MSFTextrememakeover

Thursday, July 19, 2007

Q4/07 Earnings

I'm tied up today and don't expect to post much on earnings this time around. The Xbox charge will blow earnings for both the quarter and the year, so that pretty much negates any anticipation for a "blowout". That said, Ballmer's recent public comments have had a certain unmistakable swagger. So expect the rest of the business to have done quite well. No doubt the company - and analysts with buy recommendations and/or investment banking relationships - will do their best to present the results in that light. Specifically, look for numerous references to "excluding the charge, EPS would have been...". While there's some merit to that wrt understanding how the rest of the business did, the reality is that rightly or wrongly (it's clearly wrongly btw) Xbox is part of MSFT's overall business now. In fact it's a significant part, especially for top line revenue and revenue growth. So excluding that charge is a bit like saying "the date went really well except for the part where I got drunk, spilled a glass of red wine all over her new dress, and she slapped me in the face".

The major focus, of course, will be on anything that gives a sense of how Vista is doing (answer: not nearly as well as it should be, all company rhetoric aside) and of course guidance for the year. Again, listening to the swagger coming out of Ballmer, Witts (who incidentally rivals Liddell for B-O-R-I-N-G) and others at the recent partner meeting, they seem to be very optimistic about FY08 - at least for now. So I don't anticipate any negative change to previous guidance. There's even a chance they could raise it slightly.

WRT the stock, it has suddenly reversed course and been surprising strong after tracking near perfectly against my earlier $28's downside forecast. Not sure what to make of that, except possibly that those comments coming out of the partner meeting caused the street to jump the gun and buy heading into earnings. Hopefully, there are enough positives on the conference call - or at least absence of negatives - that we avoid a post earnings selloff like INTC experienced. Of course, INTC had nicely outperformed the NASDAQ on the year heading into that, whereas MSFT - even given the recent strength, and in this, its major new product year - is still lagging it by more than 6%. So we'll see.

Pre-earnings:

Post-earnings and conference call:

So,

  • PC growth was stronger than expected (by a full 1%)
  • Foreign exchange helped revenue (by a full 2%)
  • "Each business grew revenue at double-digit rates at the high-end of our guidance"
  • The Windows premium mix did better than expected (up 17% to 72%)
  • MBD revenue was up 19% versus guidance of 13-14%
  • Enterprise agreement renewals exceeded the historic range of 66-76%
  • Dynamics bookings were up 24% (not great vs Salesforce.com, but better than normal)
  • They sold 400K less Xbox consoles (thereby avoiding the loss per unit * 400K)
  • 243M shares were bought back on the Q for $7B+ (thereby boosting EPS)
  • Headcount growth came in lighter than usual (again, should have helped income even though it's still excessive at ~10%)
And...

MSFT only managed to meet street expectations on EPS. Huh? Hey, I only report the stuff. I guess Ballmer's swagger was reserved for top line results only - part of a disturbing trend. BTW, notice how the earnings "caption" always gives away the plot? Last Q, for example, when earnings for a beat were there, the caption was "Microsoft Reports Record Profits". This Q, when it's just a meet, the caption is "Microsoft's Annual Revenue Surpasses $50B".

To determine why EPS weren't higher I reviewed the financials. FWIW, the first thing I always do is take MSFT's efforts to make growth of revenue vs earnings less easy to compare, and rearrange it so that it's clear cut. That yields a table that looks like this:

