Microsoft Stock Surges To Post Dotcom High On Earnings Beat

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Software giant Microsoft (NASDAQ:MSFT) has delivered impressive Q1 FY 16 results which has topped consensus estimates. The company has reported non-GAAP revenue of 21.7 billion, representing a 6.5% Y/Y decline and non-GAAP net income of $5.4 billion and non-GAAP EPS of $0.67. On a GAAP basis, Microsoft reported revenue of $20.4 billion, 12% lower than the prior year; net income of $4.6 billion compared to $4.54 billion a year ago and EPS of $0.57, 5.6% better than last year’s comparable period. The huge disparity between GAAP and non-GAAP results highlight the big negative effect that FX headwinds are continuing to have on Microsoft.

Microsoft hiked its quarterly dividend to $0.36 and bought back shares worth $6.9 billion during the quarter.

Luckily, the market was prepared for the FX impact. Microsoft stock is up 10% to $52.87, its highest since March 2000, as the investing world gave the thumbs up to the company.

Segment Revenues

A more comprehensive look into Microsoft earnings result can be seen below:

Source: Microsoft

Microsoft reorganized its segments for the second time in three years. Its results now fall under three main segments:

1. Intelligent Cloud: This consists of a)Server products and cloud services, b) Azure revenue, and c)Enterprise mobility
2. Productivity and Business Processes: This segment consists of a) Office Commercial Products and b)Dynamic CRM.
3. More Personal Computing: This segment consists of a) Windows OEM, b)Phone Revenue, c)Search Advertising Revenue and d)Xbox Live.

Segment results were a mixed bag. Overall, Intelligent Cloud grew 8% Y/Y to $5.9 billion; Productivity and Business Processes revenue fell 3% Y/Y to $6.3 billion while Personal Computing revenue declined 17% to $9.4 billion.

Items of particular note were Office 365, Azure, and Windows OEM. Microsoft said that Office 365 revenue grew nearly 70% in constant currency terms, with an additional 3 million Office 365 users added to the fold to bring up the number to 18.2 million subscribers. Azure revenue and compute usage more than doubled.

Meanwhile, Windows OEM revenue fell 6%, which was better-than-feared, compared to the overall PC market which fell in double-digits during the quarter. Microsoft attributed this to the launch of Windows 10 which helped spur the PC ecosystem innovations as well as drive sale of premium hardware devices. The company said that Windows 10 OS is now installed in 110 million devices.

What the results say about Microsoft’s Cloud Ambitions

The broad takeaway is that although Microsoft’s results will continue to be dragged down in the near future by its huge exposure to the weak PC market, its transition to the cloud is working well. Although Windows OEM revenue decline is responsible for the company’s huge revenue decline due to the sheer size of the segment, strong Office 365 and Azure growth should offset some of the decline and aptly prove that Microsoft’s cloud transition is working according to plan.

But one thing is clear: Microsoft’s move to the cloud will take time to fully take effect as I explained in this article. In the article, I compared Microsoft to Adobe Systems (NASDAQ:ADBE) which recently became the first old-line software company to complete its cloud transition. Adobe was able to complete the move to the cloud in a record three years simply because the company has a much leaner revenue structure with much fewer products in its portfolio compared to Microsoft.

Microsoft’s sheer size dictates that it will take at least a couple of years more before it can become a fully-fledged cloud company. During this transition, you can expect Microsoft’s top line to contract for a few more quarters before stabilizing. This is chiefly because Microsoft will not recognize Windows 10 license revenue on the same scale that it did with prior Windows OSes. Windows revenue used to account for nearly 30% of Microsoft’s top line.

But in future, there is strong possibility that Microsoft might begin to charge for Windows 10 upgrades via the cloud. Microsoft has not said as much but this appears to be the logical direction to go.

Microsoft Stock Has Upside Potential

The fact that Microsoft stock made such strong gains even after the company reported a smaller revenue tells you that investors now understand the company’s game plan. Microsoft stock appears to have limited downside but good upside potential.