Cloud transition is going well, though, and Windows 10 looks incredibly promising

Microsoft Corp.'s (MSFT) fiscal Q2 2015 earnings are in the books.  In some regards Microsoft had a terrific quarter.  But as you sift through the report some details appear troubling, as well.

I. Costs Cuts, Cloud Transition Lead to Some Revenue Drops

The balance sheet started off in the hole thanks to a $650M USD charge taken on the acquisition of the Nokia Devices unit from Finland's Nokia Oyj. (HEL:NOK1V).  Windows Phone revenue per device and Xbox revenue both dropped by around 20 percent, despite strong sales of both Lumia smartphones and Xboxes over the holiday season.  

Microsoft's cost cutting is to blame for this decline in hardware revenue.  It wasn't totally a loss, though -- Microsoft's Xbox games revenue rose 79 percent, offsetting the decline in hardware revenue.
Xbox holidays
Price cuts dented Microsoft's hardware revenue, but software sales made up for it on the Xbox front.

Overall, this is a repeated theme throughout Microsoft's earnings.  Microsoft is taking a hit on the hardware front, in many markets, in order to grow its software and licensing sales.  Overall there's some indicators that this strategy is proving successful.  But at worst Microsoft appears to be breaking even in some segments growth-wise, when hardware and software are cumulative considered.

That said, there were some declines in software/licensing revenue -- both cyclic and exceptional.

Windows OEM revenue took a 13 percent hit and Office consumer revenue dropped 25 percent.  Office is attracting record numbers of subscribers, but many of them are partaking of the free offerings on Google Inc.'s (GOOG) Android OS, Apple, Inc.'s (AAPL) iOS, and via browser web clients (with Office Online).
Office 365
In total 9.2 million consumers are now subscribed to Office 365, a key pillar of new CEO Satya Nadella's cloud-driven vision for the company.  That's up from 7 million in FY2015 Q1.

II. "Geopolitical Issues" in Russia, China, and Japan Wreak Havoc

Windows revenue was hit by a couple of factors.  First there was a cyclic slowdown in Windows 7 and 8 enterprise licensing as enterprise customers anticipate the release of the eagerly awaited Windows 10 this fall.  Second, Microsoft reported major declines in business in select regions including China and Russia on what Satya Nadella termed "geopolitical issues".

The issues in both regions are reflective of broader industry-wide woes due to conflict between the Obama administration and the governments of China and Russia.  In both Russia and in China, officials have suggested that Windows may be a "security threat" due to America's aggressive National Security Agency (NSA) domestic and international spying program.

Microsoft faced tough conditions in China and Russia over security concerns and other political issues.
[Image Source: The Next Web]

Russia and the U.S. are also at odds over Ukraine and over allegations of oil price manipulation by the Saudis and the Obama administration.  In China Microsoft has faced accusations of tax evasion.  In addition spats over taxes and surveillance, the Chinese government also refused to upgrade from Windows XP in part due to its claim that Windows 8 was "too expensive".

In the earnings call, CEO Nadella acknowledged the political issues dragging down its business in these two regions, commenting:

Where there are execution issues, we will address them.  Where there are macroeconomic issues, we will weather them.

Microsoft also saw sales slowdown in Japan, due to decreased consumer spending in the top Asian economy.  

Japan Sales Tax
Japan saw a big jump in its sales tax last year.  The impact was somewhat delayed but was felt during the holiday season.

That spending decline was traced largely to an increase in the local sales tax.  Chief financial officer Amy Hood acknowledge the dip in Japanese licensing was a bit of a surprise, remarking:

Overall, the only surprise I think was in commercial licensing, where we had a little bit of a headwind from foreign exchange as well as macro conditions in China and Japan.

It is unclear whether the foreign factors will ease over 2015, or continue to cause problems for Microsoft financially.  But the sort of good news is that these issues aren't isolated to Microsoft alone.  They're also impacting the growth of Apple and Google -- among others.

III. By the Numbers

A stronger U.S. dollar also impacted earnings.  Three-quarters of Microsoft's business is done outside the U.S.  At constant prices for licensing and devices a stronger dollar meant higher relative value to earnings in the U.S., but lower earnings in the overseas units relative to the USD.

In addition to the fiscal and regional issues and the Nokia charge, Microsoft also took an additional restruturing charge of $243M USD.

