06 June 2010

MSFT: Look Ahead to June 2010 Quarterly Results

This post describes our model of Microsoft's (NASDAQ: MSFT) Income Statement for fiscal 2010's fourth quarter, which will end on 30 June.

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results the company will report.  Estimates for each line of the Income Statement are derived from management's guidance, the company's historical financial results, and other publicly available data.

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

Microsoft develops and sells the operating system software that runs on more than 90 percent of personal computers.  It also has dominant application software and server software franchises.   In addition, the company provides various online services, such as the Bing search engine and online advertising.  Microsoft also sells video game consoles, entertainment devices, and computer peripherals.

Net Income in fiscal 2009 was $14.6 billion, down 17.6 percent from fiscal 2008.  Revenue slipped 3.3 percent in 2009, from $60.4 billion in 2008 to $58.4 billion.  Microsoft's 10-K for fiscal 2009 notes that the "unfavorable global economic environment" caused "consumers and businesses [to] cut back on spending, which reduced PC shipments and IT investments."

Microsoft is included in the Dow Jones Industrial Average and the S&P 500.  For many years, the company's shares have generally traded at a price between $20 and $30, with occasional excursions outside the range.  The company's market capitalization is now roughly $225 billion.

The company is organized into five operating segments: Client, Server and Tools, Online Services Business, Microsoft Business Division, and Entertainment and Devices Division.  The Business Division contributed the most Revenue ($18.9 billion) and led the way in Operating Income ($11.9 billion) in 2009.  Online Services lost $2.4 billion and Entertainment and Devices essentially broke even.

Microsoft is poised to reap handsome profits from the launch in October 2009 of Windows 7, which is the latest version of its desktop operating system, and from the 15 June 2010 release of Office 2010.  The company hopes to sell 270 million Windows 7 licenses in 2010. 

While there will be upgrades, Microsoft's sales also depend on how many new computers will be purchased by businesses and consumers.  The prospects in this regard are positive.  iSuppli reported a 23 percent increase in global PC shipments in the first quarter of 2010, from 66.5 million in 2009 to 81.5 million units.  Gartner projects 22 percent more personal computers will be shipped in 2010 than 2009.  The research firm also expects faster growth for home PCs than for business PCs, with the pace of corporate IT spending more dependent on the economic recovery.

A significant proportion of the Client segment's Revenue is due to the sale of new personal computers on which the equipment manufacturer has installed a version of Windows.   Revenue to Microsoft is maximized when the new PCs come with a premium version of Windows.  Therefore, the trend towards low-priced computers, such as netbooks running less-capable operating systems, could be a concern in Redmond. 

The sale of increasingly popular Macintoshes and new iPads could also be taking a bite out of Microsoft's Revenue, if the consumers would otherwise have purchased Windows-equipped PCs.

With Office 2010 and other products, Microsoft is taking initial steps towards cloud computing to counter a threat from Google and others.

With its dominant franchises, 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.

In fiscal 2010's third quarter, which ended on 31 March 2010, Microsoft earned $0.45 per diluted share.  This EPS amount was 36 percent greater than the $0.33 Microsoft made in the same quarter of fiscal 2009.  Reported earnings equaled our target for the March 2010 quarter.  Readers wanting to take another look at Microsoft's March 2010 quarter might wish to review our Income Statement and Financial Gauge analyses.

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

When Microsoft announced its third quarter results on 22 April 2010, it slightly revised the expected range for its fiscal 2010 operating expenses.  These expenses are now expected to be between $26.1 billion and $26.3 billion.  The range had been $26.2 billion to $26.5 billion.
More specific comments on the company's outlook were made during the conference call following the earnings release:

"Beginning with the Windows division, we expect revenue to grow slightly faster than the overall PC market in the fourth quarter."

"For the fourth quarter, consumer and business non-annuity revenue, approximately 40% of the total, should track towards PC shipment growth, while we expect annuity revenue to be up low single digits."

"The server and tools business generally aligns with server hardware shipments and business IT spending. Similar to many observers, we expect server shipments to show healthy year-over-year growth."

"As a result of our operational initiatives, improved Xbox 360 console costs and a continuing favorable revenue mix, we now expect full year gross margin to expand 1%, compared to the prior year."

"We estimate that our capital spending for the year will be no more than $2 billion and our effective tax rate should be approximately 25% for both the quarter and the year."

Given the guidance and the recent strength in PC shipments, we have estimated that Microsoft's Revenue in the June quarter will equal $15.7 billion.  This amount is 20 percent more than Revenue of $13.1 billion in the June 2009 quarter.

In fiscal 2009, Microsoft's Gross Margin was a lucrative 79.2 percent of Revenue, and it has been 80.1 percent so far in fiscal 2010.  For the June quarter, we will use 80 percent as our estimate.  This ratio translates into a Cost of Goods Sold of (1 - 0.80) * $15.7 billion, or $3.14 billion. 

The company's guidance for Operating Expenses in fiscal 2010 is $26.2 billion, give or take $100 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 in the year's first three quarters, we estimate that the R&D expense in the June quarter will be $2.35 billion, and the SG&A expense will be about $4.75 billion.

The Revenue and expense estimates would result in Operating Income of $5.46 billion.  This figure is 37 percent greater than Operating Income in the June 2009 quarter.

We assume, with less certainty, net non-operating income (e.g., interest) of $150 million.  We'll also assume an income tax rate of 25 percent.  These values would lead to Net Income of $4.2 billion ($0.47/share).  This is 38 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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