Earnings Call: Q4 2010

Jul 22, 2010

Welcome to the Microsoft Fourth Quarter Fiscal Year 20 10 Earnings Conference Call. At this time, all participants are in a listen only mode. Today's call is being recorded. If you have any objections, you may disconnect at this time. I would now like to turn the call over to Mr. Bill Kofed, General Manager, Investor Relations. Sir, you may begin. Thank you, Barb, and thank you, everyone, for joining us this afternoon. As usual, with me today are Peter Klein, Chief Financial Officer Frank Brode, Chief Accounting Officer and John Ciesopf, Deputy General Counsel. Today, Peter will start with overall takeaways from the quarter fiscal year. Then I'll give you the details of our performance before handing it back to Peter, We will discuss our outlook. After that, we'll take your questions. Our earnings press release today includes an addendum of financial highlights with detailed information about revenue, operating expenses and other items. We have also posted our quarterly financial summary slide deck, is intended to follow the flow of our prepared remarks as well as provide a reconciliation of differences between GAAP and non GAAP financial measures. You can find these documents at the Investor Relations website at microsoft.com/msft. In addition, as part of our ongoing efforts to improve and incorporate your feedback, we will post today's prepared remarks to our website immediately following the call Today's call will be webcast live and recorded. If you ask a question, it will be included in our live transmission, In the transcript and any future use of the recording, you can replay the call and view the transcript at the Microsoft Investor Relations website until July 22, 2011. This conference call is protected by copyright law and international treaties. Unauthorized reproduction or distribution of this call or any portion of it without the expressed written permission of Microsoft We will be making statements during this call that are forward looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could materially differ because of factors discussed in today's earnings press release, in the comments made during this conference call and in the Risk Factors section of our Form 10 ks, Form 10 Q and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward looking statement. Okay. And with that, I'll turn the call over to Peter. Thanks, Bill, and good afternoon, everyone. I'm very pleased to share with all of you our strong financial results. We achieved record revenue, operating income and earnings per share for both the 4th quarter and the full year. This quarter, our strong revenue performance was both broad and deep with every business achieving double digit growth. Strong sales execution closed the year with 4th quarter bookings increasing 27%. For the year, both the Windows division and Server and Tools business We are equally enthusiastic about the customer and product momentum we've achieved this year across the breadth of our portfolio. Of course, I have to start by noting Windows 7, which has received tremendous market response. With 175,000,000 licenses Sold to date, it is the fastest selling operating system ever, now runs on over 15% of all PCs worldwide. Capitalizing on the recovery of the server hardware market, Windows Server 2,008 R2 has enjoyed strong demand and increased Windows Server market share. With the launches of Exchange 2010 and most recently SharePoint 2010 and Office 2010, we delivered key innovations in our productivity portfolio. Equally as important for our long term growth, we made significant strides in our cloud initiatives by bringing Windows Azure to market And by increasing customer traction with our commercial online services. Throughout the year, we continued to update and enhance Bing, Which has now achieved 13 consecutive months of market share growth. And finally, we focused on consumers with our new Xbox 360 console The announcement of Connect and Windows Phone 7 coming to market this holiday season. Meanwhile, As a result of our ongoing commitment to managing costs, we held annual operating expenses roughly flat. Our continued revenue strength And cost discipline drove yet another consecutive quarter of margin expansion and record annual profits in the Windows division, Server and Tools Business and Entertainment and Devices division as well as the company in total. We grew full year operating income by almost $4,000,000,000 and generated operating cash flow of $24,000,000,000 Of this amount, we returned about 2 thirds or almost $16,000,000,000 to shareholders in the form of stock repurchases and dividends. Finally, I'm particularly pleased by our growth in earnings per share of 50% for the 4th quarter and 30% for the full year. So it's been a great fiscal year and an outstanding Q4. With those remarks, I'll now turn the call over to Bill to provide more details on the quarter. Thanks, Peter. As I review this quarter's performance, keep in mind that all growth comparisons relate to the corresponding period of last year, unless I specify otherwise. As Peter noted in his opening remarks, we finished the year with terrific financial results. Total revenue for the quarter grew 22 percent to over $16,000,000,000 a record 4th quarter result. Windows, online services, entertainment devices, server and tools, the business division, each of our operating segments Grew revenue double digits this quarter, reflecting broad based strength across all of our businesses. 