Microsoft Corporation 10-Q Summary: Quarter Ended March 31, 2006
Business Context and Reporting Period
This Form 10-Q covers the quarterly period ended March 31, 2006 (Fiscal Q3 2006) and the nine months ended March 31, 2006. Microsoft Corporation develops, manufactures, licenses, and supports software products for servers, PCs, and intelligent devices, including the Windows operating system, Office productivity suite, and the Xbox gaming console. The company is currently transitioning its Xbox business to the new Xbox 360 console and preparing for the future launch of Windows Vista.
Key Financial Metrics
| Metric (in millions) | Q3 2006 | Q3 2005 | 9 Months 2006 | 9 Months 2005 |
|---|---|---|---|---|
| Revenue | $10,900 | $9,620 | $32,478 | $29,627 |
| Operating Income | $3,888 | $3,329 | $12,591 | $11,572 |
| Net Income | $2,977 | $2,563 | $9,771 | $8,554 |
| Diluted EPS | $0.29 | $0.23 | $0.92 | $0.78 |
| Cash from Operations | $4,563 | $5,003 | $11,123 | $12,629 |
| Cash & Equivalents | $4,351 | $3,782 | $4,351 | $3,782 |
| Short-term Investments | $30,465 | $32,900 | $30,465 | $32,900 |
| Total Assets | $66,854 | $70,815 | $66,854 | $70,815 |
Debt and Liquidity: The company has no material long-term debt. Total cash, cash equivalents, and short-term investments totaled $34.82 billion as of March 31, 2006. The company maintains a strong liquidity position to fund operations, dividends, and share repurchases.
Material Changes vs. Prior Period
- Revenue Growth: Revenue increased 13% in Q3 and 10% for the nine-month period. Growth was driven by the Q2 launch of Xbox 360, increased licensing of Windows Server and SQL Server, and growth in Windows Client OEM licensing.
- Operating Income: Operating income rose 17% in Q3 and 9% for the nine months. This was primarily due to revenue growth and a significant decrease in legal settlement charges ($438 million decrease in Q3; $612 million decrease for nine months).
- Cost of Revenue: Cost of revenue increased 49% in Q3, largely due to higher unit costs and volume associated with the Xbox 360 launch.
- Share Repurchases: The company repurchased $4.88 billion of common stock in Q3 and $15.57 billion for the nine months ended March 31, 2006, accelerating the pace of its $30 billion repurchase program.
- Segment Performance: The Home and Entertainment segment saw an 85% revenue increase in Q3 due to Xbox 360, though operating losses widened due to console costs. The MSN segment reported a decline in operating income due to falling Internet Access revenue and increased R&D investment.
Guidance, Outlook, and Risks
- Outlook: Management expects revenue to grow at a faster rate in Q4 2006 compared to Q4 2005, driven by significant product launches. Operating income growth is expected to exceed revenue growth due to lower legal settlement costs, partially offset by expenses for new product launches (Windows Vista, SQL Server 2005, Xbox 360).
- Market Estimates: Worldwide PC shipments are estimated to grow 12-14% in fiscal 2006. Server hardware shipments are expected to grow 11-13%.
- Legal Contingencies: Significant risks remain regarding antitrust and intellectual property litigation.
- European Commission: A Statement of Objections regarding compliance with the 2004 decree could result in fines up to €2 million per day.
- Korea: The Korean Fair Trade Commission (KFTC) ruled against Microsoft, requiring the distribution of a Windows version without Media Player/Messenger. Microsoft has appealed.
- Patent Litigation: A $115 million verdict was rendered against Microsoft in the Z4 Technologies case on April 19, 2006 (subsequent to period end); Microsoft intends to appeal.
- Share Repurchase Plan: Approximately $6.4 billion remains of the $30 billion approved repurchase amount, expected to be completed by December 2006.
Key Facts for Investor Verification
- Xbox 360 Economics: Verify the trajectory of Xbox 360 unit costs and the timeline for achieving positive margins on console sales, as current operations are selling at a loss.
- Legal Exposure: Monitor the status of the European Commission Statement of Objections and the Korean Fair Trade Commission appeal, as fines or mandated product changes could impact revenue and margins.
- Unearned Revenue: Note that $8.9 billion in unearned revenue is recognized ratably; verify the mix of multi-year licensing versus undelivered elements to assess future revenue visibility.
- Stock-Based Compensation: Confirm the impact of SFAS 123(R) adoption and the trend of declining stock option amortization expense on future operating income.
- MSN Segment: Assess the impact of the decline in narrowband Internet Access revenue and the ramp-up of the new adCenter advertising platform on future profitability.