Can Vista Be Credited With Microsoft's Stellar Q1 Gains?

It was indeed an astounding quarter for Microsoft, with operating income having grown last quarter at an annual rate of 32%. A big part of that growth is attributable to Windows Vista. But does the fact that customers are adopting it truly signal that customers are embracing it? Yesterday, the company's chief financial executives offered some very revealing data.

What recession? Since Chris Liddell's arrival as Microsoft's Chief Financial Officer, the company's timing and execution have been impeccable. He has five business divisions whose books he manages, but the weight of capital expenditures in the revenue of at least two divisions have been more than offset by gains in the other three that help Microsoft to cruise right along.

"The first quarter represented an outstanding start to the fiscal year," Liddell stated during yesterday's Microsoft quarterly conference call to analysts, "with every part of the company performing at or above expectations. In particular, we're very happy that consumer demand across our total product range propelled revenue, operating income, and earnings per share growth by 27%, 32%, and 29%, respectively."

Those are annual growth rates, which are phenomenal for a 32-year-old company.

What sets the stage for this perfect chain of events is the overall global PC market, whose predicted slowdown has failed to show up on time. Global growth in hardware is as much as 12% annually, Liddell reported, which is 1% higher than predictions at mid-year and several points higher than many analysts had forecast at the beginning of the year.

"PC growth rates in emerging markets continued to outpace that of mature markets," reported Investor Relations General Manager Colleen Healy, "driven by robust growth in Brazil, Russia, India, and China, which grew a combined 20%." Just by itself, Liddell added later, Russia's PC market annual growth rate was an astounding 100%.

There is this undeniable fact: Demand is high for Windows Vista. Thus far, Liddell stated, 85 million units of Vista have shipped, versus 45 million units of Windows XP during its first year of sales. "Clearly we're very happy with the Client division overall," he told a UBS analyst, referring to its 25% annual revenue growth rate. "Since we've launched Vista, the revenue growth has been in excess of 20% for three quarters in a row."

But from whom is that demand coming? One aspect of Liddell's character thus far during his tenure as Microsoft's CFO has been his clarity. Unlike most any other senior executive, he uses the fewest euphemisms and hyperactive participles, opting instead to get straight to the point. And Liddell's point was this: Vista demand is higher not necessarily because it's just so much better than XP, but because the market is different now.

A full 75% of the "mix" for Vista sales during the previous quarter belonged to the Premium SKU, the most expensive setup. For Q1 2006, 59% of the mix for Microsoft OS sales belonged to the high end, including XP Media Center Edition.

Over 80% of the revenue to the Client division, which represents Windows, comes from OEMs - companies that build computers and resell them with Vista pre-installed. (As a whole, the company takes in 30% of its revenue from OEMs.) But the rate of revenue growth from OEM sales is increasing faster than the rate of shipment growth to those OEMs, because they're paying more for Windows, thanks to the higher demand for the Premium SKU. Consumer premium units grew at an astounding rate of 150%, Healy reported, compared to a business premium growth rate of just 11%.

Since OEMs are demanding Vista at a faster rate than before, they're going to call for the version that adds the most value to their systems. Right now, that's the Premium SKU.

Also, as Liddell pointed out, the market is different now because of client annuity agreements. Simple box sales constitute an infinitesimally small fraction of overall Windows sales; most of what Microsoft does not sell to OEMs are in effect "pre-sold" to subscribers. As a whole, the company makes 40% of its revenue from annuity agreements. With annuities growing as a percentage of overall sales, subscribing customers have automatic expectations that those annuities will pay off with the biggest upgrades in the shortest amount of time. So demand not only increases but becomes "skewed," if you will, toward the highest valued product in the mix.

"Client annuity agreements...are the best leading indicator we can think of, of people's intention to adopt," remarked Liddell. "It's still very early in the adoption cycle for businesses, but the volume licensing portion of our business was up 27% in the Client area, so that's a very good leading indicator from our point of view."

Wouldn't intention to adopt Vista be higher, a Goldman Sachs analyst asked, if Vista SP1 were made available sooner rather than later? "Certainly some businesses will be waiting for SP1 to roll [Vista] out," Liddell responded, "but in terms of [their] willingness to sign up for the client element of the multi-year agreements, their intention to roll out is, I guess, signaled by that. So it's still early days as to what the actual adoption numbers are, and we think they'll increase during the year, and obviously will be helped to some extent by SP1. But some of the leading indicators are what we feel good about."

Next: Is Vista SP1 driven more by demand or expectation?