Microsoft Corporation (MSFT) Q3 2010 Earnings Report, Transcript and Summary

Welcome to the Microsoft Third Quarter Fiscal Year 2010 Earnings Conference Call. At this time, all participants are in a listen-only mode. (Operator Instructions). Today’s call is being recorded. If you have any objections, you may disconnect at this time. I would now like to turn the call over to Mr. Bill Koefoed, General Manager, Investor Relations. Sir, you may begin.

Thanks, Barb. And thanks everyone for joining us this afternoon. With me today are Peter Klein, Chief Financial Officer; Frank Brod, Chief Accounting Officer; and John Seethoff, Deputy General Counsel. Today Peter will start with overall takeaways from the quarter. Then I’ll give you the details of our performance before handing it back to Peter, who will discuss our outlook. After that we’ll take your questions. Please note 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 remarks as well as provide a reconciliation of differences between GAAP and non-GAAP financial measures. You can find these documents at the Microsoft 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 April 22, 2011. This conference call is protected by copyright law and international treaty. Unauthorized reproduction or distribution of this call or any portion of it without the expressed written permission of Microsoft may result in civil and criminal penalty. 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 materially differ because of factors discussed in today’s earnings press release, in the comments made during this conference call and in the risk factors 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 statement. Okay, Peter, it’s all yours.

Thanks, Bill. Good afternoon everyone. Our third quarter results reflect our strong product momentum, continued focus on controlling costs and the beginning stages of a return in business hardware spending. This quarter we generated record third quarter revenues and operating cash flow. In addition, as a result of revenue growth and our ongoing focus on cost management, when adjusting for the impact of the Tech Guarantee programs this year. We had our third consecutive quarter of year-over-year margin expansion. Strong demand for Windows 7 is a primary contributor to our performance. As evidence of that strong demand both internal and external checks show that over 10% of all PCs worldwide are already running Windows 7. While reaching this level of penetration in six months qualifies Windows 7 as our fastest selling operating system ever, it also illustrates how much opportunity still remains. As I have met with investors, I’ve commented on the tremendous product momentum we have, which was evidenced this quarter across all our businesses. Bing achieved 10 consecutive months of market share growth since its launch and both the U.S. Department of Justice and the European Commission cleared our search agreement with Yahoo! Azure, our cloud development platform became commercially available in 41 countries. In the mobile space, we announced Windows Phone 7 and Kin. At last Friday, we released Office 2010 to manufacturing and are looking forward to its launch in June. All of this was achieved while continuing to focus on managing costs and prioritizing our investments. As a result, we delivered operating income and earnings per share growth ahead of revenue growth with earnings per share of 36% over last year. We also returned $3.1 billion of cash to investors through dividends and stock repurchases. So in summary, I’m pleased with our continuing performance this quarter. We had great momentum with current products in market. We have a very exciting pipeline of new products to come and we continued to deliver strong financial results. I’ll 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 for our fourth quarter and the next fiscal year.

Thanks Peter. As I review this quarter’s performance, keep in mind that all growth comparisons relate to the corresponding quarter of last year unless I specify otherwise. As Peter said, we had another strong quarter. Overall, GAAP revenue grew 6% to $14.5 billion. During the quarter we deferred $305 million of revenue related to the Microsoft Office 2010 Technology Guarantee program. Adjusting for this amount, revenue would have been $14.8 billion, 8% growth over the prior year period. GAAP operating income grew 17% year-over-year, while EPS grew 36%. Operating cash flow this quarter was $7.4 billion, an all time record for the company. Foreign exchange had a positive impact to revenue of about $200 million this quarter. In terms of overall revenue mix, geographically emerging markets grew more than 20%, while mature markets grew mid single digits. While consumer demand continued to be strong, we saw renewed strength from small and mid-market customers with year-over-year growth of more than 15%. Within the enterprise customer segment, we saw the beginning of a recovery in IT hardware spend but as we’ve discussed on past calls, we continued to see lengthened sales cycles. Enterprise agreement renewal rates, taking into consideration the extended sales cycles are within our historical range. Unearned revenue was $12.3 billion, down sequentially as is typical, but better than last year’s seasonal trend and roughly flat year-over-year. Our unearned revenue balance would have been up more than $100 million or 1% year-over-year when considering the recognition of undelivered elements, primarily associated with our prior Windows XP sales and the revenue deferral from our Office 2010 Technology Guarantee program. Multiyear annuity billings were up mid single digits year-over-year. This quarter’s growth from volume licensing is beginning to offset the unearned revenue declines we’ve seen over the past several quarters as we…

