There are many euphoric sounding articles on MSFT´s Q4 and FY2017 numbers going around. Headlines like ´Microsoft metrics showcase cloud business model mastery´ and even articles in New York Times, Forbes etc. A lot of people refer to an article from TBR research. This research is not publicly accessible but I would love to understand some of the premises and bases they used.
I think Microsoft is doing a good job but also it is still very early in the transition. With this article, I want to dispel some of the myths or in my opinion (IMO) badly informed articles. I am a MSFT shareholder and I work in the Microsoft ecosystem so I need Microsoft to be successful. Therefore, this article is intended as constructive criticism, to make sure that nobody at Microsoft feels that they have arrived. No sirs, the journey is just starting…
Putting the numbers in perspective
This is the first time Amy Hood has given real cloud revenue numbers. Normally she has always use commercial cloud revenue run rate. Now she stated that the Cloud revenue was 15B. However, that 15B includes 2,2B of LinkedIn (LI) Recognized revenue in 2017. Therefore, the real number without LI is closer to 13B (that is why Hood has always given run rate numbers and not real revenue numbers imo)
LinkedIn buys MSFT at least 4B of Cloud revenue in a flat calculation. I looked at the LinkedIn annual reports (available until end of 2015 only) and the growth rates are descending from 86%, 54%, 46% to 31%. So let us assume a 20% growth to normalize. If we use MSFT terminology of run rate LI in in 2018 will add 4,8B of pure cloud revenue. So not that hard to get to the stated 20B of cloud revenue runrate by the end of FY 2018. 20B- 4,8B= 15,2B. To get to 15,2B from 13B is only 15% growth. In my opinion after buying LI Satya should have aggressively restated his Cloud revenue objective.
LI is basically 5B of cloud revenue that has been bought for 26B. Cloud revenue with about 1B in positive operating cashflow but a lot of amortization because of goodwill and employee stock options that need to be paid. If you put 26B in low risk equity you will get at least a 5% return (1,3B). Estimates of MSFT cost of capital (OTC:WACC) range from 10,5% to 16% so that is the minimum return MSFT needs on its investment for it to be accretive. In 2017 MSFT recognized 2.268B of LI revenue with a negative operating income of 949M instead of what it should reach (10,5%) 268M. So a gap of 1.187M.
The Q4 numbers.
There was a lot of wow about the huge increase in operating and net income in Q4 of 73% and 109%. However, everybody seems to forget about Nokia. First MSFT no longer has the operating losses of Nokia (in my estimates about 500M a quarter). Furthermore, MSFT took a one-time charge in Q4 last year of 630M and 480M related to the restructuring of the phone business. In addition, MSFT had a 1.8B positive tax impact relating to the phone business, which they recognized in Q4. So 0.5B+1.11B+ 1.8B= 3,4B! of impact of which only 500M is a structural improvement. So the Q4 Net income of 6,5B comparing to the 3.1 (both GAAP) seems like a 109% growth of which 2.91B is a one off. Adding the 2.91 to last year’s 3.1 gives 6.01B. So the real sustainable growth is 6,5/6= 8%. The commercial bookings in Q4 are up 30% which is great but 3 years ago as an analyst mentioned they also went up 23% in the last quarter.
Microsoft has shredded 2B of Nokia related operating losses but has bought at least 1B a year of LinkedIn operating losses. That is still a positive J
Microsoft´s real cloud revenue is 15B including Linkedin. This is 15.5% of overall revenue if I take GAAP revenue numbers and even less when I take non GAAP revenue as a comparison. Compare this to born in the cloud competitors like FB or Google which are over 95% or full enterprise cloud companies like Salesforce or Adobe which are over 90% as well (by the way it is my expectation that MSFT will buy Adobe one day). Even Oracle and IBM are claiming similar percentages of cloud based revenue as MSFT.
AWS´, Microsoft´s biggest competitor in the cloud, revenue in Q1 2017 was up 42 percent to $3.66 billion. Using similar cloud run rate extrapolations as MSFT (which AWS doesn´t do. They use real revenue) would lead to about 20B in calendar year 2017. Of MSFT´s 13B of real cloud revenue my guess is that more than half is O365, then a bit of EMS and Dynamics which leaves about 40% or less for Azure which would make Azure revenue (that is where MSFT competes with AWS) about 5B and I think I am being nice in my estimates.
Microsoft business segments
MSFT has three business segments, Productivity and Business Processes (PBP), Intelligent Cloud segment (IC) and More Personal Computing (MPC). The biggest revenue contributor is still MPC at 36% then PBP at 34% (remember including all of the LI revenue) and then IC at 30%. If you look at the operating income % it is 25%, 39% and 36%.
MPC is in a down market that will go down structurally. In PBP Microsoft is basically converting on premise installed base to the cloud. And IC is where the real battle for market share happens. Amy made an interesting comment: for the first time, Office 365 Commercial revenue surpassed revenue from our traditional licensing business.
Segment gross margin $ are increasing in PBP and IC but gross margins are declining due to continue investment.
Simplifying the MSFT strategic imperatives: MSFT needs to protect and milk as long as possible the more personal computing segment. MSFT needs to convert the office installed base as quickly as possible to the cloud in order to defend its market share from others (Google, Slack etc) but the real battle for new market share is in the Azure space. That is where for the last two years the real focus of Microsoft has been, Azure, Azure and Azure. They have to do this against a backdrop of decreasing gross margin% due to a higher cloud mix which has lower gross margin % then selling software licenses.
In order for the stock price to keep up the speed of growth of the cloud workloads needs to stay above 50% for the next 3 years imo.
Conclusion. Microsoft under Satya is doing a great job in transforming itself and I have a lot of respect for the choices made. However the road is long and specifically Q1 2018 will be challenging as Microsoft is making all the changes in the field now and a lot of people will be moved, changing roles or more busy with understanding if they still have a job.
Disclosure: I am long Microsoft
Disclosure: I am/we are long MSFT.