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Microsoft Corporation’s (MSFT - Analyst Report) fiscal first-quarter earnings of 62 cents beat the Zacks Consensus Estimate by 8 cents, or 14.8%. This was significantly better than the 3.0% average miss in the preceding four quarters. Shares jumped 5.3% in extended trading.

Revenue

Revenue of $18.53 billion was down 6.9% sequentially and up 15.7% from last year, beating our estimates by 4.1%.

Operating Structure Changed

Management changed the operating structure beginning from the first quarter of fiscal 2014. Accordingly, the company now has two main segments: Devices & Consumer and Commercial.

Devices & Consumer includes licensing (non-volume licensing of the Windows OS and related software; non-volume licensing of Microsoft Office for consumers; Windows Phone, including related patent licensing; and certain other patent licensing), hardware (entire Xbox platform, Surface and Microsoft PC accessories) and other (resale, including Windows Store, Xbox LIVE transactions and the Windows Phone Marketplace; search advertising; display advertising; Subscription, comprising Office 365 Home Premium; Studios, comprising first-party video games; retail stores; and other consumer products and services not included elsewhere).

Commercial includes commercial licensing (server products, volume licensing of the Windows OS and Office for business) and other (Enterprise Services, including Premier product support services and Microsoft Consulting Services; Online Services, comprising Office 365 other than Office 365 Home Premium, other Microsoft Office online offerings, and Dynamics CRM Online; Windows Azure; and other commercial products and online services not included elsewhere).  

Devices & Consumer

Licensing, hardware and other revenue made up 23%, 8% and 9% of quarterly revenue taking the contribution of the Devices & Consumer segment to 40%.

The licensing side of the business was mixed, with revenue increasing 1.2% sequentially but declining 7.2% year over year. Management said that Office attach rates were positive for the quarter and Windows Phone appeared stable. Windows OEM was weak, offsetting the strength in other areas.

Hardware revenue on the other hand strengthened considerably in the last quarter, increasing 26.9% sequentially and 37.0% year over year. Management said that growth was driven by Surface devices, particularly in the education and retail segments. The much-criticized RT devices did better than the Pro line.

Other revenue increased 4.8% sequentially and 16.8% year over year. Both advertising and online marketplaces did well in the last quarter. Advertising was the major driver, with its 47% growth coming from both increasing query volumes and rising RPS.  Management stated that Bing now has 18% market share.

Commercial

Commercial licensing revenues increased 7.3% year over year, with server product revenue growing 12%. Sequential comparisons will be available from next quarter. Commercial office products also did well, growing 11% from the prior year.

Commercial other revenues increased 28.4%. Cloud services are becoming more popular, with commercial cloud revenue growing 103%. Office 365 and Azure grew triple-digits. Dynamics CRM also contributed to the strength in cloud revenue because two-thirds of customers moved to the cloud.

Operating Results

Microsoft’s gross margin of 72.4% grew 56 basis points (bps) sequentially although still 156 bps below the year-ago quarter. The commercial licensing and other revenue saw solid gross margin expansion (up 9,173 bps and 1,716 bps, respectively) on a sequential basis. D&C licensing and hardware gross margins expanded 5 bps and 6,970 bps, respectively, while other D&C gross margin shrank 231 bps.

Operating expenses of $7.08 billion were down 13.9% sequentially and up 8.4% from last year. On a sequential basis, R&D increased 95 bps as a percentage of sales, but was more than offset by a 342 bp decline in S&M and another 63 bp decline in G&A. All expenses declined as a percentage of sales from the year-ago quarter, more than offsetting the weaker gross margin. As a result, the operating margin expanded 366 bps sequentially and 103 bps year over year to 34.2%.

The company generated a net income of $5.24 billion, or 28.3% net income margin compared to $4.97 billion, or 25.0% in the previous quarter and $4.47 billion, or 27.9% in the year-ago quarter. Since there were no one-time items in any of the quarters, the pro forma and GAAP earnings were same at 62 cents a share compared to 59 cents in the previous quarter and 53 cents in the year-ago quarter.

Balance Sheet

Inventories were up 34.8%, as Microsoft built inventories going into the holiday season. As a result, inventory turns went from 11.6X to 7.8X. Days sales outstanding (DSOs) dropped from 80 to 54.

Microsoft ended with a cash and short term investments balance of $80.67 billion, up $3.65 billion during the quarter. The net cash position was around $64.74 billion, up from $61.42 billion at the beginning of the quarter. In the last quarter, the company generated $8.21 billion in cash flow from operations, spent $1.00 billion to repurchase its debt, $2.19 billion on share repurchases, $1.92 billion on dividends, and $1.23 billion on capital assets.

Guidance

Microsoft provided guidance for both the second quarter and fiscal year 2014.

For the second quarter, the company expects D&C licensing revenue of $5.2-5.4 billion, D&C hardware revenue of $3.8-4.1 billion, D&C other revenue of $1.7-1.8 billion, Commercial licensing revenue of $10.7-10.9 billion and Commercial Other revenue of $17-1.8 billion. Microsoft expects COGS of $7.9-8.3 billion, opex of $8.5-8.6 billion and unearned revenue n line with historical levels.

For 2014, it expects opex of $31.3-31.9 billion, a tax rate of 18-20% and capex of $6.5 billion.

Key Takeaways

Microsoft managed to surprise to the upside, which is a positive, particularly because of the momentum in Sarface RT sales. But the reporting structure has become much more complicated and it has become much harder to determine just how much of a beating Windows is getting, which is the main concern regarding Microsoft.

Management did assure that the PC business was better than expected and that there were signs of stabilization. This is not exactly in line with estimates provided by independent market research companies. We therefore have to take a wait-and-see approach.

One thing that was obvious however was the momentum in the cloud business. Microsoft has started discounting some services pretty heavily, but the segment gross margin didn’t take a hit. This seems to indicate solid volumes.

Another encouraging sign was the continued momentum in Office, both on the consumer and commercial sides of the business. Whether the company will be able to leverage this strength to push its Surface products remains to be seen. But Microsoft is clearly focused on app development, so sales could pick up.  

Apple’s (AAPL - Analyst Report) iPads remain in very strong demand at the high end and chromebooks based on Google’s chrome OS are now some of the hottest-selling items on Amazon.com (AMZN - Analyst Report). Microsoft is targeting Apple devices rather than Google devices because of the margins involved. This seems to be a good idea though of course there is some risk involved.

Microsoft shares currently carry a Zacks Rank #4 (Sell).

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