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Microsoft Q1 Results: Cloud & Mobile Drive Earnings Beat

Microsoft Corporation (MSFT) reported encouraging first quarter 2015 results with earnings of 54 cents exceeding the Zacks Consensus Estimate of 49 cents. Management is clearly focused on its cloud-first mobile-first strategy and its effects are already showing in the results. Following the earnings announcement, share prices jumped 3.1%.

Microsoft Corporation - Earnings Surprise | FindTheBest


The company took most of the Nokia-related restructuring charges in the last quarter itself. The lower headcount and product rationalization in this business is having a near-term impact on results. But the benefits of focusing on fast-growing segments that play to its strengths are already telling on results.

It’s now clear that 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.

Digging into the details-

Revenue

Revenue of $23.20 billion was up 0.8% sequentially and 25.2% from last year, better than the Zacks Consensus Estimate of $21.59 billion.

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, Phone Hardware, Computing and Gaming Hardware and D&C Other revenue made up 18%, 11%, 10% and 8% of quarterly revenue, respectively taking the contribution of the Devices & Consumer segment to 47%.

D&C licensing revenue of $4.09 billion was slightly short of the guided $4.1-4.2 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.

Accordingly, the 5.8% decline from last year was attributable to lower revenue across product lines. Windows OEM revenue was down 2% overall with non-pro revenue down 1% and pro revenue down 4% (in-line with normal business PC replacement cycles). Office Consumer revenue also declined 5%, which management attributed to the transition to Office 365 Home and Personal (Office 365 is a subscription model, so upfront licensing revenue takes a big hit during the transition). Phone licensing revenue sank 46%, being worst affected by the low-end mix.

Revenue from Computing and Gaming Hardware, which includes the Xbox and Surface platforms jumped 70.2% sequentially and 65.2% year over to $2.45 billion, significantly higher than the guided $1.7-2.0 billion. Surface devices generated $908 million (up from 409 million in the Jun 2014 quarter), driven by Surface Pro 3, which is seeing growing interest among users. Management said that Surface Pro 3 was now in 28 markets. There was marked progress on the gaming side, where the company sold 2.4 million Xbox consoles during the quarter, driving platform revenue up 58%. Xbox LIVE apps grew more than 20%. Xbox One was also made available in 28 markets, and the initial sales into the channel in China helped results in the last quarter.

The $2.61 billion contribution from Phone Hardware was driven by lower-priced Lumia devices, which jumped from 5.8 million units in the Jun 2014 quarter to 9.3 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 dropped 3.8% sequentially while growing 10.6% year over year. Office 365 subscribers grew by 7 million or 25% during the quarter. Bing results were also encouraging with the 140 bp increase in market share generating a 23% increase in search advertising revenue. Moreover, management said that both RPS and volumes contributed to the increase.

Commercial Segment

Commercial Licensing revenues fell 12.0% from the previous quarter while staying 2.9% above year-ago levels. The segment was a mixed bag with strength on the server side partially offset by softness on the office side. Overall strength in the SQL Server, System Center and Windows Server segments generated 11% growth from last year. A growing mix of premium products for on-premise infrastructure and a 10% increase in Windows volume licensing drove results. Office was impacted by the Office 365 transition, falling 7%.

Commercial Other revenues saw extremely strong growth of 6.4% and 50.2% from the previous and year-ago quarters, respectively. Commercial Cloud services grew 128% from last year, the main driver of the increase. Adoption of Office 365 and strength in products like its enterprise mobility suite and Azure Active Directory also grew.

Operating Results

Microsoft’s gross margin of 64.3% was down 318 basis points (bps) sequentially and down 806 bps from the year-ago quarter. A number of factors impacted the gross margin in the last quarter.

The hardware side of the business saw much higher volumes, growing as a percentage of the mix. But the negative mix was partially offset by much stronger margins within these businesses.

Gross margin by segment-

D&C Licensing: 93.3% (down 60 bps sequentially, 279 bps year over year, benefiting from the end of the commercial agreement with Nokia).
Computer & Gaming Hardware: 19.5% (up 1,828 bps sequentially, 539 bps year over year, the positive effect of stronger Surface gross margins and a mix shift to next-generation Xbox consoles).
Phone hardware: 18.4% (up 1,745 bps sequentially and also up from last year, the positive effect of business integration efforts).
D&C Other: 17.2% (down 648 bps sequentially and 416 bps from last year, due to increased investments in online infrastructure).

The commercial segment gross margin of 80.7% benefited from increased scale and engineering efficiencies in cloud services.
Commercial Licensing: 92.2% (up 42 bps sequentially and 44 bps year over year) and
Commercial Other: 33.4% (up 290 bps sequentially, down 1,629 bps year over year.

Operating expenses of $7.94 billion were down 13.4% sequentially and up 12.2% from last year. The sequential increase in the last quarter was mainly on account of S&M, which dropped 396 bps sequentially as a percentage of sales. R&D and G&A also declined a respective 15 bps and 91 bps. The increase in COGS offset the year-over-year decline in all other expenses. As a result, the operating margin expanded 184 bps sequentially and shrank 408 bps year over year to 30.1%.

The company generated net income of $5.68 billion, or 24.5% net income margin compared to $4.74 billion, or 20.3% in the previous quarter and $5.24 billion, or 28.3% in the year-ago quarter. Restructuring charges were $1.14 billion. Reported earnings including restructuring came to 54 cents, down from 55 cents and 62 cents in the previous and year-ago quarters, respectively.

Balance Sheet

Inventories jumped 18.1%, with inventory turns sliding from 11.4X to 10.5X. Days sales outstanding (DSOs) went from 76 to 51.

Microsoft ended with a cash and short term investments balance of $89.19 billion, up $3.48 billion during the quarter. The net cash position was around $65.47 billion ($7.95 a share), down from $63.06 billion ($7.63 a share) at the beginning of the quarter. In the last quarter, the company generated $8.35 billion in cash flow from operations, spent $1.50 billion to repay its debt, $2.89 billion to repurchase shares, $2.31 billion to pay dividends, $1.28 billion to purchase capital assets and $141 million on acquisitions.

Guidance

For the second quarter of 2015, the company expects D&C Licensing revenue of $4.0-4.2 billion, Computing and Gaming Hardware revenue of $3.5-3.8 billion, Phone Hardware revenue of $2.0-2.2 billion, D&C Other revenue of $2.3-2.4 billion, Commercial licensing revenue of $10.8-11.0 billion and Commercial other revenue of $2.5-2.6 billion. Microsoft expects COGS of $9.5-9.9 billion and opex of $8.6-8.8 billion. Capex will increase sequentially.

The full opex is expected to be $34.2-34.6 billion and full-year year tax rate 20-22%.

Recommendation

Microsoft’s first 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 (GOOGL) 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 expects the business to break even next year. In the meantime, it is sparing no expense to succeed.

Microsoft shares carry a Zacks Rank #4 (Sell). Better-ranked technology stocks to consider at this time are Intel Corp (INTC), Micron (MU), both of which carry a Zacks Rank #2 (Buy), or a company like Sunedison, which currently has a Zacks Rank #1 (Strong Buy).

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