In its third quarter of its 2017 financial year, Microsoft posted revenue of $22.1 billion, up 8 percent year-on-year, with an operating income of $5.6 billion, up 6 percent on a year ago; net income of $5.7 billion, up 28 percent; and earnings per share of $0.61, an increase of 30 percent over the same quarter a year ago.
As ever, Microsoft also offered alternative figures that book Windows 10 revenue up front instead of amortized over several years and hold exchange rates constant to remove the impact of rate fluctuations year-on-year (which gives some indication of year-to-year changes in actual sales transactions, if not of money in the bank). This quarter the currency differences are for the most part small, with an impact of only about 1 percent (the dollar was weaker than Microsoft expected), but Windows revenue deferral continues to be significant. Under these adjusted figures, revenue was $23.6 billion, up 7 percent; operating income was $7.1 billion, up 5 percent; net income was $5.7 billion, an increase of 16 percent; and earnings per share were $0.73, a 19 percent increase.
Microsoft currently has three reporting segments: Productivity and Business Processes (covering Office, Exchange, SharePoint, Skype, and Dynamics), Intelligent Cloud (including Azure, Windows Server, SQL Server, Visual Studio, and Enterprise Services), and More Personal Computing (covering Windows, hardware, and Xbox, as well as search and advertising).
The period January 1 through March 31 represented the first full quarter of Microsoft’s ownership of LinkedIn. LinkedIn’s numbers are accumulated within the Productivity and Business Processes group, but Microsoft is also breaking them out separately. The social networking site had revenue of $1.0 billion, with a cost of revenue of $0.4 billion and operating expenses of $1.0 billion, for an operating loss of $0.4 billion.
The Productivity group as a whole reported revenue of $7.96 billion, up 22 percent year-on-year. $1.0 billion of that revenue, or 15 of those 22 points of growth, came from LinkedIn, so even the longstanding businesses did well and were up 7 percent. Operating income was $2.8 billion, down 7 percent. Without LinkedIn’s contribution, it would have been up 6 percent. Commercial Office products and services revenue was up 7 percent overall. On the upside, Office 365 revenue was up 45 percent, and the number of commercial Office 365 seats grew by 35 percent, for the first time passing 100 million monthly active users. Commercial non-cloud Office revenue was down 13 percent, however, as a result of the shift to cloud products.
On the consumer side, overall Office and Office 365 revenue was up 15 percent, with 26.2 million Office 365 subscribers. This is up 1.3 million quarter-on-quarter.
The Cloud group reported revenue of $6.8 billion, up 11 percent year-on-year, with operating income of $2.2 billion, unchanged year-on-year. The growth was attributed to growth in both cloud services and server products; the flat operating income was due to increased operating expenses in sales, engineering, and developer engagement. Server product revenue was up 6 percent, and Azure revenue was up 93 percent. Enterprise Services revenue, however, was down 1 percent, due to a decline in support agreements for Windows Server 2003, partially offset by growth in consulting services.
Across enterprise and consumer, the cloud business remains a strong growth area, although the continued near-doubling of Azure revenue continues to be suggestive that the absolute revenue of that group is low. In aggregate, the company claims that its cloud annualized run rate is now $15.2 billion (up $1.2 billion on the previous quarter).
The Personal Computing group reported revenue of $8.9 billion, down 7 percent, with operating income of $2.1 billion, an increase of 20 percent. The Windows numbers suggest a stabilization of the PC market: Windows Pro OEM revenue was up 10 percent, and non-Pro down just 1 percent. In both cases, Microsoft says that this is outperforming (respectively) the commercial and consumer PC markets. Windows subscription revenue was up 6 percent. Overall gaming revenue was up 4 percent on the back of 7 percent growth in Xbox software sales, and Xbox Live monthly active users were up 13 percent. Search revenue was also up 8 percent, thanks to higher search volume and higher revenue per search.
But the hardware story was unhappy. Phone revenue was down $0.7 billion; it’s now essentially wiped out, with Microsoft reporting “no material phone revenue” in the quarter, and “negligible” revenue expected for next quarter.
Surface revenue was also down, falling 26 percent due to increased competition and what Microsoft called “product end-of-lifecycle dynamics.” The 10Q document spells this out rather more clearly: fewer Surface devices were sold.
This is not altogether surprising. On the one hand, the mainstay product of the Surface line—the Surface Pro 4—is looking increasingly long in the tooth. It hasn’t been updated to use a Kaby Lake processor, nor to support USB Type-C or Thunderbolt 3. When Surface Pro was a new product, this might have been tolerable, because there were few similar systems on the market. Today, however, companies including Samsung, HP, Dell, and Lenovo all offer broadly comparable 2-in-1 machines.
Surface is looking quite ignored. Microsoft is having an event in New York City next week, and, though the event has an education focus, there is some hardware element to it, but sources close to the matter tell us that neither a refreshed Surface Pro nor a refreshed Surface Book are going to be launched next week. With its hardware looking increasingly old and competition better than ever, further decline of the Surface business seems inevitable. Microsoft’s outlook for the next quarter concurs, though it does not expect the decline to be as steep as it was this quarter.
Overall, the quarter told a similar story to previous ones. The transition from perpetual licenses to cloud subscriptions is steady, and Microsoft’s cloud services are strong. But the numbers continue to have frustrating gaps. For example, the aggregation of Office 365 revenue—which spans not just Exchange, SharePoint, and other cloud-hosted services, but also (for many subscribers) on-premises Office 2016 ProPlus software—with Azure revenue means that two very different things are being combined. Microsoft is continuing to build large, expensive data centers dotted around the world, but there’s no clear reporting of what the associated capital and operational expenditure is. Nor is there any good indication of how cloud revenue (and expenses) are split between Azure, Office 365, Dynamics 365, Bing, and Xbox Live.
As such, it continues to be difficult to tell whether the cloud business is strong across the board or if the revenue growth is primarily driven by a move from perpetual Office licenses to recurring subscriptions. With large-scale movement from on-premises installations to the cloud, we’d expect to see some degree of cannibalization between Office 365 and on-premises Exchange and SharePoint, and Azure and on-premises Windows Server and SQL Server. Such trade-offs won’t be one-for-one—companies may well add new cloud workloads in addition to, rather than instead of, their on-premises deployments—but we’d certainly expect to see some movement. Thus far, it’s not clear that we are. Azure is a solid cloud platform with a number of compelling features; we’re just left with little idea of how big it actually is.