A closer look at Microsoft Q1 2014 Results

Microsoft delivered record first quarter revenue. This holiday, the company will see competitive opening price points on tablets and laptops, such as the Dell Inspiron 15 for less than $300 and will also see exciting mobile devices from six inch phones to 10 inch tablets, many with Microsoft Office.

In the six inch category, Microsoft is incredibly excited by the Nokia Lumia 1520 tablet announced this past Tuesday. For eight inch tablets, Toshiba, Dell, Lenovo will have devices available for less than $300 and for 10 inch tablets; the company of course likes the Nokia Lumia 2520 with LTE.

Total revenue was up 7% to $18.6 billion and came in at about $700 million better than the company’s expectations. Without the impact of foreign exchange, revenue would have been $200 million or one percentage point better.

Annuity revenue was particularly strong and grew 11%, driven by commercial performance. Cost of goods sold increased 23%, which was in line with the company’s expectation of over 20% growth. This increase was primarily due to service cost and also higher depreciation related to the CapEx investments Microsoft made this quarter for cloud services strategy. As a result, gross margin grew 3% to $13.5 billion, reflecting the changing mix of revenue.

In R&D, Microsoft is continuing to focus its resources while accelerating cadence. Operating income and earnings per share, both declined 3% to $6.4 billion and $0.63, respectively. Unearned revenue grew a healthy 14% to $20.1 billion and the company’s contracted not billed balance grew to over $21 billion, driven by commercial strength.

Microsoft’s inventory balance sequentially increased by $675 million, mostly due to build the Xbox 360 and Xbox One. Ahead of holiday selling season, Xbox represents over half of the company’s inventory balance.

Inventory for Surface products declined sequentially even as the company built levels ahead of this week Surface 2 and Surface Pro 2 launches. This quarter, Microsoft announced a 22% increase in its quarterly dividend to 28% and also announced $40 billion share repurchase program. The company returned $3.8 billion of cash to shareholders, high quarterly amount since the second quarter of fiscal 2011.

Performance of each Reporting Segments:

Microsoft’s devices and consumer licensing segment is comprised principally of Windows OEM, consumer office and Windows Phone, including related patent licensing. Windows OEM business performed better than expected, declining 7% versus the company’s expectation of a mid-teens decline.

The management believes it is seeing stabilization in business PCs, which grew again this quarter and drove Pro revenue growth of 6%. The company also saw better than expected performance in the consumer part of business.

Non-Pro revenue declined 22%, but with several points better than expected. Excluding the impact of China, which continues to have a different dynamics than other emerging markets, non-Pro revenue declined 17%.

Moving to Devices and Consumer other. As a reminder, this segment includes the online marketplaces, advertising, Xbox Studio, Office 365 Home Premium and other consumer products and services. This quarter revenue growth in this segment was driven by both an increase in advertising revenue and also volumes in online marketplaces.

Search advertising revenue grew 47% driven by continued revenue per search improvements and query volume growth. Bing has now grown its share of search queries in the U.S. to 18%. Gross margin declined slightly due to higher royalty costs and also infrastructure cost growth as the company expanded geographic footprint of its services.

Moving to Commercial Business. With all up commercial revenue across both on-premise and cloud services grew 10% this quarter. Notably even as the company invests for growth, it saw gross margin expansion in commercial cloud business.

Across commercial portfolio, the company saw healthy renewal, a continued shift to premium products and strong adoption of its cloud services. Microsoft’s enterprise cloud strategy is resonating with customers and server product revenue grew 12%. SQL Server revenue grew double-digit with SQL Server Premium revenue growing over 30%.

Office products also remained strong and grew 11%. Within this, SharePoint, Exchange and Lync collectively grew double-digits with Lync growing nearly 30%. Helping to drive this demand for Server and Office product is deployment of hybrid cloud solution. This quarter, revenue for the company’s commercial cloud services grew over 100% as services such as Office 365, innovative Azure services for comprehensive cloud solution.

Revenue in the Commercial Licensing segment grew 7% and in Commercial Other segment, revenue grew 28% to $1.6 billion. As a reminder, Corporate and Other is where Microsoft consolidates adjustments for tech guarantees, pre-sales and the like. In the comparable quarter of last year, the company had aggregate deferrals of $1.4 billion for Windows and Office and this quarter deferred $113 million, primarily related to Windows 8.1 pre-sale.

Future Outlook

Devices and Consumer

In Licensing, Microsoft expects revenue to be $5.2 billion to $5.4 billion. This range reflects similar dynamics to what the company saw in the first quarter. As noted earlier, the company expects the business PC market to be stable; however, the consumer PC market is subject to more volatility.

In Hardware, the company expects revenue to grow 35% to 45% to $3.8 billion to $4.1 billion, reflecting the expanded Surface line up and the much anticipated Xbox One launch. The 10 percentage point range reflects variability in device unit volumes. In the consumer hardware business, such variability is not uncommon, especially during launches and the holiday season.

