Updated from 12:09 p.m. EST

Shares of Microsoft ( MSFT) edged higher on Friday after a strong earnings report that drew cheers from Wall Street analysts.

Powered by strong video-game and PC sales, Microsoft beat second-quarter estimates Thursday and raised its guidance for the full fiscal year. The Redmond, Wash.-based software maker's video-game business also posted its first profitable quarter on record revenue, thanks to blockbuster sales of Halo 2.

Analysts generally reacted to the report by raising their earnings forecasts for the company and reiterating their largely favorable ratings on Microsoft shares.

With this wind at its back, Microsoft's stock, which was down earlier, was recently up 5 cents, or 0.2%, $26.16 in recent trading on Friday. It closed Thursday up a dime to $26.11.

"Overall I thought it was a very good earnings report," said Rich Parower, portfolio manager of the ( SHGTX) Seligman Global Technology Fund , which counts Microsoft as one of its top holdings.

But "people were anticipating good results," Parower added, explaining why investors didn't bid up the stock farther. "It's also one of the largest-market-cap companies -- No. 1 or No. 2. It takes a lot to move the stock that much."

Microsoft earned $3.46 billion, or 32 cents a share, in the second quarter, including a stock-based compensation charge of 3 cents a share. A year ago, Microsoft posted second-quarter net income of $1.55 billion, or 14 cents a share, including stock-based compensation charges of 20 cents a share related in part to a one-time option transfer program.

Excluding the stock charge, Microsoft delivered pro forma net income of 35 cents a share in the second quarter. That beat the consensus estimate gathered by Thomson First Call that called for earnings excluding stock-based compensation of 33 cents a share and the company's guidance of 32 cents a share excluding stock charges.

Revenue rose 6.5% to $10.82 billion from $10.15 billion a year earlier and nearly 18% from $9.19 billion in the previous quarter. That also beat the consensus estimate of $10.55 billion for the second quarter and exceeded the company's targeted range of $10.3 billion to $10.5 billion.

"We are impressed by MSFT's execution and ability to continually deliver strong operating results that indicate it is holding or gaining share in its key markets," said Prudential Equity Group analyst Brent Thill in a report on Friday. Thill reiterated his "overweight" rating on Microsoft's shares and his $32 price target.

(Microsoft has not been a recent investment-banking client of Prudential.)

Looking forward, Microsoft said it expects to earn 27 cents to 28 cents a share, including stock compensation, on revenue of $9.7 billion to $9.8 billion in the third quarter. Analysts' estimates currently call for third-quarter earnings of 28 cents a share including stock charges and 32 cents a share excluding stock-based compensation on $9.66 billion in revenue.

The company also raised its outlook for fiscal 2005, which ends June 30. Microsoft said it expects to earn $1.09 to $1.11 a share, including 15 cents in stock charges, on $39.8 billion to $40 billion in revenue in fiscal 2005. That represents top-line growth of 8% to 9% for the year. Excluding stock-based compensation, Microsoft's fiscal '05 earnings should now range from $1.24 to $1.26 a share.

The latest consensus estimate called for fiscal 2005 earnings of $1.26 a share, excluding stock charges, on $39.29 billion in revenue.

This is the second time Microsoft has raised guidance for the year. Three months ago, Microsoft raised its targets for the year, saying it expects to earn $1.07 and $1.09 a share including stock charges on revenue ranging from $38.9 billion to $39.2 billion.

"I think guidance suggests solid PC sales going forward, as well as continued success in server sales," said Tony Ursillo, an analyst with Loomis, Sayles & Co., which holds Microsoft shares.

Ursillo characterized the December quarter as a "good quarter" helped by both currency fluctuations and Halo 2.

Curt Anderson, general manager of Microsoft investor relations, was a little more ebullient about the December quarter. "This is a great blowout quarter," he said in a telephone interview. "The strength was across the board."

On the consumer side, Microsoft's previously unprofitable home and entertainment division, which also includes video-game and Xbox console sales, scored an 11% revenue jump to $1.4 billion. That resulted in operating income for the first time of $84 million, reversing an operating loss of $397 million last year.

Microsoft has sold 6.3 million units of Halo 2 since its Nov. 9 launch, and its Xbox console also outsold rival Sony's ( SNE) PlayStation 2 during the critical holiday quarter. This helped Microsoft nearly meet its goal of selling a total 20 million Xbox units since the console's debut about six months ahead of schedule, Anderson said.

However, because the game-console cycle is winding down, home and entertainment will not be profitable for the rest of the fiscal year, CFO John Connors said in a postclose conference call. Microsoft, which is widely expected to release the next-generation Xbox by next Christmas, is standing by its projection that the home and entertainment division will post sustainable profits in fiscal 2007.

Analysts praised the performance of the Home and Entertainment division, saying it bodes well for the future.

"We increasingly believe that Microsoft could take share from Sony in the U.S. and Europe based on a stronger, more cohesive online strategy and high-quality content drivers such as the Halo franchise," said Morgan Stanley analyst Mary Meeker, in her own report on Friday. "Achieving profitability ... is a huge victory for Microsoft, proving that the business model works to the many doubters."

(Morgan Stanley has done investment banking for Microsoft in the last year.)

Meanwhile, on the business side, Microsoft's server and tools division delivered its 10th consecutive quarter of double-digit revenue growth, with sales jumping nearly 18% to $2.52 billion.

Stonger-than-projected PC sales benefited Microsoft's client, or Windows operating system, unit. It posted a 5.3% year-over-year jump in revenue to $3.22 billion in the second quarter and a 20.8% climb in operating income to $2.53 million.

Microsoft's other cash cow, its information worker, or Office, unit, delivered sales of $2.78 billion. That's a 3% decline from a year ago, which benefited from sales of Office 2003.

Its online unit, MSN, registered a 7.7% increase in revenue to $588 million and recorded operating income of $130 million, reversing a $95 million lose in the year-earlier quarter.

The fledgling mobile and embedded devices division, which sells software for smart-phones, shrank its operating loss to $4 million in the quarter from $110 million a year ago. Sales increased 44% as Microsoft sold more software licenses for smartphones in the quarter than it did during all of last year.

"The company outperformed in every business division," said Lehman Brothers analyst Neil Herman, in his report on Friday. "We believe the outlook for MSFT remains extremely strong and expect the server business to be a key driver in the coming quarters."

(Lehman has provided both investment banking and non-investment banking services for Microsoft in the last year.)

Microsoft enjoyed a $253-million currency benefit during the quarter.

The company's unearned, or deferred, revenue -- a key measure of how many business customers are renewing their contracts to buy Microsoft software on a subscription basis -- climbed $184 million sequentially to $7.966 billion, in line with the company's forecast of a modest sequential rise.

The increase in unearned revenue -- a blemish in the previous quarter -- testifies to continued strength in Microsoft's licensing business, Anderson said.

The company stood by its forecast for unearned revenue to $8.6 billion by the end of its fiscal year, after dipping sequentially in the third quarter and then rising again in the fourth quarter.

"Unearned revenue commentary was extremely positive. It appears that MSFT is benefiting from a more favorable corporate spending environment," said Citigroup Smith Barney analyst Tom Berquist in a report Friday.

(Microsoft has been both and investment banking and non-investment banking client of Citigroup in the last year.)

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