Microsoft is one of the world’s most valuable companies, and its 2020 financial results are record-breaking again. But things did not look so well just a few years ago.
Every annual report with financial statements within it, tells a story. And a story that Microsoft’s annual report and financial statements tell is a classic “comeback” story.
Microsoft’s story is about once a dominant company that ruled in the PC era and later got under pressure as consumers shifted from PC to smartphones. Moreover, new cloud-based competitors emerged that threatened Microsoft’s business software dominance.
Microsoft went through several bad years. The issue was not primarily in company profits at the time, as it was able to keep making money from its legacy products. The problem was that its strategy for how it plans to become relevant in the new age was quite unclear. Everything culminated by the questionable acquisition of another struggling company that once dominated its market. The company name was Nokia.
Nokia’s acquisition sort of marks the low point for Microsoft, but since then, Microsoft was able to pull itself together. The company made a hard decision to leave smartphone business (and effectively consumer business) behind and refocus entirely on its business-focused productivity & server software.
It took some time, for sure, but looking back, the last couple of years were hugely successful for Microsoft in terms of financial performance and its stock price. But the story is not over yet, and it looks that things are poised to get even better for Microsoft.
Here you can have a video version of Microsoft journey made by the Wall Street Journal. It is only over 2 minutes but gives you the main idea.
In this article, I will walk you through Microsoft’s financial statements from its annual report. I will explain what is going on using custom charts and will summarize key takeaways for you. My aim is to show you the numbers simply and visually, but mainly tie the numbers to the “business” behind the numbers. I will cover both the income statement and key things from the balance sheet and cash flow statements.
🏢 What Business is Microsoft In? (Quick Overview)
Before we jump into financial results from annual financial statements, let me give you a quick overview of what business Microsoft is in and what are its biggest revenue sources. The aim is to provide you with a rough idea of what company we are talking about.
It might look that Microsoft does not need any introduction since everybody has heard of it. But the truth is that Microsoft’s business changed significantly in the last six years. So What Business is Microsoft in, and where does its revenue come from?
Nowadays, the main focus of Microsoft is software and cloud-based services for business, that can be divided into these areas:
Business productivity: It is represented mainly by Microsoft Office, which offers a wide variety of office tools. These are not limited just to traditional Excel, Word, and PowerPoint. The Office also includes a note-taking tool (OneNote), communication tools (Microsoft Teams, Skype), or business intelligence tools (Power BI).
The second biggest part of Microsoft’s business based on revenue are server products and services. It includes both traditional on-premise Microsoft Server and Microsoft SQL Server and also the modern Azure cloud. Traditional server products are still an essential revenue stream and even growing very slowly each year. Crown jewel, however, is fast-growing Azure cloud
Two revenue sources mentioned above make together more than 60% of Microsoft revenue. The third important revenue source, but less than it used to be, is Windows, with a 16% share on Microsoft’s revenue.
The rest of the revenue is spread out into different smaller revenue sources. The biggest from these other smaller streams are Gaming with an 8% share on revenue and Search (5% of revenue).
Microsoft offers a wide variety of software products and cloud services. Their unifying theme is that they are all focused on business customers. Yes, it offers Windows and Office productivity tools to individual consumers too, but the consumer market is no longer the focus of the company.
The key thing to realize is that Microsoft is not a consumer company anymore (except its gaming division). It is all about business customers.
In line with its focus on commercial & productivity tools, the recent announcement by Microsoft that it is closing Microsoft Store physical locations should not be a surprise. There are also many more subtle changes Microsoft is doing that suggests that consumers, at least for now, is not something it wants to focus on.
Some of Microsoft’s announcements might seem supporting the idea that Microsoft is trying to get get back to a consumer market. One example can be Microsoft’s new Surface Duo device, altough these attempts are focused mainly on “professionals” and productivity, which is in line with Microsoft’s business focus. More recently we have seen the news that Microsoft is interested into acquisition of popular social app TikTok
Apart from the important revenue streams mentioned above, Microsoft also has a few smaller business-focused offerings for hiring and learning (LinkedIn) or CRM (Dynamics 365). These are not a significant driver of profits nowadays, but it might change in a couple of years. And if other business needs arise in the future, that can be solved by a software tool or cloud service; I bet Microsoft will come after it.
That should be enough for a quick overview of what Microsoft’s business is. If you want to dig deeper into the history of Microsoft, then this Wikipedia article should cover you well.
✈️ High-Level Overview of Microsoft’s Financial Statements (Charts & Key Takeaways)
In this part of the article, you can find a visual summary of key metrics from Microsoft’s financial statements and also key takeaways from them. Below the takeaway, you will find variety of visualizations of the income statement, cash flow statement, and balance sheet that you can explore. If you are more of a classic table person, I have you covered too.