In Devices and Consumer Other, the company expects revenue to be $1.7 billion to $1.8 billion. Search revenue should continue to grow reflecting improved revenue per search and query volume. As a reminder, in Q2 of the prior year, Microsoft launched Halo 4, which contributed $380 million of revenue to this segment.

Commercial

The company expects revenue to grow 9% to 11%, in line with the first quarter.

In Commercial Licensing, Microsoft expects revenue to be $10.7 billion to $10.9 billion, with similar dynamics to what it saw in the first quarter. This includes healthy renewals and strong annuity revenue growth from volume licensing with Software Assurance.

In Commercial Other, the company expects revenue to be $1.7 billion to $1.9 billion, reflecting ongoing momentum in its commercial cloud business and enterprise services. As CIOs increasingly look to capitalize on the opportunities of cloud computing, the management is confident they will continue to look to Microsoft for their IT solutions.

Cost of Revenue

Moving on to cost of revenue, the company expects it to be $7.9 billion to $8.3 billion next quarter. This range primarily relates to the unit variability assumed in hardware revenue.

Operating Expenses

Microsoft expects OpEx to grow 6% to 8%, to $8.5 billion to $8.6 billion. The company also reaffirms its full-year guidance of $31.3 billion to $31.9 billion. The company continues to invest in innovative experiences for its customers while remaining focused on expenses.

Microsoft still expects full year capital expenditures to be about $6.5 billion, even though the company only spent $1.2 billion in the first quarter. Given the nature of the investments, there is variability from quarter-to-quarter due to company’s success based approach as well as the timing of delivery and completion.

The company expects its tax rate for the full year to be between 18% and 20%, depending on its geographical mix of earnings. When adjusting for tech guarantees and product deferrals, Microsoft expects unearned revenue to be roughly in line with historical trends.

Waiting eagerly, the Troublesome Blackberry

‘We don't have to be all things to all people in our market’, said Thorsten Heins, President and CEO, BlackBerry in Q1, no wonder the company wants to sell itself before November falls.

The recent news of Nokia opens its gates to Microsoft created a lot of buzz in the market which left Blackberry eagerly waiting for a prospective buyer. The present situation of Blackberry was quite anticipated as it had opted to raise over a billion dollar by reducing its headcount to build its own Ecosystem. 

Thorsten Heins led Blackberry into a new direction which seemed promising but nothing could keep the company afloat. The fact that Mr. Heins failed to lift up the company, now all eyes are on him if he can at least do the job of selling the company, and if he does, it would be the most profitable thing he might have ever done in quite some time.

At current prices, Bloomberg estimates Heins' compensation package could be worth approximately $44 million if ousted after sale, plus bonus benefits and retirement savings and equity awards may bring in a couple more million for him, the total figure could go as much as $55.6 million. He would be pretty much desperate to look out for a prospective buyer to take in the troublesome Blackberry.

Fairfax Financial and its Chief Executive, Prem Watsa, which hold approximately 11 per cent of BlackBerry, are considered among possible buyers. Watsa resigned from the BlackBerry Board due to potential conflicts of interest.

Blackberry’s worth:

·  By the time this year ends, BlackBerry's pile of cash could be as much as $2.6 billion, which is quite low.

·  Also, if one considers their patents and intellectual property, it could be between $1 billion apiece, or $4 billion in total.

·  The Enterprise Data Network should be about $1.2 billion worth to its highest bidder; and additional software can be at $1.5 billion but, minus the $800 million which is an estimated figure of shuttering its handset business.

·  In total, the Company could be worth between the range of $5.5 billion, or $10.50 per share, or as much as $8.5 billion if broken up.

Key interesting highlights of Blackberry so far:

·  Three of their four regions returned to sequential revenue growth as BlackBerry 10 continues its roll out; Europe, Middle East and Africa their largest regions, represented 43% of revenue in Q1 and was up 9%, North America represented 25% of revenue and was up 30%, Asia Pacific represented 17% of revenue and grew 35%.

·  Blackberry shipped 6.8 million smartphones in the first quarter compared to 6 million in the fourth quarter which represented a 13% increase. Approximately 40% of these devices were BlackBerry 10 devices.

·  BlackBerry 10 is now available across 147 countries including the United States and has been an effective launch product to showcase the renewed and re-engineered BlackBerry 10 experience to both consumers and enterprises.

·  BlackBerry 10 QWERTY devices started its rollout late in the first quarter and with over 320 carrier acceptances completed today.

·  Q10 is now available in 96 countries including the U.S. with 50 more countries expected to launch within Q2.

·  Secure Work Space offers an idea of BYOD mobile security solution providing organization the flexibility to embrace BYOD on multiple platforms without sacrificing security.

·  60% of BlackBerry Fortune 500 customers have already ordered, downloaded or installed BES 10.

·  Generated cash flow from operations of $630 million in Q1 and ended Q1 with $3.1 billion in cash, highest cash position in the past three years.

