Earnings show Microsoft is adapting well to changing market

Microsoft just released its earnings, indicating it had a good quarter ($20.6 billion revenues with income of $3.1 billion) that exceeded expectations. Indeed, Microsoft seems to be making many right moves to take advantage of a changing marketplace. But what does an analysis of Microsoft’s earnings tell us about the larger marketplace?

Windows

Microsoft’s reliance on Windows sales still accounts for a major portion of its revenues (about one third), although a few years ago it accounted for the majority share of revenues. Windows sales were essentially flat overall, but there a few bright spots. Commercial PC sales were up slightly, resulting in more Pro licenses, which were up 2 percent. This is aligned with what Intel said about its recent earnings, which is that enterprises are starting to refresh systems, including deploying Windows 10. This is in line with what I’ve seen as well. And while consumer PC sales have been stagnant, the sales we are seeing seem to involve higher-value machines that translate into higher-level licenses for Microsoft.

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So the PC space is still stagnant but overall not as bad as some had predicted. I expect more companies will migrate to Windows 10 over the next 6-12 months, and that will mean more enterprise PC refresh, as most companies will buy new machines rather than upgrade just the OS. And the new form factors available to consumers this year should mean a reasonable holiday shopping season, with higher-end PCs bringing average sales prices up over the bargain basement pricing of years past.

Cloud

Microsoft showed substantial growth in its Azure cloud services (102 percent) and has become a real alternative to AWS. This is a strong endorsement of the Microsoft strategy of concentrating on value-added services for its key enterprise market rather than trying to take on AWS as a general purpose cloud platform. Indeed, for many enterprises, Azure is now the preferred platform for cloud and hybrid deployments.

Additionally, the shift to online services like Office 365 is progressing rapidly — and even more rapidly in the consumer space than I had expected (revenues up 19 percent). Businesses are moving towards online for Office (revenues up 5 percent) rather than buying installed packages/licenses for each machine and are extending this to include Dynamics 365 (up 6 percent) for other business back office processes. This phenomenon is industry-wide and is affecting all app providers.

In the short term, this shift to online services means lower revenues for Microsoft, as the total immediate income is less. But long term, this is good for Microsoft, as it obtains a recurring revenue stream. And by spending less on installed software, enterprises free up capital to invest in new areas like IoT, AI, app migration, etc., all areas that Microsoft and others have targeted for future growth.

Xbox

Gaming is moving to the cloud and being driven by Android and iOS mobile devices, resulting in a reduction in the sale of hardware Xboxes (down 33 percent). At the same time, online Xbox Live gaming on smartphones and other platforms grew by 4 percent. I expect a continued decline in physical Xbox sales concurrent to strong growth in cloud-based gaming. The market is changing mostly from a dedicated hardware platform for gaming to a general purpose cloud-based model, and generic devices are now powerful enough in most cases to allow satisfying game-play.

This trend will continue long-term and will ultimately be positive for Microsoft, as recurring subscriptions will help it make investments that it needs to remain competitive. And the continued cross platform transition, and away from its Windows-only approach of a couple of years ago, should continue to make Microsoft a strong competitor in online gaming and general entertainment on all platforms that matter, not just its own dedicated hardware.

But the decline in specialized gaming devices does have some negative implications for other chip suppliers. As we move to more online gaming and rely less on “souped-up” hardware in game consoles, the number of graphics chips AMD and Nvidia will sell into this space will fall. Certainly there remains a “gamers” market, but the reduction in game console sales could affect AMD in particular as it is a primary supplier for Xbox.

Devices

The one bright spot in devices is that sales of Surface Pro and Surface book were up substantially, with revenues for Surface up 9 percent year-over-year. Of course, this is the same group that sells the Microsoft Windows phone, and the number of phones sold is dropping precipitously. Phone revenues fell 71 percent YoY. This is a clear indication of how hard it is to make money in the smartphone business unless you have immense scale, with few companies able to do that. Indeed, Windows’ share of the phone market is a rounding error compared to Android and iOS’s. While Microsoft is selling its loss-prone feature phone business, the Surface hardware device business is not something that will create huge revenues for the company. But it is important in that it provides Microsoft with the ability to produce high margin “halo devices” that can drive innovation in the rest of the industry (much like Google does in mobile devices). I don’t see Microsoft exiting this business anytime soon.

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All in all, I think it was a good quarter for Microsoft, as it pivots to new businesses and business models. Clearly the transition is still a work in progress. But like the general market, the digital transformation to a cloud and services oriented ecosystem will take some time and cause some disruptions. Still, Microsoft’s latest earnings show that the transition is well underway, and there won’t be as many bodies along the side of the road as some people thought.

Jack Gold is the founder and principal analyst at J.Gold Associates, LLC., a technology analyst firm based in Northborough, MA., covering the many aspects of business and consumer computing and emerging technologies. Follow him on Twitter @jckgld or LinkedIn at https://www.linkedin.com/in/jckgld.