TBR 4Q10 Microsoft Initial Response

TBR

T EC H N O LO G Y B U S I N ES S R ES EAR C H , I N C .

Microsoft Corp.

SOFTWARE BUSINESS QUARTERLYSM

4Q10 INITIAL RESPONSE

Publish Date: January 28, 2011 Author: Jillian Mirandi ([email protected]), Research Analyst Content Editor: Stuart Williams, SBQ Practice Manager

Fourth Calendar Quarter 2010

Second Fiscal Quarter 2011 Ended December 31, 2010

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Microsoft 4Q10 Initial Response | Software Business Quarterly ©2011 Technology Business Research, Inc. 2

Microsoft tightens its grip on desktop software as it looks to cloud for growth

Microsoft Corporate Strategies • Drive adoption of cloud services with Azure, Office

Web Applications and Office 365 to offset margin pressure with volume.

• Maintain dominance of Windows and productivity software products to drive strong cash flow.

• Expand presence in enterprise software (middleware and applications) to capture high-margin revenue growth.

• Leverage Xbox and entertainment offerings to position Microsoft at the core of the digital home.

TBR Position: Microsoft’s Business, Windows and Entertainment divisions spur growth in 4Q10.

• The desktop software market is Microsoft’s to lose, and the company tightened its grip on these critical markets in 4Q10. Microsoft’s Windows and Windows Live divisions maintained pace with the overall PC shipment growth during the quarter, even as the threats of netbooks, tablets and mobile devices lurk in the shadows.

• In the Microsoft Business Division, home to the Office franchise, revenue increased 24% year-to-year, as Microsoft benefited both from the fortification of core Office sales and through growth of new offerings such as Lync.

• Even as cloud becomes increasingly pronounced in Microsoft’s messaging to customers, the company is not taking its foot off the accelerator of core Windows and Office products, maintaining a long-held presence that drives large streams of revenue and profit.

Executive Summary

MSFT 4Q10 PERFORMANCE VS. EXPECTATIONS

(in $ Millions) Consensus Guidance Range Actual

Revenue 15,650$ N/A 19,953$

Operating Income N/A N/A 4,085$

Non- GAAP EPS 0.68$ N/A 0.77$

MSFT 1Q11 GUIDANCE AND EXPECTATIONS

(in $ Millions) TBR Estimate Consensus Guidance Range

Revenue 16,400$ 16,040$ N/A

Operating Income 6,154$ N/A N/A

Non-GAAP EPS N/A 0.55$ N/A

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Key Developments

Microsoft is moving software closer to hardware

• The lines between hardware and software are obscured, with the customer value proposition focusing more on delivering a solution versus IT hardware and software, spurring Microsoft to broaden its deployment models with both cloud and appliance delivery.

• Microsoft’s move into the appliance space broadens the IT arenas in which it competes, and places the company in competition with vendors like IBM, Oracle, HP, Symantec and EMC.

• In 2010, Microsoft entered the appliance market when it introduced Azure platform appliance, a turnkey cloud platform enabling customers to deploy in their own datacenters. Microsoft extended its appliance strategy in 4Q10, announcing a partnership with HP to deliver the HP Database Consolidation Appliance.

Microsoft launches cloud-based CRM to increase the pressure on Salesforce.com and Oracle’s CRM

• Following the early warm reception of Office 365, as illustrated by the oversubscribed beta, Microsoft recently announced that Microsoft Dynamics CRM Online, its cloud-based CRM offering, will launch globally in 40 countries.

• Dynamics CRM Online has been available in the U.S. since 2008, but with Salesforce.com generating 30% of its revenue abroad, and Oracle tapping into the global CRM market as well, Microsoft needed to open the solution up geographically. Microsoft has a large, established, international market it plans on further monetizing through its growing number of cloud solutions.

Microsoft’s revamped Partner Network is crucial to revenue growth

• In 4Q10, Microsoft increased training, resources and support, helping partners increase success in the market. The fourth quarter saw new features for cloud partners, including Microsoft’s Gold Competency award for the highest-skilled partners addressing the most specific customer needs.

• Key to future growth, Microsoft updated its partner network to further address the cloud. Microsoft’s partner network grants partners early access to new cloud technologies, deepening the bond between vendor, partner and customer.

