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Microsoft 4Q16 Earnings Show Strengthening Cloud Position

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Microsoft Corporation (MSFT - Free Report)  reported fourth quarter 2016 earnings per share adjusted for Windows 10 deferrals and currency effect of 69 cents, which beat the Zacks Consensus Estimate of 58 cents. Increased investment in the cloud impacted margins in the last quarter although FX was surprisingly an offsetting factor. All segments did better than guided. Shares jumped 4.24% in response.

 

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Encouragingly, annuity-based revenue continued to grow, offsetting declines in transactional revenue indicating that the user base continues to migrate to the cloud.

Management didn’t revise the targeted $20 billion in annualized commercial cloud revenue run rate by 2018. But they did highlight Microsoft’s advantages to explain why Azure’s triple digit growth rates are likely sustainable at least in the near future.

For instance, the company has a hybrid and hyperscale cloud spanning multiple jurisdictions, which makes it ideal for multinational companies and banks that have operations all over the world and are required to be in compliance with laws of the countries in which they operate. This is what Microsoft says has drawn 80% of the world’s largest banks to Azure.

Microsoft also offers 33K cloud services, which helps it capture big customers like Boeing (BA - Free Report) , Rolls-Royce and Schneider Electric. Another important customer it recently won is Facebook (FB - Free Report) , which will be using Office 365 for its 13K employees.

Microsoft looks less and less like a company dependent on the PC market, although the majority of PCs around the world still do run on its Windows OS. The enterprise refresh cycle is on and the company confirmed that the majority of its customers were already running Windows 10 pilots. So adoption should accelerate in the following quarters, leading to regular annuity-based revenue (the company has confirmed that Windows 10 will now be offered as a service).  The close tie-up with Bing is a huge positive with 40% of search revenue already driven by Windows 10.

Microsoft’s Surface continues to grow nicely in support of the BYOD trend. While there may be a temporary negative impact due to sale of the phone business, this is a good thing because it rids Microsoft of the only ailing element in its business.  

The numbers in detail-

Revenue

Reported revenue of $20.61 billion was up 0.4% sequentially and down 7.1% from last year, missing the Zacks Consensus Estimate by 6.8%.

Currency had a 5 point positive impact on revenue, better than the guided negative 3 points. The segment-wise impact of currency widely missed guidance (the company guided the Productivity, Intelligent Cloud and More Personal Computing impacts to be -3 points, -3 points and -2 points, respectively but the actual impacts were 8 points, 10 points and -2 points, respectively).

Management said that most markets performed generally in line with expectations with the exception of Latin America, the Middle East and Africa where there is a higher mix of transactional revenue. Transactional business was weak overall impacted by the PC market, while annuity-based business remains strong and with strengthening prospects.

Segment highlights were as follows-

Productivity & Business Processes

This segment, which includes the Office and Dynamics CRM businesses, grew 6.9% sequentially and 4.6% (up 8% in constant currency or CC) year over year. Revenues beat guidance with the help of strong Office 365 adoption but was impacted by currency.

The Commercial business (products + Office 365 & related cloud services) revenue was up 5% from year-ago levels (up 9% CC). Office 365 saw commercial seat growth of 45% from last year. This is an area of tremendous focus with reselling partners up to 90K in the last quarter as Microsoft goes all out to target the SMB segment. It also signed some big accounts such as Facebook and Hersheys (HSY - Free Report)  Discovery Communications and Cushman Wakefield. This was partially offset by the ongoing decline in commercial products (down 9% CC in the last quarter).

The Consumer business revenue grew 19% (18% CC) from last year with subscriber growth up 52.0% and particular strength in Japan. Office 365 consumer subscriptions are now at 23.1 million, up from 22.2 million in the previous quarter.

Dynamics and cloud services revenue grew 6% (7% CC) with Dynamics billings growing 20% and the CRM installed base more than doubling year over year. Monthly paid seats touched 10 million, up more than 20% year over year.

Intelligent Cloud

This segment, which includes server and enterprise products and services reported revenue of $6.71 billion, which was up 10.1% sequentially, up 6.5% (up 10% CC) year over year and better than guided. There was growth across server products, cloud services and enterprise services as offset by negative currency impact.

Server product and cloud services revenue grew 5% year over year (up 8% CC). Annuity revenue grew double-digits while transaction revenue declined. The high point was Azure revenue, which grew 108% CC year over year, with Azure premium services up triple digits for the eighth straight quarter and Azure compute usage doubling. Enterprise Mobility customers almost doubled to 33K with the installed base growing 2.5X versus last year.

