Highlights From MSFT's Q2 Conference Call: Lots of Strength, Expect PC Market Challenging

Microsoft Corp (NASDAQ: MSFT) reported Q2 EPS of $0.78, $0.02 better than the analyst estimate of $0.76. Revenue for the quarter came in at $20.89 billion versus the consensus estimate of $20.93 billion. Shares are currently trading at $29.50, up $1.38 (+4.91%)

Highlights From MSFT's Q2 Conference Call:

• (Peter S. Klein) We saw strong demand for our business products and services, and had a record holiday season driven by the unique entertainment experience we have built with Xbox 360.
  
• This quarter, the strength of our product portfolio enabled us to grow revenue 5% to $20.9 billion.
  
• Combined with our ongoing operating expense discipline, even as we prepare for a big launch year, we delivered record earnings per share of $0.78.
  
• We saw broad-based growth across geographies, with particular strength in emerging markets. Within our segments, the Microsoft Business Division had another good quarter, as businesses and consumers around the world looked to Microsoft to meet their productivity needs.
  
• Six quarters post launch, Office 2010 continues to exceed our expectations, with increased consumer and business PC attach worldwide.
  
• We saw double digit revenue growth across our key business application workloads, including Exchange, SharePoint, Lync and Dynamic CRM and ERP.
  
• With Office 365 we give customers powerful productivity and collaboration tools at great value. Today more than 100,000 businesses have made the commitment to our online services. Whether on premise or in the cloud, Microsoft remains the top choice for productivity.
  
• The Server & Tools business delivered another strong quarter as we continue to execute on our strategy of cloud optimizing every business.
  
• CIOs are increasingly turning to our business infrastructure offerings including Windows Server, Hyper-V and Systems Center as they look to Microsoft for the security, flexibility and manageability they need to build world class private clouds.
  
• This quarter marked the ninth consecutive quarter of double digit growth for Windows Server Premium revenue and the eleventh quarter of double digit revenue growth for Systems Center. On the data platform, we remain the worldwide unit share leader with SQL Server.
  
• This year, we will bring to market the next generation of our server offerings, including Windows Server 8, SQL Server 2012 and Systems Center 2012, which deepen and broaden our platform for the private cloud.
  
• Combined with the power of Windows Azure for the public cloud, our offerings give enterprises the identity, virtualization, application development and management tools they need to officially progress into the new era of hybrid IT.
  
• The PC market was challenged this quarter with particular softness in the consumer segment. However, Windows 7's momentum in the Enterprise continued, and today over one-third of enterprise desktops worldwide are on Windows 7.
  
• And with the future release of Windows 8, we believe the ecosystem will benefit from the new range of capabilities and scenarios that it enables.
  
• In Search, we saw improvements in RPS this quarter as we partnered closely with Yahoo! (Nasdaq: YHOO) to address the monetization challenges of the combined-ad platform. We are pleased with the progress and are working hard to continue that trajectory.
  
• In the year since Windows Phone launched, we have worked diligently alongside our partners, including Nokia (NYSE: NOK), to bring a differentiated experience to the mobile platform. Earlier this month, at the Consumer Electronics Show, we showcased the latest innovation in Windows Phone to very positive reviews. With these new devices, we are increasing the choices for consumers around the world to find a Windows Phone that is exactly right for them.
  
• As I mentioned, Xbox 360 had a record holiday season, as we continue to differentiate home entertainment, whether it's using Bing voice search on Xbox to quickly find the movies and shows you want to watch, or enabling more interactive TV as we demonstrated at CES with Sesame Street and Elmo, Xbox and Kinect are bringing together our technologies to redefine the living room experience.
  
• Beyond gaming and entertainment with the Kinect for Windows program, which launches February 1, our technology will further innovation and creativity across industries.
  
• During the quarter, we started the integration of Skype's world-class communications products and global network platform into our portfolio of products and services. While it is still early, we are excited by the momentum we have seen thus far and by the opportunities to redefine social and real-time communications for consumers and businesses around the world.
  
• As I have consistently mentioned, operating expense management is a priority for Microsoft. Reflecting our ongoing discipline and prioritization of investments, operating expenses grew just 4% this quarter.
  
• In summary, we delivered solid financial results despite a challenging PC market. The strength of our product portfolio drove solid top-line growth.
  
• We delivered record earnings per share, and we are well-positioned for future growth.
  
