Microsoft Corporation's Results Aren't That Bad

| About: Microsoft Corporation (MSFT)
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Lately, not a day passes without a technology giant failing to meet analyst expectations. On Thursday evening, Microsoft (NASDAQ:MSFT) has joined to the caravan of technology companies that missed expectations. The company reported a net income of 66 cents per share on revenues of $19.9 billion whereas the analysts were looking for 75 cents per share of net income and $20.73 billion in revenues.

Microsoft continued to suffer from a declining PC market as consumers are switching from PCs to tablets at a rapid rate. Speaking of tablets, the company ended up writing off its Surface RT business as it wasn't that profitable of an idea for the company. The write-off was as large as $900 million.

For the full-year, Microsoft generated $77.85 billion, up from $73.72 that was generated in 2012. Microsoft's operating expenses fell from $34.43 billion to $30.83 billion, which increased the operating profits from $21.76 billion to $26.76 billion. As a result, net income rose from $16.98 billion to $21.86 billion, translating into $2.61 per share, up from $2.02 per share in 2012. This is impressive because the company's good results came at a time PC industry is suffering sharp declines in revenues and profits.

Between June 2012 and June 2013, Microsoft generated $14 billion in positive cash flow, increasing the company's total cash holdings from $63 billion to $77 billion. During the same period, the company's total assets increased from $121 billion to $142 billion.

All of Microsoft's 5 divisions posted revenue growth for the quarter as well as the full year. The Windows division generated $4.41 billion for the quarter (up from $4.15 billion) and $19.23 billion for the full year (up from $18.4 billion) even though the size of the PC market has dropped by double digits since last year. Server and Tools division generated $5.50 billion for the quarter (up from $5.00 billion) and $20.28 billion for the full year (up from $18.53 billion). Online Services division generated $804 million for the quarter (up from $735) and $3.20 billion for the full year (up from $2.87 billion). Microsoft Business division generated $7.21 billion for the quarter (up from $6.32 billion) and $24.72 for the full year (up from $24.11). Entertainment and Devices division generated $1.92 billion for the quarter (up from $1.78) and $10.17 billion for the full year (up from $9.56 billion).

In the last year, Microsoft spent a lot of money for development and marketing of its new products such as Windows 8, Windows Phone 8, Xbox One and Windows Surface which affected the company's profitability. While the PC market for the consumers continued to shrink as consumers chose tablets over PCs, the market for the businesses posted a small growth, which was beneficial for Microsoft. While individuals can use tablets for their daily tasks such as surfing the internet, listening to music and chatting with friends, businesses usually need more sophisticated hardware in order to conduct their daily tasks and PC doesn't really have many alternatives for a lot of business establishments.

Part of Windows division's growth came from the Windows Upgrade Offer that was made through last year to many users of older versions of Windows. Excluding this offer, Windows division wouldn't have posted a revenue growth. In fact, the revenues would have been down by $281 million or 6% without the deferred revenues from the Windows Upgrade Offer campaign. During the quarter (and the year) Microsoft spent so much money on marketing the new Windows that its operating income decreased significantly (by $1.3 billion) despite higher revenues. In Microsoft Business division, a large chunk of Microsoft's growth was due to Microsoft Office subscriptions and upgrades. Also, the company's Servers and Tools division has been stealing market share from IBM and Oracle as it continues to grow at a faster rate than the market itself grows (high single digit growth for Microsoft vs. low single digit growth for the overall market including Oracle and IBM).

In the quarter, Microsoft's gross margin was 71.84%, down from 76.94% in the same quarter a year ago. For the full year, the gross margin was 73.99%, down from %76.22 in 2012. On the other hand, the net profit margin for the full-year was up from 23.02% to 28.08%, which is pretty healthy.

Microsoft's future outlook had both positive and negative items. First, the bad news: Microsoft expects PC market to shrink further and the company's OEM revenue is expected to fall by around 15%. In Entertainment and Devices division (which includes Xbox, Skype and Windows Phone) the company expects revenues to fall by a low single-digit percentage. This is interesting because (according to Nokia's call today) Windows Phone continues to grow at double-digit rates. Microsoft probably expects Xbox sales to drop sharply before launching the new version in the holiday season. Now the good news: in Servers and Tools division, the revenue is expected to grow at around 8-9%. In Microsoft Business division, the company expects its revenues to grow by around 5%. In Online Services division (which includes Bing) Microsoft expects a 10-12% revenue growth in search revenues but some drop in display revenues.

The company also has about $20 billion of unrecognized revenue. Because Microsoft employs a subscription system, not all revenue is recognized at once. For example, if someone subscribed to Microsoft Office for $12 per year, the company would recognize $1 per month in this person's subscription fee rather than one-time recognition of $12.

After the earnings report, Microsoft's share price dropped from $35.44 to $33.21. The company's earnings of $2.61 per share translate into a P/E ratio of 12.7, down from 18.3 prior to the earnings announcement. Excluding the company's cash holdings, its P/E ratio would have been 9.1 which is below the S&P 500 average of 16 and the industry average of 17. Also, keep in mind that Microsoft's historical P/E average is 12.

Microsoft has a couple items to work on, such as falling PC revenues and relatively high operating expenses. Other than these items, the company had a good quarter and a good year. Microsoft has a lot of newly launched products as well as a number of products in the pipeline. The company continues to be a strong investment. If the company's share price falls below $30-31, I will add more shares because there is strong long-term support around that level.

Disclosure: I am long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.