Microsoft Corporation (MSFT) Q3 2013 Earnings Report, Transcript and Summary

Welcome to Microsoft's fiscal year 2013 third quarter earnings conference call. [Operator instructions.] I would now like to turn the call over to Chris Suh, general manager of investor relations. Chris, you may begin.

Thank you operator, and thanks everyone for joining us this afternoon. 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 April 18, 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 expense related to the non-tax-deductible European Commission fine. Details of the adjustments can be found in our financial summary slide deck and press release. And with that, I’ll turn the call over to Peter.

Thanks, Chris, and good afternoon everyone. Before I get into my comments about the quarter, let me say a few words about the CFO transition we announced today. As we all do throughout our careers, at various times we assess our personal and professional goals and priorities. Sometimes we change jobs, sometimes we change companies, and sometimes we step back to focus on family and other personal goals. As we approach the end of our fiscal year, for me personally, it’s a good time to refocus my priorities to spend time with family in a way I haven’t previously had the chance. I feel great that the company is on a path to an exciting future in devices and services, and I couldn’t be more proud of, and confident in, the finance organization. I look forward to working with my successor on the transition, including getting out and meeting with many of you. I have truly enjoyed working with all of you. And now on to the quarter. I’m pleased to report we drove revenue and earnings per share growth of 8%, even as we navigate an evolving device market. Our results reflect our diversified portfolio as well as the investments we have made in key strategic areas. During the quarter, we launched the new Office, our enterprise cloud services continued to gain traction, and we continued to take market share in the data platform. Before I dive into more details on our progress in these areas, I want to address what’s top of mind for many of you, which is our Windows business. There is no doubt that the device market is evolving. Consumers and businesses are increasingly shifting their focus to touch and mobility, and as a result, they want touch-enabled computing devices that are ultrathin, lightweight, and…

Thank you, Peter. First, I’m going to review our overall results, and then I’ll move on to the details by business segment. Our diversified portfolio helped us deliver solid financial growth this quarter. Revenue was up 8% to $18.8 billion, and operating income increased 5% to $6.7 billion. Earnings per share grew 8% to $0.65. Foreign exchange had a $180 million, or 1 percentage point, negative impact to revenue this quarter and a $99 million, or 2 percentage point negative impact to net income. From a geographic perspective, we saw similar growth rates across both developed and emerging markets. Multiyear licensing revenue continued to be strong, growing 16%. Additionally, unearned revenue grew 13% to $17.1 billion. And our contracted not billed balance was over $21 billion. In the Windows division, revenue was flat this quarter. Within that, OEM revenue performance was in line with the underlying x86 PC market, which continues to be challenged as the PC market evolves beyond the traditional PC to touch and mobile devices. This quarter, inventory levels were drawn down as the channel awaits new Windows 8 devices. Non-OEM revenue grew 40% this quarter, driven by sales of Surface and continued double digit growth in volume licensing. Businesses continue to value the Windows platform, and volume licensing of Windows is on track to deliver almost $4 billion in revenue this year, and nearly three-quarters of enterprise agreements that we signed this year include Windows. Additionally, this quarter we saw continued progress in the transition of Windows XP to Windows 7, and now two-thirds of enterprise desktops are running Windows 7. Next, I’ll move on to our server and tools business, where we continue to have good momentum. Revenue grew 11%, highlighted by multiyear licensing revenue, which grew 20%. The strength in multiyear licensing reflects the…

