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

The Jan. 2007 consumer launches of Windows Vista and the Office 2007 System product family helped Microsoft earn a record US$4.93 billion on US$14.40 billion in revenue during its third quarter of fiscal year 2007 (Q3'07), which ended Mar. 31, 2007. Even without the one-time recognition of revenue deferred from previous quarters (due to upgrade programs for Vista and Office), revenue would have grown 17% from the previous year's quarter. The strong quarter caused Microsoft to increase its guidance for FY'07, but the company warned that growth in FY'08 would probably be slower, now that these flagship product launches are out of the way.

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

Core Businesses Shine

Microsoft's core businesses—desktop OSs, business software, and server software—all did well during the quarter, showing 22% revenue growth before the one-time effect of recognizing deferred revenue from upgrade programs for Vista and Office 2007. However, the company's online and entertainment businesses continued to rack up sizeable losses.

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

Client. The Client business segment, consisting of desktop versions of Windows, increased revenue 67% from the year-ago quarter to US$5.27 billion—significantly higher than Microsoft's previously stated expectation of 54% to 56% growth. The group also earned a record US$4.24 billion in profit. Results in this segment were bolstered by the recognition of approximately US$1.2 billion in deferred revenue from Q1'07 and Q2'07, during which Microsoft offered free or discounted Windows Vista upgrades to consumers who purchased a new PC with Windows XP. Without that deferral, revenue would have grown about 30%—still much higher than Microsoft's expectation of 16% to 18% growth without the deferral.

One reason for the surprisingly strong quarter: sales of higher-priced versions of Windows, particularly Vista Home Premium, outpaced expectations. Microsoft previously predicted that about 60% of FY'07 Vista revenue would come from premium-priced editions of the OS; in Q3, the actual percentage was 71%. Because premium-priced versions of Windows XP made up only 53% of sales in the year-ago quarter, this difference allows revenues to grow faster than unit sales—a phenomenon Microsoft calls the "mix-shift."

Vista's launch also contributed to the strong growth in several ways. First, commercial and retail revenue was up 63% from the previous year (excluding the effects of the deferred upgrade revenue), as customers upgraded some existing PCs from XP to Vista. Second, while PC unit sales grew only between 10% and 12% for the quarter, OEM unit sales of Windows were up 20%. According to Microsoft, this is a normal occurrence during the launch of a new OS, and comes as system builders (small OEMs) stock up on the new OS when it becomes available, and as larger OEMs replenish their inventories after the consumer launch. Improved progress on piracy prevention also contributed to the discrepancy between unit sales of Windows and actual PC sales.

Finally, Client revenue growth got a slight artificial boost because Microsoft no longer defers some revenue from Vista sales to account for undelivered elements (such as Internet Explorer updates), whereas it did with Windows XP. The company expects this accounting change to add US$220 million to FY'07 Client revenue, and US$660 million to FY'08 Client revenue.

Vista appears to be having a minimal effect on PC sales—worldwide unit sales were up approximately 10% to 12% from the previous year's quarter, in line with recent quarterly figures, and Microsoft expects hardware shipments to grow at approximately the same rate through FY'08.

Although Microsoft did not offer detailed FY'08 expectations for each business segment, it did note that Client growth would face difficult comparables in the second half of FY'08 due to the Vista launch in FY'07,

Business. The Microsoft Business Division, which includes the Office suite, Exchange Server, and other business productivity tools, also grew faster than expected—revenue was up 34% from the previous year's quarter to US$4.83 billion, notably higher than Microsoft's expectation of 27% to 28% growth, leading to a record US$3.42 billion profit. As with the Client segment, results in the Business segment were boosted by the recognition of US$500 million in deferred revenue from Q2'07, during which Microsoft offered free upgrades to Office 2007 to consumers who purchased Office 2003 on new PCs. Without that deferral, revenue would have grown about 20%.

Microsoft credited the strong growth in this segment to a variety of factors, including very strong retail sales of the Office 2007 System and a 20% increase in billings for Dynamics business management software.

Server and Tools. Server and Tools, which has been Microsoft's fastest-growing business for the last several years, earned US$979 million on US$2.75 billion in revenue. This revenue growth of 15% from last year was slightly slower than Microsoft's expectations of 16% to 17% growth, but Microsoft did not explain the reason for the shortfall. Professional services revenue (e.g., support, consulting) was a bright spot, growing 28% from last year to about US$530 million.

Entertainment and Devices. Microsoft shipped only 500,000 Xbox 360 consoles to retailers during the quarter, compared with 1.7 million in the year-ago quarter, which was the first full quarter in which the console was available. Consequently, the group's revenue decreased 21% from the year-ago quarter to US$929 million, as Microsoft predicted it would. While this division's loss of US$315 million was lower than the year-ago quarter's loss of US$402 million, it was higher than the US$289 million loss last quarter (Q2'07). Microsoft blamed the loss on marketing expenses associated with the launch of the Zune music player, and increased warranty costs for Xbox 360—Microsoft extended the warranty from 90 days to one year during Dec. 2006. Despite the continued losses, Chief Financial Officer Chris Liddell said that profitability is still the "target" for this business segment in FY'08.

Online. The Online business segment's revenues grew 11% from the previous year's quarter, to US$623 million, outpacing expectations. However, this segment's losses were US$200 million—the highest figure since Q3'03, when this segment was called MSN—due to the continued investment in new online services such as Live Search and Windows Live. Microsoft said that advertising revenue grew 23% from last year, to US$453 million for the quarter, offset by a continued decline in Internet access revenue as customers terminate MSN dial-up accounts to purchase broadband from other providers. Liddell said that the company is still not pleased with its search query market share, which is hovering around 10%, far behind Google (which is close to 50%) and Yahoo (near 30%).

First Guidance for FY'08

Reflecting the strong quarter, Microsoft raised its guidance for the third time in FY'07: the company now expects to earn between US$1.47 and US$1.49 per share (including legal expenses) on revenues of US$50.9 billion to US$51.2 billion—a revenue increase of 15% to 16% from the previous year.

In Microsoft's first preliminary discussion of FY'08 financials, Liddell said that revenue growth in FY'08 will probably slow to between 11% and 12%, coming in between US$56.5 billion and US$57.5 billion. However, the company expects expenses to grow more slowly in FY'08 than FY'07, particularly in the area of online infrastructure—that is, while the company is still going to increase its spending on datacenters in FY'08, the rate of increase is slowing from the big build-out that began in FY'07. Consequently, earnings should grow more quickly (about 14% to 15%) than revenue. The company will give more detailed FY'08 guidance in its next quarterly earnings call and at the July 2007 Financial Analyst Meeting.

Microsoft also continued its recent pattern of large stock repurchases during the quarter, spending about US$6.7 billion to buy back 237 million shares. Consequently, the company's cash decreased from US$28.9 billion at beginning of the quarter to US$28.2 billion at the end. In fall 2006, the company's board of directors authorized the repurchase of up to US$36.2 billion worth of stock by July 2011; approximately US$22.5 billion of that authorized amount remains.

More detailed information about Microsoft's financials can be found at www.microsoft.com/msft.