Microsoft's Q1 FY2017 - steady as she goes but work to be done

Profile picture for user gonzodaddy By Den Howlett October 20, 2016
Summary:
Microsoft turned in a solid result for Q1 FY2017 but the underlying numbers are all over the map.

Microsoft closed out Q1 FY2017 with cheery news by handily beating market expectations. While the detailed numbers are obfuscated by the company's lack of transparency into what this means, it was hard to avoid the 116% jump in Azure revenue. Here's what we know:

  • Total revenue as reported: $20.453 billion compared to $20.379 billion - essentially flat.
  • Operating income as reported: $5.225 billion compared to $5.793 billion - down 9.8%

If you enjoy the way Wall Street likes to see the numbers then you get a 3% year over year increase in revenue with operating income flat but when you apply constant currency measures then you get a 5% increase in revenue and a 4% increase in operating income. Confusing isn't it so why was Wall Street (and just about everyone else glomming on these numbers) happy? The Street had expected revenue to be flat in non-GAAP terms whereas Microsoft beat by approximately $600 million.

Let's look at the revenue breakdown changes as reported in summary form:

fyq1-msft

But it is when you get to the breakdown that things get more complicated.

product-breakdown-currency-impact

As you can see, the component parts are all over the map ranging from -72% for the phones business - no surprise there given Microsoft is exiting that business - to the 116% for Azure. I was taken with the Dynamics number, up 11% but more importantly the relatively low currency impact. This suggests to me that Dynamics, while it did well compared to the previous period growth, and specifically the CRM element, it is not making the global impact that we see from competitors.

Nadella bigs up AI

Satya Nadella, CEO Microsoft has certainly shown how adept he is at making Wall Street happy, now he has to find a way to continue dropping the good news even while global macro indicators remain shaky at best. To that extent, the company's presentation massaged the way it shows metrics to show the most favorable but sometimes confusing position. For example, while it was happy to report 24 million Office 365 consumer subscribers, the closest we get on commercial is 40% growth. That's still eye popping but then this time last year that growth was slated at 66%. Microsoft says there are now 85 million active Office 365 commercial users.

Across industries, customers such as eBay, European airline, jet, global pharmaceutical company, Allergan, the Fortune 100 companies like the energy leader Exelon and Liberty Mutual Insurance are choosing Office 365 to help make their employees more productive and secure.

Talking to the manner in which Microsoft is less about Windows and more about distribution to any device Nadella said:

Customers love the power of Office on any device. We now have more than 45 million outlook monthly active devices on iOS and Android more than 70% increase year-over-year.

Nadella's main theme was to talk to the next generation of cloud software that is being improved with AI functionality:

Last week we unveiled a new class of purpose built intelligent apps in Dynamics 365 designed to remove any impedance that exists between productivity, collaboration and business process. Using advanced analytics a machine learning, these new apps glean insights from previously siloed data to transform how people work across finance, sales, marketing and customer service. They monitor customer relationship help, reveal connections, forecast demand and predict risk and the deep integration with Office 365 makes it easy to take action communicate and collaborate in real time or schedule a follow up.

That provided a natural segue to talking up the recent HPE CRM deal where Dynamics replaced Salesforce:

Our innovations the Dynamics 365 build on our existing momentum, dynamics online paid seats more than doubled year-over-year and customers increasingly prefer our cloud solutions with more than 70% of the new dynamics CRM and ERP enterprise customers choosing dynamics online. Companies like HP, Inc. are replacing their existing CRM systems with Dynamics 365 to take advantage of the built-in intelligence and our latest release and transforming engagement with customers and partners.

You can see straight away where this is going and why the hype around AI in enterprise apps is capturing the imagination.

Microsoft next focused on what they term Intelligent Cloud and a new set of metrics. Check this slide:

intellgient-cloud

While Nadella talked up success among the Fortune 500 and big wins such as at the UK's Ministry of Defense, alongside its hybrid approach to cloud infrastructure, Microsoft is clearly going after Rackspace and Amazon Web Services entry level users, touting that 40% of Azure instances are used by startup as and ISVs. Even so, the company claims it is on a annualized run rate of $13 billion and on track to hit its $20 billion revenue goal for 2018 in this category.

Nadella said:

It's not just the Silicon Valley startups anymore, it is the core enterprise that is also becoming a digital company.

Turning to commentary on the numbers, Amy Hood, CFO Microsoft gave a telling warning about the current state of the overall IT economy:

Overall, our total Windows commercial business revenue across small and mid-size businesses enterprises and academic institutions was flat and grew 2% year-over-year in constant currency.

Microsoft is clearly operating well at all ends of the economy, but it is that flatlining in SMB I find a worry. Regardless of what anyone says, Microsoft still holds a near monopoly in the business market and even if you factor the significant numbers of SMB/startups that will use Apple machines, that still leaves a hefty market for Microsoft to attack. Add in the fact that Surface devices have, at last, started to get some kudos and you have to wonder about underlying macro weakness. Even so, throughout the analyst call, both Nadella and Hood were keen to talk about revenue mix and Azure as the underpinning for upselling higher value services like Dynamics  and enhanced security services.

My take

The Street was happy in after hours trading so who am I to carp?

As with all other large vendors that have been around a few decades, one should never under estimate their ability to transform off the back of high margin cash cows. Microsoft is no exception, combining a solid performance in this quarter with headline grabbing deals with the likes of Adobe while returning $6.6 billion back to shareholders through buybacks and dividends. It's a smart combination of strategies that helps draw the customer into the 'new' without a hideous forced march.

We should continue to watch these numbers closely because as the world's business operating system for all practical purposes, (unless you think all apps are going Android), what we see in Microsoft's numbers are a reflection of the broader economic outlook. Right now Microsoft is being cautious but it does worry that they talk up AI so much when the reality is much more modest.

Salesforce won't be pleased that Nadella rubbed in the HP deal and quietly reminded everyone why it is buying LinkedIn. Toss in a bit of AI and all of a sudden, Microsoft looks like the cool kid on the block once again.