• Chart: Microsoft Financials for the Last Five Quarters
• Chart: Revenue and Profit (Loss) by Business Segment

Surprisingly strong growth in SQL Server and OEM sales helped Microsoft take in revenues of US$9.74 billion in the first quarter of fiscal year 2006 (which ended Sept. 30, 2005), an increase of 6% from the same quarter last year. Earnings, which came in at US$3.14 billion (US$0.29 per share) were hurt by a legal settlement with RealNetworks but still came in 24% ahead of the same quarter last year. However, Microsoft warned that year-over-year earnings will decrease in its next quarter, thanks to the costly launch of the Xbox 360 game console.

(For an overview of Q1'06 financials and how they compare with previous quarters, see "Microsoft Financials for the Last Five Quarters".)

SQL Server Shines, Consumer Businesses Miss

The current quarter saw five of Microsoft's seven businesses meet or exceed the company's previously stated expectations. The exceptions were MSN and Home and Entertainment—the company's two consumer-oriented business segments.

(For a chart showing Q1'06 and Q1'05 revenues and profit or loss by business segment, see "Revenue and Profit (Loss) by Business Segment".)

Core businesses. Server and Tools continues to be the main engine of Microsoft's growth. In Q1'06, revenue was up 13% from the previous year to US$2.53 billion, slightly ahead of expectations, mostly from strong sales of SQL Server, which had revenue growth of 15% from last year. This is somewhat surprising, given that a new version of SQL is due in Nov. 2005, but Microsoft said that organizations often purchase databases in conjunction with new line-of-business applications, so they would have little incentive to wait for a new version of the database. On the downside, this could mean a lack of pent-up demand for SQL 2005, resulting in minimal financial impact from this major product launch. In fact, Microsoft is predicting only 9% to 10% year-over-year revenue growth for Q2'06.

Windows Client revenues grew 7% to US$3.19 billion, at the high end of expectations. However, this segment's revenue grew more slowly than PC unit growth, which Microsoft estimated at 15% to 17%. Microsoft blamed the discrepancy on several factors, including a shift toward purchases from large OEMs, which get a price break on Windows compared with smaller system builders, and strong purchases from consumers, who are more likely to buy Windows XP Home or Media Center Edition, which cost less than the Windows XP Professional SKU purchased by most businesses. In addition, licenses sold through the volume and retail channels declined 19%. This reflects a normal decline in retail sales toward the end of the OS life cycle, and the fact that many businesses have chosen not to include Windows Client upgrades in their multiyear license agreements. Microsoft expects Windows Client revenue growth to pick up slightly in Q2, coming in at 8% or 9% above last year's figure.

Information Worker revenue grew 4%, to US$2.68 billion. These numbers were at the high end of Microsoft's expectations, thanks to strong back-to-school retail sales of Office 2003 and stronger-than-expected sales of "category applications" (products other than Office, such as Project). Microsoft expects growth to accelerate in this segment in Q2, coming in between 6% and 7%.

Emerging businesses. Microsoft's two smallest business segments both did better than expected: Business Solutions posted 16% revenue growth, to US$181 million, from strong sales across the category, while Mobile and Embedded grew 51%, to US$74 million, as unit sales of Microsoft's platforms for wireless devices grew 130% over the previous year. Both segments came closer to profitability than ever before, with Business Solutions losing only US$12 million and Mobile and Embedded losing only US$2 million.

However, Microsoft's two consumer-focused businesses fared poorly in Q1'06. Microsoft expected a year-over-year revenue decline of 5% to 7% in the Home and Entertainment business ahead of the Nov. 2005 launch of the Xbox 360, but revenues actually dropped 17% because of weaker-than-expected console sales and a delay in release of some third-party game titles. The Xbox 360 launch means that Q2 will be a big quarter for Home and Entertainment in terms of sales—quarterly revenues are expected to be between 26% and 32% higher than the previous year, coming in around US$1.8 billion—but marketing expenses and the fact that Microsoft loses money on each console will mean higher losses as well. Over the life of the console, which is expected to be four to five years, Microsoft says it will break even on hardware costs as component costs come down, and it expects to turn a profit from sales of game software and Xbox Live subscriptions. Microsoft also announced official sales expectations for Xbox 360 for the first time: it expects to sell between 4.5 million and 5.5 million consoles by the end of June 2006.

MSN's revenue also fell short of expectations, growing only 1%. During a question and answer session after the earnings call, Microsoft acknowledged that MSN's paid search revenue had declined from the previous quarter, in sharp contrast to competitors such as Google, where advertising revenue (most of which comes from paid search) rose 14% from the previous quarter. Chief Financial Officer Chris Liddell acknowledged that MSN would have to do a better job monetizing search results and suggested that the forthcoming launch of adCenter, MSN's platform for selling paid search listings, would help reverse this trend.

Stock Buyback Accelerates

Q1'06 net income was affected by a US$361 million charge to settle antitrust disputes with RealNetworks. (The remainder of the settlement, which amounted to US$761 million, was set aside earlier or will be accounted for in a different fashion, as a portion of it relates to cooperative marketing agreements.) The company also restated its year-ago results to account for a US$536 million settlement with Novell and other legal expenses that were pending during Q1'05, but not finalized until after the company had announced Q1'05 earnings. (These legal costs were reported in U.S. Securities and Exchange Commission filings and appeared in Microsoft's FY'05 reports.) Including both of these legal settlements, Microsoft's net income increased 24% year over year, a fairly impressive figure, given the revenue increase of merely 6%.

Total unearned revenue stood at US$8.81 billion, a slight decline from Q4'05, but in line with Microsoft's expectations. Unearned revenue, which represents expected future income from multiyear license agreements and deferred revenue from some product sales, often peaks in Q4 because of the large number of multiyear license agreements that come due and are renewed during that quarter.

Microsoft also announced that it is accelerating its stock repurchase plan. While it had originally planned to buy back up to US$30 billion in stock by the middle of 2008, it will now complete this repurchase by the end of 2006. The company repurchased US$3.12 billion worth of stock in Q1'05 and will continue at a similar pace through the next five quarters.

For a complete view of Microsoft's financial results, see www.microsoft.com/msft.