Microsoft Corporation (MSFT) Q2 2013 Earnings Report, Transcript and Summary

Welcome to Microsoft's fiscal year 2013 second quarter earnings conference call. All lines have been placed in a listen-only mode until the question-and-answer session. Today's call is being recorded. If anyone has any objections, you may disconnect at this time. I would now like to turn the call over to Chris Suh, General Manager of Investor Relations. Chris, you may begin.

Thanks, operator and thanks, everyone for joining us this afternoon. This does feel like a bit of a homecoming. Some of you may remember, I was in IR a number of years ago. I am excited to be back and looking forward to working with all of you. With me today are Peter Klein, Chief Financial Officer, Frank Brod, Chief Accounting Officer; and John Seethoff, Deputy General Counsel. On our website, microsoft.com/investor, is our financial summary slide deck which is intended to follow our prepared remarks and provides a reconciliation of differences between GAAP and non-GAAP financial measures. As a reminder, we will post today's prepared remarks to our website immediately following the call until the complete transcript is available. Today's call is being 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 January 24, 2014. During this call, we will be making forward-looking statements that are predictions, protection or other statements about future events. 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 factor section of our Form 10K, 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. Before I hand the call over to Peter, I would like to remind you all that all growth comparisons we make on the call today will relate to the corresponding period of last year. Also, unless specified otherwise, all impacted numbers for the current quarter have been adjusted for the cumulative effect of the revenue deferral and recognition related to Windows, Office and Xbox videogame and the details of those adjustments can be found in our financial summary slide deck and press release. With that I will turn it over to Peter.

Thanks everyone for joining us. I am pleased to welcome Chris as the new head of investor relations. Chris has been with Microsoft for over 16 years and has been in diverse finance role which gives him a good background for this role. I also want to thank Bill for all he has accomplished over the past four years and congratulate him on his new role as the CFO of the Skype division. This quarter we had record revenue of $22 billion and record earnings per share of $0.81. It has been an exciting quarter with the launch of Windows 8 and Windows Phone 8. In the enterprise, we continue to see solid demand for our business products and services with particularly strong growth in multiyear licensing. Multiyear licensing revenue benefited from healthy renewals of enterprise agreements as customers continue to make long-term commitments to the Microsoft platform. Our robust portfolio of enterprise products and services enable CIOs to build efficient infrastructure, unlock business insight, improve productivity and support bring your own device. In the data center, recent releases of Windows Server 2012 and System Center 2012 are driving customer wins and strong renewals. Our cloud OS roadmap uniquely positions us to support the hybrid infrastructure needs of CIOs by providing one consistent platform that can span their own data center, our partners data center, or Windows Azure with ultimate flexibility, portability and scale. On the data platform, we are growing our revenue share as enterprises continue to move mission-critical workloads to SQL Server and deploy it for their business intelligence solutions. In productivity, we are excited about the upcoming launch of the new Office, and how it redefines user experience with mobility, social and cloud features. The new Office features a fast fluid design that takes full advantage of…

Thanks, Peter. First, I am going to review our overall results and then I'll move on to the detail by business segment. Revenue for the quarter was up 5% to $22 billion. Operating income was $8.3 billion, up 4% and earnings per share was $0.81, also up 4%. Foreign exchange had a $200 million, or one percentage point negative impact to revenue this quarter and $154 million, or two percentage point negative impact to net income. From a geographic perspective, we saw growth return in developed markets and saw mid-teens growth in emerging markets. Bookings were strong growing 11% as we're continuing to see customers making long-term commitments to our products. You see the results in the following metrics. Multi-year licensing revenue grew 15%. Unearned revenue grew 13% to $17.4 billion, and our contracted not billed balance was over $21 billion. Moving to Windows. This quarter total revenue grew 11%. Within that OEM revenue outperformed underlying x86 PC market, reflecting increased demand in our distribution channel. While inventory levels ended the quarter at slightly higher levels than the prior year, we believe them to be in a healthy range given the recent launch. Non-OEM revenue grew over 40% driven by Windows 8 upgrade, sales of Surface and double-digit growth in volume licensing. Within the x86 PC market, we saw similar trends to prior quarters with emerging market outperforming developed markets and business outperforming consumer. The Consumer segment was the most impacted by the ecosystem transition as demand exceed the limited assortment of touch devices available. Next, I'll walk through our server and tools business, which posted another solid quarter with 9% revenue growth. Product revenue grew 9%, and within that multi-year licensing revenue grew 17%. On the strength of both, new and existing customer bookings grew a solid 15%. For…

