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

A holiday rush on Xbox consoles and continued strong server sales pushed Microsoft revenues to US$12.54 billion for the quarter ended Dec. 31, 2006, while net income declined to US$2.63 billion compared with US$3.65 billion in the corresponding quarter of the previous fiscal year. The company's desktop software revenue and profit declined due to delays recognizing revenue for its latest releases, Windows Vista and Office 2007, but PC sales growth and strong corporate interest in Office have caused Microsoft to raise revenue estimates for the rest of the fiscal year.

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

Deferrals Slow Biggest Segments

Microsoft's Windows and Office businesses appeared weak due to deferral of revenues from the company's fiscal second quarter into the third quarter, which ends March 31, 2006. Meanwhile, sales of the money-losing Xbox console and high spending in the race against Google continue to drag on the company's overall earnings, but both showed some signs of turning a corner on profitability.

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

Client. As expected, revenue in Microsoft's most profitable segment fell 25% from the previous year, due to deferral of US$1.1 billion in revenue for the Express Upgrade to Windows Vista program, which offers free Vista upgrades to purchasers of new PCs. The deferred revenue will be recognized in the company's third fiscal quarter, after Vista's Jan. 30 release. Without the deferral, revenue would have grown 9%, a healthy result that Microsoft credits to strong PC sales growth. Microsoft attributed the growth to the success of the Express Upgrade program as well as "the continued value proposition of Windows XP"—consumers apparently did not put off holiday PC purchases for Vista's release. Microsoft now expects 11% to 12% revenue growth in the Client segment for FY'07 (ending June 30, 2007) versus its most recent estimate of 9% to 10%. An important factor: Microsoft expects sales of premium products such as Windows XP Media Center and Windows Vista Home Premium to reach 60% of the Windows Client total for this fiscal year, compared with 52% for the previous fiscal year.

Business. Revenue in the Business segment, Microsoft's biggest, fell 5%, due to US$500M in deferred revenue for the Office 2007 Technology Guarantee Program. The deferred revenue will be recognized next quarter. Without the program, revenue for this quarter would have grown 9% thanks to early purchases of Office 2007 by businesses. Microsoft raised its revenue growth estimate for the Business Division to 10% to 11% for this fiscal year (versus a previous estimate of 8% to 9%) thanks to better-than-expected sales of Office 2007.

Server and Tools. This segment remains Microsoft's fastest-growing, increasing 17% from Q2'06 to US$2.85 billion, better than expected. As in previous quarters, SQL Server was the primary driver, growing 30% over the previous year. Microsoft expects the segment to grow a total of 16% to 17% this fiscal year.

Entertainment & Devices. This segment showed 76% revenue growth to US$2.96 billion. Microsoft has now sold more than 10 million Xbox 360 consoles, which in part accounts for the unit's loss of US$289 billion. That loss was partially offset by high game sales, particularly of the new title Gears of War, which sold 2.7 million copies in its first two months. Microsoft now projects sales of 12 million consoles by the end of the fiscal year, down from a previous target of 13 to 15 million, and the company expects next quarter's revenue to be 16% to 25% lower than in the corresponding quarter of the previous year. The company might be deliberately trying to slow console sales: Microsoft Chief Financial Officer Chris Liddell said that the company was making tradeoffs in the Xbox business to reach profitability in the Entertainment & Devices division by FY'08 as planned, and the division loses money on each console sold.

Online. The online segment grew 5% over the previous year and saw its first quarter of search revenue growth since Microsoft switched from Overture (a division of Yahoo) to its own AdCenter platform. However, the unit's revenue growth came mostly from a 20% increase in display ad sales; Liddell admitted that he was "not happy" with the unit's results in search, where ComScore and Nielsen NetRatings both estimate that Microsoft has lost share while Google has gained. Increased costs due to spending on Windows Live and MSN services have also pushed the unit's loss up by 167% over the previous year. Microsoft now expects 3% to 8% revenue growth for the Online segment this fiscal year, down from an earlier estimate of 7% to11%.

Profitability Drops, Some Recovery Likely

Net income fell 28% and operating income fell 26% for the quarter, compared with the same quarter last year. The drop was caused by US$1.6 billion of revenue deferrals for Windows Vista and Office 2007 and should be made up when the deferred revenue is recognized in the following quarter.

Those deferrals and seasonal Xbox console sales also pushed Microsoft's cost of revenue to an unusual 28.9% of revenue. While that figure should drop next quarter, the company's continued growth in lower-margin areas, such as server software, consumer hardware, and online advertising, portends continued slow erosion of margins.

For further details on Microsoft financials, see www.microsoft.com/msft.