22 April 2010

MSFT: Income Statement Analysis for the March 2010 Quarter

Microsoft (NASDAQ: MSFT) earned $0.45 per diluted share in fiscal 2010's third quarter, which ended on 31 March 2010.  Earnings per share were 36 percent greater than the $0.33 Microsoft made in the March 2009 quarter.

This post examines Microsoft's Income Statement for the quarter and compares the entries on each line to our "look-ahead" estimates.  Our EPS target for the latest quarter was $0.45 per share, which is the figure the company reported.

The principal sources for the income statement analysis were the earnings announcement, the conference call presentation [ppt], 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 peripherals.  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 $14.5 billion in the March quarter was 6.3 percent more than last year.  Although this was the most Revenue achieved by Microsoft during a fiscal third quarter, it fell short of our target.  We had expected Revenue to be 4 percent higher, $15.1 billion to be exact.

Microsoft also uses what they call Adjusted Revenue, which takes deferrals into account.  Adjusted Revenue in the latest quarter was $14.8 billion.

The Revenue increase was due, according to Microsoft, to "strong sales of Windows 7" and rising personal computer sales.  Microsoft estimated that personal computer sales grew 25 to 27 percent.  Digging deeper, Microsoft estimated that consumers bought about 30 percent more PCs than they did last year, and business purchased 14 percent more PCs.

Three months ago, Microsoft commented that sales of business PCs "were roughly flat."  Businesses began to spend again during the first months of calendar 2010.

While the Windows franchise was indeed strong, as listed below, sales were slower at other segments of Microsoft.  It seems disappointing that the recovery in business PC purchases did not lead to better results at the big Microsoft Business Division, where sales declined, and at the Server and Tools unit, where growth was tepid.  To be fair, Microsoft had to defer some $300 million Revenue until
Office 2010 is made available.

Microsoft Operating SegmentQ/E Mar 2010 Revenue ($M)Q/E Mar 2009 Revenue ($M)Percent Change
Windows and Windows Live $4415$344828%
Server and Tools357534912.4%
Online Services56650711.6%
Microsoft Business42434508-5.9%
Entertainment and Devices166516292.2%
Source: Earnings Press Release

The Cost of Goods Sold in the quarter, $2.76 billion, was 19 percent of Revenue.  This ratio translates into a Gross Margin of 81 percent.  The margin expanded a hefty 160 basis points relative to the March 2009 value of 79.4 percent.  The Gross Margin also surpassed our 78.8-percent target

Rising revenue and cost controls probably led to the margin expansion.  Microsoft did mention that Xbox 360 console costs had decreased.  The cost reductions achieved were partially offset by increased online (mainly traffic acquisition) costs.

The $2.22 billion spent on Research and Development was almost exactly the same as in the year-earlier quarter.  It also matched our estimate.  As a percentage of Revenue, R&D expenses decreased from 16.2 percent to 15.3 percent.

According to the 10-Q,

The decrease [during the first nine months of fiscal 2010] in research and development expenses was primarily driven by a decrease in third-party development and programming costs and the capitalization of certain software development costs, offset in part for the three months ended March 31, 2010 by a 4% increase in headcount-related expenses.
Sales, General, and Administrative expenses [Microsoft reports these as Sales and Marketing expenses and General and Administrative expenses] increased 11.8 percent to $4.36 billion.  This amount was 4.3 percent less than our $4.55 billion estimate.  These expenses equaled 30.0 percent of Revenue, up from 28.5 percent last year.

Again, we turn to the 10-Q for an explanation,

Sales and marketing expenses increased for the three months ended March 31, 2010 primarily due to increased advertising and marketing of Windows 7 and increased sales force expenses related to Windows 7.

General and administrative expenses increased during the three months and nine months ended March 31, 2010 primarily driven by increased legal charges ...  and the transition expenses associated with the inception of the Yahoo! Commercial Agreement. These increases were offset in part by a 3% and 7% reduction in headcount-related expenses during the three months and nine months ended March 31, 2010, respectively.

Together, R&D and SG&A expenses totaled $6.575 billion in the March quarter.  Through the first nine months of the fiscal year, the total was $19.0 billion.  Now, with one quarter remaining, Microsoft decided to slightly reduce its operating expense guidance for the year to "$26.1 billion to $26.3 billion," from $26.2 billion to $26.5 billion.

Subtracting the various operating expenses from Revenue yields Operating Income of $5.17 billion, which exceeded last year's $4.44 billion by 16.6 percent.  The reported amount was just slightly more than our $5.15 billion target for Operating Income.

Non-operating items -- mostly investment income and expenses -- summed to a $168 million gainWe had expected a net gain of $200 million for these items.  In the year-earlier quarter, Microsoft had recorded $420 million of "Other-than-temporary impairments" on investments, as a result of the market conditions at that time.

The 25-percent effective income tax rate was consistent with expectations.  It was lower than last year's rate because more of the company's earnings were garnered outside the U.S.

Bottom-line Net Income rose by 35 percent to $4.006 billion ($0.45 per diluted share), compared to earnings in the year-earlier quarter of $2.977 billion ($0.33 per share).  In a statistical oddity (i.e., dumb luck), the latest result was almost identical to our $4.012 billion target.

Full disclosure: Long MSFT at time of writing.

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