Microsoft's transition to a mobile and cloud services firm will weigh on margins over time relative to its traditional licensing model. We're comfortable with our $46 fair value estimate and wide economic moat rating.
Quarterly revenue came in at $26.5 billion, up 4.8% from last year and in line with our estimate. A modest outperformance in the D&C business due to smartphone, tablet, and console sales helped offset slightly weaker-than-expected commercial licensing sales. The weakness was due partly to geopolitical factors, and a difficult comparison as XP end-of-support refresh sales ended. Due to these factors, we expect modestly weaker results in the commercial licensing segment through the second half of the fiscal year. On the bright side, cloud-based revenue continued its torrid growth, with commercial cloud revenue up 114% from Office 365, Azure, and Dynamics CRM, boosting annualized cloud revenue to $5.5 billion.
Revenue mix weighed on profits, with gross margin at 61.7% and operating margin at 29.4%, down from last year's 65.9% and 32.5%, respectively. A larger mix of hardware sales combined with discounted Windows licensing, and higher cloud revenue weighed on margins. GAAP EPS was $0.71 for the quarter, below our $0.76 estimate, but in line with consensus. An IRS audit adjustment reduced earnings by $0.04.
Last year's XP refresh creates a difficult comparison for a couple more quarters, while currency issues will weigh on revenue by four percentage points. Nevertheless, the transition to the cloud, mobile, and services model is on track, while - difficult comparisons aside - the core commercial business remains solid. Microsoft remains a core technology holding. We'd recommend an investment at a modest discount to our fair value estimate.
Microsoft's top-line results were consistent with our estimates, but there was some weakness in a few areas of the business which we weren't expecting. Upon closer inspection, however, we are not terribly concerned by these soft spots, as they are geopolitical in nature or due to difficult comparisons from the XP refresh last year.
In particular, management noted weakness in China and Japan. The former, because of the ongoing investigation for monopolistic practices in China, which might take some time to resolve, if ever. The latter due to last year's value added tax raise implemented in April, which pulling forward future IT investments by businesses to avoid the higher tax rate. We expect both of these factors to continue weighing on Microsoft's results over the near term. Additionally, we expect the XP refresh from last year to present difficult comparisons through the remainder of fiscal 2015, so Windows license sales growth (and likely Office license sales) will appear relatively weak.
Management's guidance for the third quarter reflected these issues, and added in a currency headwind of approximately 4%. This had the effect of making guidance appear conservative or weak, but we believe Microsoft's business remains fundamentally sound. We trimmed our estimates slightly to incorporate these headwinds, but we also expect continued strong growth in the cloud-based businesses where Microsoft appears to be gaining in scale and efficiency while also incorporating some premium pricing for certain cloud products and services. While we acknowledge that Azure and SaaS (Office 365 and Dynamics CRM) will almost certainly never approach the gross margins of a licensing model, Microsoft's gains in the cloud are another step towards replacing more traditional products with added software and services which can help increase customer stickiness.
Jan 27 2015 | Norman Young
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