Microsoft Payment Deadline Arrives With Analysts Still Guessing

Microsoft(MSFT Quote) crosses a significant threshold today, the deadline for customers to switch to a new and controversial way of paying for software.

The change cements deferred revenue's position among the most important metrics for tracking the future prospects of the world's largest software company. The trouble is, Microsoft has offered limited detail to analysts on estimating deferred revenue under its new payment plan. Consequently, only a handful of analysts are forecasting the number, and their estimates range widely.

Without the details, Pacific Crest Securities analyst Brendan Barnicle said estimating deferred revenue becomes a guessing game that requires an "enormous number of assumptions." Barnicle speculated Microsoft won't offer details on customer bookings because it would indicate the success of its transition to the new model, which the company has acknowledged it has mishandled by initially setting an earlier deadline. Barnicle has a buy rating on Microsoft and owns the stock. His firm has done banking with the company.

Under the new plan, Microsoft will bill business customers annually for the right to receive the most up-to-date versions of Microsoft Office and Windows under a two- or three-year contract. Customers pay whether they want the new software or not, just for the right to keep using the software. Under the old system, customers paid the licensing fee for one version and got the right to use it perpetually. They paid again if they wanted an upgrade.

Microsoft recognizes revenue from the subscription on a monthly basis and classifies the remainder of the year's revenue in unearned or deferred revenue and leaves future years off of the balance sheet altogether. Deferred revenue thus becomes an important signal of how much revenue will be recognized on the income statement in future quarters.

Already, analysts differ over whether the current quarter ending in September -- the first quarter of Microsoft's fiscal year -- will enjoy a bigger boost in deferred revenue compared with impressive gains booked in the fourth quarter, which ended in June.

Microsoft reported that 20% of its total fourth-quarter revenue came from annuity contracts booked in prior periods. Deferred revenue increased a whopping 38%, or $2.1 billion, year over year to $7.7 billion on June 30. That compares to an average 25% year-over-year increase in the previous four quarters, and is the largest increase since the fourth quarter of 1999, according to analysts.

In its fourth-quarter earnings release, Microsoft indicated that 32% of the approximately $7 billion in revenue expected in the first quarter already has been earned from annuity contracts booked in prior periods.

Still, at the company's annual analyst day last week, CFO John Connors warned, "You should not expect this kind of percentage growth in unearned revenue in the future."

But that's not holding back some estimates for the first quarter. For instance, Prudential Securities analyst John McPeake bullishly forecast that deferred revenue could climb to as much as $1.1 billion from the fourth quarter to $8.8 billion in the first quarter. That represents a year-over-year increase of nearly 52%. McPeake has a buy rating on Microsoft and owns shares of the stock.

By contrast, First Albany analyst Mark Murphy said he believes deferred revenue will increase between $300 million and $600 million in the first quarter ending in September from the fourth quarter. That still brings deferred revenue to between $8 billion and $8.3 billion, representing a year-over-year increase of between 38% and 43%. Murphy has a strong buy rating on Microsoft and his firm hasn't done any banking with it.

"I believe most of the conversion to annuity licensing was in the month of June. And I don't think you're going to see as much in the month of July," said Murphy, explaining why he believes the dollar increase will be lower in the current quarter than the past one. "Human nature is to wait until the last minute, but IT spending nature is to spend at the end of the quarter."

Murphy said he believes many investors incorrectly think that deferred revenue will stop growing after the deadline passes. Much like the newspaper business, he said, as long as the number of customers grows, deferred revenue will grow.

Murphy also argues that Microsoft's future becomes less heavily tied to the PC cycle as more customers buy software through a subscription rather than with hardware. To illustrate, he draws an analogy to the cable industry: "If you get cable TV, I don't care when or how often, you get a TV," he said.

Last week, however, Goldman Sachs analyst Rick Sherlund told Microsoft execs that he believes Microsoft's growth in 2003 will depend on PC demand and how much deferred revenue the company books in the current year. But Sherlund added that he's not sure analysts have good metrics to estimate deferred revenue because the company has declined to say how much of its market has moved to the subscription model. Microsoft is on Sherlund's U.S. recommend list and his firm has done banking business with Microsoft.

CEO Steve Ballmer responded, "We're not failing to share with you visibility that we have." Rather, Connors explained, it's difficult to get a handle on the fiscal year 2003 unearned revenue balance because of today's deadline and other factors. He said the company should have more insight as it finishes the September quarter.

In an interview Friday, Rebecca LaBrunerie, Microsoft's product manager of worldwide licensing and pricing, elaborated on why it's so difficult to predict the unearned revenue balance. First, she said you can't draw any conclusions from the number of customers who already converted because they received such large discounts, which expire after today.

Second, she explained that the company set a July 31 deadline in order to accommodate government budgets that end in June. That suggests that Microsoft may be expecting government agencies to make the transition to the new program in July.

LaBrunerie, however, also pointed out that the end of June -- and Microsoft's fiscal year -- is a major deadline for the company's sales staff to close deals. That could mean most deals have been signed in the past quarter.

And so the guessing on deferred revenue continues until the fall, when, analysts hope, Microsoft can offer more guidance after reporting numbers from the current quarter.