• Chart: Microsoft Financials for the Last Five Quarters
• Chart: Revenue and Profit (Loss) by Business Segment
• Sidebar: From Seven Businesses to Five

Strong sales and renewals of multiyear license agreements and better-than-expected PC sales helped Microsoft turn in 16% year-over-year revenue growth in the quarter ending June 30, 2006 (Q4'06), the company's best quarterly revenue performance in two years. Operating income, which measures revenue minus the normal costs of doing business, also grew 30% over last year, to US$3.88 billion (although net income dropped because of an abnormally low tax rate in the previous year's quarter). Microsoft also announced plans to buy back up to US$20 billion worth of stock and gave more details about expected expenses for FY'07.

(For a chart detailing Microsoft's recent financial performance, see "Microsoft Financials for the Last Five Quarters".)

Core Businesses Shine

All seven of Microsoft's business segments met or exceeded revenue expectations announced last quarter, but costs increased significantly in Home and Entertainment and MSN, leading to bigger losses in these segments. (For a chart detailing the results of each business unit, see "Revenue and Profit (Loss) by Business Segment".)

Beginning in FY'07 (which started July 1, 2006), Microsoft will change its financial reporting structure, moving from seven to five business segments. (For details, see the sidebar "From Seven Businesses to Five".)

Core businesses. Windows Client, Microsoft's largest and most profitable business, showed 12% revenue growth from the same quarter last year (to US$3.38 billion), well ahead of expectations. The results were due to better-than-expected PC sales, particularly to consumers. In addition, revenue from commercial and retail sales of Windows (as opposed to sales on OEM machines) was up 6%, the first year-over-year increase in this area since Q1'05. Microsoft did not explain the reason for this growth, but more organizations are probably adding existing Windows desktops to multiyear license agreements in anticipation of the release of Vista for businesses in late 2006.

Quarterly revenue for the Server and Tools segment came in at US$3.18 billion, making Server and Tools Microsoft's second-largest business ahead of Information Worker. SQL Server continues to stand out in this category, posting revenue growth of 35% over the previous year. Total unearned revenue for products in the Server and Tools segment enjoyed an unprecedented 25% spike from Q3 (to US$3.79 billion), suggesting strong sales and renewals of multiyear license agreements that confer upgrade rights. (When a customer pays for a portion of a multiyear agreement, Microsoft books this revenue as unearned, then recognizes it over the term of payment.)

Information Worker revenue was up 6% over last year's quarter, to US$3.13 billion. This growth is in line with recent quarters. However, total unearned revenue for products in the Information Worker segment skyrocketed 39% from Q3, to US$3.61 billion, suggesting that companies are adding Office 2007 to multiyear license agreements ahead of its expected launch in late 2006.

Emerging businesses. MSN's quarterly revenue dropped 3% from the previous year, to US$580 million, because its adCenter advertising platform, which allows advertisers to place sponsored search listings in MSN Search, has not yet captured enough advertisers to make up for the transition from Yahoo's Overture platform. In addition, MSN's losses ballooned to US$190 million, up from US$26 million in Q3'06 and reversing a US$101 million profit a year ago in Q4'05. This reflects the growing investment in Windows Live, a major overhaul of Microsoft's consumer online services to better compete with Google. Microsoft Chief Financial Officer Chris Liddell predicted that this business unit would begin to increase revenues again in the second half of FY'07, but admitted it would not be profitable until FY'08 or beyond.

Home and Entertainment revenues grew 94% from the same quarter last year to US$1.14 billion, in line with expectations, but its losses more than doubled to US$414 million, as sales of the Xbox 360 console outstripped last year's sales of the original Xbox. (Microsoft sells each console at a loss, hoping to profit on sales of games, peripherals, and Xbox Live subscriptions.) Total Xbox 360 sales now stand at 5 million, in line with Microsoft's expectations.

Microsoft's two smallest businesses both exceeded expectations in the quarter. In Q4, Microsoft Business Solutions (MBS) showed 16% revenue growth over last year's quarter to US$280 million and turned in its second-ever profitable quarter, while Mobile and Embedded showed 41% revenue growth from last year's quarter to US$113 million—its fifth consecutive quarter with 40% annual growth or higher. In addition, both businesses showed profits for the full fiscal year for the first time.

Unearned Revenue, Buyback

Microsoft booked US$6.08 billion in new unearned revenue in Q4'06, a sharp jump from the US$3.67 billion it booked in each of the last two quarters and US$3.03 billion booked in Q1. This allowed the company's total unearned revenue stash to grow from US$8.90 billion in Q3 to US$10.9 billion in Q4. Nearly all of this jump in unearned revenue came from volume licensing agreements, with particular strength in renewals of Enterprise Agreements by large organizations. This bodes well for Microsoft's financial results throughout FY'07, as this unearned revenue will gradually be moved to earned revenue.

Microsoft also announced a plan to buy back up to US$20 billion worth of stock in the next two months by using a so-called modified "Dutch auction"—the same technique Google used to sell shares in its initial public offering in Aug. 2004. Current shareholders will have until Aug. 17 to indicate how many shares they are willing to sell at a price between US$22.50 and US$24.75 per share. Participants will not be forced to sell their shares for a lower price than their bid, but may receive a higher price. Based on these stipulations, Microsoft will set the buyback price at the lowest possible number that lets it buy back 808,080,808 of shares. Shareholders will receive details of the offer in a mailing sent out July 24.

In addition, Microsoft announced it had completed the US$30 billion buyback it began in summer 2004, and said it might buy back another US$20 billion worth of additional stock by 2011, but did not commit to this plan or give a detailed schedule.

FY'07 Incremental Expenses Detailed

Microsoft did not significantly change its financial predictions for FY'07, but offered more details about planned expenses.

In its Q3 earnings call, Microsoft surprised analysts and shareholders by revealing that its FY'07 expenses would be about US$2.4 billion higher than most analysts had previously estimated, and its stock subsequently dropped more than 10%.

In the Q4 earnings call, Liddell broke this $2.4 billion down into several buckets:

• Sales and marketing expenses will be about US$900 million more than originally anticipated, including about US$450 million in marketing for the launches of Windows Vista and the Office 2007 System, and US$450 million in incremental field sales costs as Microsoft staffs up its sales force to push these and other new products
• Research and development will be about US$1 billion more than originally anticipated, with this unanticipated expense divided evenly among the Business Division (probably for its Unified Communications platform), the Entertainment and Devices Division (some of which is probably going to the forthcoming Zune family of digital media devices), Server and Tools, and Microsoft Research
• Operating expenses for online services, such as MSN, Windows Live, Office Live, and CRM Live (a recently announced hosted customer relationship management service), will be about US$500 million more than originally estimated.

For a complete view of Microsoft's financial results and a link to an audio Webcast of the Q4'06 earnings call, see www.microsoft.com/msft.