Thanks Bill. Now I’ll discuss our expectations for our fourth quarter and the next fiscal year. From a macro perspective, we expect the next quarter to be similar to the third quarter with continued strength in hardware shipments. We were encouraged by the recent uptick in business PC growth and expect that this business refresh cycle will continue over a couple of years. Before I get into my commentary by division, remember that the June quarter is the close of our fiscal year. As such, it is historically a seasonal high for our enterprise sales and we’re entering it with a strong sales pipeline. While we’ve noted early signs of improvement, the business spending environment and associated sales cycles remained challenging. We will be very focused on closing deals during the quarter and we expect that unearned revenue will likely return to normal seasonal patterns. Beginning with the Windows division, we expect revenue to grow slightly faster than the overall PC market in the fourth quarter. Attach, inventory and premium mix gain should more than offset macro trends particularly that of the emerging markets growing faster than mature markets. Turning to the Microsoft business division, we’re very excited about the launch of Office 2010 this June, as it will provide the best productivity experienced across the PC, phone and browser. The combination of Office 2010, SharePoint 2010, Exchange 2010 and Office Communications Server will be the practical platform for IT, delivering anywhere access to your document and unmatched collaboration. For the fourth quarter, consumer and business non-annuity revenue, approximately 40% of the total, should track towards PC shipment growth, while we expect annuity revenue to be up low single digits. The server and tools business generally aligns with server hardware shipments and business IT spending. Similar to many observers, we…

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 multipart questions. Barb, can you please go ahead and repeat your instructions?

Thank you. (Operator Instructions). And first is Heather Bellini with ISI.

Hi. Good afternoon, guys. I was wondering if you could talk about your comment about a return to normal seasonality in unearned revenue. I guess, what I’m wondering -- had the Tech Guarantee benefit Q3 deferred. So when we’re looking if normal seasonality were to happen in Q4, are we taking the Q3 ending balance and thinking about it that way or should we be thinking about adjustments for the Tech Guarantee? Thank you.

Yeah. Take it as it is.

Great. Thank you very much.

Thanks Heather.

Next is Walter Pritchard with Citigroup.

Hi. Could you guys talk about on the server side, it looks like non-annuity revenue grew a little bit slower than server units and I guess, you’re seeing an uplift in version mix there, which should be helping the situation. Just curious to get some more detail on that as well as what you think we should see looking forward into June and beyond?

Yeah. You have to break it down, I think, you have to break it down into its components. There’s actually two pieces of the non-annuity business of the transactional business, the Windows Server piece and then the other pieces of the business. The Windows Server non-annuity piece actually grew a mid-teens, so tracked towards the hardware market. The other products, things like SQL Server and Visual Studio grew slower than that in anticipation of a product release [account]. So it tends to be less correlated particularly in quarters where there is a significant growth year-very-year. So that was the issue there. In terms of looking forward, I think we gave the guidance on what we expect for the transactional business, particularly as we launch Visual Studio and SQL Server tracking more towards the server hardware market.

Great. Thanks.

Yeah.

Barb, can you ask next question.

Next is Adam Holt with Morgan Stanley.

Terrific. Thank you. My question is about Office. As we near the release, I was hoping you could talk to us about how you’re thinking about what the impact should be, what you think about with respect to the average selling price opportunity on Office? And in particular also, you mentioned transactional revenue for the next quarter. Should we assume that transactional revenue continues to accelerate as we get deeper into the Office cycle? Thanks.