Thanks, Chris. For the remainder of the call, I will discuss our expectations for the fourth quarter, and share some thoughts on fiscal year 2014. Let me start with the fourth quarter. In the Windows division, similar to this quarter, revenue will continue to reflect sales of Surface and strong volume licensing, while OEM revenue will be impacted by the declining traditional PC market as we work to increase our share in tablets. Within server and tools, product revenue, including transactional and multiyear licensing, is about 80% of the division total revenue. Enterprise services is the remaining 20%. We expect both product and enterprise services revenue to grow low double-digits. In the Microsoft business division, multiyear licensing revenue, which is approximately 60% of the division’s total, should grow low double digits. Excluding the recognition of revenue from the Office upgrade offer, transactional revenue, which is the remaining 40% of the division total, should be in line with the x86 PC market. As a reminder, when updating your Q4 models, we expect to recognize approximately $780 million of revenue related to the Office upgrade offer. In the online services division, we expect revenue to grow low double-digits, reflecting growth in search revenue, partially offset by lower display revenue. Moving on to the entertainment and devices division, we expect revenue to grow mid teens. For the fourth quarter, we expect COGS to grow mid teens, including Surface. Other income and expense includes dividend and interest income, offset by interest expense and the net cost of hedging. In the current low interest rate environment, we expect these items to generally offset. We are reducing our full fiscal year guidance for operating expenses to $30.2 billion to $30.5 billion. This range excludes the impact of the European Commission fine of $733 million. At the full fiscal year, we expect our effective tax rate, excluding the expense related to the European Commission fine, to be 17-20%, and we continue to expect capital expenditures to be about $3.5 billion. Excluding the impact of the Office upgrade offer, unearned revenue should roughly follow historical seasonal patterns. Now turning to fiscal 2014, we expect fiscal 2014 operating expenses to be $31.6 billion to $32.2 billion, which represents growth of 4-6% from the midpoint of our updated fiscal 2013 guidance. We will continue to prioritize our spending while investing in the significant opportunity that is ahead of us. As we look towards the future, we have a solid foundation of products and services in market, and our leadership team is collectively focused on advancing every one of our businesses. You can expect to hear more about the specific actions we are taking over the next few months. And with that, I’ll turn the call over to Chris and we’ll take some questions.

Thanks, Peter. We want to get questions from as many of you as possible, so please just keep to one question. Operator, please go ahead and repeat your instructions.

[Operator instructions.] And our first question comes from Mark Moerdler with Sanford Bernstein. Your line is open, sir.

Thanks for the cloud data. We’ve been looking for a lot of this, so it’s very helpful. Let me ask two related parts to that. Can you give us a sense on the growth metrics in terms of Office 365, which is what you’re starting to give here, in terms of revenue, users, customers, something that we can think about there? And the second half of it, can you give us a sense in terms of the percentage of Office 365 customers that are net new to Exchange? I know you’ve given little bits of data on SMB and new SMB customers, but any sense there would be appreciated.

On Office 365, the metric that we gave was net seat additions were up 5 times over the prior year, so that gives you some growth metric in addition to the revenue number. To your point on Exchange or more broadly, I would say about other workloads, we’re seeing exactly that dynamic. So not only are we addressing and reaching new customer segments like SMB, but many of them have never had a productivity server workload before. Not just Exchange, but others as well. And even those that had Exchange are now using other workloads, and so we’re seeing most of our customers having more than one workload. So across every dimension in terms of new revenue streams from the service, new customer segments, and new workloads, there’s a lot of new, and that’s what’s driving the growth and the opportunity that we’ve been looking for.

And our next question is from Philip Winslow with Credit Suisse. Your line is open, sir.

You provided a little bit of color on Surface. Obviously we’re seeing expanding portfolio there. I just want to get a sense of how this evolving, especially on the distribution side, and how the product is doing versus your expectations. And then when you start to think about going forward, how would you also expect the product portfolio to evolve, as well as distribution?

As I said, we are expanding both the product set and distribution, and that is broadly, all devices, inclusive of Surface. We are expanding distribution of Surface. We are now in 22 countries, 70 retailers. And we’ll continue to look to expand that. Not only just expanding, but improving the experience. And that’s true not just for Surface, but for broadly Windows 8 devices. And so we’ll be investing against that for both Surface and a broader array of Windows 8 devices at multiple price points, including lower price points going forward.

Walter Pritchard with Citigroup, your line is open.

I wonder if you could weigh in. There’s been a bit of a debate this quarter around what the underlying PC market did. And I think you see numbers ranging out there from mid single digit declines to a mid teens decline. I’m just wondering if you could weigh in on that. In the past you’ve given some sort of range. And then related to that is if you look at the second half, I’m wondering how we should set our expectations around this mid to high end Haswell release from Intel in terms of impact it may have on the PC market versus the later year, more holiday time, lower end Atom release, and how those two chip releases may have an impact on what you’re expecting from the device market and overall impact on Windows?