4th quarter GAAP operating income grew 49 percent while EPS grew 50%. Looking at the full year and adjusting for the tech guarantees, we had 4 Executive quarters of margin expansion with EPS growing faster than revenue every quarter. Operating cash flow was up 46 percent to a 4th quarter record $5,600,000,000 As for the year, Operating cash flow surpassed $24,000,000,000 as Peter noted, also a record. Customer demand was strong across the breadth of the Microsoft portfolio this quarter as we saw total bookings growth accelerate to 27%. In the enterprise, businesses continue to invest in and commit to the Microsoft platform. Sales execution and enterprise agreement renewal rates have improved as Our unearned revenue at the end of the quarter was $14,800,000,000 up a very healthy 21% sequentially. The contract is not billed balance ended the year over a record $15,000,000,000 The small Mid market customer segment continued to experience robust growth and was up approximately 20%. Finally, Continuing a trend this year, consumer demand was fantastic with growth in Windows, Office, Search and Xbox. Geographically, we saw strength across all regions led by emerging markets. Growth in the U. S. Improved this quarter, while demand in Europe remained healthy. The PC market continues to thrive and we estimate the market grew between 22% 24% with both consumer and business growing From a geographic perspective, emerging markets remain a significant driver of the PC market with almost twice the growth of mature markets. With that PC backdrop, I'll move on to the Windows and Windows Live division. Windows revenue grew over $1,000,000,000 or 32% this quarter when adjusted for the Windows Tech Guarantee last year. Total OEM license growth was 26% and outpaced the PC market for the Q3 in a row. Consumer and business licenses both grew approximately 26%. The business PC refresh cycle has accelerated and we recorded the 2nd straight Quarter of double digit business license growth. As in past quarters, to help you bridge PC growth to OEM revenue growth, We have provided a reconciliation slide in our earnings deck. At 31% growth, adjusted Windows OEM revenue outgrew PC shipments by 7 percentage points this quarter. The hardware segment mix was a 3 point headwind to revenue. As I mentioned earlier, emerging markets continue to outpace mature markets. Windows attached and inventory Drove 6 percentage points of growth. We exited the quarter with normal inventory levels and continue to benefit from solid detached gains in both business and consumer. Finally, upsell and channel dynamics drove 7 percentage points of growth, reflecting a higher Windows 7 offering mix. Enterprise adoption of Windows 7 accelerated and the non OEM portion of the Windows division grew 36%, driven by an increase in volume licensing To businesses and retail sales of Windows 7. Clearly, the Windows franchise is thriving. Importantly, customer satisfaction for Windows 7 is incredibly high at 94% and businesses are deploying Windows 7 in the enterprise. In the browser, IE8 is now the fastest growing and most popular web browser in the market with IE9 coming soon. Now let's move to server and tools, which posted 14% revenue growth in the 4th quarter and had a record year with $14,900,000,000 of revenue. We estimate the underlying server hardware market grew 25% to 28%. Non annuity revenue grew approximately 20%. Windows Server grew with the market, while SQL Server 2,008 R2 and Visual Studio Developer Tools Also contributed to the growth. Annuity revenue, which is approximately 50% of the business, grew about From a product perspective, Windows Server, SQL Server and System Center all experienced double digit growth. Enterprise services about 20% of revenue grew 3%. Windows Server continues to gain share as businesses replace and procure new hardware in the data center. We estimate Windows Server grew its market share over 1 percentage point, while at the same time increasing premium mix to about 25%. Our virtualization suites almost doubled this quarter. In addition to the share gains in the traditional server market, Microsoft is leading the way to the cloud with our Windows Azure Services platform. Just last week at the Worldwide Partner Conference, we unveiled a number of new cloud innovations and partnerships, further increasing the alignment between our on premise Windows Server, SQL Server and System Center products with the Azure platform. Next, I'll move on to the Online Services division, which grew 13%. The online advertising component of the division grew 15% primarily driven by our search business, which again outperformed the market. We continue to be encouraged by Bing's ongoing share gains Due to the pace of exciting innovation and differentiation