Fiscal Q4 numbers for Microsoft disappoint, net income down 29%

Analysts had been settling on 13% as the average earnings hit that a company in the IT sector should take in this down economy, which some believe may be finally on the mend. But the early report from Microsoft, minutes in advance of its quarterly conference call Thursday, was not good by comparison: Net income was down 29% year-over-year to $3.05 billion, on revenue that was down 17% from the year-ago quarter to $13.1 billion.

It could be Microsoft's first genuinely bad quarter since the year terrorism struck the US, and it has managed to drive its full-year net income down 18% over fiscal 2008.

Three years ago, Microsoft deferred some revenue from a relatively good quarter, on account of early coupon sales of Windows Vista. That deferral helped the company boast record earnings during a later quarter in 2007. This year it deferred some revenue again, but just $276 million. That might help come fiscal Q2 2010, but not much.

A check of today's 8-K report delivered to the US Securities and Exchange Commission reveals one very troubling number Microsoft execs will have to answer for today: Earnings from the Client division (meaning, Windows Vista and XP) dropped 33% on the quarter and 17% on the year, to just $2.17 billion, on 29% lower revenue year-over-year.

For reasons that may be chocked up to rumors that the company would confirm further job cuts of up to 5,000 -- a downsizing move analysts tend to applaud -- the bad news triggered a bit of a rally in Microsoft stock this afternoon, up a half of one percent over yesterday's close on the NASDAQ.

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7:10 pm EDT July 23, 2009 • The argument from Microsoft Chief Financial Officer Chris Liddell this afternoon goes like this: The entire information technology economy, from Microsoft's vantage point, contracted by as much as 25% over 2008. That means that once businesses' reduced expenditures are factored in along with reduced consumer trends, the IT economy is only 75% the size now that it was last year.

So any weakness, any at all, in Microsoft's general business performance can be attributed to the economy, not to reduced demand for products.

Here's how Liddell put it, in a response to a Merrill Lynch analyst during this afternoon's quarterly conference call: "It depends on whether you're talking about Client, Server & Tools, or [Microsoft Business Division]. It's in the 20 - 25% contraction if you do all of those combined. So if you think about overall PCs down in sort of that 16 - 18% [range], you see...server hardware down 24%, then the transactional businesses really follow those quite closely, adjusted for things like inventory...So if you think on average that our underlying hardware shipment decreases were in the 20 - 25% range on average, then that's what the transactional business was as well, plus or minus a little bit."

Is that as bad as things can possibly get? In other words, can we expect to see "deltas" of 25% in the coming quarters, or will they be less? Liddell's response was sobering: We've reached bottom, he says, but we won't lift from bottom for awhile.

"Do I think that's the bottom? Yes, I do think that's the bottom, but...I think it's probably going to continue to be tough for a quarter or two. So I wouldn't necessarily promise that it's going to be significantly better, but if you look at a combination of the first and second quarter [of fiscal 2010], that's the first half of the year, then that's probably a good surrogate for the transactional business for the second half of the calendar year, the first half of the fiscal year."

During that time, Liddell also warned analysts to expect gross margins to stay around the low- to mid-30s, which is not exactly great news.

The Server & Tools side of the business reported declining revenues by 6% on the quarter, but operating income just about flat for the quarter. That helped Microsoft to maintain a plus sign for the division's entire year, with operating income up 17% over 2008. Though SQL Server has been a perennial bright spot for the company, Windows Server and SharePoint are also showing good performance. And as CFO Liddell kept reminding analysts, this was despite a 24% year-over-year decline in business' overall spending on IT equipment.

By losing less this quarter than in previous quarters, the Entertainment & Devices division ended up being a (relatively) bright spot, dropping $130 million this quarter versus $171 million for the year-ago quarter. Xbox 360 console sales dropped a bit, but outperformed the rest of the gaming market. It was the decline in Zune sales that hurt that division worst, but the word "Zune" didn't even crop up on Liddell's radar during the call.

The Online Services business continued to lose money, but that was expected on account of investment in the Bing relaunch. So with the Business Division dropping only 16% in earnings, it's the Client business that was left as the shock of the day, down 33% on the quarter year-over-year. Anticipation of Windows 7's launch could be one reason -- translated, that means the market was ready to kick Vista off of its radar. Microsoft expects to defer as much as $1.3 billion in revenue from coupon-based pre-sales of Win7 for another two quarters, until the end of this calendar year, Liddell said.

Even then, he added, he doesn't expect businesses to invest too heavily in Windows 7 just yet, not until the overall IT spending trends begin to trend forward again. And although Office 2010 is another big new brand on the horizon, Liddell literally and quite frankly warned analysts not to expect much positive impact from Office on the Client division.

"Given that it's going to launch in the fall of next year," Liddell said, "I don't really see a significant impact in 2010 as a result of it. In fact, it could be a headwind for the first half, then start to turn around in the second half, and you start to see a very good situation in terms of 2011. But if you're trying to model 2010, it's not going to be a significant positive. It'll certainly help in terms of annuity sales, and help mitigate some of the negative transactional impact that we're seeing."

Toward the end of the call came the inevitable question of whether Microsoft foresaw any negative impact on account of the forthcoming Google Chrome OS. CFO Chris Liddell handled it by characterizing Chrome OS as only half an operating system:

"We've been fighting free OS in the client area for quite some time, as you all know, and I would point to the general value that we think Windows has, and in particular, around Windows 7, which we think is going to be our best-ever operating system," Liddell remarked. "And we still believe that a very, very large majority of people are going to want both a client and an Internet-based experience on their PCs. So of course, people want to surf the Internet and access it -- they can do that quite freely with Windows and all the Internet Explorer and [other] choices that they have. So a browser-only-based light software may have applicability, as it does with Linux-based systems already, but we don't see that significantly changing just because of Chrome OS coming out."

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