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Microsoft Corporation’s (MSFT - Analyst Report) fiscal third-quarter earnings of 72 cents beat the Zacks Consensus Estimate by 5 cents, or 7.5%. This was better than the 5.5% average positive surprise in the preceding four quarters, sending share prices up 2.9% in extended trading.

Revenue

Revenue of $20.49 billion was down 4.5% sequentially and up 17.7% from last year, more or less in line with our estimates. All segments grew strongly from the year-ago quarter and declined only slightly from the seasonally strong Dec quarter. Microsoft Business Division grew both sequentially and year over year.

Segment Specifics

The Windows and Windows Live Segment generated 28% of Microsoft’s quarterly revenue, down 3.0% sequentially and up 23.3% year over year. Microsoft stated that two-thirds of enterprise desktops had migrated to Windows 7, three-quarters of new enterprise agreements included Windows and volume licensing deals grew double-digits.

OEM revenue was in line with x86 demand, according to Microsoft. While this may be considered good, it is a fact that the market itself is shrinking as PCs give way to mobile computing, so this is the primary drag on the Windows business. Non-OEM revenue grew 40%, driven by the Surface tablet and commercial sales of Windows.

The Microsoft Business Division, which generated 31% of revenue, grew 11.0% sequentially and 8.7% from last year. The business side grew 10%, of which multi-year licensing grew 16%. The consumer side more or less reflected consumer PC trends, benefiting from increasing attach rates and the subscription model, which saw strong initial adoption.

The new Office, which incorporates touch, social and mobile aspects and SkyDrive, which can be used to access files across devices are expected to drive revenues going forward. Microsoft stated that revenue from other products, such as SharePoint, Exchange and Lync increased double-digits, with Lync alone increasing more than 30% (90 of the Fortune 100 using Lync).

The Server & Tools segment, at 25% of total revenue, was down 2.8% sequentially and up 10.2% year over year. Microsoft’s multi-year licensing revenue grew 20% year over year, with SQL server up 16%.

The services side also strengthened, growing 11% from last year. Based on System Center growth of 22% and share gains with Hyper-V (virtualization product), Microsoft stated that it was seeing growth in the data center segment as well. Overall trends indicate continuing strength in the enterprise. Virtualization and cloud computing are proving to be very beneficial for Microsoft’s S&T business.

Microsoft generated 12% of revenue from the Entertainment & Devices segment, down 32.9% sequentially and up 56.6% year over year. The sequential decline was because of seasonality. The increase from the year-ago quarter was related to an 18% increase in Xbox Live members to more than 46 million and transactional revenues that grew at twice the rate. Windows Phone also contributed to the increase according to Microsoft.

Skype, acquired from eBay Inc (EBAY - Analyst Report) in 2010 had minutes touching 161 billion, up 56% from last year.

The Online Services business, or online advertising, generated 4% of revenue, down 4.3% sequentially and up 17.7% year over year. Microsoft is investing in technology and innovation and it is this work that is improving user experience and helping Bing take some share in the U.S. The revenue per search (RPS) continued to improve in the last quarter.

Operating Results

Microsoft’s gross margin of 76.6% increased 316 basis points (bps) sequentially and shrank 66 bps year over year. The gross margin is closely related to the mix, since margins on hardware and software products differ widely. Therefore, the decline in Entertainment & Devices revenue (mostly hardware) positively impacted the sequential comparison.

Operating expenses of $8.09 billion were up 1.2% sequentially while declining 14.2% from last year. On a sequential basis, R&D and G&A increased 110 bps and 269 bps, respectively as a percentage of sales. Cost of sales and G&A grew 66 and 148 bps, respectively from last year. All other were down.

The operating margin by segment was as follows—Windows 60.7% (a sequential increase of 461 bps), Microsoft Business Division 64.9% (up 230 bps), Server & Tools 39.3% (down 162 bps) and Entertainment & Devices 13.5% (down 229 bps). The Online Services business continues to generate a loss, although narrower than in the past.

The company generated a pro forma net income of $6.06 billion, or 29.6% net income margin compared to $6.38 billion, or 29.7% in the previous quarter and $5.11 billion, or 29.3% in the year-ago quarter.

Balance Sheet

Inventories were up 28.4%, which lowered inventory turns from 13.7X to 9.0X. Days sales outstanding (DSOs) went to 53, up from around 61 at the end of the Dec 2012 quarter.

Microsoft ended with a cash and short term investments balance of $74.48 billion, up $6.17 billion during the quarter. The net cash position was around $60.29 billion, up from $54.12 billion at the beginning of the quarter. In the last quarter, the company generated $9.67 billion in cash flow from operations, spent $1.03 billion on share repurchases, $1.93 billion on dividends, $108 million on acquisitions and $930 million on capital assets.

Guidance

Microsoft lowered its 2013 opex expectations to $30.2-30.5 billion (previous $30.3 to 30.9 billion), which excludes the European Commission fine of $733 million. The tax rate for the year is expected to be 17-20% (maintained) and capital expenses around $3.5 billion (maintained).

Key Takeaways

The only major surprise was with respect to the Windows business, which did better than expected given the weak PC market. While IDC has stated that Windows 8 had not helped PC shipments and in fact contributed to its decline, we were not disappointed because Win 8 was targeted at touch-based devices and not the traditional PC market.

The traditional desktop/notebook segment continues to migrate to Windows 7 albeit at a slower rate. Microsoft remains strong in the enterprise segment, which is again more likely to purchase traditional computers. Windows 8 is supplementing these sales by helping to build the company’s position in the mobile segment. While mobile growth is not expected to be quick or easy, Microsoft has set foot in the right direction.

Other positives include Microsoft’s growing cloud business, improving prospects for its S&T business, the subscription model for consumers in the MBD business, strong position in the game console segment and growing search market share.

Microsoft’s new touch-based devices may be expected to supplement its growth in other areas. However, competition from popular platforms by Apple (AAPL - Analyst Report), Samsung and others makes growth difficult.

While the search business is growing steadily, Microsoft is still way behind market leader Google . Google has had phenomenal success in the mobile segment. Microsoft’s focus on mobile hardware is therefore very important. In the meantime, the cannibalization of its core x86 market remains an overhang on the shares. 

Microsoft shares currently carry a Zacks Rank #3 (Hold).

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