Microsoft ( MSFT) has a tough act to follow: itself.After running up 39% since mid-June, the software giant will have to convince investors that there's room for the stock to grow. It may be a tough sell -- in the short run, at least. With second-quarter earnings hitting the wire after Thursday's close, the consensus of the sell-side analysts who follow the stock is a target price of $32.35, not much above Wednesday's closing price of $31.09. But give it a few quarters, say managers who hold the stock, and the picture could change. "Microsoft underperformed the market for so long, now that it's moving, it's like an oil tanker -- hard to stop," says Alan Lowenstein, a portfolio manager with American Fund Advisers. For the first time in years, the company is getting the kind of feel-good buzz usually reserved for Apple ( AAPL). Lowenstein and other Microsoft bulls cite two recent developments to bolster their case:
- The so-far successful launch of Vista, the first new version of Windows in about five years, is a big one. Major business customers got their hands on the long-delayed product in November, and sales were reportedly stronger than expected. Consumers will get the software next week, and it will come pre-installed on the vast majority of new PCs sold in the world.
- With Sony (SNE) lagging badly in the video game-console race, cumulative sales of Xbox 360 hit 10.4 million units in December, comfortably above Wall Street's and Microsoft's expectations.
Moreover, most versions of Vista are more expensive than corresponding versions of older versions of Windows, so revenue and margins will both get a boost -- but not immediately. Most analysts who really understand how large businesses purchase technology believe the new software won't be a massive seller until late 2007 or 2008. That's because IT budgets aren't what they used to be, and in any case, moving to a new version of an operating system takes lots of time to test against the myriad other software programs already in use. Still, there's plenty of enthusiasm on the buy side. Brent McGibbon, principal of McGibbon Asset Management and a holder of the stock, has been impressed with the company's success in the gaming arena. He figures Microsoft may realize a profit on the Xbox 360 ahead of its 2008 target and praises the company for "its innovative work," not a phrase generally associated with Microsoft. His price target: "Maybe as high as $50 in the next 12 to 18 months."
Read the Fine PrintBecause Vista and the newest version of Office software are shipping so late, Microsoft opted to give customers an upgrade coupon for both products. It was probably a smart move from a marketing perspective, but it creates a number of complications related to revenue recognition.
At first glance, the company's numbers are likely to suffer in comparison to the year-ago quarter. But if Wall Street is right, the company actually did rather well. Here's how to read the fine print in the earnings release: The guarantee will trip about $1 billion from the client business unit, the group that includes Windows, Microsoft estimates. But those dollars will be reflected on the balance sheet as deferred or unearned revenue. Ultimately, revenue from the guarantee will move back to the income statement in much the same way any deferred revenue would. A year ago, the company's client unit added $3.4 billion to the top line. Microsoft figures it will be more like $2.5 billion to $2.6 billion in the most recent December quarter before adding back deferred revenue. If the total of actual plus deferred revenue is much below $3.6 billion, something went wrong. Similarly, the business division, which oversees sales of Office, will experience a shift of some $500 million away from the income statement and onto the balance sheet. A year ago, the group posted revenue of $3.7 billion. This year it likely will range from $3.3 billion to $3.4 billion, the company says. Adding back revenue from the guarantee (for the newest version of Office) should bring the total to about $3.8 billion.
Naturally, the guarantee also affects the overall top line. The company expects revenue of $11.8 billion to $12.4 billion in the quarter, which would be flat with the year-ago period. But that excludes $1.5 billion in deferred guarantee money. If the forecast is accurate, total revenue will be the equivalent of $13.5 billion to $13.8 billion, or growth of 12% to 17%. On the bottom line, Microsoft expects an EPS of 22 cents to 24 cents a share, which is 29% to 35% below the 2006 quarter. But adding back 11 cents to reflect the guarantee moves the needle to an EPS of 33 cents to 35 cents a share. Wall Street, which is well aware of the issue, is looking for an EPS of 23 cents on total revenue of $12.07 billion.