·  Revenue for the first quarter fiscal 2014 was 3.1 billion, up 15% from the fourth quarter and up approximately 9% from one year ago.

·  Looking at their revenue mix, hardware revenues grew by 33% when compared to the fourth quarter and was approximately $2.2 billion.

·  Service revenue was approximately $794 million or 26% of revenue and was down $153 million or 16% from the fourth quarter. 

Now everyone's guessing who would be the one to acquire Blackberry, the news can come out in the near or not too distant future. 

Nokia Opens its gates to Microsoft

Salo, Finland which is the one of the heart and soul development facilities for the Nokia Lumia Windows phone, will soon become the home ground for Microsoft. Steve Ballmer seemed pretty excited to have a chance to talk about the very bold and exciting deal transaction that they announced today.

Microsoft is acquiring Nokia's phone business, so called mobile phone business as well as its smart device business. Secondly, along with acquisition of Nokia's phone business, Microsoft has also been assigned the right to Nokia's license, IP license with Qualcomm and other key IP licenses.

Ballmer said they are licensing not buying, ‘we are licensing Nokia's patents to be able to use them not only with our Windows phone and other phone product lines but across the Microsoft product set’. And also mentioned Nokia brings significant expertise in areas such as supply chain and demand planning and has mature operational systems in place that will be a key asset for the combined entities.

They are licensing the ability to use Nokia's HERE mapping geospatial location service to use that and modify it broadly in their products. Nokia Company will continue under the Nokia name. It retains the NSN business which is a network infrastructure business, its location and mapping business, its CTO office and the patent licensing business that goes along with the advanced technology work they are doing.

Nokia ships well over 200 million phones a year, the vast majority of those are mobile or feature phones that get sold for prices as low as say $25 and are often the first connection with technology that people in many places in the world have with any kind of communications or information technology device.

Mr. Ballmer said he is pleased to be acquiring the full capability of Nokia in phones, from mobile phone the smart devices, from engineering, to marketing, manufacturing, supply chain management and the like.

Nokia is a phenomenal company that Microsoft really had a chance to work with and got to know over the last two and half years. They knew the company earlier, but the working partnership has been quite remarkable.

Ballmer pointed out a few key points in his remarks.

We know we need to accelerate. We're not confused about that and we see opportunities to do so. We want to strengthen the overall opportunity for Microsoft from a devices and services perspective and the opportunity for our partners as well.  We are going about why this is a smart acquisition. It is a smart acquisition from a financial and assets perspective.

Today they have the Best Selling Lumia 520 at an entry level price point, the 620, the 720, the 820, the 920 which was voted smartphone of the year by Engadget's readers, the same year the iPhone 5 and Galaxy S3 launched and now the best camera phone in the world, the Lumia 1020. In just over two years, Nokia has gone from shipping no Windows phones to now shipping 7.4 million last quarter.

The Nokia windows phone momentum has made windows phone the fastest growing mobile platform with 78% year-over-year growth. Every quarter for the past eight quarters, more customers have activated windows phones than in the prior quarter. Microsoft is building momentum, but they still have a low share today.

Nokia's mobile phone division reaches a whole new customer segment from Microsoft shipping over 53 million phones last quarter. Terry Myerson, Executive Vice President, Operating Systems said, ‘We are excited to partner with this team to bring the next billion people on to the Internet. In the area of imaging, the Lumia 1020 has no equal’.

Some Financial Aspects of the Acquisition Deal:

First, Microsoft is paying €3.79 billion for Nokia's devices and services business, which includes thousands of design patents, key brands. Additionally €1.65 billion is being paid to license Nokia's broad intellectual property portfolio for 10 years with an option to convert to a perpetual license.

Microsoft expects this deal to have a negative $0.08 impact on adjusted basis and a $0.12 impact to GAAP earnings per share in fiscal 2014 based on the close date in early calendar 2014. The smartphone market is expected to reach over 1.7 billion units a year.

By owning the devices and services business, Microsoft will now be able to capture and utilize the entire growth profit of the device, which for Lumia was about $3 per unit in Nokia's most recent quarter. Using assumptions that are in line with industry forecast and current performance and trajectory, after it is integrated into Microsoft, we estimate that they will achieve operating income break even for this business when they sell approximately 50 million smart devices a year.

Nokia sold over 53 million mobile phone units in their second quarter and their strength in growth markets creates a unique opportunity for Microsoft to reach these users as they transition to smartphones.

Mr. Ballmer ended his speech saying, ‘The Lumia Windows phones in the market are some of the best products Microsoft has ever built in terms of capability, design, quality. We are very, very firm in our commitment and belief’.

So one of the things which I think we are more sort of acutely focusing on is, how do companies really make big acquisitions work? Only time can tell. And since we all know that Steve Ballmer is retiring, I personally feel he is going to be remembered for this acquisition along with numerous feathers on his hat. Wish him Luck.