Behind the Numbers: Microsoft Continues Its Transition to the Cloud

Behind the Numbers: Microsoft Continues Its Transition to the Cloud
Photo credit: Paul Thurrott

On Tuesday, Microsoft announced financial results for its fiscal fourth quarter: net income of $3.1 billion on revenues of $22.6 billion. For the full year, the software giant earned a net income of $16.8 billion on revenues of $85.3 billion.

The results cement Microsoft’s transition from a maker of traditionally-delivered software—mostly Windows and Office—to one of the premier providers of cloud services, especially for businesses. Fully two-thirds of Microsoft’s revenues are now derived from cloud-based services, and this part of its business is steadily growing.

While we’ve already covered the news around this announcement, I’d like to dive a bit deeper into the numbers and see what Microsoft really revealed about the strength and evolution of its business. This is based on the supporting financial documentation Microsoft has provided and its post-earnings conference call with analysts and the press.

A few thoughts.

Cloud transition comes with a cost. Transitioning a business as big and complex as Microsoft is by definition difficult and expensive. But in this case specifically, the move to the cloud is a double-edged sword. On the one hand, the steady cadence of subscription-based services will provide a financial stability that was never possible when it shipped “big bang” Windows and Office releases only every three years or so. But cloud services also come with a higher cost of revenues, because Microsoft needs to build out its infrastructure globally. And that reality, ironically, will result in less financial stability during the transition period especially.

Cloud services revenues are experiencing explosive growth. These numbers should eliminate any doubt that Microsoft’s focus on cloud services is the right one. Azure revenues are up over 100 percent. Office 365 revenues are up by 54 percent for businesses, and by 19 percent for consumers. Microsoft’s cloud businesses—which are encompassed by its Intelligent Cloud and Productivity and Business Processes segments—accounted for $13.7 billion of Microsoft’s $20.6 billion in quarterly (GAAP) revenues. All told, Microsoft says its cloud services are on a $10 billion annual run rate, and its goal is to hit $20 billion annually by 2018.

Microsoft’s overall business actually grew year-over-year. If you compare this quarter’s revenues to the same quarter a year ago, you will see a modest decline of 7 percent. One might assume that this decline is related to the lower margins (but steadier income) Microsoft derives from cloud services. But most of the difference is attributed to a $2 billion revenue deferral related to Windows 10, and if we examine revenues without that deferral, we actually see a gain over last year. And, as important, that Microsoft actually beat analyst expectations.

Windows 10 has been a mixed blessing so far. Windows 10 is Microsoft’s strongest Windows release in several years, but its decision to give the OS away for free to upgraders for one year is controversial and has had some negative effects on Microsoft’s earnings. (Not helping matter, the gambit hasn’t paid off, either: The software giant admitted last week that it would not meet its goal of 1 billion active Windows 10 devices within 2-3 years of the initial release.) Windows Pro revenue grew only 2 percent in the quarter, but Windows consumer revenue jumped 27 percent. Which sounds good until you realize that we’re comparing sales to the quarter last year right before Windows 10 was released. But the real damage can be seen in the full year results: In Windows 10’s first year in market, Windows Pro sales are down 21 percent and Windows consumer sales are down 27 percent. Yikes.

Microsoft’s phone hardware business is dead. In the year-ago quarter, Microsoft posted a loss thanks to $8.4 billion in charges related to a write-down of its phone hardware business. Since then, the pain has only continued: Microsoft is no longer even trying to sell phones, and it has declined for the first time to even report how many units it actually did sell in the previous quarter. But phone revenues declined an incredible 71 percent year over year, and Microsoft posted another $1.1 billion in write-down and restructuring charges in the most recent quarter. In a related 10Q filing, Microsoft essentially states that its phone strategy is to not sell phones, so that it will lose less money on that business. It boggles the mind.

I’m not convinced that Surface is a solid business.Microsoft has never reported Surface unit sales, but Surface revenue in the quarter was up just 9 percent year-over-year, or $76 million. That’s a far cry from the $870 million decrease in phone revenues, and the Surface businesses simply isn’t big enough to make a dent in its phone-related losses. Given the low margins of hardware sales and Microsoft’s historic quality problems, it’s unclear to me that Surface is a viable long-term business. And with the transition to the cloud, one might make an excellent case that Microsoft should no longer make hardware at some point.

Microsoft announcing two new Xbox One models suddenly makes sense. At a recent industry conference, Microsoft announced two new Xbox One consoles, the Xbox One S, which ships next month, and a next-generation Xbox “Scorpio” console, which will arrive in time for the holiday 2017 selling season. Now we know why: Xbox revenue declined 9 percent in the quarter thanks to low console sales, while Xbox Live growth was attributed almost entirely to Windows 10, not the Xbox One. Clearly, Microsoft is hoping to balance out short-term Xbox revenues by releasing a steady stream of hardware upgrades alongside games and related services. And by transitioning Xbox to be more of a service that works across different device types, including consoles, PCs and tablets.