Microsoft Corporation’s (MSFT) fourth quarter 2011 results were again impacted by weakness at consumer PCs. However, the company went on to beat the Zacks Consensus by 11 cents, or 19.0%.
Revenue
Revenue of $17.37 billion was up 5.7% sequentially and 8.3% from last year, just exceeding consensus expectations of $17.25 billion. Growth in the last quarter was driven by the server & tools business, as well as better-than-expected performance of the Microsoft Office platform and Xbox 360. Currency was neutral to the performance.
Management commentary and Intel Corp’s (INTC) results indicate that the enterprise refresh cycle continues and the Wintel combination is far from dead.
Revenue by Segment
The Windows and Windows Live Segment generated 27% of quarterly revenue, up 6.6% sequentially and flat year over year. Given PC unit growth of 1-3% (management estimate), it appears that Microsoft outgrew the PC market, indicating higher penetration. This was obviously on account of strength in the enterprise segment (up 8%), where refresh rates continue.
Management stated that 25% of enterprise desktops have shifted to Windows 7, while 90% have committed to a deployment plan. However, consumer PC units remain soft, declining 2%. Overall attach rates were up 1%, with more than 400 million Windows 7 licenses sold to date (more than 50 million in the last quarter).
OEM sales remain a major driver of segment performance, which along with higher attach rates, neutral channel dynamics and negative segment mix, netted a 1% decline in OEM sales. Additionally, emerging markets were again a strong driver, accounting for around half of PC shipments.
The Microsoft Business Division, which generated 33% of revenue, grew 10.0% sequentially and 7.5% from last year. Business transactional revenue increased 27%, while consumer declined 8%. The weakness in consumer was due to market dynamics in developed countries that were partially offset by high attach rates.
Microsoft stated that other products, such as Lync, SharePoint 2010 and Dynamics CRM grew double-digits from last year, with the Dynamics CRM client base increasing by 300,000 and touching 2 million in the last quarter.
The Server & Tools segment, at 27% of total revenue was up 13.1% sequentially and 11.9% year over year. Microsoft stated that transactional revenue grew faster than the underlying server hardware market, which was encouraging.
Additionally, multi-year licensing revenue grew 12%. Enterprise services were up 14% and premium Windows server and System Center revenue up 20%. Virtualization and cloud computing are proving to be very beneficial for Microsoft.
Microsoft has a very healthy product line, premium revenue from which grew 20%, indicating that the momentum in its business will continue.
Entertainment & Devices generated 9%, down 23.3% sequentially and up 29.8% year over year. Xbox 360 units were 1.7 million, which although down sequentially was up 13.3% from last year. Kinect sales were also strong. Xbox Live memberships ended the quarter at 35 million active members and revenue from this segment was also strong.
Microsoft’s Windows Phone 7 ecosystem continues to gain momentum and the company stated that applications for the device had jumped 60% from 13,000 at the beginning of the quarter. Microsoft also stated that the next version, code-named Mango (with deeper social experiences, office 365 integration and IE 9) would be released in the fall of 2011.
The agreement with Nokia Corp (NOK) was closed. Although significantly lower than Apple Inc (AAPL) devices, this is a very small part of Microsoft’s total business, so we view any progress here as positive.
The Online Services business, or online advertising, generated 4% of revenue, up 2.2% sequentially and up 16.5% year over year. We think Microsoft is investing in technology and innovation and it is this work that is improving user experience and helping Bing take some share in the U.S.
The partnership with Yahoo Inc (YHOO) is increasing ROI for advertisers, but monetization is not yet satisfactory. However, in the last quarter, Microsoft saw online advertising revenue growing 20% from last year, driven by search, We consider this real progress and Microsoft stated that revenue per search (RPS) would improve by the end of the year, at which time the search alliance would spread more broadly to international markets.
Operating Results
Microsoft’s gross margin of 78.6% was up 237 basis points (bps) sequentially although down 159 bps year over year. The gross margin is closely related to the mix, since margins on hardware and software products differ widely. As hardware costs (Xbox and Kinect continue to do well, there is the related negative impact on margin.
Operating expenses of $7.49 billion were up 9.8% sequentially and 7.9% year over year. Consequently, the operating margin of 35.5% expanded 78 bps sequentially, while declining 144 bps from last year. The sequential increase in operating expenses as a percentage of sales was driven by an increase in S&M expenses. The decline from the year-ago quarter was driven by the decline in gross margin.
The operating margin by segment was as follows: Windows 62.1% (a sequential decline of 9 bps), Microsoft Business Division 62.6% (up 236 bps), Server & Tools 38.2% (up 363 bps), Entertainment & Devices 2.2% (down 947 bps) and Online Services -110.0% (up 207 bps). Margins in all except the Windows segment increased from last year.
The company generated a pro forma net income of $5.9 billion, or 33.8% net income margin compared to $5.2 billion, or 31.8% in the previous quarter and $4.5 billion, or 28.2% in the year-ago quarter. There were no one-time items in the last quarter.
Accordingly, the GAAP EPS was same as pro forma at 69 cents compared to 61 cents in the March 2011 quarter and 51 cents in the June quarter of 2010. A lower tax rate helped earnings in the last quarter.
Balance Sheet
Inventories were up 29.9%, with inventory turns down to 10.8X. Days sales outstanding (DSOs) went to 79, up from 56 at the end of the March quarter.
Microsoft ended with a cash and short-term investments balance of $52.8 billion, up $2.6 billion during the quarter. The net cash position was around $4.84 a share. In the last quarter, the company generated $5.9 billion in cash flow from operations, spent $1.26 billion on share repurchases, $1.35 billion on dividends and $642 million on capital assets.
Guidance Reiterated
Microsoft reiterated the fiscal 2012 operating expense guidance of $28-28.6 billion, an increase of 3-5% from 2011.
Our Recommendation
We remain optimistic about Microsoft overall, based on the fact that it continues to gain from the enterprise refresh, emerging markets strength and growth in data centers and cloud computing. We also expect the entertainment division to benefit from pre-holiday builds and new products (Mango). Additionally, expense control remains quite good.
The sore point for Microsoft at this time is the less than exciting performance of consumer-type computing markets in developed countries. Microsoft has significant exposure to this market, so the softness does have an impact on its results. We therefore have a Neutral recommendation on the stock. Microsoft shares also carry a Zacks Rank of #3, implying a Hold recommendation in the short-term (1-3 months).
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