Microsoft expands deployment options and partnerships to grow revenue in new markets

Executive Summary

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Office 2010, Microsoft’s Business division and Kinect drove revenue growth across segments as Microsoft focuses on diversifying revenue

Executive Summary

Quarterly Segment Performance

Division Key Changes & Drivers 4Q10

Revenue Growth

YTY Trends to Monitor

Windows & Windows Live

• Continued strong Windows 7 demand and accelerated adoption of Windows 7 by enterprises drove the segment’s 4Q10 growth.

• The significant decrease is due to the impact of Windows 7 launch and presales.

• Windows shipments kept up with the PC shipments and are shipped on 20% of PCs worldwide.

$5,054 million

–26.8%*

Microsoft expects the PC refresh cycle to continue throughout FY11, contributing to increases throughout the year.

Server & Tools

Server & Tools revenue showed strong growth compared to 4Q09, as Windows Azure adoption has risen rapidly in 4Q10 as more customers adopt cloud solutions.

$4,390 million

14.2%

We expect Server & Tools to grow year-to-year in 1Q11 as both existing and new customers migrate to the cloud.

Online Services Group

The Online Services segment revenue increased year-to-year in 4Q10, but its operating profit remains a problem area, at –$543 million.

$691 million

3.5%

Bing now powers Yahoo’s algorithmic and paid search results in the U.S and Canada. Facebook results are also integrated into search results. This deal with Yahoo could produce an uptick in growth and revenue in 1Q11.

*Negative year-to-year growth impacted by Windows 7 presales and launch

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Office 2010, Azure and Kinect drove revenue growth across segments as Microsoft focuses on diversifying revenue (Cont.)

Executive Summary

Quarterly Segment Performance

Division Key Changes & Drivers 4Q10

Revenue Growth

YTY Trends to Monitor

Microsoft Business Division

• Microsoft Office (comprised of Office, SharePoint, Exchange and Lync) generated 90% of MBD’s revenue, while Dynamics generated about 10% of revenue.

• Revenue increase primarily reflected licensing of the 2010 Microsoft Office system to transactional business customers, growth in multi-year volume licensing revenue and an increase in Dynamics.

$6,033 million 27.1%

TBR expects Microsoft Business Division to continue increasing in 1Q11 as the adoption of Office 10, Office 365 and Dynamics Online expands globally.

Entertainment & Devices

Entertainment & Devices reported the highest segmental growth. Kinect performed better than expected and drove the purchases of various Xbox products.

$3,698 million

27.4%

TBR anticipates Microsoft’s entertainment and devices will significantly increase again year-to-year in 4Q10, as Kinect is incorporated to the growing Windows Phone 7.

TBR


Financial Model Strategy

Revenues • Revenue growth was weighted toward the Microsoft

Business division, increasing significantly by 27.1%, and Entertainment & Devices division, increasing by 27.4%.

• Kinect ramped Xbox sales, selling 8 million standalone and bundled sensors in 60 days over the holiday season.

Expenses • Cost of sales increased from 19.1% of total revenue to

24.2% of total revenue, reflecting higher Entertainment & Devices sales, which historically have lower margins than software.

• S&M expenses increased 5.7% year-to-year and R&D rose similarly 5.1% year-to-year.

• G&A expenses significantly decreased 15.9% year-to-year to $945 million in 4Q10 as Microsoft continues to trim overhead costs.

Margins • Gross profit rose 33.2% in 4Q10, but gross margin

decreased year-to-year from 80.9% to 75.8%.

Kinect sales drove revenue growth, but at a higher price

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MICROSOFT'S PROFITABILITY AND GROWTH

Operating Margin Net Margin Revenue Growth Year-to-Year

SOURCE: TBR AND MICROSOFT

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$8,513 $8,165

$2,079 $2,185 $4,743 $4,770

$15,394 $15,120

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MICROSOFT OPERATING METRICS

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Product Strategies

• Gear product functionality and capabilities toward SMB customers, delivering ease of use versus enterprise-level functionality.

• Counter open-source threats with selective participation and risk mitigation.

• Expand target markets by investing in consumer and enterprise products.

