Microsoft Corporation (MSFT) reported second quarter 2010 earnings that beat the Zacks Consensus Estimate by 16 cents, or 27.12%. Revenue beat by 6.4%.
MSFT’s revenue surprise was driven by growing attach rates and inventory builds for Microsoft’s Windows 7 operating system on consumer PC platforms.
Eleven of the 32 analysts polled by Zacks have made upward revisions to their earnings estimates on MSFT over the past 30 days, as checks indicated very strong attach rates for the Windows 7 OS during the last quarter.
The surprise history is also very encouraging. Microsoft earnings have beaten the Zacks consensus by an average of 10.46% during the four preceding quarters. Further, the positive surprise from MSFT has been growing in each successive quarter, having beaten the Zacks Consensus by 25.00% in the Sep 2009 quarter.
However, Microsoft’s second quarter earnings excluding the recognition of deferrals related to Windows 7 would reduce earnings by $0.19, resulting in a miss of $0.03. This could be the reason for the slight downward movement in the MSFT share price despite the huge quarter.
Revenue
Microsoft’s revenue of $19.0 billion was up 47.2% sequentially and 14.4% year over year. This includes $1.7 billion in deferred revenue related to the Windows 7 Upgrade Option as well as initial sales of Windows 7 to OEMs and retailers that were recognized in the quarter. All MSFT segments contributed to the sequential growth, although Windows and Xbox were the strongest. Foreign exchange had a very small impact on revenue in the last quarter.
Approximately 30% of total MSFT revenue came from annuity, 30% from OEM, 25% from licenses and 15% from other business. Annuity was slightly soft in the last quarter at MSFT, mainly due to the lengthening of enterprise agreement sales cycles.
Microsoft management estimates that the PC market was up 15-17% from the Dec 2008 quarter, with approximately 11% of the total market consisting of net books. This compares with a 12% share in MSFT’s Jun 2009 quarter.
Revenue by Segment
The Windows and Windows Live Segment generated 36% of second quarter revenue, increasing 163.5% sequentially and 73.4% year over year. Microsoft sold 60 million Windows 7 licenses, making it the fastest selling OS in the world. With 90% of netbooks using Windows and 50% of those powered by Windows 7, it looks as if MSFT is set to win this product cycle in a big way.
Microsoft’s biggest driver of segment performance was the growth in OEM sales, which exceeded management’s estimated PC market growth rate for the first time in 8 quarters. The holiday-driven strength in the consumer PC market, higher Windows attach rates, inventory builds and channel dynamics helped drive the increase at OEMs. However, this was partially offset by mix, with Microsoft seeing greater demand for PCs in emerging rather than developed markets and from consumers rather than business users.
The retail strategy is also paying off for MSFT, with the newly launched retail version of Windows 7 driving very strong sales at both physical retail and online outlets.
The Microsoft Business Division generated 27% of second quarter revenue, up 7.7% sequentially and down 2.7% year over year. The quarter was mixed for the segment, with business PCs particularly slow, as OEMs put off spending in anticipation of the next product cycle. However, annuity-based sales were relatively better.
The consumer side for MSFT also did well, driven by the OEM and retail business. SharePoint, Office Communication Server and dynamic CRM products did very well. The newly launched beta version of Office 2010 was downloaded 2 million times.
The Server & Tools segment, at 22%, grew 11.9% sequentially and 2.7% year over year. Microsoft management stated that OEM and licensing only revenue (non-annuity) grew faster than the x86 server hardware market, while annuity revenue grew only slightly. Revenues from virtualization offerings, such as Premium editions of Windows Server and Systems Center were particularly strong.
Entertainment & Devices generated 17%, up 53.5% sequentially and down 8.8% year over year. The sequential strength was due to stronger demand, driven by the holiday season. However, the decline from MSFT’s year-ago quarter was due to a 13% decline in console shipments, partially offset by higher sales of Elite and Special Edition consoles, which carry higher average selling prices (ASPs). Other bright spots include higher software attach rates and continued growth in Xbox Live.
The Online Services business, or online advertising, which generated 3% of revenue, continued to struggle, with MSFT seeing slow growth in the search business and a weaker display business, due to an unfavorable foreign exchange impact. According to ComScore, Bing’s U.S. market share continued to inch upwards, with the Dec 2009 share at 10.7%.
