Microsoft Corporation (MSFT) reported fourth quarter 2010 earnings that beat the Zacks Consensus Estimate by 5 cents per share, or 10.2%. Revenue also beat the Zacks Consensus, exceeding by 5.0%.
Currency had a net 2% positive impact on revenue in the last quarter, as Microsoft’s hedging program and a softening of the dollar versus other currencies more than offset the negative impact of the euro.
Revenue of $16.0 billion was up 10.6% sequentially and 22.4% year over year, driven by record revenues in the Windows and Servers & Tools segments. Management stated that Microsoft witnessed strength across enterprise (both large and SMB), as well as consumer markets.
Management estimates that the PC market (units) was up 22-24% from the June 2009 quarter, while OEM sales of Microsoft’s Windows 7 installed PCs grew 26%, indicating further market share gains.
Revenue by Segment
The Windows and Windows Live Segment generated 28% of fourth quarter revenue, up 3.0% sequentially and 46.3% year over year. The Windows segment usually experiences seasonal strength in the June quarter. The company witnessed increased sales of Windows 7 premium at both enterprise and consumer customers.
On a year-over-year basis, Windows 7 licenses into the consumer and enterprise markets were both up by around 26%. Management stated that Windows 7 was the fastest selling OS ever made, running on 15% of all PCs worldwide.
OEM sales remain a major driver of segment performance, which exceeded management’s estimated PC market growth rate for the third time in 10 quarters. The higher Windows attach rates, inventory builds and channel dynamics fueled the increase at OEMs.
However, this was partially offset by mix, with the demand for PCs in emerging markets roughly double the demand from developed markets. The mix of business versus consumer was stable in the quarter, as enterprise refreshes continued to accelerate. Non-OEM sales (businesses and retail) were up 36%.
The Microsoft Business Division, which generated 33% of revenue, grew 23.7% sequentially and 15.0% year over year. Both enterprise and consumer segments helped drive growth, although consumer was much stronger. The consumer segment, which includes OEM and retail, grew 51% year over year. The business was seasonally strong, driven by the back-to-school season. The business portion grew 8%, with annuity up 6% and non-annuity up 15%.
Management stated that Office 2010 was one of the major growth drivers and the integration with SharePoint, Office Communications Server and Dynamics CRM also contributing to the growth.
The Server & Tools segment at 25% of total revenue grew 12.2% sequentially and 14.3% year over year. Although the growth rate remains lower than the estimated growth in server hardware shipments, which was up 25-28%, the gap appears to be narrowing.
All channels grew double-digits in the last quarter. Annuity, which accounted for 50% of segment sales, grew 15% from the year-ago quarter. The OEM and licensing only (non-annuity) business accounted for 30% of segment revenue and grew around 20%. All the product lines, including Windows Server, SQL Server and Systems Center were up double-digits. Services, at 20% of revenue, grew 15%.
Microsoft has a very healthy product pipeline and a growing presence in the cloud computing arena, which should drive growth in ensuing quarters.
Entertainment & Devices generated 10%, down 3.9% sequentially and up 34.6% year over year.
Gaming revenue grew 30% from a year ago, driven by a 26% increase in xBox 360 console sales, although flat sequentially. However, membership growth for Xbox Live remained strong, with the digital marketplace revenue overtaking subscription revenue for the first time.
Non-gaming revenue was up 23%, driven by PC accessories sales and increased investment in computer hardware. The pipeline remains strong and we expect the Windows Phone 7 and newly-introduced motion-controlled Xbox to revitalize the segment.
The Online Services business, or online advertising, generated 4% of revenue; flat sequentially and down 22.7% year over year. However, Bing’s market share in the U.S. has been inching upward, which should help revenue growth going forward.
The gross margin for the quarter was 80.2%, down 77 basis points (bps) sequentially and 2 bps year over year. The decline was related to higher sales of lower-margin hardware (Entertainment Devices segment).
Operating expenses of $6.93 billion were up 5.5% sequentially, but up 7.0% year over year. Consequently, the operating margin expanded 130 bps sequentially and 623 bps from the year-ago quarter G&A expenses were down significantly as a percentage of sales, followed by R&D. However, both cost of sales and S&M increased as a percentage of sales. The improvement was possible because of management’s restructuring actions over the past year that lowered the cost base.
The operating margin by segment was as follows—Windows 67.3% (a decrease of 198 bps from the third quarter), Microsoft Business Division 62.6% (up 76 bps), Server & Tools 38.5% (up 343 bps), Entertainment & Devices -10.8% (down 2,076 bps) and Online Services -123.2% (up 279 bps). The Windows and Online Services operating margin also declined on a year-over-year basis.
The company generated a pro forma net income of $4.5 billion, or 28.2% net income margin compared to $4.0 billion, or 27.6% in the previous quarter and $3.1 billion, or 23.6% in the year-ago quarter. There were no one-time items in the last quarter. Accordingly, the GAAP EPS was $0.51 compared to $0.45 in the March 2010 quarter and $0.34 in the June quarter of last year.
Inventories increased 47.7%, with inventory turns dropping from 22.0X to 17.1X. Days sales outstanding (DSOs) jumped up from 57 to around 74, indicating sluggish collections and also, possibly, a back-end loaded quarter.
The company ended with a cash and short-term investments balance of $36.8 billion, down $2.9 billion during the quarter. The net cash position was $3.63 a share. In the last quarter, the company generated $5.6 billion in cash flow from operations, spent $3.8 billion on share repurchases, $1.1 billion on dividends and $758 million on capital assets.
Management did not provide revenue guidance, but stated that operating expenses for fiscal 2011 would be $26.9 – $27.3 billion, an increase of 4.5% from 2010.
Microsoft is undoubtedly the leader in computing operating systems and judging from the growing success of the Windows 7 OS, the company will be able to retain the lion’s share of revenue flowing from the segment. Management has stated that 15% of all PCs are already running Windows 7 (compared to 10% at the end of the preceding quarter), indicating strong adoption rates and significant growth potential.
Moreover, Microsoft is poised to benefit from new product cycles in both the enterprise PC and server markets, especially the ongoing transition to virtualization and cloud computing.
The company also remains one of the largest players in the gaming hardware market and its gaming platform should benefit from continued adoption of Windows Live. Motion control gaming devices and Natal will be other drivers.
Additionally, the company’s new Windows 7 smartphone should do well, but we will be keeping an eye on how the company targets this extremely competitive and highly crowded market. While the online services business remains a drag on overall results, Microsoft’s Bing will gain share.
It will be interesting to see how the market develops, especially since the company has now to contend with not just Yahoo Inc. (YHOO) and Google Inc. (GOOG), but also Apple Inc. (AAPL), which has recently entered the market with a new-age, feature-rich interactive platform.
We currently have an Outperform recommendation on Microsoft shares, since growth prospects continue to look solid for a couple of years at least. However, our short-term rating is Hold, reflected in the Zacks Rank of #3 on the shares, because near-term concerns regarding currency could pressure shares.