Microsoft Over PC Market Blues - Analyst Blog

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Microsoft Corporation's ( MSFT ) third quarter results topped the Zacks Consensus Estimate by 3 cents. Despite Gartner's positive revision to PC market estimates (1.9% growth compared to previous estimate of a 1.2% decline), just 3 analysts raised estimates since then.

Since this did not impact the Zacks Consensus, some upside versus estimates was expected. Share prices appreciated 3.1% in after-hours trade.

Revenue

Revenue of $17.41 billion was down 16.7% sequentially and up 6.0% from last year, exceeding estimates by 1.3%. All segments contributed to the sequential decline, but only Entertainment & Devices did not contribute to the increase from last year.

Segment Specifics

The Windows and Windows Live Segment generated 27% of Microsoft's quarterly revenue, down 2.4% sequentially and up 4.0% year over year. Given PC unit growth of 2-4% (management estimate), it appears that Microsoft grew faster than the market. Enterprise was again very strong, the 8% growth driving quarterly results for the segment.

The strong performance indicates that the enterprise refresh continues (Windows 7 now in 40% of desktops). Management also stated that volume licensing growth was up double-digits. On the consumer side, netbooks remained a drag given stiff competition from tablets, particularly Apple's ( AAPL ) iPad. However, consumer excluding netbooks was up 6%.

Another encouraging data point was the OEM premium mix, which was up 4 percentage points. Overall, both market growth and mix worked in Microsoft's favor in the last quarter, with the market growth and increasing attach rates encouraging OEMs to build some inventory.

The Microsoft Business Division , which generated 33% of revenue, fell 7.4% sequentially, while growing 10.7% from last year. Office 2010 adoption is very strong. The annuity side of the business was the major driver of the increase from last year (up roughly 13%), helped by increase in transaction-based sales of around 5%.

Microsoft stated that other products such as SharePoint, Exchange and Lync were all up double-digits from last year. Microsoft's success with CRM could give Salesforce.com ( CRM ) something to worry about. In the last quarter, Dynamics CRM grew over 30%, with customers touching 33,000 and users touching 2.25 million.

The Server & Tools segment, at 26% of total revenue, was down 4.2% sequentially and up 11.4% year over year. Microsoft's multi-year licensing revenue grew at a high-teens percentage rate year over year, with SQL server up in the high-teens and the premium mix up over 30%. Windows Server Premium was up in the high-teens and System Center up 20%. Microsoft also remains optimistic about Azure.

Overall trends indicate continuing strength in the enterprise (enterprise services were also up 21%). Virtualization and cloud computing are proving to be very beneficial for Microsoft's S&T business.

Microsoft generated 9% of revenue from the Entertainment & Devices segment, down 61.9% sequentially and 16.5% year over year. The greater-than-expected decline was attributed to the weak gaming market, although Microsoft remained positive given its 42% market share (1.4 million units sold in the last quarter).

Microsoft is doing plenty here, expanding TV content, enhancing Xbox LIVE experiences and announcing new phones using its latest OS-Lumia from Nokia ( NOK ) and Titan II from HTC to be available on the AT&T ( T ) network . Xbox Live memberships reached 40 million in the December quarter (not updated by Microsoft in the last quarter).

All these subscribers are able to access television content acquired through recent partnerships. However, while LIVE may be considered successful, the phone OS has not yet yielded desired results. Skype, acquired from eBay Inc ( EBAY ) in 2010 had minutes touching 100 billion, up 40% from last year.

The Online Services business, or online advertising, generated 4% of revenue, down 9.8% sequentially and up 9.1% year over year. We think that 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. (up 140 basis points year over year). The partnership with Yahoo Inc ( YHOO ) remains on track, with increasing ROI for advertisers. But monetization remains below expectations.

Operating Results

Microsoft's gross margin of 77.3% jumped 429 basis points (bps) sequentially and 102 bps year over year. The gross margin is closely related to the mix, since margins on hardware and software products differ widely.  In the last quarter, low-margin Xbox sales declined more than expected, while high-margin enterprise grew more than expected.  The search agreement with Yahoo remains an offsetting factor, raising online services and traffic acquisition costs.

Operating expenses of $7.08 billion were down 2.4% sequentially and 5.4% year over year. The operating margin of 36.6% dropped 166 bps sequentially and grew 187 bps from last year. All expenses increased sequentially as a percentage of sales (because of the revenue decline), offsetting the significant decline in cost of sales.

However, R&D increased the most, followed by S&M and then G&A. All except R&D were down as a percentage of sales from the year-ago quarter.

The operating margin by segment was as follows-Windows 63.8% (a sequential increase of 366 bps), Microsoft Business Division 64.8% (down 128 bps), Server & Tools 38.0% (down 381 bps), Entertainment & Devices -14.2% (down 2,663 bps) and Online Services -67.8% (down 933 bps). All except Entertainment & Devices segment margins expanded from last year.

The company generated a pro forma net income of $5.1 billion, or 29.3% net income margin compared to $6.6 billion, or 31.7% in the previous quarter and $5.2 billion, or 31.8% 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 60 cents compared to 78 cents in the December 2011 quarter and 61 cents in the March quarter of 2011.

Balance Sheet

Inventories were up 4.5% to a normal level again, which caused inventory turns to go from 16.7X to 11.2X. Days sales outstanding (DSOs) went to 57, down from 60 at the end of the December quarter.

Microsoft ended with a cash and short-term investments balance of $59.5 billion, up $7.8 billion during the quarter. The net cash position was around $5.67 a share, up from $4.74 a share at the beginning of the quarter. In the last quarter, the company generated $9.59 billion in cash flow from operations, spent $1.02 billion on share repurchases, $1.68 billion on dividends, $84 million on acquisitions and $749 million on capital assets.

Guidance

Microsoft lowered the fiscal 2012 operating expense guidance by 0.2 billion to $28.3-28.7 billion. Opex in 2013 is expected to be up 6% to $30.3 to 30.9 billion.

Key Takeaways

The key takeaway from Microsoft's third quarter was the strength in the PC market. HDD shortages had a less-than-expected impact on the PC market and enterprise refresh rates were particularly strong. This drove the revenue surprise, despite EDD falling below expectations.

We expect the PC market to remain buoyant in the next quarter and benefit from Windows 8 in the second half. Add to this a strong business division, growing opportunities for S&T, growing Bing market share and continued initiatives in EDD and we really like where the company is now. At a P/E of 51.7X, Microsoft shares look cheap.  

Of course, we recognize the danger of tablets that are still largely based on iOS or Android, since these devices are eating into its netbook sales. We expect this phenomenon to continue because of the popularity that iOS and Android-based devices have already encountered. We think this will take time to overcome and we therefore have a long term Neutral recommendation on the stock.

In the near term however, we expect growing optimism and believe that positive estimate revisions could raise the Zacks Rank from the current #3, which implies a Hold recommendation in the short-term (1-3 months).


 
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Business , Stocks

Referenced Stocks: AAPL , CRM , EBAY , MSFT , NOK

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