Microsoft released their second quarter results from fiscal year 2015 today. The holiday quarter saw an 8% rise in revenue over 2014, coming in at $26.47 billion last quarter. However the cost of revenue for the quarter was up almost $2 billion, so the operating income for Q2 2015 fell 2% year-over-year to $7.776 billion, from $7.969 billion a year ago. Net income fell to $5.863 billion, with an increase in total taxes paid due to an IRS audit adjustment, and restructuring expenses which totaled $243 million. Earnings per share was down 9% to $0.71, meeting analysts’ expectations for the quarter, and $4.5 billion was returned to shareholders for Q2.

Breaking down the business, Microsoft has two main segments. Devices and Consumer (D&C) is the business line that focuses on hardware and software aimed at the consumer, and Commercial is the segment aimed at business and enterprise needs. Looking at D&C, it is further broken down into licensing, which includes Windows Phone licensing, Windows OS licensing, and traditional Office sales. Computing and Gaming Hardware is Xbox and Surface lines, Phone Hardware is the new Smartphone business purchased from Nokia last year, and D&C Other includes First-Party games, Xbox Live revenues, Online Advertising, and Office 365 Home, Personal, and Student revenues.

Microsoft Q2 2015 Financial Results (GAAP)
  Q2'2015 Q1'2015 Q2'2014
Revenue (in Billions USD) $26.470 $23.201 $24.519
Operating Income (in Billions USD) $7.776 $5.844 $7.969
Gross Margin (in Billions USD) $16.334 $14.928 $16.197
Net Income (in Billions USD) $5.863 $4.540 $6.558
Margins 61.7% 64.3% 66.1%
Basic Earnings per Share (in USD) $0.71 $0.55 $0.79

Taking a look at D&C Licensing, revenue is down 25% to $4.17 billion, with a gross margin down 22% to $3.88 billion. Both are slightly higher than Q1 2015, but there have been some major changes to Microsoft’s licensing models which directly impact this segment. Windows Phone licensing revenue fell 61% year-over-year, mostly due to the fact that Nokia is no longer paying them for the OS since they have been acquired by Microsoft. In addition, Windows Phone has been moved to no cost licensing. Windows OEM revenue also declined 13%, which Microsoft attributes to a return of the business PC and Pro market returning to a pre-Windows XP end of support level, as well as new lower-priced licensing for devices sold to education institutes. Non-Pro revenue declined 13% due to low price point devices and the new licensing model for low cost products. To cap off the D&C Licensing segment, Office Consumer revenue declined 25% due to the move of users to the subscription based Office 365.

Computing and Gaming Hardware had an 11% year-over-year drop in revenue, down to $4 billion. Gross margin is much lower for hardware, but it did show a 12% gain over 2014, to $460 million. Xbox saw a 20% decline in revenue, however price promotions did drive strong Xbox One sales for the holidays. Xbox 360 sales declined. Surface on the other hand had revenue of $1.1 billion, up 24%, which was driven by Surface Pro 3 and accessories sales. Xbox had a gross margin decline, due to the higher platform costs of Xbox One over Xbox 360 at this point in the product lifecycle, and Surface Pro 3 drove a gross margin improvement.

Moving to phones, Microsoft cracked the 10 million smartphones per quarter number, with 10.5 million Lumias sold, which was up both year-over-year and quarter-over-quarter. The growth has been driven by low cost smartphones, which helps explain the myriad of low-cost devices announced in the past year. Almost 40 million non-Lumia phones were sold, declining over the previous year as the feature phone market dries up. Overall revenue for the quarter was $2.28 billion, with a gross margin of $330 million, or 14%.

The final D&C segment is “Other”, and this division saw a strong gain, with a 30% increase in revenue over last year, up to $2.44 billion. Gross margin was up 42% as well, to $550 million. First-party games had a strong quarter, with revenue up 79%, driven by Minecraft, Halo, and Forza franchises. Xbox Live had revenues up 42%, which is attributed to higher Xbox Live transactions. Online Advertising had search revenue up 23%, due to higher revenue per search and increase search volume, but display advertising revenue declined. The Bing search engine has 19.7% US market share, up 150 basis points over last year. Office 365 continues its strong growth, with 30% more customers than just last quarter. The total number of Office 365 subscribers is now at 9.2 million.

The Commercial segments are next, with this broken into Licensing and Other, with Licensing including volume licensing, Windows Server, and Office, and Other is the cloud based services (and needs to be renamed). Total revenue for commercial grew 5% to $13.27 billion, with the gross margin coming in at a 3% gain to $10.83 billion. Licensing revenue was down slightly to $10.68 billion, a drop of 2% over last year. This was due to a 13% drop in Office commercial sales, a 7% increase in Server product revenue, and a 3% gain in Windows volume licensing. Other revenue was up 46% to $2.59 billion, with Commercial Cloud growing 114% driven by strong sales of Office 365 Business, Azure, and Dynamics CRM Online.

Microsoft Q2 2015 Segment Overview (in Billions USD)
  Q2'2015 Q1'2015 Q2'2014 Percentage for quarter
D&C Licensing Revenue $4.17 $4.09 $5.54 15.8%
D&C Licensing Gross Margin $3.88 $3.82 $4.98 23.8%
D&C Computing and Gaming Hardware Revenue $4.00 $2.45 $4.47 15.1%
D&C Computing and Gaming Hardware Gross Margin $0.46 $0.48 $0.41 2.8%
Phone Hardware Revenue $2.28 $2.61 $1.98 8.6%
Phone Hardware Gross Margin $0.33 $0.48 $0.05 2.0%
D&C Other Revenue $2.44 $1.81 $1.87 9.2%
D&C Other Gross Margin $0.55 $0.31 $0.39 3.4%
Commercial Licensing Revenue $10.68 $9.87 $10.90 40.3%
Commercial Other Revenue $2.59 $2.41 $1.77 9.8%
Commercial Overall Gross Margin $10.83 $9.91 $10.50 66.3%

Commerical is where Microsoft makes its money, with about 66% of their gross margin coming from the commercial segments. Microsoft is well established in the enterprise, and has been very successful at moving those customers to its cloud offerings. Office 365 has been very successful, and they have just announced the Office 365 Government cloud as well with special requirements that will appease that market.

