Microsoft Corporation
Q3 2006 Earnings Call Transcript

Published: 28 Apr 2006

[Operator:]

Good afternoon, and welcome to the Microsoft 2006 fiscal year third quarter earnings conference call. (Operator Instructions) I would now like to turn the conference over to Ms. Colleen Healy, General Manager, Investor Relations. Please go ahead.

[Colleen Healy:]

Good afternoon, everyone, and thank you for joining us today. This afternoon, I'm joined by Chris Liddell, Senior Vice President and Chief Financial Officer, and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the third quarter of fiscal year 2006 and an overview of expectations for Q4. I will then provide detail around our third quarter results and then turn it back to Chris for a more detailed discussion of our guidance for the fourth quarter and a preliminary look at our current expectations for fiscal year '07. After that, we will take your questions. We filed our 10-Q today in conjunction with our earnings release. Therefore, you have available the earnings release, MD&A, 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 10-Q and the quarterly financial summary slide deck on the investor relations website at www.microsoft.com/msft. Today's call is being 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 webcast of today's call at the Microsoft investor relations website. A replay of the call will be available at the same site through the close of business on April 27, 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 or transmission of the text or audio of today's 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 risks uncertainties. Actual results could differ materially, because of factors discussed in today's earnings press release and the comments made during this conference call and in the management's discussion and analysis section of our 10-Q, our 2005 Form 10-K and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. With that, please flip to slide 4, where Chris will begin his comments. Chris.

[Chris Liddell:]

Thanks, Colleen and good afternoon, everyone. Thanks for taking the time to join us for today's call. I'm going to begin with the key points from our third quarter's performance and then take a look at quarter four and fiscal 2007. During the quarter, revenue growth accelerated to 13% from 9% in quarter two and 6% in quarter one. We had good market momentum of recently launched products, which remained strong, and we continued our execution on returning cash to shareholders. Our operating income was, however, lower than we had guided in the quarter, which can be attributed in the following order to

[Colleen Healy:]

Thanks, Chris. As Chris mentioned, the accelerating revenue growth thus far in fiscal year '06 resulted in 13% growth during the quarter, which was driven by customer demand for our new products as well as healthy PC and server hardware sales. Specifically during the quarter, revenue was $10.9 billion, consistent with guidance entering the quarter. Operating income was $3.9 billion, which includes $397 million of legal charges and was lower than our guidance. Earnings per share were $0.29, which includes $0.03 for legal charges. And we returned over $5.8 billion to shareholders through stock repurchases and dividends. I will highlight drivers of the strong revenue performance during the quarter, as well as outline the areas of incremental costs and investments. I will start by discussing top line financial and business momentum points, and I will follow up with revenue performance for each of the business groups. Then I will discuss operating expenses, and I will wrap up with an overview of operating income performance, as well as balance sheet and cash flow information. All growth comparisons I mention relate to the comparable quarter of last year, unless otherwise specified. Revenue growth this quarter was driven by strong business and consumer market momentum for our new products. Server & Tools had yet another outstanding quarter, growing over 16%. Home & Entertainment grew 85% as Xbox sales more than doubled. MED and MBS grew 46% and 21%, respectively, on robust demand for our Windows Mobile and Microsoft Dynamics product lines. Taken together, these four businesses grew revenue 29% and delivered roughly 75% of our absolute revenue growth for the quarter. We were also very pleased with the continued strength in PC shipments for the quarter, which resulted in Client revenue growth of 8%. The IT spending environment was largely in line with our expectations. As mentioned, PC hardware and server market growth remains robust. Demand was generally healthy across all customer segments, and from a regional perspective, EMEA and emerging markets continue to be relatively strong. We estimate PC market growth during the quarter at 12% to 13%, which was in line with our expectations three months ago. Consistent with the past several quarters, consumer PC shipment growth outpaced business shipments, and emerging market growth continued to significantly outpaced mature markets. PC unit demand was broad-based regionally, with double-digit growth rates in all geographies except for North America and Japan. Our mix of product billings for the quarter was around 35% for OEMs, 27% for multi-year licensing agreements, 20% from license-only sales and the balance from our other businesses. This mix is different from the prior year, as a result of strong growth in our Home & Entertainment business and a shift from license only to multi-year licensing agreements. We had good results overall from a volume licensing perspective, with strong renewals on enterprise agreements. In addition, select and open annuity results for the quarter were very strong relative to non-annuity licensing. As a result of these robust annuity licensing results, our unearned revenue balance ended the quarter at $8.9 billion, which was a little higher than we had anticipated, and up 12% over the same period in prior year. Our contracted not billed balance at the end of March was lower sequentially and continued to exceed $9 billion. Taking into account our reported revenue and changes in the unearned and contracted not billed balances, you will find that our bookings growth for the quarter approached 15% overall and in excess of 10% for our core businesses of Client, Information Worker and Server & Tools. Now, let's work our way through the P&L. Revenue growth for the quarter was negatively impacted by 1 percentage point due to foreign exchange rates. Breaking this down by business segment, Client revenue grew 8%, driven by OEM revenue growth of 10%, offset by a 6% decline in commercial and retail licensing. The OEM revenue growth resulted from 16% license unit growth. As you have seen in previous quarters, the difference between OEM license unit growth and revenue growth is caused primarily by three factors