it brings to the market, June marks the 13th consecutive month of share gains in the U. S, which is now up over 4 points since launch. Turning to the Microsoft Business division, revenue grew 15% and Office 2010 is off to a great start. Consumer revenue, which includes OEM and retail, grew 51% Following the launch of Office 2010 heading back into the back to school season. The business portion of MBD grew 8%. Non annuity license sales jumped 15%, trending toward PC shipment growth as expected. The annuity licensing portion of the business grew 6%, driven by an increase in enterprise demand. Office and the integration with SharePoint, Office Communications Server and Dynamics CRM had strong demand and each of these products grew double digits this quarter. The cloud enhances these productivity scenarios and our customers are purchasing suites of our online services at an increasing pace. 70% of our business productivity online seats represent new business to Microsoft. Let's move on to the Entertainment and Devices division, which grew 27%. Gaming revenue grew 30 As we sold 1,500,000 consoles, a unit increase of 26%, taking share as we grew faster than the overall market. Xbox Live continues to be a tremendous asset with over 25,000,000 members. This year marked the first time that Xbox Live Digital Marketplace revenue exceeded subscription revenue, illustrating The service is increasing level of customer engagement and monetization. Non gaming revenue was up 23%, driven by growth in Windows Embedded and sales of PC accessories that generally align to PC market growth. This quarter at E3, we unveiled Kinect, the Xbox 360 motion sensor, which will enable you to play games and control your music Earlier this week, we announced product and pricing for the all new Kinect experience. The Kinect experience with more than 15 games available this holiday begins in North America on November 4. Now let me cover the remainder of the income statement. Foreign exchange had a 2% positive impact to revenue this quarter. We experienced a headwind from the euro as one would expect, but this was more than Set by our hedging program and the dollar weakening in other currencies. Cost of goods sold increased 23% $3,200,000,000 driven primarily by increased online costs, royalties and other charges. Operating expenses were $6,900,000,000 in the quarter under our guidance range and we are very pleased with the Q4 execution And fiscal discipline. Headcount decreased 4% year over year. We repurchased $3,800,000,000 of shares and paid $1,100,000,000 of dividends. So to wrap up, our product cycle momentum continues with the release of Office 2010 and the breadth of our portfolio, which drove record results. Our cost discipline remains strong. In the cloud, we have great momentum and are seeing businesses invest in the Microsoft platform. And with that, I'll hand it back to Peter, who's going to discuss our business outlook. Thanks, Bill. I'll now share our thoughts on the Q1 and total fiscal year 2011. We are entering the year with great momentum. We are encouraged by the resurgence in business PC shipments and expect the business PT refresh cycle to continue through fiscal year 2011. The recent refresh of our enterprise product has positioned us Windows division revenue to grow roughly in line with PC shipments for the Q1 full year, excluding the $700,000,000 revenue impact from the Windows 7 retail launch And $276,000,000 from the technology guarantee revenue carried over from fiscal year 2,009. For the Microsoft Business division, consumer and business non annuity revenue, approximately 40% of the total, should continue to track with PC shipment growth rates for the Q1 full year. Annuity revenue for the Q1 full year should grow low to mid single digit. Moving to the server and tools business. For the Q1, we expect non annuity revenue to be up mid to high single digits as first quarter bookings are sales cycle driven, intend to be the softest seasonal quarter irrespective of hardware shipments. For the full year, we expect non annuity revenue to generally track with the hardware market. We expect annuity revenue to grow roughly high single digits for the Q1 and full year. Enterprise services revenue should grow mid single digits. For the Online Services division, our online advertising business should outperform the overall online advertising market. Regarding our search partnership with Yahoo! We are working closely with them to migrate both algorithmic and paid traffic in North America for this holiday season. And finally, I'll cover the Entertainment and Devices division. Based upon the compelling wave of consumer offerings coming to market, We expect revenue will grow in the mid teens for the Q1 full year, following its normal seasonal skew to the first half of the year. Moving to cost of goods sold. Gross margins will be impacted by product mix and particularly by the increase in hardware sales that will drive growth We remain focused on diligently managing our cost structure and are lowering our full year operating guidance to between $26,900,000,000 $27,300,000,000 which includes our estimate