RealMoney Silver - MSFT Shows Why It's Microsoft

MSFT Shows Why It's Microsoft
By Bob Faulkner
RealMoney Contributor
1/24/2008 7:13 PM EST

Updated from Jan. 23 with earnings results

Microsoft (MSFT) reported another very strong quarter with its fiscal second-quarter results Thursday afternoon. More importantly, the guidance for its March quarter suggests there could be a little upside from a tough comparison last year.

Revenue was $16.37B (+31% YY; +19% QQ) and EPS was $0.50. Allowing for the deferral of revenue last year for the technology guarantee program, revenue growth year-year was actually 15%. GM was 78.4%, up 730 bps YY but down 220 bps sequentially. OM was 439.6%, up 1,200 bps from last year but down 340 bps from the prior quarter.

Here again, the deferral last year is responsible for the large margin gains. The balance sheet remains among the strongest of any company. CFO was $4.6B more than double last year's $2.0B. The cash account was down about $0.5B after acquisitions and share repurchases. A/R increased $2.7B with DSOs increasing five days to 64 days. In addition, the Unearned Revenue account was $12.2B on the balance sheet vs. $11.6B last quarter and the Contracted Not Billed value increased $0.5B to $11.5B.

Microsoft had its second consecutive "very strong" quarter driven in part by PC unit growth about 3% above expectations and total bookings up more than 20%. The Client segment was $4.34B (+16% YY adjusted for deferrals; +5% QQ) with operating margin of 77.5% up on both compares.

OEM license growth continued strong at 18% year-year with Vista Premium licenses running on 75% of the boxes. Windows Vista sales have surpassed 100 million licenses thus far, and with Service Pack 1 coming out, we may see strong growth continue.

Servers/Tools revenue was $3.28B, up 15% YY and 13% QQ. The segment's operating margin was 35.8%, down slightly from last year but a solid 260 bps up from fiscal first quarter. Windows Server and SQL Server licenses were both growing double digits in the quarter. There was also a significant shift to annuity licensing in advance of new product offerings later in the year.

Business Solutions is now the single largest business segment at $4.81B (29% of total; +20% YY; +17% QQ) with broad-based demand growth from all products and channels.

Entertainment revenue was $3.06B, up 3% YY and 59% QQ with the unit reporting its second consecutive operating profit. The company sold 4.3M Xbox 360 consoles and experienced very strong software and accessory attach rates.

Guidance for Q3/08 is for revenue to be in the $14.3B-$14.6B range or plus/minus 1% year-year. Keep in mind last year's March quarter included the $1.64B revenue deferral. Operating income is expected to be in the $5.6B-$5.7B range with EPS of $0.43-$0.45. Current consensus is for revenue of $14.4B and EPS of $0.44.

Microsoft is hitting on all cylinders and it has manifested itself in very strong fundamentals the last two quarters. Given the momentum in the company's business, I have to believe that the guidance is a target that they are convinced they'll exceed. I do, too.

Preview

Microsoft is scheduled to report its second-quarter results tomorrow after the close and will have a conference call at 5:30 p.m. EST. Current consensus estimates are for revenue of $15.95 billion (up 27% year over year and 16% quarter over quarter) and EPS of 46 cents.

In the prior quarter, Microsoft reported revenue of $13.76 billion (up 27% year over year and 3% quarter over quarter) and EPS of 45 cents. The gross margin was 80.6%, down 370 basis points year over year but up 480 basis points sequentially. The operating margin was 43.0%, up 160 basis points from last year and more than 1,000 basis points from the prior quarter, largely due to strong revenue growth and controlled expenses.

The balance sheet remains among the strongest of any company. Cash from operations was $5.8 billion, up by $1.8 billion from the prior year. The cash account was down about $2.0 billion after acquisitions and share repurchases. Accounts receivable decreased $1.4 billion, with days sale outstanding dropping 17 days, to 59 days.

Microsoft had the strongest quarter it has experienced in years with all divisions up double digits year over year. PC unit growth came in about 3% above expectations, and overall bookings grew in excess of 30%. Client and Business Solutions each represent 30% of revenue and were up 25% year over year and 20% year over year, respectively. Client also experienced solid margin expansion, whereas the Business Solutions operating margin was about flat with the prior year. Server and Tools (21% of revenue) increased 16% year over year with flat margins as well. The big winner for the quarter was Entertainment at $1.9 billion, up 87% from last year and profitable for the first time. This was driven by the huge demand from Halo 3 as well as 1.8 million hardware units.

Guidance for second quarter 2008 was for revenue to be in the $15.6 billion to $16.1 billion range, or up 13% to 17% sequentially, with GAAP EPS of 44 cents to 46 cents. This assumes PC unit growth in the 11% to 13% range.

After its first quarter, described by management as one of its strongest in years, I think most investors are expecting more of the same for December. It's no secret that personal computers sold well for the holidays, as did video-game hardware and software. On the enterprise side of the equation, much of Microsoft's revenue was already on the balance sheet in the form of subscription-based licensing that it has moved toward over the course of the last several years.

With that, here are my areas of focus on the conference call:

PC unit growth and any changes to expectations for the year;

revenue and operating margins for the respective divisions;

unit demand for XBox and game software;

additions to deferred revenue on the balance sheet as well as contracted, not billed (i.e., off-balance sheet);

commentary on Windows Vista along with Service Pack 1; and

outlook for third quarter along with any changes in the guidance for full year 2008.

The current consensus estimates for third quarter are on the weak side on a relative basis. Granted, the March quarter a year ago was a big one for the company with the launch of Vista and Office 2007. The results were amplified by about $1.7 billion in revenue from the second quarter of 2007 that was deferred into the third quarter as part of the company's technology guarantee program. Those events came with a high level of launch expenses, however, some of which were also deferred into the fiscal third quarter.

While the comparison is a difficult one, I think it's possible that the earnings guidance may wind up being a little better than consensus because of the lower expense levels.