Microsoft's outlook reflects juggling of Windows' price decline, cloud rise

Microsoft isn't alone in trying to milk existing business slow enough for its cloud business to offset declines. But Windows' rapidly plunging price isn't helping matters.

Microsoft's third quarter outlook illustrates a common conundrum for enterprise technology's old guard: How do preserve existing cash cows long enough for new businesses to take off?

The company's second quarter earnings were solid enough, but the outlook for the third quarter and the remainder of the fiscal year highlights challenges. These issues include:

  • An end to the Windows XP upgrade cycle that drove Windows licenses as well as Office attach rates.
  • Macro economic uncertainty that is going to ding the enterprise businesses.
  • Brutal declines in Windows average selling prices where the ultimate destination will be free.
  • A stronger U.S. dollar, which hurts revenue gains overseas.

Add it up and Microsoft's third quarter revenue outlook was $2.4 billion to $3.2 billion short of expectations. Of that sum, only $800 million or so can be attributed to a stronger dollar.

Here's how Microsoft CFO Amy Hood set up the outlook.

In FY14, it was our Q2 through Q4 results that most benefited from Windows XP end of support. As such, our growth rates across Windows Pro and transactional Office will be impacted as our Business moves back to pre-XP levels. On a geographic basis, we expect year-on-your revenue declines in China, Russia, and Japan. In Japan, Q3 represents an even tougher comparison, with the anniversary of the VAT, which again will create different comparables -- difficult comparables in Windows and Office. We currently expect the geographic dynamics, challenging comparables from XP, and FX headwinds will be in place throughout the remainder of our fiscal year.

China has "geopolitical issues," but Microsoft's cloud business is doing "fairly well," said Hood.

More: Microsoft feels impact of its transition to the cloud; end of XP migration boost | Microsoft Q2: Surface, enterprise lead the charge | Hands-on with the Windows 10 January Technical Preview (build 9926) | Microsoft to make Windows 10 free to Windows 7, 8.1 and Windows Phone 8.1 users | ZDNet Windows 10 coverage |Windows 10: The big questions ahead | Windows 10 goes hologram happy | Microsoft to offer a paid version of its internal Cosmos big-data service | Microsoft acquires Revolution Analytics

Jefferies analyst John DiFucci said Microsoft's March outlook was "shockingly low" and reflects more than a Windows XP upgrade hangover. Here's a look at Microsoft's guidance via Wells Fargo:

microsoft-outlook.png

Aside from "commercial other," which is Microsoft's cloud business, growth is so-so. That situation isn't unique to Microsoft. Other enterprise giants whether it's SAP, Oracle, IBM or some other company are all milking existing businesses while growing cloud.

Stifel analyst Brad Reback said the biggest issue for Microsoft is the reality that Windows will be free or close to it. He said:

Microsoft faces competitive pricing pressures across a number of fronts (not just sub 9-inch tablets). For example, the fact that Microsoft cut prices in the education market (a market where it has massive share) suggests just how far Chromebooks have come. We also highlight that the free Window 10 upgrade along with Windows-as-a-Service offerings have the potential to negatively impact cash flow and profitability dynamics. The bottom line is we expect ASP headwinds to continue in coming quarters as Windows growth continues to decouple from PC unit growth.

As for Microsoft management, the commitment is to be smart about allocating capital and navigate the business model curves. The biggest theme is that the transition will take time. Hood said:

The overall goal of continuing to have more customers every quarter move to the cloud is actually the structural guidepost we have on a multi-year journey.

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