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

Strong sales of business software helped Microsoft post year-over-year revenue growth of 13% in the quarter ending June 30, 2007 (Q4'07), although operating income growth was much lower—only 3%—because of a US$1.06 billion charge related to defective Xbox 360 game consoles. However, unearned revenue grew by 16% from the year-ago quarter, reflecting exceptionally strong sales of multiyear license agreements, particularly Enterprise Agreements (EAs). Thanks to the strong unearned revenue figure, Microsoft raised its guidance for FY'08, and now expects revenue to grow between 11% and 13%, coming in around US$57 billion.

In an unusual occurrence, revenue actually decreased from Q3 to Q4, but this was a result of a one-time deferral of US$1.7 billion in revenue from Q2 to Q3 related to upgrade programs for Windows and Office; without that deferral, revenue patterns would have been normal.

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

Business and Online Segments Beat Expectations

Performance was mixed in Microsoft's core businesses, with the Business segment blowing past expectations. The Client segment and the Server and Tools segment, in contrast, came in at or slightly below expectations. Emerging businesses came in largely on track with revenue expectations, although the Xbox charge deepened losses.

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

Business. Revenue from the Business segment, which includes Office, Exchange, and Dynamics, grew 19% from last year's quarter to US$4.63 billion, far better than Microsoft's expectations of 13% to 14% growth. This fueled a similar 19% increase in operating income, to US$2.99 billion, marking only the second quarter in which this segment earned more profits than the Windows Client segment—historically Microsoft's most profitable business. (This happened in Q2'07 as well, but that was an unusual quarter because of revenue deferrals related to upgrade programs for Windows and Office.) Contributing to the growth was a 24% increase in revenue from Dynamics business management software offerings.

In addition, the balance of unearned revenue attributable to the Business segment leapt to US$5.77 billion, up from US$4.34 billion at the end of Q3 and from US$4.78 billion a year ago. This reflects strong renewals of multiyear license agreements for products in this segment. (Microsoft books revenue from multiyear license agreements as unearned revenue, and then recognizes this revenue over the course of the payment period.) Notably, Microsoft said that EA renewal rates were higher than a year ago, reflecting continuing interest in Office 2007 and momentum for SharePoint Server 2007, both of which were released early in 2007.

Client. Client growth came in at the low end of expectations, growing 14% year-over-year to US$3.81 billion. This is a significant slowdown from last quarter, in which year-over-year growth was nearly 30% (not including the one-time effect of the revenue deferral from Q2 to Q3). The main contributor to Q4 growth was new PC shipment sales, which increased between 11% and 13% worldwide, Microsoft estimates. Revenue growth outpaced PC shipment growth slightly because more consumers are buying premium editions of Vista (mainly Vista Home Premium) than they did of XP. Microsoft expects Client revenue growth to slow in FY'08, coming in at only 9% to 10%.

Server and Tools. Usually Microsoft's fastest-growing segment, Server and Tools revenue increased only 15% from last year's quarter, slightly slower than the company's expectation of 16% to 17%. However, Microsoft noted that sales of multiyear license agreements were stronger than expected in this segment, which contributes to a shortfall in the current quarter but will bolster results for the next year. Specifically, the unearned revenue balance for this business grew 25% from last year, to US$3.65 billion, suggesting strong interest in Windows Server 2008 and SQL Server 2008.

During the call, Microsoft noted that SQL Server has now shown 40 consecutive quarters in which year-over-year revenue growth was 10% or higher.

Entertainment and Devices. Revenue for this business dropped 10% from last year to US$1.16 billion, coming in near the low end of Microsoft's expectations, while losses nearly tripled from last year to US$1.20 billion—more than the entire quarter's revenues. The main reason for the loss was a US$1.06 billion charge related to a widespread defect in Xbox 360 consoles, which Microsoft announced two weeks before the earnings call. The company reiterated its prediction that the Xbox business and this segment would become profitable in FY'08, and predicted 30% to 40% year-over-year revenue growth in Q1'08. (For more details on the reasons for the charge and Microsoft's optimism for FY'08, see "Xbox 360 Failures Acknowledged".)

Online. Revenue from consumer online services grew 19% from last year to US$688 million, outpacing Microsoft's high-end expectation of 15% growth. An important contributor to this growth was an increase in traffic to Microsoft's Web search site—according to comScore, Live Search market share rose from 10.3% in May to 13.2% in June, while competitors Google and Yahoo declined slightly. The increase was largely due to a promotional program called Live Search Club, and while this may be a one-time effect, it suggests that concentrated marketing efforts can increase traffic. According to Microsoft Chief Financial Officer Chris Liddell, Microsoft is also earning more revenue per search than it was a year ago, and growth in the company's display advertising business remains strong. Despite the revenue growth, however, the Online segment increased its quarterly loss from US$187 million a year ago to US$239 million this year, and Liddell warned that losses will continue and perhaps increase through FY'08, noting that some of the expected profits from the Entertainment and Devices business will be offset by increased investment into online services.

Unearned Revenue Jumps

Microsoft's fourth fiscal quarter is always a strong quarter for volume license agreements, but Q4'07 was exceptional, with EA renewals coming in above their usual maximum rate of 75%. For the last two years, the growth of revenue from volume license agreements in Q4 has created big jumps in unearned revenue—the company's unearned revenue balance stood at US$9.17 billion at the end of FY'05, US$10.90 billion a year later, and is now at US$12.65 billion. Nearly all of this growth has come in the Business segment and the Server and Tools segment, while Client-segment unearned revenue has remained relatively flat. This suggests that most businesses continue to upgrade Windows only when they buy new PCs, rather than covering the OS on multiyear agreements.

In general, this growth in what Microsoft calls "annuity revenue" helps the company smooth out its earnings from quarter to quarter and makes it less reliant on big marketing pushes around each product launch. As the company moves more toward delivering subscription-based services in addition to or as replacements for on-premise software, this trend could accelerate.

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