of Yahoo! Search integration expenses. We expect our effective tax rate to remain approximately 25%. Pushing to the balance sheet. We expect that the Q1 unearned revenue balance will track to normal historical patterns on a sequential basis after adjusting for the impact of tech guarantees in the prior year. Capital expenditures for fiscal year 2011 will be about $2,500,000,000 This will be the 2nd year in a row in which CapEx spending will be lower than depreciation expense. We will continue to generate strong free cash flow remain committed to returning capital to shareholders through dividends and stock repurchases. So in summary, I'm very pleased by our outstanding financial results for the quarter and the full year. We have great product momentum in the market, Strong business and consumer demand for our most recent wave of products. With the exciting pipeline of consumer products arriving to market this holiday season, We are well positioned to continue this momentum this coming year. On that note, I'm looking forward to seeing all of you at our Financial Analyst Meeting next week. And I'll now return the call to Bill so that we can begin taking your questions. Thanks, Peter. We want to get questions from as many of you as possible, So please stick to one question and avoid long or multipart questions. Barb, can you please go ahead and repeat your instructions? Okay, thank you. We will now begin the question and answer And first is Walter Pritchard with Citi. Hi. I was wondering if you could elucidate a little On the PC side, your assumptions for fiscal 2011 and just talk about tablets and how you're thinking about that market. Are you talking about growing in line with traditional PCs? And What impact do you think in tablets will have on the market? And what may be your share in that area? And how does that affect your growth rate? Yes. We're very excited about the market. The PC market is the PC market excluding tablets. But obviously, we're super happy with both the sort of state of PC market and the customer traction for Windows 7. We think tablets are very interesting and remind us that there are always new scenarios and new opportunities And we're constantly working with our partners and our OEM partners. In fact, I think one of the things that's driven the PC market and Windows growth this year Has been the work we've done with our OEM partners on multiple scenarios and form factors and price points to hit all those. Tablets, I think, are interesting and great, because I think they sort of enlarge the overall opportunity. I think they're additive to the opportunity. And again, it reminds us that there are lots of interesting new scenarios that we are continuing to work on. And so we're excited by that. Great. Thanks. Thanks, Walter. Next question, Barb? Next is Adam Holt with Morgan Stanley. Great. Thank you. Looks like a really good start to office. 8% business growth was the highest number I think you've seen in 2 years. Do you think business revenue growth can get to same levels you saw with The previous office cycle reached north of 20%. And why wouldn't the annuity business for office grow faster than low single digits In the heart of the cycle next year. Thanks. Yes. Thanks, Adam. I'm not going to give guidance on business rent other than the driver framework that we gave. In terms of the annuity business, obviously, this is in terms of the deferred revenue that we've had the last year or year and a half It has been slow and so we're kind of digging out of that hole of the recognitions that we have from the deferred revenue balance. And so in the course of this year, we'll be building that back up. And as I Said, we expect Q1 unearned revenue to also return to normal historical sequential patterns. So we feel good about sort of the opportunity To continue to drive bookings with office, but in terms of the annuity revenue recognized growth that's impacted by sort of the billings that we saw over the course of the last year. But having said that, we're certainly very optimistic about business uptake of ops 2010. Terrific. Thank you. Barb, can you move to the next question? And next is Heather Bellini with ISI. Hi. Yes. Good afternoon. I was wondering if You guys could talk about the decline in the consumer premium mix and what percentage of the decline is related to emerging markets And what are the other reasons, if that doesn't explain all of it? Thanks. Thanks, Heather. All of it. It's all related to the growth in emerging markets. That was easy then. Thank you. Yes. Thank you. Barb, next question please. And next is Philip Winslow with Credit Suisse. Hi, guys. Great quarter. I just wanted to have one question back on the Windows division. If you look at that commercial and retail license line, it Still remain very strong year over year and even sequentially. Obviously, in the first part of the fiscal year, that was driven by consumers upgrading to Windows 7. Just what are you And then also as we start to think about fiscal 'eleven, obviously, that does include commercial licenses too. What would you expect for the impact of potentially enterprises