Microsoft's Turnaround Plan Takes a Hit With Earnings Shortfall

Strong Growth in Cloud Services Not Enough to Make Up for Revenue Loss

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Microsoft shares fell Friday, reversing a march toward a historic high, after the company's earnings report suggested the progress made in its corporate turnaround took a step backward.

The software maker Thursday reported third-quarter earnings that fell short of analysts' estimates because of a higher tax rate and said sales in the current period will fall short of some projections, sending the shares down. Chief Financial Officer Amy Hood said results are being hurt by weakness in one-time purchases of software, what Microsoft calls its transactional business.

Microsoft Chief Executive Officer Satya Nadella is navigating a transition to cloud and subscription-based products, seeking to lessen its reliance on such one-time purchases. Yet many of its customers still buy the old way, and it's those clients that are paring purchases as they deal with a sluggish economy, Hood said. Strong growth in cloud-services, such as the Azure computing platform and Office 365 software, won't be enough to make up for the shortfall in the current quarter. Before this report, Nadella had been posting better-than-projected results, fueling a 31% gain in the stock in the past year.

"There's still a long ways to go in terms of the multiple-year transition in the company from a Windows and on-premise software company to a cloud, mobile and service-oriented company," said Sid Parakh, a portfolio manager at Becker Capital Management, which has about $3 billion under management.

Microsoft shares fell as much as 7.5%, the most in eight months, to $51.60 Friday morning. They were trading at $52.13 at 9:38 a.m. in New York. The stock was up 31% in the past year through Thursday, compared with a decline of 0.4% on the Standard & Poor's 500 Index.

Profit excluding certain items in the third quarter, which ended March 31, was 62 cents a share, and sales adjusted for deferrals were $22.1 billion, Microsoft said in a statement. Analysts on average estimated profit would be 64 cents on revenue of $22.1 billion, according to data compiled by Bloomberg. Net income declined to $3.76 billion, or 47 cents a share.

Estimates didn't include a one-time tax adjustment to account for an expected increase in the full-year tax rate partly related to its cloud business, Hood said. Without this "catch-up adjustment," Microsoft would have beaten analysts' profit projections, she said. The full-year tax rate should be closer to Microsoft's usual 20% to 21% rather than the 24% adjusted rate in the fiscal third quarter, she said.

Intelligent Cloud unit revenue, made up of Azure and server software, will be $6.5 billion to $6.7 billion in the fourth quarter, the company said on a conference call. Sales in Productivity, made up mostly of Office programs, will be in that same range. More Personal Computing -- which includes Windows, Xbox and Surface tablets -- will bring in $8.7 billion to $9 billion. Some of those numbers were below what many analysts had expected, UBS AG analyst Brent Thill noted on the call, and Hood agreed.

Microsoft has pledged to reach annualized revenue of $20 billion in its corporate cloud business by the fiscal year that ends in June 2018. At the end of last quarter, that metric stood above $10 billion, Hood said. The company has been adding customers and workloads for the Azure computing program, which let clients run and store applications in Microsoft's cloud-data centers.

The persistent weakness in one-time software purchases and the shifting tax rate shows the transition Nadella is attempting -- away from the PC market and these kinds of sales -- will be neither simple nor short. It will change Microsoft from a company with the Windows operating system as its flagship to one that relies more on its Office, Azure and the SQL Server database products; from a company selling software that clients buy once and install on their own PCs, in their own offices or data centers, to one that sells more services delivered in the cloud.

In the third quarter, Microsoft's unearned revenue, a measure of future sales, was $25.9 billion. Two analysts polled by Bloomberg had expected an average of $24.8 billion.

The quarter was an abysmal one for worldwide personal-computer shipments, which slid to their lowest quarterly total since 2007, according to market researcher Gartner Inc. Microsoft's sales of Windows to computer makers fell 2% -- better than the overall PC market, but underscoring the impact on the Windows business.

Revenue in the More Personal Computing segment, which includes Windows and Xbox, rose 1% to $9.5 billion, topping the $9.17 billion average estimate of four analysts polled by Bloomberg, bolstered by increases in search and Xbox Live revenue.

Revenue from productivity software rose 1% to $6.52 billion. That compares with the $6.57 billion average analyst estimate. Office 365 revenue climbed 63% in constant currency, the company said.

Dan Morgan, senior portfolio manager at Synovus Securities, said third-quarter revenue in Microsoft's cloud and server group came in a bit below his projections, particularly given the company's focus on cloud for future growth. Revenue from Intelligent Cloud, the unit that includes Azure and server software, was $6.1 billion, compared with the $6.26 billion average estimate of analysts.

-- Bloomberg News

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