Microsoft posts historic revenue stumble in quarterly earnings

Revenue down 6%, net income off 32%.

For the first time in its 23-year history as a public company, Microsoft's revenue dropped in year-over-year comparison as the company reported a whopping 6% decline in revenue for its fiscal third quarter coupled with a 32% decline in net income as compared to the same quarter a year ago.

The revenue drop was 3.5% greater than what analysts were expecting. A poll of analysts by Thomson Reuters showed expectations for third-quarter revenues of $14.09 billion, down from $14.45 billion in the same quarter last year.

In the earnings report, Microsoft reported revenue of $13.65 billion for the third quarter ended March 31. Net income was $2.9 billion, down from $4.3 billion in the same quarter of 2008.

The news was bleak across all of Microsoft’s business units, with drops in every segment except servers and tool, which has been Microsoft’s most consistent performing business segment for the past two years.

Microsoft said revenue in the client and business divisions was down due to weakness in the global PC and server markets.

"Like last quarter's results, this quarter really shows how dependent Microsoft is overall on sales of PCs to businesses. Business PC sales were down 16%; client revenue dropped 16%," said Matt Rosoff, an analyst with independent research firm Directions on Microsoft.

Microsoft also leans heavily on multiyear volume licensing contracts, so-called annuity contracts, it has with corporate users, especially Enterprise Agreements (EA). Those agreements run for three years and give users licenses for software, most notably Microsoft’s historic cash cows – Windows and Office.

A significant portion of those contracts historically expire in Microsoft’s fiscal fourth quarter and the company pushes hard for renewals.

Rosoff says Directions on Microsoft has seen some evidence of discounting on those multiyear agreements. "That shows how important it is to Microsoft's long-term business that those Q4 EAs are renewed, and ideally that companies cover additional products on them.”

Microsoft CFO Chris Liddell said on Thursday’s earnings call with financial analysts that he expects EA renewal rates to remain at historic levels but that growth would be in the single digits. He also said the company is not significantly discounting volume licensing contracts and called the annuity contracts “one bright spot” on the earnings report.

Microsoft reported that annuity licensing was up 5% over the prior year and represents 35% of the company’s product billings.

Rosff says the fourth quarter will be critical for EA and Microsoft’s long-term outlook.

“I could see more companies choosing to cover Windows upgrades on an EA because of the positive reviews of Windows 7, and because so many of them skipped Vista," he said.

Windows 7 is expected to ship this fall.

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Rosoff said corporate customers may also renew Office coverage in their EA agreements given that Office 2010 is coming next year, but that Microsoft still has a sell job given that many users upgraded to Office 2007. "So perhaps, given the economy, companies will sit out Office 2010. That would be a big problem,” he said.

Rosoff also said the fourth quarter will be a big test for Microsoft in the server and tools business. “If companies decide that Windows Server 2008 R2 looks good, they'll probably cover the Core CAL on their EAs. That pulls through some revenue for Exchange and SharePoint as well, so that would be good for business revenue.”

Overall, Liddel said the outlook is solid. “Over the next 18 months will bring a new wave of products to market. In the short term results will be impacted by current economic conditions, but the overall outlook is strong,” he said.

“We believe the recovery will be slow and gradual.

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