Microsoft Corporation
Q4 2006 Earnings Call Transcript

Published: 21 Jul 2006

[Operator:]

Good afternoon and welcome to the Microsoft 2006 fiscal-year fourth-quarter earnings conference call. Your lines have been placed on listen-only until the question-and-answer session of today's conference. Please be advised this call is being recorded. If you have any objections, please disconnect at this time. I would now like to turn the call over to Colleen Healy, General Manager, Investor Relations. Please go ahead.

[Colleen Healy:]

Thank you. 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; Frank Brod, Corporate Vice President of Finance and Administration, and Chief Accounting Officer; and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the fourth quarter of fiscal year 2006 and an overview of expectations for fiscal year 2007. I will then provide details around our fourth quarter results and then turn it back to Chris for a more detailed discussion of our guidance for the full year and first quarter of fiscal 2007. After that, we will take your questions. Our earnings release includes an addendum of financial highlights, which contains more detailed information about revenue, operating expenses and other items. We have also posted our quarterly financial summary slide deck, which is intended to follow the flow of our remarks today in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance, and provides reconciliations of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the financial highlights 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 webcast of today's call at the Microsoft investor relations website. A replay of the call will be available at this same site through the close of business on July 20, 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 and 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 our 2005 Form 10-K, subsequent quarterly reports on 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. With that, let me now turn it over to Chris.

[Chris Liddell:]

Thanks, Colleen, and good afternoon, everyone. We are pleased to be with you today to share our results and talk with you about how we see fiscal 2007 shaping up. I will start today’s call with highlights from last year’s performance and then give you an overview of our expectations for next year. Let me remind you that we will discuss quarter 4 and fiscal year ’06 results on the reporting structure of seven operating segments, and we will provide fiscal year 2007 guidance under the new reporting structure of five segments. You heard directly from Frank Brod on Monday of this week, when we provided you with a preview of our new reporting structure. I would like to say that I am delighted that Frank has joined our team during the quarter as Chief Accounting Officer. He brings a wealth of knowledge to the team with his prior work experience, plus his participation in the standard-setting process at the FASB. Looking at results, fiscal year 2006 marked our return to double-digit revenue growth, with top-line growth coming within our guidance provided at our last financial analyst meeting. Revenue growth accelerated throughout the year, resulting in 11% growth over fiscal year 2005. Not only did we benefit from better-than-expected PC demand and an overall healthy tech economy, we also enjoyed strong customer acceptance of our newly launched products. Our Home and Entertainment, Server and Tools and Business Solutions groups, which all had launches during the year, turned in a combined 20% plus year-over-year revenue growth. The Home and Entertainment division made significant progress, and sold 5 million Xbox 360 consoles for the year. Second, our core businesses turned in an excellent performance with double-digit bookings growth in both the quarter and full year. Unearned revenue finished the year growing 19%, which is a tremendous performance. We saw broad-based strength from business customers for not only our core Windows, Office and server products, but also increased demand for communications products and services. Third, you will see the both Business Solutions and Mobile Embedded Devices exceeded our original revenue guidance for the year, and achieved operating profitability, which we forecast to be sustainable going forward. We are particularly pleased about hitting this missed milestone, given the change in our reporting structure, and I want to give credit in particular to the teams working on those businesses. Finally, we made substantial progress on our strategy of returning cash to shareholders during fiscal year 2006. We have purchased over $6 billion of shares since I last talked with you, and we closed the year returning over $23 billion of cash to shareholders through dividend and stock repurchases. I am very pleased to announce on the second anniversary of our $30 billion stock buyback plan that we have completed that program in half the time originally authorized. With that program now completed, our Board of Directors has authorized a $20 billion tender offer to be completed over 20 business days, starting tomorrow. They have also given authorization to repurchase up to an additional $20 billion of company stock at management's discretion. This latter authorization expires in June, 2011. Moving to fiscal 2007 guidance, the coming year brings the second major installment on our multi-year product cycles and a period of improving revenue growth for the company. Let me make a couple of key points about the year. First, we are expecting continued double-digit revenue growth. The launches of Windows Vista and Office 2007 will drive significant revenue growth in the second half of the year. Combine that with the seasonally strong entertainment and devices revenue around the holiday, and you will see a very strong revenue growth in Q2 and beyond. Second, growth in operating income in the first half of the year will lag revenue growth due to increasing mix of Xbox 360 console revenue and related costs, coupled with significant investments and preparations for the launches of our flagship products. This trend should reverse in the second half of the year, when we expect operating income will grow faster than revenues. Third, we are making some big investments in key areas of long-term growth. You are going to hear more from me today on these subjects, with additional color and detail at the financial analyst meeting next week, about how these investments will help drive future growth for the company. Fiscal 2007 is going to be an important and exciting year for us. We are very pleased with our expected top-line growth and we believe we are making the right investments for our future. In particular, our announced tender buyback combined with our expected revenue performance lays the groundwork for strong EPS growth in fiscal 2007, while still investing in innovations to drive future long-term growth. With those high-level themes for 2006 and 2007, I am going to turn the call over to Colleen now for some more details on how the 2006 fiscal year closed out.

