Microsoft Corporation (MSFT) Q4 2010 Earnings Report, Transcript and Summary

Welcome to the Microsoft fourth 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.

Thank you, Barb. And thank you, everyone for joining us this afternoon. As usual, 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 and fiscal year. Then I will 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. Our earnings press release today includes an addendum of financial highlights with detailed information about revenue, operating expenses, and other items. We have also 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. In addition, as part of our ongoing efforts to improve and incorporate your feedback, we will post today's prepared remarks to our website immediately following the call until the official transcript is available. Today’s call will be webcast live and recorded. If you ask a question, it will be included in our live transmission, in the transcript, and any future use of the recording. You can replay the call and view the transcript at the Microsoft Investor Relations website until July 22nd, 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. And with that, I'll turn the call over to Peter.

Thanks, Bill and good afternoon, everyone. I’m very pleased to share with all of you our strong financial results. We achieved record revenue, operating income, and earnings per share for both the fourth quarter and the full year. This quarter, our strong revenue performance was both broad and deep, with every business achieving double-digit growth. Strong sales execution closed the year with fourth quarter bookings increasing 27%. For the year, both the Windows Division and Server and Tools Business achieved record revenue. We are equally enthusiastic about the customer and product momentum we’ve achieved this year across the breadth of our portfolio. Of course, I have to start by noting Windows 7, which has received tremendous market response. With 175 million licenses sold to date, it is the fastest selling operating system ever and now runs on over 15% of all PCs worldwide. Capitalizing on the recovery of the server hardware market, Windows Server 2008 R2 has enjoyed strong demand and increased Windows Server market share. With the launches of Exchange 2010 and, most recently, SharePoint 2010 and Office 2010, we delivered key innovations in our productivity portfolio. Equally as important for our long-term growth, we made significant strides in our cloud initiatives by bringing Windows Azure to market and by increasing customer traction with our commercial online services. Throughout the year, we continued to update and enhance Bing, which has now achieved 13 consecutive months of market share growth. And finally, we focused on consumers with our new Xbox 360 consoles and the announcements of Kinect and Windows Phone 7, coming to market this holiday season. Meanwhile, as a result of our ongoing commitment to managing costs, we held annual operating expenses roughly flat. Our continued revenue strength and cost discipline drove yet another consecutive quarter of margin expansion and record annual profits in the Windows Division, Server and Tools Business, and Entertainment and Devices Division, as well as the company in total. We grew full-year operating income by almost $4 billion and generated operating cash flow of $24 billion. Of this amount, we returned about two-thirds, or almost $16 billion, to shareholders in the form of stock repurchases and dividends. Finally, I’m particularly pleased by our growth in earnings per share of 50% for the fourth quarter and 30% for the full year. So, it’s been a great fiscal year and an outstanding fourth quarter. With those remarks, I’ll now turn the call over to Bill to provide more details on the quarter.

Thanks Peter. As I review this quarter’s performance, keep in mind all growth comparisons relate to the corresponding period of last year unless I specify otherwise. As Peter noted in his opening remarks, we finished the year with terrific financial results. Total revenue for the quarter grew 22% to over $16 billion, a record fourth quarter result. Windows, Online Services, Entertainment and Devices, Server and Tools, the Business Division, each of our operating segments grew revenue double digits this quarter, reflecting broad-based strength across all of our businesses. Fourth quarter GAAP operating income grew 49%, while EPS grew 50%. Looking at the full year and adjusting for the tech guarantees, we had four consecutive quarters of margin expansion with EPS growing faster than revenue every quarter. Operating cash flow was up 46% to a fourth-quarter record $5.6 billion. As for the year, operating cash flow surpassed $24 billion as Peter noted, also a record. Customer demand was strong across the breadth of the Microsoft portfolio this quarter, as we saw total bookings growth accelerate to 27%. In the enterprise, businesses continue to invest in and commit to the Microsoft platform. Sales execution and enterprise agreement renewal rates have improved as unearned revenue at the end of the quarter was $14.8 billion, up a very healthy 21% sequentially. The contracted not billed balance ended the year over a record $15 billion. The small and mid-market customer segment continued to experience robust growth and was up approximately 20%. Finally, continuing a trend this year, consumer demand was fantastic with growth in Windows, Office, Search, and Xbox. Geographically, we saw strength across all regions, led by emerging markets. Growth in the U.S. improved this quarter, while demand in Europe remained healthy. The PC market continues to thrive and we estimate the market grew…