I intentionally won’t go into too much detail here, since the purpose of this part of the article is to give you a bird eyes view of the main developments in Microsoft’s financials. If you aren’t satisfied with the level of detail, don’t worry, we will soon get to it in the following part of the article.
In case you are new to my posts about companies and visualizations, I published post “7 Best Charts for Income Statement Presentation & Analysis”, where I explain most of the financial statements visualizations that I use here.
How Much Revenue and Profits Microsoft Earned and Where it Comes From (Income Statement Overview)
- Microsoft had another great year in 2020. Revenues continued to grow as it did for the last several years, and in the 2020 fiscal year, Microsoft achieved record revenue of $143bn (14% annual growth).
- Microsoft’s revenue increased by $17.2bn in 2020 (14% growth), and around 40% of this increase came from Azure and another 20% from Office for commercial customers. Azure revenue grew by 56% in 2020, and it was the main reason why its “Server Products & Services” segment was growing by $8.8bn. The Office is currently far more significant revenue source than Azure, but because Office grew “only” by 12%, it was not enough to match Azure’s revenue increase in dollar amount.
- Long term trend underlying Microsoft’s revenue growth is declining share of the revenue from on-premise product licensing and increasing share of cloud-based services like Office 365 or Azure.
- Microsoft is predominantly focused on products & services from business customers. It sells its software like Office or Windows to consumers too, but it is just a small piece of total revenue. The only remaining consumer-focused business is Gaming (Xbox product & services).
- LinkedIn’s revenue grew by 20% to $8.1 bn in 2020, which is 6% of total revenue. On the operating income level, LinkedIn is probably still losing money. Microsoft acquired LinkedIn at the end of 2016 (2017 fiscal year).
- Additional to 14% revenue growth, Microsoft managed to keep the growth of expenses under control. All expense groups grew slower than revenues, with the only exception of R&D expenses. Total expenses grew by 9% and therefore increasing even more Microsoft’s respectful operating margin to 37% of revenues.
- Microsoft’s net income increase by $5bn compared to last year, continuing with a stable increase as both revenue and operating margin increase.
- Overall, Microsoft had a great year (again!). And since Microsoft continues investing and innovating in areas of high growth cloud-based tools & services, it is hard to see why Microsoft’s financial results should continue in is current growth trajectory.
Microsoft’s Income Statement in Table Format
|Office products and services||+3.5||+11%|
|Server Products and Cloud Services||+8.8||+27%|
|Cost of revenue: Product||+0.3||-2%|
|Cost of revenue: Service and other||-3.4||+13%|
|Research and development||-2.4||+14%|
|Sales and marketing||-1.4||+8%|
|General and administrative||-0.2||+5%|
|Impairment, integration, and restructuring||-||-||-|
|Other income (net)||-0.7||-89%|
|Income before taxes||36.5||43.7||53.0||+9.3||+21%|
How Much Cash Microsoft Earned and How It Was Spent (Cash Flow Statement Overview)
- Operating Cash flow and Free Cash flow as % of revenue is stable since the 2017 fiscal year with small growth.
- Microsoft continues investing cash into its property and equipment, mostly related to building its cloud infrastructure data centers.
- For the last four years, Microsoft is keeping its “cash pile” stable at around $135bn. Therefore, it opens more space for returning cash to investors.
- From $45bn of Free Cash Flow, Microsoft paid out $38bn to shareholders as dividends or stock repurchases.
- Microsoft acquired GitHub in 2018 for $7.5bn, mostly paid in stocks.
Microsoft’s Cash Flow Statement in Table Format
|Goodwill and asset impairments||-||-||-|
|Depreciation, amortization, and other||+1.1||+10%|
|Net gains on invest. & derivatives||+0.6||-72%|
|Deferred income taxes||+6.5||-100%|
|Changes in oper. assets & liab.||-5.3||-138%|
|Net operating cash flow||43.9||52.2||60.7||+8.5||+16%|
|Additions to property and equipment||-1.5||+11%|
|Free Cash Flow||32.3||38.3||45.2||+7.0||+18%|
|Acquisitions (net of cash & assets acquired)||-0.1||+6%|
|Net purchases of marketable securities||+6.4||+1 193%|
|Net investing cash flow||-6.1||-15.8||-12.2||+3.5||-23%|
|Cash premium on debt exchange||-||-|
|Issuance (Repayments) of short-term debt||0.0|
|Proceeds from issuance of debt||0.0|
|Repayments of debt||-1.5||+38%|
|Common stock issued||+0.2||+18%|
|Common stock repurchased||-3.4||+18%|
|Common stock cash dividends paid||-1.3||+10%|
|Net financing cash flow||-33.6||-36.9||-46.0||-9.1||+25%|
|Effect of FX rate||-0.1||+75%|
|Change in cash & equivalents||4.3||-0.6||2.2||+2.8||-476%|
How Microsoft’s Balance Sheet Changed? (Balances Sheet Overview)
- Total assets increased by +$15bn to $301bn in 2020 mainly thanks to increasing investments into property and equipment (+$7.7bn). The rest was mainly increase in Account receivables and Cash.