Thanks, Chris. Through the remainder of the call, I will discuss our expectations for the third quarter and full fiscal year 2013. Looking ahead with Windows, we know that our growth depends on our ability to give customers the exciting hardware they want, at the price-points they demand and a wider range of apps and services to meet their diverse needs. We are hard at work with our partners to meet these goals. One of our biggest partners, Intel, not only delivered the Clover Trail chip this year, they have said they will deliver their next generation chip, Haswell, in 2013, which will enable even more advances in the device market. This is just one example of the innovation we are seeing from our chip partners. We also need to continue to work with our hardware partners as they create thin and lightweight devices on both x86 and ARM chipsets that offer compelling touch experiences that bring Windows 8 to life. You have started to see the next wave of Windows devices at CES, and collectively we will work to ensure that we have the most compelling devices and the right mix of devices in the marketplace. During the quarter, we launched the first device in our Surface family of products. We recently increased production and expanded distribution to third-party retail partners. Next month, we will make Surface Windows RT available in 14 additional countries. At the same time, we will also launch Surface Windows 8 Pro, which provides the power and performance of a laptop in a tablet package. With the broadening of the Surface lineup, we will continue to highlight the power of Windows 8 tightly integrated with fantastic hardware. On the app front, we are deepening our engagement with developers. While the number of apps in the…

Thanks, Peter. We want to get questions from as many of you as possible, so please just stick to one question and avoid long and multi-part question. Operator, please go ahead and repeat the instructions.

Thank you. We will now begin the question-and-answer session. (Operator Instructions) Our first question comes from Philip Winslow of Credit Suisse. Your line is open, sir.

Thank, guys and congrats on a good quarter in a pretty tough macro environment. Just wanted to spend a moment on Surface. You obviously talked about ramping up production and distribution of that. Just what are some of your goals as you look at Surface, RT and Pro for this year? Within that context, how should we think about the profitability of the Surface? Thanks.

Thank, Phil. As we said, we think of Surface as one part of the overall Windows 8 story. Certainly this quarter it was a contributing factor to the revenue growth in Windows Business. What it does is it highlights some interesting innovation that can happen to demonstrate the power of Windows 8 when tightly integrated hardware and software and new categories of devices, and where, obviously we had some limited distribution this quarter in our stores. As you know, we are excited about expanding that. So our goal is to continue to build that business to highlight the incredible power of Windows 8 in an interesting set of devices. We are going to expand geographically. We are going to expand the product line up. We are going to expand retail distribution and capacity. So we look forward to continuing the growth of that business.

Thanks, next question please.

Our next question comes from Walter Pritchard with Citigroup. Sir, your line is open.

Just wondering, Peter, if you could talk about, obviously, one of the big differences here between your devices and market and some of the competing devices I think is price point of touch machines, Windows devices, are much higher. I am wondering if you could just talk about what you learned here in the first three or four months of the Windows launch? How important price is to the customer base in terms of driving units? What do you think the outlook is in terms of getting price points down on the devices in aggregate in order to potentially drive some demand?

Thanks, Walter. We have learned a lot this quarter. We learned a lot about the types of experiences and scenarios and to some extent the price points the customers are looking for from their devices. We saw some really great demand for some of the touch devices that we brought to market. In some cases, we didn’t have the supply that we needed to satisfy that demand. From a price point, we learned what we have always suspected, which is this segmentation and differentiation. There is one of the powers in the Windows ecosystem, obviously, is the variety of devices and form factors and experiences at a variety of price points. We learned that that continues to be important. As I said, we are working very closely with both our chip partners as well as the OEMs to bring the right mix of devices which means, to your point, the right set of touch devices at the right price point depending on the unique needs of the individual. We learned a lot about that and one of things you will see is a greater variety of devices at a bigger variety of price points that meet the differentiated needs of our consumers.

