Microsoft Corp's strategy of selling more long-term software licences to big business customers is helping to cushion the blow from plummeting PC demand and a faltering start for its Windows 8 system. Personal computer sales fell 14 percent in the first three months of the year, just as Microsoft tries to ramp up sales of the latest iteration of Windows. But the company's ability to keep hold of big customers rescued its third-quarter results, which came in better than expected on Thursday.
Microsoft shares rose as much as 5 percent to $30.24 in early morning trading on Friday. The company posted an 18 percent growth in revenue and earnings, well ahead of Wall Street expectations - a seemingly strong performance for a quarter with the worst decline in PC sales on record. But excluding revenue "deferred" from previous quarters, the flagship Windows unit showed zero growth.
"Despite concerns over the PC environment and slower uptake of Windows Phone and Surface tablet devices, MSFT has showed that the work it's done has been paying off," Oppenheimer & Co analyst Shaul Eyal wrote in a research note to clients. "Given the company's ability to show its diversity in a declining PC market, we believe Microsoft is putting in the necessary effort to succeed in the post PC-centric world." Eyal, who has an "outperform" rating on Google's stock, cut his price target to $34 from $36.
Some analysts, however, said declining PC sales remains a concern and the lack of excitement surrounding Windows 8 and Office would weigh on shares in the near term. "Microsoft has successfully transitioned into an enterprise software company and these results show that, because the strength of server and tools and the actual way they sell licenses to business is making up for the missing PC sales," said Kim Caughey Forrest, an analyst at Fort Pitt Capital.
Effectively, Microsoft no longer relies on a new PC to make money from software. Only 20 percent of the company's product revenue comes from computer makers paying license fees to put Windows on their machines. About 45 percent comes from multiyear licensing agreements with customers - generally big companies paying millions of dollars for three-year access to Microsoft's Windows and Office software.
The strength of that model is reflected in Microsoft's total unearned revenue balance - a measure of the strength of its long-term business - which rose 13 percent from a year earlier and now stands at $17.1 billion. "The fact that volume licensing or just the unearned revenue growth is 13 percent year on year, those are impressive numbers," said Sid Parakh, an analyst at investment firm McAdams Wright Ragen. "That's saying that customers are in fact buying into a longer-term roadmap."
Parakh points out that the dire PC numbers collated by industry trackers Gartner and IDC do not reflect sales of Microsoft's Surface tablet - even though they are modest - or users upgrading their software without buying new computers. So even though the rise of new mobile devices is supplanting desktop PCs, the ubiquity of Microsoft's products is not fading.
On top of that, its other business-focused units are performing strongly. The server and tools unit, which makes server software and runs the data centers that enable remote or "cloud" computing, increased sales 11 percent in the quarter, helped by rapid growth in multiyear licensing. Some analysts noted the company's strong growth in its cloud business.
"While Amazon Web Services (AWS) appears to be the 800 pound gorilla in the market today, Microsoft may be one of the few companies capable of competing with AWS' scale," Evercore Partners analyst Kirk Materne wrote in a note. He raised his price target on the stock to $32 from $30. The unit that makes Office - which still owns the corporate software market - posted a 5 percent increase in sales, after discounting some deferred revenue - also helped by growing multiyear deals.
That helped mask the indifferent performance of the Windows unit, which is still the most reliant on a healthy PC ecosystem. Excluding gains from deferred revenue, Microsoft's flagship unit showed no growth at all, disappointing investors hoping for a stronger showing from the new Windows 8 system.
Meanwhile, strong Xbox sales and slow improvement in its nascent phone software business, alongside a narrower loss in its perennially money-losing online unit, produced figures that broadly pleased investors. "Entertainment had a good number and the Windows number didn't crater, but it was weak," BGC analyst Colin Gillis said. Overall, the company beat Wall Street estimates only because the average analyst forecast dropped more than 10 percent over the last two weeks, spurred by the steep drop in PC sales numbers.
Microsoft's share rise on Friday may offer little comfort to long-term investors in the stock, which analysts say is mired in essentially the same place it was 11 years ago. The S&P 500 is up 37 percent over that time. Microsoft also announced yet another key executive departure, this time Chief Financial Officer Peter Klein. He is at least the seventh top Microsoft executive to leave the company in the last five years, and while Klein was never seen as a candidate to succeed Chief Executive Steve Ballmer, his departure is still another headwind for the company.