Microsoft Corporation (MSFT) Q1 2011 Earnings Report, Transcript and Summary

Welcome to the Microsoft's First Quarter Fiscal Year 2011 Earnings 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, Barb, and thank you, everyone for joining us this afternoon. As usual, with me here today are Peter Klein, Chief Financial Officer; Frank Brod, Chief Accounting Officer; and John Seethoff, Deputy General Counsel. Today we filed our Form 10-Q. In addition, we posted our earnings release and financial summary slide deck on our new Investor Relations website at microsoft.com/investor. The slide deck is intended to follow the flow of our prepared remarks and provide a reconciliation of differences between GAAP and non-GAAP financial measures, as well as a summary of segment reporting to industry historical results. As was the case last quarter, we will post today's prepared remarks to our website immediately following the call until the complete 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 October 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 expressed written permission of Microsoft may result in civil and criminal penalty. Today, 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. Good afternoon, everyone. I'm pleased to be able to share with you our excellent results for the first quarter, which reflect the ongoing strength and breadth of our product portfolio. Demand from both businesses and consumers drove healthy revenue growth. We delivered record first quarter revenue, operating income and earnings per share. We continue to control costs while prioritizing our investments into the highest growth opportunities, resulting in another quarter of margin expansion. As we discussed at our Analyst Meeting in July, we have eight core focus areas that we feel have the greatest opportunity to drive shareholder value. This quarter, we had exceptional momentum across these focus areas and I want to start today's call by giving you some important highlights. First, Microsoft Business Desktop is thriving with Enterprises and small- and medium-size businesses investing in our products and services. Not only are companies adopting Windows 7 and Office 2010 at historically high rates, they are also investing in our Office productivity platform, including SharePoint, Exchange, Dynamics CRM and Lync, the newly rebranded Office Communication server, all of which grew double digits this quarter. Server and Database businesses had strong momentum as our data center and cloud offerings remain a top priority for our customers as they continue to adopt the Microsoft platform. In addition, Windows Azure had strong subscription growth and we announced a number of platform enhancement this morning at our Professional Developers Conference. As I mentioned at the beginning of the call, consumer demand for our products continue to drive terrific results this quarter. In terms of our core focus areas, Xbox momentum continued with our console outselling every competing console in the U.S. for the fourth consecutive month, being used at an all-time high with almost double the number of queries since its launch last year. And consumers continue to show their strong preference for Windows 7 and Office 2010. Customer satisfaction across our products remains at record-high levels. We also made exciting progress in the mobile space with the recent launch of Windows Phone 7 in Europe and Asia and the upcoming November 8 launch in the U.S.. So in summary, I'm very pleased with our performance this quarter. We executed well in all of our core focus areas, and are off to a good start for the year. With that, I'll hand it back to Bill to provide more details on the quarter's results.

Thanks, Peter. I'll start today by noting that all of my comments are adjusted for the $1.5 billion of revenue, which was deferred in the first quarter of last year. As you probably recall, this deferral was related to the Windows 7 Upgrade Program and Windows 7 licenses sold in advance of general availability in the first quarter of last year. We've reconciled this non-GAAP view to GAAP results in our earnings slide deck. All growth comparisons I make on the call today will relate to the corresponding period of last year unless I specify otherwise. Okay, now to our results. We started this fiscal year with great financial performance. Total revenue for the company was up 13% to $16.2 billion. Operating income and EPS grew 20% and 19%, respectively, again, outpacing revenue growth. Bookings for the company were up an outstanding 24% this quarter. Bookings growth over the last three quarters was the highest in the last three years. Operating cash flow passed $8 billion for the first time ever, and was up 34%. A number of the demand patterns and trends we saw in the second half of our fiscal year 2010 were sustained through the first quarter of 2011. In the first quarter, consumer demand for Office 2010 and Xbox were outstanding. And we're pleased with the continued adoption and growth of Windows 7 and Bing. Sales to small and medium businesses were exceptionally strong with revenue up over 30%. This growth was partially due to a greater level of partner engagement as we had an increase of over 15% in the number of partners selling Microsoft products around the world. We also saw strengthening trends in the Enterprise segment despite what is typically a seasonally weak quarter. Our compelling product portfolio across Windows, Server & Tools…

