24 July 2009

MSFT: Income Statement Analysis for the June 2009 Quarter

Microsoft Corp. (NASDAQ: MSFT) earned $0.34 per share in the three months that ended on 30 June 2009, down from $0.46 in the same quarter last year.  The April-to-June period is the fourth quarter of the Microsoft's fiscal year. 

This post examines the Income Statement for the quarter and compares its entries to our "look-ahead" estimates.  Our Net Income estimate almost exactly matched the reported amount ($3.045 billion vs. $3.014 billion).   We attribute this result to dumb luck.  We show below that our estimates for Revenue and many of the expense items were not nearly so accurate.

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 financial metrics we use to analyze Cash Management, Growth, Profitability and Value.

Some background information about Microsoft and the business environment in which it is currently operating can be found in our look-ahead.

Please click here to see a full-sized, 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 was 17 percent less than in the year-earlier quarter, and it was 12.7 percent less than in the March 2009 quarter.  Since we had estimated that Revenue would decline by 5.3 percent, the actual figure fell far, far short of our expectations. 

Each of Microsoft's reporting business segments experienced a Revenue decline in the June quarter,  

"... primarily [due to] weakness in the global PC market and the unfavorable economic environment."

The two segments where Revenue fell the most were Client, down 28.7 percent, and Entertainment and Devices division, down 25 percent.  Fewer Xbox consoles were sold, and the price per console fell.

Microsoft estimated:

"total worldwide PC shipments from all sources declined approximately 5% to 7%."

In formulating our Revenue estimate, we had assumed that the decline in Microsoft's total Revenue would be somewhat less severe than the fall in worldwide PC shipments.  In fact, the decline was much more harsh.  It seems pretty clear that a growing proportion of the computers sold were netbooks for which Microsoft receives much less Revenue.

In fiscal 2009, total Revenue was 3.3 percent less than in 2008.  This is the first time Microsoft's Revenue in one fiscal year was less than in the previous year.

The Cost of Goods Sold in the quarter was 19.7 percent of Revenue, which translates into a Gross Margin percent.  Because our target for the Gross Margin was 78 percent, Microsoft did a couple of points of better than the 80.3 percent we anticipated.

Research and Development expenses were 7.3 percent less than our $2.4 billion estimate.  One reason for the lower R&D expenses was that Microsoft was able to capitalize $105 million of certain Windows 7 software development costs. However, because Revenue in the quarter was so weak, R&D expenses were higher as a percentage of Revenue, 17 percent vs. 16 percent, than we anticipated.

Sales, General, and Administrative expenses were a substantial 9.3 percent below our estimate.  These expenses increased from 30.8 percent of Revenue to 32.5 percent.  The recent quarter included $193 million of legal costs.

The quarter included a special operating charge of $40 million for employee severance costs associated with the cost-cutting actions announced earlier.  We had budgeted $300 million for this item.

Operating Income was 30 percent less than in the June 2008 quarter.  However, Operating Income was only 7.3 percent weaker than our projection because operating expenses were also much less.

The Client division's quarterly Operating Income was down 33 percent from June 2008 to June 2009.

Non-operating investment income and interest summed to $155 million, which was substantially better than in recent quarters.  For one thing, we didn't count on the $100 million of gains on derivatives and "foreign currency remeasurements."  We had expected a net expense of $200 million for non-operating items.

The Income Tax Rate was 26.5 percent, which matched the predicted 26.5 percent.

Net Income of $3.0 billion ($0.34/share) was 25 percent below last June's value, but it was eerily close to our prediction.

Chris Liddell, chief financial officer at Microsoft, said it plainly:

    “Our business continued to be negatively impacted by weakness in the global PC and server markets.”

The weakness is most clearly seen in the top-line Revenue figure, which fell by an unprecedented amount.  However, the "resource management" cost-cutting measures announced at the beginning of the year have already gained traction. "Headcount-related expenses" were 6 percent less in the June 2009 quarter than in the same period last year.

[Microsoft is] "eliminating up to 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information technology by June 30, 2010.")

Despite significant challenges,
  • The fall in IT spending (especially by businesses),
  • The increasing popularity of netbooks,
  • Competition from open source software, and even
  • Cloud computing.
Microsoft still managed to earn $3.0 billion in the quarter, and the net Cash Flow from Operations was $3.8 billion.

On the day before the earnings announcement, Microsoft announced that Windows 7 and Windows Server 2008 R2 "were released to manufacturing" and will become available to the public on 22 October 2009.

Full disclosure: Long MSFT at time of writing.

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