Thanks, Bill. I will now share our thoughts on the first quarter and total fiscal year 2011. We are entering the year with great momentum. We are encouraged by the resurgence in business PC shipments, and expect the business PC refresh cycle to continue through fiscal year 2011. The recent refresh of our enterprise product has positioned us well to meet customers’ needs as they return to investing in information technology. Turning to our outlook by business, we expect Windows division revenue to grow roughly in line with PC shipments for the first quarter and full year, excluding the $7 million revenue impact from the Windows 7 retail launch and $276 million from the technology guarantee revenue carried over from fiscal year 2009. For the Microsoft business division, consumer and business non-annuity revenue, approximately 40% of the total, should continue to track with their PC shipment growth rates for the first quarter and full year. Annuity revenue for the first quarter and full year should grow low to mid-single digits. Moving to the Server and Tools business, in the first quarter we expect non-annuity revenue to be up mid to high-single digits as first-quarter bookings are sales cycle driven, and tend to be the softest seasonal quarter irrespective of hardware shipments. For the full year, we expect non-annuity revenue to generally track with the hardware market. We expect annuity revenue to grow roughly high single digits for the first quarter and full year. Enterprise services revenue should grow mid single digits. For the Online Services Division, our online advertising business should outperform the overall online advertising market. Regarding our search partnership with Yahoo!, we are working closely with them to migrate both algorithmic and pay traffic in North America to this holiday season. And finally, I will cover the Entertainment…

Thanks Peter. We want to get 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.

Okay, thank you. (Operator Instructions). And first is Walter Pritchard with Citigroup.

Hi, I was wondering if you could elicit a little bit on the PC side your assumptions for fiscal ’11, and just talk about tablets and how you are thinking about that market. Are you talking about growing in line with traditional PCs, and what impact do you think tablets will have on the market, and what maybe your share in that area and how does that affect your growth rate?

Yes. We are very excited about the market; the PC is the PC market excluding tablets. But obviously we are super happy with both the state of the PC market and the customer traction for Windows 7. You know, we think tablets are very interesting and remind us that there are always new scenarios and new opportunities, and we are constantly working with our partners and our OEM partners. In fact, I think one of the things that has driven the PC market and Windows growth this year has been the work we have done with our OEM partners on multiple scenarios and form factors and price points in all those. Tablets, I think, are interesting and great because I think they sort of enlarge the overall opportunity. I think they are additive to the opportunity, and again it reminds us that there are lots of interesting new scenarios that we are continuing to work on, and so we are excited by that.

Great, thanks.

Thanks Walter.

Next question Barb.

Next is Adam Holt with Morgan Stanley.

Great. Thank you. It looks like an overly good start to Office, 8% business growth was the highest number I think you have seen in two years. Do you think business revenue growth can get to the same levels you saw with the previous Office cycle; we were each north of 20%. And why wouldn’t the annuity business for Office grow faster the low single digits in the heart of the cycle next year? Thanks.

Yes, thanks Adam. You know, I’m not going to give guidance on business revenue rather than the driver framework that we gave. In terms of the annuity business, obviously this is in terms of the deferred revenue we had the last year, year and a half, has been slow and so we’re kind of digging out of that hole, the recognitions that we have from the deferred revenue balance. And so in the course of this year, we will be building that backup. And as I said, we expect Q1 unearned revenue to also return to normal historical sequential pattern. So we feel good about the opportunity to continue to drive bookings with Office, but in terms of the annuity revenue recognized growth that is impacted by sort of the billings that we saw over the course of the last year, but having said that we are certainly very optimistic about business uptake of Office 2010.

Terrific, thank you.

Barb, can you move to the next question?

And next is Heather Bellini with ISI.

Hi, yes, good afternoon. I was wondering if you guys could talk about the decline in the consumer premium mix, and what percentage of the decline is related to emerging markets and what are the other reasons if it doesn’t explain all of it? Thanks.

Thanks Heather, all of it. It is all related to the growth in emerging markets.

That was easy then. Thank you.

Yes, thank you.

Barb, next question please.

And next is Philip Winslow with Credit Suisse.