Great. Thanks, Bill. For the remainder of the call, I'll discuss our expectations for the second quarter and the remainder of fiscal 2011. According to many recent surveys, Enterprise IT spend should continue to grow for the remainder of the fiscal year. With the depth and breadth of our offerings, we are well-positioned to grow our share of the IT spending market. We expect business PC and server hardware purchasing to remain the high priority for most businesses. The business PC refresh cycle should continue through at least the remainder of this fiscal year. As was the case this quarter, we expect business PC growth to outpace consumer PC growth, and emerging market growth to outpace developed market growth. And we're confident that tablets will expand the PC market and we're enthusiastic about our opportunity, along with our partners, to bring Windows to additional form factors and new usage scenario. Windows will continue to provide the choice and value that customers want across devices. With that back up, I'll now turn to segment expectation. Windows division revenue should go roughly in line with the PC market for the second quarter and the full year, when excluding the impact of the prior-year Tech Guarantee and revenue attributed to the launch spike. For the second quarter of fiscal year 2010, you should exclude $1.7 billion of revenue related to the Tech Guarantee and $600 million of revenue related to the launch spike. For the full year, you should exclude $300 million and $700 million, respectively, the latest of these events. Moving on to Server & Tools. For Q2 and the full year, we expect non-annuity revenue approximately 30% of the total, to generally track with the hardware market. Multiyear licensing revenue, approximately 50% of the total, should grow high-single digits for the…

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?

[Operator Instructions] The first question comes from Adam Holt with Morgan Stanley.

My question is about Office. Obviously, also a very good start for 2010. As you look back at 2007 business growth, by which exceeded 20% for a number of quarters. As you think about the internals in terms of penetration and duration of this cycle, what are your early thoughts about how like they'd compared and where are you seeing evidence on successor on some of the bundling that you have talked about.

Yes, at a high level, certainly, I'd point you to the guidance framework that we just talked about on what we expect relative to the business PC market. And obviously, the business hardware refresh is a great underlying driver for that business, as well as excitement around the product. And in terms of Office, I think the thing that's most encouraging for me is the breadth of the strength around and across all customer segments, whether that was small- and medium-size businesses and Enterprises. In terms of the integration story, Bill touched on the strong growth across all of those businesses and I think you're really starting to see that resonate very well with customers. And in fact, as we had anticipated when we were talking about anticipating off of 2010, and that was going to be a key part of the story and I think we're starting to see that play out early days, which I think can sustain for a while.

And next is Heather Bellini with ISI Group.

Peter, I was wondering, you mentioned that the Enterprise 7 -- Windows 7 Enterprise Upgrade cycle would last at least through the end of fiscal '11. And I guess I'm just wondering if you could share with us how the upgrade cycle itself is tracking versus your expectations from a few quarters ago?

Yes, I would say two things. One, just in terms of Enterprise's desire to upgrade, very strong, sort of high level. I think what we're seeing is people actually doing their deployments a little bit faster than I think we expected than we'd seen in the past. In terms of the overall business, obviously we're seeing Enterprise and businesses refresh their hardware, which is obviously a great thing in terms of the Windows 7 business.

The next is Walter Pritchard with Citi.

Bill, Peter, I'm wondering if you could talk a bit about just Enterprise Agreements in general. And we're certainly not back to a normal economic environment but your performance there, especially the improvements over the last several quarters here seems to suggest that maybe you are getting back to kind of normal behavior from customers despite headcount being pressured. I'm just wondering if you can talk to us about what you're seeing as the drivers of growth in that part of the business more generally?

