Microsoft revenue dips, Windows shows signs of recovery

Microsoft at an event in 2016Jack Narcotta, senior analyst at TBR, says Microsoft’s Windows business is showing signs of recovery as PC OEMs find success in commercial and premium consumer PC markets.

Microsoft revenue fell 7 percent to $20.61 billion with a profit of $3.12 billion in Q4 ended June 30, 2016.

Microsoft appears to have shed most of the lingering effects of declining Windows licensing revenue that hampered its performance over the last two years. The maturation of the Windows 10 operating system is helping PC OEMs in commercial markets more effectively sell Windows Pro licenses with new PCs, and a broader range of Windows 10powered premium 2-in-1 and thin-and-light notebook PCs are garnering the attention of consumers, lifting Windows’ non-Pro license revenues.

While global PC demand remains weakened, pockets of growth are emerging in these premium consumer and commercial PC segments. While year-to-year revenue growth in its Productivity and Business Processes and Intelligent Cloud Segments shows Microsoft’s footprint in cloud markets is expanding, but Windows remains near the center of its value proposition to consumers and businesses.

“This past year was pivotal in both our own transformation and in partnering with our customers who are navigating their own digital transformations,” said Satya Nadella, chief executive officer at Microsoft. “The Microsoft Cloud is seeing significant customer momentum and we’re well positioned to reach new opportunities in the year ahead.”

Microsoft’s overall revenue declined 7.1 percent year-to-year to $20.6 billion in 2Q16, and gross profit declined 14.1 percent from 2Q15 to $12.6 billion. Operating profit improved 250 percent year-to-year to $3.1 billion, but the gain was due entirely to an unfavorable comparison with 2Q15, which absorbed a significant write-down of the Nokia handset business.

Excluding 2Q15, operating profit in 2Q16 was Microsoft’s lowest quarterly operating income in nearly four years, a function of the greater sales, marketing and research and development investments Microsoft has made to catch up to rivals in cloud markets. However, declines across these metrics would have been less were it not for the impact of foreign currency exchange rates, and the volume of revenue and profit are clear indicators of Microsoft’s ability to generate handsome margins in competitive markets.

TBR believes OEMs are moving to capitalize on greater demand for commercial notebooks and premium consumer 2-in-1 PCs, focusing on building customer loyalty and brand strength for both the OEMs themselves and Windows that promises to accelerate refreshes of older models and encourage sales of new, higher-priced devices. While TBR believes 2Q16 is an incremental step for Windows revenue recovery, it is a step forward nonetheless.

Premium consumers and commercial PCs are emerging as valuable assets to Windows’ recovery efforts

In PC markets, the challenges that have persisted over the last few years to halt Windows revenue decline are receding as Windows 10 gains momentum in growing markets such as premium notebook PCs and commercial PCs. Microsoft’s More Personal Computing segment, of which TBR estimates Windows OEM license revenue accounted for approximately 65 percent of segment revenue, declined 3.7 percent year-to-year to $8.9 billion, but plummeting Phone sales were responsible for the majority of the decline. Surface PC revenue climbed 8.6 percent year-to-year to $964 million, which in turn helped boost both non-Pro and Pro Windows license sales from 2Q15.

Microsoft’s announcement in early July 2016 that it expects to miss its goal of 1 billion Windows device users by 2018 illustrates how the company will be challenged to transform short-term momentum from Windows 10 adoption into sustainable growth. While Microsoft is attributing some of the expected miss to selling its Windows-powered phone business to FIH Mobile, a subsidiary of Taiwan-based contract manufacturer Foxconn, TBR believes slower PC sales forecasted beyond 2017 are also a contributor.

However, TBR believes the end of the year-long trial period on July 29, 2016, for enterprises of Windows 10 – after July 29 enterprises downloading Windows 10 will be charged a subscription fee of $7 per month, per seat – will help spur Windows license purchases among enterprises, helping fill some of the revenue and profit gap created by fewer PCs shipped, and continuing to shift Windows’ overall product mix to more lucrative Pro licenses.

The end of Nokia’s feature phone business is a new beginning in mobile device markets for Microsoft

Despite significant investments and strong commitments to revitalize the Windows Phone business after acquiring Nokia’s handset business for $7.2 billion in 2014, Microsoft’s mobile segment floundered against Android OEMs and Apple, and as recently as calendar 1Q16 feature phones accounted for nearly 40 percent of Microsoft’s total handset revenue and nearly 80 percent of unit shipments, ratios significantly out-of-sync with global market trends and competitors. Selling the feature phone business to FIH Mobile, laying off nearly 9,000 employees since 2015 and writing down more than $8 billion Nokia-related assets were not surprises. Microsoft’s future in mobile is in software, not hardware.

However, while Windows-powered smartphones have a trivial presence in the global smartphone marketplace compared to iOS or Android devices, TBR believes Microsoft’s software-first go-to-market strategy will create new opportunities for Microsoft. A hardware-agnostic approach promises greater interoperability of Windows PCs with Android and iOS ecosystems, broadening the appeal of Windows PCs or other Microsoft connected device, especially in enterprise markets where user mobility across all devices is becoming a priority.

A Surface Phone may appear as an alternative to BlackBerry and a reference design for potential OEMs, but TBR believes Microsoft will not pursue that device to the degree it has built out its Surface PC business; price wars in the PC market are ending and the mobile market is filled with volatility and hyper-aggressive competition. Instead, TBR believes will focus on supporting PC OEMs’ efforts to capitalize on the growing demand for cross-device access, helping fortify the value propositions of cross-device Windows services such as Continuum, as well as Continuum-ready devices such as HP Inc.’s Elite x3 handset, released in July 2016.

Jack Narcotta, senior analyst at TBR

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