Yeah. Let me get your last question first. Certainly as we’ve said, we expect the largest part of the impact from the launch actually to happen in fiscal year ‘11. So typically what you’d see, since we’re launching it in the May, June timeframe, typically what you’d see is several quarters after that the impact of that. So you should see that in the first half of fiscal year ‘11. It terms of average selling price, it’s a little hard to talk about that now. It’s going to be a function of obviously mix but I would just think about it the way the Office 2007 launches. The one thing I would add to that, where you will see it is in the platform side of the business. So when you see the Enterprise CAL and how we monetize the enterprise versions of the productivity infrastructure for SharePoint on Exchange is where you’ll see opportunities for overall revenue growth from an ASP perspective, for an (inaudible).

Terrific. Thank you.

Thanks Adam.

Barb.

And next question is from Sarah Friar with Goldman Sachs.

Great. Thanks for taking my question. Peter, on the cost side, I mean, you highlighted this great expansion that you’ve seen as you’ve -- you’re starting to read the benefits of those cost controls that you took a few about a year ago. As you look out to Q4, your guidance would suggest actually a sequential decline in the operating margin and yet you should be hitting, pretty strong product cycles still on Windows and Office beginning to come into the mix. Why wouldn’t we get more margin expansion in Q4? And then as you look at fiscal ‘11 costs, what are the puts and takes of why costs go up versus what other measures you can do to keep them down?

Yeah. The biggest thing driving the Q4 expenses is revenue driven expenses that are associated with primarily our enterprise annuity business, which are going to be up, fair amount both sequentially and year-over-year and so that’s the biggest thing you’ll see in Q4. The other thing you’ll see in Q4 is, as I talked about, the wave of product launches that we’ve got coming, including Office 2010 and SQL Server. So it’s just, what’s happening this quarter is sort of, not unique but those are the things that are really driving what you’re seeing in Q4. And of course, those have been embedded in our guidance all year long and the fact of the matter is we’ve been -- we try to manage our costs in such way as possible and bring it down whenever we can, which we did this quarter. The dynamics in FY ‘11, as you note there’s a lot of puts and takes and we’re always prioritizing and aligning our investments. But all up, you should think the things that are driving it are similar. There’s some revenue driven as we continue to grow revenue and there’s also some sales and marketing associated with some key launches that we will have, particularly in the first half of the year related to the consumer businesses like Natal and phone. And I would say, keep in mind that is a pretty measured increase of only 3% to 5% for the full year.

Okay. Great. Thanks for the color.

Yeah. Thanks Sarah. Barb?

And next is Brent Thill with UBS.

Thanks. Peter, considering the strength of the product cycle and the uptick we’re seeing in corporate spend. It’s still surprising to hear about lengthening sales cycles and I think the unearned was below the Street estimates. What are customers citing the reasons why they are not pre-signing up? Are they just waiting for all these products to be launched before they’re renewing or are they trying to get our hands around what you’re hearing from the customer base.

Yeah. There’s a couple of things. One that is true, particularly when there is so many products that are launching. So there’s a bunch of revenue that’s going to come through on the non-annuity side that people are waiting for launches for. And I do think that hardware, if you think about what’s happened over the last year. The first thing that got hit and decreased earliest and fastest was hardware and that’s what’s coming back first. And I think that over time, as we’ve been saying and I think most other people are saying, over the course of calendar 2010 and certainly into 2011, you’ll start to see the growth in the overall IT spend. For us in particular, from a sales cycle perspective, Q4 is just seasonally our biggest quarter. And so when you combine sort of the sales cycle and the product cycle, kind of converging on Q4 and beyond, as well as where we’re I think in the stage of what businesses are doing in terms of first refreshing their hardware that kind of converges over the next two or three quarters probably.

Thanks.

Next question, please.

Next is John DiFucci with JP Morgan.

