“Get all excited and go to a yawning festival.”
-Steve Martin, The Grandmother Song
Shares of Microsoft (MSFT) opened 4% higher on Friday after the software giant posted third-quarter revenue and profits that beat Wall Street's expectations.
Excuse me if I don’t pop the champagne cork just yet. I’m as much a fan of still-new CEO Satya Nadella as anyone, but there’s much less sustainable growth behind this “beat” that’s driving the stock higher. And, in fact, the stock is already selling off that opening euphoric rise.
Microsoft said its revenue for the quarter rose 25% to $23.2 billion, while net income totaled $4.5 billion, or 54 cents a share, down 8%. Absent a previously disclosed $1.1 billion restructuring charge, net income would have been up 10%. Wall Street analysts expected $22 billion of revenue and earnings per share of 49 cents, according to FactSet.
So where did the extra $1.2 billion of sales, a significant 5% beat, come from? Booming cloud services and a recovery in corporate demand for computers running Windows? Not really. Rather, the newly acquired phone business from Nokia (NOK) added $2.6 billion of fresh revenue while Xbox and Surface tablet sales climbed because of new product cycles. It’s an apples to oranges, or to not offend Tim Cook, a bananas to oranges comparison.
“The revenue beat remains driven by the Phone and Gaming Hardware segments this quarter, whose strength may be volatile,” Sterne Agee analyst Robert Breza warned in a note this morning. “Sustainable growth in core businesses remains the focus until the cloud becomes significant.”
Growth in niche units
Beneath the surface, Microsoft’s position is similar to other aging tech giants such as Intel (INTC), IBM (IBM) and even Hewlett-Packard (HPQ). Just like its peers, Microsoft is growing quickly in some hot, new niches. But those sales remain relatively tiny and, mostly, much less profitable than the huge-but-shrinking legacy businesses.
For example, Microsoft’s consumer and corporate licensing units, mainly Windows, Office and Windows server software, brought in $14 billion, or about 60% of total revenue, in the quarter. But they also represented 87% of the company’s $15 billion gross profit. Revenue at those two units was down 1% from a year earlier.
The rest of the company – from Xbox One and Surface tablets to sexy cloud offerings – grew revenue 108%, or 49% if you exclude the phone business acquired from Nokia. Heady days. And the units turned in an even more exciting 205% increase in gross profits, or 132% excluding Nokia.
But that still comprised only 13% of the total gross profit.
Even more importantly, Microsoft didn’t disclose actual operating profits by segment, but these largely start-up businesses almost inevitably have greater expenses beyond the gross cost than the tried and older software businesses. If we could see the real numbers, the contrast would be even more dramatic.
Increases in game console, phone and tablet sales may have come in ahead of Wall Street expectations, but they also aren't likely to continue increasing at the same pace. Sales of the XBox One, introduced in the fourth quarter of 2013, are already tailing off and losing market share to Sony's (SNE) more popular Playstation 4.
Microsoft also benefitted from a refreshed tablet line including the Surface Pro 3, but $908 milion of total sales are still a blip in the tablet ecosystem. Whether Microsoft can sustain Surface sales, let alone grow to become a significant player, remains highly questionable.
And sales of 9.3 million Nokia Lumia phones represented only "modest growth" over the prior year when Nokia ran the business, Microsoft disclosed, with share gains coming at the low end of the market. At least it wasn't selling the phones for less than they cost to make, but the quarter's gross profit included "non-recurring items resulting from business integration efforts," the company said. In other words, don't count on much more growth or profits here.
So much of the initial excitement arose from the old beating Wall Street expectations game. That's an old trick, and it has benefitted Microsoft in the past. Analysts at Bank of America Merrill Lynch warned that the company's guidance for next quarter ("which we believe they are almost guaranteed to beat") is similarly hedged for a win.
Make no mistake, Satya Nadella is making some smart choices even without the strongest line-up of products in all the key areas. But Microsoft's third-quarter surprise doesn't mean he's turned the corner. Not even close.