[Chris Liddell:]

Thanks, Colleen. So, I am going to spend my remaining time on the call giving you a view of what we are expecting for the fourth quarter, followed by a preliminary snapshot of fiscal 2007. Please keep in mind that all of our growth figures that I will be using reflect year-over-year growth to the comparable period, unless otherwise noted. Before giving specific financial guidance, let me outline some of the key assumptions that we've used for the fourth quarter. We estimate that for the fourth quarter, PC unit growth should be 10% to 11%. Our expectations for growth in the total server hardware market remain unchanged at 11% to 13% for the full fiscal year, and we're assuming that changes in foreign exchange rates will not have a major impact on our year-over-year growth rates in our forecast. Also, we continue to expect overall IT spending and our ability to participate in the marketplace to remain healthy. So for some detailed guidance, we expect fourth quarter revenue of $11.5 billion to $11.7 billion, representing year-over-year growth of 13% to 15%. Revenue by business group is as follows. For Client, we expect revenue growth of 7% to 8% for the fourth quarter. We expect OEM units to grow roughly in line with the market, and we expect commercial and retail business growth to lag overall growth. In Server & Tools, we're raising our expected revenue growth to 17% to 18% for the fourth quarter. We expect that the strong customer acceptance of SQL Server in the last two quarters will continue in the fourth quarter. Information Worker revenue should grow 5% to 6% for the fourth quarter. We expect the increased annuity mix in our billings to continue as we move closer to the launch of Office 2007. And we will continue to look forward to releasing a broad public beta of Office 2007 this spring. For Microsoft Business Solutions, we expect revenue growth to be between 11% and 13% for the fourth quarter. Our new Dynamics products have been met with great customer and partner enthusiasm, and we look forward to carrying that momentum into Q4 and beyond. Our new Dynamics branding campaign started in March and should provide good momentum going forward. For MSN, we're expecting revenue to decline 4% to 5% for the fourth quarter. This reflects continued decreases in our access business, continued transition to Ad Center for delivering our paid search results, offset by growth in display revenue. Mobile & Embedded Devices revenue should grow between 15% and 25% for the fourth quarter, driven by the availability of new devices based on Windows Mobile 5.0. Home & Entertainment revenue is expected to grow 85% to 110% for the fourth quarter. This reflects a reduction in the implied revenue guidance we gave you in January, due primarily to lower expectations for the Xbox 1 business. We continue to see very strong demand for Xbox 360 consoles, and we are making good progress in our ability to supply that demand. Because of this increased optimism and strong console shipments in Q3, we are tightening our previously announced fiscal year shipment guidance of 4.5 to 5.5 million consoles to the top end of that range, to 5.0 million to 5.5 million consoles. Given the growing mix shift to annuity billings in front of key product launches in fiscal year '07, we are increasing our unearned guidance, and now expect unearned revenue to finish the year up 10% to 12%, up 2 percentage points from where we guided in January. We continue to estimate that our contracted not billed balance will finish the year above $9 billion. So when you combine our overall revenue growth within the net increase in unearned and contracted not billed, you'll see that we are delivering strong year-over-year booking performance for the Company in fiscal 2006. Operating income should be between $4 billion and $4.2 billion, representing 34% to 40% growth over the prior year, or 7% to 11% growth if you exclude legal charges of $756 million taken in that year-ago quarter. For fully-diluted earnings per share, we expect $0.30 per share for the fourth quarter, and expect to have an effective tax rate of 31% for quarter four. So with quarter four guidance, we arrive at the following expectations for the full fiscal year 2006

[Colleen Healy:]

Let's now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi-part questions and limit yourself to just one question. Operator, will you please repeat the instructions?

