Q1 MSFT Earnings Need Cloud to Overcome Transition Costs

The Q1 MSFT earnings are expected after the market close today (Thursday).

The short story is that transition costs will weigh down Microsoft Corp.'s (Nasdaq: MSFT) Q1 earnings, while continued strength in the company's cloud-based products could deliver enough oomph to manage a beat.

Layoffs, consolidation and restructuring costs from the deal to acquire the Nokia devices unit, which closed in April, will drag on earnings for the next few quarters. But that will be offset by the increasing payoff from Chief Executive Officer Satya Nadella's new "cloud first, mobile first" strategy.

The Q1 Microsoft earnings will tell us how well Nadella is managing this multi-faceted transition. The more successful he has been, the more likely MSFT will beat expectations.

Here's what investors need to know about the Q1 MSFT earnings report:

What to Watch for in the Q1 MSFT Earnings

The numbers: According to Yahoo! Finance, analysts are looking for earnings per share (EPS) of $0.49, down from $0.62 a year ago. EPS has declined in six of the last nine quarters. The forecast for revenue is $22 billion, an 18.8% increase over sales of $18.53 billion in the same quarter a year ago.

Q1 MSFT earningsThe last quarter: Microsoft missed on earnings last time, with an EPS of $0.55 a share falling short of expectations for $0.60 a share. But revenue of $23.38 billion beat forecasts for $23 billion.

The stock: MSFT stock has been flat over the past quarter, but is up nearly 19% for the year. Microsoft stock closed at $44.38 yesterday (Wednesday). MSFT raised its dividend from $0.28 to $0.31 Sept. 16.

The background: Microsoft's failure to establish itself in the mobile market has hurt the company. Revenue from Windows licenses has slumped along with overall PC sales in recent years. Former CEO Steve Ballmer was never able to put together an effective strategy to move Microsoft into the future. Now that task has fallen to Nadella.

Now here's what will matter most in the Q1 MSFT earnings...

Keys to the quarter: The 18,000 layoffs that Nadella said in July would be spread over one year will incur some costs. So will more than $1 billion in restructuring charges associated with the Nokia deal. But they're necessary for Microsoft to compete in the years to come.

Last quarter, Microsoft reported sales growth of 147% in its cloud services. That includes Office 360 as well as Azure, its business cloud service.

With Office 360, Microsoft is moving customers away from buying licenses toward an annual subscription model. It has proven a smart move. Microsoft reported that subscribers had doubled year over year last quarter. Investors will want to keep an eye on this number - MSFT needs that impressive growth to continue.

Sales of Windows to business customers as well as consumers, should continue to benefit from the end of support for Windows XP earlier this year. Upgrade-resistant customers have had no choice but to buy a new version, although this quarter will probably be the last to see that benefit.

In addition, Nadella is now aggressively giving Windows away on mobile devices with screens of 9 inches or smaller. It's a gamble that sacrifices some revenue to get a bigger foothold in mobile.

MSFT's Hardware Business Matters, Too

The hardware side, while only about 13.4% of MSFT's revenue, still provides investors with a measure of how some of its long-term strategies are working. The hardware strategy needs to succeed to bolster the software and cloud strategies.

The Surface 3 had just been introduced as of the last report. Whether sales remained strong through Q1 will say a lot about the health of Microsoft's mobile strategy. Just as telling will be sales of the Lumia smartphones, Microsoft's primary means of showcasing Windows for mobile devices.

Finally, investors will want to pay close attention any clues Nadella surrenders in the conference call about the progress of Microsoft's transition. It's doing what it needs to do now, and has a great shot at regaining its former glory. But for now MSFT faces a lot challenges.

"The decision to go all in by risking the past - Windows - in order to have a piece of the future [in] mobile and cloud is the right one, in our opinion," BMO Capital Markets analyst Joel Fishbein told MarketWatch. "But it's still very unclear how Microsoft gets there."

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What About Windows 10? The latest version of Windows won't appear until sometime next year, so it won't affect earnings for a while. But if Microsoft makes one key change to Windows 10, it could have a major impact on MSFT stock...

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About the Author

David Zeiler, Associate Editor for Money Morning at Money Map Press, has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He's interviewed a number of well-known personalities - ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.

Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He's an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun's web site from 2007-2009. Dave's been writing about Bitcoin since 2011 - long before most people had even heard of it. He even mined it for a short time.

Dave has a BA in English and Mass Communications from Loyola University Maryland.

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