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How Microsoft Is Silencing Critics

By Bob Ciura – Jan 30, 2014 at 6:00AM

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Microsoft's superb cloud-based products and services have proven that it's a company that can thrive in the post-PC world.

Microsoft (MSFT 1.97%) has released its fiscal second-quarter results, and for the most part, had only great things to say. The company was successful across its major hardware products, including the recently released Xbox One console. Even the Surface tablet had some success in the most recent quarter. What really drove its quarterly results, though, were Microsoft's cloud-based offerings.

While Microsoft's quarterly report showed strength across many of its operating segments, there's a clear disparity emerging between its hardware and software businesses. The real story here is Microsoft's booming cloud-based and software operations.

Microsoft: A tale of two companies
To be sure, both of Microsoft's newly organized operating segments posted strong headline numbers. The devices and consumer segment posted strong sales gains, led by the Xbox and surprising growth from Bing. Microsoft sold 7.4 million Xbox units in the last quarter, half of which were the newly released Xbox One consoles. Bing grew search share to 18.2% and advertising revenue grew 34%.

There's an important caveat, however, when it comes to Microsoft's consumer-oriented hardware products, which is that they aren't very profitable. Gross margin on the devices and consumer hardware unit stood at just 10% over the past two quarters.

The real growth engine at Microsoft is its commercial licensing, which accounts for nearly half of the company's total revenue. Gross margin at that division clocked in at 92% over the past two quarters. Microsoft showed a tremendous ability to rise above what's amounted to relatively modest overall IT spending at the enterprise level, because it's taking share from competitors.

Microsoft's cloud-based offerings are performing tremendously. Its commercial cloud services, which include Office 365, Azure, and Dynamics CRM Online, more than doubled quarterly revenue versus the same quarter last year.

Is the cloud a modern-day gold rush?
By now, it's far from a secret how much potential the cloud holds. That's why a slew of large-cap technology giants are rushing to transition their business models away from hardware, and instead toward cloud-based offerings. Consider how hard International Business Machines (IBM -0.55%) has worked to get away from hardware. In the fourth quarter, its hardware revenue collapsed 26%. To its credit, the company's cloud revenue hit $4.4 billion during the quarter, representing a 69% increase. Unfortunately, IBM's fledgling cloud services couldn't offset weakness in its flagship segments, which caused total revenue to fall 5%.

Microsoft is excelling in its efforts to break away from hardware and the personal computer, and this needs to continue for positive momentum to last. Other "Old Tech" companies, which rose to prominence during the dawn of the PC, are struggling mightily now that the PC is past its prime. For example, chip giant Intel (INTC 3.20%) has flailed thus far in its attempts to meaningfully penetrate the mobile device and smartphone market.

No where are the troubles surrounding the PC market more evident than in Intel's operating results. Intel's full-year 2013 revenue and earnings per share dropped 1% and 11%, respectively, versus the prior year. Its gross margin fell more than 2 percentage points. The company continues to aggressively invest in its mobile technologies, but those efforts have failed to pay off so far.

Microsoft's cloud advantage a source of strength
Microsoft's most recent quarterly results show a company with a two-sided business model. One, cloud-based services, is performing much stronger than the other and is a window into Microsoft's future.

Technology giants that rose to power during the PC boom are at an important cross-road. Companies that execute their transitions away from hardware and toward the cloud the quickest will be the biggest winners. While IBM and Intel are still struggling in their attempts to cut ties with the old technology world, Microsoft is proving it's already successful in this regard.

Bob Ciura owns shares of Intel. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel, International Business Machines, and Microsoft. 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.

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