11 December 2009

MSFT: Look Ahead to December 2009 Quarterly Results

Microsoft (NASDAQ: MSFT) earned $0.40 per share in the first quarter of fiscal 2010, which ended 30 September 2009Net income was $0.48 per share in the year-earlier quarter.

In October, we examined Microsoft's Income Statement for the September quarter and compared the entries on each line to our "look-ahead" estimates.  We later performed a financial gauge analysis of Microsoft, which determined that the GCFR Overall gauge slipped from 60 of the 100 possible points to 56.

We have now modeled Microsoft's Income Statement for the quarter that will end on 31 December 2009.  The intent of this exercise was to produce a baseline for identifying deviations, positive or negative, in the actual data that the company will announce on 28 January 2010.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

First, we present some background information.

A high-tech Goliath, Microsoft is best known for operating system and application software, but the company also sells video game consoles, music players, and computer peripherals.

Windows 7, which replaced the disappointing Windows Vista, became available on 22 October 2009.  It's not yet clear whether the new operating system will trigger a new cycle of personal computer sales.  Inexpensive netbook PCs have been selling well, but these devices bring less Revenue to Microsoft than more capable computers.  Most netbooks run an older, low-priced version of Windows, and many run Linux

Microsoft is also developing a platform, called Azure, to make software services available via cloud computing.  The company recently combined two business units to create the new Server and Cloud Division.

Microsoft also launched a new campaign involving Windows MobileSmartphones that run this operating system compete with Apple's (NASDAQ: AAPL) iPhone, Research in Motion's (NASDAQ: RIMM) Blackberry, Palm's (NASDAQ: PALM) Pre, and Nokia's N97, among others.  Android, an open source operating system based on Linux and supported by Google (NASDAQ: GOOG), is likely to become popular.

The launch of the Bing search engine in May 2009 was a high-profile effort to increase revenue from online advertising.  The $100 million spent to promote Bing has had some success, but Microsoft still has a long way to go to threaten GoogleComScore, Inc. (NASDAQ: SCOR) data of U.S. searches in October 2009 indicated that Google performed 65.4 percent, Yahoo! Inc. (NASDAQ: YHOO) conducted 18.0 percent, and Microsoft sites (Bing) were used for 9.9 percent of searches.

On 29 July, after months of false starts, Microsoft and Yahoo jointly announced a 10-year partnership agreement that will result in Bing becoming "the exclusive algorithmic search and paid search platform for Yahoo! sites."  The U.S. is reviewing the antitrust implications of this agreement.

Certainly, Microsoft is no stranger to antitrust authorities.  U.S. oversight of Microsoft's 2002 antitrust settlement was extended last April for 18 months.  In Europe, Microsoft is reportedly close to settling charges it unfairly bundled the Internet Explorer web browser with Windows.

Now, we are ready to look ahead to December's results.

The earnings announcement reporting Microsoft's results for the September period included neither revenue nor earnings guidance. The press release only provided guidance for operating costs:

Microsoft is reducing operating expense guidance to $26.2 billion to $26.5 billion, for the full year ending June 30, 2010.

The previous guidance for these expenses had been $26.6 billion to $27.0 billion. 

More specific comments on the company's expectations for the December quarter and the rest of fiscal 2010 were made during the conference call following the earnings release:

... in the second quarter we expected the Windows Division revenue, excluding the impact of the Windows 7 upgrade program, to be in line with overall PC market growth. ...  In the second quarter, we expect to recognize virtually all of the $1.7 billion of Windows 7 upgrade revenue deferrals from the last two quarters.  ...

In the second quarter, we expect Microsoft’s business division dynamics and revenue trends to be to be largely the same as they were in the first quarter with growth lagging PC shipments ...

For the full year, the consumer and business non-annuity revenue, approximately 40% of the total, should face the same trends as in the second quarter, with increasing pressure in advance of the next product cycle and as such could continue to lag PC shipments. We continue to expect annuity revenue representing 50% of the total to be broadly flat for the full year. ...

we now expect COGS as a percentage of revenue to increase one point this year compared to the two we discussed at last call.

With operating expenses, we also continue to make excellent progress. We’re lowering our guidance for the full year to a range of $26.2 billion to $26.5 billion, down from what we said in July.

The Gartner research firm:

"predicts worldwide PC shipments will total 298.9 million units in 2009, a 2.8 percent increase from 2008.  In 2010, PC shipments are projected to reach 336.6 million units, a 12.6 percent increase over 2009."

"While PC shipments are now expected to increase ...  The market value of global PC shipments is now forecast to total $217 billion in 2009, a 10.7 percent decline from 2008. "

Revenue in the current quarter will primarily be driven by the industry considerations discussed above.  In addition, there is also a seasonality factor.  In the previous five fiscal years, Revenue in the December quarter averaged about 27.8 percent of annual Revenue.

We have settled on $17.0 billion ($15.3 billion + $1.7 billion previously deferred) as our target for Microsoft's Revenue in the December 2009 quarter.  This figure is 2.2 percent more than Revenue in the December 2008 quarter.

Microsoft typically achieves a lucrative Gross Margin of approximately 80 percent of Revenue.  Because of the weak economy and the growing proportion of netbooks, our Gross Margin target for the December quarter is 79 percent.  This ratio translates into a Cost of Goods Sold of (1 - 0.79) * $17.0 billion, or $3.6 billion. 

The company's guidance for Operating Expenses in fiscal 2010 is now about $26.35 billion, give or take $150 million.  This figure covers R&D expenses and SG&A expenses.  (We group Sales & Marketing and General & Administrative into one category, but Microsoft reports them separately.)  Given both the guidance and actual figures for these expenses in previous quarters, we estimate that the R&D expense in the December quarter will be $2.4 billion and the SG&A expense will be about $4.2 billion.

The Revenue and expense estimates above for the December 2009 quarter would result in Operating Income of $6.8 billion.  This figure is 15 percent greater than Operating Income in the December 2008 quarter.

We assume, with little certainty, net non-operating income (e.g., interest) of about $150 million.  We'll also assume an income tax rate of 25 percent.  These values would lead to Net Income of $5.2 billion ($0.58/share).  This is roughly 26 percent more than Net income in the year-earlier quarter.

Please click here to see a full-sized, normalized depiction of the projected results next to Microsoft's 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.

Full disclosure: Long MSFT at time of writing.

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