[Colleen Healy:]

Thanks, Chris. In the interest of providing more time on today's call for Chris to discuss our fiscal year 2007 guidance, I am going to keep my remarks about our fiscal fourth quarter and fiscal 2006 performance brief. Overall, it was a strong finish to the year. Specifically, during the quarter

[Chris Liddell:]

Thanks, Colleen. I am going to spend my remaining time on the call talking about what we see coming for the full year and the first quarter, and then close with my comments with some color on today's stock buyback announcement. Before we get into specific guidance, let me outline some of our key assumptions. The fiscal 2007 forecast assumes a broad continuation in the economic conditions and demand from where we exited in 2006, and our forecast does not include any significant impacts from foreign exchange movements. We expect PC unit demand to continue to remain healthy but to moderate from the growth rates we saw in 2006, particularly in our fiscal second quarter, ahead of the launch of Windows Vista. Specifically, we expect PC unit growth for fiscal 2007 to be 8% to 10% for the year and between 9% and 11% for the first quarter. We estimate that PC unit growth rates will be higher in consumer segments than in business segments, and higher in emerging markets than in mature markets. On the server hardware front, we estimate the total market should grow 10% to 12% for the year. Let me go through some detailed guidance. For the full year, we expect our revenue to come in between $49.7 billion to $50.7 billion, growing 12% to 14%. This is in line with the guidance we gave you in April and is actually a little better on dollar terms, given our stronger finish to fiscal year 2006. Our growth is driven by broad-based revenue growth across all of our five segments. For the first quarter, we expect revenue of $10.6 billion to $10.8 billion, which represents a growth rate of 9% to 11%. There are a couple items to note when you consider our first-quarter revenue

[Colleen Healy:]

Great. 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 your instructions?

[Operator:]

Thank you. (Operator Instructions) Our first question comes from Heather Bellini with UBS.

[Heather Bellini:]

Great, thank you, good afternoon. I was wondering, Chris, if you could give us an idea what Vista release assumptions are embedded into your guidance for fiscal year ‘07 in terms of timing? Then I just have a follow-up to that, if possible.

[Chris Liddell:]

Sure, Heather. Embedded in that in Vista is the November release to business and January to consumers. On the Office side, by the end of the year for business and the beginning of next year for consumers, so it is the same base case as we have previously talked about.

[Heather Bellini:]

Okay, and I guess the granularity that I was looking for is if so many people are moving to annuity agreements as a result of Vista, as evidenced by your strong bookings growth this quarter, even if it did slip from the January consumer release out for let's just say a month or two, would it really impact your guidance that much, given that the enterprise customers have basically paid you already and you are just recognizing that revenue on a systematic basis?

[Chris Liddell:]

Yes, that is a good observation and you are correct. There will be a relatively modest impact. There will obviously be some FTP sales that we would lose if it was to be deferred. To give you a sense of order of magnitude, and obviously this depends on the shape of the year as much as anything else, but if we were to see a slip let's say of a quarter, to give you a financial magnitude, we think that would have an impact of around $200 million to $400 million. Obviously, revenue that we would like to see but not significant in the overall guidance.

[Heather Bellini:]

Okay, great. I appreciate it. Thank you.

[Colleen Healy:]

Thanks, Heather. Next question, please.

[Operator:]

Thank you. Our next question comes from Kash Rangan with Merrill Lynch.

[Kash Rangan:]

Thank you very much. Just a couple of questions. One, if you could just talk about when you expect to actually do your launch-related spending? In other words, Bill Gates I think was mentioned in the press talking about an 80% probability of release of Vista on time in January. I am wondering how you are going to be timing the actual launch activities surrounding what still seems to be sort of a moving target. Secondly, if you could give us a little bit more color on how this Dutch auction process will actually work mechanically? Not to expect too much on it, but if you could just give us a little more bit more color on how you can accomplish the range of $22.50, $24.70, that will be useful perspective as well. Thank you.