• Leverage desktop strength in transition to SaaS.

• Provide well-received platforms to support partner customization and development.

Go-to-Market & Product Strategies

Beyond Kinect, intelligent video could be broadly used across the Microsoft portfolio

Software Stack

BIBI

AppsApps

MWMW

DBDB

OSOS

Software Stack

BIBI

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MWMW

DBDB

OSOS

Services Strategies

• Enable and facilitate partner delivery of services and solution customization to end customers.

• Participate and cooperate in partner engagements as a product expert.

• Increase annuity service agreements to provide revenue stability.

• Deliver services directly to large end-users that require a direct relationship with Microsoft.

• Deliver the education and training needed to promote and foster the Microsoft ecosystem.

Services Offerings

ConsultConsult

PremiumPremium

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SupportSupport

EducationEducation

Services Offerings

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EducationEducation

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EducationEducation

• TBR believes Microsoft plans to use its 3-D sensing technology to add a unified communication platform in its Office division, similar to Citrix’s HD Faces, built into collaboration platform GoToMeeting, and Cisco’s WebEx. Microsoft Office is missing this key feature, leaving revenue on the table for companies like Citrix, Cisco and now Salesforce.com as it integrated recently acquired DimDim technology into its platform.

• Microsoft’s acquisition of Canesta offers the company a patented “electronic perception technology.” This technology is a 3-D image sensor chip that, combined with Canesta’s software and a camera, allows users to control computers and devices through hand and body movements.

• Microsoft’s Xbox Kinect already uses 3-D sensing technology, allowing users to play control-free. However, when Kinect was made, Microsoft chose Canesta’s competitor PrimeSense to provide the technology, as it was cheaper to implement. TBR believes Microsoft wanted to test the market and get its R&D prepared for integration of more sensing technology.

• In addition to Canesta, Microsoft acquired 3DV systems in 2009, a company that has a similar 3-D movement technology. By acquiring two companies with 3-D gesture recognition technology, Microsoft gains a competitive advantage by shrinking the space for competitors to move in and acquire similar technology.

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Go-to-Market & Product Strategies

Indirect Sales Strategies

• Leverage partners to provide sales coverage across a large global base; minimize investments in internal sales.

• Support partners with marketing resources, development funds and training/certification.

• Implement tiered rebate programs to target specific markets or products.

• Cooperate with partners on joint sales engagements.

• Share support sales and delivery opportunities as a differentiator.

Direct Sales Strategies

• Target largest accounts directly to meet customer needs for continuity and deep global relationships.

• Partner with VARs and SIs to maintain channel involvement, even for direct named accounts.

• Overcome customer apprehension regarding SaaS by offering Microsoft-hosted solutions.

Microsoft combines security and management infrastructures to create Forefront Endpoint 2010

• Traditionally, many companies had a separate endpoint security and management systems. Both aspects are very important, but deploying two systems requires the company to have two of everything (e.g., two maintenance policies), increasing overall costs.

• To address this issue, Microsoft released Forefront Endpoint 2010, a new solution that combines security and management infrastructures into one solution.

• The new solution provides better protection for companies because it gives managers a consolidated viewpoint of the health and protection of all user systems, and allows them to fix possible weaknesses on one console. With a new antivirus engine, it also increases security through better threat recognition.

• In addition, the solution reduces the overall cost to customers, as it eliminates the need to have separate versions of policies for security and management.

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Mix by LOB

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Resource Management Strategy

Microsoft loses executives to competing cloud and mobile solutions providers

Strategy

• Expand headcount outside its U.S. headquarters to decrease development expenses and harness overseas talent.

• Use brand and familiarity to sell new solutions such as cloud.

• Leverage cash to fund smaller-scale, tuck-in acquisitions.

• Infuse management with outside talent to facilitate Microsoft’s expansion beyond traditional markets.

• Fund datacenter buildout to support Online Services offerings.

Executive Changes • Matt Miszewski, general manager of Microsoft’s

government business, has recently moved to cloud competitor Salesforce.com.

• Johnny Chung Lee, an executive in the Kinect group, is leaving Microsoft to join cloud competitor Google.

• Senior Director of Corporate Strategy and Acquisitions Fritz Lanman left Microsoft in 4Q10 to found his own mobile start-up.

