Thursday, July 24, 2014

Microsoft Is Changing For the Better: Evidence From 2014 4Q

Before looking at the numbers for FY14 Q4, I think it's more important to cover the many tells that things are really changing at Microsoft, for the better.

The first signs appear in Mr. Nadella's memo to employees about the 18,000 employee workforce reduction. Having been responsible for a reduction myself (about 1% of MSFT's, but 15% of our workforce), and having been part of several Wall Street reductions myself, I can say that they are almost always done badly for the organization's survivors and inhumanely for the affected employees. So what about this announcement?

The first was a quick reprise of contextual messages.  The company is on the road to becoming a platform and productivity company, which employees had heard the previous week. Having a focus, however, isn't a be all and end all.  

Aligning the organization, changing its culture, and improving communications and decision making within the organization are key initiatives that will take time.  The organizational staff reduction, unfortunately, is part of that longer-term change.  Thus, the CEO makes it clear that this is not an effort to cost cut one's way to success, as has been done with blazing incompetence by the likes of  "Chainsaw" Al Dunlap, and Ed Lampert at Sears, to name two. Along with these reductions will come resource additions in other areas.  The key message to employees: your organization is committed to grow, not to shrink its way to success. 

Finally, there is a human element, expressed in the statement, "We will offer severance to all employees impacted by these changes, as well as job transition help in many locations, and everyone can expect to be treated with the respect they deserve for their contributions to this company."  This isn't a phrase that would normally be offered by HR or by the general counsel; it really seems like it is a sentiment coming from the CEO, and that's good for the effected employees and for the survivors as they go through the grieving process with their former colleagues. 

On the quarterly conference call, there was a clear distinction between the styles, presentations, and nuances of the CEO and the CFO.  In fact, CFO Amy Hood sounded absolutely liberated from her former role of merely explicating and micro-parsing the financial numbers (deferred revenue forecasts, contracted versus billed revenue), and she added the CFO's restrained nuance to the always more enthusiastic and high level comments of a new CEO. Long term investors expect and like this differentiated,tag team approach. Together, it was a much more well stitched together set of messages than the previous environment, dominated by the overbearing Steve Ballmer.  
GAAP revenue for FY14 Q4 increased 18% year-over-year to $23,382 million, which included $1.99 billion of revenue from the inclusion of NDS for a partial quarter.  GAAP gross margin  of $15,787 million increased by 10%, and the GMR was a robust 67.5%, although this was down from an unusually higher rate in the prior year period.  

GAAP operating income of $6,482 million grew 7% over the prior-year period, and the margin was 27.7%, with all the moving parts. Nokia NDS contributed $(692) million to the quarter's operating income, of which $127 million was for integration and restructuring expense in the period. 

Diluted EPS of $0.55 per share declined 7% on a GAAP basis from $0.59 in the prior year period.  Dividends per share were $0.28 in FY14 Q4.  On a non-GAAP basis, which is interesting but not decisive to an investment thesis, diluted EPS of $0.66 increased 10% over the prior-year period. 

This Is A Software Company

While HP struggles to become more software-oriented, and while IBM divests a commodity server business to become more software oriented and relevant to corporate buyers, MSFT already is a software company with robust margins, despite appearing to become more of a hardware company through acquiring Nokia NDS.  

What's more important than this artificial hardware/software duality is the nature of the enterprises who will operate data centers, private, public, and hybrid clouds.  These are the customers who need to make significant investments, and they look to their trusted vendors to help them through their decision making process,  

Another thing about the new CEO is that it is clear that he can talk about customer requirements, hardware, software, data security, and computational issues with engineering, product development, and real life, customer-facing experience.  This kind of credibility will resonate with Microsoft sales forces and with the customers: this is a big deal and a big change from an MBA-type blathering on about "the cloud."  

This shows up, in our opinion, in the quarterly results where commercial cloud revenues increased by 147% year-over-year, driven by Azure, storage, computing services and the CRM online product.  The annualized revenue run rate for cloud revenues was cited as being $4.4 billion at the end of the quarter.

Microsoft Dynamics revenues were up 13%.  As a small enterprise, one of my companies adopted an early version of the former Great Plains/Dynamics software, and as a non-IT user, I found it uninviting and logically convoluted. However, for small and medium size businesses, facing the prospect of Oracle or SAP, is even more unpalatable. 

What About Commodity Hardware?

Server licensing revenue increased by 14% year-over-year.  Server product revenue increased by 16%. The Microsoft SQL Server product line had a major refresh with Server 14, and its revenues were up 19%.  

The corporate IT executives are under more and more pressure to deliver services of demonstrable performance and value from among the buzzwords, of clouds, big data, business intelligence, and BYOD. CEO Satya Nadella made the point when Microsoft, "operating some of the planet's most massive data centers," approaches customers with their Cloud OS platform, they build instant credibility.  He said that this platform represents one of the company's largest revenue opportunities, for as public cloud use increases the data center is where revenue growth will come from. 

Even, the much maligned Bing! search engine continues to garner share of U.S. searches, now north of 19% and revenue per search went up in the quarter.  This business is targeted to be stand alone profitable in 2016. 

Late To Tablets?

Microsoft Surface, for all of its being late to market, was built from the ground up on a totally different premise from most tablets, which as we've said are put to non-productive uses.  For business users, small, medium and large, productive work will involve working on documents, spreadsheets, and presentations. Surface has, and continues, to make its point that it is a viable laptop replacement with the virtues of a tablet. The CEO noted that a new form factor launch of Surface was tabled.  

The Surface Pro 3 is aimed at facilitating easy note taking, as with a pen, tying it in easily with One Note, which had been a forgotten application for a long time. 

Making and Office 365 accessible through apps for iOS was a small, but master stroke. Google Docs won't be the answer for most users, nor will Chromebooks for price/value.  The jury is still out on this venture, but Microsoft has planted a viable flag in the marketplace. 

The CEO's core investment principles were also interesting:
  • Invest in the core platform and productivity businesses, e.g. cloud and device operating systems.
  • Consolidate overlapping development efforts, which is a corollary of the reductions and reinvestment in fewer management layers and fewer competing groups.
  • Run all businesses on a clear, simple model of business and productivity metrics.  This will be interesting and if it takes, it will mean that the culture will have changed dramatically.
There is a lot to like in the way FY 2014 closed under CEO Satya Nadella. 

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