Microsoft Reports Solid First Qtr 2014: Does 'One Microsoft' Make Sense?

Introducing the quarterly results, Microsoft CFO Amy Hood's talking points script must have had the word, "execution" written in large, bold type.  We would hear over and over about how well the company had executed against its goals in the quarter, given the macro headwinds in tech, the move to "One Microsoft," and the higher "cadence" of the company, as demonstrated by the release of Windows 8.1 less than a year after the initial version.

The highlight on execution was probably deliberate, and it was done to differentiate Microsoft's performance from that of HP and IBM, where both CEOs lamented their teams' lack of execution.  The real story in the quarter was the performance of the Commercial segments, formerly referred to as the Enterprise segment.

Following the most recent Analyst Day, we wrote,

"The Enterprise businesses are attractive and Microsoft may ultimately be a stronger competitor than Oracle and other established players on the software and services sides, but that is still an open question.
One of the most interesting slides from Kevin Turner's presentation is one depicting revenue from three large scale corporate customers, pre and post-cloud computing services.  It shows Office 365 and Azure customers, and the year-over-year revenue gains are on the order of 20% or better.  Again, the problem is that the sales efforts and compensation models for these businesses are quite different from the consumer businesses.  Let the Microsoft Enterprise stand alone and do its thing while creating value unencumbered by the legacy of a consumer-unfriendly culture endemic to Microsoft."  

 Total Commercial Licensing and Other Business increased 10% yr/yr, from $10.19 billion to $11.2 billion in the current year's quarter.  Commercial Licensing revenue increased 7% yr/yr to $9.59 billion. The more transactional annuity business increased by 8%, which also helped by allowing more revenue recognition in the current quarter; the company said that contract renewals had also been strong. Other Commercial Licensing Business increased 28% yr/yr to $1.6 billion, as Microsoft's cloud conversions and new business gained traction.  The company said that two-thirds of new Microsoft Dynamics ERP customers chose a cloud configuration for the software deployment.

Overall, this segment's performance was clearly head and shoulders above that of the comparable commercial businesses of HP and IBM.  Given that the company has a new segment financial reporting format, the company provided both a new and old presentation to help during the transition.  In what was formerly called "Servers and Tools," revenue increased by 11% to $5.052 billion, while operating income increased by 17% to $2.026 billion.  SQL Server revenue grew by double digits, while SQL Server Premium revenue grew by more than 30%. So the problems HP and others faced with the erosion of commodity x86 server sales and margins did not hit Microsoft in the quarter.

Under the new presentation, which shows Gross Profit contribution by business segment, I took the Commercial Business gross profit as a percent of Microsoft's consolidated gross profit less the 'corporate' gross profit, and one sees that the commercial businesses accounted for 67% of the gross profit dollars in the quarter compared to 62% of the gross profit dollars in the prior year period.The rest of the corporate gross profit comes from Devices and Consumer Licensing. For me, the commercial business performance was the high water mark for performance in the quarter.

The problems in the personal computer markets did affect Microsoft, but not as badly as would have been expected.  Windows OEM revenues fell 7% yr/yr, but that compares to a 15% yr/yr decline in the fourth quarter of FY13.

Bing;s Search advertising revenues increased 47% yr/yr, and the Bing! search engine had an 18% U.S. market share in the quarter.  Search volumes and revenues per search both increased in the quarter, due to better algorithms and advertising.

The model upgrades for Surface generated $401 million in sales, with the 32 MB Surface RT being the popular model. Inventories are in place for the selling season, but the levels are not as aggressive as with the introduction.

A lot is expected from the Xbox product launches, but I have some doubts about the heavy duty gamers caring that much about a somewhat incremental hardware upgrade.  The gamers care about the games, and Microsoft is not in that business.  The future of Surface, Windows 8.1, Windows Phone, and Xbox are all TBD.  It sounds like the company is trying to improve its own lackluster performance, but it remains to be proven, beyond one Christmas season.

The company returned $3.8 billion in cash to shareholders in the quarter, with a 22% increase in the dividend.  This is certainly nothing to sneeze at.  However, looking at where profits are generated in the consolidated company, it still isn't clear at all that there should be "One Microsoft."

Finally, I would question if there exists one person who could make a believable claim to have the skill sets and the inside credibility to lead this company on a multi-year path to sustained organizational optimization and shareholder value creation.  More on this later.