Microsoft's Transition Remains on Track

Quarterly revenue came in at $26.5 billion, up 4.8% from last year and in line with our estimate. A modest outperformance in the Devices & Consumer (D&C) business due to smartphone, tablet, and console sales helped offset slightly weaker-than-expected commercial licensing sales. The weakness was due partly to geopolitical factors, and a difficult comparison as XP end-of-support refresh sales ended. Due to these factors, we expect modestly weaker results in the commercial licensing segment through the second half of the fiscal year. On the bright side, cloud-based revenue continued its torrid growth, with commercial cloud revenue up 114% from Office 365, Azure, and Dynamics CRM, boosting annualized cloud revenue to $5.5 billion.

Revenue mix weighed on profits, with gross margin at 61.7% and operating margin at 29.4%, down from last year's 65.9% and 32.5%, respectively. A larger mix of hardware sales combined with discounted Windows licensing, and higher cloud revenue weighed on margins. GAAP EPS was $0.71 for the quarter, below our $0.76 estimate, but in line with consensus. An IRS audit adjustment reduced earnings by $0.04.

Last year's XP refresh creates a difficult comparison for a couple more quarters, while currency issues will weigh on revenue by 4 percentage points. Nevertheless, the transition to the cloud, mobile, and services model is on track, while--difficult comparisons aside--the core commercial business remains solid. Microsoft remains a core technology holding. We'd recommend an investment at a modest discount to our fair value estimate.

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