28 October 2010

MSFT: Income Statement Analysis for the September 2010 Quarter

Microsoft (NASDAQ: MSFT) earned $0.62 per diluted share on a GAAP basis in the September-ending first quarter of fiscal 2011, up 56 percent from $0.40 in the same three months of last year. 

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 $0.06 per share (about 10 percent) more lucrative than our $0.56 EPS estimate.

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

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.  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 2010 was $18.8 billion, up nearly 30 percent from the prior year.  Revenue increased 7 percent, from $58.4 billion in 2008 to $62.5 billion. 

The company's market value is presently over $220 billion.

Microsoft is organized into five operating segments: Windows and Windows Live, Server and Tools, Online Services, Microsoft Business, and Entertainment and Devices.  The Business Division contributed the most Revenue ($18.9 billion) in 2010, but the Windows Division produced slightly more Operating Income ($12.1 billion).  Online Services lost $2.4 billion.  Server and Tools did well with Operating Income of $5.0 billion.

A significant proportion of the Windows segment's Revenue is due to the sale of new personal computers on which the equipment manufacturer has installed a version of the company's software.  It is, therefore, dependent on the number of personal computers shipped.

With Office 2010 and other products, Microsoft is taking initial steps towards cloud computing to counter a threat from Google and others.
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 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 September quarter rose 25.3 percent, from $12.9 billion last year to $16.2 billion in the last three months.  The earlier quarter's Revenue was less than it might have been because $1.5 billion in potential Revenue was recorded as deferred because of the then-impending launch of Windows 7.  Excluding the deferral, Revenue rose 12.5 percent.

The September 2010 quarter had the fourth-highest Revenue ever for Microsoft and a record amount for a September quarter.

The latest Revenue amount exceeded our $15.9 billion target by 1.9 percent. 

The Revenue increase was primarily due, according to Microsoft, to "strong sales of Windows 7, the 2010 Microsoft Office system, Server and Tools products, and the Xbox 360 console and video games."  More than 240 million Windows 7 licenses have been sold to date.

Microsoft estimated that personal computer sales grew between 9 and 11 percent.  The company announced it "continues to see a healthy and sustaining business PC refresh cycle." 

The table below breaks down quarterly Revenue by business segment.

Microsoft Operating SegmentQ/E Sept 2010 Revenue ($M)Q/E Sept 2009 Revenue ($M)Percent Change
Windows and Windows Live $4,705$4,24011.0%
Server and Tools3,9613,55211.5%
Online Services5274878.2%
Microsoft Business5,0974,51712.8%
Entertainment and Devices1,7691,41225.3%
Source: 10-Q

The Cost of Goods Sold in the quarter was $3.14 billion, or 19.4 percent of Revenue.  This ratio translates into a Microsoftian Gross Margin of 80.6 percent.  When compared to the 78.0-percent Gross Margin in the September 2009 quarter, the margin became 260 basis points more profitable.

Microsoft exceeded our 80.0-percent target for the Gross Margin by 60 basis points.

The $2.2 billion Microsoft spent on Research and Development was 6.3 percent more than in the same period of last year.  The reported amount was 5.7 percent greater than our $2.1 billion estimate.  As a percentage of Revenue, the R&D expense decreased from 16.0 percent to 13.6 percent.

Most of the R&D spending increase was due to "headcount-related expenses."

Sales, General, and Administrative expenses -- Microsoft breaks these out as Sales and Marketing expenses and General and Administrative expenses -- increased 6.0 percent to $3.74 billion.  The latest amount was 10 percent less than our $4.16 billion estimate, signaling better-than-expected cost control.  SG&A expenses equaled 23.1 percent of Revenue, down substantially from 27.3 percent last year.

Together, R&D and SG&A expenses totaled $5.94 billion in the September quarter, which is only about 22 percent of the midpoint of Microsoft's $26.9 billion to $27.3 billion operating expense guidance range.   Microsoft did not lower the guidance range in response to the first quarter's results.

Subtracting the various operating expenses from Revenue yields Operating Income of $7.12 billion in the most recent quarter.  Operating Income increased 58.8 percent when compared to the same period of last year.  As was the case for Revenue, the Operating Income growth rate was inflated by the prior-year deferrals.

Better-than-expected Revenue and lower-than expected SG&A expenses pushed Operating Income 9.7 percent above our $6.49 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 Sept 2010 Operating Income ($M)Q/E Sept 2009 Operating Income ($M)Percent Change
Windows and Windows Live $3,206$2,82213.6%
Server and Tools1,5841,18034.2%
Online Services(579)(496)N/A
Microsoft Business3,3212,79218.9%
Entertainment and Devices36024546.9%
Source: 10-Q

Non-operating items -- mostly investment income and expenses -- summed to a $114 million gainWe had expected a net gain of $100 million for these items. 

The effective income tax rate of 25.2 percent was consistent with expectations.

Bottom-line Net Income rose by an impressive 51.4 percent to $5.41 billion ($0.62 per diluted share), compared to earnings in the year-earlier quarter of $3.57 billion ($0.40 per share).  With better-than-expected Revenue and lower expenses, the company surpassed our estimate for the latest quarter of $4.95 billion ($0.56 per share) by almost 10 percent.

In summary, it was an excellent beginning to the fiscal year for Microsoft.  Revenue increased due to strong sales of many of the company's products.  The sales rise was not at the expense of profitability:  the Gross Margin was once again in the 80-percent stratosphere.  Other expenses increased at a pace much less than Revenue growth and less than we expected.  There were no surprises of consequence in the non-operating half of the Income Statement, ensuring that profits reached the bottom line. 

Full disclosure: Long MSFT at time of writing.

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