Microsoft Corporation (MSFT) Q2 2010 Earnings Report, Transcript and Summary

Welcome to the Microsoft second quarter fiscal year 2010 conference call. (Operator Instructions) I would now like to turn the call over to Mr. Bill Koefoed, General Manager, Investor Relations. Sir, you may begin.

Thank you, and thanks everyone for joining us this afternoon. Let me begin by welcoming Peter Klein to his first earnings call as Microsoft’s Chief Financial Officer. Also joining us today are Frank Brod, Chief Accounting Officer and John Seethoff, Deputy General Counsel. Today Peter will start with takeaways from the second quarter of our 2010 fiscal year. Then I will get into the details of the quarter before handing it back to Peter, who will discuss our business outlook. After that, we will take your questions. We filed our Form 10-Q this afternoon. In addition we posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks, as well as provide a reconciliation of differences between GAAP and non-GAAP financial measures. You can find these documents at the Investor Relations website at Microsoft.com/MSFT. Today’s call will be webcast live and recorded. If you ask a question, it will be included in our live transmission, any future use of the recording and in the transcript which will be posted on our website. You can replay the call and view the transcript at the Microsoft investor relations website until January 28, 2011. This conference call is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this call or any portion of it without the express written permission of Microsoft may result in civil and criminal penalties. We will be making statements during this call that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today’s earnings press release, in the comments made during this conference call, and in the risk factor section of our Form 10-K, Form 10-Q and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statements. Okay, Peter, it is all yours.

Thanks Bill. Good afternoon, everyone. It is a pleasure to be joining you for my first earnings call. I have met with many of you over the last two months and during my prior roles at Microsoft and I look forward to spending time with many more of you in the months ahead. Over the course of my career both inside and outside of Microsoft, in good economies and bad, I have learned that there are a few constants that persistently translate to success; working with great people and relentlessly focusing in creative value for customers, employees and shareholders. I am delighted to have the opportunity to do that in my new role, building on our current momentum and driving future growth. Now let me share some thoughts on our second quarter results. We reported record revenue and record profits. These results were driven in large part by strong consumer demand for Windows 7 and PCs. While consumer demand remains healthy, we have not seen a return of enterprise spending growth. Meanwhile our ongoing work in managing expenses and aligning our cost structure to the highest priorities has enabled us to drive earnings growth ahead of revenue growth. We also returned $4.8 billion of cash to investors through dividends and stock repurchases. As we have previously discussed, we are just starting our strongest product cycle ever. This quarter was highlighted by the successful launches of Windows 7, Windows Server 2008 R2 and Exchange 2010. We released Office 2010 to beta and introduced more Bing innovations this quarter. Bing has now gained market share each month since its launch. We also announced upcoming releases of two very important and compelling offerings that will drive growth into the future, Windows Azure and Natal. Azure is our cloud platform which is providing developers, partners and our customers a smooth transition to the cloud with tools and processes they already know. Natal, which is based on our natural user interface work, will energize this generation’s gaming and entertainment experience starting this coming holiday season. So in summary, I am very pleased with our progress this quarter. We have momentum with products and markets. We have an exciting pipeline of new products and we delivered strong financial results. I will now hand the call back to Bill to give you some additional details on the quarter and then come back and provide some thoughts on our outlook.

Thanks, Peter. I will start with the company overview and then go through revenue performance for each of our business units. I will then review the rest of the income statement. Please keep in mind that all growth comparisons relate to the corresponding quarter of last year unless I specify otherwise. As Peter mentioned, we had an exceptional quarter with record revenue and profit. Overall revenue grew 14% to just over $19 billion, primarily driven by strong Windows 7 consumer demand. Net income and earnings per share were $6.7 billion and $0.74 respectively. Excluding the $1.7 billion of revenue recognized from the Windows 7 upgrade program and Windows 7 licenses sold in advance of general availability, revenue grew 4%. Foreign exchange did not have a significant impact on revenue during the quarter. Our product billing mix in the second quarter was roughly the same as last year with 30% annuity, 30% OEM and 25% license only with the balance coming from our other businesses. Now let me dive deeper into the overall revenue mix. Geographically emerging markets grew mid teens while mature markets grew single digits. In terms of segments, consumer demand continued to be the driver of growth. While we saw stabilization in the business segment, as Peter mentioned, we have not seen a return of enterprise spending growth to date. Enterprise agreement sales cycles have lengthened and multi-year annuity revenue was flat year-over-year. Unearned revenue was $12.5 billion, down slightly from last year. On a sequential basis, unearned revenue was down primarily due to this quarter’s recognition of the $1.7 billion of Windows 7 revenue that I referred to earlier. Our contracted not billed balance was approximately $13 billion, down slightly from last year. Now for the PC market. PC hardware shipments grew substantially during the quarter fueled…

