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

Continuing strong growth in the Server and Tools business segment and efficiencies in Xbox 360 production gave Microsoft US$3.48 billion in net income on US$10.81 billion in revenue in Q1'07 (the quarter ended Sept. 30, 2006), ahead of its previously stated expectations. The company increased FY'07 revenue estimates slightly to account for the strong quarter but noted that it will have to defer approximately US$1.5 billion from Q2 to Q3 as a result of offering discounted upgrades for upcoming products.

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

Servers, Xbox Beat Expectations

Four of Microsoft's five business segments met or exceeded the company's previously stated revenue goals for Q1, with Server and Tools and Entertainment and Devices showing particularly strong growth, and the Client segment coming in slightly below expectations. (For a chart detailing the results of each business unit, see "Revenue and Profit (Loss) by Business Segment".)

Server and Tools. This segment continues to drive Microsoft's revenue growth, increasing 17% from Q1'06 to US$2.50 billion—well ahead of Microsoft's high-end expectation of 14% growth. As in recent quarters, this strength was driven primarily by sales of SQL Server, whose revenues increased 30% over the previous year. Microsoft expects this segment's growth rate to temper only slightly in Q2 to 14% or 15%.

Windows Client. Revenue in the Client segment, Microsoft's most profitable business, grew only 4% from the previous year's quarter to US$3.30 billion—lower than Microsoft's estimate of 5% to 6% growth. The largest contributor to this segment, OEM revenue, grew only 4%, which was well behind industrywide PC unit sales growth of 11%. Microsoft blamed the discrepancy on stronger growth in emerging markets (where piracy rates are higher and Microsoft charges less for its OS) and the relative strength of the consumer market. (Consumer editions of Windows are priced lower than business editions.) Another small contributing factor: Microsoft deferred US$45 million of revenue from Q1 to Q3 to account for the beginning of a program to offer discounted upgrades from Windows XP to Windows Vista. This program will have a much greater impact in Q2, when Microsoft expects to defer about US$1 billion in Client segment revenue to Q3. Microsoft expects strong year-over-year growth in the Client segment for the second half of FY'07, after Vista is released. (For more details about how the coupon program will affect Microsoft's finances, as well as other changes, see the sidebar "Coupons and Accounting Changes".)

Business. Revenue in the Business segment, Microsoft's top-grossing segment, grew only 4% to US$3.42 billion. All the products in the Office System, as well as Exchange Server, will get major upgrades in the next quarter. Many businesses are waiting for these upgrades, or have already paid for them via multiyear licensing programs, such as Enterprise Agreements and Software Assurance. (Unearned revenue from these programs grew by nearly US$2 billion in Q4'06.) Microsoft expects to defer US$500 million in Business segment revenue from Q2 to Q3 to account for an Office guaranteed-upgrade program.

Entertainment & Devices. This segment showed 70% revenue growth to US$1.03 billion, well ahead of Microsoft's top expectation of 60% growth. The growth allowed the division to cut its losses from US$173 million in last year's quarter to only US$96 million, showing good progress toward Microsoft's promise of consistent profitability by FY'08. During the quarter, Microsoft sold about 900,000 Xbox 360 consoles, bringing the total installed base to more than 6 million.

Online. This segment showed a 4% drop in revenue from the previous year to US$539 million, coming in at the bottom of Microsoft's expectations. As in recent quarters, Microsoft blamed the result on moving its paid search platform from Overture (a division of Yahoo) to Microsoft's own AdCenter platform. Because Microsoft has fewer search advertisers than Overture, its revenue per search is lower than it was when it outsourced paid search. However, Chief Financial Officer Chris Liddell said that revenue per search has almost reached its previous level, and he is confident that the Online group will begin to show better results in Q2, predicting 3% to 5% growth from the previous year. Nonetheless, increased costs in this division from the launch of new Windows Live and MSN services have turned this business segment into a consistent money-loser, and Microsoft has given no timeline for when it will become profitable again.

Strong Earnings

Because of stronger-than-expected revenue growth, Microsoft's operating income of US$4.47 billion outstripped the company's top expectation of US$4.2 billion, and net income came in at US$0.35 per share, ahead of the company's top estimate of US$0.32 per share. The net income figure is particularly impressive given that Microsoft had expected to repurchase up to US$20 billion of its own stock through a tender offer, but was able to buy back only US$6.95 billion worth (including both the tender offer and other buybacks) during the quarter. Completing the repurchase as anticipated would have added another one cent to Q1 earnings per share.

Unearned revenue, which is a reasonable measurement of the company's success in selling multiyear license agreements, declined less than expected from the previous quarter (when many multiyear agreements were up for renewal). It now stands at US$10.10 billion, a 15% increase from the previous year. This suggests that companies are interested enough in upcoming products, such as Office 2007, Exchange 2007, and Windows "Longhorn" Server, to pay for them in advance.

Complete financial results are available at www.microsoft.com/msft.