The real story behind Microsoft's $20 billion quarter

Wall Street is high on Microsoft these days despite lingering questions about the future of Redmond's core products

If you listen to the financial analysts, all is well in Redmond. Microsoft has released another sunny quarterly earnings report, with $6.63 billion in net income, which beats Apple's analogous quarter by about 10 percent (although it's worth noting Microsoft is running about 0.5 percent behind the same quarter last year).

The biggest increase came from the Entertainment & Devices Division, driven almost exclusively by the Kinect and its pull-along Xbox effect, yielding an operating income profit of $0.68 billion for the quarter, up 86 percent from the same quarter last year. Windows Phone 7, widely regarded as a misfire, was not broken out separately.

More surprising was that the Business Division -- read: Office -- made just under $4 billion in operating profit for the quarter on $6 billion in sales, up 24 percent from the year before.

So businesses are still happily jogging on the Office upgrade treadmill, right? Sort of.

It turns out consumer activity in 2009 was a substantial part of the Office surge, according to Microsoft's 10-Q: "Consumer revenue increased $471 million or 49 percent due to sales of the 2010 Microsoft Office system. The growth in consumer revenue includes the recognition of $224 million of revenue associated with the Office Deferral," in which "Office Deferral" refers to copies of Office 2007 sold at the end of 2009 with guaranteed free upgrades to Office 2010. Half of the consumer revenue increase is due to an accounting technique that shifted items sold in 2009 (viz, Office 2007 with an upgrade guarantee) to income in 2010.

Yet Office upgrades on the corporate side were still impressive. Business Division revenue increased $0.7 billion, or 18 percent, year-to-year, "primarily reflecting licensing of the 2010 Microsoft Office system to transactional business customers [which is to say, one-time sales], growth in multi-year volume licensing revenue, and a 7 percent increase in Microsoft Dynamics revenue." There's no separate accounting for volume licenses, but in the analyst's call, a Microsoft spokesman said that multiyear licenses were up less than 10 percent. That's still pretty good.

The not-so-good news starts with Windows 7 sales. As Gregg Keizer reported in Computerworld, the revenue numbers for Windows are subject to two adjustments, one of which is similar to the adjustment for the Office 2007 sales in 2009.

First, PC manufacturers started ordering large quantities of Windows 7 to go along with new machines that they expected to sell as soon as the OS was released. Microsoft calls this a prelaunch spike and estimates it at $0.56 billion.

Second, just like the Office 2007 copies sold with guaranteed upgrades, Microsoft sold lots of copies of Windows Vista in late 2009 with guaranteed free upgrades to Windows 7. Microsoft estimates this deferral at $1.7 billion.

When you compare Windows sales in the December-ending quarter of 2009 and 2010, which numbers should you use? If you take out the spike and the deferral, quarterly Windows revenues were up 3 percent year-to-year. If you include the deferral but ignore the spike, you see a 5 percent decrease in Windows revenue year-to-year. And if you include the deferral and the spike, Windows sales were down a whopping 30 percent compared to last year.

PC sales were up 3 percent year-to-year, so it makes sense that Windows sales would be up about the same. But if the increase in Windows revenue tracks new PC sales alone, where are all the upgraders?

Finally, Microsoft lost a gut-wrenching $0.54 billion in its Online Division, which includes Bing, last quarter. From the 10-Q: "OSD operating loss increased due to higher cost of revenue and research and development expenses, offset in part by increased revenue. Cost of revenue grew $110 million driven by costs associated with the Yahoo! search agreement. Research and development expenses grew $68 million, or 28 percent, primarily due to headcount-related expenses associated with the search portion of the business." And the rest of it is just bleeding away. Microsoft's Online Division operating loss in the past four quarters comes to $2.5 billion. The four quarters before that came to a $2 billion operating loss. That's a whole lot of money to put on the line to play with Google.

We're left with what has become a recent refrain: Microsoft's numbers are looking good in the short term, but the future of core products remains unclear, and so far, Redmond's cloud and mobile strategies don't seem to be paying off.

This story, "The real story behind Microsoft's $20 billion quarter," was originally published at InfoWorld.com. Get the first word on what the important tech news really means with the InfoWorld Tech Watch blog. For the latest business technology news, follow InfoWorld.com on Twitter.