The trouble spots caused Microsoft to miss on some, but not all, financial metrics versus analyst forecast.  Analysts surveyed by Bloomberg had predicted a profit -- excluding certain items of $0.75 USD/share ($6.19B USD) on a revenue of $26.5B USD.  Microsoft missed on revenue but outperformed mildly on profit, delivering $0.77 USD/share ($6.36B USD) (excluding certain items) on a revenue of $26.3B USD.

Concern among investors largely revolved around commercial-licensing revenue. Analysts had hoped for $10.9B USD in revenue for the quarter; Microsoft reported $10.7B USD.  Likewise, unearned revenue -- a deferred licensing revenue metric -- rose 9 percent but only hit $21.2B USD, well short of analyst hopes of $21.8B USD.

Microsoft earnings

An analyst survey by Thomson Reuters I/B/E/S showed less of a suprise among some analysts, who precisely predicted earnings of $0.71 USD/share (including charges, $0.77 USD/share excluding them) on revenue of $26.3B USD.  Total profit was $5.86B USD including charges, or $6.19B USD USD excluding them.

Good news for investors came in the form of the announcement of a $40B USD share repurchase expenditure, which will run through Dec. 31, 2016, burning away roughly half two-fifths of the company's $90.2B USD cash pile.  The share repurchasing program supplements existing dividends of $0.31 USD/share/quarter ($10.2B USD total, annually) that Microsoft pay out.  It echoes Apple's recent $90B USD share buyback effort.

IV. Signs of Success

One success story was the Surface Pro 3, which saw device and accessories revenue soar 24 percent to $1.1B USD.  In addition to selling a record 10.5 million Windows smartphones, Microsoft also moved an additional 39.7 million non-Windows units  -- legacy holdings from the Nokia Devices acquisition which Microsoft is regearing under its "Microsoft First" banner for developing markets.  

Surface Pro 3

In total Microsoft sold 50.2 million mobile phones for the quarter, of which just over 20 percent were Windows smartphones.  To put that in perspective, in Q4 2013 Nokia moved 63.4 million units (according to figures from the Int'l Data Corp. (IDC)), of which just under 13 percent were smartphones.

Overall sales contracted by roughly a fifth, but the smartphone mix increased by roughly 50 percent.  This is all indicative of Microsoft's efforts to slowly cull the lowest end parts of the Nokia Devices unit and bring the mid-range budget models into the Windows camp over time.

Bing was another success story of the earnings report.  It reached a record market share of 19.7 percent of global searches for the quarter according to Microsoft's estimates.  Search ad revenue rose 23 percent, offsetting a decline in display ad revenue.

Driven by Office 365 and Windows Azure, the so-called "Microsoft Commercial Cloud" saw 114 percent revenue growth, and is on pace to bring in $5.5B USD in revenue in the next fiscal year.  It appears that Microsoft is patiently winning enterprise clients over to its cloud-driven vision.

Satya Nadella
Satya Nadella is patiently growing the Commercial Cloud, a key growth segment for Microsoft's enterprise revenue. [Image Source: VentureBeat]

Microsoft spent $1.5B USD in capital investments, with much of the spending devoted to data centers to support its cloud computing push.  Overall, it reported an effective tax rate of 25 percent.

V. What's Ahead

With the quarter's close CEO Nadella creeps up on the close of his first year as CEO, it appears that Microsoft is making substantial strides towards restructuring to his cloud driven vision.  

Microsoft businesses

There are plenty of items to watch with a wary eye, but also numerous positives signs including rising enterprise Commercial Cloud revenue, rising consumer Office 365 subscriptions, the success of the Surface 3 Pro, and strong Xbox game sales.

With Windows 10 waiting in the wings, 2015-2016 could shape up to a game changing period in which Microsoft will look to reestablish its dominant position in the tech space -- including the mobile market.

Microsoft business
Microsoft is gunning for a ubiquitous flexible platform. [Image Source:]

If all goes according to plan Microsoft will be the first platform to provider to leverage a fully flexible platform covering a gaming console, desktop PCs, laptop PCs, hybrid PCs, tablets, phablets, smartphones, and other form factors.  This should be a boon for developers and may put Microsoft in an enviable position.

Sources: Microsoft, Bloomberg Businessweek, Reuters

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