Upgrading to Windows 7 and sort of on top of, I guess, the PC replacement cycle. Thanks. Yes. No, it's great. We're very optimistic about that opportunity. But remember, it's a small part of the business, about 20% of the business. So while there's great intent to deploy and we're already seeing great deployment, So that is a little bit of a tailwind, but it's not by any stretch of the imagination a material mover of the business, but it is a nice additive. Barb, next question please. Next is Sarah Friar from Goldman Sachs. Great. Thanks for taking my question guys. Two questions. Just first On the overall environment, you sound incredibly upbeat. You've clearly had a very strong quarter. Was there any shift as you got towards the end of the quarter because clearly others through earnings I've started to note more weakness in Europe, for example, our government spending. So I'd just love to get your perspective. Yes. We didn't really see any differences Throughout the quarter and we are encouraged. We had strong demand and strong sales execution and obviously did This is slightly better than we had hoped and talked about last quarter for our product set. So we're thrilled with customers adopting our product. There was really no difference throughout the quarter. So it sounds like with the product cycles, your kind of expectation is you can kick through even some slight decline on the macro side? Yes. We certainly feel really good about the traction of our products, Ed. No doubt. Great. That's a lot of you there. Bart, next question, please. And next is Brent Thill with UBS. Peter, you're continuing your strong expense discipline in the quarter. I'm just curious You could talk about fiscal 2011 and what really changes as we go into next year to continue that discipline. You did take your expense guidance down a little Relative to your passcode, and if you could just explain what drove that? Yes. It's the same thing. This is an ongoing process, something we think about every day. And so Continually as we go through, we're always scrubbing. We're always looking at our plans. We're always looking to make the most effective use of the money. And as we've done that and we make progress, then we can lower our guidance and that's just what we did. We did better in Q4 Than we expected and we're continuing to take that into next year and we'll just focus on it continuously. Thanks, Brent. Operator, next question? Next is Kathryn Edward with Jefferies. Hi, good afternoon. Your contracted but not billed balance was up $1,500,000,000 this quarter. Can you tell us about that? Yes. I mean, as we said, it was strong bookings quarter all up. If you look at the revenue and the unearned and the C and Our bookings growth was 27%. And so it's reflective of the sales execution and the enterprise demand for our products. And it's interesting, Bill's kind of touched on this. It was very broad based across geographies and across products and across customer segments and size. And so that's what's really driving that. Will that continue to increase? I would just we haven't given guidance on that. We did give expectations on the unearned. So I would take that as sort of a proxy for how things are going. Okay. Thanks, Peter. Thank you. Next question, Barb. And next is Kash Rangan with Merrill Lynch. Hi. Thank you very much. Looking at the unearned balance for server and tools and MBD, it looks like it's back up to multi quarter highs And also your unearned metric, which you reported is well above what it has been the highest it's been in 8 quarters. Yet at the same time, the guidance for the annuity growth rate, it still sounds like we're in recession listening to your guidance on What seems to be low to mid single digit. Can you help us understand the disconnect here? It seems to me that You're being a little bit conservative with your annuity guidance for what seems to be 2 big product lines. Given the improvement in bookings off balance sheet, on balance sheet, It occurs to me that as the deferred revenue start to build up in your words and the normal seasonality that you should Take your guidance up in the next few quarters. So comments or reactions explanation would be appreciated. Thank you. Yeah. What you're seeing Kash is the Next year are a function of the deferreds that we've had. And as you mentioned, this is the Q1 where we've really bumped it up. So the recognitions in the annuity revenue that you're seeing The reported number is a function of sort of the challenges we've had on our deferred balance. And so as we build that up over time, you'll start to see the annuity business Paul, do better. So that's what you'll see as you get towards the latter part of next year, because this is the Q1 where we really saw that unearned balance So if the deferred continue to build up normal seasonality, why don't we should expect you to take your guidance For the annuity growth rate in your 2 main businesses, right? It's too early to tell. You should just take the guidance that we gave. It's our guidance for FY 2011. Okay, great. Thanks. Barb, next question please. Next is Brad Reback with Oppenheimer. Hey, guys. How