• Head of Microsoft’s Server & Tools Business, Bob Muglia, will be leaving the company this summer. CEO Steve Ballmer stated that Microsoft was looking for a change in this segment, and a new head would be put in place. Muglia recently announced he will be joining Juniper Networks.

Investments • Microsoft acquired Canesta in 4Q10 for the company’s patented

3-D image sensor chip technology.

• Microsoft continues to invest in the cloud, adding to its portfolio and expanding its solutions globally.

• The Online Services business, which generated operating losses of $2.5 billion, remains an area of long-term investment for Microsoft.

• Microsoft continues building datacenters across the U.S., most recently starting development in Iowa, Washington and Virginia.

• Microsoft is in discussions to invest $2.5 billion in Indonesia to develop cloud computing systems in the region.

Puget Sound

Headcount

40,371

International

Headcount

34,679

Other U.S.

Headcount

53,735

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Income Statement

MICROSOFT CORP.

Consolidated Statement of Income

(in $ Thousands Except per Share Data)

CALENDAR QUARTER 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 Est.

FISCAL QUARTER 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 Est.

Net Sales 19,022,000$ 14,503,000$ 16,039,000$ 16,195,000$ 19,953,000$ 16,400,000$

Cost of Sales 3,628,000$ 2,755,000$ 3,170,000$ 3,139,000$ 4,833,000$ 3,444,000$

Gross Profit 15,394,000 11,748,000 12,869,000 13,056,000 15,120,000 12,956,000

Sales and Marketing 3,619,000 3,203,000 3,602,000 2,806,000 3,825,000 3,608,000

General and Administrative 1,124,000 1,152,000 987,000 938,000 945,000 956,667

Research and Development 2,079,000 2,220,000 2,350,000 2,196,000 2,185,000 2,237,750

Operating Income 8,513,000 5,173,000 5,930,000 7,116,000 8,165,000 6,153,583

Investment Income 370,000 168,000 94,000 114,000 332,000 177,000

EBITD 8,883,000 5,341,000 6,024,000 7,230,000 8,497,000 6,330,583

Provision for Income Taxes 2,221,000 1,335,000 1,506,000 1,820,000 1,863,000 1,583,000

Net Income 6,662,000$ 4,006,000$ 4,518,000$ 5,410,000$ 6,634,000$ 4,747,583$

Net Income per Share 0.74$ 0.45$ 0.51$ 0.62$ 0.77$

Diluted Shares Outstanding 8,951,000,000 8,876,000,000 8,821,000,000 8,695,000,000 8,570,000,000

AS A PERCENTAGE OF REVENUE

Net Sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Cost of Sales 19.1% 19.0% 19.8% 19.4% 24.2% 21.0%

Gross Margin 80.9% 81.0% 80.2% 80.6% 75.8% 79.0%

SG&A 24.9% 30.0% 28.6% 23.1% 23.9% 27.8%

R&D 10.9% 15.3% 14.7% 13.6% 11.0% 13.6%

Operating Margin 44.8% 35.7% 37.0% 43.9% 40.9% 37.5%

Investment Income (Expense) 1.9% 1.2% 0.6% 0.7% 1.7% 1.1%

EBITD 46.7% 36.8% 37.6% 44.6% 42.6% 38.6%

Income Taxes 11.7% 9.2% 9.4% 11.2% 9.3% 9.7%

Net Margin 35.0% 27.6% 28.2% 33.4% 33.2% 28.9%

YEAR-TO-YEAR CHANGE

Net Sales 14.4% 6.3% 22.4% 25.3% 4.9% -13.8%

Cost of Goods Sold -7.1% -2.1% 22.6% 10.5% 33.2% -5.1%

Gross Profit 21.0% 8.4% 22.4% 29.5% -1.8% -15.8%

SG&A 5.6% 11.8% 7.7% 6.0% 0.6% -3.8%

R&D and Engineering -9.2% 0.4% 5.6% 6.3% 5.1% 7.6%

Operating Income 43.3% 16.6% 48.7% 58.8% -4.1% -27.7%

Investment Income (Expense) 222.9% 143.3% -39.4% -59.7% 0.0% -37.5%

EBITD 57.6% 31.9% 45.4% 51.7% 0.0% 32.9%

Income Taxes 51.7% 24.4% 37.3% 52.8% 0.0% 32.9%

Net Income 59.6% 34.6% 48.4% 51.4% 0.0% 32.8%


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Balance Sheet

MICROSOFT CORP.

