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Microsoft 3Q16 Results, Rising Costs Send Shares Down

Microsoft Corporation MSFT reported third quarter 2016 earnings per share adjusted for Windows 10 deferrals and currency effect of 62 cents, which missed the Zacks Consensus Estimate of 63 cents. FX and a higher tax rate were negatives. The Intelligent Cloud segment revenue came in at the low end of guidance. The revenue guidance for the next quarter was below estimates. Shares plunged 5.1% in response.

The last quarter saw continued strength in annuity-based revenue, with transactional revenue (greatly impacted by the PC market slump, especially in certain emerging geographies) disappointing. The tax rate is related to mix of revenue from different geographies. So the investor reaction seems overdone.

The company is half-way to the $20 billion in annualized commercial cloud revenue run rate by 2018 with management saying that the commercial cloud revenue run rate touched $10 billion in the last quarter.

The PC market, which is a pressure on not just Microsoft but other exposed companies such as Intel INTC, Advanced Micro Devices AMD and HP HPQ, will continue to impact results in the next quarter as well.

Microsoft’s own Surface tablet is showing a very nice double-digit growth trajectory that may be expected to continue. Phones are of course down and likely to remain in that mode.

Microsoft maintains that Xbox One is tracking better than past generation consoles and said that bringing top Xbox One titles to the Windows store led to a 50% increase in gaming hours on Windows 10. It expects to release new games at E3.

Windows 10 remains extremely important strategically despite the fact that it is not yet generating significant revenue growth. Microsoft is building its own ecosystem through this platform and the strategy is likely to take off before long. Enterprise adoption should help revenue in the next fiscal year. In the meantime, the close tie-up with Bing is a huge positive with 35% of search revenue already driven by Windows 10.

The numbers in detail-

Revenue

Reported revenue of $20.53 billion was down 13.7% sequentially, down 5.5% from last year and missing the Zacks Consensus Estimate by 5.0%. Revenue deferrals on account of Windows 10 were $1.54 billion. Currency had a $838 million impact on revenue with the segment impact coming in roughly as guided. 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, declined 2.5% sequentially while growing 1.0% (up 6% in constant currency or CC) year over year. Revenues were in line with guidance and impacted by the slowdown in PCs.

The Commercial business (products + Office 365 & related cloud services) revenue was consistent with year-ago levels (up 7% CC). Office 365 saw seat growth of 57% and revenue growth of 63% CC from last year. This is an area of tremendous focus with reselling partners up to 85K in the last quarter as Microsoft goes all out to target the SMB segment. This was partially offset by the ongoing decline in commercial products (down 11% CC in the last quarter).

The Consumer business revenue grew 3% (6% CC) with subscriber growth up 7.8% and renewals also remaining strong. Office 365 consumer subscriptions are now at 22.2 million, up from 20.6 million in the previous quarter.

Dynamics and cloud services revenue grew 4% (9% CC) with the CRM installed base more than doubling year over year and Dynamics AX revenue growing double-digits.

Intelligent Cloud

This segment, which includes server and enterprise products and services reported revenue of $6.10 billion, which was down 3.9% sequentially, up 3.3% (up 8% CC) year over year and at the low end of guidance because of difficult comps.

Server product and cloud services revenue was consistent with last year (up 5% CC). Annuity revenue grew double-digits while transaction revenue declined. The high point was Azure revenue, which grew 120% CC year over year, with Azure premium services up triple digits for the seventh straight quarter, Azure compute usage and Azure SQL database more than doubling. Enterprise Mobility customers more than doubled to 27K with the installed base growing 4X.

Enterprise Service revenue grew 11% (15% CC).

More Personal Computing

This segment, which comprises mainly the Windows, Gaming, Devices and Search businesses, dropped 25.3% from the seasonally stronger Dec Quarter but was still 1.6% (3% CC) higher than last year. Revenues were better than guided.

