quarter.
- Intelligent Cloud (server products, Azure, and enterprise mobility)--revenue was up 3% (up 8% in constant currency) to $6.1B. The segment's operating profit plummeted 14% to $2.2B.
Server products and cloud service revenue grew 5% in constant currency. Azure revenue was up 120% Y/Y in constant currency while enterprise mobility customers more than doubled to 27k.
- More Personal Computing (Windows, hardware, and Bing)--revenue grew just 1% (up 3% in constant currency) to $9.5B. The segment's operating profit, however, performed much better after increasing 57% to $1.65B.
Windows OEM revenue outperformed the market after declining 2% in constant currency with Microsoft attributing this to a favorable consumer product mix (consumers buying more high-end Windows products). Surface revenue was up 61% in constant currency to $1.1B primarily driven by sales of the new Surface Pro 4 and Surface Book. Windows phone revenue continued on its downward trend after posting a 46% decline in constant currency to 662M units. Xbox Live monthly users grew 26% Y/Y to 46M. Search advertising revenue ex-TAC increased 18% in constant currency with Microsoft saying that continued adoption of Windows 10 (more than 270M installed devices) as well as the integration of Bing into Windows 10 was helping.
- Productivity and Business Processes (Office and Dynamic business apps)--revenue grew 1% (up 6% in constant currency) to $6.5B. The segment's operating profit was down 7% to $3B.
Office commercial products and cloud services posted revenue growth of 7% in constant currency with Office 365 revenue increasing 63% Y/Y in constant currency. Office consumer products and cloud services revenue increased 6% in constant currency with Office 365 consumer subscribers hitting 22.2M. Dynamics products and cloud services posted 9% revenue growth in constant currency with Dynamics CRM seats online doubling.
FQ4 Revenue Guidance
Microsoft gave fiscal fourth quarter guidance that came in below expectations. The company said that it expects FQ4 revenue in the range of $21.7B-$22.4B, the midpoint being well below Wall Street consensus of $23.1B. Segment guidance was as follows:
- Intelligent Cloud: $6.5B-$6.7B.
- More Personal Computing: $8.7B-$9B.
- Productivity and business processes: $6.5B-$6.7B.
A Deeper Dive Into Microsoft's Personal Computing Division
Microsoft's Personal Computing division, the company's largest revenue segment, is the chief reason why the company's FQ4 guidance came in below expectations. Ongoing weakness in the PC market is to blame for poor expected Windows OEM hardware sales.
Microsoft's rapidly declining phone business is not helping much either. During FQ3, Microsoft sold a mere 2.3M Lumia handsets down from 8.6M a year ago, good for a massive 73% Y/Y decline. Microsoft moved 4.5M Lumia handsets during the previous quarter which means FQ3 sales were down a huge 49% Q/Q. Meanwhile, sales of non-Lumia handsets that Microsoft inherited from Nokia (NYSE:NOK) fell 36.4% Y/Y to 15.7M units.
That tells you how quickly the company's phone business has been disintegrating. The tailspin seems to suggest that Microsoft may no longer be interested in the business and might decide to sell it in the near future.
Surface though remains a bright spot for Microsoft. Surface tablets are now the best-selling online after having overtaken Apple's (NASDAQ:AAPL) tablets late last year helped by the popularity of Surface Pro 4 and Surface Book. And this is not about Microsoft offering price competitive products to compete with Apple. Surface Pro 3, Surface Pro 4 and Surface Book sell at an average price of $844 compared to just $392 for an Apple iPad. This speaks volumes about how far Microsoft has come when it comes to manufacturing hardware that appeals to the consumer.
Microsoft does not divulge Xbox sales in its reports. The general feeling, however, is that Xbox One is not doing well. Microsoft revealed that it had managed to sell 10M Xbox One consoles one year after its launch. Electronic Arts revealed in February that Microsoft and Sony combined had sold 55M PS4 and Xbox One consoles. Sony's sales are pegged at 35M which implies that Microsoft has sold ~20M Xbox One consoles to-date. This implies that Microsoft has only managed to sell 10M Xbox One units over the 18-month period since its last announcement.
Some analysts contend that we are at the beginning of the end of the console era while others have projected that Microsoft's upcoming major upgrade on Xbox One could revive its flagging fortunes. I guess we will never know until the upgrade arrives, which, rumors say, maybe as early as this fall. After all, the 55M combined sales by the two companies are actually double the sales of the prior generation consoles (PS3 and Xbox 360) and suggests that it might be too early to call a peak on the console industry.
Microsoft Stock Analysis
Microsoft stock tanked 8% after the earnings report, partly due to the earnings miss and partly due to the weaker-than-expected guidance. The stock is up 20.5% over the past 12 months and was trading at just a dollar below its post-dot.com era high. Microsoft stock has risen 150% since Satya Nadella took over at the helm from Steve Ballmer compared to 55% gain by the S&P 500 over a similar timeframe.
Microsoft's transition into a cloud company is still moving in the right direction albeit at a slower pace than many investors had hoped for. The shift to a cloud model is clearly depressing sales of Windows OEM licenses and pulling down overall revenue. But Microsoft indicated that it expects the division's revenue to increase to $6.5B-$6.7B in FQ4 compared to $6.1B during FQ3 while Windows 10 adoption remains on track to hit 1B installed devices by 2018. This might help to offset some of the weakness in the company's hardware division.
Microsoft stock might not make good gains over the next 2-3 quarters due to the huge declines in the phone business coupled with the slower-than-expected cloud and hardware growth. The phone business might, however, soon reach a bottom while the hardware division is likely to see significant improvements. Microsoft stock remains a good hold for long-term investors.