Microsoft Corporation
Q2 2006 Earnings Call Transcript

Published: 27 Jan 2006

[Operator:]

Good afternoon and welcome to the Microsoft 2006 fiscal year 2nd quarter earnings conference call. Your lines have been placed on listen-only until the question and answer session of the conference. This call is being recorded. If you have any objections, please disconnect at this time. I will now turn the call over to Miss Colleen Healey, Senior Director, Investor Relations. Please go ahead. Thanks Laura. Good afternoon everyone and thank you for joining us today. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer, Scott Di Valerio Corp. VP, Finance and Administration, and Chief Accounting Officer and John C. Todd, deputy general counsel. Today’s call will start with Chris providing some key takeaways for the second quarter of fiscal year 2006 and an overview of expectations for the rest of the fiscal year. Scott will then provide detail around our second quarter results and then turn it back to Chris for a more detailed discussion of our guidance for the third quarter and full fiscal year. After that, we’ll take your questions. We filed our 10Q today in conjunction with our earnings release. Therefore, you have available the earnings release, MDNA, financial statements and footnotes. We have also posted our quarterly financial summary slide deck which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the 10Q and the quarterly financial summary slide deck on the investor relations website at www.microsoft.com/msft. Today’s call will be recorded. Please be aware that if you decide to ask a question it will be included in both our live transmission as well as any future use of the recording. As always, shareholders and analysts can listen to a live web cast of our call at the Microsoft investor relations website. A replay of the call will be available at the same place through the close of business on January 26, 2007. This conference call report is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this report or any portion of it may result in civil and criminal penalties. Any recording or other use of or transmission of the text or audio to this call is not allowed without the express permission of Microsoft. 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 risk and uncertainty. Actual results could differ materially because of factors discussed in today’s earnings press release, in the comments made during the conference call and in the management discussion and analysis section of our 10Q or 2005 10K or other reports and filings with the securities and exchange commission. We do not take any duty to update any forward-looking statements. With that, please click to slide number four, where Chris’s comments will begin. Chris? Thank you colleen and good afternoon everyone, thanks for joining us on today’s call. I’d like to begin by highlighting the key points from our second quarter performance and take a look at the rest of fiscal year 2006. We had a very good second quarter with highlights being three extremely successful product launches, good growth in our core businesses and delivery of operating income and earnings this year in line with expectations. We have been looking forward to this quarter as we kick off the broadest multi-year product cycle in the company’s history. Looking back on quarter 2, we’re off to an excellent start. During the quarter we had significant on time and successful launches of products for both consumers and businesses. The quarter’s new product launches created a lot of justifiable excitement in the marketplace. For example, the highly anticipated XBOX 360 had a phenomenal reception by consumers. Demand for the product has been high and we look forward to increasing the console availability in the second half of the fiscal year, with the addition of our third manufacturing partner. Just as eagerly anticipated and well-received by business customers was SQL Server 2005 and Dynamic CRM 3.0. And during the quarter, we positioned ourselves well for continued momentum and setup pipeline success with two community technology preview releases of Windows Vista, the initial Beta releases of Office 12 and Exchange 12 and many Beta versions of our Window Live Update. Our core software businesses enjoyed healthy growth, driven by strong demand from corporate customers and strong PC and Server unit segments. Growth in client revenue and a robust PC environment was driven by consumer strength during the holiday season. The real highlight for the quarter was that Server Tools continues its impressive string of double digit revenue growth. SQL Server generated over 20% of year over year revenue growth during the quarter, significantly outpacing the database market and our expectations from last quarter. SQL Server 2005 is quite simply an outstanding product, meeting the needs of customers and we were delighted to have seen the faster than expected adoption at and after the launch. We were pleased to see both business solutions and mobile and embedded devices continue their recent momentum and, in both cases, achieve operating profitability t his quarter. While we do not expect them to remain consistently for the remainder of fiscal 2006, their strong revenue and profit performance reinforces their trajectory to exit emerging status sometime in fiscal 2007. Lastly, during the quarter, we continue to have momentum on returning cash to shareholders. We announced a one cent increase in our quarterly dividend, equating to a 12 _ percent increase. And we purchased 7.7 billion dollars worth of our stock, our largest ever quarterly stock buyback. Overall, we’re pleased with our performance in both Q2 and the first half of fiscal 2006. So now, I’d like to make a few points about how the rest of the fiscal year is shaping up. First, we continue to expect double-digit revenue growth for fiscal 2006, driven by sustained momentum in our core software businesses and by strong demand for the XBOX 360. Second, we will continue to invest in our businesses. As we mentioned on the last call, we are investing in our core businesses of client Information Worker and server tools for product launches. We will also continue to invest in MSN in order to bring rich and compelling services and content to our users and a world-class advertising platform to our advertisers. I’ll discuss a little bit more about the investment in MSN later in the call. We’re confident that we’re making the right investments for products in the near-term horizon as well as initiatives and products that will benefit us