Thanks, Walter. We will take the next question, please.

Our next question comes from Rick Sherlund with Nomura. Your line is open.

Thank you, and Chris, welcome back to IR.

Thanks, Rick.

MBD, I just want clarification because the revenue growth is a little slower than I would have thought but it looks like what we are seeing is a transition in the business. It looks like in business transactional, it is more multiyear licensing and the bookings growth would suggest that that business is changing to be more revenue over time versus upfront. Just want a clarification if I am thinking about that correctly.

Thanks, Rick. You are thinking about that absolutely correctly. We have seen big increases in multiyear annuity business. Bookings growth was very strong. So you are seeing that transition to long-term commitment to the business. Secondarily, this quarter obviously in a prelaunch quarter, cyclically you tend to see a slowdown in transactional business as well but that was secondary to this longer-term trend of transition to the multiyear commitment.

Okay, thanks, Rick. Next question, please.

Our next question comes from the Adam Holt with Morgan Stanley. Sir, your line is open.

Great, thank you. Sorry to ask a model question. My question is about cash flow and I guess two factors around cash flow. Could you just drill in a little bit into the delta between bookings growth and billings growth in the quarter? Then could you also just touch on the inventory in the quarter? It looked like it was a little above what it normally is. Thank you.

Well, as always there's sort of difference between bookings growth and billings growth is going to be function of the mix of long-term agreements, right? Because, our multi-year licensing agreements are three-year agreements and so bookings will include all of that revenue from the agreements and then typically those are billed a year a time, so the billings growth sort of that one-year of billings. And, so to the extent we see this sort of growth in the multi-year licensing business, you are going to see a buildup of bookings growth is going to be fast. You are going to see a buildup of deferred revenue now move in sort of into billings and then recognition for the income statement over time. And, so to the extent we continue to see transition to long-term commitment, you will expect to see that trend continue. Your second question was on inventory, when you say inventory, you mean on the balance sheet?

Yes.

Yes. The inventory is a function of both, what's happening in the Xbox business and Surface. They are sort of offsetting impact this quarter. Some of it is from Surface and then some of it is from the Xbox business.

Terrific. Thank you.

Our next question comes from Heather Bellini with Goldman Sachs. Your line is open.

Great. I had a question about, Peter, you mentioned the renewal rates in MBD continue. I guess, they are at a record and continue to move higher. I am just wondering if you could share with us what's driving the increase in the renewal rates and how much runway do you have left there. Then actually I had a follow-on Adam's question about inventory, because usually it goes down in the December quarter. Obviously, you have Surface now, so it jumped up, but did we see the traditional Xbox work down of inventory that we normally see? So, should we be looking at the fact that the delta between the drawdown that you normally see and the fact I think it went up or was roughly flat this quarter was the result of Surface?

Okay. I'll start with your first question, which was MBD renewal rate, you know, I think it's a combination of things. Heather as you know over time, we've been broadening the notion of how we think about productivity and so I think it's a combination of a couple of things. One is, just the product set, Lync is a big driver, SharePoint, Exchange, so the connection between the collaboration and communications' technology and the enhancements to just the productivity applications themselves, I think Office 365 and the roadmap to the cloud is really exciting to customers and part of the reason they are making the long-term commitment to MBD and to the Office and related products, is because our roadmap to the cloud really resonates with them in how they get there over time and how that works. I think also, our roadmap from a capability perspective and what's coming in the new Office, with social, again, advances in the cloud is really driving sort of a roadmap that's compelling to customers and so that's why they are making long-term commitments to the platform, so that's great to see. In inventory, yes, you are thinking about it right. I think we saw the normal sort of drawdown from the Xbox business in any offsetting increase there was related to Surface.

Kash Rangan with Bank of America Merrill Lynch. Your line is open.

