21 March 2010

MSFT: Look Ahead to March 2010 Quarterly Results

This post describes our model of Microsoft's (NASDAQ: MSFT) Income Statement for the third quarter of fiscal 2010, which will end on 31 March.

The intent of our look-ahead exercises is to produce a baseline for identifying surprises, positive or negative, in the reported data.  GCFR estimates are derived from guidance provided by company management, when available, and the company's historical financial results.

First, we present some background information about Microsoft and the business environment in which it is currently operating.

Microsoft is best known for operating system and application software, but it also sells video game consoles, music players, and computer peripherals.

Management, as reported in Softpedia, hopes to sell licenses for 300 million copies of Windows 7 before the end of 2010.  The high-tech Goliath sold 90 million copies in the first four months after the latest client operating system became available on 22 October 2009

Many more personal computers are expected to be sold in 2010 that 2009, and this should benefit Microsoft.  Gartner forecast that worldwide PC shipments would increase nearly 20 percent this year, with mobile computers likely to be especially strong.  The release of new software also tends to create demand for new computers.

Inexpensive netbook PCs sold well in 2009, but these devices are not expected to maintain their growth trajectory.  Netbook sales generally result in less per-unit software licensing revenue for Microsoft.

For smartphones, Microsoft is replacing Windows Mobile with Windows Phone 7 Series.  The new platform will face many rivals, including Apple's (NASDAQ: AAPL) iPhone, the Linux-based Android open source operating system supported by Google (NASDAQ: GOOG), and the MeeGo combination from Intel (NASDAQ: INTC) and Nokia (NYSE: NOK).

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.

The launch of the Bing search engine in May 2009, backed by a $100 million promotional campaign, was a high-profile effort to increase Microsoft's revenue from online advertising.  Although generally considered successful, Microsoft still has a long way to go to threaten GoogleComScore, Inc. (NASDAQ: SCOR) data of U.S. searches in February 2010 indicated that Google performed 65.5 percent, Yahoo! Inc. (NASDAQ: YHOO) conducted 16.8 percent, and Microsoft sites (i.e., Bing) were used for 11.5 percent of searches.

A 10-year agreement with Yahoo that allows Bing to be "the exclusive algorithmic search and paid search platform for Yahoo! sites" cleared regulatory review in the U.S. and Europe.

Certainly, Microsoft is no stranger to antitrust authorities.  U.S. oversight of Microsoft's 2002 antitrust settlement was extended in April 2009 for 18 months.  To resolve concerns raised in Europe about the bundling of Internet Explorer with Windows, Microsoft implemented a scheme that allows users to select a browser from a menu of alternatives.

Now, we are ready to look ahead to Microsoft's results for the March 2010 quarter.

The earnings announcement reporting Microsoft's results for the December period reaffirmed guidance from three months earlier regarding operating costs:

In addition, Microsoft offers operating expense guidance of $26.2 billion to $26.5 billion, for the full year ending June 30, 2010.

More specific comments on the company's outlook were made during the conference call following the earnings release:

"... keep in mind that our third quarter tends to be seasonally weaker than our second and fourth quarters.

"In the third quarter, we expect Windows Division revenues to be roughly in line with the overall PC market growth.

"The Microsoft Business Divisions revenue in the third quarter should largely demonstrate the same dynamics as in the first half. Consumer and business non-annuity revenue, approximately 40% of the total, will face ongoing pressure in advance of the next product cycle, and as such should lag overall PC shipments until Office 2010 becomes generally available in June. We expect annuity revenue, representing 60% of total revenue, to be broadly flat for the full year.

"We expect server shipments to show year-over-year growth in Q3 and Q4 for the first time in several quarters. We expect non-annuity revenue which is approximately 30% of the total to move generally in line. Annuity revenue should grow mid single digits while services should be roughly flat for the year.

"we now expect cost of goods sold as a percentage of revenue to be roughly flat for this fiscal year."

Microsoft had Revenue of $19.0 billion in the December 2009 quarter, but this figure included $1.71 billion in deferred revenue related to the Windows 7 release.

Given the guidance and the recent strength in PC shipments, our working estimate for Microsoft's Revenue in the March quarter is $15.1 billion.  This amount is 10.6 percent more than Revenue of $13.65 billion in the March 2009 quarter.

In fiscal 2009, Microsoft's Gross Margin was a lucrative 79.2 percent of Revenue, and it was 79.7 percent in the first two quarters of fiscal 2010.  For the March quarter, we will use 78.8 percent as our estimate.  This ratio translates into a Cost of Goods Sold of (1 - 0.788) * $15.1 billion, or $3.2 billion. 

The company's guidance for Operating Expenses in fiscal 2010 is $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 the guidance and actual figures for these expenses so far this year, we estimate that the R&D expense in the March quarter will be $2.2 billion, and the SG&A expense will be about $4.5 billion.

The Revenue and expense estimates would result in Operating Income of $5.15 billion.  This figure is 16 percent greater than Operating Income in the March 2009 quarter.

We assume, with little certainty, net non-operating income (e.g., interest) of $200 million.  We'll also assume an income tax rate of 25 percent.  These values would lead to Net Income of $4.0 billion ($0.45/share).  This is 35 percent more than 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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