longer-term. And even with these investments, we expect to deliver strong double-digit earnings growth the second half of the year. So with those opening remarks, I’d like to turn the call over to Scott for more details on the quarter and then I will provide you with more details on the rest of the fiscal year. Thanks, Chris, and good afternoon everyone. As Chris mentioned, Q2 is a good quarter overall, with revenues slightly below our guidance and bottom line results largely in line with our expectations. During the quarter, revenue was a record $11.8 billion up 9% from the prior year, driven by growth in our core software businesses and home entertainment. Operating income was $4.7 billion, which is at the high end of our expectations entering the quarter and driven by operating profitability in six of our seven busy seasons. We delivered good earnings growth with earnings-per-share of $.34. When adjusted for tax-rated benefits realized in the quarter of $.01 per share, this is also at the high end of our guidance. We kicked off a significant multi-year product cycle with launches of XBOX 360, SQL Server 2005, Dynamic CRM 3.0 and a host of other products. And, lastly, we returned over $8.5 billion to shareholders in the form of stock repurchases and dividends. So while revenue is slightly below our guidance, we had a successful quarter, which I will highlight over the next several minutes. I will start by discussing topline financial and business points and will follow with the revenue performance of each of the business units. Then I’ll wrap up with an overview of operating income performance as well as balance sheet and cash flow information. All comparisons are meant to relate to the comparable quarter of last year, unless otherwise specified. Our core businesses had another good quarter. Overall revenue growth was driven by server and tools revenues which grew 14% on the strength of SQL sales and client revenue growth of 8%, driven by the strength of PC hardware shipments. Add in a good quarter by Information Worker, and our three largest businesses grew revenue by a combined 9%, representing $785 million in absolute revenue growth. Another key driver for the quart4r was the launch of XBOX 360 which drove home entertainment revenue growth of 13%. We’re also pleased with the continued momentum in our Microsoft Business Solutions and Mobile Imbedded Business units which grew 17% and 40%, respectively. The IT spending environment was also largely in line with our expectations. The clear highlights were strong demand in the enterprise and continued strength of the PC and Server harder market growth. Demand was generally healthy across all customer segments and, from a regional perspective, EMEA and the emerging markets were relatively strong. We estimate PC market growth during the quarter at 14-15%, which is stronger than we expected 3 months ago. A very strong holiday sales season resulted in consumer PC shipment growth outpacing business shipments for the third consecutive quarter. From a form factor perspective, growth in notebook PC shipments continues to outpace desktops. PC unit demand was broad-based regionally with double-digit growth rates in all geographies, except for North America and Japan and emerging market growth rates continue to significantly outpace mature markets. Our mix of product billings for the quarter was generally consistent year-over-year with roughly 35% from OEMs, 25% from multi-year licensing agreements, 20% from license-only sales and the balance from our other businesses. We had good results, overall, from a volume licensing perspective with the strongest growth in enterprise agreements, where our renewal experience remains within our historical range of 65-70%. Select and open annuity results for the quarter are also very good, relative to non-annuity licensing. Our unearned revenue balance ended the quarter where we expected it, at $8.8 billion, up slightly from the prior quarter and represents an 11% increase over the prior year. The sequential change in unearned balance was impacted by the relatively small amount of multi-year contract value that was up for renewal during the quarter, relative to prior year amounts. Our contracted, not billed balance at the end of December was up sequentially and now exceeds $9 billion. Before I get into the revenue details for each business group, I’d like to point out that the foreign exchange rate impact on revenue was not meaningful to our overall revenue growth. So now, let’s move on to a discussion of revenue by business segment. Client revenue grew 8%, driven by OEM revenue growth of 10%, offset by a 2% decline in commercial and retail licensing. The OEM revenue growth resulted from 15% license unit growth. The different between OEM licensing growth and revenue growth is caused primarily by a shift in channel mix toward larger OEMs with volume pricing, growing volume in emerging markets, and the relative strength of the consumer segment of the PC market, which results in higher volumes of Windows XP Home Edition and Media Center Edition, relative to total units sold. As we discussed last quarter and consistent with the relative strength of the consumer segment of the market, we continue to see a change within the sales mix of our premium edition operating systems, licensed to OEMs. Our OEM premium mix is up 2 percentage points from the prior year, at 49%. A larger percentage of premium edition sales were made to consumers purchasing Windows Media Center, which carries a lower priced premium relatively to Windows Professional. All in all, we were pleased to see the significant market traction and continued growth for Windows Media Center edition, which has sold over 6.5 million licenses to date. Server Tools continue to deliver double-digit revenue growth for the company, reflecting broad adoption of Windows Server System products and an exceptionally strong SQL Server 2005 product launch. SQL Server 2005 provides a data management and analysis platform that enables organizations to reliably manage mission-critical information entered in complex business applications. Its business intelligence capabilities enable companies to gain greater insights from their business information. The value proposition of the product is outstanding and we’re delighted to see that many customers agree. Revenue for the quarter was $2.9 billion, a 14% increase over the prior year. Continued share gains in the enterprise resulted in SQL Server revenue growth in excess of 20%. During the quarter, we also successfully launched digital studio 