Xbox Gift From Microsoft?

SAN FRANCISCO -- Microsoft(MSFT Quote) is expected to deliver a "gnarly" second-quarter earnings report after Thursday's closing bell.

Gnarly, not in surfer-dude speak, but in the sense that comparisons with year-ago results may seem tangled and difficult to decipher. In the second quarter of last year, a significant chunk of software revenue was deferred to the third quarter of 2007, according to Matt Rosoff, analyst with Directions on Microsoft.

For example, in last year's second quarter the company reported $140 million more in deferred sales of Windows Vista and Office software than it had expected.

Microsoft will likely report adjusted figures as well as traditional comparisons with the second quarter of 2007, Rosoff said. "It's a complicated year of earnings. It'll be gnarly."

Officially, however, the Street will be looking to see if holiday Xbox sales can provide an upside surprise. Sell-side analysts are looking for total second-quarter revenue of $15.95 billion and earnings per share of 46 cents for the quarter ended in December, according to Thomson Financial.

Microsoft shares began to rise in early October, hitting a one-year high of $37.50 in November after its last blowout earnings report raised the consensus target price to $40.

But the stock, like much of the tech sector, has fallen back in recent weeks, closing Wednesday at $31.93.

"All of Microsoft's divisions are going to do well, with the exception of the online services group," Rosoff said.

The online services unit has many issues to contend with, Rosoff said, beginning with the integration of advertising firm aQuantive, a mid-2007 acquisition. The fortunes of Microsoft's online advertising division are tied to the company's search business. "People are looking for ... any gain in search market share, which is lagging and, if anything, losing share," Rosoff said.

Microsoft's piece of the online search market grew 1.8% in December to nearly 14%, compared with 56% for Google(GOOG Quote) and 18% for Yahoo!(YHOO Quote), according to Nielsen Online.

In Microsoft's earnings announcements, "the wild card is always MSN properties," including the search business, says Kim Caughey, senior equities analyst at Fort Pitt Capital Group. Microsoft provides little insight into its online network business, which is just a small piece of its overall business. "I'm not expecting great things," but MSN and other online businesses could provide some upside surprise. Fort Pitt held just over 200,000 shares of Microsoft at the end of December, according to a filing.

"Like the rest of the people on the planet, we're looking to Xbox to provide upside [from] the holiday season," Caughey says. "We expect the Xbox was the No. 2 seller," after Nintendo's Wii.

The Entertainment and Devices division "will show another profitable quarter for Halo 3," an Xbox game that hit the streets in September, Rosoff said. In the past, Xbox console sales have been a loss leader that boosted software revenue.

But Microsoft has cut costs on its platform, and strong holiday sales of Xbox will "not drive them into the red" this quarter, Rosoff added. "This will be a strong quarter from that division."

Caughey says she's also looking for more upside from sales of Microsoft's premium business editions of its Vista operating system, released in early 2007.

The trend toward premium editions helped to sharply boost revenue during the first fiscal quarter. And Microsoft has previously reported that the pace of corporate agreements to buy and roll out Vista in the near future has been picking up speed.

But Caughey says she'll be focused on what Redmond says about sales in its Servers and Tools division, seeking evidence that its market share is expanding. Several server upgrades will see the light of day in the coming months, including the release of Windows Server 2008 in late February.