No Pain, No Gain in Microsoft Q3 Earnings

Investors should have seen this coming. After Intel (NAS: INTC) posted relatively soft numbers earlier this week, largely in part to overall weakness in the broader PC market, longtime partner-in-crime Microsoft (NAS: MSFT) is following suit with its own uninspiring figures ahead of one of its most important product launches in years.

Shares are trading down over 2% as of this writing. How bad could it be?

Can I get your digits?
Revenue in the fiscal first quarter was a hair over $16 billion. That's down 8% from the $17.37 billion in sales that Mr. Softy put up a year ago. However, much of this drop is attributed to $1.36 billion in deferred revenue related to the company's Windows Upgrade Offer, Windows 8 pre-sales to OEMs, and Office Offer. Non-GAAP revenue that includes these deferrals puts revenue right back at $17.36 billion, essentially flat with last year. The bulk of these adjustments are related to the Windows Upgrade Offer and Windows 8 pre-sales.

Source: Microsoft.

Operating income came in at $5.31 billion, representing a 33% operating margin. Net income fell 22% to $4.47 billion, or $0.53 per share. Let's dig into each segment to see what's responsible for that profit pullback, starting with its three biggest cash cows.

With the launch of Windows 8 looming in exactly one week, it's not surprising that Windows sales this quarter came in light as consumers hold off on purchases. The Windows and Windows Live division saw GAAP revenue fall by a third to $3.24 billion. On a non-GAAP basis, which includes an adjustment for the $1.17 billion deferral, revenue still decreased 9%. The segment's operating income got cut exactly in half to $1.65 billion.

The global PC market remains sluggish, with total units down 8.3% in the third quarter, so no one should be surprised that the Windows segment isn't particularly inspiring.

The deferral effects were less pronounced in the business segment at just $189 million. Microsoft Office is also seeing an overhaul soon, so again we see some expected purchasing delays. On a GAAP basis, the business division saw sales inch down just 2.4% to $5.5 billion, which translates into a modest 1% gain on a non-GAAP basis.

Operating income here was also down slightly at $3.65 billion. Still, Google (NAS: GOOG) is escalating the competition for enterprise productivity software with its Google Apps suite, which is cheaper for enterprise customers than Office. Microsoft said the productivity server offerings like Lync, SharePoint, and Exchange put up double-digit growth.

The server and tools division grew sales by 8% to $4.55 billion, which translated into operating income of $1.75 billion -- more than Windows. The company attributed this to strength in its SQL Server offering and over 20% growth in System Center revenue. However, this is continued deceleration in this segment, and the lowest gain in two years.

Source: Microsoft.

This is indicative of the broader slowdown in enterprise tech spending, and Microsoft isn't immune to those trends.

The stragglers
Following the massive $6.2 billion goodwill impairment last quarter in the online services division, it grew revenue by 9% to $697 million. Online ad revenue increased 15%, which Microsoft said was driven by increased revenue per search. However, the segment generated an operating loss of $364 million, a continuing theme. The good news is that's the smallest lost the segment has posted in over four years.

Entertainment and devices effectively operated at break-even, with sales also about flat from a year ago. Microsoft sold 1.7 million Xbox 360 units this quarter. That's down from 2.3 million a year ago, but the console is maintaining its top dog status in the domestic market with 49% market share. Lifetime Xbox 360 unit sales are now up to 70 million.

No pain, no gain
Microsoft is now on the brink of one of its largest coordinated product rollouts in its history as it revamps most of its flagship products. Windows, Office, and Windows Phone are all seeing major upgrades this fall, and this transitional quarter was expectedly weak.

The company launches Windows 8 along with its Windows RT Surface tablet next Friday. That means it will have to compete with Apple's (NAS: AAPL) iPad Mini event next week to vie for consumer and media attention. The Surface is challenging the full-size iPad directly at the same $499 price point. Of course, the iPad's broader success in driving tablet adoption is also an important contributing factor to the weak PC market.

Microsoft also has three important OEM partners to help launch Windows Phone 8: Samsung, HTC, and Nokia (NYS: NOK) . All three of these companies have unveiled their latest Windows Phone devices just in time for the holidays.

Every player in the PC value chain is relying on Windows 8 to rekindle growth, including Microsoft itself. However, OEMs, investors, and consumers remain cautiously optimistic on its prospects, since it's such an ambitious attempt to reimagine Windows from the ground up. It's a bold move, but a risk that Microsoft needs to take.

This quarter's results show that Microsoft needs this risk to pay off.

It's been a frustrating path for Microsoft investors, who've watched the company fail to capitalize on the incredible growth in mobile over the past decade. However, with the release of its own tablet, along with the widely anticipated Windows 8 operating system, the company is looking to make a splash in this booming market. In this brand-new premium report on Microsoft, our analyst explains that while the opportunity is huge, the challenges are many. He's also providing regular updates as key events occur, so make sure to claim a copy of this report now by clicking here.

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Evan Niu, CFA, owns shares of Apple. The Motley Fool owns shares of Apple, Google, Intel, and Microsoft. Motley Fool newsletter services recommend Apple, Google, Intel, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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