[Operator:]

(Operator Instructions) Our first question is from Steve Mahedy, Banc of America Securities.

[Steve Mahedy:]

My question would be relative to fiscal year '07 guidance. You mentioned the moderation in the PC and server markets. Could you just give us a little detail on how you formulated the growth rates that you're assuming? And then also a tighter range on topline revenue relative to bottom-line; is there some flexibility on your spending during the course of the year, which perhaps would put us at the higher end of the EPS range?

[Chris Liddell:]

In terms of PC market, we don't give out numbers at this stage, obviously. We have seen a moderation in the PC unit growth rate through the course of this year, so we were seeing 15% to 17% or thereabouts in quarter one, and it came down to 14% to 15% then 12% to 13%; and in the fourth quarter, as I just mentioned, we're talking about 10% to 11%. So we have seen it come off, if you like, strong mid double digits to just about double-digit rates. So we're not expecting the trend to significantly weaken from that, but we expect that moderating number that would come out of the year to be more like what we expect for next year. So that's the basis of our expectations going into the new year. In terms of the tightening of the range, to some extent it is influenced, clearly, by things like Xbox, where we could have quite a big sales variation, but not necessarily a big operating income variation, to the extent that the contribution from that business will not be as significant driving down to operating income. So that's one of the reasons why you're seeing that variation. In terms of could we see expenses there being at the top end of the range, absolutely. Those are some of the decisions that we will have to make during the course of the year and as we round out our budgeting cycle going into the fiscal year.

[Steve Mahedy:]

You mentioned the PC moderation is clear and you can see the correlation there. However, in contrast, in the moderating server market, it still looks like you continue to see strong results there, given the product cycle. Is there a little bit of a detachment relative to what's happening in the server market, given your ability to gain more share there?

[Chris Liddell:]

Again, it's quite a different trend, in terms of our sales relative to the server market. This is our sales relative to the PC market. So there's a lot of moving parts in the PC market. For example, our progress on piracy, the mix shift between consumer and business, and then the other moving part is our commercial and retail sales. So all of those go into our expectation of Client revenue growth relative to PC growth. In the server market, we tend to expect our sales of underlying Windows Server to follow more closely the market. And then we have been able to and we certainly would hope to expect to be able to pick up market share in things like SQL Server.

[Colleen Healy:]

We have been pretty consistent throughout the fiscal year thus far, expecting 11% to 13% hardware growth. The numbers directionally that we have given you for fiscal year '07, we feel, are right and it looks like in terms of third-party data, we're pretty much in line.

[Operator:]

Our next question comes from Charlie DiBona, Sanford Bernstein.

[Charlie DiBona:]

I was wondering if we could maybe talk a little bit about the margin structure and some of the add-backs for this quarter? In the legal expense add back for this quarter, are you adding back a reserve you might have taken related to the European EUR2 million a day fine? And is there any build-in for that fine into your guidance?

[Chris Liddell:]

We don't specifically comment on individual ones, but if I can put it this way, there's no change from our previous position. So there's nothing inside the legal reserve as a result of a change.

[Charlie DiBona:]

There is nothing inside the legal --

[Chris Liddell:]

You asked whether there is anything in the legal reserve that results in a potential fine. All I'm saying is there's nothing in there -- there's no delta in that figure. I cannot comment on whether we had it in originally, because we don't give that level of detail out. But to the extent we did or didn't, it hasn't changed.

[Charlie DiBona:]

So your guidance for next year -- does it include reserving EUR2 million a day?

[Chris Liddell:]

Same comment -- there's no change in our previous assumption.

[Charlie DiBona:]

So absent that, you see pretty substantial margin compression for next year, yet you have been talking about pulling forward expenses for Vista into the last couple of quarters and certainly into Q4 here. How do you reconcile those two things? It seems like you're spending fairly aggressively -- very aggressively -- through next year and not seeing leverage to your revenue acceleration.