Thanks, Bill. Now I will discuss our expectations for calendar 2010. From a macro perspective, IT spending should improve from the recessionary levels of 2009. Taking into account second quarter results, we are incrementally positive towards the PC and server hardware markets. As we have been saying, we expect the business hardware refresh cycle to begin this calendar year occurring gradually over a couple of years. When thinking about the remainder of fiscal 2010, keep in mind that our third quarter tends to be seasonally weaker than our second and fourth quarters. Now addressing each of the divisions individually. In the third quarter, we expect Windows Division revenues to be roughly in line with the overall PC market growth. Attach gains and inventory rebuild relative to the prior year should offset macro trends of consumer PCs growing faster than business PCs and emerging markets growing faster than mature markets. When thinking of sequential trends in the third quarter, keep in mind Q2 included a large retail launch impact. For the full year, we expect Windows Division revenue to grow in line with the overall PC market growth. The Microsoft Business Divisions revenue in the third quarter should largely demonstrate the same dynamics as in the first half. Consumer and business non-annuity revenue, approximately 40% of the total, will face ongoing pressure in advance of the next product cycle, and as such should lag overall PC shipments until Office 2010 becomes generally available in June. We expect annuity revenue, representing 60% of total revenue, to be broadly flat for the full year. The release of the Office 2010 beta this quarter was an important milestone. We have received terrific feedback from early adopters about the flexibility and powerful new ways to stay productive across the PC, browser and phone. As you…

Thanks, Peter. We want to get to questions from as many of you as possible, so please stick to one question and avoid long or multi-part questions. Barb, can you please go ahead and repeat your instructions?

(Operator Instructions) The first question comes from the line of Adam Holt - Morgan Stanley.

My question is around average selling prices. If you look at the average selling prices in the quarter, they improved sequentially and obviously you are seeing both mix help that on the consumer side. But as we get a little bit deeper into the corporate upgrade cycle you are going to see a lot higher dollar value. How should we be thinking about average selling prices? Should we see steady sequential improvement there or some of the puts and takes around where you are seeing growth in the PC market going to offset that?

Obviously, the biggest driver of the ASPs will be the business PC refresh and the growth in that. The timing of that remains uncertain. We maintain our general view which we have had, that that will start to occur this year and occur gradually over the next couple of years. As that does, that obviously has an impact on our average selling price. What we saw this quarter on the consumer side was the great adoption of Home Premium as well as Windows 7 on netbooks which is driving that up sell that Bill talked about. Those two things combined will be the driver and it really depends on the macro.

Do you think you saw a one-time spike there or do you think that premium mix can remain at that high level?

We think, as we said in the guidance, revenue is going to be in line with PCs. There are some headwinds from emerging markets and consumers. So we will have to offset that with the ASPs and attach.

The next question comes from the line of Sara Friar - Goldman Sachs.

Can I ask a question on the cost side? There still seems to be some debate on the Street as to how tight a reign you will keep on costs even though you have done a phenomenal job thus far. So I know you aren’t guiding for fiscal 2011 on this call but could you maybe just philosophically talk a little bit about the growth rate? I think you have messaged a low single digit inflation type rate, and then on the COGS side flat for next year is a great outcome. For next year with Azure and so on kicks in I am assuming we should assume the gross margin continues to come down.

Obviously, it is too early to talk about FY11. We are working through that planning process right now and as soon as we get through that I will certainly get out and talk to everybody about that. Let me hit the operating costs. We are executing against our plan very effectively. I have been focused on even before taking this role working with Chris and the leadership team on that and feel great that we have a thoughtful plan that we have come up with and we are doing what we said and executing against that. A big part of that is prioritization and making sure the resources are allocated to the higher return areas. That will be the approach we take when we build our FY11 plan absolutely. So that approach stays the same.

On the COGS side and the assumption that Azure will continue to drive that down?

I think there are multiple dynamics on the COGS side. It is too early to get into that for FY11. There are puts and takes in online services, traffic acquisition costs, offset by improvements we make across the board, whether that is Xbox 360 consoles and some of our operations as well. So we have to get through the planning process on that.

The next question comes from the line of Brent Thill - UBS.

On the enterprise agreements, I think you mentioned the sales cycle has lengthened and you are flat year-over-year. Can you elaborate in terms of what you expect for the second half of the fiscal year on enterprise agreements? I would think considering the robustness of the product cycle that that would start to trend back up.