- On Liabilities & Equity side of the balance sheet, +$15bn balance increase was mainly reflected in +$16bn increase in Equity.
- Microsoft has $60bn of long term debt (excluding leasing), and a major part of it was secured in 2017 (fiscal year) when it acquired LinkedIn. Debt is being slowly repaid, and its share decreases. This trend is slightly offset by increase in lease liabilities from finance and operating leases. Total Microsoft’s lease liabilities were $17bn in 2020.
Microsoft’s Balance Sheet in Table Format
|Cash and cash equivalents||+2.2||+20%|
|Accounts receivable (net)||+2.5||+8%|
|Other current assets||+1.2||+10%|
|Equity and other invest.||+0.3||+12%|
|Property and equipment, net||+7.7||+21%|
|Operating lease assets||+1.4||+19%|
|Other long-term assets||-1.6||-11%|
|Current portion of long-term debt||-1.8||-32%|
|Current portion of lease liab.||+0.3||+18%|
|Other current liabilities||+1.2||+2%|
|Long-term lease liabilities||+4.2||+34%|
|Other long-term liabilities||-1.2||-3%|
|Total liabilities and equity||258.8||286.6||301.3||+14.8||+5%|
Data source for the above visuals and tables is Microsoft’s annual report (K-10) that the company submits to the Security and Exchange Commission (SEC) and also other documents that Microsoft provided for investors. You can find them on Microsoft’s investor relation website, including conference call recordings and their transcripts.
🔵 Breakdown & Analysis of Microsoft’s Revenues (Income Statement)
Microsoft earned $143bn in revenue in 2020, which was an annual growth of 14%. Not bad for a company that also has large legacy product lines with slow growth rates. Let’s dig deeper into Microsoft’s revenue breakdown. What precisely this revenue consists of and where it comes from? How did it develop thorough the last five years? And what is driving its growth?
Microsoft’s financial statement offers three different ways of how we can break down its revenues. We can split it into products or services or if it is coming from the US or other countries. However, the core revenue breakdown that offers the biggest detail and understanding of how Microsoft makes money is its operating segment breakdown, which should be in line with how Microsoft looks at its business internally.
This breakdown divides Microsoft’s business into three segments that can be further broken down into product groups in the following way:
- Productivity and Business Processes
- Office products and services
- Other (mostly Dynamics)
- Intelligent Cloud
- Server Products and Services
- Enterprise services
- Personal Computing
- Search advertising
Although the high-level grouping makes some sense, at least for the first two segments, I prefer to jump directly into individual product revenue streams, where you can see what is happening.
The chart below offers a look at total revenue development and detailed revenue streams for the last five years. On the right, you can find a difference in $ and growth rate versus the previous year.
Just have a look and explore the chart below. It should give you a good idea about which segment/product lines provide the most significant piece of Microsoft’s revenue, which is the fastest-growing in dollar amount and percentage growth. I will meet you below the chart, and we will look at each product revenue stream individually.
The chart above shows that the three main ways how Microsoft earns revenue come from:
- Server Products and Services ($41.4bn a year)
- Office products and services ($35.3bn) and
- Windows ($22.3bn).
These together make up more than three-quarters of Microsoft’s revenues.
Chart also shows us the fastest-growing source of Microsoft’s revenue. The most significant revenue increase in the dollar amount is from Server Products and Services segment, which provided over half of the total revenue increase in 2020. It is also the fastest-growing part of revenues since 2015.
In the second place are Office products and services. The third most significant revenue contributor was Windows trailed by LinkedIn, a business that Microsoft acquired at the end of 2016 (2017 fiscal year) for $27bn.
Let’s dig deeper into each item of the revenue individually. Details above are the most detailed split of revenue that Microsoft provides. However, Microsoft offers enough comments in its financial statements about what drives different pieces of revenue that we can easily get into much bigger detail for the most significant revenue sources and better understand what is going on under the hood.
Office Products and Services Revenue (Productivity and Business Processes)
It used to be the biggest part of Microsoft revenue until 2018. It is growing at a stable rate of around 10% for the last few years.
Microsoft Office Products and Services include a growing number of tools. Some of them are updated versions of classics like Outlook, Excel, Word, or PowerPoint, but some are new products that Microsoft did not have before and which got customers’ attention. One of the new tools is Teams, Microsoft’s business communication tool, and another one is a business intelligence tool Power BI.