At first glance - and ignoring the usual losers - the issue would appear to be Client (see red highlight). That failure of earnings growth to match revenue growth is a real concern. But it's been one for a while, and includes such macro items as an increasing percentage of sales coming from emerging markets (where Windows sells for less). Indeed, Client revenue growth (at least) was actually within forecast (14% vs guidance of 14-15%). It's actually Server & Tools that came in light on revenue versus guidance (15% vs the 16-17% forecast). Additionally, they only matched on earnings growth (versus exceeding it as they have on some previous occasions). According to Liddell, some of the top line issue may have been a result of stronger than expected EA renewals. Whether that played any part in the bottom line impact is unclear. Finally, you have MBD coming in way above plan on revenue (19% vs guidance of 13-14%), but only matching that growth on earnings (it too has done better than that in some previous quarters). Bottom line, who knows? It's a $100M-$300M earnings mystery wrapped in an enigma - or maybe I'm just too tired to analyze it further. On the all-important Vista issue, it's clear from comments that adoption is behind expectation. Liddell's actual euphemism was something along the lines of "we're broadly happy with Vista adoption". But in the Q&A, he was forced to concede that MSFT took down expectations for next year from 85% Vista/15% XP to just 78% Vista. What did Ballmer say again? Oh right, "Vista will be great - bet on it". He must have meant "eventually". Rounding things out we have the pre-announced Xbox loss, which came in at $.08 (the high end of the previously given range of course). That took total losses in E&D for just the past two years to a whopping $3.176B. Yup, that's a "strong business" alright. Finally, Online continues to be a financial sinkhole and will lose money again next year (Xbox business plan redux?). Forecast revenue growth of 10-13% for Online in FY08 is also a joke compared to GOOG, YHOO, or the market as a whole.

So overall, revenue came in roughly as I expected. However, bottom line results were weaker (I expected 1-2 cents upside). Guidance for next year is in line with what I anticipated (i.e. a slight increase), which ultimately is good. But the implicit confirmation about Vista sluggishness, combined with the lack of margin and earnings acceleration next year - and guidance to continue hemorrhaging in Online, will likely take the wind out of the sails of the extra bullishness that had been building following management's recent upbeat comments. Some analysts may still take their estimates up slightly following the call (assuming that MSFT was just being conservative as usual). But I doubt we'll see anything like what followed IBM's strong results. BTW, IBM stock has now handily outperformed MSFT over 1, 3, 5 and 10 years. So much for MSFT being the "new IBM" - we should be so lucky.

For its part, MSFT is down in AH trading. Although exactly how much is subject to some debate (NASDAQ reporting last trade @ $30.90, down .61 from the close; MSNmoney and YHOO say $30.83, down .68). It will likely open weak tomorrow as a result (despite the MM's best efforts). It could have been worse though. Just look at GOOG in AH - down $39.06 according to MSNmoney (and it was down forty-something at one point). That should also hurt the market tomorrow.

Update:

"For people who think Microsoft is still a growth story, it's disappointing. It's a mature company in a mature industry with declining prices," Chowdhry added. "For people who think Microsoft is a value company, what they delivered today was quite good."

8 Comments:

  • You know, I almost agree with you that the XBox is wrongly part of MSFT's business. Really one of the big things preventing it from doing better is the simple fact that the brand "Microsoft" is an albatross around it's neck. MSFT is pretty absent when words like "innovation" get tossed around. Sadly Microsoft has become this generations Big Blue, while Google and Apple have all the sex appeal, which of course we know turns into huge stock growth. Of course you don't get those stock climbs without risk and this current generation MSFT is all about stability and minimizing the unknown, which is also going to translate to minimized stock fluctuations, either positive or negative.

    As a stock holder properties like the XBox, Zune and Marketplace are really the only ones that give me hope that something will happen to really raise stock value. Vista, Office, SharePoint, Live, Spaces, etc. are all in broad mature markets and even grand gestures like Office 2007's Ribbon or Vista's "vistaness" barely raise the market's pulse. Even in the developer tools segment, which I'm intimate with, MSFT only holds a slice of a pie, not dominates it.

    By Blogger Shawn Oster, at 2:52 PM  

  • Any thoughts on this?

    Joel Hirsh, an analyst at Kovitz Investment Group in Chicago, expects the stock to rise as much as 20 percent within 18 months.

    ``Yes, they are trying to find growth, but it's not like they aren't growing already,'' said Hirsh, whose firm manages $1.1 billion, including Microsoft shares. ``The beauty of this company for us is that other people are bored of it.''

    http://www.bloomberg.com/apps/news?pid=conewsstory&refer=conews&tkr=MSFT:US&sid=aF38gj9Ej3cE

    By Anonymous Anonymous, at 8:30 AM  

  • "As a stock holder properties like the XBox, Zune and Marketplace are really the only ones that give me hope that something will happen to really raise stock value"

    These properties give you hope?!? Oh, I get it - you mean hope as a stock holder in one of MSFT's competitors.

