(MSFT) Microsoft Looks Bright in 2012

Microsoft Corporation’s (MSFT) second quarter results were a couple of cents higher than the Zacks Consensus Estimate. The last month has seen 10 analysts lowering estimates for the quarter, which took the Zacks Consensus down a penny. Therefore, without the revisions, Microsoft would have exceeded expectations.

While the client PC business was slightly impacted by the Thai flooding, all other areas of the business saw good growth. Investors reacted as may be expected, taking share prices up 2.42% in after-hours trading.

Revenue

Revenue of $20.89 billion was up 20.2% sequentially and 4.7% from last year, just short of consensus expectations of $20.93 billion. Growth in the last quarter was again led by the Entertainment & Devices segment (up triple digits sequentially), with all segments other than Windows growing strong double-digits. The increase from the year-ago quarter followed a similar pattern.

Management commentary and Intel Corp’s (INTC) results indicate that the enterprise refresh cycle continues and the Wintel combination is far from dead. Of course, we may expect some changes this year, as Microsoft launches Windows 8.

Segment Specifics

The Windows and Windows Live Segment generated 23% of Microsoft’s quarterly revenue, down 2.7% sequentially and 6.3% year over year. Given PC unit decline of 2-4% (management estimate), it appears that Microsoft saw slight declines in its market share.

The weakness was again on the consumer side of the business (down 6% from last year), particularly in netbooks, excluding which consumer would have been up 2%. Apple’s (AAPL) iPad has played a major role in weakening demand for netbooks, something Microsoft will be addressing with Windows 8, which is expected to launch next month.

Enterprise refresh rates drove a 2% increase in that segment. Management also cited HDD supply shortage and macro economic uncertainty for the segment’s weak performance in the last quarter.

OEM revenue was down 7%, as PC market declines, lower Windows attach rates and segment mix were negative, while channel dynamics remained neutral. Additionally, shipments to emerging markets continued to outpace those to developed markets.

The Microsoft Business Division, which generated 30% of revenue, grew 11.7% sequentially and 4.1% from last year. Business transactional revenue increased 3%, due to stronger attach rates worldwide. Consumer declined 17% (2% excluding the $224 million technology guarantee in the year-ago quarter). The annuity portion (multi-year licensing) was also strong, growing 12%.

Microsoft stated that other products, such as Lync (up 30%), Dynamics CRM (up 30%) SharePoint, Exchange and Dynamics ERP each grew double-digits from last year. Management expressed optimism about the cloud-based Office 365 that was launched in the third quarter and management stated that customer momentum was strong.

The Server & Tools segment, at 23% of total revenue was up 12.3% sequentially and 8.7% year over year. Microsoft’s multi-year licensing revenue grew at a mid-teens percentage rate year over year, with both premium Windows server and System Center revenue and SQL server revenue growing double-digits.

The increase in premium revenue is encouraging, indicating growth trends in the business and also continued strength in the enterprise segment. Enterprise services also grew strongly. Virtualization and cloud computing are proving to be very beneficial for Microsoft.

Entertainment & Devices generated 20%, up 115.8% sequentially and 14.6% year over year. Xbox 360 led the U.S. console market in the last quarter and Microsoft stated that the company shipped 8.2 million units. Kinect sales were also strong, touching 18 million units in the last quarter. The gaming side of the business appears to be doing extremely well, with engagement increasing 50% from November to December.

Xbox Live memberships reached 40 million, up from 35 million at the end of the September quarter. All these subscribers will be able to access television content acquired through recent partnerships.

At CES 2012, Microsoft showcased new LTE Windows phones from Nokia Corp (NOK) and HTC that will soon be available on the AT&T (T) network. The new Windows Phone, code-named Mango (with deeper social experiences, office 365 integration and IE 9) is expected to put the company back into the smartphone business. Microsoft stated that Skype, which it bought from eBay Inc (EBAY) last year had 200 million subscribers at year-end.

The Online Services business, or online advertising, generated 4% of revenue, up 25.4% sequentially and 13.5% year over year. We think that 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. (up 3 percentage points year over year). The partnership with Yahoo Inc (YHOO) is increasing ROI for advertisers, and Bing-powered searches (including Yahoo) is now 27% of the total market (up 2.2% year over year).

Operating Results

Microsoft’s gross margin of 73.0% dropped 525 basis points (bps) sequentially and 277 bps year over year. The gross margin is closely related to the mix, since margins on hardware and software products differ widely.  Microsoft also saw higher royalty costs in the last quarter due to higher transactional sales on Xbox Live. Additionally, the search agreement with Yahoo is raising online services and traffic acquisition costs.

Operating expenses of $7.25 billion were up 13.5% sequentially and 4.3% year over year. The operating margin of 38.3% dropped 319 bps sequentially and 264 bps from last year. The higher cost of sales was the primary reason for the decline in operating margin, although Microsoft also spent heavily on sales and marketing, which increased sequentially as a percentage of sales. Both S&M and G&A declined as a percentage of sales compared to the year-ago quarter, while all other expenses increased.

The operating margin by segment was as follows — Windows 60.2% (a sequential decline of 661 bps), Microsoft Business Division 66.1% (up 101 bps), Server & Tools 41.8% (up 425 bps), Entertainment & Devices 12.5% (down 547 bps) and Online Services -58.4% (up 2,062 bps). Margins in Windows and Entertainment & Devices segments declined significantly from last year, with other segments growing.

The company generated a pro forma net income of $6.6 billion, or 31.7% net income margin compared to $5.7 billion, or 33.0% in the previous quarter and $6.6 billion, or 33.2% 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 78 cents compared to 68 cents in the September 2011 quarter and 77 cents in the December quarter of 2010.

Balance Sheet

Inventories were down 40.5% to a normal level again, which caused inventory turns to go from 6.7X to 16.7X. Inventories were depleted as holiday-driven sales came in line with expectations. Days sales outstanding (DSOs) went to 60, up from 53 at the end of the September quarter.

Microsoft ended with a cash and short term investments balance of $51.7 billion, down $5.7 billion during the quarter. The net cash position was around $4.74 a share, down from 5.41 a share at the beginning of the quarter. In the last quarter, the company generated $5.86 billion in cash flow from operations, spent $1.04 billion on share repurchases, $1.68 billion on dividends, $8.6 billion on acquisitions and $498 million on capital assets.

Guidance Reiterated

Microsoft lowered the fiscal 2012 operating expense guidance to $28.5-28.9 billion.

Our Recommendation

We remain optimistic about Microsoft overall, based on the fact that it continues to gain from the enterprise refresh, emerging markets strength and growth in data centers and cloud computing. We also expect the entertainment division to benefit from pre-holiday builds and new products (Mango). Additionally, expense control remains quite good.

The sore point for Microsoft at this time remains the less than exciting growth trends in consumer-type computing markets in developed countries. Microsoft has significant exposure to this market, so the softness does have an impact on its results. We therefore have a Neutral recommendation on the stock.

In the near term, there could be further pressure on earnings as the PC market remains under pressure and the company sees increasing competition from Google’s (GOOG) Android and Apple’s iOS. However, Microsoft’s answer is Windows 8 and Mango, both of which should do extremely well. Therefore, Microsoft shares currently carry a Zacks Rank of #3, implying a Hold recommendation in the short-term (1-3 months).

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