Hi. Thank you very much and happy New Year. It's already quite a bit into the year, but what I was wondering was in the holiday season post a launch for Microsoft typically we get a big effect to the PC industry. It's happened every cycle, and I guess we had some competition from tablets and we didn't quite see that kind of whiz-bang effect with a typical Windows launch. I am curious to get your take on what is it that the media and the industry seems to have gotten it wrong? What are the misperceptions about Windows 8, and how do you think the year is going to play out as far as Windows 8 receptivity in the consumer market and business market.

Yes. Thanks, Kash. Windows, as I talked about, Windows 8 is a sort of big, bold, re-imagining of Windows across the whole ecosystem, and I think this was the start of that process. I think, we all collectively learned a lot about from the user interface to the touch devices. And, as I tried to give context on the call, there's a lot of things we are working on with our partners that I think to continue to drive this process forward over the next several quarters whether it's the chipset, whether it's with developers or the kinds of applications that people want and certainly for the kinds of touch devices that they write price points that consumers want I think all of that continuously improving, we are continuously learning and happens over time, but this is a big ambitious re-imagining of Windows, and this quarter was the first step in that process.

Got it. So, the traction, the ramp should get better over time and so we should not be judging the cycle for the December quarter necessarily.

I highlighted the things that drive that exactly.

Thank you.

Thank you, Next question, please.

Brent Thill with UBS, your line is open.

Peter, just on the gross margins, they have been under pressure the last several years. There is a lot of components that go in that you get to see but certainly we don’t get to see. Can you give us just the puts and takes of perhaps, is there any change later in the year, when you start to see some of the components of the COG, the expenses start to come off, or not?

Well, COGS is always going to be a function of the mix of the types of revenue and so its really depend on what your underlying assumptions are about the differing components of the revenue, whether that’s hardware related revenue in Xbox and now in Surface, whether its multiyear licensing business in enterprises and what online services. So at any point in time, it's really going to depend on that mix of revenue, which is just going to cycle over time. So we try to give you some sense for the rest of the year how we see that playing out in total at Microsoft and again that’s going to be a function of the mix we see between the various components.

And tend to reiterate in Peter's guidance, excluding Surface. I think Peter just high-single digits COGS for (inaudible) Surface.

That’s right.

Thank very much. Next question, please.

John DiFucci with JPMC, your line is open.

Thank you. Peter, you said that the Windows OEM revenue outperformed the x86 PC market and your comments imply some Windows inventory build into the channel which I believe you normally see during a quarter with a Windows launch as OEMs build inventory in preparation for the launch. Would it be accurate to assume that the Windows outperformance was primarily relative to the PC market? Was it primarily due to the inventory build or was there something else there happening? Was there anything else used to give us that bridge which you haven’t for a while now, but I just wondered if any of those other factors had a big influence?

Yes, the three biggest components of the 11% total revenue growth, that 11% adjusted for the recognition of the deferrals, in the Windows business were the retail upgrades, the sales of the Surface and then multiyear licensing agreements within enterprises. To your point, there was some tailwind from inventory which was normally as you highlight what we see in the launch quarter and as Chris said, it's within the healthy range that we typically see. But that was some tailwind. But the three big impacts all up on the Windows revenue were the retail upgrades, sales of Surface and the enterprise annuity business which continues to grow double-digit.

Any detection of any piracy effects or changes?

We are going to run the same long-term trend on piracy that we have always been. I wouldn't highlight anything specific to this quarter, but as always we are fighting piracy across all the dimensions and the long-term trend should be good, but that will cycle up and down in any given quarter.

Thank you. Next question, please.

Colin Gillis with BGC Financials, your line is open.

Hi, Peter, the trend in OSD in terms of the smaller losses. Is that a run rate that we can think about going into the March quarter? Also when you talked about the improvement in revenue per search, is there any more color or quantification you can put around that?

On the first question, the guidance we gave on the revenue, we continue to work hard on the cost structure, but certainly as we highlighted the dynamics on revenue will be relatively consistent to what you see this quarter. In terms of the monetization, it's what we have been very focused on here. Part of it is the work we have done with our partnership with Yahoo. Part of it's the quality of the searches that we have been doing. It's the realization of all the work we have been doing on both the search engine as well as the app platform to make sure it's finally tuned to deliver the best economic result and that's what we been talking about this for, gosh, a year and a half, two years. We have been really focused on that with our best talent and you start to see that paying off and that's what's driving the monetization.

