Microsoft Corporation's (MSFT) fourth quarter earnings topped the Zacks Consensus Estimate although revenues were just short. Non-GAAP earnings including revenue deferrals related to the Windows 8 upgrade of $540 million and excluding goodwill impairment of $6.2 billion resulted in earnings of 74 cents, which exceeded the Zacks Consensus by 11 cents, or 17.5%. Revenue

Revenue excluding deferrals of $18.05 billion was up 3.7% sequentially and 4.0% from last year, exceeding estimates by 0.4%. All except the Windows segment contributed to the increases in the last quarter, although Server & Tools and Entertainment & Devices were particularly strong. The softness in Windows was not surprising, since customers were expected to delay purchases ahead of the Windows 8 launch.

Segment Specifics

The Windows and Windows Live Segment generated 23% of Microsoft's quarterly revenue, down 10.4% sequentially and 12.6% year over year. Management stated that the promo upgrade offer for qualifying Windows 7 PCs pushed out $540 million in revenues. Management estimates that total PC unit growth was flat, with business PCs increasing 1% and consumer PCs declining 2%.

Enterprise was again very strong and Windows 7 is now in 50% of desktops, up from 40% at the end of the last quarter. Management also stated that volume licensing again grew double-digits. Microsoft attributed the softness in consumer to PC market issues in developed countries, as offset by higher attach rates.

There was no alleviation in pressure from tablets, particularly Apple's (AAPL) iPad. However, attach rates declined 1% on an overall basis, helping  the decline in OEM sales.  

The Microsoft Business Division, which generated 35% of revenue, grew 8.2% sequentially and 7.0% from last year. Deployment of Office 2010 continued to gain momentum, with the annuity side of the business remaining the major driver of the increase from last year (up roughly 12%), helped by increase in transaction-based sales of around 2%. Microsoft stated that other products such as SharePoint, Exchange and Lync remained strong.

Microsoft's success with CRM could give Salesforce.com (CRM) something to worry about. In the last quarter, Dynamics CRM grew over 25%, with customers touching 36,000 and users touching 2.7 million. The acquisition of Yammer closed, with the best-in-class enterprise social networking expected to boost its cloud offerings.

The Server & Tools segment, at 28% of total revenue, was up 11.4% sequentially and 12.7% year over year. Microsoft's multi-year licensing revenue grew more than 20% year over year, with SQL server up 20% and SQL premium up over 30%. Windows Server Premium grew double-digits and System Center around 20%.

Microsoft also remains optimistic about Azure. Overall trends indicate continuing strength in the enterprise (enterprise services were also up 15%). 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, up 10.1% sequentially and 19.4% year over year. The segment is finally showing signs of sustainable improvement.

Despite the market weakness that contributed to the 39% decline in Xbox units, Microsoft increased market share during the quarter from 42% to 47%. It also added new partners to Xbox LIVE, where memberships grew 15%. The newly introduced SmartGlass will help connect phones, PCs and tablets to Xbox, which is expected to attract more users to the platform.

Windows Phone units increased more than 50% sequentially, with apps on the platform touching 100,000. Microsoft also said that Windows Phone 8 was around the corner.

Skype, acquired from eBay Inc (EBAY) in 2010 had minutes touching 115 billion, up 50% from last year.

The Online Services business, or online advertising, generated 4% of revenue, up 4.0% sequentially and 8.1% year over year. We think that 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. (up 120 basis points year over year).

The partnership with Yahoo Inc (YHOO) remains on track, with increasing ROI for advertisers. But monetization remains below expectations. The company wrote down goodwill on the aQuantive acquisition in the last quarter.

Operating Results

Microsoft's gross margin of 76.9% dropped 35 basis points (bps) sequentially and 170 bps year over year. The gross margin is closely related to the mix, since margins on hardware and software products differ widely.

The significant decline from the year-ago quarter was mainly on account of payments made to Nokia (NOK) with respect to joint strategic initiatives, the inclusion of Skype and higher headcount expenses.  The search agreement with Yahoo also remains, raising online services and traffic acquisition costs.

Operating expenses of $7.51 billion were down 6.1% sequentially and up 0.3% year over year. The operating margin of 35.4% dropped 126 bps sequentially and 18 bps from last year. S&M expenses increased 132 bps sequentially as a percentage of sales, with both R&D and G&A declining. However, lower S&M and G&A offset higher R&D in the year-ago quarter.

The operating margin by segment was as follows - Windows 57.8% (a sequential decline of 601 bps), Microsoft Business Division 65.2% (up 33 bps), Server & Tools 41.1% (up 313 bps) and Entertainment & Devices -14.8% (down 61 bps). The Online Services business continues to generate a loss.

The company generated a pro forma net income (excluding deferrals and goodwill impairment) of $5.7 billion, or 31.6% net income margin compared to $5.1 billion, or 29.3% in the previous quarter and $5.9 billion, or 33.8% in the year-ago quarter. Including goodwill impairment charges, the GAAP EPS was a loss of 6 cents compared to income of 60 cents in the March 2012 quarter and 69 cents in the June quarter of 2011.

Balance Sheet

Inventories were down 19.5%, which raised inventory turns from 11.2X to 14.6X. Days sales outstanding (DSOs) went to 80, up from 57 at the end of the March quarter.

Microsoft ended with a cash and short term investments balance of $63.0 billion, up $3.5 billion during the quarter. The net cash position was around $6.23 a share, up from $5.67 a share at the beginning of the quarter. In the last quarter, the company generated $7.67 billion in cash flow from operations, spent $1.03 billion on share repurchases, $1.68 billion on dividends, $526 million on acquisitions and $622 million on capital assets.

Guidance   

Microsoft maintained its 2013 opex expectations of a 6% increase to $30.3 to 30.9 billion.

Key Takeaways

Microsoft had a more or less regular quarter, with Windows revenue impacted by purchase deferrals and S&T and Business Division seeing good growth. Windows Phone numbers are encouraging, although the growth is off a small base. However, it is significant that the company was able to grow share in the gaming segment, considering the condition of the market and we think the platform approach here is the way to go.

Of course, we recognize the danger of tablets that are still largely based on iOS or Android, since these devices are eating into its netbook sales. We expect this phenomenon to continue because of the popularity that iOS and Android-based devices have already encountered. We think this will take time to overcome and we therefore have a long term Neutral recommendation on the stock.

We expect the jump in Windows 8 to be tempered by dynamics in the PC market and therefore think the shares will not gain much. We have a Zacks Rank of #3 on the shares, which implies a Hold recommendation in the short-term (1-3 months).

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Tickers in this Article: MSFT, YHOO, AAPL, CRM, NOK

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