Microsoft Corporation (MSFT) reported an exceptional first quarter 2011 considering recent concerns about the slowing down of the computing market. The company’s earnings beat the Zacks Consensus Estimate by 7 cents, or 12.7%. Revenue also beat the Zacks Consensus, exceeding by 2.9%. Microsoft’s results in the last quarter were driven by Office 2010, Windows 7 and the XBox 360 product lines. Shares are already up 3.31% in pre-market trading.
Revenue
Revenue of $16.2 billion was up 1.0% sequentially and 25.3% from last year. Management estimates that the PC market (units) was up 9%−11% year over year, a significantly slower rate than the 22%−24% growth witnessed in the June quarter, while OEM sales of Microsoft’s Windows 7 installed PCs grew 11%, compared to 26% in the June quarter.
Revenue by Segment
The Windows and Windows Live segment generated 30% of first quarter revenue, up 5.2% sequentially and 82.6% year over year. The Windows segment usually experiences seasonal strength in the June quarter, so the sequential increase from June may be considered respectable. Microsoft stated that the company had sold 240 million Windows 7 licenses to date and adoption rates in the enterprise segment continued to increase in the last quarter. Around 71% of total sales were premium sales, with enterprise accounting for 40% and consumer 31%.
OEM sales remain a major driver of segment performance (75% of segment revenue), in line with Microsoft’s estimated PC market growth rate. Overall PC market, hardware mix and channel dynamics were responsible for the growth in OEM sales. While demand for PCs in emerging markets remain significantly higher than developed markets, the positive mix shift in the last quarter was on account of the lower mix of consumer versus enterprise, which benefited from corporate refreshes. Windows attach rates were down 1% from last year. Non-OEM sales (businesses and retail) were 25% of segment revenues.
The Microsoft Business Division, which generated 32% of revenue, declined 2.6% sequentially and grew 16.1% year over year. Both enterprise and consumer segments helped drive growth, although consumer was much stronger. The consumer segment, which includes OEM and retail, grew 26% year over year. The business portion grew 11%.
Microsoft stated that Office 2010 was very successful in the first full quarter since its launch and unit shipments were 20% higher than Windows 7 during the comparable period after its launch. Integration with SharePoint, Office Communications Server and Dynamics CRM also contributing to the growth.
The Server & Tools segment at 24% of total revenue was down 1.3% sequentially and 15.3% year over year. Segment performance came from both multi-year agreements (up 10%) and non-annuity (up 15%). Additionally, the Windows server premium mix grew 4%, virtualization suites were up more than 50% and Windows Azure subscriptions grew 40%.
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%, up 12.2% sequentially although down 5.1% year over year. The primary driver of segment performance was the XBox console, which grew 38% over last year, outselling all others in the U.S. market. Microsoft’s Halo: Reach did particularly well, bringing in $350 million of revenue. Membership growth for Xbox Live remained strong. Microosft has already launched the Windows phone in Europe and Asia, and expects to launch the device in the U.S. on November 8.
The Online Services business, or online advertising, generated 4% of revenue; down 6.7% sequentially and up 7.6% year over year. The increase from the year-ago quarter came after a long time and is evidence of Bing’s slowly increasing market share.
Operating Results
Microsoft’s gross margin of 80.6%, up 38 basis points (bps) sequentially and 261 bps year over year. This was despite the 10% year-over-year increase in COGS related to higher sales of lower-margin hardware (Entertainment Devices segment).
Operating expenses of $5.94 billion were down 14.4% sequentially, but up 6.1% year over year. Consequently, the operating margin expanded 697 bps sequentially and 925 bps from last year.
All expenses declined as a percentage of sales both sequentially and year over year. However, as a percentage of sales, S&M expenses declined most significantly in the sequential comparison and the decline in both G&A and S&M were most significant in the year-over-year comparison. The improvement was possible because of management’s restructuring actions over the past year or so that have lowered the cost base.
The operating margin by segment was as follows: Windows 69.4% (a sequential decline of 210 bps), Microsoft Business Division 66.3% (up 372 bps), Server & Tools 41.2% (up 264 bps), Entertainment & Devices 21.3% (up 3,203 bps) and Online Services -106.3% (up 1,692 bps). The Windows and Online Services operating margin also declined on a year-over-year basis. Operating margins in all except the Online Services segment grew in the last quarter.
The company generated a pro forma net income of $5.4 billion, or 33.4% net income margin compared to $4.5 billion, or 28.2% in the previous quarter and $3.6 billion, or 27.7% in the year-ago quarter. There were no one-time items in the last quarter. Accordingly, the GAAP EPS was same as pro forma at 62 cents compared to 51 cents in the June 2010 quarter and 40 cents in the September quarter of last year.
Balance Sheet
Inventories increased 67.8%, with inventory turns dropping to 10.1x. Microsoft saw another huge increase in inventories in the June quarter, which brought turns down from 22.0x to 17.1x. The significant amount of inventory accumulation is a concern. Days sales outstanding (DSOs) went to 54, down from 74 at the end of the June quarter.
Microsoft ended with a cash and short term investments balance of $44.2 billion, up $7.4 billion during the quarter. The net cash position was around $4 a share. In the last quarter, the company generated $8.2 billion in cash flow from operations, spent $4.4 billion on share repurchases, $1.1 billion on dividends and $564 million on capital assets.
Guidance
Microsoft declared that fiscal 2011 revenue would be $26.9 to 27.3 billion. No operating expense guidance was provided, so we assume expectations remain unchanged at $26.9 – $27.3 billion, an increase of 4.5% from 2010.
Our Take
Microsoft is undoubtedly the leader in computing operating systems and judging from the continued success of the Windows 7 OS, the company will be able to retain the lion’s share of revenue flowing from the segment.
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. The company also remains one of the largest players in the gaming hardware market and its gaming platform should benefit from continued adoption of Windows Live. Motion control gaming devices and Natal will be other drivers.
Additionally, the company’s new Windows 7 smartphone should do well, but we will be keeping an eye on how the company targets this extremely competitive and highly crowded market. While the online services business remains a drag on overall results, Microsoft’s Bing has been taking share.
It will be interesting to see how the market develops, especially since the company has now to contend with not just Yahoo Inc. (YHOO) and Google Inc. (GOOG), but also Apple Inc. (AAPL), which has recently entered the market with a new-age, feature-rich interactive advertising platform.
All these positives notwithstanding, we have a short-term Sell rating on Microsoft shares, given the fact that the company will continue to be impacted by the changing dynamics in the consumer PC segment. We also point to the lack of growth in Windows 7 attach rates in the last quarter. However, our long term (3-6 months) recommendation is Outperform.
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