Microsoft's (NASDAQ: MSFT) third-quarter earnings report last week was impressive on multiple fronts. The company handily beat analyst estimates for EPS, but the strong performance of both Office and the subscription-based Office 365 stole the show.
Microsoft's biggest cash cow
Microsoft Office generates an enormous amount of profit for the company, and competition from Google's (NASDAQ: GOOG)(NASDAQ: GOOGL) web-based productivity apps represents the most serious challenge to Microsoft's biggest cash cow in years. But based on Microsoft's earnings, it's clear that Google is losing the battle.
On the consumer side, Office revenue jumped by 15% year over year. This number doesn't include Office 365, which is accounted for in the "devices and consumer other" segment, and it's somewhat surprising that cannibalization from Office 365 didn't drive Office revenue down. This growth was driven by higher attach rates with Pro versions of Windows, sales of which rose by 19% during the quarter, which was at least partially driven by the end of support for Windows XP.
Consumer Office 365 added roughly 1 million subscribers during the quarter, boosting the total number to 4.4 million. Office 365 is inherently a tougher sell on the consumer side, given that Google's productivity apps are free and that Microsoft offers free web-based versions of Office programs as well. But the unmatched feature set of full Microsoft Office is ideal for those requiring more than the simple documents and spreadsheets capable of being produced with free alternatives.
Based on the rapid growth of consumer Office 365, there are plenty of people willing to pay a premium for Microsoft's productivity suite. A less expensive option, Office 365 Personal, was launched during the quarter, and an option for university students to pay just $79.99 for four years of access is available as well. Along with a new native iPad app and the free web apps, Microsoft is trying to keep as many users as possible using some form of Office.
The all-important enterprise
In terms of profitability, the enterprise market is far more important to Microsoft than the consumer market. Office performed well on the enterprise side during the third quarter, with Office revenue rising by 6% year over year, and Office 365 revenue growing by 100%. Similar to the consumer side, Office and Office 365 are accounted for in different segments.
Enterprise Office 365 now has a $2.5 billion annual run rate, making the 100% year-over-year growth seem even more impressive. Beyond revenue, the gross margin is also expanding, with the scale of Office 365 now sufficiently large enough to drive margins up faster than revenue.
The "commercial other" segment, which contains both Office 365 and other cloud products like Azure, posted year-over-year revenue growth of 31%, while gross margin expanded by 80%, driven largely by Office 365. Consumer Office 365 gross margin also expanded, driving a 26% gross margin expansion in the "devices and consumer other" segment.
Microsoft Office is still growing amid serous competition, and it will continue to be an extremely profitable business for Microsoft. What's more, as consumers and businesses shift to Office 365, Microsoft will enjoy a stream of subscription revenue without having to resell new versions of Office every few years. The growth of both traditional Office as well as Office 365 in the enterprise is a sign that Google isn't making enough of a dent in Microsoft's enterprise market share to be noticeable. While the battle certainly isn't over, Microsoft is clearly winning at this point.
The bottom line
Microsoft put together a stellar quarter, beating analyst estimates and posting solid growth across the board. The rapid growth of Office 365, especially in the enterprise market, along with the lack of cannibalization of traditional Office sales, leads to the conclusion that Microsoft Office remains the de facto standard. For all of the success that Google has had with consumers, the enterprise is a different beast, and the company has yet to find a formula to wrestle significant business away from Microsoft.
Timothy Green owns shares of Microsoft. The Motley Fool recommends Google (A shares) and Google (C shares). The Motley Fool owns shares of Google (A shares), Google (C shares), 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.