Software goliath Microsoft (click ticker for report: ) reported slightly weaker than expected first quarter results Thursday afternoon. Revenue shrank 8% year-over-year to $16 billion, which was a bit lighter than consensus estimates. However, if we add back deferred revenue of $1.3 billion, then year-over-year growth was flat. Earnings fell 22% year-over-year to $0.53 per share, which was also a bit worse than consensus expectations. Again, with deferred revenue added back, earnings look much better at $0.65 per share.
The Servers & Tools business remained strong, growing 8% year-over-year to $4.55 billion. SQL Tools revenue grew 8%, but System Center was the standout, with revenue surging over 20%. Though transactional revenue fell, the company’s new multi-year licensing business should create smoother recurring revenue and boost total revenue. Going forward, product revenue is expected to grow at a low double-digit pace for fiscal year 2013, and enterprise services revenue is expected to grow at a mid-teens rate for the year. We’re huge fans of this highly profitable (38.4% operating margin) business, and we think it gets overshadowed by Windows and Office.
The firm’s Business division experienced some pressure. Segment revenue fell 2% year-over-year $5.5 billion, though multi-year licensing agreements grew at a double digit pace. The firm’s operating margin was fantastic, increasing about 50 basis points to 66.3%. We think Office revenues–and aggregate business division revenues–will grow at a low double digit rate for the fiscal year. A continued refresh cycle–driven by a new Office upgrade and a migration from XP (service expires in 1.5 years)–should provide a nice boost to the business. The combination of Servers & Tools and Business makes Microsoft one of the top enterprise technology companies in the world, and we expect both segments to drive tremendous growth in the near term.
Windows & Windows Live were incredibly weak, with revenues slipping 33% year-over-year to $3.24 billion. However, when considering Windows 8 upgrade preorders, revenue fell just 9%. Obviously PC markets were weak, but we suspect some of the weakness was driven by customers waiting for the Windows 8 product launch—which had more OEM preorders than Windows 7. Oddly, management didn’t have any guidance about the division’s performance. We continue to monitor trends closely.
The Online Service business grew 9% year-over-year to $697 million, with advertising revenue increasing 15%. We don’t think Bing is taking ad dollars from Google, but the two advertising formats offer different value propositions, which could be the key driver behind the revenue gains. The division continues to lose money, but when all of Microsoft generated $5.7 billion in free cash flow during the quarter, it may be unfair to complain about a segment loss of $364 million.
Overall, we thought the quarter was mixed. We’re bullish on the future of the Service & Tools division, as well as the Business division, and we think management’s guidance for strong growth (while enterprise spending remains weak) is a testament to the strength of the underlying businesses. On the other hand, we were disappointed in the firm’s comments with respect to the Surface and Windows 8. Though we think management is excited about both products, they also added to the amount of uncertainty that continues to cloud both product launches. The Surface could be a huge success if it’s packaged appropriately with enterprise investment. And Windows 8 could be applauded by consumers, with people liking the touch screens on desktops and a new operating system for the first time in years. We’re anxiously awaiting the customer response for both products.
All things considered, the long-term future for Microsoft is bright, and we believe the stock is incredibly cheap on a discounted cash flow basis. As a result, we own the cash cow in the portfolio of our Dividend Growth Newsletter.