I think you're seeing the console and some several things. Obviously, one is just macroeconomics and businesses investing in IT again. And I think the other is that our product portfolio, and through the combination of those two things has gotten Enterprises really wanting to invest both in their IT infrastructure and in our portfolio of products. And so as we had hoped in the course of the last year, we thought those two things might come together. The last thing I'll say is the accelerated interest in the cloud. It's when you add on top of it where we've come in terms of our cloud offerings and what that means for Enterprises as they think about investing for the long term. They want to invest with somebody who can make the transition from their own premise infrastructure to the cloud as soon as possible. And I think you're seeing that as well. So the conversations that we're having always included our new product portfolio, as well as our cloud offerings. And I think that taking into account the better macroeconomic environment has all come together to really drive a better environment.

And next is Sarah Friar with Goldman Sachs.

Peter, on the cost side, you have tremendous operating margins this quarter. As you look forward, you maintained the cost goal for the full year. Is that an anticipation of what's coming around the Windows Phone launch and Connect, or are there ways to continue to see you be a lot more efficient on the cost side over the next couple of quarters?

As you know, we're always looking at ways to get as efficient as we can on the cost. And right now, we're executing against the plan, we feel very good about our plans we've been talking about over the last couple of quarters. And first quarter was good, and we continue to executing at that plan. I'm not seeing in Q2, we do have some launches coming out and that was always in our plan and those are starting off and going on very well.

And next is from Brent Thill with UBS.

Peter, if you could drill one level deeper in the covered to an inning, maybe give us a sense of what inning you think we're in, in terms of the corporate upgrade?

In our guidance, we talked about the rest of this year. I think we have to see how that plays out. That's sort of where we have visibility and what we're talking about. But certainly, over the last couple of quarters, looking forward over the next couple of quarters and then talking to customers in what they're looking to invest in, clearly our priority is investing in refreshing their hardware and the related Microsoft products that come along with that.

And next is Phil Winslow with Credit Suisse.

Just wanted to focus on the Server & Tools division for a minute. Peter, what are your OEM partner's telling you about just where we stand in the server refresh cycle and how much do they see these sort of being high growth as what we're seeing in service and should either continuing or not continuing into next year?

Similar to PCs, I think it's a similar dynamic. These businesses are investing broadly in their infrastructure whether that's PCs or servers. And on our outlook, we talked about how we expect that to continue for the rest of this fiscal year. So it's very similar to what we just talked about in terms of the PC refresh.

And next is Katherine Egbert with Jefferies.

And if I do some math, I come up with about 40% of you revenue coming from all consumer sources and about 60% business. It looks like the consumer revenue was about flat year-on-year and the business revenues growing high teens. Is that accurate?

Well, yes. It's hard to answer that question because I don't know exactly your math. I will point out a couple of key highlights on the consumer side. If you look at Entertainment and Devices, the Xbox growth of 27%. That's something that we feel really good about and gives us great momentum heading into the holidays with Kinect, and the same thing with our Search revenue outgrowing the market. So those are the sort of the key highlight.

And Consumer and Office was up 26%

Correct. So we actually feel really good about the consumer revs. It's hard to answer that specific question without ...

We feel good about the business growth so it was a good quarter for both.

And next is Kash Rangan with Merrill Lynch.

It's good to see the cash flow and the operating margins, also you bought back a ton of stock in the quarter. My question is about growth. I just want to answer this from a quantitative standpoint. Incrementally rounded to the last two quarters, what's your confidence level in your growth there? I just noticed some of the forward-looking indicators, your business tends to lag with all the spending because you have this annuity model for the most part. Look at the unbilled portion, and that's at a record high. You're renewals, you better priced better than before. The first half have given nicely. What is your incremental confidence with respect to your revenue growth rate considering expenses tied up, I would assume that there's a lot of operating leverage for that incremental revenue. Talk to us about your confidence in your revenue growth outlook?

Obviously, we feel pretty good. We had such a strong performance in the business side. And that flow through, if you look at our outlook on the annuity side to your point, we've slightly increased our annuity revenue outlook in MBD and STD, which reflects the strength in the billings that we've seen. And as you pointed out, it takes time for that to flow through to the income statement and it will throughout the rest of the year.

And next is John DiFucci with JPMorgan Chase.

