Forget the Red Flags, Nadella and Investors Optimistic on Microsoft Direction

Put Microsoft's latest quarterly earnings on a business dashboard of some of the company's traditional key performance indicators, and the screen would light up red.

• Windows OEM revenues down 22 percent!
• Office commercial products and services revenues down 2 percent!
• Earnings per share (EPS) off 10 percent!

So why did Microsoft CEO Satya Nadella sound so sanguine in the earnings call Thursday? "Overall, I'm pleased with our business performance," Nadella said, according to a Seeking Alpha transcript.

Could it be that the words "I'm pleased" mean something different to Nadella than they do the rest of us? After all, later in the call he said, "I'm pleased with our renewed partnership with Yahoo!" That would be the deal that was widely regarded as Yahoo CEO Marissa Mayer getting everything she wanted, including a new back-out clause, in a renegotiation.

For their part, investors seemed actually ecstatic with Microsoft's results. Microsoft shares were up a whopping 10 percent to close at $47.87 on Friday.

From the context of the rest of his remarks, it's pretty clear that Nadella was also actually optimistic. Microsoft did manage to scratch out a 6 percent year-over-year revenue increase, despite struggling in some of its historically core businesses. And the EPS figure, while lower than the year-ago period, beat analyst estimates.

Nadella legitimately pointed to three headwinds in this last quarter: the negative impact on Microsoft of the strong dollar, a bruising IT purchasing environment in Microsoft's second-biggest market of Japan, and a tough comparable because of Windows XP. The January-March period of 2014 was the absolute peak of the Windows XP end-of-life migration. Windows client purchases fell from those highs back to more normal levels in the most recently completed quarter. Normal would also be the new normal of a contracting PC industry.

One traditional metric, server software sales, was a bright spot. Microsoft CFO Amy Hood said server products and services revenues were up 12 percent, and revenues for premium offerings of SQL Server, System Center and Windows Server were up 25 percent.

It was cloud and devices that Nadella directed investors' attention to. "Our momentum in cloud is a highlight," he said. He fired off data points, including a $6.3 billion annualized run rate for Microsoft's commercial cloud, a seventh consecutive quarter of triple-digit commercial cloud revenue growth, 50 million Office 365 monthly active users, 5 million organizations in Azure Active Directory, three-x growth year-over-year in storage transactions in Azure, and a doubling of enterprise paid seats for Dynamics CRM Online year-over-year.

On the device side, Microsoft made some serious money in the quarter on Surface to the tune of $713 million, and that's ahead of the Surface 3 availability. Nadella pointed to the 64 percent usage of OneNote by Surface Pro 3 users as evidence of the potential for Microsoft's better-together story and hinted that the new Windows 10 upgrade strategy will provide opportunities to continue monetizing customers for years after the initial system purchase.

Windows Phone results were mixed. Still not making any real headway against Android devices and iPhones, Microsoft at least seems to be getting some of the Nokia acquisitional hiccups under control. Lumia sales volumes hit 8.6 million units for the quarter, and Hood reported that Microsoft has reduced the operating expense base in the phone business from an annualized rate of $4.5 billion at acquisition to less than $2.5 billion.

As a recurring theme during the call, Nadella encouraged investors not to think of Microsoft's transition as a one-to-one shift from the old revenue sources of on-prem Windows, Office and server software to the new revenue sources of cloud services and, to a lesser extent, devices.

He argued that, yes, Microsoft is getting the direct dollars -- the Office 365 subscription where there used to be a boxed suite of Office applications, the Azure infrastructure where there used to be a server closet. But he made the case that Microsoft is positioned for a lot of net-new workloads, such as Power BI, Delve, e-discovery and mobility management.

"We definitely are seeing one-for-one migration, but the opportunity in every one of our offerings from Office 365 to Dynamics to Azure has a non-zero-sum component to it," he said.

It's a message that, for now, Wall Street seems to be buying.

Posted by Scott Bekker on April 24, 2015