Microsoft Corporation (MSFT) reported third quarter 2010 earnings that beat the Zacks Consensus Estimate by 3 cents, or 7.14%. Revenue was basically in line, beating by 0.4%.
Revenue
Revenue of $14.5 billion was down 23.8% sequentially and up 6.3% year over year. The sequential decline was on account of seasonality, as well as $1.7 billion in deferred revenue related to the Windows 7 Upgrade Option and initial sales of Windows 7 to OEMs and retailers that were recognized in the second quarter.
Revenue growth from the comparable prior-year quarter was driven by both consumer and enterprise demand. Particularly, the company saw increased demand from small and medium sized consumer OEMs, as well as the first signs of spending on enterprise hardware.
Management estimates that the PC market (units) was up 25-27% from the Mar 2009 quarter, with approximately 10% of the total market consisting of net books compared to an 11% share in the Dec 2009 quarter. Consumer PCs grew 30%, while business PCs grew 14%.
Revenue by Segment
The Windows and Windows Live Segment generated 30% of third quarter revenue, decreasing 36.1% sequentially and increasing 29.7% year over year. The company witnessed increased sales of Windows 7 premium at both enterprise and consumer customers.
On a year-over-year basis, Windows 7 licenses into the consumer and enterprise markets were up 35% and 15%, respectively, as Windows 7 remained the fastest selling OS in the company’s history. With 90% of netbooks using Windows and 50% of those powered by Windows 7, the company is set to win this product cycle in a big way.
The biggest driver of segment performance was the growth in OEM sales, which exceeded management’s estimated PC market growth rate for the second time in nine quarters. The higher Windows attach rates, inventory builds and channel dynamics helped drive the increase at OEMs.
However, this was partially offset by mix, with the demand for PCs in emerging markets outpacing demand in developed markets and higher demand from consumer rather than business users. The retail strategy is also paying off, with the newly launched retail version of Windows 7 growing 26%, fueled by very strong sales at both physical and online outlets.
The Microsoft Business Division generated 29% of third quarter revenue, down 10.6% sequentially and 5.8% year over year. However, revenue would have been up 1% from the year-ago quarter if the Technology Guarantee deferral of $305 million related to Office 2010 was added back.
The non-annuity business remained slow, as OEM spending was a bit sluggish. Annuity-based sales were flattish compared to the year-ago quarter. The consumer side did well, driven by the OEM and retail business. This portion of the business will continue to benefit from the newly launched Office 2010 and SharePoint 2010.
Of particular note is the recent success in Microsoft’s cloud offerings, with the company announcing several big customers, such as Starbucks Corp (SBUX), McDonald’s (MDC), GlaxoSmithKline plc (GSK), Coca-Cola Enterprises (CCE), Aviva plc (AV) and the Swedish Red Cross.
The Server & Tools segment at 25% of total revenue declined 7.0% sequentially and grew 3.1% year over year. This was quite a bit lower than the estimated growth in server hardware shipments, which was in the high-teens percentage range.
Management stated that the OEM and licensing only (non-annuity) business accounted for 30% of segment revenue and grew in the mid-teens percentage range. Annuity, which accounted for 50% of segment sales, was similar to the year-ago quarter. Services, which made up the balance, grew 5%.
The company’s virtualization offerings—the Systems Center and Windows Server Premium editions—were up 20% each. While overall segment performance was a little disappointing, Microsoft has a very healthy product pipeline and a growing presence in the cloud computing arena, which should drive growth in ensuing quarters.
Entertainment & Devices generated 11%, down 42.6% sequentially and up 6.3% year over year. The sequential decline was as expected, as seasonal demand in the second quarter dropped off in the third.
Gaming revenue declined 4%, driven by lower xBox 360 console sales, which declined 71% sequentially and 12% year over year. However, software attach rates remained strong, as did membership growth and revenues from Xbox Live, partially offset by the Halo games in the year-ago quarter, which made for difficult comps.
Non-gaming revenue was up 14%, driven by increased investment in computer hardware and a stronger mobile segment. The mobile pipeline remains strong and we expect the Windows Phone 7 and the Kin phones to revitalize the segment.
The Online Services business, or online advertising, generated 4% of revenue, declining 2.6% sequentially and 21.5% year over year. However, Bing’s market share in U.S. has been inching upward, which should help revenue growth going forward.
Operating Results
The gross margin for the quarter was 81.0%, up 8 basis points (bps) sequentially and 162 bps year over year. The improvement from the year-ago quarter was attributable to relatively higher volumes.
