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

Six of Microsoft's seven business units showed a profit in the quarter ending Dec. 31, 2006, but revenues were lower than expected, at US$11.84 billion, because of shortages of Xbox 360 game consoles. In addition, operating income was down slightly from last year (as expected) to US$4.66 billion because of higher marketing costs and negative margins on the Xbox 360 console. Meanwhile, the company continued its aggressive stock buyback plan and raised its dividend to US$0.09 per quarter.

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

Emerging Businesses into the Black

For the first time ever, six of Microsoft's seven business units showed an operating profit during the company's second quarter of fiscal year 2006 (Q2'06), thanks to higher-than-expected revenues in the company's two smallest businesses, Microsoft Business Solutions (MBS) and Mobile and Embedded. However, revenue shortfalls in the other emerging businesses, MSN and Home and Entertainment, caused the company's total revenue to come in about US$60 million less than expected.

For a chart detailing the results of each business unit, see "Revenue and Profit (Loss) by Business Segment".

Core businesses. Server and Tools continues to drive Microsoft's revenue growth, posting 14% growth over the previous year to US$2.91 billion. The company expected only 9% to 10% annual growth, and credited continuing strong sales of SQL Server (where revenues were up 20% from last year), driven in part by the launch of SQL Server 2005. Enterprise services, such as support contracts and consulting, also contributed to this business unit's strength, posting 17% growth from last year. As a result of the strong quarter and continuing demand for products such as SQL Server 2005 and Windows Server 2003 R2, Microsoft raised its guidance for Server and Tools, and now expects 15% to 16% revenue growth for the full year.

Revenue from the Client division (which encompasses Windows desktop OSs) came in at US$3.46 billion, up 8% from last year. Even though PC shipments grew 15% during the quarter, OEM revenue was up only 10%, mainly because consumer purchases outstripped business purchases, and consumers generally buy Windows XP Home or Media Center Edition, both of which cost less than Windows XP Professional. Microsoft also blamed the discrepancy on high PC growth in emerging economies, where piracy rates are high, and the fact that multinational PC makers (who get a price break on Windows because of their volume) accounted for a greater percentage of overall sales than during the same quarter last year. Revenue from retail upgrades and multiyear license agreements was down 2%, a trend that Microsoft expects to continue through the remainder of its current fiscal year (which ends June 30, 2006).

Information Worker revenue came in at US$2.98 billion, up 5% from last year. Microsoft claimed that a higher percentage of this revenue came from long-term licensing agreements than last year, as corporate customers anticipate the next version of Office due in late 2006.

Emerging businesses. The Home and Entertainment business unit posted US$1.56 billion in revenue, which was up 13% from last year—far lower than Microsoft's expectations of between 26% and 32% growth. Microsoft blamed the shortfall on shortages of the Xbox 360, and lowered its forecast for the first 90 days to 2.5 million units (down from 2.75 million to 3 million). Moreover, of the 1.5 million Xbox 360s sold in Q2, only about 100,000 were sold in Japan, a continuation of the sales trends seen with the first Xbox, despite renewed efforts to attract more Japanese gamers with this console. However, Microsoft noted that attach rates for games and hardware add-ons were higher than any previous game console launch from any vendor, with average sales of 4 games and 3.5 hardware items per customer. Also, Microsoft claimed that the shortages were sporadic rather than systematic, and will be resolved early in 2006. Given these two trends, the company continues to predict profitability for the Home and Entertainment business in FY'07.

MSN revenues were down 2% from last year, to US$583 million, as the company continues to lose subscribers for dial-up Internet access and fails to earn enough new revenue from advertising to make up for these defections. Microsoft acknowledged that revenue from paid search was down from last year's quarter, in contrast to increases for competitors Google and Yahoo. The company blamed the decline on lower keyword prices in paid search listings provided to MSN Search by Overture (a division of Yahoo). In 2006, MSN is rolling out its own paid search platform, adCenter, but it warned that lower advertiser volumes on adCenter, compared with those delivered by Overture, could continue to cause deterioration of keyword pricing, leading to slower revenue growth than its competitors.

Microsoft's two smallest businesses, MBS and Mobile and Embedded, both outstripped expectations. MBS revenues grew 17% to US$242 million on the launch of Dynamics CRM 3.0 and strong sales in Europe, while Mobile and Embedded revenues were up 40% to US$101 million on sales of new Windows Mobile 5.0 devices. Both divisions showed their first-ever profit, and Microsoft Chief Financial Officer Chris Liddell said that this profitability will become a regular occurrence beginning in FY'07.

Other News

Because of increased marketing costs associated with the launch of Xbox 360 and SQL Server 2005, and the high cost of goods for the Xbox 360, operating income was down 2% from the previous year to US$4.66 million—in line with Microsoft's previously stated expectations. Net income in Q2'06 was up 5% to US$3.65 billion due to investment income of US$480 million and a tax benefit of US$108 million. Unearned revenue, which comes mostly from companies signing long-term licensing agreements, came in at US$8.83 billion, up slightly from the previous quarter and in line with Microsoft's expectations.

The company continues to accelerate its stock buyback program: it repurchased more than US$7.35 billion in stock during the quarter, decreasing the average number of diluted shares outstanding from 10.77 billion during the last quarter to 10.64 billion this quarter. Microsoft also announced in Dec. 2005 that it is increasing its quarterly dividend a penny per share, or 12.5%, to US$0.09 per share. The new dividend will be paid on Mar. 9, 2006, to all shareholders of record as of Feb. 17.

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