26 July 2010

MSFT: Income Statement Analysis for the June 2010 Quarter

Microsoft (NASDAQ: MSFT) earned $0.51 per diluted share in fiscal 2010's fourth quarter, which ended on 30 June 2010.  This EPS amount was 50 percent more than the $0.34 Microsoft made in the same quarter of 2009.

This post examines Microsoft's Income Statement for the quarter and compares the entries on each line to our "look-ahead" estimates.  Reported earnings were $0.04 per share more than the $0.47 we had forecast for the quarter.

The principal sources for the income statement analysis were the earnings announcement, the conference call presentation [ppt], and the transcript [docx].

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.

Before getting into the details, we will take one step back to introduce the subject of today's analysis.

Microsoft develops and sells the operating system software that runs on more than 90 percent of personal computers, and 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.  Additional background information about Microsoft and the business environment in which it is currently operating can be found in 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 in the June quarter rose 22.4 percent, from $13.1 billion last year to $16.0 billion in the last three months.  Fluctuations in currency exchange rates boosted the quarter's Revenue by 2 percent.  The reported Revenue value (a record amount for a June quarter) exceeded our $15.7 billion target by 2.2 percent. 

The Revenue increase was mainly due, according to Microsoft, to "strong sales of Windows 7 and the 2010 Microsoft Office system, which were released in fiscal year 2010, and PC market improvement."  The company has sold 175 million licenses to operate Window 7.

Microsoft estimated that personal computer sales grew between 22 and 24 percent.  PC growth rates were similar for businesses and consumers.  Growth rates were almost twice as high in emerging markets than in mature markets.

License renewal rates from enterprise customers have improved.

The table below breaks down quarterly Revenue by business segment.

Microsoft Operating SegmentQ/E June 2010 Revenue ($M)Q/E June 2009 Revenue ($M)Percent Change
Windows and Windows Live $4,548$3,16943.5%
Server and Tools4,0123,52813.7%
Online Services56550112.8%
Microsoft Business5,2504,56715.0%
Entertainment and Devices1,6001,25727.3%
Source: Earnings announcement

The Cost of Goods Sold in the quarter was $3.17 billion, or 19.8 percent of Revenue.  This ratio translates into a Gross Margin of 80.2 percent.  The Gross Margin was 80.3 percent in the June 2009 quarter, and we were expecting 80.0 percent in the most recent quarter.

It's not clear if costs associated with the Kin discontinuation were material enough to affect the Gross Margin.

The $2.35 billion Microsoft spent on Research and Development matched our estimate exactly.  The amount was 5.6 percent more than in the same period of 2009.  As a percentage of Revenue, the R&D expense decreased from 17.0 percent to 14.7 percent.

Sales, General, and Administrative expenses -- Microsoft breaks these out as Sales and Marketing expenses and General and Administrative expenses -- increased 7.7 percent to $4.59 billion, due to increased advertising and marketing expenses.  The latest amount was 3.4 percent less than our $4.75 billion estimate.  SG&A expenses equaled 28.6 percent of Revenue, down substantially from 32.5 percent last year.

Together, R&D and SG&A expenses totaled $6.94 billion in the June quarter. For the entire fiscal year, the total was $25.93 billion.  Microsoft's operating expense guidance for the year had been $26.1 billion to $26.3 billion.

Subtracting the various operating expenses from Revenue yields Operating Income of $5.93 billion for the fourth quarter.  Operating Income increased 48.7 percent when compared to the same period of last year.

Better-than-expected Revenue and lower-than expected SG&A expenses pushed Operating Income 8.6 percent above our $5.46 billion target for the quarter.

The table below list Operating Income by business segment.  The three segments with the most Revenue were responsible for all Operating Income.

Microsoft Operating SegmentQ/E June 2010 Operating Income ($M)Q/E June 2009 Operating Income ($M)Percent Change
Windows and Windows Live $3,063$1,92958.8%
Server and Tools1,5461,20628.2%
Online Services(696)(585)N/A
Microsoft Business3,2842,70621.4%
Entertainment and Devices(172)(141)N/A
Source: Earnings announcement

Non-operating items -- mostly investment income and expenses -- summed to a $94 million gainWe had expected a net gain of $150 million for these items.  The most significant change from last year was that Microsoft had a net loss of $163 million on derivatives in the most recent quarter, compared to a $71 million gain in June 2009.

The quarter's effective income tax rate of 25.0 percent was identical to the rate we had assumed. The reported tax rate was lower than last year's 26.5 percent rate because more of the company's earnings were garnered outside the U.S.

Bottom-line Net Income rose by an impressive 48 percent to $4.52 billion ($0.51 per diluted share), compared to earnings in the year-earlier quarter of $3.045 billion ($0.34 per share).  With better-than-expected Revenue, the company easily surpassed our estimate for the latest quarter of $4.208 billion ($0.47 per share).

In summary, it was an excellent end of the fiscal year for Microsoft.  The top line of the Income Statement grew at a rate over 20 percent, and the bottom line was up about 50 percent.  The Gross Margin remained in the 80-percent stratosphere, and other costs rose at a pace much slower than Revenue increased.

Full disclosure: Long MSFT at time of writing.

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