Microsoft: In-Depth Analysis for the December 2010 Quarter

| About: Microsoft Corporation (MSFT)
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Microsoft (NASDAQ: MSFT) earned $0.77 per diluted share on a GAAP basis in the December-ending second quarter of fiscal 2011, up 4 percent from $0.74 in the same three months of 2009.

The year-earlier results were boosted by the release of Windows 7, which became available in October 2009.

This post examines Microsoft's Income Statement for the quarter and compares the entries on each line to our "look-ahead" estimates. Reported earnings were a substantial $0.10 per share better than our $0.67 EPS estimate.

The principal sources for the income statement analysis were the earnings announcement, the ensuing conference call presentation [pptx] and transcript [docx], and the formal 10-Q report.

In a second article, we will report Microsoft's scores as measured by the GCFR financial gauges. The follow-up post will also provide the latest figures for the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.

Before getting into the details, we will take one step back to introduce the subject of today's analysis.

First, we present some background information about Microsoft and the business environment in which it is currently operating.

Microsoft develops and sells the operating system software that runs on more than 90 percent of personal computers. It also has dominant application software and server software franchises. In addition, the company provides various online services, such as the Bing search engine and online advertising. Microsoft also sells video game consoles, entertainment devices, and computer peripherals.

Net Income in fiscal 2010 was $18.8 billion, up nearly 30 percent from the prior year. Revenue increased 7 percent, from $58.4 billion in 2009 to $62.5 billion.

Microsoft is included in the Dow Jones Industrial Average and the S&P 500. For many years, the company's shares have generally traded at a price between $20 and $30, with occasional excursions outside the range. The company's market value is now about $250 billion on a fully diluted basis.

The company is organized into five operating segments: Windows and Windows Live, Server and Tools, Online Services, Microsoft Business, and Entertainment and Devices. The Business Division contributed the most Revenue ($18.9 billion) in 2010, but the Windows Division produced slightly more Operating Income ($12.1 billion). Online Services lost $2.4 billion. Server and Tools did well with Operating Income of $5.0 billion.

Microsoft successfully launched Windows 7 in October 2009 and Office 2010 in June 2010. The company sold 240 million Windows 7 licenses in the first 12 months after the launch date.

In addition to upgrades from older versions, a significant proportion of the Windows revenue is due to the sale of new personal computers on which the equipment manufacturer has installed the latest software. Research firm Gartner reported that PC shipments increased in 2010, but the pace disappointed in the fourth quarter. The research firm attributed slowing sales to competition from tablet computers, such as the iPad, and other consumer electronic devices. Business spending on PCs has been stronger than consumer spending, and sales in emerging markets have recently grown more robustly than sales in developed regions.

Windows has always been designed to run on the x86 CPUs developed and made famous by Intel (NASDAQ: INTC). However, the next version of Windows will also be compatible with ARM processors. This should facilitate the use of Microsoft's flagship product on greater numbers of tablets and smartphones, which generally are built around low-power ARM chips.

With Office 2010 and other products, Microsoft is taking initial steps towards cloud computing to counter a threat from Google (NASDAQ:GOOG) and others.
Additional background information about Microsoft and the business environment in which it is currently operating can be found in the look-ahead.

Please click here to see a normalized depiction of the actual and projected results for the just-concluded quarter, as well as the quarterly Income Statements for the last couple of years. Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats. The standardization facilitates cross-company comparisons.

Revenue in the December quarter increased 4.9 percent, from $19.0 billion in the previous year to a record-high $19.95 billion in the last three months. This is an impressive accomplishment considering the earlier quarter's revenue received a substantial one-time boost from the recognition of $1.7 billion in previously deferred revenue. Excluding this deferral in the prior period, Revenue in the latest quarter rose 15 percent.

Revenue amount in the most recent quarter exceeded our $18.8 billion target by 6.1 percent. We had thought that slowing personal computer sales would be more of a drag on Microsoft's results.

The Revenue increase was primarily due, according to Microsoft, to "strong sales of the Xbox 360 console and accessories, including Kinect, the 2010 Microsoft Office system, and Server and Tools products." Microsoft claims "Kinect is the fastest selling consumer electronics device in history."

It's probably also worth noting more than 300 million Windows 7 licenses have been sold to date. Sales of the flagship product to businesses have been particularly robust.

The table below breaks down quarterly Revenue by business segment.

