24 October 2009

MSFT: Income Statement Analysis for the September 2009 Quarter

Microsoft (NASDAQ: MSFT) greatly surpassed estimates by earning $0.40 per share in the three months that ended on 30 September 2009, which was the first quarter of fiscal 2010.  Net income was $0.48 per share in the same quarter last year.

Windows 7, which replaces the disappointing Windows Vista, became available one day before the release of earnings for the September quarter.  Many are wondering if the new operating system will trigger a new cycle of personal computer sales.

This post examines the Income Statement in the earnings announcement and the accompanying 10-Q, and it compares the entries on each line to our "look-ahead" estimates.

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 various 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 the beginning of the 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 in the September quarter was 14.2 percent less than last year.  Since we had estimated Revenue would fall 15 percent, Microsoft' top-line was a little better than we expected.

10-Q blames the Revenue decline on the following "primary contributing factors"
  • Revenue deferrals totaling $1.5 billion, mostly due to sales of Vista with a minimal cost update to Windows 7.
  • Fewer licenses for Microsoft Office 2007 to businesses.
  • Changes to foreign currency exchange rates.
Each of Microsoft's business segments reported lower Revenue, although a couple of the declines were negligible.  Revenue fell the most, 10.4 percent, at the Microsoft Business Division.

The Cost of Goods Sold in the quarter was 22 percent of Revenue, which translates into a Gross Margin of 78 percent.  Our target for the Gross Margin was a slightly more profitable 79 percent.  Microsoft commented that "increased online costs, including traffic acquisition costs," added to the CGS.

Research and Development expenses were 10.2 percent less than our $2.3 billion estimate, which was based on Microsoft's guidance for Operating Expenses in the entirety of fiscal 2010.  According to the 10-Q,

The decrease in research and development expenses was primarily driven by a 6% decrease in headcount-related expenses, as well as by capitalization of certain Windows 7 software development costs and completion of product development of Windows 7.

Sales, General, and Administrative expenses were a remarkable 20 percent less than our $4.4 billion estimate, which was also based on the company's fiscal year guidance.  According to the 10-Q,

Sales and marketing expenses decreased primarily as a result of an 8% decrease in headcount-related expenses and decreased corporate marketing and advertising campaigns.

General and administrative expenses decreased primarily driven by a 16% decrease in headcount-related expenses and decreased legal expenses.

The repeated references to "decreased headcount-related expenses" shows the results of actions taken to cut costs, including the elimination of up to 5000 jobs.  (Microsoft recorded a $290 million charge in the March 2009 quarter to cover employee severance costs.)

Operating Income, which is the difference between Revenue and the operating expenses identified above, decreased by 25 percent, when compared to the September 2008 quarter.  However, Operating Income outran our projection by 31 percent, primarily because R&D and SG&A expenses were so much lower than expected.

Non-operating investment income and expenses summed to $283 million, which was substantially better than in recent quarters.  We had expected a net of $100 million for the non-operating items. The improvement was mostly due to gains on interest rate, commodity, and equity derivatives and to net gains from "foreign currency remeasurements" because of a weakening U.S. dollar.

The Income Tax Rate was 25.0 percent, compared to the predicted 26.0 percent.  A greater proportion of earnings were subject to lower foreign taxes.

Net Income of $3.574 billion ($0.40/share) was 18 percent below last September's value, but it was 37.5 percent greater than our prediction.

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

“We are very pleased with our performance this quarter and particularly by the strong consumer demand for Windows,” ...  “We also maintained our cost discipline, which allowed us to drive strong earnings performance despite continued tough overall economic conditions.”

Despite significant challenges,
  • Businesses spending less on information technology, including personal computers.
  • The increasing popularity of netbooks that use inexpensive software,
  • Competition from open source software and software-as-a-service "cloud computing"
  • Customers deferring software purchases until release of Windows 7.
... Microsoft still managed to earn $3.5 billion in the last three months, and the net Cash Flow from Operations during this period was $6.1 billion.

Full disclosure: Long MSFT at time of writing.

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