Hi, guys. Great quarter. I just wanted to have one question back on the windows division, if you look at that commercial and retail license line, it still remained very strong year-over-year and even sequentially. Obviously, in the first part of fiscal year that was driven by consumers upgrading to Windows 7, just what are you seeing there? Then also, as we start to think about fiscal ’11, obviously that does include commercial licenses too, what would you expect for the impact of potentially enterprises upgrading to Windows 7 and sort of on top of I guess the PC replacement cycle. Thanks.

No, it is great. We are very optimistic about that opportunity, but remember it is a small part of the business, about 20% of the business. So, while there is great intent to deploy, and we are already seeing great deployment, so that is a little bit of a tailwind, but it is not by any stretch of imagination a material mover of the business, but it is a nice additive.

Barb, next question please.

Next is Sarah Friar from Goldman Sachs.

Great. Thanks for taking my question guys, two questions. Just first, on the overall environment, you sound incredibly upbeat, you clearly had a very strong quarter, was there any shift as you got towards the end of the quarter, because clearly others through earnings have started to note more weakness in Europe, for example, our government spending. So we just love to get your perspective.

Yes, we didn’t really see any differences throughout the quarter, and we are encouraged. We had strong demand and strong sales execution, and obviously, it did slightly better than we had hoped and talked about last quarter. For our products set though, we’re thrilled with customers adopting our products. And there was really no difference throughout the quarter.

So, it sounds like with the product cycle, your kind of expectation is you can kick through even some slight decline on the macro side?

Yes, we certainly feel really good about the traction that our products had, no doubt.

Great. Thanks.

Barb, next question please.

And next is Brent Thill with UBS.

Peter, you are continuing your strong expense discipline in the quarter, I am just curious if you could talk about fiscal ’11, and what really changes as we go into next year to continue that discipline? You did take your expense guidance down a little relative to your past guidance, if you could just explain what drove that?

Yes, it is the same thing. This is an ongoing process, something we think about every day, and so continually as we go through we are always scrubbing. We are always looking at our plans, we’re always looking to make the most effective use of the money, and as we have done that and we make progress, then we can lower our guidance, and that is just what we did. We did better in Q4 then we expected, and we are continuing to take that into next year, and we will just focus on that continuously.

Thanks Brent. Operator, next question.

The next is Katherine Egbert with Jefferies.

Hi, good afternoon. Your contracted but not billed balance was up 1.5 billion this quarter, can you tell us about that?

Yes. I mean, as we said it was strong bookings quarter all up, if you look at the revenue and the unearned and the CMB [ph]. You know, our bookings growth was 27%, and so it is reflective of the sales execution and the enterprise demand for our products, and it is interesting, Bill has kind of touched on that, it was very broad-based across geographies and across products and across customer segments and size. And so that is what is really driving that.

Will that continue to increase?

You know, I would just – we haven’t given guidance on that. We did give the expectations on the unearned. So, I would take that as bit of a proxy for how things are going.

Okay, thanks Peter.

Thank you.

Next question Barb.

And next is Kash Rangan with Merrill Lynch.

Hi, thank you very much. Looking at the unearned balance for server and tools and MBD, it looks like it is back up to multi-quarter highs, and also your unearned metric which you reported is well above what it has been, the highest it has been in eight quarters. Yet, at the same time the guidance for the annuity and growth rate, it still sounds like we are in recession listening to your guidance for what seems to be low to mid single digits. Can you help us understand the disconnect here? It seems to me that you are being a little bit conservative with your annuity guidance for what seems to be two big product lines. Given the improvement in bookings off-balance sheet and on balance sheet, it occurs to me that as the deferred revenue starts to build up in your words, and there is normal seasonality that you should take your guidance up in the next few quarters. So, comments or reactions, an explanation would be appreciated. Thank you.

Yes, what you are seeing Kash is the – it is the recognition next year, a function of the deferreds that we’ve had. As you mentioned, this is the first quarter where we really pumped it up. So the recognitions in the annuity revenue that you are seeing next year in the reported number is a function of the challenges we had on our deferred balance. And so as we build that up over time, you will start to see the annuity business probably do better. So that is what you will see as you get towards the latter part of next year, because this is the first quarter where we really saw that unearned balance kick off.

So, if the deferreds continue to build up normal seasonality, should – we should expect you to take your guidance up for annuity growth rate in your two main businesses, right?

