Updated from Jan. 25

Microsoft ( MSFT) beat Wall Street's second-quarter estimates, while delivering investors a nice windfall in the form of higher-than-expected deferred third-quarter revenue.

Shares rose 2% Friday morning, as Citigroup raised its price target on the software giant to $33 from $30. Shares rose 60 cents to $31.05.

The company said Thursday it posted a profit of 26 cents a share on sales of $12.54 billion.

Analysts polled by Thomson First Call were looking for a profit of 23 cents a share on revenue of $12.08 billion.

Guidance for the rest of the year was generally in line with expectations, although Microsoft cut its forecast of cumulative Xbox 360 video-game console sales to 12 million by the end of June, down from earlier projections of 13 million to 15 million consoles.

Wall Street's reaction was positive but restrained. Shares of Microsoft were up 97 cents, or 1.7%, to $30.97 in after-hours trading.

Deferred revenue, a key metric, came in at $1.64 billion, above the company's earlier guidance of $1.5 billion, largely because the company offered customers coupons that will allow them to upgrade to new versions of Office and Windows when the products are generally available. The revenue represented by the coupons is on the second-quarter balance sheet and will move to the income statement in the third quarter.

As expected, the bigger deferred revenue balance hurt comparisons to last year's net income and revenue -- the coupon cost trimmed the bottom line by an estimated 11 cents a share -- but knowing the shift is an accounting effect and not a sales problem, Wall Street appeared to take the negative comparisons in stride.

Net income was off about 28%. Revenue was actually up 6% but would have been up 20% without the drag of the coupons, CFO Chris Liddell said during a conference call with analysts.

The larger-than-expected deferred revenue balance indicates good acceptance of both Vista and Office and is likely a harbinger of strong sales to come for both key products, said analyst Ken Allen of T. Rowe Price. "It was an impressive quarter with strength across the business."

Indeed, sales for most of the company's business units were $100 million to $400 million above the company's projections. T. Rowe Price holds shares of Microsoft.

Microsoft executives seemed pleased with the quarter and were generally upbeat about sales of PCs, as well as of Microsoft products. "Results this quarter exceeded our expectations across the board, with revenue growth at or above our high-end guidance for all divisions," said Chris Liddell, chief financial officer at Microsoft. "Healthy PC and server markets as well as broad-based business and consumer demand for Microsoft offerings fueled revenue growth this quarter."

Revenue from the company's entertainment division, which includes the Xbox 360, rose by 75% year over year to $2.96 billion, largely on strong sales of the game console. The division's loss widened a bit to $289 million from $286 million a year ago, largely because the company still loses money on each Xbox console it sells.

There were also higher expenses associated with Microsoft's extension of the Xbox warranty to one year from 90 days, the company said.

Why the forecast was cut so sharply isn't clear, though Liddell made references to unsold Xboxes still in the distribution channel and Microsoft's desire to make the entertainment unit profitable by 2008.

One division that did not perform terribly well was online services. Revenue grew 5%, but it turned from a profit of $58 million to a loss of $155 million in the quarter.

Beyond the Xbox news, Microsoft's guidance held few surprises. The company said revenue will range from $13.7 billion to $14 billion, with an EPS expectation of 45 cents to 46 cents, including 12 cents related to the technology guarantee. Wall Street was looking for 46 cents a share in profit on sales of $13.99 billion.

Microsoft tweaked guidance higher for the full year and now forecasts revenue of $50.2 billion to $50.7 billion with EPS ranging from $1.45 to $1.47. Wall Street forecasts called for $1.45 a share and revenue of $50.4 billion.

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