Consolidated Balance Sheets

(in $ Thousands)

CALENDAR QUARTER 4Q09 1Q10 2Q10 3Q10 4Q10

FISCAL QUARTER 2Q10 3Q10 4Q10 1Q11 2Q11

ASSETS

Current Assets

Cash & Cash Equivalents 9,422,000$ 8,155,000$ 5,505,000$ 8,161,000$ 4,023,000$

Short-term Investments 26,677,000$ 31,511,000$ 31,283,000$ 36,012,000$ 37,299,000$

Accounts Receivable - Net 11,196,000 9,137,000 13,014,000 9,646,000 12,874,000

Deferred Income Taxes 2,056,000 2,222,000 2,184,000 2,344,000 2,548,000

Inventory 589,000 501,000 740,000 1,242,000 861,000

Other 2,547,000 2,992,000 2,950,000 2,176,000 2,149,000

Total Current Assets 52,487,000 54,518,000 55,676,000 59,581,000 59,754,000

Property, Plant, Equip. (Net of Dep.) 7,402,000 7,372,000 7,630,000 7,771,000 7,799,000

Other, Net 22,207,000 23,020,000 22,807,000 24,188,000 24,188,000

Total Assets 82,096,000$ 84,910,000$ 86,113,000$ 91,540,000$ 91,741,000$

LIABILITIES AND EQUITY

Current Liabilities

Accounts Payable 3,171,000$ 3,279,000$ 4,025,000$ 3,654,000$ 3,863,000$

Short-Term Debt 2,249,000$ 2,249,000$ 1,000,000$ 1,000,000$ -$

Accrued Compensation 2,417,000 2,885,000 3,283,000 2,252,000 2,402,000

Income Taxes Payable 721,000 901,000 1,074,000 2,136,000 1,439,000

Short-term Unearned Revenues 11,361,000 11,171,000 13,652,000 12,767,000 12,063,000

Securities Lending Payable 2,911,000 2,794,000 182,000 909,000 1,355,000

Other 2,885,000 3,145,000 2,931,000 3,139,000 3,190,000

Total Current Liabilities 25,715,000 26,424,000 26,147,000 25,857,000 24,312,000

Long-term Unearned Revenues 1,167,000 1,089,000 4,939,000 1,152,000 1,354,000

Other 10,931,000 11,687,000 8,852,000 17,589,000 17,333,000

Total Liabilities 37,813,000 39,200,000 39,938,000 44,598,000 43,825,000

Stockholders' Equity

Common Stock & PIC 62,566,000 62,517,000 62,856,000 61,935,000 61,646,000

Retained Earnings (18,283,000) (16,807,000) (16,681,000) (14,993,000) (13,165,000)

Total Stockholders' Equity 44,283,000 45,710,000 46,175,000 46,942,000 48,481,000

Total Liabilities & Equity 82,096,000$ 84,910,000$ 86,113,000$ 91,540,000$ 92,306,000$

FINANCIAL RATIOS

Days Sales Outstanding 53.0 56.7 73.0 53.6 58.1

Fixed Asset Turnover 10.2 7.9 8.6 8.4 10.3

Days Cash Outstanding 170.8 246.2 206.4 245.5 186.4

Total Asset Turnover 0.93 0.69 0.75 0.73 0.87

Debt/Asset Ratio 0.46 0.46 0.46 0.49 0.48

Current Ratio 2.04 2.06 2.13 2.30 2.46

Return on Assets 21.6% 21.9% 22.7% 24.2% 23.6%

Return on Equity 41.6% 41.6% 43.2% 45.9% 44.4%

Average Annual Revenue Per Employee 647,058$ 661,591$ 705,269$ 743,040$ 753,134$

Employee Count 90,701 90,001 88,596 88,500 88,550


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T EC H N O LO G Y B U S I N ES S R ES EAR C H , I N C .

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