Thank you. Next question, please.

Brendan Barnicle with Pacific Crest Securities, your line is open.

Thanks so much. Peter, you highlighted the market share gains you guys are seeing in SQL Server and specifically you talked about BI and mission-critical applications. I was just wondering if you could give us any more color on the use cases and applications where you guys are particularly seeing the biggest gains and any impact that pricing maybe having on that. Thanks.

The biggest impact is the capabilities that we have delivered with SQL Server 2012. In terms of the use cases, there is couple of things that fall into those buckets of mission-critical and BI. In terms of mission-critical, we are seeing large enterprise customers re-platform on SQL for any number of things, underneath their ERP, underneath what are the major sort of LOB apps they have that sort of drive their business and that's really an emerging trend with 2012 and what that does. That's really advance and I would add that that's been one of the drivers of our transition to multi-year licensing, because now we're seeing customers commit more and more to SQL as part of their multi-year enterprise agreements as well. On BI side, the combination of SQL as well as SharePoint and Excel is really compelling to customers in terms of the business insights they can generate from their line of business application systems, and I think really the combination of the types what you see frontend on Excel, on top of the SQL database is really good of a driver for both businesses frankly and that's a lot of what's driving the multi-year licensing business up about MBD and FTB.

Gregg Moskowitz with Cowen & Company. Your line is open.

Okay. Thank you. You had mentioned that over 60% of enterprise desktops now are running on Windows 7, looking forward how do you expect the cadence of migration activity to unfold from now until the termination of XP support in early to mid-2014. Does it continue at a similar pace for a while and at what point do we probably see this moderate?

Well, the one thing I would say is not only over 60% of Windows 7, but about 90% have expressed, they have a plan to do that and so I expect to see sort of steady drumbeat between now and end-of-life for XP support in April 2014 for that to continue because the incentive is there and the express desire to do that has been expressed by our customers, so I would expect to see that continue over the next year, year-and-a-quarter.

Operator, I think we have time for two more questions, please.

Thank you. Our next question comes from Raimo Lenschow with Barclays. Your line is open.

Yes. Thanks for taking my question. Just to follow-on, on that one. You had one quarter Windows 8 now. What was the feedback that you had from the enterprise so far? I mean, obviously, they are still in the middle of the Windows 7 upgrade as well, but what's the point that they liked about Windows 8?

Yes. There's a couple of things. They like the ability to get thin lightweight devices with the kind of security and manageability that they are used to manage their business and also there's early interest in new applications being developed with the Windows 8 interface which is a new way for their users to interact with their business applications, so I think you will see those two things are early information in driving the business interest in Windows 8.

Final question, please.

Yes, sir. Last question comes from Ed Maguire with CLSA. Sir, your line is open.

Thank you. Good evening. I wanted to follow-up on Rick's question about the transition from the transactional to a multi-year deal. How much --

I think we lost the question.

I am sorry. Mr. Maguire, (Operator Instructions). Mr. Maguire, your line is open.

Thank you. How much of your. Just going back to Rick's question, regarding the transition of transactional to multi-year revenues, what in your business reflects the transition in purchasing of on-premise to hosted or cloud offering like from Office to Office 365 or Server to Azure and other similar transitions?

Well, a cloud purchase will sort of mirror multi-year annuity pressures. It's a very similar way to accomplish the same thing. You are making a long-term commitment, the revenue is going to be recognized in a similar fashion. Today, we see a hybrid where customers are buying multi-year enterprise agreements. They'll also add-on some cloud services with that, but it will manifest itself in our financial results in a very similar way.

Okay. So, that will wrap up our Q&A portion of today's earnings call. We look forward to seeing many of you at the numerous events and conferences, which we'll be participating in this quarter. For those of you unable to attend in person, these events will generally webcast and you will be able to follow our comments at microsoft.com/investor. Please contact us if you have any additional questions or details. Thanks again for joining us. Take care.

Thank you for your participation on today's call. The call has concluded. You may disconnect at this time. Thank you.