You know, it is too early to tell. You should just take the guidance that we gave as our guidance for FY11.

Okay, great. Thanks.

Barb, next question please.

Next is Brad Reback with Oppenheimer.

Hi guys. How are you?

Good.

So, Peter in the slides on 18, you talked about COGS being sort of negatively impacted next year, based on the expectation of mid-teen growth in E&D, can you give us any sense of what the headwind is on the COGS side?

Well, what I tried to do is give you the drivers, and I think, you know, you should go through your model, think about what assumptions you are going to make and clearly the assumptions, the biggest one that we like to call out that we think is most material by far is the growth in E&D and the headwind from the hardware sales, which is obviously a great thing for the long term, but in the short term will provide a headwind to COGS. And so, the reason we like to give you the drivers, it allows you the flexibility to kind of work that through your models as you come up with your product mix.

I understand, not to pick you, but you did put the mid-teen guidance out there, so based on that there is no way to give us any sense of what type of headwind that generates, so we’re all on the same page here.

I will just say, Brad, do the math. And I think it will come out whatever your assumptions are for the driver framework. So, let us move on to the next question.

And next is Sandeep Aggarwal with Caris & Company.

Hi, thanks for taking my question. Peter, you know, we are in the mid of enterprise refresh and you know, premium mix for business edition has gone up from 28% to 29%, but if I look at the historical trend during the mid of enterprise refresh, actually you have been in mid to late 30s in terms of the business premium mix. You know, why it has only seen only 100 basis points improvement or is there a time maybe in the next few quarters where we can see it reaching to the historical level.

Yes, I would say, one, it is early in the refresh cycle. So, we should watch it. I think that really is the answer.

Next question please Barb.

And next is Ed Maguire from CLSA.

Yes, good afternoon. Last quarter, you provided some metrics around your online services subscription, can you provide some at least directional indications and help us understand as well some of the traction around Azure and how that may be impacting some of the traditional server revenues.

Yes, we talked about on the sort of commercial – the productivity online services as Bill talked about, you know, 70% of those wins have been competitive wins, which has just been really good. We’re really accelerating the traction there. On the Azure side, it is early, we just launched that this year. The productivity online services are further along from a customer perspective, but we have really accelerated the developers and the users we have on the Azure platform. It is not material to the financials now, but we are really sort of establishing a leadership position in that of users. And we have had some – on the productivity side, we have had some great wins, we had the State of Kentucky, which was many, many – 700,000 users. So, acceleration and continued progress and leadership in that.

Next question please Barb.

And next is Gregg Moskowitz with Cowen.

Okay, thank you. Good afternoon guys. Just a follow up on Office 2010, qualitatively Peter, how are you thinking about consumer and enterprise adoption rates in the first 12 months or so post release as compared with the similar period, with regard to Office 2007?

Yes, you should just take the guidance that we gave you on the non-annuity side. We sort of expected to track PC shipments, which is a pretty strong result, especially given some mix of PCs to emerging markets where we have slightly lower cash. So we will – this quarter will be a big quarter, we'll look at the back-to-school and see how we are doing. But other than that, we are very excited – off to a great start; as you saw, the 51% number is a very strong number for early on.

And Barb – Barb, let's move on. Let's make this the last question.

And the last question comes from Rob Breza with RBC Capital Markets.

Hi, thanks for sneaking me in. Just quickly, maybe as a follow-up to Gregg's question, as you look at the PC shipments, your expectations for Q1 are helpful. If we look at the trend kind of in the second half of the year, would it be natural to assume after back-to-school holiday season that we see a slight tail-off or can you just give us kind of maybe a front-half kind of second-half thought? Thanks.

We are not giving color on sort of half-by-half. The one thing I would say that will continue all year is that emerging markets will continue to grow faster than developed markets and that has an impact on our business.

Great. Thank you.

Thanks, Rob.

Okay. So that will wrap up the Q&A portion of today's earnings call. We look forward to seeing many of you at the Financial Analyst Meeting next week where we will provide more details about our long-term strategies and provide you with a hands-on opportunity to experience our technology and engage in great discussions with our management team. For those of you who are unable to attend in person, you will be able to follow the day from our Investor Relations website at microsoft.com/msft. Please contact us if you need additional details. We sincerely hope to see you there. Thanks again for joining us today and have a great day.

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