Microsoft Office Products and Services category includes both legacy on-premise office licensing and also modern Office 365 subscriptions, where companies can choose from different packages of tools. So how are these different parts developing?
Firstly, let’s clarify that the vast majority of Office revenue is coming from commercial customers. Only around $5bn in 2020 came from the consumer version of office products (mostly Office 365). So we can safely ignore this consumer piece as immaterial and concentrate on commercial customers.
If we look under the hood and compare how Commercial Office 365 is growing versus its traditional on-premise Office licensing, we see two different businesses. Commercial Office 365 currently makes up the majority of Office revenue and is growing very quickly (24% in 2020). The reason behind this growth is not only the number of business users but also the increase in average price when customers migrate to more expensive subscriptions.
On the other hand, legacy on-premise business is in decline. Therefore 24% growth in Office 365 turns into 11% growth if you take into account a decrease in on-premise licensing revenue.
Microsoft likes to mention Office 365 high growth in its presentations and conference calls quite often. Still, the total number is what really matters because if customers switch from on-premise licensing to Office 365, it is apparent that we will see high growth for a while in Office 365. Switching to Office 365 also means higher pricing and therefore contributes to revenue growth.
To sum up, it looks that Microsoft is doing great overall with Office and 11% annual growth is a good achievement, given its already big market presence. But let’s be clear that part of this growth is thanks to customers switching from on-premise licensing to Office 365 and also by customers with cheaper Office 365 subscriptions switching to more expensive packages to have access to more premium tools.
This development can drive the growth of revenue for a while at current levels, but after the legacy portfolio gets converted into Office 365, growth will slow down unless Microsoft takes some action. To keep the growth at 11%, conversion of Office 365 customers to higher subscriptions would have to accelerate, or user growth would have to increase, or Microsoft would have to raise prices of Office 365.
LinkedIn Revenue (Productivity and Business Processes)
LinkedIn is with Office and Dynamics tools (that I will describe later) part of the Productivity and Business Processes segment. Microsoft acquired LinkedIn in the 2017 fiscal year (end of the 2016 calendar year) for a whopping $27bn. It was perceived as a surprising and questionable move, and the jury is still out on if this acquisition will deliver what was promissed.
In 2020 LinkedIn contributed $8.1bn to Microsoft’s revenue, which was 20% growth. It would be even higher but last quarter growth slowed down to 10% y/y thanks to COVID-19. Even though people used LinkedIn more, companies used LinkedIn less to seek employees, which meant slower growth.
However, revenue is not the main problem LinkedIn has, because it is probably still losing around $1bn a year in operating income. On top of that, synergies that were communicated as reasoning for doing the deal did not fully realized yet.
With Microsoft behind LinkedIn and keeping its current momentum, Microsoft should be able to get its money back. But getting its money back does not justify the reasoning behind this acquisition.
The LinkedIn acquisition was sold to investors by Microsoft as a significant opportunity for synergies between the companies. If you can check Microsoft’s presentation on the LinkedIn deal, you will see that it contains a lot of vague corporate “mumbo jumbo” reasons, but between them, one can spot few “realistic” integration opportunities.
One of them is the integration of LinkedIn Sales Navigator with Dynamics 365. This part already happened a can help differentiate Dynamics 365 on the market (More about Dynamic later).
Another synergy that was mention and that I see as a viable opportunity is an integration of LinkedIn Learning content into Office. It will allow companies to create a custom learning plan that can be built from external content that LinkedIn hosts or can be structured as a combination of external content and internally created content.
This looks like a real value proposition for businesses that can make money, and integrating it with Office 365 can give Office even more customer stickiness. I was writing about this opportunity already last year and it looks that it will become real soon since it was specifically mentioned on 2020 Q4 earnings call.
“A new learning app in Teams will allow organizations to integrate LinkedIn Learning, as well as their own content, to create a continuous feedback loop between work, skills, and the learning to upskill and reskill employees.”
— Satya Nadella, Microsoft’s CEO, Q4 2020 Earnings Call
To sum up, LinkedIn is not a bad acquisition even with its current performance, but some synergies that were announced as a reason for the acquisition did not happen yet, even thoug it looks the things are moving in the right direction. But it will be a slow process and it will take years before we see some of them bringing significant revenue.
Note: Growth in LinkedIn revenue between 2018 and 2017 is not comparable because the 2017 value is only for half of the year. LinkedIn was acquired at the end of the 2016 calendar year, but it falls into the 2017 fiscal year that ends in June 2017.
Dynamics Revenue (Productivity and Business Processes)
Dynamics is not a household name, but its cloud version Dynamics 365 might be one of the drivers of Microsoft growth in years ahead, even though Dynamics is tiny now at approximately $3bn of annual revenue. (In the graph above it is included within “Other” category).
