Microsoft’s Transition to the Cloud Will Be a Drawn-Out Slog

Microsoft has reported its fiscal second-quarter results.

The numbers: Microsoft put together a solid Christmas quarter. Sales rose 8% from the previous year’s second quarter to $26.5 billion, narrowly beating Wall Street’s expectations. Search advertising grew 23%. Surface tablet revenue reached $1.1 billion, up 24%, and the company sold 6.6 million Xbox devices.

The takeaway: Microsoft isn’t collapsing—as some hypothesized it might, given how the company missed the mobile revolution and still relies on the PC market. Its 10.5 million Lumia smartphones sold last quarter represent just 2% or so of the global smartphone market. But the company is still huge, still growing, and still quite profitable, generating almost $6 billion in net income last quarter.

What’s interesting: Microsoft is in the early stages of what will clearly be a long, slow, potentially painful transition to the cloud. Specifically, it is shifting toward a model of selling software as subscription-based services, and away from its “old” business of selling one-time software licenses.

The good news is that this “old” business continues to be fabulously profitable. Even last quarter, its two biggest gross-margin drivers were its “commercial licensing” business ($9.9 billion in margin contribution, or 61% of total) and “devices and consumer licensing” ($3.9 billion in margin contribution; 24% of total).

But both of those businesses are shrinking. Commercial licensing sales were roughly flat last quarter, while the consumer business declined by 25% year-over-year. Gross margin also declined in both businesses.

Meanwhile, Microsoft reported solid growth rates for its future prospects—the cloud businesses. It now has 9.2 million subscribers to its Office 365 Home and Personal service, up 30% from the first quarter. And separately, commercial cloud revenue grew 114% year-over-year, reaching a $5.5 billion annual run rate.

The problem: That’s only about 5% of Microsoft’s annual sales, which are expected to top $98 billion this fiscal year. There’s a lot of change still ahead.