Microsoft appears to have shed most of the lingering effects of declining Windows licensing revenue that hampered its performance over the last two years. The maturation of the Windows 10 operating system is helping PC OEMs in commercial markets sell Windows Pro licenses with new PCs more effectively, and a broader range of Windows 10 powered premium 2-in-1 and thin-and-light notebook PCs are garnering the attention of consumers, lifting Windows’ non-Pro license revenues.
While global PC demand remains weakened, pockets of growth are emerging in these premium consumer and commercial PC segments. While year-to-year revenue growth in its Productivity and Business Processes and Intelligent Cloud Segments shows Microsoft’s footprint in cloud markets is expanding, Windows remains near the center of its value proposition to consumers and businesses.
Microsoft’s overall revenue declined 7.1% year-to-year to $20.6 billion in 2Q16, and gross profit declined 14.1% from 2Q15 to $12.6 billion. Operating profit improved 250% year-to-year to $3.1 billion, but the gain was due entirely to an unfavorable comparison with 2Q15, which absorbed a significant write-down of the Nokia handset business.
Excluding 2Q15, operating profit in 2Q16 was Microsoft’s lowest quarterly operating income in nearly four years, a function of the greater sales, marketing and research and development investments Microsoft made to catch up to rivals in cloud markets.
However, declines across these metrics would have been less were it not for the impact of foreign currency exchange rates, and the volume of revenue and profit are clear indicators of Microsoft’s ability to generate handsome margins in competitive markets.
TBR believes OEMs are moving to capitalize on greater demand for commercial notebooks and premium consumer 2-in-1 PCs, focusing on building customer loyalty and brand strength for both the OEMs themselves and Windows that promises to accelerate refreshes of older models and encourage sales of new, higher-priced devices. While TBR believes 2Q16 is an incremental step for Windows revenue recovery, it is a step forward nonetheless.
Premium consumers and commercial PCs are emerging as valuable assets to Windows’ recovery efforts
In PC markets, the challenges that persisted over the last few years to halt Windows revenue decline are receding as Windows 10 gains momentum in growing markets such as premium notebook PCs and commercial PCs. Microsoft’s More Personal Computing segment, of which TBR estimates Windows OEM license revenue accounted for approximately 65% of segment revenue, declined 3.7% year-to-year to $8.9 billion, but plummeting Phone sales were responsible for the majority of the decline. Surface PC revenue climbed 8.6% year-to-year to $964 million, which in turn boosted non-Pro and Pro Windows license sales from 2Q15.
Microsoft’s announcement in early July 2016 that it expects to miss its goal of 1 billion Windows device users by 2018 illustrates how the company will be challenged to transform short-term momentum from Windows 10 adoption into sustainable growth. While Microsoft attributes some of the expected miss to selling its Windows-powered phone business to FIH Mobile, a subsidiary of Taiwan-based contract manufacturer Foxconn, TBR believes slower PC sales forecasted beyond 2017 are also a contributor.
However, TBR believes the end of the year-long trial period on July 29, 2016, for enterprises of Windows 10 — after July 29 enterprises downloading Windows 10 will be charged a subscription fee of $7 per month, per seat — will help spur Windows license purchases among enterprises, helping fill some of the revenue and profit gap created by fewer PCs shipped, and continuing to shift Windows’ overall product mix to more lucrative Pro licenses.
The end of Nokia’s feature phone business is a new beginning in mobile device markets for Microsoft
Despite significant investments and strong commitments to revitalize the Windows Phone business after acquiring Nokia’s handset business for $7.2 billion in 2014, Microsoft’s mobile segment floundered against Android OEMs and Apple, and as recently as CY1Q16 feature phones accounted for nearly 40% of Microsoft’s total handset revenue and nearly 80% of unit shipments, ratios significantly out-of-sync with global market trends and competitors. Selling the feature phone business to FIH Mobile, laying off nearly 9,000 employees since 2015 and writing down more than $8 billion Nokia-related assets were not surprises. Microsoft’s future in mobile is in software, not hardware.
However, while Windows-powered smartphones have a trivial presence in the global smartphone marketplace compared to iOS or Android devices, TBR believes Microsoft’s software-first go-to-market strategy will create opportunities for Microsoft. A hardware-agnostic approach promises greater interoperability of Windows PCs with Android and iOS ecosystems, broadening the appeal of Windows PCs or other Microsoft-connected devices, especially in enterprise markets where user mobility across all devices is becoming a priority.