(MSFT) Microsoft’s First Quarter Earnings Post Soft – As Expected

Microsoft Corporation’s (MSFT) first quarter earnings of 53 cents missed the Zacks Consensus Estimate by 4 cents, as PC market slowdown and stock clearance before the Windows 8 launch impacted revenue growth.


Revenue excluding deferrals of $16.01 billion was down 11.4% sequentially and 7.9% from last year, missing estimates by 2.5%. All except the Entertainment & Devices segment contributed to the sequential decline in the last The softness in Windows was not surprising, since customers were expected to delay purchases ahead of the Windows 8 launch.

Segment Specifics

The Windows and Windows Live Segment generated 20% of Microsoft’s quarterly revenue, down 21.7% sequentially and 33.4% year over year. The Windows 8-related stock clearing was more or less as expected, but Microsoft’s results were also impacted by the PC market slowdown that impacted Intel (INTC) and Advanced Micro Devices (AMD).

The consumer segment was worse impacted than enterprise (as expected), with transaction revenues declining in both. Microsoft was however upbeat about multi-year licensing revenue, which grew 15% year over year.

While there was no alleviation in pressure from tablets, particularly Apple’s (AAPL) iPad, Microsoft mentioned that it had certified over a thousand unique Windows 8 systems, including tablets, convertibles, laptops and all-in-ones. So growth rates should pick up in the near future.

The Microsoft Business Division, which generated 34% of revenue, dropped 12.5% sequentially and 2.1% from last year. Here too, the weakness in the PC market impacted transactional revenue. However, multi-year licensing revenue grew 8%.

Microsoft stated that other products such as SharePoint, Exchange and Lync remained strong. Microsoft’s success with CRM could give Salesforce.com (CRM) something to worry about. In the last quarter, Dynamics CRM grew over 30%. The acquisition of Yammer added best-in-class enterprise social networking expected to boost its cloud offerings.

The Server & Tools segment, at 28% of total revenue, was down 10.6% sequentially while growing 7.1% year over year. Microsoft’s multi-year licensing revenue grew more than 19% year over year, with SQL server up more than 20% and System Center around 20%. Overall trends indicate continuing strength in the enterprise. Virtualization and cloud computing are proving to be very beneficial for Microsoft’s S&T business.

Microsoft generated 12% of revenue from the Entertainment & Devices segment, up 9.4% sequentially and flattish year over year. The segment is finally showing signs of sustainable improvement and will benefit from the holiday season in the current quarter.

Despite the market weakness that contributed to the 29% decline in Xbox units, Microsoft increased market share during the quarter from 47% to 49%. The newly introduced SmartGlass will help connect phones, PCs and tablets to Xbox, which is expected to attract more users to the platform.

Management did not shed light on Windows Phone units, but said that the device lineup for Win 8 was significant

Skype, acquired from eBay Inc (EBAY) in 2010 had minutes touching 120 billion, up 58% from last year.

The Online Services business, or online advertising, generated 4% of revenue, down 5.2% sequentially while growing 11.5% 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..

The partnership with Yahoo Inc (YHOO) remains on track, with increasing ROI for advertisers. But monetization remains below expectations. The company wrote down goodwill on the aQuantive acquisition in the last quarter.

Operating Results

Microsoft’s gross margin of 74.0% dropped 298 basis points (bps) sequentially and 430 bps year over year. The gross margin is closely related to the mix, since margins on hardware and software products differ widely.

Therefore, the increase in Entertainment & Devices revenue combined with the decline in other segments resulted in a weaker gross margin. The search agreement with Yahoo also remains, raising online services and traffic acquisition costs.

Operating expenses of $6.53 billion were down 13.0% sequentially and up 2.2% year over year. The operating margin of 33.2% dropped 220 bps sequentially and 830 bps from last year. S&M expenses declined 254 bps as a percentage of sales, but was offset by increases in all other costs.

The operating margin by segment was as follows—Windows 50.7% (a sequential decline of 709 bps), Microsoft Business Division 66.3% (up 109 bps), Server & Tools 38.4% (down 274 bps) and Entertainment & Devices 1.0% (down 274 bps). The Online Services business continues to generate a loss, although narrower than in the past.

The company generated a pro forma net income of $4.47 billion, or 27.9% net income margin compared to $5.70 billion, or 31.6% in the previous quarter and $5.7 billion, or 33.0% in the year-ago quarter.

Balance Sheet

Inventories were up 42.8%, which lowered inventory turns from 14.6X to 10.3X. Days sales outstanding (DSOs) went to 56, down from around 80 at the end of the June quarter.

Microsoft ended with a cash and short term investments balance of $66.6 billion, up $3.6 billion during the quarter. The net cash position was around $54.69, up from $51.10 at the beginning of the quarter. In the last quarter, the company generated $8.48 billion in cash flow from operations, spent $1.63 billion on share repurchases, $1.68 billion on dividends, $1.15 billion on acquisitions and $603 million on capital assets.


Microsoft maintained its 2013 opex expectations of a 6% increase to $30.3 to 30.9 billion. The tax rate for the year is expected to be 19-21%, capital expenses of around $3.5 billion.

Key Takeaways

Microsoft had a more or less regular quarter, with Windows revenue impacted by purchase deferrals and S&T and Business Division also impacted by weakness in the PC market. Windows Phone numbers are encouraging, although the growth is off a small base. However, it is significant that the company was able to grow share in the gaming segment, considering the condition of the market and we think the platform approach here is the way to go.

Of course, we recognize the danger of tablets that are still largely based on iOS or Android, since these devices are eating into its netbook sales. Microsoft’s Surface could be a game-changer and Win 8 will stimulate growth over the next few quarters.

However, growth in Windows 8 will be tempered by dynamics in the PC market and therefore think the shares will not gain much. The Zacks Rank on Microsoft shares is #3, which implies a Hold recommendation in the short-term (1-3 months).

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