Microsoft FQ3 Mixed, Walking From Yahoo Deal More Likely

Summary: Quarter was mixed--not the blockbuster Wall Street was looking for. FQ3 revenue was slightly below consensus (surprising). Operating income and EPS were strong (after factoring out impact of EU fine and a reduction in the tax rate). June revenue outlook okay, but EPS guidance is below current consensus. FY2009 guidance fine--above consensus for both revenue and EPS. Not surprisingly, stock is down.

Impact on Yahoo deal: This will make it more difficult for Microsoft to complete the deal. In recent days, the bid value had climbed almost all the way back to $31. Now it will be down again. If Microsoft wants to raise its offer, it will have to offer more shares or cash. Yahoo has now dug itself in deep. Not surprising, therefore, that Microsoft appears to be laying the groundwork to walk away.

Revenue of $14.45 billion is slightly short of consensus. This is disappointing.

EPS strong: $0.47, above guidance, consensus, and whispers due to stronger than expected operating income (EU fine and tax benefit canceled each other out). This is good, but won't likely neutralize concerns about revenue.

Free Cash Flow: Actually down year over year on lower cash from operations (lower deferred revenue) and higher capital expenditures. Lower deferred revenue also not good news.

Outlook: June revenue guidance is fine--range of $15.5-$15.8 billion, modestly above consensus of $15.6 billion. June EPS guidance, however, is below the current consensus: $0.45-$0.48, versus the current consensus of $0.48.

2009 Guidance: FY2009 revenue guidance is good--range of $66.9-$68.0 billion, above current consensus of $66.5 billion. 2009 EPS guidance is very good: $2.13-$2.19, above consensus of $2.10.

Segments: Only division that exceeded consensus was Entertainment and Devices (which is essentially irrelevant). Windows and Office both lagged.

Model updated (please see link below).

CONFERENCE CALL NOTES (Listen via link below)

Interminable preamble...

Chris Liddell:

EDD drove results [unfortunately].

Macro economy: Obviously not immune, but we're not seeing it. We remain confident.

Colleen: "Normalized" revenue growth 14% after adjusting for guaranteeing

PC units expectations moderated by couple of points since January in some regions.

Contracted not billed up sequentially.

Client revenue down 2% after adjusting for tech guarantees.

• OEM units up 5%, 4 points slower than PC market. Three reasons:
  
  • Last year OEMs rebuilt inventory (tough comp)
  • Inventory levels higher than normal entering quarter
  • Increase in shipments of unlicensed PCs, esp. in Asia.
• PCs up 13%
  
• OEM revenue up 1%, after adjustment.
  • Increasing volume emerging markets
  • Offset by premium mix.
• Commercial and retail down 13% after adjusting. Growth would have been up 20

Server and Tools

• Revenue up 23rd quarter in a row
• Unearned revs up 35%+ vs last year
• Launched three big products

Online Services Business

• Online up 29% ex Aquantive (impressive)
• Search queries and pageviews up y/y.
  

EDD

• XBOX still outselling PS3.
• Bought Danger.

[Jonathan Kennedy taking over our call coverage. Thanks for reading! --HB]

Online Services to grow 37% to 41% in 4th quarter
EDD to grow 32% to 34%

Fiscal 2008

Diluted EPS: $1.87 - $1.90

Operating Income margins to remain generally flat year over year in fiscal 2009. Investment income to be lower. Taxes to be lower (~28%) due to shift in mix to lower tax jurisdictions.

If we achieve guidance, we will have grown EPS by 80% over three years.

Color on Yahoo: With or without Yahoo, focussed on online advertising market. Yahoo would accelerate efforts, but we have an existing strategy. Can compete with organic investment. Speed is of the essence. Transition has been anything but speedy. Yahoo has unrealistic expectations. We intend to remain disciplined and have yet to see evidence that we should pay more. Yahoo loses share every quarter... we will provide updates on our alternatives next week.

Q&A Begins:

Sanford Bernstein analyst asks for color on 09 guidance... Answer: 2/3 of our business outside US. Good geographic spread, and weak dollar helps us. Good international exposure means insulation from US slowdown

UBS analyst asks about progress on piracy... Answer: On a quarter by quarter basis, it's difficult to project. Had a good performance first two quarters, poor performance this quarter. Will drive unit growth 1 to 2 percent as a result of anti-piracy measures. Gets progressively harder.

Bear Stearns analyst asks for more color on piracy, why did piracy efforts not pay off this quarter? And why acceleration on PC growth given macro weakness?... Answer: piracy needs to be looked at long-term. Specific market dynamics in China affected performance... Overall PC demand will be strong, strength in emerging markets cancels out weakness in mature markets.

Bank of America analyst asks about why operating margins declining in Q4... Answer: In any one quarter you can get quite different results due to shifts in mix. Nothing unusual in Q4. It's historically a relatively low margin quarter relative to rest of the year.

Citi analyst asks about poor performance in Client. Are you happy with what's happening in Vista cycle? Answer: No vista-related issues this quarter.

...Call ends...

Release
Conference Call Webcast (2:30 PM PT)
SAI Microsoft Financial Model

Our Final Thoughts (Pre-Release): Microsoft's stock has had a huge run in the past few weeks, in anticipation of both these results and, more recently, the possible abandonment of the Yahoo deal. From our perspective it's hard to see how Microsoft could post results rstrong enough to drive the stock even higher, but anything's possible. Our guess is that something in the results, probably guidance, will disappoint and that the stock will likely trade down after the call.

PREVIEW

Microsoft's last two quarters have been blockbusters, and the Street is expecting another one. Wall Street's printed expectations, meanwhile, are in line with the company's conservative guidance, which could set the stage for a blowout. Expectations are high and the stock has already run up, but a great quarter could send Microsoft's stock still higher, despite the dead-weight of the Yahoo deal. This would raise the value of Microsoft's bid for Yahoo, thus providing the face-saving carrot necessary to get Yahoo to the negotiating table. Microsoft's outlook and commentary about the U.S. and global economy will also obviously be critical--for the company, tech sector, and market.

After modeling the quarter, we believe there is significant upside to consensus revenue and EPS, as well as to the EPS whisper of $0.46. The consensus Street margin assumptions strike us as low, and a little extra revenue and leverage would drive an EPS blowout.

We will cover the earnings call live and will update our Microsoft spreadsheet as soon as the numbers come out.

Consensus for key metrics:

• Revenue of $14.5 billion (vs. guidance range of $14.3-$14.6 billion). Upside
  
• EPS of $0.44 (mid-point of guidance range of $0.43-$0.45) Whisper is $0.46. Upside to both.
  

Approximate consensus revenue breakdown:

• Client revenue: $4.4 billion, -18% (anniversary of Vista boom) Upside.
  
• Server/Tools revenue: $3.2 billion, +15%
• Online Services revenue: $900 million, +125% (driven by acquisition)
  
• MBD revenue: $4.8 billion, + 1% (upside)
  
• Entertainment revenue: $1.2 billion, +30%

Consensus Outlook:

• June: $15.56 billion / $0.48
• FY 2008 (June): $60.2 billion / $1.87
• FY 2009 (June): $66.5 billion / $2.10
  

See: SAI Microsoft Financial Analysis Spreadsheet