Dynamics offers business customers different modules for enterprise resource planning (ERP) or Customer Relationship Management (CRM). It can be seen as Microsoft’s answer to Salesforce.com and other similar software as a service platforms. It is currently tiny but fits company strategy very well. It might be one of the significant opportunities for revenue growth years ahead.
The cloud version of Dynamics (Dynamics 365) generates $1.5bn in annual revenue and grows by over 40% a year.
Server Products and Services Revenue (Intelligent Cloud)
Server Products and Services is the most significant revenue source ($41.4bn) and also the one with fast growth (27%). Thanks to this combination, it was the single biggest absolute revenue growth reason in 2020. Together with Office revenue source is the core driver of Microsoft’s recent success. Let’s look at it in more detail.
Server Products and Services include:
Traditional on-premise server products are the biggest part of this category (around $21 bn annually) and are still growing, although very slowly. This includes products like Windows Server and SQL server, which are mostly on-premise solutions or part of hybrid solutions.
Azure is Microsoft’s cloud service, which is the second-biggest cloud after Amazon’s AWS. Azure is an extremely fast-growing business, growing by 72% in 2019, and 56% in 2020, and it is poised to overcome on-premise server products in revenue next year.
Azure is a Microsoft real success story with revenue of around $20bn a year and fast growth. Current CEO Satya Nadella that replaced Steve Ballmer as CEO in 2014 deserves a lot of credit for how Microsoft managed to focus on Cloud solutions, including Azure and execute this strategy effectively. However, we have to give credit also to the previous CEO, Steve Ballmer, for this.
Microsoft was pushing and working on Azure and also Office 365 even during Ballmer tenure (Satya Nadella managed Azure as a vice president). The fact that Microsoft board recognized the importance of cloud for the future of Microsoft might have been the important reason why Nadella was chosen for the top job to continue pushing the cloud further. To Satya Nadella’s credit, he is quite open about it, as shown in the following video clip.
When comparing Microsoft Cloud business to AWS or Google’s Cloud, it is often too narrowly focused only on Azure because it is easily comparable to AWS.
But to compare these two clouds this way kind of misses the point where Microsoft’s cloud business is heading. Yes, it offers cloud infrastructure for other companies to use, but more importantly, Microsoft is using Azure infrastructure as a platform and is building business tools on top of that. And obviously, offering customer tools that solve their problems is much bigger added value than focusing just on providing infrastructure. And higher value leads to higher profit margins.
Enterprise Services Revenue (Intelligent Cloud Segment)
It is a smaller, slow-growing revenue stream but which fits nicely within the Microsoft business model. It includes revenue from providing premier support of its products and consulting and training on how to best use Microsoft’s products.
Windows Revenue (More Personal Computing)
Windows’ importance for Microsoft revenue is slowly decreasing, and Windows currently has a 16% share on total revenue. It is not a cornerstone of Microsoft’s business anymore, but it is still crucial as part of its full business software offerings.
The biggest piece of Windows revenue is coming from Equipment manufactures (OEM) like Lenovo, Dell, or HP that offer devices with a preinstalled Windows operating system. These OEM partners pay the licensing fee to Microsoft for that. These are both consumer-focused devices and business-focused devices. However, the majority of OEM Windows revenue is from devices with Windows Professional installed. OEM Licensing with Windows Professional is growing by around 11% annually compared with usually declining revenue from non-Professional OEM Windows licensing. In 2020 however, even the non-professinall OEM segment was growing by 5% probably because of COVID-19.
Another stream of Windows revenue is Commercial Licensing, where companies buy Windows licenses directly from Microsoft. It is a smaller part of Windows revenue (24%) but growing in double digits.
If you look at revenue for devices for the last five years, it is the worst-performing part, but the recent few years offer some good news. Long term negative trend is caused mainly by Phone business revenue evaporation in 2015 and partly in 2016 when Microsoft exited its phone business. Since 2017 devices consist predominantly of revenue from Surface devices.
Surface devices were not an instant success when Microsoft introduced them, but Surface is doing very well in the last two years, growing from around $4bn in 2017 to $6.2bn in 2020.
Gaming (Xbox) Revenue
Gaming (Xbox) is the only solely consumer-focused business that might look out of place considering Microsoft’s new business focus strategy. Therefore, rumors and comments about possible divestment of gaming business are flying around.
Xbox is a pretty significant business with $11.6bn of annual revenue, but its growth is on a lower side and increased by $0.2bn in 2020, which resulted from an 11% increase in services part of gaming revenue. Service revenue mainly came from sales of its own and third-party games (Microsoft takes a cut from the price), and it was partially offset by a decrease from the sale of Xbox hardware. If you take into account that Q4 was very positively affected by COVID-19, not much to brag about.