Operating Results
The pro forma gross margin for Microsoft’s quarter was 80.9%, up 292 basis points (bps) sequentially and 442 bps year over year. The improvement in gross margin was attributable to lower Xbox-related costs (console cost reduction and volume benefits), partially offset by higher traffic acquisition and online costs.
Operating expenses of $6.8 billion were down $1.2 billion sequentially. The operating margin for MSFT was 45.1%, up 1,037 bps sequentially from 34.7% recorded in the previous quarter. It was up 935 bps from the year-ago quarter. The sequential increase was the result of a lower COGS, as well as lower R&D, S&M and G&A expenses as a percentage of sales. The reduction in G&A and R&D expenses was the most significant and was helped by the elimination of 800 positions during the quarter.
The operating margin by segment is as follows—Microsoft Windows 78.1% (an increase of over 22 percentage points from the first quarter, including $1.7 billion in revenue), Microsoft Server & Tools 38.8% (up 143 bps), Online Services -80.2% (up 1,775 bps), Microsoft Business Division 63.4% (down 157 bps) and Microsoft Entertainment & Devices 12.9% (down 358 bps).
The sequential increase in the Microsoft Windows and Servers segment margins were very encouraging, signaling an improving trend. The decline in Microsoft Entertainment & Devices is most likely due to a combination of weaker pricing, higher R&D investments and stronger volumes.
MSFT generated a pro forma net income of $6.7 billion, or 35.3% net income margin compared to $3.6 billion, or 27.7% in the previous quarter and $4.2 billion, or 25.1% in the year-ago quarter. Our pro forma estimate excludes employee severance charges only.
Including these charges, the GAAP EPS was $0.74 in the last quarter, compared to $0.40 in the Sep 2009 quarter and $0.47 in the Dec quarter of last year.
Balance Sheet
Inventories were down 48.8%, with MSFT shipping the Win7 products booked in the previous quarter. Inventory turns were 24.6X. Days sales outstanding (DSOs) went down from 61 to around 54, impacted by the shipments discussed above.
Microsoft ended with cash and short-term investments balance of $36.1 billion, down $629 million during the quarter. The new cash position was $3.69 a share. In the last quarter, MSFT generated $5.0 billion in cash from operations, spent $3.9 billion on share repurchases, $1.2 billion on dividends and $376 million on capital assets.
Guidance
MSFT management was optimistic about revenue growth in fiscal year 2010. The Windows segment is expected to grow in line with the overall PC market. The annuity section of the Microsoft Business Division (60%) is expected to be roughly flat, while the non-annuity section continues to experience the effects of purchase deferrals.
The annuity section of the Server and Tools segment is expected to grow mid single digits, non-annuity (30%) to track the hardware refresh cycle and services to be flattish. Microsoft Online Services are expected to perform in line with the market. Both revenue and COGS (as a percentage of sales) in the Microsoft Entertainment & Devices division is expected to be flat for the year.
Management at MSFT reiterated its operating expenses guidance for the year, which is expected to be in the range of $26.2 billion to $26.5 billion. Capital spending is expected to be $2 billion and the effective tax rate 25%.
In Summary
Dec 2009 was a very strong quarter for Microsoft, in which the Windows attach rate started climbing. We believe this is a very significant quarter for MSFT, as the adoption in the new-age netbook market was strong. We think Microsoft is poised to benefit from new product cycles in both the enterprise PC and server markets. MSFT has also entered into a three-year agreement with Hewlett Packard Company (HPQ) for its cloud computing solutions.
MSFT 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. Bing’s U.S. market share continues to inch upwards, with the search engine growing slightly stronger than Google Inc. (GOOG) in December (ComScore). Although the agreement with Yahoo! Inc. (YHOO) is still pending regulatory approval, this could help the company acquire additional expertise in the space.
Microsoft also has a number of products in the pipeline, including Azure, its cloud computing platform (first product to be launched next month) and Natal, its natural user interface for entertainment devices (to launch in the holiday season).
The downsides that we see at this point for MSFT include the growing importance of emerging and consumer markets, which are essentially lower-margin, MSFT’s dependence on hardware product cycles, which will impact near-term revenue, the continued softness in business spending and the growing popularity of open source software.
We maintain our long-term Neutral rating on Microsoft shares.
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