Thank you. Peter, I have a question on the Windows business. It looks like on slide 11 you’ve got about 8% benefit from the Windows attach and inventory. And I’m assuming that’s from less piracy and then inventory build in the channel. You also got about, I think it was 10% last quarter. Now this is the second quarter into a new launch of Windows 7. I’m just curious, I mean, how sustainable is that? I would assume that piracy is going to be less during a launch even pirates have to buy legitimate copies at least for a while. And then also the inventory build in the OEM channel, I assume that would start to wane. If that happens, would you expect that benefit to start to wane here and if it does, should we be thinking that the segment mix line up above that with a corporate refresh cycle that sounds like it’s going to happen in the second half, that should start, you’d start to see less of a negative hit in that line or how should we be thinking about this?

Well, it’s a great question. You’re thinking about all of the right components of it and certainly, attach and piracy are always going to sort of cycle up and down depending on where you are. We’re working through this year sort of a work-down of the inventory from last year and we’re still working that. We’re at sort of normal inventory levels. That’s been a good year-over-year thing for us and attach, correct, is -- part of that is piracy related to the launch of Windows 7. All those things so we’ve given you specific color for Q4, what to expect for the OEM business relative to the PC business.

Sorry. Can I just add one thing?

Yeah.

The other thing is just there is an overall, I think we talked about it on prior calls, an overall secular change, which is the multinational OEMs are becoming a more significant portion of the total PC market. And that’s says good things for our attach relative to the prior mix of our revenue -- from different PC manufacturers, and...

So, and I’m sorry, just to, does that mean that you’re seeing a little less piracy and you expect to see that in some international markets?

We’re seeing that globally.

Okay. Great. Thanks.

Thanks John.

Next is Phil Winslow with Credit Suisse.

Hi, guys. Good quarter. Peter, you guys have talked about in the last few quarters seeing a pretty significant uplift in Windows revenue from the retail channel, some consumers going out to the store to upgrade to Windows 7. When you compare what you believe is sort of the corporate upgrade opportunity to be to what you’ve seen over the past couple of quarters to consumer, which one is the larger of the two? And when would you expect to see the corporate side begin? Thanks.

Well, just in sheer numbers in terms of PC shipments, the consumer is a lot bigger than the business segment. Now, the impact you get from the business segment obviously is some ASP uplift. We’re starting to and you get the corporate refresh in two ways. You can get sort of volume licensing upgrades or you can get it OEM when they buy the PCs, which is the largest piece of the revenue. And that’s what we started to see happen and you saw some of that impact this quarter with business PC shipments up 14%. That’s the sort of this is sort of the shape of the opportunity going forward as that continues and you can see that has an uplift on our OEM revenue relative to the overall PC market.

Next question, Barb.

Next is Kash Rangan with Merrill Lynch.

Hi. Thank you very much. I just wanted you to talk a little bit more about the deferred revenue trajectory going into Q4. It looks like, this year compared to the start of the year deferred revenue long-term or short-term is down a lot more than what it has been the past few fiscal years, so that would argue for a bigger than seasonal catch-up in Q4. So maybe you could talk about what is embedded in your expectations and what do you expect on the ELA side. And also, I think you’ve talked about book but not build portion of your bookings. So if you can just give us some color on how that is shaping up that would be great? Thanks.

Yeah. Just in terms of the numbers, what we sort of the guidance that we said. It’s we’re looking for sequential increase in Q4 in a similar range that you’ve seen over the last three, four, five years sequential growth. We’re starting to rebuild the balance. You started to see that happen a little bit in Q3 with our multiyear annuity billing having positive growth. So I think that’s sort of the essence of what we’re expecting and what we’re guiding to. What was your second question?

The book but not build portion on the balance, you would talk about that in your presentations in prior times, but just noted that we’ve not been talking about that in recent times, just wondering if you have an update there?

You know, I think, that’s actually a good thing that we’ll talk about in July on the Q4 call, just because it’s such a bigger issue, the seasonality in terms of our bookings in Q4 is so much more material than in Q3. I think that’s when we will talk about that.

Barb, next question.

Next is Brad Reback with Oppenheimer.

Hey, guys. How are you?

Good. How are you?