Operating expenses of $6.57 billion were down 3.6% sequentially, but up 7.7% year over year. Consequently, the operating margin expansion from the year-ago quarter was entirely on account of the stronger gross margin and partially offset by higher R&D, S&M and G&A expenses as a percentage of sales. The improvement was possible because of management’s restructuring actions over the past year that lowered the cost base.
The operating margin by segment was as follows—Windows 69.3% (a decrease of 880 bps from the second quarter, which included the $1.7 billion in deferrals), Server & Tools 35.1% (down 368 bps), Microsoft Business Division 61.8% (down 164 bps), Entertainment & Devices 9.9% (down 301 bps) and Online Services -126.0% (down 4,557 bps). All segments except Entertainment & Devices also declined from the year-ago quarter. The online services segment margins were impacted by higher traffic acquisition costs.
The company generated a pro forma net income of $4.0 billion, or 27.6% net income margin compared to $6.7 billion, or 35.3% in the previous quarter and $3.3 billion, or 23.9% in the year-ago quarter. There were no one-time items in the last quarter. Accordingly, the GAAP EPS was $0.45 compared to $0.74 in the Dec 2009 quarter and $0.33 in the Mar quarter of last year.
Balance Sheet
Inventories were down 14.9%, with inventory turns dropping from 24.6X to 22.0X. Days sales outstanding (DSOs) went up from 54 to around 57, indicating sluggish collections.
The company ended with a cash and short-term investments balance of $39.7 billion, up $3.56 billion during the quarter. The net cash position was $4.10 a share. In the last quarter, the company generated record cash flow of $7.4 billion, spent $2.0 billion on share repurchases, $1.1 billion on dividends and $408 million on capital assets.
Guidance
Management was optimistic about revenue growth in fiscal year 2010, which ends in June.
The June quarter is seasonally strong for the Windows segment, which is expected to benefit from higher attach rates, inventory builds and gains from premium versions, although the longer sales cycle could offset these positives slightly. The annuity section of the Business Division (60%) is expected to be up low single digits, while the non-annuity section is expected to grow in line with the PC market.
The annuity section of the Server and Tools segment is expected to grow mid-single-digits, non-annuity to track the hardware refresh cycle and services to grow low single-digits. Online Services is expected to perform in-line with the market, benefiting from stronger ad spending trends. Both revenue and COGS (as a percentage of sales) in the Entertainment & Devices division is expected to be flat for the year.
Management expects that cost-control measures will enable the company to generate a 1% expansion in gross margins in fiscal 2010. As a result, the operating expenses guidance for fiscal 2010 was also lowered slightly. Operating expenses are now expected to be $26.1-26.3 billion, compared to previous expectations of $26.2 billion to $26.5 billion.
Capital spending for the year is expected to be $2 billion and the effective tax rate 25%, unchanged from the previous guidance.
Our Take
Microsoft is undoubtedly the leader in computing operating systems and judging from the growing success of the Windows 7 OS, the company will be able to retain the lion’s share of revenue flowing from the segment. Management has stated that 10% of all PCs are already running Windows 7, indicating strong adoption rates and significant potential that continues to unfold.
Moreover, Microsoft is poised to benefit from new product cycles in both the enterprise PC and server markets, especially the ongoing transition to virtualization and cloud computing. In the second quarter, the company entered into a three-year agreement with Hewlett Packard Company (HPQ) for its cloud computing solutions and this quarter it added many other big customers.
Microsoft is also making strides in the still-small Online Services Business, where an agreement with HP ensures that Bing will be the default search engine on most of its PCs. Additionally, Bing’s U.S. market share is creeping up, mostly at the expense of Yahoo! Inc. (YHOO). Of course, it is still puny compared to market leader Google Inc. (GOOG).
The company also has a number of products in the pipeline that should ensure continued growth through the next few years. (Natal, for instance, its natural user interface for entertainment devices, will launch in the holiday season).
The positive sentiment is evident from recent analyst estimate revisions. In the 7 days leading up to the announcement, 4 of the 27 analysts polled by Zacks made upward revisions to their earnings estimates for fiscal years 2010 and 2011. Given the strong outlook, we expect further upward revisions over the next few weeks.
While the negatives appear small in comparison, we believe there could be some headwinds from the growing importance of emerging and consumer markets, which are essentially lower-margin, and the growing popularity of open source software, including Google’s Chrome OS to launch later this year. Additionally, the agreement with Yahoo! will be a cash drain, not that this is likely to disrupt business too terribly (Microsoft is sitting on a huge cash pile).
We believe the shares will outperform the market over the next few months.
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