Microsoft’s Future Remains Cloudy Despite Windows 7

A recent IDC report indicates that the global PC market recovered in the fourth quarter of 2009 driven by sales of cheaper laptops, a clear sign of demand returning to some extent. Global PC shipments in the fourth quarter of 2009 were up 15.2%, Y-o-Y, while the United States saw a 24% increase to 20.7 million units shipped during the same period. Shipments of consumer PCs are estimated to have grown more than 20% during the period while business PCs were roughly flat.

The rise in PC shipments helps hardware and software companies like Dell, HP, Intel, Apple, and Microsoft, (NASDAQ:MSFT), which announced its results for the second quarter ended December 31, 2009, on January 28. The company reported record revenues of $19.02 billion in Q210, a 14% increase over Q209. Operating income in Q210 was $8.51 billion, up 43% over Q209. Net income in Q210 was $6.66 billion, up 60% over Q209. EPS in Q210 was $0.74, up 57% over Q209. Revenues in Q210 include the recognition of $1.71 billion of deferred revenue, an impact of EPS of $0.14, relating to the Windows 7 Upgrade Option Program and pre-sales of Windows 7 to OEMs and retailers before general availability. Adjusting for the deferred revenue recognition, Q210 revenues were $17.31 billion, and EPS was $0.60.

Revenues increased mainly due to the launch of Windows 7 and Windows Server 2008 R2 on October 22, 2009. During the second quarter, Microsoft sold over 60 million Windows 7 licenses, making it the fastest-selling operating system in history. Operating income increased, reflecting higher revenue and lower operating expenses in most categories.

Product billing mix in Q210 was roughly the same as last year with 30% annuity, 30% OEM and 25% license, with the balance coming from other businesses. Emerging markets grew in the mid teens and mature markets in the single digits. In terms of segments, consumer demand continued to be the driver of growth.

Unearned revenue was $12.5 billion, down marginally from last year. On a sequential basis, unearned revenue was down primarily due to this quarter’s recognition of the $1.7 billion in Windows 7 revenue. The contracted but not billed balance was approximately $13 billion, down slightly from last year.

Windows and Windows Live division revenues in Q210 were $5.2 billion (excluding $1.7 billion of deferred revenue), up 28% over Q209. This increase was mainly driven by 22% growth in OEM unit sales. OEM revenue increased 21% and grew faster than PC shipments for the first time in eight quarters. Windows attach and inventory drove 10% points of OEM revenue growth. Attach accounted for about half of the increase. Year-to-date, Microsoft saw solid attach gains across all regions, channels, and form factors. Inventory accounting for the other half of the increase was a result of OEMs rebuilding inventory to exit the quarter at normal levels.

Windows 7 upselling and channel dynamics drove 6% points of OEM revenue growth, reflecting consumer demand for Windows 7 Home Premium and demand for Windows 7 on netbooks. The commercial, retail, and online portion of the Windows Division grew 55%, primarily driven by the retail launch sale of Windows 7. Windows consumer licenses grew more than 35% Y-o-Y. The highest number of Windows licenses sold in one quarter ever in Q210.

Server and tools revenue in Q210 was $3.84 billion, up 2% from $3.76 billion in Q209. The company managed to increase server sales even as the overall server market was down slightly Y-o-Y. OEM and license-only revenues outperformed the underlying X86 server hardware market shipments while the company’s annuity revenue grew in the low single digits. Customer adoptions of Windows Server 2008 R2 and Microsoft’s virtualization and management offerings continued to build momentum. Revenue from virtualization offerings such as premium editions of Windows Server and Systems Center grew in the double digits. In May, Microsoft plans to release SQL Server 2008 R2 to expand its capabilities in business intelligence and data warehousing.

Online Services Division revenue in Q210 was $0.58 billion, down 5% from $0.61 billion in Q209. Online advertising revenues declined 2% Y-o-Y. While search revenue grew, driven by market share gains by Bing, display revenue was hampered primarily by international rate declines. Microsoft notes that Bing’s market share has been up for seven consecutive months. Microsoft has signed a 10-year agreement with Yahoo! for search, and rumors are making the rounds about a similar tie-up with Apple for making Bing the default search engine on iPhone.

Microsoft Business Division revenue in Q210 was $4.75 billion, down 3% from $4.88 billion in Q209. Business revenue was down 6% due to weak business PC sales. Annuity revenue was roughly flat. Consumer revenue, which includes the OEM and retail portion of this business, increased 12% Y-o-Y, primarily due to better-than-expected consumer PC shipments, although it still lagged the overall PC market. Within MBD, Microsoft saw the double digit-growth of SharePoint, Office Communication Server, and Dynamic CRM products. During the quarter the company released a beta of Office 2010, which has been downloaded over 2 million times. Office 2010 is expected to be launched in June of this year.

Entertainment and Devices Division revenue in Q210 was $2.90 billion, down 11% from $3.26 billion in Q209. During the quarter, Microsoft sold 5.2 million consoles, a Y-o-Y decline of 13%. Due to the favorable mix shift to Elite and Special Edition consoles, console ASPs were down only slightly following the Q110 price cuts. While the software attach rate continued to grow and lead the industry at 8.8, attach revenue declined as it faced difficult comparison with the prior year. Xbox Live continued to contribute to the quarter’s performance and now has 23 million members, 35% more than a year ago.

Natal, which is based on Microsoft’s natural user interface work, is expected to be launched in the coming holiday season. Will this be a game changer in the entertainment and gaming arena? We have to wait and see. Microsoft will launch Windows Mobile 7 at the Mobile World Congress this February.

Definitely a good quarter, thanks to Windows 7, but Microsoft lost more money in its online division than it did a year ago. Microsoft is steadily losing ground to Google and Apple in the online and smart phone arenas. It needs to come out with something disruptive to shake the marketplace or make its presence felt, and a tie-up with Yahoo! is not going to help its cause much; at best it will aid in gaining market share and Microsoft knows it. Is this why the company is working on a mysterious project called Pink to integrate the Zune HD with phone capabilities to take on the iPhone and Nexus One?

In summary, Google is signaling entry into both Apple and Microsoft’s territories. Apple is a major threat to Microsoft in PCs. Microsoft has not been able to make a mark yet on mobile, a battleground for the future. Although it is finally making some headway in search, the overall online strategy remains weak and remains untapped territory for Microsoft. Windows 7 has lifted the cloud hanging over Microsoft during the Vista years, but the company’s overall future remains cloudy at best.