Yes, that is the hope. Certainly on the enterprise agreement renewals, it is starting to take longer. We are getting them done. The sales cycle is elongating. The good news is we are getting them done. Maybe not in the quarter that they expire, but when we get them done we are not dropping products off of them, and in most cases we are actually adding new products onto the EA. So we feel great about the trajectory there. I tend to agree with you as the enterprise spend does pick up given our product pipeline we feel very well positioned from an enterprise agreement perspective.

The next question comes from the line of Heather Bellini - ISI Group.

I was wondering if you could help us think about the trends in deferred revenue? Obviously that is going to be a big driver of your fiscal 2011 growth. In particular, last year was obviously a challenging year for enterprise spending and you are saying that enterprise spending isn’t coming back, so would it be fair for us to think about your sequential deferred trends for the remainder of fiscal 2010 being more in line with what you had in the back half of your fiscal year 2009 just so we can help shape our models for the upcoming season?

Well, it is hard to say. A lot of that is going to depend on the shape of enterprise spend and business spend. Obviously, we are…

Based on how you think spend is going to come out, based on your views about enterprise spending not coming back any time soon.

The thing I can say is we have a great product pipeline. We don’t have visibility into exactly what business spend is going to be, so we are just going to have to work through that over the next couple of quarters. The only thing we can control as we have been saying is the products. We feel like we are executing against those and we will keep working the enterprise agreements as we can.

So would that mean it would be unreasonable to assume…I mean last year I would imagine was a difficult closing environment as well so is a measure of conservatism with kind of seasonal growth rates like you had last year in deferred be prudent in your view versus expecting an uptick?

I would just encourage anybody to think their view, there is different views of what enterprise spending is going to be. You will just have apply your view of that.

I don’t think we are going to give guidance on that.

The next question comes from the line of Kash Rangan - Merrill Lynch.

Just wondering, there has been a lot written about how you can deploy Windows 7 on the consumer side or the business side with existing hardware without trying to upgrade. I am curious on the consumer side and the business side what are you hearing? Can you give us some anecdotal data on revenue that you are seeing from so called shrink wrap purchases on the consumer side and maybe on the business side as well? At the threshold [ph], you don’t need to buy a brand new PC but I guess you could deploy Windows 7 on the existing hardware. What are you seeing on the business and consumer markets in regard to that?

Good question. On the consumer side, we had a very good retail quarter, about $500 million which is a little bit more than we expected. So that dynamic as you highlighted is exactly happening. People are going to retail and buying shrink wrapped Windows to put on their PCs. On the business side, anecdotally a lot of interest. Businesses are incredibly enthusiastic about deploying. So we will hope to see that flow through over the coming year. So in both cases, a lot of positive momentum as you indicated.

I guess Steve Ballmer has to take his words back because he said 200 to 300 is the max we should expect, so you are off to a great start on the retail shrink wraps. Congrats.

The next question comes from the line of Brendan Barnicle - Pacific Crest Securities.

Following up on the consumer question. A year ago netbooks were a huge concern and year-over-year basis they didn’t really change as a percentage and maybe there were some pricing changes on Windows 7. Has the dilutive impact of netbooks stabilized or started to change in any way?

Yes I would definitely say it has stabilized. The mix has stayed stable. Our attach is very high at over 90% and as Bill said over 50% of that is Windows 7. So what we are finding is people want Windows 7 on all devices and all form factors. That is really what has been driving the quarter and the success of Windows 7. We have worked closely with all of our OEM partners to deliver the broadest range of devices, PCs, notebooks, whatever you have, whether it is a netbook or a laptop or a notebook or a desktop, Windows 7 is on them. So that is very positive for us.

The next question comes from the line of Brad Reback - Oppenheimer.

A couple of weeks ago you announced a bit of a reorg in the E&D segment. Could you help us understand how some of those moves can help you close the gap in those businesses, especially on the mobile side and some of the devices going forward?

They don’t change the strategy that we have in both of those businesses. You do need to separate mobile from the entertainment side or the Xbox side. The Xbox is in a very good position right now. We have a great installed base of engaged users. We have the Xbox Live asset. We have got Natal coming out. We are working through the profitability on the console costs. So a ton of momentum and a really exciting year coming up. On the mobile side our strategy remains the same. As we have been saying from a product perspective, we are working very hard on the next version of Windows Mobile. As Bill indicated, we will be talking more about that in Barcelona in a few weeks. I wouldn’t think of the organization changes as fundamentally changing the strategy. It just puts us in a better position to continue to execute against what we are doing.

The next question comes from the line of Phil Winslow - Credit Suisse.