• (Bill Koefoed) Revenue for the quarter was a record $20.9 billion, up 5% or $900 million year-over-year. Operating income was $8 billion, cash flow from operations was $5.9 billion and earnings per share was $0.78. Foreign exchange did not materially impact our net income this quarter.
  
• Enterprise demand remained strong, as our customers continued to add both products and seats to their enterprise agreements, and our renewal rates remain solid. At the end of the quarter, unearned revenue was $15.3 billion and our contracted not billed balance was approximately $19 billion.
  
• Turning to the PC market, as I mentioned last week, it was a challenging quarter for the industry. Factors such as the flooding in Thailand, macroeconomic uncertainty and competing form factors resulted in an overall market that we estimate declined 2% to 4%.
  
• In the PC market, it appears that the impact of the hard drive supply chain constraints were not limited to a specific region or OEM type. While absolute volumes were impacted, we did see the following trends continue: PC sales to emerging markets outpaced developed markets; the business PC refresh cycle continued with business PC growth of 2%; the decline of Netbooks negatively impacted consumer PCs, which were down 6%. Netbooks, which a year ago represented about 8% of the PC market now represent only 2%. Excluding Netbooks, consumer PCs grew 2%.
  
• Now I'll move on to the results for the Windows and Windows Live Division where revenue was down 6%. The primary differences between the PC market and Windows revenue were the continuing growth of emerging markets faster than developed markets and inventory drawdowns from the prior quarter.
  
• We have now sold 525 million Windows 7 licenses since launch, and as Peter mentioned, we are seeing sustained momentum on enterprise deployment.
  
• Microsoft Business Division where revenue grew 3%. Recall in Q2 last year that we recognized $224 million of revenue for the Office 2010 Technology guarantee program and if you exclude that, revenue grew 7% for the quarter.
  
• Consumer revenue declined 17% year-over-year and declined 2% when factoring in the impact of the technology guarantee program that I just mentioned.
  
• The outperformance relative to the overall PC market was driven by attach gains which continued despite being 18 months since the launch of Office 2010.
  
• Business revenue grew 9% and within business, multiyear licensing revenue grew 12% and transactional revenue grew 3%, driven by strong attach worldwide.
  
• We continued to see strong growth in our productivity solution offerings. Lync, SharePoint, and Exchange each grew double digits. We've previously shared with you the opportunity that we see for unified communications and we are beginning to realize that potential. Lync revenue grew over 30% as customers such as Volkswagen and LA Fitness chose Microsoft to be their voice and video solution.
  
• Server and Tools where revenue grew 11% driven by multiyear license revenue that was up mid-teens in enterprise services. We saw broad-based strength across our products. In our data platform business, SQL Server, grew low double digits outpacing industry growth due to the strength of our premium edition.
  
• This quarter, we saw competitive database wins against Oracle (Nasdaq: ORCL) such as U.K. based retailers, The Cooperative Group, which switched to SQL Server because of its advantages in business intelligence, security, flexibility and cost.
  
• We also saw strong market anticipation for SQL Server 2012 with over 100,000 downloads in the two months since the release candidate was made available.
  
• In the private cloud, Windows Server Premium revenue grew high teens and Systems Center grew over 20%.
  
• Online Services Division, where revenue grew 10% and operating performance improved for the second consecutive quarter. Online advertising revenue was up 13%, driven primarily by search. The increase in search revenue was driven by both weight and volume improvements. Bing's U.S. organic market share ended the quarter at 15.1%, up 40 basis points this quarter and over 300 basis points year-over-year.
  
• Now let me move to the Entertainment and Devices Division, where revenue grew 15%. According to third party research, Xbox was the number one console in the U.S. during the calendar 2011 and had 46% of U.S. console sales in December. During the quarter, we sold 8.2 million consoles, which was up over 25%, despite a soft gaming console market. Kinect continues to impress customers with 18 million Kinects having been sold since launch just over one year ago.
  
• Xbox Live members grew 33% with 40 million users now enjoying Xbox Live. In December, Xbox released the new Metro style dashboard and added dozens of new entertainment applications and content partners to the platform. While it is early, engagement has been quite impressive, as the number of people using entertainment apps from November to December increased by almost 50%.
  
• We continue to make progress with Windows Phone. During the quarter, Nokia (NYSE: NOK) began to bring some of their great new devices to market, which adds to the growing list of compelling phones available from our OEM partners.
  
• At CES, the talk of the show were the new LTE Windows Phones from Nokia and HTC that will be available on AT&T (NYSE: T) in the coming months, joining the Lumia 710, which is now available on T-Mobile.
  