When Microsoft’s CEO, Satya Nadella, was asked about the future of Gaming within Microsoft during the 2019 Q4 earnings call, this was his answer: (Note: X Cloud is Microsoft gaming streaming service).
“… it builds on the rest of the cloud investment. So, if you think about what we are doing with X Cloud, it’s a hero workload on top of Azure. So, when we think about capital allocation, what’s happening in the cloud, what’s happening in the edge, how with build the network to optimize for streaming. The same infrastructure, for example, is what Sony has decided to use as well and be on Azure as well as use our AI capabilities.”
— Satya Nadella, Microsoft’s CEO, Q4 2020 Earnings Call
So as you can see, although CEO did not confirmed or denied anything, as I see it, he suggested that there are synergies with Azure cloud and that having Microsoft’s gaming services running on Azure can be used to lure other businesses in the gaming sector into Azure.
I can also think of one other long term reason why gaming in Microsoft fits its strategy well. Microsoft is quite focused on educational tools both for non-business and business-focused, and the future of learning will be connected with gaming technology.
Gaming for now looks like a weird fit, and its future is unclear. But let’s keep in mind that even though the consumer market is not the company’s focus right now, it does not mean that there is not a long-term aspiration within Microsoft to get back into it when the right opportunity presents itself. The recent announcement that Microsoft wants to buy TikTok suggests that this might be the case.
Although Bing, which is Microsoft’s search engine, market share is tiny, and Microsoft even outsourced monetization of Search to Verizon, it still added nice $8bn to revenue in 2020. By the way, it is roughly the same as the total revenue of LinkedIn that Microsoft paid $27bn for. Growth in 2020 was only 1% vs. 9% last year driven mainly by COVID-19 impact in Q3 and mainly Q4 2020 (-18% y/y growth)
Bing, however, is not important only because it earns a few billions of dollars from advertising. It is a strategic asset because of its underlying search technology. It is crucial for Microsoft to have this expertise and continue to innovate in it inside Microsoft to be able to push search and understanding of natural language into its business-focused products.
Alternative Breakdowns of Microsoft’s Revenues
The area charts below show how are different Microsoft revenue streams important for Microsoft’s revenue and what are the trends during the last five years. Most obvious development is:
- a decrease in the share of devices on total revenue in 2015 and 2016, which was caused by smartphone business exit. It decreased the revenue but also helped margins.
- Increase in Server Products and Services to 29% share on revenue. As I mentioned before, this is driven mainly by the fast growth of Azure Cloud revenue and share of this revenue stream will continue to increase for the foreseeable future.
- Another not so much a takeaway then just a reminder is that Windows, although not anymore cornerstone of Windows strategy, is still an important revenue contributor with a 16% share on total revenues.
The second split above nicely visualizes the underlying shift within each revenue source that cloud-based services are replacing on-premise licensing model. It is not so much visible in previous revenue breakdowns because this shift is happening within the several main revenue sources. For example, Office revenue is growing by 11% on overage, but if we break it down, there is a decline in on-premise licensing (product), and users are switching to Office 365 (service)
You can also see how Microsoft splits its revenue based on if it is coming from the US or other countries. Not much to see there, the split is 50:50 and does not change much.
Finally, let me offer you a less traditional look at how different Microsoft’s revenue sources or product lines are growing. Aim of the bubble chart below is to visualize :
- How big are various revenue sources compared to each other (visualized by the size of the circle)? You can see that the most significant pieces are Server Products and Services, Office Products and Services, and Windows in the third place.
- How are different income streams growing in absolute revenue compared to the previous year? (more up is the bubble, the biggest revenue increase it represents)
- How are different income streams growing relatively (in %) compared to the previous year. The fastest-growing revenue sources are positioned on the right and slowest ones on the left.
Overall, what this chart visualizes nicely is that the biggest revenue source(Server Products & Services) is also the fastest-growing, which makes it the core driver of Microsoft revenue growth both relatively and absolutely. Office products and services are the second biggest piece. Its growth is slower than the average revenue growth. But thanks to its size, Office absolute revenue increases is a significant contributor to the total Microsoft’s revenue increase this year.
We can then see a bunch of low growth revenue sources on the bottom left, including Windows, Gaming, Search, and others. On the other hand, we also have two smaller, fast-growing revenue sources on the right, which are LinkedIn and Other (mostly Dynamics).
🔴 Breakdown & Analysis of Microsoft’s Expenses (Income Statement)
The level of detail that companies offer for expenses are usually much less granular than for revenue. And Microsoft is no exception. Below you can find a functional breakdown of total expenses into several categories.
