31 January 2010

MSFT: Income Statement Analysis for the December 2009 Quarter

Microsoft (NASDAQ: MSFT) earned $0.74 per diluted share, on a GAAP basis, in the quarter that ended 31 December 2009, which was the second quarter of Microsoft's fiscal 2010.  Earnings soared from $0.47 in the December quarter of the previous year.

This post examines Microsoft's Income Statement for the quarter and compares the entries on each line to our "look-ahead" estimates.  Our target for Net Income in the latest quarter was only $0.58 per share, an embarrassingly large $0.16 less than the reported amount.

The principal sources for the income statement analysis were the earnings announcement, the conference call presentation [ppt] and transcript (available from Seeking Alpha and Microsoft [doc]), and the formal 10-Q report.

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.

Microsoft is best known for operating system and application software, but the company also sells video game consoles, music players, and computer peripheralsWindows 7, which replaced the disappointing Windows Vista, became available on 22 October 2009.  Additional 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 of $19.0 billion in the December quarter was 14.4 percent more than last year. Our Revenue estimate, $17.0 billion, was much too low.

Microsoft recognized about $1.71 billion of deferred revenue related to  the Windows 7 Upgrade Option Program and pre-sales of Windows 7 to manufacturers and retailers before general availability.  Second-quarter Revenue would have been $17.31 billion without the deferred revenue recognition, and earnings per share would have equaled $0.60.

The company credited "exceptional" sales of Windows 7 -- 60 million by the end of December -- for the sales surge.  Revenue jumped nearly 70 percent, from $4.06 billion to $6.90 billion, at Microsoft's Windows & Windows Live Division. 

Windows 7 probably contributed to an industry-wide increase in personal computer sales, which Microsoft estimated at 15 to 17 percent.  Interestingly, Microsoft estimated that sales of consumer personal computers were up more than 20 percent, while sales of business PCs "were roughly flat."

The quarter was not as robust at Microsoft's other business segments.  Three divisions, including the large Microsoft Business Division, reported lower Revenue, as shown below.

Microsoft Operating Segment
Q/E Dec 2009 Revenue ($M)
Q/E Dec 2008 Revenue ($M)Percent Change
Windows and Windows Live
Server and Tools
Online Services
Microsoft Business
Entertainment and Devices
Source: Earnings Press Release

The Cost of Goods Sold in the quarter was 19.1 percent of Revenue, which translates into a Gross Margin of 80.9 percent, up substantially from 76.5 percent in December 2008.  Our target for the Gross Margin was 79 percent.  Microsoft indicated that decreased Xbox costs and other cost-control efforts, "offset in part by increased online costs," added to the Gross Margin.

Microsoft spent 9.2 percent less on Research and Development than in the year-earlier quarter.  As a percentage of Revenue, R&D expenses decreased from 13.8 percent to 10.9 percent.  The company spent 14.4 percent less on R&D in the December 2009 quarter than we had expected.

According to the 10-Q,

The decrease in research and development expenses
[...] was primarily driven by a decrease in third-party development and programming costs, a 3% reduction in headcount-related expenses, and the capitalization of certain software development costs. [emphasis added]

Sales, General, and Administrative (SG&A) expenses increased 5.6 percent, and the amount was 14 percent more than our $4.16 billion estimate.   These expenses added up to 24.9 percent of Revenue, still down from 27.0 percent last year.

According to the 10-Q,

Sales and marketing expenses decreased primarily as a result of decreased corporate marketing and advertising campaigns, and for the six months ended December 31, 2009, a 3% reduction in headcount-related expenses.

General and administrative expenses increased during the three months and six months ended December 31, 2009 primarily driven by increased legal charges, offset in part by an 8% decrease in headcount-related expenses for the six months ended December 31, 2009.
[emphasis added]

Together, R&D and SG&A expenses totaled $6.82 billion in the December quarter. Microsoft's guidance for these two operating expenses for the entirety of fiscal 2010 is $26.2 billion to $26.5 billion.

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 $59 million charge in the December 2009 quarter to cover employee severance costs.  There had been a  similar $290 million charge earlier in 2009.

These various operating items combined to produce Operating Income of $8.51 billion, which was 43 percent more than in 2008's fourth quarter. The increased can be attributed to greater Revenue, a much better Gross Margin, and operating expense reductions.  Operating Income surpassed our $6.84 billion estimate by 31 percent.

Non-operating items -- mostly investment income and expenses -- summed to $370 million, which was substantially better than in recent quarters.  We had expected a net of $150 million for the non-operating items.  The improvement was mostly due to better results on investments, derivatives, and "foreign currency remeasurements."   The recent quarter also included a small gain from Microsoft's sale of Razorfish.

The 25-percent effective income tax rate was consistent with expectations.  It was one percent less than the rate in the previous December quarter.  The rate decreased because more of the company's earnings were garnered outside the U.S.

Bottom-line Net Income rose by almost 60 percent to $6.66 billion ($0.74 per diluted share), compared to earnings in the year-earlier quarter of $4.17 billion ($0.47 per share). Net Income was 27 percent higher than our $5.2 billion ($0.58 per share) estimate.  Adjusted Net Income, which excludes the deferred revenue recognition, was $0.60 per share.

In summary, sales of the new Windows 7 lifted Microsoft's revenue and earnings to record amounts in the December quarter.  A global increase in personal computer sales, especially to consumers, helped.  The launch of this product also allowed Microsoft to recognize about $1.7 billion of previously deferred revenue.  Sales of Windows 7 outweighed the Revenue declines reported at Microsoft's Entertainment and Devices Division, Microsoft Business Division, and the Online Services Division.

Cost control measures, including reductions in personnel, contributed to improved margins and profitability.  A slightly lower tax rate also helped.

Full disclosure: Long MSFT at time of writing.

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