Operating Segment Q/E Dec 2010 Revenue ($M) Q/E Dec 2009 Revenue ($M) Percent Change
Windows & Windows Live $5,054 $7,193 -29.7%
Server and Tools $4,390 $3,978 10.4%
Online Services $691 $579 19.3%
Microsoft Business $6,032 $4,864 24.0%
Entertainment & Devices $3,698 $2,381 55.3%
Other $88 $27 225.9%
Total $19,953 $19,022 4.9%
Source: 10-Q

The Cost of Goods Sold in the quarter was $4.83 billion, or 24.2 percent of Revenue. This ratio translates into a Gross Margin of 75.8 percent. Most companies would love to achieve a Gross Margin this high, but it is less than Microsoft's normal 80 percent. In the December 2009 quarter, the Gross Margin was 80.9 percent of revenue.

We suspect the Gross Margin was pressured by game products becoming more prominent in the product mix and Windows contributing less.

Microsoft fell short of our 78.0-percent Gross Margin target by 220 basis points.

The $2.19 billion Microsoft spent on Research and Development was 5 percent more than in the same period of the previous year. The reported amount was 7 percent less than our $2.35 billion estimate. As a percentage of Revenue, the R&D expense increased insignificantly from 10.9 percent to 11.0 percent.

Microsoft indicated additional R&D spending "was primarily driven by a 4% increase in headcount-related expenses" and some other factors.

Sales, General, and Administrative expenses -- Microsoft breaks these out as Sales and Marketing expenses and General and Administrative expenses -- were essentially flat at $4.77 billion. The expense was just 1.6 percent more than our $4.70 billion estimate. SG&A expenses equaled 23.9 percent of Revenue, down 100 basis points from 24.9 percent last year.

Together, R&D and SG&A expenses totaled just under $7 billion in the December quarter. For the first six months of the fiscal year, these expenses were $12.9 billion, about 47.6 percent of the $27.1 billion midpoint of the guidance range for fiscal 2011 as a whole. With a reading below 50 percent, this might be a signal that expenses will be towards the low end of Microsoft's guidance.

Subtracting the various operating expenses from Revenue yields Operating Income of $8.17 billion in the most recent quarter. Operating Income decreased 4.1 percent when compared to the same period of last year. The lower Gross Margin had a greater effect on Operating Income than higher Revenue did.

Better-than-expected Revenue and lower-than expected R&D expenses pushed Operating Income 7.2 percent above our $7.62 billion target for the quarter.

The table below list Operating Income by business segment. The three segments with the most Revenue were responsible for all Operating Income.

Operating Segment Q/E Dec 2010 Op Income ($M) Q/E Dec 2009 Op Income ($M) Percent Change
Windows & Windows Live $3,251 $5,417 -40.0%
Server and Tools $1,776 $1,464 21.3%
Online Services ($543) ($463) -
Microsoft Business $3,965 $2,947 34.5%
Entertainment & Devices $679 $365 86.0%
Other ($963) ($1,217) -
Total $8,165 $8,513 -4.1%
Source: 10-Q

Other, non-operating income summed to a $332 million, which included $118 million gain on investments and $108 million gain on derivatives. We had expected a net gain of only $100 million for other income.

The effective income tax rate of 21.9 percent was significantly lower than normal, and it added about $0.02 to the quarter's earnings per share. We were looking for the tax rate to be closer to 24 percent. Microsoft explained: "The reduction in the tax rate was due to the higher mix of earnings taxed at lower rates in foreign jurisdictions and from the retroactive extension of the research and development tax credit in the United States.

The lower tax rate nearly allowed Net Income to hit $6.63 billion, nearly matching December 2009's $6.66 billion. With fewer shares now outstanding after substantial repurchases ($5 billion in the December 2010 quarter), earnings per share rose from $0.74 to $0.77.

Better-than-expected Revenue and Other Income and a lower Income Tax rate resulted in Net Income surpassing our $5.87 billion ($0.67 per share) estimate by 13 percent in absolute terms and 15 percent on a per-share basis. Game and entertainment products, which sold well, may have cut into margins slightly, but they certainly helped the bottom line. Consistent with comments from others in the industry, Microsoft experienced more robust sales growth in emerging markets than in developed ones. Similarly, Microsoft observed faster growth rates for business PCs than for consumer machines. This may be due to a greater variety of mobile computing products, including those from Microsoft, that are attractive to consumers.

Full disclosure: Long MSFT at time of writing.