Microsoft: More Positives Than Negatives

| About: Microsoft Corporation (MSFT)

Recently, Microsoft (NASDAQ:MSFT) reported its second quarter 2014 results. The following are the results, results insights and my analysis of the results.

Results summary:

For the latest quarter, Microsoft posted revenue of $24.5 billion, up 14% from $21.5 billion a year earlier, and net profit of $6.6 billion, up 3% from $6.4 billion a year earlier. On per share basis, the earnings per share stood at $0.78, up from $0.76 per share during the same period last year. Operating income improved from $7.8 billion to $8 billion. The company declared a dividend of $0.28 per common share, an increase of over 21%, from a year earlier period.

Segment insights:

The company reports its revenues under two main segment, namely Devices and Consumer segments and Commercial segments.

Devices and Consumer Segments (D&C):

Devices and Consumer includes the three segments namely Licensing, Hardware and others. These segments collectively reported revenue of $12 billion, up 13% from $10.5 billion a year earlier. Gross profit showed a decline of 14% from $6.8 billion to $5.8 billion, as the margins declined from 64.5% to 49%.


Licensing was the largest D&C segment for the company. It generated the revenue of $5.4 billion, down 6% from $5.7 billion a year earlier. The segment gross profit showed a decline of 3%.

The decline in revenues is mainly due to lower revenue from Windows OEM and Consumer Office. Consumer Office revenue declined by 24%. Windows Phone revenue increased by $340 million or 50%, reflecting higher sales of Windows Phone licenses and an increase in mobile phone patent licensing revenue.


With the decline in the global PC market, the decline in Windows OEM and Consumer Office revenues is expected to continue in the future. Windows Phone revenue to some extent will offset the revenue decline in the segment. Another reason why the Consumer Office showed the massive decline was the transition of customers to O365 Home Premium (cloud based).

The margins for the segment are also expected to come down in the future as the high margin revenues (Windows OEM and Consumer Office) is being replaced by the low margin revenues (Windows Phone). So, in the near future the segment is expected to show the negative growth.


Hardware segment generated revenue of $4.7 billion, up 68% from $2.8 billion a year earlier. The segment gross profit showed a decline of a whopping 46%.

The rise in the revenues is due to the rising contribution from Surface and Xbox. During the quarter Surface contributed about $893 million to revenues. Xbox reported decline in the margins due to addition cost related with the release of Xbox One. The margins for Surface continued to be negative.


The segment saw the release of Xbox One during the quarter, which allowed the company to sell 7.4 million consoles as compared to 5.9 million consoles during the same period last year. The initial success of Xbox One is remarkable and the company should continue to report strong sales in the future. As far as, Surface is concerned, it is highly unlikely that the company can report a positive financial outcome in near future due to high R&D and marketing related costs as well as lack of desired scale (Surface sales) that can offset these costs.


The other segment generated revenue of $1.8 billion, down 10% from $2 billion a year earlier. Gross profit showed a decline of whopping 51%.

The decline in the revenues was primarily due to lower revenue from first-party video games, offset in part by an increase in online advertising revenue due to improvement in revenue per search. The decline in revenue from the first-party video games is due to fact that no game got released during the quarter.


The improvement in the "revenue per search result" showed that the company's search technology is hitting the right algorithms, which indicates that the company is getting on the right track in the search business. The growth in the search volume showed that the company's search service is gaining acceptance, which is an excellent news as search services hold excellent growth possibilities.

Commercial segments:

Commercial segments include the two segments namely Licensing and Others. These segments collectively reported revenue of $12.7 billion, up 10% from $11.5 billion a year earlier. Gross profit improved by 10% to $10.5 billion from $9.5 billion a year earlier, as the margins stood at 82.8%.


During the quarter, licensing was the largest segment for the company. It generated revenue of $10.9 billion, up 7% from $10.1 billion a year earlier. The segment's gross profit improved 8%.

Growth in server, CAL and Office licenses led to the growth of the segment.


Other segment revenue increased $391 million or 28% to touch $1.8 billion from $1.4 billion a year earlier. The segment gross profit improved by 92% due to higher revenues and improved margins, which improved from 15.5% to 23.3%. Cloud Services revenue grew $315 million or 107%.


The company's commercial segment primarily fulfills the data center and cloud needs of enterprises. Both the solutions are in demand due to the rising trend among enterprises to shift their work/data to cloud (private as well as public). Cloud as well as data center solutions are expected to show more improvement in the future due to rising demand and improving cost-effectiveness.

The key positive from the quarterly results is the steep improvement in the commercial others segment margins, which shows that the company's cloud services are not only growing at an exceptional pace but also are performing equally well on the margins front. Which is a good news for the company's future as this is the fastest growing business of the company.


The results are good, but once again showed that in Devices and Consumer segments the company continues to lose the high margin licensing revenues, which has been replaced by the low margin revenue. This trend, if continues (and is most likely to be continue due to declining PC market) can affect the performance of the company in the times to come.

In Commercial segments, the company is increasingly focusing on the enterprise's needs in a more integrated way as the company continues to increase/improve its Cloud and Data Center offerings integration. This approach will allow the company to become a more integrated player in Cloud and Data Center businesses and allow it to cross-sell Data Center and Cloud solutions.

The company has been investing heavily to establish itself as a device manufacture. The company's approach towards the market is to offer a single or very few products that can address all the needs of users. This approach not only makes the product expensive but also limits the addressable market (due to presence of very limited price points). So, the company may take time to report any meaningful profits from the devices beyond Xbox (in the near future).

All in all, an excellent quarter that once again proved that in short term, the growth in the data-center market is good enough for the company to offset the effect of declining PC market. The company's growing presence as a cloud service provider, which is the company's biggest future growth opportunity, should allow the company to report profitable revenue growth in the long term.

The company trades with a PEx of 13.6 and offers a dividend yield of 3%. Valuations look attractive.

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This article reflects the personal views of the author about the company and one must consult its financial adviser before making any decision.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.