Good. So Peter, just switching gears back to server and tools, as I look back at my notes from last quarter, I think you guys talked about the annuity business being up mid single digits and I think it came in flat this quarter. Given my understanding that most of that is coming off the balance sheet, what would have caused that delta in that three months period?

Yeah. I think, the comment was for H2 not for Q3 up mid single digits. And so if you look at our guidance again with the seasonality of our sales cycle most of that comes from Q4, which was in our guidance that we gave today.

Okay. Great. Thanks.

Thanks Brad.

Thanks. Barb, next question.

And next is Katherine Egbert with Jefferies & Company.

Hi. Thanks. Speaking of guidance, there’s a lot of moving parts right now, multiple product cycles, revenue deferrals and economic recovery. What are you looking for to become comfortable with providing more specific guidance? What are the triggers?

Well, I’m not sure there are specific triggers. I actually having a driver framework and having a really good qualitative discussion about all the factors that drive it, is actually a great way to talk about the outlook and the environment what we’re seeing for our businesses. And so, I think, there’s no specific triggers that are going to change that. I think the dialogue that we’re having around these drivers and the framework is great.

Operator, next question.

Okay. Thank you.

And next is Brendan Barnicle with Pacific Crest Securities.

Thanks Peter. You talked about next year gross margins obviously having an impact from the hardware cycle. In the past at times you’ve talked about as you change to more cloud computing that taking a hit as well. Can you give us any range and could we see as much as 2 percentage points in change there next year?

You know, we’re not giving a range on that now. We’ll definitely talk about that at the financial analyst meeting in July.

Operator, next question.

And next is Rob Breza with RBC Capital Markets.

Hi. Thanks for taking my questions. Peter, just maybe as a follow-up to Brendan’s question, you called out in your prepared remarks the 40 million paid seats for the cloud initiative. I was wondering if you could talk about where you’re seeing the strength there and how we might expect that to be 12 months from now? Thanks.

Yeah. We’re seeing strength across a variety of our areas. You heard Bill talk about all the great customers we have our commercial online services like SharePoint and Online and Exchange Online. That’s obviously a big growth area for us. The 40 million comes from things like Live Meeting and Exchange Hosted Services and CRM Online. And so what you’re seeing is really part of our strategy. So the broadest array of commercial services for businesses of all sizes. Some of these are really aimed more at mid-market customers. Some are aimed more at big enterprise customers and we’re getting growth from both. And then the last thing that we sort of touched on but didn’t talk about in great detail was Azure, which is now available in 41 countries and what that will do really over the next couple of years.

Barb, we’ve got time for just one more question.

Okay. The last question comes from Tim Klasell with Thomas Weisel Partners.

Yeah. Good afternoon, everybody. A question about the Windows 7 upgrade cycle, it appears to us that a lot of customers are going to attach a Windows 7 upgrade with maybe a Server 2008 R2 upgrade. Are you sensing that and could that maybe delay the Windows 7 upgrade cycle a little bit more than we normally would but have the positive impact of pulling along some server sales as well?

You know, we really haven’t seen that at all, as a matter of fact when we talk to our enterprise customers, there’s a high degree of intent to deploy Windows 7 as soon as possible. There’s a, many, many, high percentage our customers are already either in pilot or pre-launch mode for deploying Windows 7. So, I think, we haven’t seen that as a phenomenon at all, people waiting for Windows 7. In fact we see the opposite that people are deploying it rather quickly.

Okay. Great. Thank you.

Thanks. Okay. So that will wrap up our Q&A portion of today’s earnings call. Remember that you can access this call on the Microsoft Investor Relations website at microsoft.com/msft. Please keep in mind that we will be in a number of conferences in the next couple of months. We’ll be at the JP Morgan Conference in May, the Banc of America/Merrill Lynch Conference, the Cowen Conference, the RBC and UBS Conferences in June. In addition, we will be previewing Natal at E3 in LA in June. Please contact Microsoft Investor Relations if you need additional details. We hope to see you there. Thanks again for joining us and have a great day.

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