[Chris Liddell:]

In terms of spending, obviously we will time that around the launch date. As we get more and more closer to that and more certain of that, we will start to work that in. We have embedded some plans already and that is characterized inside not only our first-quarter guidance but for the year overall. Some of the decisions, we will wait until we have the absolute date locked in. At this stage, we have some flexibility around that. At this stage, it is not going to be a significant difference in [pattern] of spending, but as when we lock the date in we will certainly press the button on the total spending overall. In terms of the Dutch auction, just to go back to basics, it will open tomorrow and close on August 17th, as I mentioned. People will be able to sell or offer to sell shares inside the range that we have bid during that period. In essence, they will be able to offer a certain number of shares at price points inside the range. So X shares at Y price, X plus Z at Y, at different price points. So we will have a schedule of prices at which people are willing to sell shares. We will add up the aggregate of all of those offers and strike a price which clears the market. The price at which we can buy $20 billion of value of shares, that price is the price that we will pay to everyone who has bid whether they have bid below that or not. We will play the clearing price then to all successful sellers. It is like an auction system. It is a Dutch auction in the sense that people will bid at different price points against us, and then we will take a clearing price on the market inside the range.

[Kash Rangan:]

So the clearing price ought to be somewhere between that range you are talking about? In a best case scenario, it would be $24.70, but maybe not exactly at that level?

[Chris Liddell:]

There are $0.10 increments inside the range. It clearly could obviously be at the absolute bottom or the absolute top of the range. It does not have to be inside the range. It could be inside or equal to the range limits.

[Kash Rangan:]

Great, thank you.

[Colleen Healy:]

Thanks, Kash. Next question, please.

[Operator:]

Thank you. Our next question comes from Rick Sherlund with Goldman Sachs.

[Rick Sherlund:]

Thank you. Just to follow up on Kash's comment, for clarification, you would expect one date where you will have a clearing price, so there is only one date within that range where the transaction will take place?

[Chris Liddell:]

Yes, that is correct. That is the last day. Up until that time, people can offer to tender but we will not strike the price until the very last day, by which time all offers to sell will be collected. We strike it on, if you like, the last minute of the last day. Any offers made before that will just simply be aggregated into that timing.

[Rick Sherlund:]

Will there be an advantage to offering earlier, or would you sense that people would wait until the last couple of days to submit their offers?

[Chris Liddell:]

Well, there is no advantage from a seller's point of view because we are not legally able to buy early. We are constrained by the rules of tender, which we are obviously following totally. People can logistically get some advantage, if they want to but it is entirely up to them. We do not want to influence behavior at all. We just want to stick inside the rules but the rules specify that we cannot accept offers until the final.

[Rick Sherlund:]

Okay. On the Online Services group, the guidance for the year was revenue growth of 7% to 11%, which looks pretty encouraging. I am wondering if you can offer any insight into how much of this is coming from Windows Live, MSN? Are you assuming that MSN, when adCenter begins to gain traction, I wonder if you can just give us a little more granularity on what is behind those numbers?

[Chris Liddell:]

From a revenue growth point of view, Windows Live is not a significant contributor in fiscal year ‘07. It obviously helps to drive some traffic but we are not seeing that has a big increment in this year. That is an investment in future years. adCenter will certainly help. What you have year over year is quite different shapes, so we came out of last fiscal year with our revenue for search effectively going down as we moved off, over to and onto adCenter, through the shape of this year, we are now fully on adCenter in the U.S., and as we start to get better comparables as we go through the year, you will see much better quarter-on-quarter comparison. As we scale up adCenter, it will also help, clearly. During the course of the year you will see an improvement and that is certainly embedded in the numbers that you see. Also, obviously the Access business is still decreasing, but it is becoming less significant in terms of the decrease. We are looking forward to a good continued year on the display side and a transition year on the search side.

[Colleen Healy:]

Thanks a lot, Rick. Next question, please.

[Operator:]

Thank you. Our next question comes from Charlie DiBona with Sanford Bernstein.

[Charlie DiBona:]

I would actually like to follow up on Rick's question here around MSN, because if we look at that guidance, how should we evaluate adCenter? When can we start to see you start to turn the corner and at least track towards the overall search ad market here? We would expect obviously access to be declining and display to be sort of in line with the market. Just those two things could get you to the guidance you have here. Could you give us some more granularity on how we can evaluate your progress with adCenter?

