Following Microsoft's Q3 FY2014 earnings report from last night I thought we should take a look at the big picture behind the numbers and address some of the key themes from the company's analyst conference call (which you can find here)
Let's have a quick look at the numbers for Q3. Revenue was $20.4 billion, gross profit was $14.5 billion and operating income was $7.0 billion. While adjusted revenue grew 8%, earnings per share (which came in at $0.68) grew slightly less at 5%.
Clearly Microsoft is not in any kind of financial trouble. I say this despite not exactly being a Microsoft fan. I own and use exactly zero of their products so I'm simply looking at the business as a technology investor here. Microsoft is growing slowly. No, they're not even growing as fast as Apple and they certainly are not growing anywhere close to as fast as deeply mobile companies like Facebook. But they're growing and are on very strong financial footing.
What makes Microsoft unique is its deeply entrenched position into the market. They're also making progress shifting the business model to align with their new "cloud first, mobile first" mantra. Yeah, I know the phrase is already getting tiring, but I think it says a lot about what the PC giant is doing and what they've admitted to themselves.
What have they admitted? I think they know that Apple and Android have the mobile hardware and operating systems pretty well locked up at this point. It's a very tough uphill climb for anyone to compete, including Microsoft. And because the desktop / notebook market will be deeply affected by mobile trends, the Windows OS franchise is not as valuable as it once was.
The solution? Move business IT functions into the cloud and support them from any device whether it runs Windows, Android or iOS. Sell subscriptions to cloud-based software like Office 365 rather than old licenses for Microsoft Office installed on Windows boxes. Sell the infrastructure to build apps in the Azure cloud instead of selling server boxes. Allow corporate clients to downsize their IT departments and pay part of the old equipment and staffing bill to Microsoft instead.
The migration of Microsoft to this new cloud and mobile model is in its very early days, to be clear. The "Commercial Other" line, where all cloud revenue falls, amounted to $1.9 billion, or less than 10% of total company sales in the last quarter. But the big pieces (Azure and Office 365) both grew at least 100%, so by this time next year it's possible Microsoft could be significantly further along in its transformation.
One year ago I was very bearish on Microsoft. I felt they had no chance of being a #1 or #2 in the mobile platform wars, which would hurt them compared to theoretical world where Windows Mobile was the dominant operating system. But I neglected to consider just how powerful Microsoft is with its large enterprise customer base. These are businesses that (generally) move quite slowly when it comes to IT strategy. So Microsoft just needs to move faster than its customers need them to, which I think is happening.
Microsoft is highly profitable and last night they reported $88 billion of cash offset partly by $21 billion of long term debt. They are well equipped, financially, to transform themselves over the next decade. At the end of that decade, it's possible many of its big customers may not use Windows anymore. But if they still use Office (in the cloud) and run enterprise apps via Azure, then Microsoft should make out like a bandit. However, I'm still keeping my eyes open to the possibility of Amazon, Google and others accelerating their competitive efforts against Microsoft.
What's your take? Do you think I'm too concerned about Windows market share erosion? Or maybe I'm not being aggressive enough in describing the risk? What do you think the likelihood is that Nadella's team can radically transform an old-world computing company into a cloud and mobile leader? Is it reasonable to pay 14x next year's earnings for Microsoft at this point in the turnaround when you consider the risks? Drop us a comment.