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Why Microsoft’s margins may expand

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D&C Licensing contribution declines

As mentioned earlier in this series, impending release of Microsoft (MSFT) Windows 10 led to consumers delaying their upgrades. Free to upgrade for customers using Windows 7, 8, and 8.1, Windows 10 portends a further fall in income when it is released. The company’s release mentioned the Windows decline: “Windows OEM Pro revenue declined 13%; revenue was impacted by the business PC market and Pro mix returning to pre-Windows XP end of support levels and by new lower-priced licenses for devices sold to academic customers.”

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The Windows OS decline is most visible in the company’s D&C licensing division, which covers licensing of the operating system. It is the second biggest contributor to Microsoft’s revenues and profits. Although revenues are slowly declining, the division’s margins are showing an increase. The Phone Hardware segment, which includes Nokia Lumia phones is also plagued by low margins and a small market share. Microsoft is way behind its peers Apple (AAPL) and Google (GOOG) (GOOGL) in the smartphone space.

Commercial licensing is cash flow bedrock

Among all the operating segments, the Commercial Licensing segment boasts fat margins of 93%. Approximately 66% of its overall gross margin comes from the Commercial segments. Commercial Licensing remains stable and provides the bedrock for the company’s cash flow. Owing to its long-standing presence in the enterprise, Microsoft has moved commercial customers to its cloud offerings. Office 365 subscriptions are rising and the company announced the Office 365 Government cloud.

ETFs like the Powershares QQQ Trust (QQQ) and the Technology Select Sector SPDR Fund (XLK) can be considered for exposure to Microsoft. These ETFs have an 8.00% and 9.61% exposure to Microsoft, respectively.

Transition to cloud adds to margin woes

With Microsoft’s increased focus on its “mobile first, cloud first” strategy, there is little hope for the margin to expand. As we noted in the 1Q15 earnings, a transition toward the cloud means the company must deal with reduced margins in once immensely profitable licensing markets.

The above graphic shows the shrinkage of margins in the cloud model. To read in detail about the cloud model, please read the Market Realist series, Why cloud business models differ from on-premise software.

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