Microsoft (NASDAQ:MSFT) announced its earnings for Q4 FY13 on July 18. During the quarter, Microsoft posted 14% y-o-y revenue growth to $19.89 billion. However, operating income declined by 5% to $6 billion. These figures reflect a $900 million write-down of Surface RT inventory related to a price-reduction offer for these devices.
In our pre-earnings article, we noted that the Windows OS division would be negatively impacted due to weak PC shipment number for Q2 CY13. Microsoft felt the heat from declining PC sales as its Windows division revenues (excluding Windows deferral revenue from last year) declined by 5% y-o-y. Additionally, weak PC sales also affected its Office division. However, Microsoft’s cloud initiatives continued to deliver growth in the quarter. Below, we review Microsoft’s Q4 FY 13 results by segment.
Microsoft Office Division
During Q4 FY13, Microsoft’s revenues from its business division grew by 14% to $7.21 billion. However, after considering adjustments for the recognition of previously deferred revenues related to the Office upgrade offer, the revenues grew by a modest 2%. While weak PC sales affected Office’s consumer revenues that declined by 27%, the shift to new subscription model impacted revenues due to the changes in the timing of revenue recognition. However, as subscription model sets in revenues for this division is expected to grow, and become more recurring and predictable going forward.
During the earnings announcement, Microsoft reported that Office 365 now has over one million subscribers and $1.5 billion annual revenue run rate. The adoption of Office 365 is critical for Microsoft’s growth in the coming year, and this result indicates that Microsoft’s move towards cloud based Office software suite is gaining traction. We expect Microsoft to maintain its market share at 92% over our forecast period as clients continue to adopt the feature-rich, cloud-compatible Office 2013.
Microsoft’s Windows Server division is the second largest business unit making up over 20% of its total value. It is also one of the fastest growing divisions of Microsoft. During Q4 FY13, revenue from server and tools grew 8% driven by higher SQL server sales and adoption of cloud based Azure platform.
In April, Microsoft reported that Azure had crossed the $1 billion revenue mark for the first time [Microsoft Azure Sales Top $1 Billion Challenging Amazon, April 30 2013, www.bloomberg.com]. During Q4 FY13, Microsoft announced its partnership with Oracle to offer Oracle apps on its Azure platform. Moreover, Azure platform witnessed strong customer adoption as it added 25% more enterprise customers in Q4. Many customers of Microsoft depend on SQL servers for mission critical and business intelligence needs, specifically in the big data analytics domain. As a result, Microsoft’ SQL server revenue grew by 16% outpacing the server market. We’re encouraged by the continual growth that this division posted, and it is becoming an important driver for Microsoft’s value.
Windows OS Division
Windows Operating System is Microsoft’s third largest division and makes up 15% of its stock value by our estimates. During Q4 FY13, Microsoft’s revenues from its Windows division declined by 5%. For Q2 CY13, IDC reported a 11% y-o-y decline in PC shipments and OEM revenues declined in line with the PC market [Lenovo Overtakes HP as the Top PC Vendor While U.S. Shipments Stabilize in the Second Quarter of 2013, July 10 2013, www.idc.com]. However, non-OEM revenues grew by 22% and offset the decline in OEM revenues.
As sales of smart devices gain traction across the world, we expect PC shipments will continue to decline in the coming quarters. However, Microsoft is launching Windows 8.1, an updated version of Windows 8, in the coming holiday season. We expect the updated version would fare better in the market than Windows 8. We, therefore, estimate that OEM revenue for Microsoft will decline at a slower rate in the remainder of 2013. Additionally, we expect PC sales to stabilize in the coming quarters and if Microsoft can continue to maintain its market share, it could be a catalyst for the company’s stock price.
Online Service Division (OSD)
The Online Services Division continued to negatively impact Microsoft’s overall profitability posting an operating loss of $372 million. However, this division did report some encouraging signs as online advertising revenue grew 11% due to an increase in search revenues as Bing grew its organic US search market share to 17.9% during the quarter. We forecast Bing’s global market share to increase steadily throughout our forecast period but any surprises to the upside are not expected to increase the company’s value substantially.
Entertainment and Devices Division (NYSE:EDD)
Microsoft’s Entertainment and Devices division reported 8% y-o-y growth in revenues as transactional revenue within Xbox LIVE grew by 20%. Additionally, the division continued to negatively impact Microsoft’s overall profitability, posting an operating loss of $110 million.
New Product Drives Up Costs
Microsoft reported that its cost of goods sold increased by 14%, primarily due to growth in Surface and cloud infrastructure requirement. Moreover, operating expenses grew 9% due to increase in sales and marketing cost for Surface and Windows 8. Additionally, its CapEx increased as it continued to invest in cloud infrastructure and expand its geographic footprint to support the growth in online businesses.
We are currently in the process of updating our Microsoft Model. At present, we have $41 price estimate for Microsoft, which is approximately 28% above the current market price.