[Chris Liddell:]

Yes, I think there is two ways, Charlie. One is, if you like, qualitative and through the year, we will share as much visibility as we can. I know Kevin and Ray are certainly intending to talk about it next week, just about some of the kind of qualitative metrics as we transition adCenter. The number of advertisers on us, for example, the general level of acceptance. That will give you some leading indicators of how we see the health of it. In terms of lagging indicators, the bottom line, you will be able to see our overall revenue growth. You will obviously be able to make some assumptions about what is happening on the display side because generally speaking, we are tracking in line with markets there. The access will be progressively less of a factor, so the delta will be the search side and you will be able to see, as the year goes on, on a quarter-by-quarter basis when you compare it both sequentially and also to the previous quarter, you will be able to see some of the adCenter impact directly from a financial output point of view.

[Colleen Healy:]

Thanks, Charlie. Next question, please.

[Operator:]

Thank you. Our next question comes from Adam Holt with JP Morgan.

[Adam Holt:]

Good afternoon. My question is about the detail on the expenses for fiscal ‘07, which was very helpful. Historically, you said that some of the Xbox ramp expenses are effectively going to be one-time in nature. Presumably, some of the marketing and launch-related costs for Vista and Office are also going to be one-time oriented. As you think about the long-term spending profile for the company, if you could detail what you view as sort of a moment-in-time set of expenses versus what we should expect to see on an ongoing basis?

[Chris Liddell:]

We have tried to give you visibility in that by talking about launch spending -- launch and marketing spending as a category. I will not describe it as entirely one-off because there are other launches that happen year by year, but we bracketed that, and that is the $450 million. In terms of Vista, Office 2007 and Xbox launch-related spending, that is in the category of 450, so that gives you some visibility as to, on a year-by-year basis, what you might consider as one-off. In terms of the other areas of spending, they are more ongoing in nature. Clearly in some of the businesses, we are building the business up so it is not necessarily continuous at that level. But they are not, if you like, one-off in nature, in particular when we are hiring R&D and salespeople who are continuous there afterwards.

[Adam Holt:]

If I could ask a follow-up on the bookings strength in the quarter, you noted that renewal rates were tracking towards the high-end of historical levels. Does that imply that renewals were primarily behind the strength in unearned in the quarter, or did you also see an up-tick in new customer billings? Thank you.

[Chris Liddell:]

It was a bit of both. Certainly the renewals was very strong, as you point out, and that was -- I think that was the majority of it, but also we saw good acceptance on the new side as well. The field did a fabulous job in the fourth quarter and really got out there. They had some visibility and some good products to sell and they took the opportunity to do a great job, both with existing and new customers.

[Adam Holt:]

Thank you very much.

[Colleen Healy:]

Thanks, Adam. Next question, please.

[Operator:]

Thank you. Our next question comes from Jason Maynard with Credit Suisse.

[Jason Maynard:]

Good afternoon. I had one follow-up question on spending for FY07. I wanted to get a little bit more color on what your expectations are around for cap-ex. Specifically, over a couple-year period, should we see a material change in terms of how you look at cap-ex as you build out data center infrastructure for a lot of your online services?

[Chris Liddell:]

Yes, cap-ex is going up, and we certainly talked about that externally. We will see an increase year over year of around $600 million to $700 million on cap-ex, but that covering cap-ex of all nature, so it is not only in the MSN area, which is probably the one that people are most interested in. It is also general facilities cap-ex. In the MSN area, year on year we are probably looking at an increase, depending on some of the decisions we are going to make, around $200 million to $300 million year on year. That is building the infrastructure that we believe is necessary for the future of the business, so we will be building capacity that we not only need next year but also starting to build capacity for future years there afterward, as well.

[Jason Maynard:]

I have one quick follow-up on Server and Tools, just to try to get a little bit more color around your expectations for Windows Server growth. Specifically, any commentary you are seeing about growth rates relative to the Linux growth rate opportunity as well.

[Chris Liddell:]

We are happy with the trends there. As I mentioned, we have grown, broadly speaking, in line with the market. We now have a product that can compete in the high-performance area so we think that is a good opportunity. Some of the spending we are looking at, some of the incremental spending that I bucketed into the growing and new areas, is targeted at the Windows Server area, in particular in some of the markets where Linux is strong. You are not necessarily going to see a benefit from that in fiscal year ‘07 for the reasons we talked about, but certainly that is an area where we think there is a fabulous opportunity for us and it is hence one of the reasons why we are investing in it.

[Jason Maynard:]

Thank you.

[Colleen Healy:]

Thank you. We may have time just for one or two other questions. Next question, please, Operator.

[Operator:]

Thank you. Our next question comes from Brendan Barnicle with Pacific Crest Securities.

[Brendan Barnicle:]

I was wondering, Chris, if you could give us any kind of breakdown in terms of your Client -- for guidance achieving -- on the benefits from China, particularly with Acer and Lenovo now standardizing on the Microsoft products.

