MSFT’s March 2010 quarter

MSFT reported its fiscal third (ending 31 March) quarter earnings results on April 22.  This is what I thought was interesting from the numbers themselves and the related company conference call.

the results

Revenue, factoring back in sales that are deferred under GAAP, was up 8% year over year.   Operating earnings were up 17%.  The operating leverage is due partly to the fact that incremental copies of software cost virtually nothing to make, and are therefore almost pure profit.  It also comes from continuing strong cost control.

Operating income benefitted a bit from the absence of severance charges ($290 million in the year-ago quarter), but that was offset by higher legal expense and the costs from the search agreement recently concluded with Yahoo and okayed by government regulators in February.

Net income was up by a much larger percentage, around 36%.  Although MSFT didn’t highlight this on the call, the most important reason the number was in the thirties rather than the teens was a $589 million swing from loss a year ago to profit this March on selling investment securities.  A lower tax rate helped a bit as well.

the reasons

Windows 7 adoption has been the fastest of any Microsoft OS, with 10% of personal computers worldwide now running it. (As a frustrated former Vista user writing this on a Mac, I’m tempted to analyze this as more a comment on Vista than on Windows 7.  But I have to acknowledge that W7 seems to have stemmed customer defections.  So it must be good.)

Sales in emerging markets were up by 20%+ year on year, with sales in developed markets advancing around 5%.  MSFT has begun to notice small- and medium-sized businesses upgrading their software, with revenues in this segment up 15%+.

Piracy is down.  Part of this is MSFT’s litigation efforts to enforce its intellectual property rights abroad.  Part is the increasing market share of global branded computer manufacturers vs. independent no-name “white box” makers, where software piracy is more prone to occur.

Worldwide PC sales are up 25% year on year.  MSFT estimates that consumer purchases are up 30%- and business buys up 15$.  Netbooks, where unit revenues are lower but where MSFT currently has almost all the market, are about 10% of the total.  MSFT unit sales are outpacing market growth.

upcoming quarters

Office 2010, the new Office suite, and a number of server software upgrades launch in the June quarter.  They should provide a steady boost to revenues over the next year or two.

In MSFT’s mind (and who would know better?), large corporations worldwide are clearly preparing for a major refresh/upgrade of their computer systems.  Most have pilot or prelaunch Windows 7 efforts under way now.  They’re planning to deploy W7 as quickly as they can, on the server infrastructure they have today.

Why the holdup?  I presume it’s the usual– IT chiefs want to be sure all the major bugs have been worked out of software before risk the firm’s information backbone by using it.  That takes time.

MSFT also has a large “cloud computing” business, its Online Services Division, which looks like it will report full-year operating losses of more than $2 billion.  At some point–I have no guess as to when–those losses will likely begin to diminish and eventually turn to profit.

What does MSFT do for an encore?

This is the (perhaps cruel or ungrateful) question Wall Street will eventually ask about MSFT.  The company generates enormous cash flow, has negligible debt and is in the midst of an extra-profitable period of upgrades to its basic products—the PC operating system/user interface and the collection of Office-brand business applications.

But the consumer portion of this transition, which is bigger than the business side, is quickly closing on its peak.  And since the market lows in March 2009, MSFT’s stock has doubled.  It has outperformed the S&P 500 by about 20 percentage points over this span, which already discounts at least some of the current good news.

my thoughts

I see two striking features of MSFT:  its enormous cash flow, and how that cash flow is deployed.

On the conference call, MSFT displayed justifiable pride in the fact that March quarter cash flow was a stunning $7.4 billion.  The total for the first nine months of the fiscal year was $18.5 billion.

What is MSFT doing with this money?

stock repurchases          $7.4 billion

additions to cash          $5.5 billion

dividends to shareholders          $3.5 billion

capital spending           $1.2 billion.

If I’ve read the balance sheet numbers correctly, about half of the stock repurchases go to offset the issuance of new stock to employees who are exercising stock options.  But about $3.5 billion has been used to shrink the number of shares outstanding by about half a percent.

MSFT already has about $40 billion in cash and short-term investments on the balance sheet?  Does it need more?  I don’t think so.

Anyway, it seems to me that MSFT could easily double its current dividend (not necessarily all at once; a steady increase over a year or more would be ok), which would produce a yield of 3.5%.  To do this would require a courageous further recognition by the company’s management of the firm’s maturity–a judgment Wall Street has long since made.  My guess is that it would do wonders for the stock’s price, even from here.

My initial reaction is that chances aren’t good.  But we can watch for signs.

By the way, I tried using Firefox to access the conference call and download the 10-Q, because I knew that MSFT doesn’t like Safari.  But the 10-Q wouldn’t download, the conference call narrative broke down twice and the timeline bar to skip/rehear portions appeared only intermittently and didn’t work.  I’m sure Redmond residents find this mirthful, but the humor doesn’t travel.


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