On the PC market, I would look to some of the third parties, IDC and Gartner. They’re sort of in the 12-13-14 down range this quarter. And in terms of the chipsets, we’ve always felt that with Windows 8, it was a process of the ecosystem really innovating across the board, and really starting to see that on the chips. And we’re very encouraged by both Haswell and some of the Atom processors to really improve the overall user experience that Windows 8 delivers. And over the coming selling season, I think that’s very encouraging and we’re optimistic about that.

Heather Bellini with Goldman Sachs, your line is open.

We’ve heard Intel talk about Haswell, and they mentioned it on the call, I think it was last night. You obviously mentioned it. And I guess I’m just wondering what can you guys do to specifically help grow your tablet share given you are reliant, ex the Surface products, on OEM partners to really hit a broad segment of the market. And I’m thinking in general, given the OEM partners don’t have much wiggle room on the margin side, what can you do to help stimulate your market share, in particular in the mobility and in the tablet side?

I think broadly, in improving our position in tablets, and generally in devices, there’s five or six dimensions ranging from what we’re doing with OEMs on the devices and the range of devices, and how they can have a range of price points. What the chips can do, because I think that’s a part of it. Both first party and third-party apps, and we’ve seen improvements across the board there. The user interface, and how we’re innovating across the user experience. And then distribution So if you start sort of from the bottom up, all the way to when you buy the product, we’re working across all those dimensions. And on the device side, we are working closely with the OEMs to help them take Windows 8 and show it off in all its glory, across different form factors. I talked about new smaller form factors and how Windows 8 can innovate to improve that experience. So I think the biggest thing we’re doing is helping them develop new and improved user experiences across the board, across size, across price point, and deliver a really compelling Windows 8 experience. And it’s not just the devices, like I said, it’s chips, it’s the apps, it’s the buying experience, it’s the user interface. So we’re really focused on all five or six of those dimensions going forward.

Keith Weiss with Morgan Stanley, your line is open.

You mentioned on the call that going to subscription revenues does have a near term impact on your revenues. I was wondering if you could help us understand whether we’re seeing that impact today, and perhaps to what degree, with the strong uptake of some of the cloud services, particularly like Office 365.

We are seeing that, particularly in our transactional business, in MBD, as people move from what may have been a transactional to a perpetual license, where the revenue is recognized up front, to a subscription service, where it’s recognized ratably. So you’re basically deferring the rest of the term of the subscription. So in the short term, you’ll be deferring revenues that were not in a subscription, and would have been recognized immediately. And as the subscription business is growing, you’ll see that impact growing, but over time, what you’ll get is what looks like an annuity revenue stream, that’s more predictable and has higher customer satisfaction and probably higher retention rates going forward. But in the short term, that will impact mostly in the transactional side of the MBD business.

Brent Thill with UBS, your line is open.

Peter, just on the gross margin, it’s been under pressure for the last several years, but this quarter it did bounce back. Can you just give us a sense of how you think gross margins will trend, and do you expect a slow improvement from here or expect more of the same in terms of where they’ve been in the last couple of quarters?

Gross margins, as you know, are always going to be a function of mix. And so depending on where you are in the quarter, the biggest driver of what your gross margin is going to be is mix. So if you have a big hardware quarter that has low gross margins, that will impact it. The biggest things that are going to impact the mix are going to be hardware, cloud services, and enterprise services, or people services. It is a fact that we are starting to get scale in our cloud services, and so the growth that we’re seeing in Office 365 is really coming at an improved margin as we scale that out. So within each, we made progress, and then overall, in any given quarter, for the company it’s going to be a function of mix. So obviously in a holiday quarter, where you sell a bunch of hardware, that will have an impact on gross margin. But I think one of the main takeaways for me is in particularly some of our cloud services, we’re really starting to get scale. Bing continues to improve, their margins. And Office 365 is really starting to get to scale. So those things are really encouraging.

