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Microsoft Corporation's (MSFT - Analyst Report) fiscal second-quarter earnings of 78 cents beat the Zacks Consensus Estimate by 10 cents, or 14.7%. Shares were up 3.5% in extended trading.

Revenue

Revenue of $24.52 billion was up 32.3% sequentially and 14.3% from last year, beating our estimates by 4.4%.

Devices & Consumer Segment

Management changed the operating structure at the beginning of fiscal year 2014. Accordingly, the company now has two main segments: Devices & Consumer (D&C) and Commercial.

Licensing, hardware and other revenue made up 22%, 19% and 7% of quarterly revenue taking the contribution of the Devices & Consumer segment to 48%.

The licensing side of the business was mixed, with revenue increasing 24.0% sequentially but declining 5.6% year over year. Large enterprises and developed markets in general led to increased demand for Pro shipments, which helped offset significant weakness in non-Pro sales. Non-Pro revenue in China was particularly weak. The consumer side of the business was extremely weak, with Office for consumer devices down 24% year over year.

Hardware revenue on the other hand strengthened considerably in the last quarter, increasing 218.5% sequentially and 68.4% year over year. The strength was driven by strong holiday sales of both gaming and tablet platforms.

Xbox units touched 7.4 million for the quarter, of which 3.9 million units were Xbox One, so momentum was strong despite the fact that Sony (SNE - Snapshot Report) also launched the PS4 during the quarter. Surface shipments also doubled sequentially, indicating that Microsoft is gaining ground despite strong offerings from Apple (AAPL - Analyst Report), Samsung and other Android manufacturers.

Other revenue increased 9.7% sequentially and dropped 10.3% year over year. Management said that the launch of Halo 4 in the year-ago quarter impacted that comparison. However, the quarter was very strong for the segment in other respects with Office 365 Home premium subscribers up to 3.5 million, search advertising revenue up 34% and Xbox Live transactional revenue up more than 25%.

Commercial Segment

Commercial licensing revenues increased 13.5% sequentially and 7.4% year over year. Server and Office commercial revenues were up 12% and 10%, respectively. System Center and SQL Server Premium grew double-digits, Hyper-V picked up 5 points of share and Windows volume licensing grew 10%.

Commercial other revenues increased 11.0% sequentially and 28.1% year over year. Cloud services are becoming more popular, with commercial cloud revenue growing 107% year over year. Office 365 and Azure and Dynamics CRM seats all grew triple digits.

Operating Results

Microsoft’s gross margin of 66.2% was down 619 basis points (bps) sequentially and 726 bps below the year-ago quarter, due to the much higher mix of hardware products and Xbox One launch costs. The 545 bp contraction in the D&C Hardware gross margin more than offset the expansion in other D&C categories. The commercial segment on the other hand, saw gross margin expansion across both licensing and other segments.

Operating expenses of $8.27 billion were up 16.7% sequentially and up 3.4% from last year. On a sequential basis, R&D, S&M and G&A increased 373 bps, 36 bps and 41 bps, respectively. Their increases from the year-ago quarter were 57 bps, 261 bps and 35 bps, respectively. As a result, the operating margin expanded 168 bps sequentially and 372 bps year over year to 32.5%.

The company generated a net income of $6.56 billion, or 26.7% net income margin compared to $5.24 billion, or 28.3% in the previous quarter and $6.38 billion, or 29.7% 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 78 cents a share compared to 62 cents in the previous quarter and 76 cents in the year-ago quarter.

Balance Sheet

Inventories were down 39.0%, as the inventories built up for the holiday season were sold off during the quarter. As a result, inventory turns went from 7.8X to 20.8X. Days sales outstanding (DSOs) dropped from 54 to 59.

Microsoft ended with a cash and short term investments balance of $83.94 billion, up $3.27 billion during the quarter. The net cash position was around $60.97 billion, up from $64.74 billion at the beginning of the quarter. In the last quarter, the company generated $4.41 billion in cash flow from operations, spent $588 million to repurchase its debt, $2.11 billion to repurchase shares, $2.33 billion to pay dividends, and $1.73 billion to purchase capital assets.

Guidance      

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

For the third quarter, the company expects D&C licensing revenue of $4.1-4.3 billion, D&C hardware revenue of $1.9-2.0 billion, D&C other revenue of $1.8 billion, Commercial licensing revenue of $10.4-10.6 billion and Commercial other revenue of $1.8 billion. Microsoft expects COGS of $6.1-6.3 billion (down significantly from the Dec quarter because of the hardware mix) and opex of $7.7-7.8 billion.

For 2014, it expects opex of $31.2-31.5 billion (previous $31.3-31.9 billion), a tax rate of 18-20% (reiterated) and capex of $6.0 billion (previous $6.5 billion).

Our Take

Microsoft reported another solid quarter, with strong results across most segments. The consumer side of the business was notably weaker (as expected), but it’s heartening to see the growth in tablets. This is strategically a very important segment for Microsoft, since tablets continue to eat into its core computing business. Also, consumer purchases, particularly in emerging markets continue to get more mobile.

Microsoft has been late to enter the market that is now dominated by iOS or Android. The company has made straight for the high end, despite criticism regarding the products and doubts about its ability to execute. The strong growth in the last quarter indicates that Microsoft is on the right track.

The company is still not making money on its surface devices however and management did not say when the business was expected to break even. But in the meantime, it is sparing no expense to succeed. Of course, a higher percentage of hardware in the mix is going to tell on margins and this should be expected. The addition of Nokia’s business will add to the pressure on margins.

Management did assure that the PC business was better than expected and that there were signs of stabilization. This is similar to what Intel (INTC - Analyst Report) said earlier and in line with Gartner IDC estimates.

Add to this its success in the cloud and new partnerships, such as GoDaddy, which give it a foothold in the SMB market and its plain to see its focus.

Therefore, despite its inability to replace the CEO, the shares appear to be headed up. Moreover, its strong results and guidance are likely to drive up estimates and raise the current Zacks Rank #4 (Sell) on Microsoft shares.

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