Enterprise Service revenue grew 12% (14% CC).

More Personal Computing

This segment, which comprises mainly the Windows, Gaming, Devices and Search businesses, dropped 5.9% sequentially and 3.4% (2% CC) year over year. Revenues were better than guided.

Windows OEM Pro revenue grew 2% (due to stabilization in the commercial PC market and a higher mix of business PCs sold with Windows Pro). Non Pro revenue grew 27% (on the back of a higher premium mix) from the year-ago quarter. Windows volume licensing was down 3% (up 9% CC) with annuity revenue growth offsetting transactional revenue declines. Management said that than 96% of enterprise customers were piloting Windows 10.

Gaming revenue dropped 8% CC, Xbox Live monthly active users were up 33% to 49 million. Based on excitement surrounding new games, gaming hours spent on Xbox One and Windows 10 devices increased 13% and 19%, respectively.

Next, Devices, which include phones and the Surface tablet. Phone revenue was down 35% CC while Surface revenue grew 9% (9% CC) from last year driven by Surface Pro 4 and Surface Book. Net revenue declined 35% CC.

Search ex-TAC revenue grew 16% (17% CC) as both search volume and RPS improved. Management said that more than 40% of search revenue in June came from Windows 10 devices.

Operating Results

Microsoft’s gross margin of 61.3% was down 110 basis points (bps) sequentially and 504 bps from the year-ago quarter (gross profit dollars dropped 1.4% sequentially and 14.1% year over year).

The growth in gross profit dollars by segment was as follows: Productivity up 4% CC (increased mix of cloud offerings and investments in cloud were drivers), Intelligent Cloud 5% CC (again a result of increased mix of cloud offerings) and More Personal Computing 0% CC (search and Windows OEM were drivers as offset by phones and Xbox).

Operating expenses of $8.45 billion were up 12.2% sequentially and 1.4% from last year. All expenses increased as a percentage of sales from both the previous and year-ago quarters. As a result, the operating margin shrank 541 bps sequentially and 846 bps year over year to 20.3%.

The operating margin by segment was as follows: Productivity 43.3% (down 286 bps sequentially, down 350 bps year over year); Intelligent Cloud 32.6% (down 326 bps sequentially, down 911 bps year over year); and More Personal Computing 10.8% (down 656 bps sequentially, up 258 bps year over year).

The company generated net income of $4.23 billion, or a 20.5% net income margin compared to $3.76 billion, or a 18.3% in the previous quarter and $5.24 billion, or 23.6% in the year-ago quarter.

GAAP earnings were 39 cents in the last quarter compared to 47 cents in the previous quarter and a loss of 40 cents in the year-ago quarter.

Balance Sheet

Inventories dropped 8.1%, with inventory turns going back to 12.6X from 14.2X. Days sales outstanding (DSOs) went from 54 to 81.

Microsoft ended with a cash and short term investments balance of $113.2 billion, up $7.69 billion during the quarter. The net cash position was around $59.55 billion ($7.58 a share), up from $59.16 billion ($7.53 a share) at the beginning of the quarter. In the last quarter, the company generated $8.46 billion in cash flow from operations, spent $3.67 billion to repurchase shares, $2.82 billion to pay dividends, $2.66 billion to purchase capital assets and $63 million on acquisitions.

Guidance

Management said that FX would have a negative 2-point impact on revenue growth in the fourth quarter of fiscal 2016. The Productivity segment impact is expected to be 2 points, Intelligent Cloud 2 points and More Personal Computing 1 point.

For the first quarter, Microsoft expects Productivity & Business Process revenue of $6.4-6.6 billion, Intelligent Cloud revenue of $6.1-6.3 billion and More Personal Computing revenue of around $8.7-9.0 billion. This implies total revenue of between $21.2 billion and $21.9 billion. Microsoft expects COGS of $7.5-7.6 billion, opex of $7.35-7.45 billion and other income/expense of $0.

Management said that 2017 opex would be $31.1-31.4 billion as investments in strategic growth opportunities continue. The non GAAP tax rate is expected to be 20% (+/-2%) depending on the variability of factors such as mix of services revenue versus licensing revenue, the geographic mix of revenue and the timing of equity vests. A higher mix of cloud revenue is also expected to increase the tax rate.

Recommendation

Microsoft shares carry a Zacks Rank #3 (Hold).

 

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