Microsoft (NASDAQ:MSFT) shares rose more than 3% in after-hours trading on Thursday after the Redmond tech giant reported a quarter that exceeded analysts' expectations. In the third quarter, Microsoft earned $0.62 per share on revenue of $21.7 billion. Analysts had been looking for earnings of around $0.51 on revenue of $21.06 billion.
Revenue from Microsoft's operating system, Windows, declined significantly, but its cloud services posted impressive growth. And while Microsoft remains a relatively minor player in the hardware business, its Surface PCs continue to pick up steam.
Windows revenue plunges
Windows-related revenue contracted sharply during the quarter, as demand from both businesses and consumers fell. In addition, some customers opted for cheaper PCs with less expensive or free versions of Microsoft's operating system. In total, Windows OEM revenue fell 22%.
Windows OEM Pro revenue fell 19%. Microsoft cited the end of the Windows XP upgrade cycle as the reason for the decline. Last year, Microsoft ended support for Windows XP -- its ancient desktop operating system -- which triggered an aggressive wave of PC and operating system upgrades, and led to a boom in the demand for business PCs and Microsoft's software. But that bump proved temporary, and in the third quarter, demand contracted to a more reasonable level.
On the consumer side, the drop-off was even more significant. Non-pro Windows revenue fell 26%. Microsoft cited a draw-down in channel inventory, and admitted that an increasing number of consumers are opting for lower-cost Windows devices. In an effort to compete with low-cost Chromebooks,
Microsoft has offered its hardware partners less expensive or even free versions of Windows for smaller, cheaper PCs. Consumers who may have otherwise purchased a more expensive PC with a more costly version of Windows may have opted for one of these cheaper PCs instead.
Microsoft's cloud businesses continue their rapid expansion
That cheap version of Windows is known as Windows 8.1 with Bing. In contrast to standard Windows 8.1, PC manufacturers must set Microsoft's search engine -- Bing -- as the default search engine. Users can, if they choose, change it, but plenty won't. Perhaps for that reason, Microsoft's Bing business improved during the quarter, with its share of the U.S. search market rising 150 basis points on an annual basis, to 20.1%. Search advertising revenue likewise grew, up 21% on an annual basis.
Microsoft's Office 365 continues to dominate. Although consumer revenue from Office fell 41%, much of that decline was attributable to consumers switching to a subscription in place of an expensive, upfront software purchase. Microsoft now has 12.4 million consumers subscribing to its Office service -- a 35% gain from last quarter.
Business users are also flocking to Office 365, as well as Microsoft Azure and Dynamics CRM Online. Revenue from these services contributed to Microsoft's impressive annual commercial cloud revenue growth of 106%. Use of Azure compute -- Microsoft's cloud computing platform -- more than doubled from the same period last year. In total, Microsoft's commercial cloud revenue is on pace for an annual run rate of $6.3 billion -- up from $5.5 billion last quarter.
Surface is growing, but Lumia is in decline
In terms of its hardware, Microsoft saw some growth with its line of Surface products, but sales of its handsets were muted, and Xbox console sales declined.
Surface revenue rose to $713 million, a gain of 44% on an annual basis. Microsoft specifically cited demand for the Surface Pro 3 as being the primary catalyst of its Surface revenue gain. Microsoft announced the new Surface 3 during the quarter, but the less expensive, smaller version of its Pro model has yet to launch.
Revenue from Xbox hardware fell 24% on an annual basis. Microsoft cited a decline in demand for the Xbox, as well as lower prices. Microsoft has cut the price of the Xbox One several times since last year. Microsoft did say, however, that usage of its Xbox Live service -- the Internet service that connects Xbox consoles to the Internet -- rose 30% on an annual basis.
Microsoft sold 8.6 million Windows Phone-powered Lumia handsets during the quarter, which was an 18% gain year-over-year, but down from last quarter, when it sold 10.5 million. Microsoft generated $1.4 billion from its handset sales, down from $2.3 billion last quarter.
A mobile-first, cloud-first world
Since he took the job last February, Microsoft's CEO Satya Nadella has consistently remarked that he is striving to create a Microsoft built for a "mobile-first, cloud-first world." Its third-quarter earnings report seems to support that notion. With Windows in decline, Microsoft is increasingly dependent on its subscription and cloud services. Thankfully, they appear to be doing quite well.
Sam Mattera has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.