Microsoft (MSFT) Tops Q3 Earnings And Revenue Estimates

Microsoft Corporation (NASDAQ:MSFT) reported third-quarter fiscal 2017 earnings (adjusted for Windows 10 deferrals and currency effect) of 73 cents per share, which beat the Zacks Consensus Estimate by 4 cents. Earnings per share (EPS) increased 15% year over year but declined 12% on a sequential basis.

Revenues (adjusted for Windows 10 deferrals) of $23.56 billion decreased 9.6% sequentially but increased 6.3% from the year-ago quarter (up 7% in constant currency or CC). Further, it exceeded the Zacks Consensus Estimate of $23.55 billion.

Encouragingly, annuity-based revenue continued to grow indicating that the user base continues to migrate to the cloud. We note that strong cloud growth has helped Microsoft to outperform the S&P 500 on a year-to-date basis. While the company has gained 8.1%, the S&P 500 witnessed an increase of 6.7%.

Segment Details

Productivity & Business Processes includes the Office and Dynamics CRM businesses. Revenues increased 7.8% sequentially and 22% (up 23% CC) on a year-over-year basis to $7.96 billion.

The Commercial business (products + Office 365 & related cloud services) revenue was up 7% from year-ago level (up 8% CC). Office 365 commercial revenue grew 45% (same at CC). Office 365 saw commercial seat growth of 35% from the year-ago quarter.

Based on the improving features and capabilities of Office 365, the company is winning customers like H&R Block (NYSE:HRB), Johnson & Johnson (NYSE:JNJ) , and Louis Vuitton.

The company also noted that Microsoft Teams, a new chat-based workspace for Office 365, which was launched in the previous quarter, is now available in 181 markets. Microsoft Teams was selected by the likes of Accenture (NYSE:ACN) , J. Walter Thompson, J.B. Hunt and Expedia (NASDAQ:EXPE) in the quarter.

Consumer business revenues grew 15% (up 14% CC) year over year in the quarter. Office 365 consumer subscriptions are now at 26.2 million, up from 24.9 million in the previous quarter.

Dynamics and cloud services revenues jumped 10% (up 11% CC). Dynamics 365 revenues soared 81% (up 82% CC). LinkedIn (NYSE:LNKD) contributed revenues of $975 million in the quarter.

Intelligent Cloud includes server, and enterprise products and services. The segment reported revenues of $6.76 billion, which was down 1.4% sequentially but up 10.9% (up 12% in CC) year over year. Commercial cloud annualized revenue run rate grew 52% to $15.2 billion in the quarter.

Server product and cloud services revenues went up 15% year over year (up 16% CC). Annuity revenues grew double digits. The high point was Azure revenues, which soared 94% at CC year over year. Microsoft noted that Azure premium revenues grew triple digits for the 11th consecutive quarter, with more than 80% of Azure customers using the premium services.

Adoption remains strong as evident from the growing customer base. We note that companies across diversified fields are selecting Azure to get effective results. Azure has been selected by the likes of Maersk (for supply chain management), UBS (for risk management), GEICO (for hybrid capabilities), Publicis Groupe (for developing marketing solutions) and others in recent times.

Meanwhile, enterprise service revenues slipped 1% (same at CC) in the reported quarter, due to a lower volume of Windows Server 2003 custom support agreements.

More Personal Computing comprises mainly the Windows, Gaming, Devices and Search businesses. Revenues plunged 25.3% sequentially and 7.4% (down 7% CC) year over year to $8.84 billion.

Windows OEM pro revenues increased 10% year over year, while non pro-revenues decreased 1%. Windows commercial products and cloud services revenues increased 6% on a year-over-year basis (same at CC) backed by healthy enterprise demand as customers continued to deploy Windows 10 for its advanced security and management capabilities.

Adoption rate remained strong for Windows 10 with customers like Department of Education in the U.K, British Telecommunications and the Adventist Health System deploying the same during the quarter.

Gaming revenues increased 6% in CC. Xbox Live monthly active users were up 13% to 52 million active users. During the quarter, the company unveiled Project Scorpio, its upcoming gaming console that supports 4K technology.

Surface revenues decreased 26% (down 25% CC) from the year-ago quarter due to intensified competition. The company noted that it has strong growth opportunity in the mixed-reality market with Microsoft HoloLens as adoption strengthens.

Search excluding traffic acquisition costs (TAC) revenue grew 8% (up 9% CC) as both search volume and revenue per search (RPS) improved.

Operating Results

Microsoft’s gross margin of 63.5% expanded 460 basis points (bps) sequentially and 110 bps from the year-ago quarter, primarily owing to favorable revenue mix along with commercial cloud margin improvement.

In dollar terms, gross profit decreased 1.1% sequentially but increased 9.5% year over year to $14.03 billion. The growth in gross profit dollars by segment was as follows: Productivity up 17% CC (increased mix of cloud offerings and investments in cloud were drivers), Intelligent Cloud 7% CC (again a result of increased mix of cloud offerings) and More Personal Computing 2% CC (gaming, search and Windows OEM were drivers partially offset by surface).

Operating expenses (excluding Impairment, integration, and restructuring costs) of $8.44 billion were up 5.3% sequentially and 12.1% from the year-ago quarter. The year-over-year growth was primarily due to LinkedIn related acquisition charges. As percentage of revenues, operating expenses increased 490 bps on a sequential basis and 150 bps from the year-ago quarter.

As a result, operating margin contracted 30 bps sequentially and 40 bps on a year-over-year basis to 25.6%.

The operating margin by segment was as follows: Productivity 35% (down by 9.1% sequentially and 10.1% year over year); Intelligent Cloud 32.2% (down 270 bps sequentially and 340 bps year over year) and More Personal Computing 23.7% (up 260 bps sequentially and 540 bps year over year).

Balance Sheet

Microsoft ended with cash and short-term investments balance of $136.9 billion, down $10.9 billion during the quarter. The company returned $4.6 billion to shareholders in the form of share repurchases and dividends in the reported quarter.

Guidance

Management now expects foreign exchange to impact revenues by 1% in the fourth quarter.

Microsoft anticipates commercial cloud services to continue to drive annuity growth, on the back of expanding installed base, growing consumption and higher number of renewals. Management forecasts commercial unearned revenues of $26.8–$27 billion, in line with historical seasonality.

For the fourth quarter, Microsoft expects Productivity & Business Process revenues of $8.2–$8.4 billion (2% impact from currency), Intelligent Cloud revenues of $7.2–$7.4 billion (2% impact from currency) and More Personal Computing revenues of around $8.4–$8.7 billion (1% impact from currency).

LinkedIn is expected to contribute revenues of almost $1.05 billion in the quarter.

Microsoft expects COGS of $8.2–$8.3 billion and operating expenses of $9.1–$9.2 billion. Capital expenditure is anticipated to grow sequentially and on year-over-year basis.

Management said that fiscal 2017 operating expenses would be $32.9–$33 billion (down from $33.1–$33.3 billion) as investments in strategic growth opportunities continue.

Zacks Rank

Microsoft currently carries a Zacks Rank #4 (Sell).

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Zacks' Hidden Trades

While we share many recommendations and ideas with the public, certain moves are hidden from everyone but selected members of our portfolio services. Would you like to peek behind the curtain today and view them?

Starting now, for the next month, I invite you to follow all Zacks' private buys and sells in real time from value to momentum...from stocks under $10 to ETF to option movers...from insider trades to companies that are about to report positive earnings surprises (we've called them with 80%+ accuracy). You can even look inside portfolios so exclusive that they are normally closed to new investors. Click here for Zacks' secret trade>>