But demand continues for Microsoft’s web-based Office software and Azure data and applications storage products.

Satya Nadella’s plan to reshape Microsoft Corp. as a cloud-computing company hit a snag in the third quarter, when lackluster sales of Surface tablets and weaker demand for corporate software-support services kept revenue growth in check.

Adjusted sales in the period that ended in March rose to $23.56 billion, falling slightly short of analysts’ average estimate. The miss was enough to give investors pause—the software maker’s shares slipped 1.4% following the report, after rising to a record high at Thursday’s close in New York.

Even as some businesses underperformed, the company posted another quarter of brisk demand for internet-based versions of Office software and its Azure service for running and storing customers’ data and applications. Azure sales rose 93%, while commercial Office 365—cloud-based versions of Word, Excel and other productivity software—increased 45%. Microsoft has poured billions into data centers to run these services and is now signing up customers to fill them. Meanwhile, the personal-computer market, a drag on Microsoft results for the past several years, has begun to stabilize.

“They were at an all-time high before the report with people expecting they’d blow away the numbers, so you can make the case it was priced for perfection,” said Dan Morgan, a senior portfolio manager at Synovus Trust, which owns Microsoft shares. “It feels to me the growth thesis is intact.”

Profit excluding certain items in the quarter that ended March 31 was 73 cents a share, topping analysts’ 70-cent average estimate, according to data compiled by Bloomberg. Analysts had projected sales of $23.65 billion. Earnings were higher because Microsoft exceeded its own estimates in the more profitable areas of productivity and cloud software. It was Surface hardware—a less lucrative business—where Microsoft did worse than the company had predicted, chief financial officer Amy Hood said.


Surface decline

Third-quarter sales in the company’s More Personal Computing business, which houses Windows software, Surface devices and the Xbox game console, fell 7.4% to $8.84 billion. That was below the $9.2 billion average estimate of five analysts polled by Bloomberg, owing to a 26% decline in Surface revenue.

Within hardware, Microsoft’s biggest seller is the Surface Pro line, a combination tablet and laptop with a detachable keyboard. The product line is getting old—the Pro 3 is being phased out and the newest version, the Pro 4, was introduced in 2015. Microsoft underestimated how quickly sales would drop off as the products aged, Hood said.

“This is about life cycle and price competition,” Hood said in an interview after the report, noting that Microsoft remains committed to the Surface business.


The company’s revenue shortfall was only its second since 2013. When Microsoft does miss, it’s often in the fiscal third quarter, a historically slower sales period for the software maker. The last sales disappointment was a year ago in the same period.

Other businesses performed better than expected. In the Intelligent Cloud unit, made up of Azure and server software deployed in customers’ own data centers, sales increased 11% to $6.76 billion, compared with the $6.61 billion average analyst projection. Productivity revenue, mainly Office software, climbed 22% to $7.96 billion. Analysts had estimated $7.78 billion.

“The cloud numbers looked awesome and that’s why people own the stock,” Synovus Trust’s Morgan said.

Cloud transition


As more companies shift data and computing tasks to the cloud, the market for the kinds of services Microsoft offers—alongside Amazon.com Inc., Google and a raft of smaller competitors—is forecast to hit $34 billion this year, according to IDC. The Redmond, Washington-based software maker is also trying to shift more of its Office customers to online subscription versions, while adding cloud business from professional network LinkedIn, acquired last year for $26.2 billion. Microsoft has also introduced a new Office cloud product to compete with corporate chat app Slack and added features to its web-based customer-service software, which aims to steal customers from Salesforce.com Inc.

“This is a company in transition,” said Brent Bracelin, an analyst at Pacific Crest Securities. “Cloud continues to be the biggest factor in that multiyear transition.”

Microsoft has won Azure customers like UBS Group AG, which uses the cloud service for its risk-management technology, and chocolate maker Hershey Co, which relies on Azure’s machine-learning service to analyze data coming from sensors tracking the production of its candies. Investors and analysts are paying close attention to the cloud race as they try to project which of the older, established technology companies will profit most and survive in the new world of cloud computing. Oracle Corp. and International Business Machines Corp. have been navigating their own transitions to internet-based computing from legacy hardware and software.

“With these large tech dinosaurs—Oracle, Microsoft, IBM—we are mapping all these tech titans against each other to see which are transitioning their business models to cloud in a successful way. Not all will be able to transition effectively,” Bracelin said. “Microsoft is one of the companies that has done the best job so far in pivoting.”


Even Microsoft’s PC-software business looked relatively solid. It’s been five years since the industry grew, but market researcher IDC said shipments finally increased, barely, in the first three months of 2017, with unit sales worldwide rising less than 1%. Business PC sales performed better than the consumer market, and Microsoft is benefiting as more companies upgrade to Windows 10, its latest operating system software. In the recent period, Microsoft boosted sales of Windows to PC makers by 5%, better than the increase in the broader PC market. Gaming revenue for Xbox and PC increased 4%. Windows commercial products and cloud services also expanded.

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