Microsoft Starts To Feel the Pain

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Microsoft Corporation’s (MSFT) fiscal fourth-quarter earnings of 59 cents missed the Zacks Consensus Estimate by 15 cents, or 20.3%. This was significantly worse than the 6.1% average positive surprise in the preceding four quarters and driven by a dismal performance in the Windows segment. Shares lost 6.3% in extended trading.

Revenue

Revenue of $19.89 billion was down 2.9% sequentially and up 10.2% from last year, missing our estimates by 4.0%. All segments grew from the year-ago quarter. Server & Tools and Microsoft Business Division also grew on a sequential basis.

Segment Specifics

The Client (Windows) Segment generated 22% of Microsoft’s quarterly revenue, down 22.7% sequentially, but remaining 6.4% higher than the year-ago level. Microsoft’s weakness in the last quarter was the result of pullback at OEMs as the traditional x86 market continued to shrink. Microsoft maintains that most of the weakness was on the consumer side, which the company is trying to address with better promotions and better distribution such as the agreement with Best Buy (BBY). The enterprise side, which has always been stronger for the company saw modest improvement with roughly 75% of enterprise desktops on Windows 7. Here too, Microsoft’s core market is shrinking as PCs give way to mobile computing and bring-your-own-device (“BYOD”) adoption accelerates. Non-OEM revenue grew 22%, driven by volume licensing (up double-digits) and promotions.

The Microsoft Business Division, which generated 36% of revenue, grew 14.1% sequentially and 14.7% from last year. The business side grew 7%, of which multi-year licensing grew 10%. The consumer side dropped 27%, as adoption of the subscription model remained strong. The benefit was however partially offset by weakness at x86 computing. The new Office 365, which incorporates touch, social and mobile aspects and SkyDrive and can be used to access files across devices is picking up strongly. Microsoft stated that revenue from other products, such as SharePoint, Exchange and Lync increased double-digits.

The Server & Tools segment, at 28% of total revenue, was up 9.2% sequentially and 8.1% year over year. Product and enterprise services revenue grew 9% each, with bookings also up double-digits from the year-ago quarter. System Center grew 14% and Microsoft assured that Hyper-V continued to take market share. SQL server revenue grew 16%. Overall trends indicate continuing strength in the enterprise. Virtualization and cloud computing are proving to be very beneficial for Microsoft’s S&T business.

Microsoft generated 10% of revenue from the Entertainment & Devices segment, down 24.3% sequentially and up 7.6% year over year. The weakness is in Xbox 360, of which the company sold a million units during the quarter (down 100K from the year-ago quarter). Xbox Live did better however, with transaction revenues on growing 20%. The increase from the year-ago quarter was because of higher sales of Windows Phones and Windows phone licences. Microsoft’s startegy is leading to Windows phones across all carriers in the U.S. and at multiple price points, which is helping revenues. Skype, acquired from eBay Inc (EBAY) in 2010 had minutes touching 162 billion, up 41% from last year.

The Online Services business, or online advertising, generated over 4% of revenue, down 3.4% sequentially but up 9.4% year over year. Microsoft is investing in technology and innovation and it is this work that is improving user experience and helping Bing take some share in the U.S. Advertising revenues grew 11% from last year.

Operating Results

Microsoft’s gross margin of 71.8% dropped 479 basis points (bps) sequentially and 510 bps year over year. The gross margin is closely related to the mix, since margins on hardware and software products differ widely. However, in the last quarter, Microsoft took a $900 million charge to write down Surface RT inventory to market value. Microsoft stated that higher headcount and online infrastructure expenses were other negatives for the quarter, totally offsetting the gains stemming from lower traffic acquisition costs.

Operating expenses of $8.22 billion were up 1.6% sequentially and 9.5% from last year. On a sequential basis, R&D and S&M increased 110 bps and 273 bps, respectively as a percentage of sales with. G&A as the only positive, declining 200 bps. S&M was also up from the year-ago quarter.

The operating margin by segment was as follows—Windows 24.9% (a sequential decline of 3,574 bps), Microsoft Business Division 67.6% (up 261 bps), Server & Tools 42.3% ( up 298 bps) and Entertainment & Devices -5.7% (down 1,926 bps). The Online Services business continues to generate a loss.

The company generated a pro forma net income of $4.97 billion, or 25.0% net income margin compared to $6.06 billion, or 29.6% in the previous quarter and $5.70 billion, or 31.6% in the year-ago quarter.

Balance Sheet

Inventories were down 9.1%, which lowered inventory turns from 9.0X to 11.6X. Days sales outstanding (DSOs) went to 80, up from around 53 at the end of the Mar 2013 quarter.

Microsoft ended with a cash and short term investments balance of $77.0 billion, up $2.54 billion during the quarter. The net cash position was around $61.42 billion, up from $60.29 billion at the beginning of the quarter. In the last quarter, the company generated $5.90 billion in cash flow from operations, spent $1.35 billion to repurchase its debt, $1.04 billion on share repurchases, $1.92 billion on dividends, and $1.79 billion on capital assets.

Guidance    

Microsoft introduced 2014 opex expectations of $31.3-31.9 million, with opex growth in the next quarter in the low-teens percentage range. The tax rate for the year is expected to be 18-21%.

Key Takeaways

The extent of decline in Microsoft’s Windows segment does not bode well for the next few quarters although Microsoft’s recent restructuring and refocus could get it through these difficult times.

That said, the traditional desktop/notebook segment continues to migrate to Windows 7, which is a positive under the circumstances. Microsoft remains strong in the enterprise segment, which is again more likely to purchase traditional computers. Windows 8 is supplementing these sales by helping to build the company’s position in the mobile segment. While mobile growth is not expected to be quick or easy, Microsoft has set foot in the right direction.

Other positives include Microsoft’s growing cloud business, improving prospects for its S&T business and the subscription model for consumers in the MBD business.

Microsoft’s new touch-based devices may be expected to supplement its growth in other areas. However, competition from popular platforms by Apple (AAPL), Samsung and others makes growth particularly difficult. Its recent faux pas with Xbox One is also likely to cost the company.

Microsoft shares currently carry a Zacks Rank #4 (Sell).

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