Ed Maguire with CLSA, your line is open.

You just launched your Azure infrastructure as a service. Just went generally available this week. And I’d love to get some color on how much that’s figuring in the growth in long term contracts, and what your expectations might be for more traditional infrastructure as a service uptake over the next several quarters.

Great question. It’s clearly a key enabler of our cloud OS story, and how we’re driving what we’re doing with enterprise in the data center. We have infrastructure as a service, we have now the most complete end-to-end offering through platform, and software, identity, and access. But having the infrastructure is a key enabler, and I think a real accelerator for the Windows Azure strategy, and really more broadly the cloud OS strategy. We now have a complete end-to-end story through the data center, from private, to hosted, to public, from infrastructure to platform, so I think it’s, again, a key enabler of that [all up] strategy, and an accelerator.

John DiFucci with JPMC, your line is open.

My question is for Chris. Just wanted to clarify something you said about inventories. I think you were talking about PC inventory. But with the Windows business, can you give us your assessment of what Windows inventory is at OEMs, especially given the disappointing PC shipment data this quarter?

I did mention the fact that we believe inventories were drawn down. We do think they’re at normal levels at this point, though.

Gregg Moskowitz with Cowen & Company, your line is open.

In recent periods, we’ve seen your MBD growth significantly outpace PC unit growth, although we now have a dynamic where your Office subscription is really resonating with customers. So the question is, just looking at it on a directional basis, is MBD revenue outperformance relative to PC units something that you think is sustainable going forward?

The answer is that it will depend, and certainly an offset between attach gains we’re making against the market, offset against some deferrals as revenue moves to a subscription. And so it will kind of depend each quarter. Long term, it’s a great trend, because we’re building up a banked book of business on the subscription side, which will become less and less connected to the PC market.

Raimo Lenschow with Barclays, your line is open.

If you look at IBM coming out earlier on today having a relatively tough quarter given the economy, can you just comment on a little bit of what you’re seeing out there, especially server and tools division obviously doing relatively well, but other guys are really struggling. So help us understand how you see the economy.

I think about the economy, and then I think about the value proposition of our products. Clearly there are tough spots in the economy. I think enterprises and CIOs are looking for what they’ve always been looking for, which is how do they get the best value for their dollar to move their businesses forward. And I think we have a very good story in terms of the value that enterprises and small and medium businesses get from the capabilities that they can get from us, particularly in the data center, with SQL. And as you compare SQL Server to competing products, the performance that you get relative to the price is really a compelling value proposition, and that’s what’s been enabling us to take share. The same on virtualization as well. And so I think for us, it’s a combination of having the most complete roadmap for getting to the cloud, as well as the best collection of products that have price performance characteristics that are attractive to CIOs that are allowing us to have growth in our enterprise business, particularly in server and tools.

Our last question comes from Brad Reback with Stifel. Your line is open.

Peter, as you look at the PC data over the course of the quarter, can you give us any sense of how that trended? And following up on that, as you think about the business upgrade cycle, which should be over by this time next year, do we risk a real fall off again in the PC business, because the upgrade cycle has aided what’s been a difficult PC market the last couple of quarters?

On your first question, there wasn’t anything abnormal in terms of the trends during the quarter. On your second question, the upgrade cycle, particularly for businesses, will be interesting over the next year. I think over the longer term, what’s more interesting is the long term evolution we’re seeing in the device market, which I think is actually going to be more of a driver than any temporal upgrade cycle. Innovation is happening faster, people are getting new experiences and new form factors. I think that’s what Windows 8 was designed to take advantage of, and so I think about the opportunity more about the new capabilities and the new services, and the experience that people can get on their devices and different kinds of devices, than it is about an upgrade cycle that’s driven by something else.

So that will wrap up the Q&A portion of today’s earnings call. We look forward to seeing many of you in the coming months at events such as E3, TechEd, and Build, as well as at various investor conferences. For those of you unable to attend in person, these events will generally be webcast, and you will be able to follow our comments at Microsoft.com/investor. Please contact us if you need additional details. Thanks again for joining us today, and take care.