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

Strong sales in emerging economies and a profitable quarter for the Xbox business contributed to very strong earnings in the quarter ending Sept 30, 2007 (Q1 of Microsoft's 2008 fiscal year). From the same quarter last year, revenue grew 27%—the fastest rate in seven years—to US$13.76 billion, beating Microsoft's estimates by more than US$1 billion, while operating income and net income both came in near record levels.

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

Segment Performance

Four of Microsoft's five business segments significantly exceeded the company's revenue predictions issued last quarter. The exception was the Online business, which came in at the low end of expectations.

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

Client. Revenue from sales of the Windows desktop OS—Microsoft's most profitable business—grew 25% over last year's Q1 to US$4.14 billion, well ahead of Microsoft's expectations of 15% to 16% growth, and operating income was US$3.37 billion. Microsoft credited the surprise to PC unit sales growth of 15%, instead of the 10% to 12% that Microsoft expected. PC sales were particularly strong—around 20%—in the four largest emerging economies, Brazil, Russia, India, and China (BRIC). Improved piracy protection programs, such as Windows Genuine Advantage, and a higher mix of premium-priced consumer editions also helped Microsoft increase Client revenue from last year. In the earnings conference call, Microsoft also claimed a 27% increase in revenue from multiyear agreements covering Windows client upgrades, suggesting that businesses are intending to deploy Vista.

Business. Revenue in Microsoft's Business segment grew 20% to US$4.11 billion, outpacing expectations of 14% to 15% growth, with operating income of US$2.69 billion. Strong one-time ("transactional") sales of Office to mid-size businesses and a carry-over from multiyear licensing renewals in the previous quarter were largely responsible for this growth—overall, revenue from business customers in this segment was up 25% from last year. Microsoft expects revenue growth to slow in the second half of the fiscal year, as the division will be facing difficult comparables against last year's release of Office 2007.

Server and Tools. The Server and Tools segment showed 16% revenue growth to US$2.90 billion, ahead of expectations of 11% to 12% growth; operating income came in at US$962 million. The company credited 15% growth in unit sales for both Windows Server and SQL Server, as well as 32% growth in consulting and support revenues related to recent launches of business products. The company expects growth to continue at a similar pace in Q2 and through the fiscal year, but warned not to expect much of a bump from the release of Windows Server 2008 and SQL Server 2008, as many customers have already purchased the right to upgrade to these products as part of their multiyear license agreements.

Entertainment and Devices. The Sept. 25 launch of Halo 3 helped this segment increase revenue more than 90% from last year to US$1.93 billion, well ahead of Microsoft's top expectation of 40% growth. This revenue growth translated into an operating profit of US$165 million—only the second time the segment containing the Xbox business has shown a quarterly profit. (Before FY'07, the segment containing Xbox was called Home and Entertainment; its only profitable quarter was Q2'05, when Halo 2 launched.) Halo 3 earned Microsoft approximately US$330 million in revenue, as well as spurring 1.8 million console sales, the highest figure since last holiday season. Microsoft also took pains to point out that third-party games are thriving on the Xbox 360—of third-party games that have made the top ten sales list since Nov. 2006, 27 were for the Xbox 360, while only two were for Sony's PlayStation 3 and only one for Nintendo's Wii. Support from third-party game publishers will be critical in helping Microsoft turn console gaming into a consistently profitable business. However, Microsoft expects revenue to grow much more slowly in Q2, and perhaps even decrease from last year, as many retailers were stocking up for the holiday season in Q1 and will therefore buy fewer consoles in Q2. (Like other console companies, Microsoft books revenue when it sells consoles to retail outlets and doesn't wait for "sell-through" to consumers.)

Online. Revenue in Microsoft's online services business grew 25% over last year to US$671 million, but losses more than doubled, from US$102 million last year to US$264 million. Moreover, subtracting the contribution of aQuantive, which became part of the company halfway through Q1, revenue growth was only 10%, coming in at the low end of expectations. Chief Financial Officer Chris Liddell pointed to several reasons for optimism, including 23% growth in revenue from display advertising and a 19% increase in the number of active online users (measured by Live IDs, or Passports), but acknowledged that the Online business would remain an area of investment for the foreseeable future. During the earnings conference call, Liddell denied that Microsoft would sell the advertising agencies acquired with aQuantive, although those agencies' goals (i.e., selling advertising space on competing Web sites, such as Google) might seem to conflict with the company's other online initiatives; the agencies contributed US$51 million in revenue during the quarter.

Record Profits

Cost-control measures helped Microsoft increase operating income more quickly than revenue—operating income was US$5.92 billion, up 32% from the same quarter last year. Both operating income and net income (US$4.29 billion) were near all-time highs for the company. (Operating income, net income, and year-to-year revenue growth were technically higher in Q3'07, but that quarter was artificially boosted by deferred revenue from guaranteed upgrade programs for Windows and Office. Without that deferred revenue, Q1'08 would have set records in operating and net income, and would have been the fastest rate of year-to-year revenue growth since Q1'00.)

The company also continues to buy back shares in order to reduce dilution caused by stock option and grant programs, and it repurchased more than 81 million (of the total 9.51 billion) during the quarter. Share buybacks helped earnings-per-share grow 29% from last year, to 45 cents per share, even though net income grew only 23%.

Unearned revenue, which comes mainly from companies signing multiyear licensing agreements, decreased from US$12.65 billion in Q4'07 to US$11.57 billion this quarter, but this is in line with normal seasonal trends, as many large multiyear agreements come up for renewal in Q4. At the end of the fiscal year, Microsoft expects its unearned revenue balance to be up 8% to 10% from the previous year.

During the quarter, Microsoft's board of directors approved a US$0.01 per share increase to the company's quarterly dividend, to US$0.11 per share.

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