Leading software company Microsoft (MSFT Quick QuoteMSFT - Free Report) is expected to report fiscal fourth-quarter earnings on Jul 19 after the bell. Let’s see how things are shaping up for the company heading into the earnings announcement.

MICROSOFT CORP Price and EPS Surprise

MICROSOFT CORP Price and EPS Surprise | MICROSOFT CORP Quote

Earnings Beat Hard to Predict

Our proprietary model shows that when a stock with Zacks Ranks #1 (Strong Buy), #2 (Buy) or #3 (Hold) have a positive ESP, its chances of reporting a positive surprise increases greatly.

Microsoft doesn’t satisfy the criteria because its Zacks Rank #3 (Hold) and Earnings ESP of -1.72% actually make surprise prediction difficult per our model.

Its earnings surprise history also raises concerns because after consistently beating estimates for quite some time, results were 1.59% below estimates in the last quarter taking the average four-quarter positive surprise percentage lower to 9.42%. At the same time, the Zacks Consensus Estimate for the to-be-reported quarter have moved lower since the company last reported, so they may be easier to beat right now.

That said, the shares appear undervalued, so even a modest beat might lead to a post-earnings rally.

Market Dynamics Overall Positive

The primary end markets impacting Microsoft remain PCs, Cloud and Gaming.

On the PC side, reports from both Gartner and IDC mention continuing declines in the first quarter although the rate of decline appears to be moderating. Also encouraging is the statement by both firms that there is a possibility of improvement in the second half of the year. Since Microsoft’s Windows and productivity software are generally installed on the majority of PCs worldwide, this is very good news for the company.

Microsoft’s Windows OS is also losing out to Alphabet’s (GOOGL Quick QuoteGOOGL - Free Report) Android and Chromebooks as well as Apple’s (AAPL Quick QuoteAAPL - Free Report) iPad and Macs as these two companies leverage their strength in mobile to increase penetration in the consumer segment and also target enterprises through their bring-your-own-device (BYOD) programs.                                                        

Microsoft’s Surface devices and Universal Windows Platform (same OS across mobile and desktop machines) were intended to counter these pressures. Opening up its productivity software to rival operating systems was another measure to protect revenue. These strategies appear to be working but we’ll know more as we move through the year.

Microsoft is one of the best positioned to benefit from cloud computing. Not only does it continue to pull users to its services through Office 365, but it also offers cloud infrastructure services to help enterprises transition to the cloud. Microsoft is targeting an annualized commercial cloud revenue run rate of $20 billion by 2018.

When the target was first announced it looked ambitious, but the company is currently halfway there. Its recent cloud performance has been stellar with Azure revenue growing 120% and Azure services revenue growing triple digits for seven straight quarters. So given the strong growth prospects, Microsoft’s strength at enterprise customers and its prior experience with enterprise workloads, this market is expected to remain highly positive for the company.

The gaming business will see quite a few changes in fiscal 2017. Microsoft is planning two new consoles: the Xbox One S (a trimmed-down version of Xbox One) and a yet-to-be-named powerful VR-ready console. Both devices will launch in 2017. But the company also launched a number of games at E3 including Gears of War 4, Forza Horizon 3 and Dead Rising 4. It also provided a glimpse of third-person, robot-filled game ReCore (the launch date for this is not known yet). Microsoft fell behind Sony during the last console refresh, but its new devices are interesting, as is the game lineup. So this market should play out well for the company, particularly during the holiday season.

The devices business should improve going forward because of strengthening Surface sales although there will be a temporary impact on revenue giving effect to the sale of the feature phone business.

Third, FX

FX usually has a negative impact on companies generating a chunk of their revenue overseas. Since the dollar remains strong, the negative impact may be expected to continue this quarter.

Last Quarter Disappointing

Both revenue and earnings came in below estimates. On the revenue side, there was weakness in transactional revenues, primarily in Latin America, the Middle East and Africa due to sluggish demand for PCs. The Productivity segment was in line with expectations, Intelligent Cloud was at the lower end of guidance while More Personal Computing was better than guided. The negative FX impact was roughly as guided.

All segments saw operating profit declines, which along with the higher tax rate (geographic mix-related) and negative FX impact led to the EPS coming in a penny below expectations.

This quarter, management said that FX would have a negative 3-point impact on revenue growth, in line with prior expectations. The impact on the Productivity segment is expected to be 3 points, Intelligent Cloud 3 points and More Personal Computing 2 points.

So total revenue will be between $21.7 billion and $22.4 billion (below estimates for the Jun quarter at the time). Microsoft expects COGS of $7.8–7.9 billion, opex of $8.2-8.3 billion, other income/expense of -$200 million and a GAAP tax rate of 20-21%.

Summing Up

Microsoft should report a moderate quarter with stable productivity solutions and cloud businesses, slightly offset by the evolving more personal computing business.

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