All of the D&C segments have quite low margins except for their Licensing segment, but it saw a sharp decline. Continues price pressure on the operating system has changed the way Windows is licensed, and Microsoft needs to move people to its cloud services to keep the margins up. This has been successful with Office 365, which has gained quite a few subscribers every quarter. To see a 30% gain in just one quarter, at this stage in its life, is pretty strong growth.

On the hardware side, Xbox One has slimmer margins at this point in its life than Xbox 360, driving down gross margin. The 20% decline in revenue was pretty sharp, but last year’s holiday numbers included the initial launch, which had a spike in sales that have not been seen since. Price cuts to the Xbox One have helped sales, but will further cut into the slimmer margins. Surface is a bright spot though, especially after the Surface RT write-down which caused many people to wonder if Microsoft was going to stick with hardware. The Surface Pro 3 can, I think, be called a success, after several iterations that were good devices, but not fantastic. It has had several quarters of strong growth now.

Microsoft missed a couple of analysts’ expectations, with a smaller Unearned revenue and slow sales in China and Japan. They are seeing strong gains in their cloud infrastructure, and have had some success in hardware.

Source: Microsoft Investor Relations

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  • jjj - Monday, January 26, 2015 - link

    Surface had lots of price cuts too and it's unclear how they account for price cuts,they could count the full price as revenue and count the cuts as expenses.
    It's worth pointing out that they provide gross margins not income to hide the loses in certain segments.
    In phones ASP was down hard and they lost a bit of share on quarter so when adding context,it's not actually all that good.Q1 in phones won't be good either ,they have a soft presence in China where Q1 is seasonally strong , the new models are overpriced midrange and low end that are slightly different than existing models but not better or better value.The shift away from the Nokia brand might also harm them more than they expect but devices with the new branding are just starting to show up in retail so it will take a while to see the impact.
  • ppi - Tuesday, January 27, 2015 - link

    Accounting standards do not work in a way, that discount would be reported as separate expense (at most it might be shown as separate line, but still above the revenue subtotal; nobody is however doing it so as discounts are part of sales strategy that you do not want to show off to your competitors). Case example: If your pricelist says something costs $1,000, but you give 70% discount on it, you will recognize revenue of $300.

    M$ reported segments are one of the most detailed of the tech firms (compare to e.g. AMD, Apple).
  • aryonoco - Monday, January 26, 2015 - link

    So the consumer hardware business has low margins and is barely profitable. The consumer software side still has good margins but is on a very sharp decline. Any business that's declining 23% YoY in income is basically a dying business.

    The commercial and the cloud side are very strong and keep getting stronger. Exchange is a massive success, SharePoint is right up there, and others like SQL Server are all doing very well too. Azure has been an unexpected phenomenon, and keeps getting better and better.

    The more I think about it, the more it's evident that Microsoft doesn't need the consumer side that much. I don't have the numbers but on the surface, I'd say a lot more resources (i.e., employees) are tied up on the consumer side than the commercial side, and yet the latter is the one that's growing and widely profitable. Sooner or later, Microsoft has to realise this too.
  • nathanddrews - Tuesday, January 27, 2015 - link

    Hence, free Windows 10.
  • RamarC - Tuesday, January 27, 2015 - link

    MS wants a bigger slice of the consumer side. They want to be relevant in all facets and the consumer potential is growing faster than commercial. MS just needs better vision and management to entice more consumer buy in which would lead to more hardware vendor buy in and get them out of the consumer hardware business.
  • Mayuyu - Saturday, January 31, 2015 - link

    Consumer usage of Microsoft software drives Commercial sales. Free windows 10 for consumers will increase people's familiarity of the new OS. Businesses will be less hesitant to upgrade to the latest version if their employees don't need a lot of training to use the new version.
  • 457R4LDR34DKN07 - Monday, January 26, 2015 - link

    I'm troubled by the direction Microsoft has taken as of late. I think that win 8, 8.1, 10, RT, surface, phone, xbox one, hololens have all been disappointing, They seem to try something wasting a lot of money then abandon the people who support it initially. They are losing previously loyal customers.
  • Drumsticks - Monday, January 26, 2015 - link

    I'm not sure how any of the products you listed except RT are abandoning customers. Windows 8/8.1 will be upgraded to 10, along with phones (unlike WP7, where you'd have a point, minus the technical hurdles involved anyways).

    RT is admittedly a mostly "failed" venture, but I think it accomplished one of the things it set out to do, which was to add further pressure to Intel to get a competitive chip going. It's disappointing that it won't be seeing Windows 10, but it ultimately never had much uptake.

    Also, Surface is a line that's making money now, so I don't see that they're wasting money. It's also well praised by press and public alike, imo. Xbox one is getting more sales, and hololens isn't even a product yet. Where's the money "wasting" occurring in most of those products?
  • 457R4LDR34DKN07 - Monday, January 26, 2015 - link

    3 letters WMC
  • Morawka - Monday, January 26, 2015 - link

    How much did people pay for WMC? They didn't. it was a free product included in windows xp, 7 and a addon option for 8 pro.

    WIth that said, i'm sure windows 10 will have much of the features your looking for. People just wanted microsoft to keep making a free server kernal, and got mad when microsoft stopped updating it.

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