Microsoft's Second Quarter 2014: Solid Revenue Growth Like Q1

We thought that Microsoft's fiscal 2014 first quarter was a very solid performance, demonstrating the strength and potential of its Commercial businesses.  Fiscal 2014's second quarter caught analyst estimates a bit flat-footed on both revenue and EPS.  Overall, though, the quarter's highlights and questions were really about the same as those in the first quarter.

Revenue of $24.52 billion grew 14% on a GAAP basis, and 11% on a non-GAAP basis.  Ex-currency, revenue grew 12% year-over-year on a non-GAAP basis.  Any way one looks at the quarter--and GAAP comparisons give a better view--it's a really strong performance in a revenue-challenged tech industry.

Gross margin of $16.24 billion was flat in dollars, year-over-year. The gross margin rate was a breathtaking 66.2%  Really, the pattern that may appear in the near-term future is solid revenue growth, but significantly less profit growth.  Looking at this quarter, it's as if Microsoft is investing its gross profits, which are robustly driven by the Commercial businesses, in its Devices and Consumer businesses where some product margins are non-existent.  And, this is probably the right way to tack this ship windward given where it wants to go.

Operating income of $7.97 billion grew 3%, and net income was $6.56 billion.  Diluted EPS of $0.78 was up only 3% on a GAAP basis, and declined 4% on a non-GAAP basis.  Cash returned to shareholders in the quarter was a record $4.3 billion for dividends and share repurchases.

Commercial

Commercial revenue of $12.67 billion--52% of consolidated revenue--grew 10% on a GAAP basis. Of this, licensing revenue of $10.89 billion grew 7% while Cloud and Office 365 revenue of $1.78 billion rose 28%. The real stellar performances come from the same sources as in the first quarter, namely server revenues up 12% and SQL Server Premium revenues up 25%.  Investors would have to put this growth up against the recent news of Dell and Lenovo looking to grab IBM's profitless server business; they would have to sit up and take notice of these counter-industry trends in Microsoft's business. 

Gross margin in Commercial was $10.45 billion, or a gross margin rate of 83%, and the margin comprised 64% of Microsoft's corporate gross margin dollars.  

Microsoft said that software penetration into enterprises was stronger in the largest enterprises versus medium-sized and smaller businesses.  Business trends were better in developed markets versus emerging markets.  So, the signs seem to be pointing to confidence CIOs are showing in Microsoft's commercial product offerings, both on the computing and software sides.  

Devices and Consumer

Hardware revenue of $4.73 billion was up 68%, as the Xbox One and Xbox 360 got strong responses from customers. We had our doubts about this platform launch, but clearly we misjudged the extent to which the execution in this business improved for the retail channel's holiday season. Xbox One sold 3.9 million units during a five week period in 13 markets; Xbox 360 sold 3.5 million units in the holiday period. 

The Surface and Surface RT lines got rejuvenated, as the execution going into the holiday season must have been much better than last year.  Sales of almost $900 million were significantly above the $400 million level of the prior period.  However, hardware overall turned out to be a profitless venture, as the gross margin on revenue as $0.41 billion, down 48% year-over-year on a GAAP basis. 

As long as the Commercial business is humming along, and it should continue to do so, it gives the consumer businesses cover.  The  first steps are evident in this quarter: getting the right products and the right promotions out into the retail channel with marketing dollars behind them.  Profits can follow later, if Microsoft can manage the revenue line and report acceptable profits while continuing to return cash to shareholders. 

Licensing revenue of $5.38 billion was down 6% on a GAAP basis, while gross margin of $4.98 billion was down 3%.  The gross margin rate for this segment of Devices and Consumer is a nice offset for the hardware business.  But, it just feels as if the Device and Consumer businesses are stepchilds in Microsoft.  

CEO Succession

We've posted before about the implausibility of Bill Gates wanting to take back the CEO reins at Microsoft, and an interview with the New York Times discussed his thought processes at length. A problem now is timing.  If a big decision is made to bring in an outside, superstar CEO who isn't embraced immediately by the dysfunctional culture, then will the momentum in the Commercial business and the signs of Spring in the Devices and Consumer business come to an end?  

Phones: The Unspoken Word

In the entire presentation and even into the question period, only one analyst pushed the issue of what had happened with Windows Phone.  One could almost feel the presenters taking a deep breath.  The initial lineup of Nokia Windows smart phones, including an entry level Nokia Lumia 521, seemed to have been launched haphazardly with very poor marketing support.  Even though the higher priced phones got some decent reviews for things like their cameras, the Nokia name didn't resonate in the retail channels. 

Now, with the acquisition of Nokia's phone business about to close, the future of this business and the price paid for it would make a prospective shareholder nervous.  Is Nokia to Microsoft what Autonomy was to HP?  I hope not, but it's completely unclear how Surface tablets, and Nokia phablets will play together into a coherent consumer offering.  

One Windows user experience across all devices: it sounds like a logical and ambitious goal, but how long will it take to make it a reality, with revenue and profits?