Three important takeaways from Microsoft's $19.95B record quarter

Microsoft announced fiscal 2011 second fiscal quarter results after the stock market closed yesterday. The company reported $19.95 billion in revenue and $6.64 billion net income. Business and Entertainment & Devices divisions reported enormous revenue gains, while Windows & Windows Live can only be described as abysmal. Overnight, I took another look at the numbers, from which I want to highlight three takeaways.

Wall Street didn't respond favorably to Microsoft's quarterly report, but that's typical. It doesn't seem to matter how good are the results, Wall Street won't give Microsoft a break. As I post, Microsoft shares are down 4 percent in late-day trading.

I present the takeaways -- heck, there are only three, for expediency -- in no order of importance.

The big Windows 7 sales surge is over. There are reasons why Microsoft touted two statics against one it couldn't: 300 million Windows 7 licenses sold to date and 20 percent of Internet-connected PCs running the operating system. Those numbers contrast against difficult quarterly results for the Windows & Windows Live division. Revenue fell by more than 30 percent year over year. Even when removing a one-time $1.7 billion deferral that artificially boosted fiscal 2010 Q2 revenue and created a tough year-over-year comparison, the division's revenue fell by more than $400 million.

OEM revenue grew by 2 percent, year over year (when removing the deferral), but OEM licenses declined by 5 percent. In a financial statement, Microsoft attributed its OEM license problems to a "decrease in inventory in our distribution channels and lower Windows attach rates in China." Both measures are foreboding, particularly in context of Microsoft's boasting about the number of Windows 7 license sales. Lower-inventory levels reflect slower sales, and manufacturers and retailers responding by cutting back stock. PC shipments grew at a paltry 2 percent to 4 percent during fiscal Q2, by Microsoft estimates. Growth fell short of Gartner and IDC projections. Whatever PC sales pull Windows 7 had, it's over.

Related to slowing PC sales is the question of Windows 7 saturation, at least among businesses and consumers most likely to upgrade immediately. Looking at Microsoft's 300 million and 20 percent figures differently, that 300 million licenses represents close to one-third the Windows PC install base (which is estimated to be near 1 billion). By that measure, the number of PCs running Windows 7 is anywhere from 10 percent to 15 percent less than the number of licenses sold. This backlog is another factor that will likely slow demand for new licenses at least through the remainder of Microsoft's fiscal year (ending on June 30)

China is another matter. It is the big growth market, but sales are weak. Has piracy crept back its vicious head in China? Perhaps there is simply less PC demand as mobile carriers build out cellular data networks that make cell phones more attractive alternatives to PCs. It's a well-documented phenomenon that in many emerging markets, the cell phone and not the PC is the first Internet-connected device that a family or small business owns. As mobile applications get better, cell phones can stand in for PCs costing much more.

Entertainment & Devices margins are awful. The division's revenue rose by 56 percent year over year to $3.698 billion, generating a paltry $679 million in income. Is it even necessary for me to calculate how low are the margins? The division's revenue growth added $1.3 billion to overall Microsoft revenues but little to income. From a brand image perspective, Kinect is a great product for Microsoft, and from that perspective it's a huge success. But its contribution to the quarter, which includes a spike in Xbox 360 consoles, raised margins by only a couple percent. Perhaps it's time for Microsoft to spin-off the division.

IT organizations are spending on knowledge workers again. Year over year, Microsoft Business division revenue rose a whopping 24 percent during fiscal Q2. Revenue exceeded the Windows & Windows Live division by almost $1 billion and income by more than $700 million. Typically, Windows generates more revenue and income. Office 2010 license sales are 50 percent ahead of where Office 2007 was during comparable time in the sales cycle.

Earlier this month, Gartner projected that global IT spending would be greater in 2011 than previously forecast -- $3.6 trillion, up 5.1 percent year over year rather than 3.5 percent. More than $250 million is expected to be spent on enterprise software.

Spending may be up, after being sapped by the 2007-09 recession and stock market collapse of late 2008, but Microsoft's earnings report reveals important changes. Microsoft has typically benefitted from a large number (as high as 40 percent) of businesses adopting annuity license contracts. IT organizations pay for the software plus 29 percent extra annually for two or three years. This extra, or "Software Assurance," provides access to upgrades. However, because of layoffs many businesses already had been renewing for fewer seats.

Something else new is emerging. During fiscal Q2, business non-annuity revenue grew by 40 percent compared to just 9 percent growth for annuity contracts. Consumers account for some of the transactional licenses. Businesses purchasing this way are least likely to upgrade to the next Office version or even the one after. The break-even point between a one-off sale and annuity license is 3.5 years. Presumably then, many IT organizations aren't planning on upgrading from Office 2010 any sooner than 3.5 years, and more likely longer.