To the shock of many, Microsoft (NASDAQ:MSFT) reported solid earnings last Thursday. The company blew past analyst estimates, with revenue growing by 16% and EPS jumping 17% year over year. Analyst expectations were low following the Surface-related inventory write-off earlier this year, and the stock rose by as much as 7% the following day. Shares are now near 10-year highs, and Microsoft's long-term strategy appears to be working.
The devices and consumer business
Following a reorganization earlier this year, Microsoft is now split into two main divisions. The devices and consumer division grew revenue by 4% year over year to $7.46 billion, accounting for about 40% of the total revenue. Here are some highlights from the quarter:
- Windows OEM Pro revenue rose by 6%. This includes all non-volume Pro versions of Windows, as well as academic volume licenses.
- Windows OEM non-Pro revenue declined by 22%, although the decline was less severe than the company anticipated.
- Consumer Office revenue declined, although this is partially due to a shift to Office 365, which is accounted for separately
- The number of Office 365 Home Premium subscribers has surpassed 2 million.
- Unit volume for Surface tablets more than doubled from the previous quarter, with Surface revenue of $400 million.
- Search advertising revenue grew by 47% as Bing reached a U.S. search market share of 18%.
Windows sales on the consumer side fell, but the enterprise side is more important. The growth of Office 365 is impressive, and as a subscriber, I can tell you that it's nice to pay $10 per month rather than shelling out hundreds of dollars at a time. The Xbox One is also set to launch next month, and strong pre-orders bode well for the console.
The commercial business
The commercial side is where Microsoft really shines. Both revenue and gross margin grew by 10% year over year, and strong growth across the board was the main driver of Microsoft's earnings beat. SQL Server revenue grew in the double digits, with the premium version growing by more than 30%. The Lync, SharePoint, and Exchange products also collectively grew in the double digits. Commercial cloud revenue jumped 103%, with both the number of Office 365 seats and Azure customers growing in the triple digits.
Enterprise is far more important to Microsoft than the consumer side, and the strong growth is encouraging. I think that people are underestimating the growth potential of Microsoft. Even with the PC market in decline, Microsoft is growing its revenue and profits at double-digit rates. Microsoft's dominance in enterprise doesn't appear to be going away any time soon.
Microsoft's tablet advantage
While the tablet market is dominated by Android and Apple (NASDAQ:AAPL), Microsoft actually has one very important advantage. Because most companies already rely on Microsoft for Windows, Office, servers, etc., it make sense for those companies to choose Windows tablets over the competition. This makes integration with the existing IT infrastructure simpler, and ultimately saves money.
A fairly high-profile example of this is Delta Air Lines' (NYSE:DAL) recent decision to adopt both Microsoft tablets and Nokia phones. Delta is buying 11,000 Surface 2 tablets for its pilots, who will use the tablet for charts, reference documents, and checklists, replacing a copious amount of paper documents. Delta is also buying 19,000 Nokia Lumia phones for flight attendants to use as in-flight cash registers. Delta plans to be completely paperless by the end of 2014, and the company expects to save $13 million per year in fuel costs.
The Surface 2, which runs the ARM-based Windows RT, could see specialized use like this in the enterprise. This makes Microsoft's decision to continue to make Surface RT tablets after the giant inventory write-off last quarter seem a bit more sensible. Other airlines, like United Continental, have adopted the iPad for cockpit use, and Delta has previously allowed pilots to use iPads under its "Bring Your Own Device" program. The airline expects pilots to transition to the company-issued Surface tablets over the next couple of years.
Apple is desperately trying to push into the enterprise space. At its latest event, where it announced the new iPad Air, which comes with a 64-bit processor, the company also announced that it would be giving away its iWorks Office suite for free with every OSX or iOS device. The goal is to drive enterprise adoption, but Apple faces a steep uphill climb.
Windows is dominant in the enterprise PC market, and free office software isn't going to change that. Google has been trying to supplant Microsoft Office with Google Docs, and so far success has been very limited. Microsoft owns enterprise, not just with Windows and Office but also with its myriad of other products and services. Enterprise runs on Microsoft, and Apple has very little chance of doing anything about that.
This leaves Apple extremely dependent on the consumer market. Apple is not diversified at all, with the iPhone and the iPad making up most of the company's revenue and profit. Microsoft, on the other hand, has spent the last decade diversifying its offerings, and the success of that strategy was on display in its earnings release. Microsoft has a big advantage in enterprise going forward, and that could eventually spill into the consumer side. Windows tablets, while slow out of the gate, have the potential to dominate the enterprise market.
The bottom line
Microsoft had a good quarter. The consumer side was decent, and the commercial side was extremely strong. Surface tablets are picking up the pace, and Office 365 and Azure are growing at phenomenal rates. Microsoft's strategy seems to be taking shape, and all the pieces are starting to come together. Microsoft has a bright future ahead of it.
Timothy Green owns shares of Microsoft. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.