    The only thing that gives me hope is the possibility that someday the shareholders will get so fed up that they'll fire Ballmer and the rest of the clowns running this company. Then we can get some real management who will cut these money losing jokes like XBox, Zune, MSN/Live, etc.

    I've seen 3 iPhones in public (not including my own) in three weeks of sales and two weeks of observation (I was on vacation 6/29-7/5), versus 1 Zune in public in 8 months of sales and observation. And you know AAPL is going to come out with an iPhone-like iPod pretty soon. Let's be totally honest here: there is NO state of the world in which Zune will EVER gain ANY significant market share and EVER be ANYTHING than just another clunky, money-losing MSFT product that everyone in the consumer space laughs at, further tarnishing the brand name (though at this point you could argue that "you cannot tarnish a rusted blade").

    By Anonymous Anonymous, at 8:48 AM  

  • "Any thoughts on this?"

    The "other people are bored of it" sounds right. WRT his targets, sadly that's probably an optimistic scenario under Ballmer and current company MO. Hence the reason the stock can't build momentum - 20% potential upside, a repeatedly demonstrated ~30% downside, and an under market dividend while you wait. Why would new investors bother? They're better off buying an index ETF or mutual fund (less volatility, better return).

    By Blogger MSFTextrememakeover, at 9:32 AM  

  • Hey, check out the unearned revenue section at the end of "Financial Highlights" on the press release. Big 15% jump, on top of a big jump in Q4 last year. In particular, unearned growth in MBD and S&T was pretty excellent.

    What's that mean? Enterprise Agreements. Either (a) more of them (b) companies paying more for exising products because of subtle price hikes masquerading as segmentation or (c) companies adding new products. A and C would be very good for the long-term health of Microsoft's real business, which is selling software to businesses, B would be less-good but still not-bad (as long as Microsoft's price hikes keep prices lower than the cost of switching to another vendor).

    Anyway, that's why they raised guidance for 08, and I bet we start seeing MS beat expectations by a penny or two every quarter again.

    I would be much more worried as a Google shareholder now that the paid-search growth train is slowing down. They have no other business.

    That said, online and Xbox look more and more like retained hobbies for senior execs than a real concentrated effort to expand into new areas. Jeez.

    By Anonymous Anonymous, at 12:33 PM  

  • "Hey, check out the unearned revenue section at the end of "Financial Highlights" on the press release."

    Saw it. Yes, it's a positive and according to Liddell resulted from EA renewal rates above the historical trend (I mention the latter directly in the post and then again in the S&T discussion).

    "Anyway, that's why they raised guidance for 08, and I bet we start seeing MS beat expectations by a penny or two every quarter again."

    It certainly helped, as did expected PC growth for this Q. WRT the upside on earnings, yeah that's about the extent of the likely upside.

    By Blogger MSFTextrememakeover, at 3:26 PM  

  • Please don't lump MSN in with live.com. Unfortunately, the latter is what is causing the poor performance WRT the Online numbers. MSN is making money, not losing money, but is unfortunately saddled with the millstone that is live.com (specifically Core Search) that is dragging down overall revenue.

    If anything, the lack of leadership with Online is at the top levels--e.g. Ballmer, who continues to enable the crapfest that is Core Search to suck up huge amounts of resources.

    By Anonymous Anonymous, at 10:35 AM  

  • On the one hand this is difficult to believe...
    ft's Vista SP1 fixes not out until 2009?: "The tip, incredible. The source, ironclad. Microsoft has apparently told executives at one of the world's largest PC makers not to expect a formal release of Windows Vista SP1 -- the first major set of upgrades and bug fixes to its Vista operating system -- until 2009 at the earliest."

    On the other hand, we've known for several years the Windows OS architecture and build infrastructure has become unmanageable. Perhaps Vista's is even worse.

    If true, even remotely, the mind boggles at the dominoe effect.

    Something for the radar screen...

    By Anonymous Charles, at 6:21 AM  

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