Microsoft Tops Expectations by 2 Cents, but Revenue Lags

Updated from 5:35 p.m. EDT

Buoyed by a resurgence in PC demand during the last half of March, Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) reported a 24% increase in its quarterly earnings Thursday, surpassing analysts' expectations.

But revenue was nearly $100 million below the estimates of the most pessimistic analysts, a discrepancy the company did not immediately explain.

Microsoft released its report after markets closed Thursday. Microsoft shares fell 2 7/8 to 76 1/16 in after hours trading, according to Instinet. Microsoft closed regular trading at 78 15/16, up 1/4.

For the third fiscal quarter ended March 31, the Redmond, Wash.-based company reported net income of $2.39 billion, or 43 cents a diluted share. In the comparable quarter last year, the company reported net income of $1.92 billion, or 35 cents a diluted share. Analysts polled by First Call/Thomson Financial had predicted earnings averaging 41 cents a diluted share in the latest quarter.

Revenue rose 23%, to $5.66 billion, from $4.6 billion.

Microsoft said operating income before taxes totaled $2.73 billion; investment gains added $885 million.

Revenue for original equipment manufacturers, an industry term referring to computer makers, "was light as demand for business PCs remained slow in the quarter, and we remain guarded about near-term growth," said John Connors, the company's chief financial officer, in a statement.

The sentiment is one Microsoft echoes every quarter as it guides Wall Street analysts to pick an earnings figure that it later invariably surpasses.

Microsoft said it shipped more than 1.5 million copies of its Windows 2000 business operating system, which made its debut during the quarter.

Wall Street is closely watching initial information about the Windows 2000 operating system, which made its debut on Feb. 17. Under development for three years, the business software operating system was delayed repeatedly, though it was released to manufacturers in December. Around the time of the Web-cast festival celebrating the new product, analysts said they expected some earnings to trickle in during the third and fourth quarters before a deluge in the first quarter next year, which will end in September.

The company's stock price, which for months floated between the mid-90s and the mid-110s, has suffered during the quarter as prosecutors scored a victory in one phase of the long-running antitrust case against the company and a prominent Wall Street analyst questioned Microsoft's projections for the software market.

In the antitrust case, U.S. District Judge Thomas Jackson issued a harsh ruling April 3, finding that Microsoft monopolizes the market for operating systems, illegally tied products together and employed predatory tactics to maintain and extend its monopoly. Private negotiations fell through two days earlier, on a Saturday, and the stock price fell 15 7/16, or 15%, to 90 13/16 in anticipation of the ruling. Federal prosecutors and 19 state attorneys general are now at odds over what remedies to propose in a recommendation due next week.

With a schedule set for hearings on remedies in the case, news has not been characterized by the kind of immediacy that can drastically move a stock price. Last week, as the scheduled date for the earnings report neared, Wall Street turned its focus to the company's fundamentals. On April 12, Rick G. Sherlund, a Goldman Sachs analyst, who has followed Microsoft since his firm took the company public, lowered his estimate for quarterly revenues by $200 million, to $5.75 billion from $5.95 billion, citing a possible slump in demand for personal computers. Though no analysts changed their ratings on the stock, Microsoft shares plunged 4 5/8, or 5%, to 79 1/4 Wednesday afternoon, the lowest level since early summer.

Despite the toll Sherlund's report took on the stock price, the analyst conceded that his estimate "could easily be off $100 million either way" and made it clear that his opinion had been swayed by conversations with hardware industry analysts from his own firm.

As earnings season rolled along, Sherlund's caveat began to seem his most prescient prediction. Two days after his report, computer maker Gateway (GTW Quote - Cramer on GTW - Stock Picks) said sales rose to $2.34 billion, up 11% from year-earlier levels.

Just as market players who were betting against Sherlund might have begun to relax, International Business Machines (IBM Quote - Cramer on IBM - Stock Picks) said Wednesday that its quarterly revenue had slipped by 5%, amounting to a $1 billion shortfall. But Paul Dravis, analyst for Bank of America, said IBM's problems seem to stem from its own failures to execute its strategies and are not indicative of slowing PC demand.

Still, as Sherlund lowered his revenue estimate below the consensus prediction, few thought he would be off by $100 million higher than the actual results.