Microsoft also reports gross and operating margin for these three operating segments, which allows us to deduce the total cost of revenue and total expenses for each segment. Unfortunately, detail to see the split between different functional categories for the segments is not provided anymore.
The overall growth of expenses is 9%, which is lower than 14% revenue growth. That is good news and means the operating margin increased to 37%, which is very respectful, and it would be even higher if we did not count loss-making LinkedIn revenue and expenses.
Let’s look at the individual items closer, focusing on the ones that are not growing in line with revenues.
Cost of revenue
The cost of revenue for services is growing by 13% compared to the cost of revenue for product growth of -2%. This makes absolute sense, given the revenue split development between products and services and transformation Microsoft is going through. Products are usually legacy products that Microsoft doesn’t develop so actively, and company resources are shifting to services. The total cost of revenue is growing by 7%, which is below the revenue growth.
Research and Development Expenses
Growth is in line with revenue (14%) and has increased significantly in the last three years, in line with total revenue growth. The growth in 2020 is roughly in line with the increase in the number of employees in research and development, which increased by 17% to 56 000 people. The main reason for this increase was continued investment in cloud engineering and also in LinkedIn and devices. Total Microsoft’s headcount was 163 000 at the end of 2020.
Sales & Marketing Expenses
This cost category deserves our attention because although it increases its growth to 13% increase in 2018, it slowed down again in 2019 and 2020. The question is why. What happened there?
The answer is simple. This temporary increase was mainly caused by LinkedIn as it was incorporated into the result for the full year.
Let’s compare sales and marketing expenses growth with headcount growth in sales & marketing. Headcount grew between 6%-5% both in 2018, 2019 and 2020. Microsoft says that a 4% growth in sales and marketing expenses in 2019 was influence by an increase in a commercial sales capacity and is partially offset by a decrease in marketing expenses. In 2020 increase by 8% is driven by investments in LinkedIn and commercial sales, and an increase in bad debt expense.
In 2018 (vs. 2017), Microsoft provided a similar explanation that sales and marketing expenses are driven not only by commercial sales but also thanks to LinkedIn (full-year impact of acquisition)that was offset by decreasing marketing expenses.
So although, sales and marketing expenses in 2018 were temporarily impacted by LinkedIn, general trend is that sales & marketing expenses are growing more slowly because it combines growth in a commercial sales capacity (roughly in line with headcount growth), and this growth is partially offset by other items.
General & Administrative Expenses
Not so relevant, small cost category, but it is good to see that Microsoft can keep its growth at low levels.
Impairment, Integration & Restructuring Expenses
Expenses in 2015 and 2016 are related to the closing of Microsoft’s phone division and include the write-off of Nokia acquisition and also additional integration and restructuring expenses.
Expenses as % of revenue & Margin Development
The chart below shows the same expense item we explored before as % of revenue for the last five years. You can see how the cost of revenue and services offset each other as services become more important for Microsoft. Research & Development expenses are staying roughly at a 13% share.
What drives the overall operating margin increase is lower growth in all expenses except Research & Development.
What this chart also shows is the white area at the top, which is revenue that is not spent. In other words, it is the operating margin. The operating margin of Microsoft is increasing for the last couple of years, and in 2020 was at respectful 37% of revenues.
Microsoft also offers in its financial statements a split of its margin across different high-level segments. It ranges from 40% for Productivity and Business Processes segment to 33% for the More Personal Computing segment. Intelligent Cloud operating margin is 38%. And all segments margin increased versus 2020.
Alternative visualization of Microsoft’s Expenses Changes in 2020
Visualization in the form of bubble chart below offers a summary of how different expense items are changing in 2020 compared to 2019. We can see the cost of revenue for services and R&D are items that are growing roughly at the same speed as revenue. Still, this growth is more than offset by lower growth in Sales and Marketing and lower growth in the cost of revenue for products. As I showed earlier, the cost of revenue for prouducts and the cost of revenue for services are moving in different directions as services are usually new faster-growing income streams compared to “legacy” products.
Overall it looks that Microsoft is smart in how it invests its money back into high growth areas and keeps overhead under control. Its operating margin is high across different segments.
💵 Breakdown & Analysis of Microsoft’s Cash Flow
If we want to analyze Microsoft properly, we cannot skip looking at its cash flow statement. It offers a different perspective because it focuses on cash flow when it happened and not when it was recognized as revenue or expense.
Cash flow is especially important for observing the company’s investing activity, how much free cash flow it has after investing, and how this free cash flow is used. Is it used to strengthen Microsoft’s already impressive cash pile, repay debt, or to pay out to shareholders?
Let’s look at the visualization of Microsoft’s 2020 Cash Flow Statement below. It shows how Microsoft’s $61bn cash flow from operations (Net operating cash flow) was used in 2020.