are you? Good. So Peter, in the slides on 2018, it talks about COGS being sort of negatively impacted next year. Based on the expectation Mid teen growth in E and D, can you give us any sense of what the headwind is on the COGS side? Well, what I tried to do is give you the drivers And I think you should go through your model, think about what assumptions you're going to make. And clearly, the assumptions the biggest one that we like to call out that we think Most material by far is the growth in E and D and the headwind from the hardware sales, which is obviously a great thing for the long term. But in the short term, we'll provide a headwind to COGS. And so the reason we like to give you the drivers, it allows you the flexibility to kind of work I understand that's a pick here, but you did put the mid teen guidance out there. So Based on that, there's no way to give us any sense of what type of headwind that generates? So we're all on the same page here? I'd just say Brad do the math. And I think you'll it will come out whatever your assumptions are for the driver framework. So let's move on to the next question. Next is Sandeep Bhagral with Karas and Company. Thanks for taking my question. Peter, we are in the mid of Enterprise refresh and premium mix for business addition has gone up from 28% to 29%. But if I look at the historical trend During the mid of enterprise refresh, actually you have been in mid to late 30s in terms of the business premium mix. Why it has Only seen only 100 basis points improvement or is there a time maybe next few quarters where we can see it reaching to the historical level? Yes. I would say, 1, it is early in the refresh cycle, so we should watch it. I think that really is the answer. Next question please, Barb. And next is Ed McGuire from CLSA. Yes, good afternoon. Last quarter, you provided some metrics around your online services subscriptions. Could you provide some at least directional indications and Help us understand as well some of the traction around Azure and how that may be impacting some of the traditional server revenues? Yes. As we talked about on the sort of commercial, if you think of the productivity online services, as Bill talked about, 70% of those wins have been competitive wins, which has just been really good. So we're really accelerating the traction there. On the Azure side, it's early. We just launched that this year. The productivity online services are farther along from a customer perspective. But we've really accelerated the developers and the users we have on the Azure platform. It's not material to Financials now, but it's we're really sort of establishing a leadership position in that of users. And we've had some On the productivity side, we've had some great wins. We had the state of Kentucky, which has many, many 700,000 users. So acceleration and continued progress and leadership in that. Next question please, Barb. And next is Greg Moskowitz with Cowen. Okay. Thank you. Good afternoon, guys. Just a follow-up on Office 2010. Qualitatively, Peter, how are you thinking about consumer and enterprise adoption rates in the 1st 12 months or so post release as Compared with a similar period with regard to office 2,007? Yes. You should just take the guidance that we gave you on the non Annuity side, we sort of expected to track PC shipments, which is a pretty strong result, especially given the mix PCs to emerging markets where we have slightly lower cash. So we'll this quarter will be a big quarter. We'll look at the back to school and see how we're doing. But Other than that, we're very excited. Off to a great start. As you saw, the 51% number is a very strong number for early on. And Barb, let's move on. Let's make this the last question. And the last question comes from Rob Breza with RBC Capital Markets. Hi. Thanks for sneaking me in. Just quickly maybe as a follow-up to Greg's question, as you look at the PC shipments, your expectations for Q1 are helpful. As we look at the trend kind of in the second half of the year, would it be natural to assume after back to school holiday season that we see a slight tail off? Or can you just give us kind of maybe We're not giving color on sort of half by half. The one thing I would say that We'll continue all year that emerging markets will continue to grow faster than developed markets and that has an impact on our business. Great. Thank you. Thanks, Rob. Okay. So that will wrap up the Q and A portion of today's earnings call. We look forward to seeing many of you at the Financial Analyst Meeting next week, Well, we will provide more details about our long term strategies and provide you with a hands on opportunity to experience our technology and engage in great discussions with our management team. For those of you who are unable to attend in person, you will be able to follow the day from our Investor Relations website microsoft.com/msft. Please contact us if you need additional details. We sincerely hope to see you there. Thanks again for joining us today and have a great day. And that concludes today's call. Please disconnect your lines at this time.