Microsoft's record quarter: shareholders paid for some of those earnings

Responding to my recent posting about Microsoft's lackluster XBox 360 performance, Blackfriars reader Jon Kai opened my eyes to some numbers in Microsoft's recent quarterly earnings that I had not dug into. I had skimmed both the SEC 10-Q filing and the earnings numbers, and concluded that Microsoft by and large had a very impressive quarter in calendar Q1 2007. After all, what is there not to like about growing revenues by 32% and operating income by 69% year-over-year? Even quarter to quarter, both numbers were up, weren't they? How could anyone complain?

Actually, there is room to complain. See, those earnings were great, but they came at a cost. Shareholders paid for most of the upside surprise, not customers. I'll describe why I think this in a minute.

Before I describe the analysis, let me ask the following question: if Microsoft's record earnings were so great, why isn't Microsoft's stock moving? After all, the period we're talking about included Microsoft's biggest launches in the last five years, Windows Vista and Office 2007. These are supposed to be the engines of growth for years to come. And if earnings are up, the stock should be too. What is wrong with those Wall Street people?

In my opinion, the answer to that last question is, "nothing." The reason that everyone isn't running out and buying Microsoft stock is the company's balance sheet tends to be paying for its earnings nowadays.

Everyone knows that Microsoft has billions in cash. It has billions more in investments, plants and equipment, accounts receivable, goodwill, and intangible assets. Those assets are offset by liabilities, things like accounts payable, accrued compensation, income taxes, and unearned revenue (more about that in a minute). Overall, that balance sheet represents the worth of the company. And that's the problem: Microsoft has been drawing down its balance sheet over time. It stood at nearly $70 billion nine months ago. It was $66 billion at the beginning of the year. As of March 31, it's less than $64 billion.

Now, this topic actually did come up during the earnings call. Microsoft reported that it had redeemed about $1.7 billion in unearned revenue from its Technology Guarantee program during this quarter as the result of the Vista and Office launches. Microsoft had deferred that revenue collected from computers shipped in calendar Q4 2006 with Windows XP that would later have to be upgraded to Vista for free.

But if you back out that $1.7 billion from Microsoft's earnings for the quarter ended March 31, you find that it earned $0.31 a share, not $0.50. If you back out the entire change in the balance sheet between the beginning of the year and now, you find that Microsoft earned $0.24 a share. As a point of comparison, during the Christmas quarter before Vista and Office were available to consumers, Microsoft earned $0.26 a share.

Said another way, Microsoft achieved record breaking earnings during the Vista launch quarter by taking money out of its assets, not through amazing sales of Vista and Office.

Now taking money of its savings account isn't necessarily a big deal. After all, companies use their assets to fund all kinds of activities to make more money in the future. We know, for example, that Microsoft is using some of its cash horde to buy back its own stock shares. And there is no doubt that it is using its assets in other ways, such as investing in XBox 360 development, Microsoft Live, and various advertising networks. Whether those investments are good investments is something for its management and shareholders to judge. However, as a point in contrast, Apple Inc. has been launching a lot of products over the last nine months and has added almost $2 billion to its balance sheet and assets in the same period that Microsoft's assets dropped $6 billion.

We tell our kids that any time you dip into your savings account, it should be for a good reason. Most of the time, when we're earning money, we expect to be adding to our savings account, not subtracting from it. So that poses the question to investors: is this a good reason?

Microsoft's own numbers tell us the way it is making more and more each quarter is partly funded by making each share worth less and less in assets. At the very least, this fact that Microsoft is dipping into its assets to pay for its record earnings makes me question just how successful those Vista and Office launches really were. Judging from the reaction of Microsoft's stock price after those record earnings -- and the fact that it remains lower than it was three months ago before the Vista launch -- that fact hasn't been lost on Wall Street either.

Full disclosure: Neither the author nor Jon Kai have positions in Microsoft at the time of writing.

Technorati Tags: Balance Sheet, Earnings, Financial analysis, Microsoft, Office 2007, Technology Guarantee, Vista, Windows