We can see above that from $61bn, part of it ($15bn) was used to invest in property and equipment. These are investments mainly into Microsoft’s data centers, hardware for these data centers, and partially also for office space for its ever-growing workforce.
By deducting investment into property and equipment, we arrive at $45bn of free cash flow. Free cash flow is one of the most crucial cash flow metrics, showing how much cash can Microsoft generate. Everything that visualization above shows below the Free Cash Flow part is about how Microsoft spends its free cash flow.
Just be aware that this is a “standard” way and not so great one how to calculate “Free Cash Flow”. If you really want a more proper number about how much “free” cash Microsoft has after investing, we need to adjust free cash flow for investing done through leasing. And if you want a current free cash flow to estimate future one, you also need to adjust for stock-compensation. If we do all these adjustments Microsoft Free Cash Flow would be $34bn in 2020 and not $45bn.
Let’s ignore the smaller items and focus on the three main ways how Microsoft used its $45bn (or $34bn adjusted)
- Microsoft used $6bn to repay its debts. Microsoft’s debt increased significantly in 2017 because it financed its massive $27bn LinkedIn acquisition by debt and is slowly repaying it each year.
- The second-largest cash outflow was $15.1bn paid to shareholders as a dividend.
- The biggest cash outflow item was $23bn for repurchasing its own stocks, which in fact, is just another way to return earned cash back to investors.
If we add it up, then you can see from $45bn of free cash flow, $38bn was paid back to shareholders. It shows the maturity of Microsoft’s business, where it can self finance its investment activity and still return a hefty amount to investors.
If we look at cash flow for the last five years, we can see that operating cash flow is growing every year, and even though Microsoft invests more money each ear into its data centers and offices, it still can increase its free cash flow.
Free cash flow is one of the most important metrics that show the cash that the company can generate and is one of the core inputs (the adjusted version) into how companies are valued. Investors expect this trend to continue for some time, and then it is no surprise that Microsoft stock price just shot up at the same time and currently is competing with Amazon and Apple for the title of the most valuable company in the world.
Before we leave the cash flow statement, let me breakdown also investing cash flow. We can see that Microsoft was “saving” around $13bn to $14bn each year and increasing its cash pile, which ended in 2018. We can also see that in 2017 it paid about $26bn for acquisitions, which is mainly LinkedIn. To be able to keep paying out money to shareholders and keep its current cash pile and even increase it, Microsoft needed to borrow money to finance the LinkedIn acquisition.
⚖️ Breakdown & Analysis of Microsoft’s Balance Sheet
The balance sheet of a technology & software company like Microsoft is usually straightforward. Unfortunately, it does not show the main part of the business, which is the value of the intellectual property it internally develops.
All those software products that tens of thousands of software engineers are working on do not show there. It only shows investments in the physical part of its cloud infrastructure as part of the property and equipment category, which is the less valuable part of Microsoft’s business.
Still, a balance sheet is important to look at, even in the case of Microsoft, but we won’t spend too much time with it. The chart below shows Microsoft’s balance sheet in US dollars during the last five years, and below it, you can find a similar chart showing the relative size of different balance sheet items as % of total assets.
The thing that jumps at me when I look at this chart is that cash (or more precisely Cash equivalents + marketable securities) represented around half of the assets and started dropping to 46% just recently as Microsoft stopped growing it.
We can also spot big changes in the balance sheet structure in 2017 (fiscal year) as Microsoft acquired LinkedIn for $27bn. LinkedIn is also the reason behind the increase in Goodwill since around 60% of the price paid for LinkedIn was actually premium above market value. And since the LinkedIn acquisition was finance by debt, you can see a significant increase in long-term debt, which is Microsoft slowly repaying each year.
The chart below shows how different balance sheet items moved in 2020, both absolutely and relatively.
When looking at Microsoft’s number, please note that Microsoft’s fiscal year does not end in December, but in June. Therefore revenue for 2019 of $126bn is revenue from July 2018 to June 2019.
Accounting approaches how to treat revenues or recognize assets change in time, and companies only offer two or three years of consistent data. I prefer to have at least a five-year history to see medium-term trends, which then creates a problem of the first two or three years not being consistent. If there is an issue with inconsistency with older years, I try to adjust earlier financial statements to make data more consistent. To do that, I use information company itself provided. If the company did not provide it, I show the historical years as they were reported.
📚 Resources & Links
Official Annual Reports (K-10)
- Microsoft’s Annual Report 2020 (10-K)
- Microsoft’s Annual Report 2019 (10-K)
- Microsoft’s Annual Report 2018 (10-K)
- Microsoft’s Annual Report 2017 (10-K)
- Microsoft’s Investor Relation Website: Place where you can find earnings call transcripts and other supplemental documents and data.
- Historical Overview of Microsoft (Wikipedia)
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