10 December 2010

MSFT: Look Ahead to December 2010 Quarterly Results

This post describes our model of Microsoft's (NASDAQ: MSFT) Income Statement for fiscal 2011's second quarter, which will end on 31 December 2010.

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 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.  Microsoft's  10-K for fiscal 2010 states:

Revenue increased mainly due to strong sales of Windows 7, which was released during fiscal year 2010, and PC market improvement. [...]  Diluted earnings per share increased reflecting increased net income and the repurchase of 380 million shares during fiscal year 2010.
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 roughly $235 billion.

The company 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.

Microsoft continues to reap handsome profits from the launch in October 2009 of Windows 7 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, 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.  The prospects for new computer sales are generally positive, but the pace of growth is now expected to be a little less than forecast earlier this year.  Research firm Gartner has trimmed its forecast for the number of personal computers shipped in 2010 from 22 percent more than in 2009 to 14 percent.

Sales of personal computers in emerging markets have recently grown more robustly than sales in developed regions.  PC sales to businesses have been stronger than sales to consumers.  It's possible that consumer interest in tablets and smartphones have been a drag on sales of conventional consumer PCs and notebooks.

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.

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.  Readers wanting to take another look at Microsoft's September 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 December 2010 quarter.

In the press release on 28 October 2010 announcing September's quarterly results, the company's guidance for the current fiscal year was limited to a statement reaffirming operating expenses would be between $26.9 billion and $27.3 billion.

Fortunately, more specific comments on the company's outlook were made during the conference call presentation (pptx and docx) following the earnings release.  Microsoft described its expectations for the second quarter of fiscal 2011 and for the full year.

We've considered the guidance and industry forecasts for PC shipments to come up with the following rough Revenue estimates for each Microsoft operating segment in the December quarter.   Our estimate for total Revenue in this period is $18.8 billion.

Note that in the December 2009 quarter, Microsoft recognized about $1.71 billion of deferred revenue related to  the Windows 7 Upgrade Option Program and pre-sales of Windows 7 to manufacturers and retailers before general availability. 

Microsoft Operating SegmentQ/E December 2009 Revenue ($M)
Q/E December 2010 Revenue ($M)
Percent Change
Windows and Windows Live $5,073$4,900-3.4%
Server and Tools3,8484,2009.1%
Online Services5816003.3%
Microsoft Business4,7495,40013.7%
Entertainment and Devices29383,70025.9%

Microsoft's Gross Margin, as a percentage of Revenue, has long been close to 80 percent, an extremely lucrative rate.  For the December 2010 quarter, we expect it to be modestly lower because less-profitable hardware products will account for a growing percentage of the product mix.  We are estimating a Gross Margin of 78 percent for the current quarter, which would translate into a Cost of Goods Sold of (1 - 0.78) * $18.8 billion, or $4.14 billion. 

The company's guidance for Operating Expenses in fiscal 2011 is $27.1 billion, give or take $200 million.  This figure covers R&D and SG&A expenses.  (We group Sales & Marketing and General & Administrative into one category, but Microsoft reports them separately.)  For the December estimate, are using 26 percent of the guidance mid-point, or 0.26 * $27.1 billion = $7.05 billion.

Based on fiscal 2010's results, we have allocated one-third of the expense to R&D and the remaining 2/3 to SG&A

The Revenue and expense figures would result in estimated Operating Income of $7.6 billion.  This amount is 10 percent less than Operating Income in the December 2009 quarter.  (Special items boosted the year-earlier figure.)

We assume net non-operating income (e.g., interest) of $100 million.  We'll also assume an income tax rate of 24 percent.  These values would lead to Net Income of $5.87 billion ($0.67/share, depending on the number of shares outstanding).  This is 12 percent less 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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