2005, BizTalk Server 2006, and Windows Server 2003R2, adding to our already strong product lineup. Our enterprise services businesses also continued to show solid progress, with revenue growth of 17%. Information Worker revenue was in line with our expectations, growth 5% to $3 billion. Revenue growth related to volume licensing and pre-installed versions of Office in Japan were strong. This quarter we experienced an increased annuity mix in our overall billings, which we attribute to customers desiring to acquire both Office 2003 and Office 12 upon its release later this calendar year. During the quarter, we also released a preview of Office 5, our future services offering targeting small businesses as well as the technical data of Office 12, which garnered positive reviews from the industry. MBS revenue was $242 million, which was higher than our expectations and up 17% from the prior year, driven by the early release of Microsoft Dynamics CRM 3.0 and strong results in EMEA. As a result of the strong revenue growth, we were pleased to see MBS achieve operating profitability in the quarter. We also shipped new versions of Dynamics GP 9.0 and Dynamics SL 6.5 during the quarter. MSN revenue was $593 million, down 2%, driven by advertising growth of 12%, offset by an expected decline of 33% in narrow-band access revenue. We are pleased with the display advertising, which grew in excess of 20% for the quarter. We improved display advertising pricing and increased our inventory while increasing the number of users of our services. Active Hotmail accounts grew to 230 million, compared to 191 million in the prior year. And, active Messenger accounts grew to 205 million, compared to the 156 million of the prior year. As you know, we’re in the middle of a transition in search advertising business, moving from Yahoo’s platform to our own proprietary platform called MSN Ad Center, which we began testing in the US during the quarter. The ramp-up of a new ad platform requires significant investment from Microsoft, both in development costs as well as in reduced revenues related to fewer numbers of overall advertisers and resulting lower key word pricing. The good news is that response to our platform has been great and we are ramping up deployment by rapidly envoying advertisers and moving more search traffic to the platform. On algorithmic search, we are continuing to grow query volume, improving relevance and are investing in several search verticals. We have recently launched mapping, the birds-eye flyover mapping service and are soon to launch news and images. We continue to invest in search for long term and believe there’s lots of innovation yet to come. The decline in our narrow-band access revenue is in line with our expectations as customers continue to move on to broadband. MBD revenue for the quarter grew 40% on broad strength across the Windows Imbedded and Windows Mobile product lines as we continue to capitalize on growing market demand for connected devices. Windows Mobile licenses for connected phone-enabled devices grew in excess of 70% from the prior year. Windows Imbedded product growth of 64% was driven by the increasing use of Windows CE and Windows XP Imbedded in a wide range of smart devices such as point of sale terminals and thin clients. As a result of the strong revenue in the quarter, MBD also achieved it its first quarter of operating profitability. Home and entertainment revenue growth for the quarter was 13%, driven by the XBOX 360 launch and solid growth of our consumer hardware and PC games product lines. During the second quarter, XOB 360 achieved an unprecedented video game console launch, and we are thrilled with the results. We were first to market in 19 countries with XBOX 360 and have garnered record software attach rates, indicative of the strength of our games portfolio. On XBOX Live, we continue to lead the way in online gaming. Whereas, on XBOX Version 1, about one in ten customers are connected to the XBOX Live service, on XBOX 360 more than half of all consoles are connected. We’re off to a strong, early start with all these factors and coupled with the continuing uncertainty of our competitors entering the next generation, we are right where we want to be. Demand for XBOX 360 consoles has been incredibly strong and feedback on the platform has been incredibly positive. Our previous challenge in the quarter was meeting the high consumer demand for the console. We sold 1.5 million XBOX 360 consoles in the 2nd quarter, with 900,000 consoles in North America, 500,000 consoles in Europe and the remainder in Japan. This is lower than we expected due to component charges stemming from challenges in ramping supply of a complex product like XBOX 360. We believe that this is a short-term manufacturing challenge and we have taken steps to increase supply to meet the strong consumer demand for the console. A key indicator of platform health is the attach rate for games and accessories. According to NPD, software attach for the XBOX 360 in the US was more than 4 per console and accessory attach was more than 3 per console for the quarter. Both are records with consumers purchasing nearly double the amount relative to any other console launch in history. The software results, in particular, highlight that we have launched XBOX 360 with an incredibly strong lineup of games. XBOX Live continues to lead the way in defining online entertainment and is regarded as the standard by which all other online gaming services will be measured. Since the launch of XBOX 360, XBOX Live members have downloaded over 4 million pieces of high definition games, music and movie content from the XBOX Live marketplace. Lastly, our XBOX Version 1 platform remains a great value to consumers. We sold over 2.2 million XBOX 1 consoles in the first half of the fiscal year, bringing the installed base to over 24 million worldwide, with 16 million in North America and 6 million in Europe. All the demand for XBOX 1 consoles and software sales was negatively impacted by the momentum and excitement surrounding the XBOX 360 launch. Now for the rest of the income statement and balance sheet. While revenue increased 9%, cost of revenue increased 19%. This increase was due to costs primarily associated with the XBOX 360 console volumes. The remainder of operating expenses increased about $750 million or 18%. As we discussed in the past, we are investing aggressively in our businesses to satisfy customers and to compete and win in the marketplace. Investments this quarter were focused around the following areas