Windows OEM Pro revenue declined 11% (due to inventory being worked down) while non Pro revenue grew 15% (on the back of a higher premium mix) from the year-ago quarter. Windows volume licensing was down 2% (up 6% CC) with annuity revenue growth offsetting transactional revenue declines.

Gaming revenue grew 6% CC, Xbox Live monthly active users were up 26% to 46 million. Video game revenue grew 11%. Underscoring the advantages of UWP, Microsoft said that 10 million hours of gameplay have been streamed from Xbox One  to Windows 10 PCs since the new OS was launched.

Next, Devices, which include phones and the Surface tablet. Phone revenue was down 46% CC while Surface revenue grew 55.8% (61% CC) from last year driven by Surface Pro 4 and Surface Book. Net revenue declined 9% CC.

Search ex-TAC revenue grew 14% (18% CC) as both search volume and RPS improved. Management said that 35% of search revenue in March came from Windows 10 devices.

Operating Results

Microsoft’s gross margin of 62.4% was up 387 basis points (bps) sequentially and down 466 bps from the year-ago quarter (gross profit dollars dropped 8.0% sequentially and 12.1% year over year).

The growth in gross profit dollars was as follows: Productivity 1% CC (increased mix of lower-margin cloud services remains a factor), Intelligent Cloud 3% CC (affected by cloud-related investments as offset by margin improvements in Azure and enterprise services) and More Personal Computing 6% CC (due to improvements in search and Surface).

Operating expenses of $7.53 billion were down 4.7% sequentially and 3.3% from last year. COGS and S&M declined sequentially as a percentage of sales, although R&D and G&A were up. All but S&M expenses increased from last year. As a result, the operating margin expanded 47 bps sequentially while declining 549 bps year over year to 25.7%.

The operating margin by segment was as follows: Productivity 45.9% (down 350 bps sequentially, down 270 bps year over year); Intelligent Cloud 35.9% (down 478 bps sequentially, down 699 bps year over year); and More Personal Computing 17.4% (down 141 bps sequentially, up 450 bps year over year). Currency was negative for Productivity opex and positive for the other two segments. Cloud innovation and building related sales capacity were the primary investment areas driving up capex.

The company generated net income of $3.76 billion, or a 18.3% net income margin compared to $5.00 billion, or a 21.0% in the previous quarter and $5.33 billion, or 24.5% in the year-ago quarter.

Reported earnings were 47 cents compared to a loss of 62 cents in the previous quarter and income of 62 cents in the year-ago quarter.

Balance Sheet

Inventories dropped 9.3%, with inventory turns dropping from 14.6X to 12.6X. Days sales outstanding (DSOs) went from 56 to 54.

Microsoft ended with a cash and short term investments balance of $105.6 billion, up $2.91 billion during the quarter. The net cash position was around $59.16 billion ($7.53 a share), down from $58.21 billion ($7.36 a share) at the beginning of the quarter. In the last quarter, the company generated $10.37 billion in cash flow from operations, spent $3.86 billion to repurchase shares, $2.84 billion to pay dividends, $2.31 billion to purchase capital assets and $559 million on acquisitions.

Guidance        

Management said that FX would have a negative 3-point impact on revenue growth in the fourth quarter of fiscal 2016. The Productivity segment impact is expected to be 3 points, Intelligent Cloud 3 points and More Personal Computing 2 points.

For the fourth quarter, Microsoft expects Productivity & Business Process revenue of $6.5-6.7 billion, Intelligent Cloud revenue of $6.5-6.7 billion and More Personal Computing revenue of around $8.7-9.0 billion. This implies total revenue of between $21.7 billion and $22.4 billion (below current estimates for the Jun quarter). Microsoft expects COGS of $7.8-7.9 billion, opex of $8.2-8.3 billion, other income/expense of -$200 million and GAAP tax rate of 20-21% (non GAAP tax rate of 21-23%).

Management said that 2017 opex would be flat to up from 2016 as investments in cloud and reallocation of expenses may be expected to continue.

Recommendation

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

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