[Chris Liddell:]

We saw good growth in OEM units relative to PC units in the quarter, and we are predicting that general trend is not necessarily to be as strong as it is out of the quarter, but going forward. It is too early to really say there is a substantial difference as a result of those contracts but our efforts aimed at anti-piracy generally we believe adds let's say 1 to 2 percentage points on our year-by-year basis -- it might move around in the quarter -- between OEM units and PC units. Clearly the price point for some of those sales is lower so it does drag down our average price, but in terms of our growth rate, it generally helps by about 1% to 2%.

[Brendan Barnicle:]

Great, thank you.

[Colleen Healy:]

Great, thanks. Next question, please, Operator.

[Operator:]

Thank you. Our next question comes from Brent Thill with Citigroup.

[Brent Thill:]

Good afternoon. Regarding MSN, how should we think about the return to profitability? Is that more of a ‘08 timeframe? If you could also just follow up regarding adCenter. You mentioned it is online now in the U.S. The rest of the world, your timing on when you expect that initiative will be fully up?

[Chris Liddell:]

In terms of MSN, it is full-on the U.S. It is in the U.K. in August. It is in France now. It is in Singapore now. We are not giving a particular schedule for when we will be 100% in the year but clearly it is in our line of sight. It is not far off that we are going to have 100% of our business anyway on adCenter. What was the other half of your question? Sorry.

[Brent Thill:]

Regarding profitability in MSN.

[Chris Liddell:]

Profitability, yes. We have said, as I said in the previous quarter, that we do not expect MSN to be profitable in this fiscal year. By definition, therefore, it is later out than that. Based on the revenue guidance that we have given and some of the expense guidance that we have given, I imagine people will be able to get some shape of what we are looking at. We see for MSN that fiscal year ‘07 will be an investment year.

[Brent Thill:]

Thank you.

[Colleen Healy:]

Thank you. We have time for one last question please, Operator.

[Operator:]

Thank you. Our final question comes from Laura Lederman with William Blair.

[Laura Lederman:]

Saved by the bell. Real quickly, can you talk about SQL Server growth? Is that going to be in line with the Server and Tools growth, or higher? You have done so great in the database market for several years. Also, when you talk about the 50,000 new users for CRM, could you talk about how much of that was hosted in the quarter versus how much was on premise? Thank you.

[Chris Liddell:]

On the SQL Server side, we are looking at 35% growth. It has been extremely successful and is growing faster than the Server and Tools business overall. I am not sure I want to put a number out for what that will look like going forward but embedded inside our guidance is what we consider to be very good growth. We still think from a price point of view, a quality point of view, it is a great product relative to its competitors -- all the reason why we have been able to achieve market share growth in the past. There is no reason to assume they are not going to continue in the future.

[Colleen Healy:]

Laura, could you repeat your hosted question? We just did not hear it.

[Laura Lederman:]

Sure. The 50,000 new users added for the CRM last quarter, can you give us a sense how much of that was hosted, how much of that was on premise? What is going on there in the mix?

[Colleen Healy:]

Yes, we are delighted with that figure, even stacking against competitors. It is a nice volume for us. It is good momentum. It really does represent the choices that we are giving customers, Laura. It is not just hosted. It is not just a license from Microsoft. As you know, currently you can buy a license from Microsoft, host it yourself. You can go to our partners -- they will host it for you. The 50,000 is inclusive of both of those. We are looking forward to being able to offer additional choice to consumers by hosting ourselves, really starting second quarter of calendar year 2007.

[Laura Lederman:]

Final question, if you look at the Business division growth of 9% to 10% for ‘07, can you talk a little bit about what you see driving that, and the components as well? Just a little bit of granularity.

[Chris Liddell:]

Sure, that is for the division overall. Obviously with Office 2007 coming along, that is a big driver, although that is more of the second half of the year. Also, as we see some of these enterprise agreements that we are signing flowing through the accounts, that will certainly help. Growth in the CRM and ERP products, so the old MBD segment will continue to grow very strongly and that will help the overall division as well. In particular in the second half of the year, but general strength across all of those areas.

[Laura Lederman:]

Thank you.

[Colleen Healy:]

Great.

[Chris Liddell:]

We are going to have to cut off now, but I appreciate all of your questions. I will hand it back to Colleen. Look forward to seeing a number of you in a week's time.

[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 July 20, 2007. In addition, you can hear the replay by dialing 866-455-0436 or, for international calls, dial 203-369-1258. The dial-in replay will be available through the close of business July 28, 2006. Thanks again for joining us today.

[Operator:]

Thank you. This does conclude today's Microsoft conference call. We thank you for your participation. You may now disconnect.