Thursday, April 24, 2014

Microsoft's Third Quarter Shows a Strong Platform and Challenges Ahead

Microsoft reported FY14 Q3 revenues of $20,403 million versus an adjusted $18,831 million for the prior-year period, an increase of 8.3%, or about 7% on a constant currency basis.  Gross margin increased 3% year-over-year on an adjusted basis, and diluted EPS of $0.68 per share increased by 5% over the adjusted $0.65 per share in FY13 Q3.

$1,895 million was returned to shareholders through share repurchases in the quarter, and $2,322 million through dividends.  $4,167 million out of $10,099 million in cash flow from operations is a healthy amount of cash to return, and it fits with the now well established activist shareholder creed.

The strength of the company shows, I believe, when you consider that 81% of the quarter's revenues came from Devices and Consumer Licensing ($4,382 million), Commercial Licensing ($10,203 million), and Commercial, Other ($1,902 million).  

Even more telling, 95% of the corporate gross margin came from these same three business segments: Devices and Consumer Licensing ($3,906 million), Commercial Licensing ($9,430 million), and Commercial, Other ($475 million).

Despite all the hype around tablets, and "Bring Your Own Device" into the enterprise, Windows and the Office suite are still what most people comfortably use to do their real work in the enterprise.  So, Windows Pro OEM revenue grew 19%, as business PC growth in developed markets led the way in the quarter. Non-Pro Windows revenue declined by 15% (9% excluding China), so Windows OEM revenue increased 4% in total. 90% of enterprise desktops run Windows 7 or Windows 8.

The Office 365 nascent franchise now has 4.4 million users, and the company added a million users in the quarter.  Making the free version of Office 365 available for iPAD, and engineering it specifically for that platform, was a long overdue step, and the new CEO made it with aplomb.  Making Office for iOS 7.1 count for the five device licenses included in Office 365 enhances the value proposition for the product.

Bing's ad revenue was up 38% , and its share of search grew by 170 basis points.

Microsoft's server business, hardware and database, give it a lot of credibility with corporate IT officers. SQL server revenue increased by more than 15% in the quarter.Cloud revenue doubled from a relatively small level, as it has for HP.

The acquisition of Nokia Devices and Services is about to close, and hence the financial comparisons in the coming quarters will be even fuzzier than they are now.

The question and challenge will be "What can Microsoft make of Nokia Devices and Services?"  Microsoft continues to really lack a champion for its consumers, whether of Office, XBox, games, tablets and phones. What credibility it has on the corporate enterprise hardware and software sides comes from a different mindset.  CEO Satya Nadella came from this business, and he brings lots of easy credibility because he speaks the language of customers and developers in those businesses.

Check out his video presentation at Build 2014.  The way he handled questions was relaxed, sincere, and credible to his developer audience.  There was none of the ear shattering volume, bluster and rote litany of buzzwords from the Ballmer reign.

I wonder if anyone in the organization can speak for the consumer experience with those same virtues? Apple can charge outrageous prices for their devices for a few reasons: they all work relatively intuitively, the design and functionality of the phones and tablets are clean and present a consistent philosophy, the attention to detail even in the packaging is obsessive, and if there is anything wrong with the consumer's experience with the device or using it, the company stores make it right.

If Nokia is going to be the hardware platform that carries the Windows environment forward into a "Mobile-first, Cloud-first" world then can this be done without suffering the kind of 23% gross margin rates Microsoft is experiencing in its consumer devices now?  Can someone, perhaps from Nokia or wherever, inculcate that care of the retail customer to the levels to which the IT and developer customers have been accustomed?

Microsoft has never treated its retail customers well, and it has never provided them with the kind of experience they deserve.  A monopolist never acts that way, because it doesn't have to amaze or delight: it merely has to satisfy.

Here was a very simple, but penetrating question for Satya Nadella from an Android third-party developer, "Why should I spend my time and resources developing for Windows?" (paraphrase)  Here's the CEO's response:
?You want to build for Windows because we are going to innovate with a challenger mindset. We're not coming at this as some incumbent trying to do the next version of Windows. We're going to come at this by innovating in every dimension, the dimension of hardware, the software experiences across the Windows family, and go after this in such a way that you see us make progress with rapid pace.
In fact, today was a massive milestone. If you look at what we've done on the phone, the update to the PC and tablet, the new devices Stephen showed, this is all what you can come to expect from us, and we'll keep pushing at it.
There will be a couple of things that will be pretty unique to what we do. One is what I call the sensibility we have of bringing end users, developers and IT professionals together. That's one thing that we've always felt is what birthed the magic of platforms, from sort of the first version of Windows to what we think is Windows in this era of mobile first, cloud first. (I don't think the real end users were ever in anyone's mind at Redmond)
And then the second real attribute for us is to be able to create a developer opportunity which is broad. So one of the things that we are doing is making sure that the opportunity for you as developers across the Windows family is expanding. Some of the changes that both Joe described and Terry alluded to where we are going, which is to be able to make your new applications built for WinRT and the Windows Store, in fact, the fact that you can use them in the desktop mode, that completely opens up a huge base of users for your applications that you're targeting Windows with.
So this notion of creating the broadest Windows opportunity for your sockets for you is a huge priority for us, and we have huge volume still. We have hundreds of millions of PCs, tablets and phones still on a run-rate basis, and a billion-plus PCs that will all be upgrading. So therefore we have a significant opportunity for any application you target Windows.  (This is the "ching ching" answer that is music to their ears.) 
And then the last thing is, we are betting on this platform ourselves. You saw from Kirk Koenigsbauer how we're building the next generation of Office applications for this platform. So we are going to basically use the same platform that we want you to target to build our own set of applications.
So those would be the three reasons, because we're going to innovate with a challenger mindset, we're going to create the broadest platform opportunity in terms of sockets for you, and we are going to bet on that platform ourselves, and that's the reason why you should target Windows. (Applause.)"
So, the stock is fairly valued on its near-term prospects, with good support from the dividend, and the new CEO is bringing a fresh look to his long-time employer. (he has a nice quote from T.S. Eliot that covers his experience well) A new independent board member who comes from the analyst perspective has joined the board.  A critical acquisition, its integration and the opportunity to really become a premier consumer technology brand await.  

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