[Chris Liddell:]

At this stage, as you know, we're not giving business-by-business shape, so your comment is correct at the Company level. I will point back to some of our prepared remarks. Clearly, we have decided to aggressively invest in this next year in a number of areas, and they do add up. Broadly, across the areas of marketing to launch new product, so clearly with Vista and Office 2007 coming, we will be spending in that area to ensure the success of that, building on some of the other businesses in the area. So Xbox 360, we still see a big year in fiscal year '07 for that. IPTV will launch. We will have some marketing spend associated with that. Windows Mobile, we think, will potentially have a big year next year. Dynamics branding and then overall corporate advertising -- some of the work that you've seen. So that's in the new products area. In terms of new opportunities, things that we are building which will be revenue-generating beyond fiscal year '07 -- the areas, again, that I talked about in prepared -- communications, collaboration, security and management, high-performance computing and also some of acquisitions we are doing. Lastly, and we have foreshadowed this previously, the services strategy and, in particular, MSN is an area that we expect to invest aggressively next year. So you are correct. The net result of all of that, as we are guiding, will mean that we will not see an accompanying level of operating income growth equal to revenue growth. But we will still see, in our view, extremely good revenue growth. The combination of this year and next fiscal year with our guidance adds up to $10 billion to $11 billion of revenue growth. So in our view, we are investing. We appreciate we're investing aggressively relative to some of your models, but we believe it's the right thing to do, to drive what we think is extremely good growth going forward.

[Operator:]

Our next question comes from Adam Holt, JP Morgan.

[Adam Holt:]

Another question on the margins, if I could. Understanding you're not giving quarterly guidance, is it safe to assume the head count adds and a lot of the marketing expenditure is going to be front-end loaded for next year? Secondly, are you making any assumptions around any kind of customer incentives during the holiday season to maybe give consumers that buy PCs Vista upgrade rights?

[Chris Liddell:]

Sorry, I will have to give you the blanket answer that we're not going to give a lot of details about the shape of next year. I apologize for that, but that's the sort of stance. It's hard to half answer your question without doing that. If I can talk about this fiscal year, where we are giving some numbers out, clearly, we have front-ended, if you like, some of the hiring associated with some of the product development that we see in future years. I'm certainly comfortable saying that; you can see that in our head count numbers. I will comment on the positive aspect of that. There has certainly been a lot of commentary in the time that I've been at the Company about retention of people. What we are finding is we are having an extremely good time and being extremely successful in the market in hiring the people that we want. So the good news from my point of view is whilst it's a front-end cost, it's a good sign from an employment point of view. In terms of the second half of your question, about tech guarantees, we're not commenting on that. Clearly, we will look at the shape of previous releases in terms of what is a sensible thing to do for our customers and partners as we get closer to the release. But with that being nine-odd months away, we are really not commenting at this stage on exactly what we might do or when we might do it.

[Operator:]

Our next question comes from Heather Bellini, UBS.

[Heather Bellini:]

Not to beat a dead horse here, but looking at the operating margin, is this a change in the strategy for the Company where, over the next few years, we might see revenue accelerate from these new product launches that you have talked about, but that the Company is willing to sacrifice earnings growth? I'm not just talking about fiscal year '07, but a change in strategy where you are just going to keep reinvesting back, where earnings growth is going to be below revenue growth and you're not going to get the type of margin leverage that I think people expected when the CFOs of all the different business units were put into place?

[Chris Liddell:]

I can't give you specifics of the directional guidance for '08 and '09. I think we will talk more at the financial analyst meeting about our strategy and how that might play out. Again, if I can just talk to what we have put out today, clearly, from our point of view, we have made a strategic decision with respect to next year that, given the set of opportunities and the revenue growth potential that we see, we're willing to make that trade-off next year, and we've been willing to make the trade-off not only next year but to get ahead of it, if you like, in the third and fourth quarter as well. So you are correct in that sense. I don't want to say or extrapolate at this stage and say you can necessarily expect that in fiscal year '08 and '09. We will talk more strategically when we get together and talk about strategy in July.

[Operator:]

Our next question comes from Rick Sherlund, Goldman Sachs.

[Rick Sherlund:]

Chris, as I look at next year, the revenues look good. So I think that we collectively as analysts, have captured the opportunity for Vista okay on the revenue side. But the expenses, I've got to tell you, we're not that bad in forecasting expenses. Your expenses are about $2.4 billion more than I have estimated. I don't know if you are just not ready to talk yet about the online businesses that you're building, but I don't think Xbox mix makes that big a difference in my model. I don't think spending a couple hundred million dollars more launching products makes that big a difference. There's something like really big here that I'm not sure we have quite put our fingers on yet, but it sounds like you are building a Google or building a Yahoo! inside the Company. Ray Ozzie in this Fortune article said, this is real expensive. It's going to cost billions of dollars. I didn't know it was going to cost a couple billion dollars in '07, but that's what looks like to me. It looks more like you are kind of really ramping up your online business and the decisions been to take a lot of the benefits of the product cycle that we're going to get next year and just plow that right back into the business to kind of gear up for battle in the online market. I'm just not sure if I'm missing something, but that's the way it comes across to me.

