Microsoft Corporation’s (MSFT) third quarter 2011 results were again impacted by weakness at consumer PCs. However, the company went on to beat the Zacks Consensus on both the top and bottom lines, with revenue and EPS exceeding by 1.4% and 8.9% (5 cents), respectively.


Revenue of $16.43 billion was down 17.7% sequentially and up 13.3% from last year. The year-over-year comparisons are more meaningful this quarter, since the previous quarter was seasonally strong. Microsoft made progress in online business division and saw particular strength in its Office, server, Xbox and Kinect product lines.

Management estimates that the PC market (units) was down 1-3% year over year, compared to the 2-4% growth witnessed in the December quarter. Enterprise remained strong, while consumer disappointed.

The general trend is similar to earnings reports from other technology majors, such as Intel Corp (INTC), Advanced Micro Devices (AMD) and Novellus Systems (NVLS). Also, premium sales dropped slightly to 70%, with consumer at 38% and enterprise at 32%.

Revenue by Segment

The Windows and Windows Live Segment generated 27% of quarterly revenue, down 12.0% sequentially and flat year over year. Microsoft stated that the enterprise refresh continued in the last quarter and was still in its early stages, helping business PC growth of 9%.

However, consumer was decidedly weak, on account of weak netbook sales, deteriorating consumer purchasing power and the diversion of consumer spend. Microsoft stated that the company had sold over 350 million Windows 7 licenses to date.

OEM sales remain a major driver of segment performance and growth in this area was just a point short of PC market growth. Overall, the hardware mix, Windows attach rates and channel dynamics were positive to OEM revenue growth, while PC market growth, segment mix and other OEM adjustments were negative in the last quarter. Additionally, emerging markets were again a strong driver, accounting for more than half of PC shipments.

The Microsoft Business Division, which generated 32% of revenue, declined 12.9% sequentially and grew 23.8% year over year. Both annuity-based (up 5%) and non-annuity (transactional) revenue (up 28%) increased from year-ago levels.

Microsoft continued to see very strong demand for Office 2010 in both enterprise and consumer segments. Microsoft stated that other products, such as Lync, SharePoint 2010 and Dynamics CRM grew double-digits from last year.

The Server & Tools segment, at 25% of total revenue was down 6.5% sequentially and up 14.8% year over year. Here too, both annuity and transactional revenue grew from the year-ago quarter, with annuity growing 11% and transactional growing faster than the server hardware market. Enterprise services were up 12%.

Virtualization and cloud computing are proving to be very beneficial for Microsoft. The company signed important agreements with Target Corporation (TGT) and Toyota during the quarter.

Microsoft has a very healthy product line (SQL, Windows Server 2008 R2) Azure, premium revenue from all of which grew double-digits, indicating that the momentum in its business will continue.

Entertainment & Devices generated 12%, down 47.7% sequentially and up 16.2% year over year. The sequential weakness was seasonal, and increase from the year-ago quarter was helped by Kinect (2.4 million sensors sold in the last quarter).

Xbox 360 units were also strong at 2.7 million, up 80.0% from last year. Xbox Live memberships ended 2010 at 30 million active members and revenue from this segment was also strong.

Microsoft’s Windows Phone 7 ecosystem continues to gain momentum and the company stated that there was a spike in developer interest following the agreement with Nokia Corp (NOK). At 2010-end there were 24,000 registered developers and management stated that applications were at 13,000 at the end of the March quarter. Although significantly slower than Apple Inc (AAPL), this is a very small part of Microsoft’s total business, so we view any progress here as positive.

The Online Services business, or online advertising, generated 4% of revenue, down 6.2% sequentially and up 14.5% year over year. We think Microsoft is investing in technology and innovation and it is this work that is improving user experience and helping Bing take some share in the U.S.

The partnership with Yahoo Inc (YHOO) is increasing ROI for advertisers, but monetization is not yet satisfactory. We consider this real progress and Microsoft stated that revenue per search (RPS) would improve by the end of the year, at which time the search alliance would spread more broadly to international markets.

Operating Results

Microsoft’s gross margin of 76.3% was up 50 basis points (bps) sequentially although down 473 bps year over year. The gross margin is closely related to the mix, since margins on hardware and software products differ widely. 

Operating expenses of $6.82 billion were down 1.9% sequentially and up 3.8% year over year. Consequently, the operating margin dropped 617 bps sequentially and 92 bps from last year. The sequential increase in operating expenses as a percentage of sales was due to seasonality. All except cost of sales were down from last year.

The operating margin by segment was as follows — Windows 62.2% (a sequential decline of 214 bps), Microsoft Business Division 60.3% (down 547 bps), Server & Tools 34.6% (down 588 bps), Entertainment & Devices 11.6% (down 673 bps) and Online Services -112.0% (down 3,346 bps). Margins in all except the Online Services segment also declined from last year.

The company generated a pro forma net income of $5.2 billion, or 31.8% net income margin compared to $6.6 billion, or 33.2% in the previous quarter and $4.0 billion, or 27.6% 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 61 cents compared to 77 cents in the December 2010 quarter and 45 cents in the March quarter of 2010. A lower tax rate helped earnings in the last quarter.

Balance Sheet

Inventories were down 22.6%, with inventory turns steady at 22.4X. Days sales outstanding (DSOs) went to 56, up from 59 at the end of the December quarter.

Microsoft ended with a cash and short term investments balance of $50.2 billion, up $8.9 billion during the quarter. The net cash position was around $4.53 a share. In the last quarter, the company generated $8.7 billion in cash flow from operations, spent $848 million on share repurchases, $1.3 billion on dividends and $658 million on capital assets.

Guidance Reiterated

Microsoft reiterated the fiscal 2011 revenue guidance of $26.9 to $27.3 billion and operating expense of $27.2-27.7 billion. It also provided initial operating expense guidance of $28-28.6 billion for 2012, an increase of 3% from 2011.

Our Recommendation

Microsoft appears to be firing on cylinders and we are pretty optimistic about its growth prospects in 2011. However, we think some of the uncertainty in the PC market continues, which is the reason for our conservative Neutral recommendation on the stock. Microsoft shares also carry a Zacks #3 Rank, implying a Hold recommendation in the short-term (1-3 months).

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