On the operating expense side, if I back into the midpoint of your guidance, it basically implies a year-over-year increase in OpEx in the second half of about 10.9% give or take versus obviously the decline in the first half. Now I understand that we are starting to anniversary some of the headcount reductions but I just want to get a sense for what is driving that increase or what line items or initiatives?

So the biggest ones are the ones I talked about. There are the Yahoo! integration expenses, which is a one-time, new expense that we didn’t have last year. And then given the increased revenues we will see over the recessionary levels that we saw last time, there are just some variable sales costs that go along with that. So those drive year-over-year increases and those are the two biggest things. Obviously, we have been aware of those, it has been included in our plan and our guidance that we have had for the last several quarters.

The next question comes from the line of John Difucci - J.P. Morgan.

It looks like the OEM unit license growth on the OS is about 5 to 7% greater than the PC unit growth. With the launch of Vista, that delta was like 8 to10%. I am just curious because there were some decent reviews on Vista when it came out but there were some questions at that point and in the end it really looks like Windows 7 is going to be a much greater success for you. I am just curious if you think you can see some more I guess…I know there are a lot of things that affect that but inventory build in the launch of a new OS seems to have a big effect. Where the inventories are today, do you think you can see even more benefit in the following quarter?

Inventories are at about normal levels. So we feel pretty good and all the checks we have done on sell through, inventories are at a normal level. In terms of the comparison to Vista, it is a different world now. We have some headwinds that we may not have had then in terms of the segment mix that Bill talked about in terms of consumer and emerging markets, which is really some headwind. So if you break that out granularly and you look at the attach and inventory gains of 10%, half of that being attach, that is a good result. As I mentioned before, for us to continue to grow in line with the PC market, given those headwinds of the segment mix, we are going to have to continue to do better on attach and inventory and some of the XO [ph] as well.

The next question comes from the line of Sandeep Aggarwal - Collins Stewart.

By when can we expect market share gain by also translating into revenue growth acceleration and any update on the timing of regulatory approval for the Microsoft-Yahoo! deal?

No updates. We are still waiting for regulatory approval and we are still hopeful we will close that deal early this year. It is a long-term process. We are continuing to gain share. What we really need to do is get the Yahoo! deal done, get that integrated and start to get the benefits of scale. So this is something you would expect to see in 2011 and beyond.

The next question comes from the line of Todd Raker - Deutsche Bank Securities.

Turning to the enterprise adoption cycle around Win 7, can you give us any sense in terms of what you are seeing when you are talking to corporate out there? I know you don’t want to pre-announce Service Pack 1 but any kind of visibility in terms of how you think the adoption cycle might play out over the course of this year would be useful.

It is hard to say exactly how it will play out. I will tell you the activity and the conversation, there is nothing about waiting for service packs. Everybody is really super excited about Windows 7 right now, and so there is a ton of activity. How that will play out in the deployment cycles remains to be seen and people are working through that. I would say there is way more business activity now than in previous launches.

The next question comes from the line of Katherine Egbert - Jefferies.

It looked like you bought back almost $4 billion in stock this quarter. Is that right? And then can you just tell us what your philosophy is going forward on repurchases and dividends?

It was about 3.6. My philosophy over the long-term is going to be very consistent with what we have been doing. We had a target amount of appropriate cash we think we need to have and then the operating cash flow after capital and acquisitions will be over the long-term distributed back to shareholders in the form of dividends and share repurchases. So exactly same consistent philosophy we have had over the last several years.

The next question comes from the line of Tim Klasell - Thomas Weisel Partners.

The guidance on the entertainment and devices division is roughly flat. Could you walk us through some of the puts and takes particularly as we get into later stages of the product cycle and the macro of them [ph]?

The puts and takes are you should think about sort of the whole generation of gaming. We have Natal coming out this year and so you should think of it beyond sort of the rest of this fiscal year. Then how we go up and down depends on the timing of software titles. We have industry leading attach but there is a big difference on timing when we have first party titles versus third party titles. So I would consider what we are doing, excellent growth, and then it sort of gets re-energized with Natal as we head to holiday next year.

So maybe roughly flat for the calendar year or roughly flat for the fiscal year?

That was the fiscal year. We haven’t talked about FY11 yet.

So that will wrap up the Q&A portion of today’s earnings call. Remember that you can access this call on the Microsoft Investor Relations website at www.microsoft.com/msft. Please keep in mind that we will be at a number of conferences in the next couple of months, including Mobile World Congress in February. In addition, Bob Muglia, President of Server and Tools will present at the Goldman Sachs Conference in February and Peter will deliver a keynote speech at the Morgan Stanley conference in March. Please contact us if you need additional details. We hope to see you there. Thanks again for joining us today.

That concludes today’s call. Please disconnect your lines at this time.