[Chris Liddell:]

I'm certainly happy to address that. In terms of your $2.4 billion, I probably wouldn't get to the same number as that -- I don't, obviously, have visibility into your model, but relative to the starting base of fiscal year '06. I would characterize it as being a broad-based approach across multiple fronts. I don't think there's any Trojan Horse there that we haven't talked about that is sitting below the surface that we don't want to talk about. I would say, to the extent there's a difference between your expectations of where we are coming in, I would list the sort of 12 to 15 things that I mentioned before, and we would be accelerating the pace in virtually all of those, relative to, possibly, your expectations. So there are some big numbers there; that is certainly true. And there's certainly some big potential spending and opportunities that we foresee in the MSN Windows Live area. So that is certainly true. But we're not building into our guidance things that we're not talking about.

[Rick Sherlund:]

Are we going to talk more at the July analyst meeting about the online business?

[Chris Liddell:]

Absolutely. Yes, that is an absolutely key and fundamental part of our strategy going forward, so yes, you can expect to hear a lot about that.

[Rick Sherlund:]

Because there is a lot going on there. I keep hearing more about it, but we haven't really had an articulation yet of what's going on. So we should anticipate that maybe we'll have a better understanding of what's going on there at the July analyst meeting?

[Chris Liddell:]

Yes. I'm certainly happy to take that feedback, firstly. And secondly, we had foreseen that we would spend a reasonably high proportion of the time talking about that, to the extent that it's a new area, perhaps relative to some of the other ones that you have heard about previously.

[Operator:]

Our next question comes from Kash Rangan, Merrill Lynch.

[Kash Rangan:]

Just following up on Rick's question earlier, the numbers certainly look big on that incremental expense side. I'm just curious to see if a material component of that incremental spending is from stock-based compensation? Because the times when you would publicly disclose that figure, as in fiscal '05, it was running at $2.4 billion. So should we be thinking that there is another perhaps $1 billion or maybe even $0.5 billion or so of stock-based compensation that is being factored into your operating income? Because we do hear about the enormous amounts of money being paid to hire some of the super sharp programmers in the Wall Street Journal, et cetera. So is that behind your thinking, or maybe not? If you can clarify, that will be great.

[Chris Liddell:]

It's definitely not to do with increasing pay for the CFO, not from the billions, anyway. No, there's nothing that we are building in that is significant from a stock-based compensation point of view. We only disclose the numbers historically rather than forecast, but you shouldn't expect to be surprised there and anything new or substantial. Clearly, we are hiring a large number of people, so you will see the expense associated with those people. But you won't see huge fundamental shifts in our pay structure.

[Kash Rangan:]

So I guess, when you report your operating income on a segment basis, we should start to see where exactly these investments are going in and how they are tracking to the way you explained the 15 different initiatives or whatnot, right?

[Chris Liddell:]

That's correct. Yes, you will. We'll continue to try and be as transparent as possible, certainly, in retrospect.

[Operator:]

Our final question comes from Robert Breza, RBC Capital Markets.

[Robert Breza:]

Hi, thanks for taking my question. I'm wondering, Chris, can you talk a little bit about maybe how we should think about the shape of '07, just in terms of the product releases, knowing about the enterprise. Is there anything you can qualitatively tell us, look at the December quarter versus the March quarter?

[Chris Liddell:]

Sorry, you just came in and out a little bit on your question there. But I got most of it, about the shape of the year. No, I'm sorry. I have to go back to what I said before, which is we are really sticking at this stage at a yearly rate. I mean, clearly, with the launches coming for business availability in December and consumer availability in January, there's going to be some implications associated with that. We're already seeing some patterns of change, for example, in our Information Worker area. We're seeing a shift from license to annuity, and that could well be in anticipation of the benefits of Office 2007. We will have some quarterly changes, almost certainly, associated with Xbox as a result of holiday season sales. So it will be some reasonably big quarterly trends that you can expect to see. But, I'm sorry, you will have to wait until July for us to give you the visibility into that.

[Colleen Healy:]

Thank you, everybody, for your participation in today's call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our investor relations website through close of business April 27, 2007. In addition, you can hear the replay by dialing 866-454-2121, or for international calls, dial 203-369-1241. The dial-in replay will be available through the close of business May 5, 2006. Thanks again for joining us today.

[Operator:]

Thank you. This does conclude today's conference call. We thank you for your participation.