Peter, my question has to do with PC market, PC sales, unit sales. You and your Windows OEM revenue bridge, which is always very helpful. You start off from PC market with 10% growth. But industry analysts are coming out and I know, you're not doing their work, but it's actually quite different from what we've seen out there from an industry analysts by about 2.5%, in this quarter, which is a bigger range than we usually see. Just wondering, can you just help us out a little bit with that because little things come out throughout the quarter and we take a look at those, and we realize that a lot of your, at least the Windows business and also MBD and with the Office is driven by that, fairly significantly driven by that. Any comments on that, the difference?

Actually, John, I'll take that. So IDC said 10% and Gartner said 8%, so our range of 9% to 11% was slightly higher than Gartner's and IDC is within the mid-range. So we feel like our analysis of the PC market obviously, we look at those data points as well as others, which is completely in line. So happy to talk to you about it after the call, one-on-one, call down if you want.

And the next question comes from Jason Maynard with Wells Fargo.

I just have a question on Windows 7. The premium mix was pretty good this quarter. I'm just curious, in light of your commentary about the Enterprise adoption cycle, it's fair to say you're anticipating sort of similar levels pointing out there in terms of how that percentage mix plays out for the rest of the year?

Yes, generally speaking, the biggest factor in premium mix is going to be the business mix, and as we talked about, we expected those dynamics to continue for the rest of this year.

And next is Brad Reback with Oppenheimer.

So Bill, I think you had highlighted earlier in the call the big win with the Office 365 product at New York. It was a fairly competitive bid, it looks like. Could you guys maybe talk to what the economics of that look like to you from a profitability standpoint over the life of that contract? Clearly, a lot of consumers as people move to the cloud that, that could negatively impact the P&L. So maybe you could talk to a real world example.

Bill touched a little bit on the business model. We talked about this a little bit at our Analyst Meeting. These kind of wins and these cloud deals, it provides totally new economic opportunity for us. These are scenarios that we're not in today. In many cases, their customers have that customers today. In some cases, it's revenue than we may have for them to think us that we're not getting. Sitting in New York is a perfect example. We have others like Starbucks and others, where we're addressing totally new scenarios, Azure is a great example of that. It really increases our penetration in that market. Similarly, we've talked about how in the mid-market we can really increase our penetration services like this. So that's sort of our business model how it creates economic profit for us.

And next is Edward Maguire with CLSA. Edward Maguire - Credit Agricole Securities (USA) Inc. Looking at the double-digit growth in your Business division products, could you talk about what's driving that and how closely that growth may be linked to the Windows 7 activity?

Yes, it's not really tied to the Windows 7 activity. It's more a function of the product cycle with Office 2010 and all the related products like SharePoint and Exchange and Lync. And as we touched on briefly before, so if the confluence of the macroeconomic environment picking up and Enterprises investing in their infrastructure, they're seeing the value that you'd get the increased productivity and the cost savings that you get. And that's what's really driving the interest in those products, and new versions of those products that just introduce capabilities that manufactures really want.

And our last question comes from Gregg Moskowitz with Cowen and Company.

Peter, you mentioned that the Windows Server Premium mix was up four points. So I think you're now at 29%. And I believe that at least a few quarters back, Microsoft has suggested that it would be difficult to get this above 30%. Is that still kind of the ceiling we should be thinking about? Or do you think given this momentum that you could drive the premium mix higher than that?

Well, first thing I'd say is the premium mix is over 20%. We haven't given an exact number on that. It's probably, I think it's best to continue to track it and not sort of set a ceiling or an expectation for it.

Okay, so that will wrap up our Q&A portion of today's earnings call. As many of you know, today's a busy day for us here in Redmond, as we have PDC going on here. I'd encourage you, if you haven't, to look into the replays of the keynotes that we've done at PDC. We also look forward to seeing many of you at a number of call conferences we'll be participating in this quarter. For those who of you are unable to attend in person, you'll be able to follow our comments at microsoft.com/investor. Please contact us if you need any additional details. Thanks, again for joining us today and take care.

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