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Microsoft Corporation’s (MSFT - Analyst Report) fiscal fourth quarter earnings were short of the Zacks Consensus Estimate. But the recent restructuring announcement, directional clarity and the decision to focus on fast-growing segments that play to its strengths have increased optimism about Microsoft’s shares. As a result, shares appreciated 1.4% in extended trading.

Nadella’s vision includes the repositioning of Microsoft in a cloud-first mobile-first world where Microsoft’s services and technology will reach 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).

Revenue

Revenue of $23.38 billion was up 14.6% sequentially and 17.5% from last year, roughly in line with our estimates.

Devices & Consumer Segment

Following the acquisition of the Nokia Devices and Services (NDS) business that closed on Apr 25, 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 20%, 6%, 8% and 8% of quarterly revenue, respectively taking the contribution of the Devices & Consumer segment to 43%.

Nokia contributed 1% of total revenue (included in D&C Licensing) and all of the Phone Hardware revenue in the last quarter. Since Nokia has been acquired, it will not make any contribution to D&C Licensing revenue going forward.

The ex-Nokia licensing revenue of $4.31 billion was slightly ahead of the guided $4.1-4.3 billion. Office Consumer revenue accounted for most of the strength, jumping 21% and outgrowing the consumer PC market. Windows OEM revenue grew at a much slower rate of 3% as OEM Pro revenue growth of 11% was largely offset by the OEM non-Pro decline of 9%. Both OEM Pro and consumer licensing benefited from the withdrawal of XP support. Phone licensing revenue jumped 95% due to the recognition of $382 million of revenue upon the ending of the Nokia licensing agreement.

Revenue from Computing and Gaming Hardware declined sequentially but grew 23.2% year over to $1.44 billion. Management expected revenue of $1.3-1.5 billion from the segment, which includes the Xbox and Surface platforms. The company sold 1.1 million Xbox consoles during the quarter driving platform revenue up 14%. Management said that channel inventories were worked down during the quarter. While growth rates for the Surface platform were not mentioned, management did say that the revenue of $409 million was driven by second generation devices and Surface Pro 3, which has seen stronger uptake than its other products.

The $1.99 billion contribution from Phone Hardware was driven by lower-priced devices (500 and 600 series Lumia phones). Overall, 5.8 million Lumia smartphones and 30.3 million non-Lumia devices were sold during the quarter. Management said that non-Lumia phones performed in line with the market.

D&C Other revenue jumped 20.5% year over year although it was down sequentially. Both Office 365 Consumer and Bing showed positive year-over-year trends. Office 365 subscribers grew by more than a million. Additionally, search advertising revenue grew 40% due to RPS growth, volume increases and the expiration of the North America RPS guarantee payments to Yahoo (YHOO - Analyst Report). Bing has gained 190 bps of U.S. market share over the past year.

Commercial Segment

Commercial licensing revenues grew more than 8.7% from the previous quarter and 5.6% from a year ago. Server and Office commercial revenues were up 16% and 4%, respectively from the year-ago quarter. Server products grew 14% with SQL Server and System Center growing double-digits. Windows volume licensing was up 11%, with both annuity and non-annuity revenue growing.

Commercial Other revenues saw extremely strong growth of 18.9% and 43.7% from the previous and year-ago quarters, respectively. Commercial Cloud services grew 147% from last year, the main driver of the increase. Enterprise service revenue growth was also very strong at 11%.

Operating Results

Microsoft’s gross margin of 67.5% was down 336 basis points (bps) sequentially and down 433 bps from the year-ago quarter. A number of factors impacted the gross margin in the last quarter.

The Computing and Gaming Hardware margin shrank sequentially but was up very strongly from the year-ago quarter when Microsoft took a Surface RT inventory charge. The last quarter also included inventory adjustments related to a transition to its latest Surface products and charges for not shipping products at a certain form factor. Rationalizing the device portfolio resulted in charges in the newly-formed phone segment. A lower gross margin in the display business offset the benefits of strong volumes in the rest of the D&C Other business. Higher volumes and scale benefits drove a huge increase in the commercial business, particularly the “Other” side of the business.

Operating expenses of $9.18 billion were up 22.6% sequentially and 11.6% from last year. The sequential increase in the last quarter was related to S&M, which increased 266 bps sequentially as a percentage of sales. All except COGS declined as a percentage of sales from the year-ago quarter. As a result, the operating margin shrank 592 bps sequentially and shrank 226 bps year over year to 28.3%. The sequential decline was because of higher COGS and SG&A while the decline from the year-ago quarter was attributable to higher COGS.  

 

 

The company generated a net income of $4.74 billion, or 20.3% net income margin compared to $5.66 billion, or 27.7% in the previous quarter and $4.97 billion, or 25.0% in the year-ago quarter. Restructuring charges were $127 million of 2 cents a share. So the pro forma earnings came to 57 cents a share compared to 68 cents in the previous quarter and 59 cents in the year-ago quarter.

Balance Sheet

Inventories jumped 38.5%, with inventory turns sliding from 12.4X to 11.4X. Days sales outstanding (DSOs) went from 60 to 76.

Microsoft ended with a cash and short term investments balance of $85.71 billion, down $2.72 billion during the quarter. The net cash position was around $63.06 billion ($7.63 a share), down from $65.75 billion ($7.96 a share) at the beginning of the quarter. In the last quarter, the company generated $9.51 billion in cash flow from operations, spent $2.00 billion to repay its debt, $1.17 billion to repurchase shares, $2.31 billion to pay dividends, $5.63 billion on acquisitions and $1.33 billion to purchase capital assets.

Guidance

For the first quarter of 2015, the company expects D&C Licensing revenue of $4.1-4.2 billion, Computing and Gaming Hardware revenue of $1.7-2.0 billion, D&C Other revenue of $1.8-1.9 billion, Commercial licensing revenue of $9.8-9.9 billion and Commercial other revenue of $2.2-2.3 billion. Microsoft expects COGS of $7.5-7.9 billion and opex excluding integration and restructuring charges of $8.5-8.7 billion. The full year tax rate is expected to be 21-23%.

Management expects to incur pre-tax restructuring costs of $1.1-1.6 billion in fiscal year 2015, most of which will be charged in the first half of the fiscal year. Expected synergies are $1 billion with the phone business achieving profitability in 2016. Nokia integration costs are expected to be around $150 million a quarter.

Recommendation

Microsoft’s fourth quarter was not too bad although missing our expectations. Most encouraging is 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. Moreover, it is better to scrap a product that is either misaligned or incapable of delivering on its goals. That said, the company is still not making money on its Surface devices and management did not say when the business was expected to break even. But in the meantime, it is sparing no expense to succeed. Another headwind is the declining benefit related to XP end-of-life that will impact margins going forward.

Microsoft shares carry a Zacks Rank #3 (Hold). Better-ranked technology stocks to consider at this time are Intel Corp (INTC - Analyst Report) or NVIDIA Corp (NVDA - Analyst Report), both of which carry a Zacks Rank #1 (Strong Buy).

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