• In October, Skype officially joined Microsoft. This quarter over 200 million people used Skype to communicate with family, friends and businesses. For calendar year 2011, over 300 billion minutes of calls were made over the Skype network, an increase of 50%.
  
• Cost of goods sold increased 17%, driven by the following: first, we saw an increase in costs resulting from the strong Xbox console sales and increased Xbox royalties.
  
• Second, Enterprise Services continued to grow rapidly. And third, Online Services and traffic acquisition costs increased. Operating expenses were $7.3 billion, an increase of 4%, driven primarily due to compensation, legal expenses, and Puerto Rican excise taxes. This quarter we returned $2.7 billion to shareholders in buybacks and dividends.
  
• (Peter S. Klein) PC growth in emerging markets will outpace developed markets, and business PC growth will outpace consumer PC growth. We also expect the hard disk drive shortage to continue to challenge the PC market through at least the next quarter.
  
• Turning to the Microsoft Business Division, for the third quarter and full fiscal year, transactional revenue, approximately 40% of the division's total, should lag the overall PC market, reflecting a higher mix of PC shipments to emerging markets. And multi-year licensing revenue, approximately 60% of the division's total, should grow low double digits.
  
• Moving to Server and Tools, approximately 30% of the division's revenues comes from transactional licensing, 50% from multi-year licensing and 20% from Enterprise Services.
  
• For the third quarter and full fiscal year, we expect transactional revenue to generally track with the hardware market, multi-year licensing revenue should grow low double digits and Enterprise Services revenue should grow high teens.
  
• (Q&A) My question is about the material improvement in OSD [Online Systems Division] margins quarter-on-quarter. It looks like you held firm on expenses year-on-year. Does that reflect a new philosophy around that business in terms of driving profitability? And can you update us on where think you are on the RPS improvement? (A) As we've been saying, the key to profitability in that business is to grow our top line because it scales really well, the marginal impact of that is very high because it's a high fixed cost business. We have been, as we've been growing share and improving our RPS, especially this quarter, holding the line on operating expenses and really streamlining. The most important thing long-term, as we've said, is to continue to grow that share and grow the revenue per [ph] served (23:20). So we're pleased with that trajectory and want to keep on that. And we are watching the costs very carefully so that that revenue marginally goes to the bottom line and that's what you saw happen this quarter; and that's the trajectory we hope to stay on.
  
• Just wondering on the EDD [Entertainment & Devices Division] side, it looks like you called out the Nokia payments as part of COGS as a driver and I'm wondering, you've been pointing us to mix of revenue type as mainly the driver there of COGS. Could you help us out with how meaningful those payments were and how should we expect those to continue to track as we move into future quarters? (A) Yeah, it's part of it. There were several things impacting the gross margins in the E&D business. Obviously one is just the volume of consoles and the mix of consoles, high end versus low end, the mix of software whether it's first party or third party, that has a different margin characteristic. And so that's the biggest piece in E&D. Then the Nokia piece is also another piece that plays into that. But the biggest piece is the mix of business in the E&D business, and the Nokia is also another driver of that.
  
• Thanks, yeah, on the hard drive shortage issue, I spoke with Gartner on Monday, and they were looking for PCs of down 1%. You guys have said down 2% to 4%, and they helped reconcile that, suggesting that there were some issues in terms of the pipeline of products and if inventories were reduced in the pipeline, that might reconcile why the two of you are viewing the industry somewhat differently. I'm just curious if you think that's going to continue into the next quarter? I know we're going to see impact in this next quarter. I'm just curious whether you and Gartner might be more in line with each other going forward or if there's more inventory reduction in that pipeline that might be an ongoing impact above and beyond perhaps what we're seeing from the numbers that Gartner and IDC are giving us? (A) Yeah, that's impossible to say, Rick. I'd say, obviously for this quarter we obviously are very confident and comfortable with the estimate. As we said during the remarks, we expect the impact to continue on at least through the next quarter and I think the best thing to do at the end of that, we'll probably all have a better view and we can kind of assess where we are and what it looks like going forward. (A) I'd say just generally on the inventory as well, obviously, as I said in my remarks, there was an inventory draw down to end the quarter. I think there was an overall - I think both IDC and Gartner have also talked about the fact that the overall supply chain for PCs is obviously leaner than it was three months ago. So we'll have to see how fast people kind of ramp back up, how fast the PC ecosystem rebounds, and that will obviously impact, as Peter mentioned, inventory at the end of the quarter as well. So a good question.

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