Cautious on Microsoft

The first quarter is strong, but revenue guidance disappoints.
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Updated from 7:52 a.m. EDT

Investors remained cautious on

Microsoft

(MSFT) - Get Report

Friday after the software giant glutted them with mixed earnings data.

Shares were recently down 47 cents, or 1.7%, to $28.09 after the Redmond, Wash., company posted first-quarter results Thursday that beat analyst estimates and raised its guidance for fiscal 2005. Investors were torn between that positive news and weaker-than-expected second-quarter revenue guidance, as well as a surprising drop in unearned revenue.

"The knee-jerk reaction, which was generally still accurate, is that the deferred revenue fell on a sequential basis more than people expected and the guidance for the December quarter was underwhelming," said Tony Ursillo, an analyst with Loomis, Sayles & Co., which holds Microsoft shares. "I think what it speaks to is it's just not that easy for Microsoft to post upside anymore," Ursillo added of Microsoft's December-quarter guidance.

Microsoft earned $2.9 billion, or 27 cents a share, in the first quarter, including a stock-based compensation charge projected at 5 cents a share. A year ago, Microsoft posted first-quarter net income of $2.6 billion, or 24 cents a share, including stock-based compensation charges.

Excluding the stock charge, Microsoft had pro forma net income of 32 cents a share in the first quarter, beating the consensus estimate gathered by Thomson First Call and the company's target, both of which were 30 cents a share.

Revenue rose 12% to $9.2 billion from $8.2 billion a year earlier, but declined 1.1% from $9.3 billion in the previous quarter. That exceeded the consensus estimate of $9 billion for the first quarter and the company's targeted range of $8.9 billion to $9 billion.

Looking forward, Microsoft said it expects to earn 28 cents a share, including $715 million in stock-based compensation, on revenue of $10.3 billion to $10.5 billion in the second quarter. Analyst estimates currently call for second-quarter earnings of 32 cents a share, excluding stock-based compensation, on $10.6 billion in revenue.

Microsoft has in the past released its estimates for stock-based compensation costs on a per-share basis, but did not Thursday. "We've made the decision to record equity compensation, and it's part of our GAAP reporting and we're going to report it as such," said Curt Anderson, senior vice president of investor relations. "Our view is it isn't a true reflection of our business pulling it out."

The company also raised its outlook for fiscal 2005, which ends June 30. Microsoft said it now expects to earn between $1.07 and $1.09 a share, including 16 cents a share in stock-based compensation, on revenue ranging from $38.9 billion to $39.2 billion this fiscal year. Excluding stock-based compensation, Microsoft fiscal '04 earnings should range from $1.23 to $1.25 a share.

The latest consensus estimate called for fiscal 2005 earnings of $1.24 a share, excluding stock charges, on $38.9 billion in revenue.

Previously, Microsoft estimated it would earn $1.21 to $1.24 a share, excluding stock-based compensation of 16 cents a share, on revenue ranging from $38.4 billion to $38.8 billion in fiscal 2005.

While Microsoft tooted its horn about raising its full-year earnings target a couple pennies and revenue by $400 million to $500 million, Ursillo, for one, wasn't wildly impressed, noting that about half of that comes from the first-quarter upside. The remainder -- roughly $250 million -- is just a fraction of the approximately $30 billion in revenue the company expects to earn in the remaining three quarters of the year, Ursillo noted.

Anderson, meanwhile, said Microsoft's second-quarter revenue target may be short of analyst estimates because the company is seeing more business move out to the second half of the year, and analysts may not have realized that the company faces tougher year-over-year comparisons.

Last year, Microsoft's second-quarter sales enjoyed a boost from the launch of Office 2003, currency exchange rates and subscription sales, Anderson said.

"This quarter was exceptionally strong," Anderson said, highlighting the 12% top-line growth. "We think that's a great start. We think we're seeing a lot of strength in commercial businesses."

The results were partially driven by a 10% year-over-year increase in PC shipments this quarter -- higher than Microsoft's projection calling for 6% to 8% growth, Anderson said.

On a postclose conference call, CFO John Connors projected PC-shipment growth of 7% to 9% in the second quarter and server shipment growth of 14% to 15%. He said his view of IT spending has not fundamentally changed from three months ago, when he predicted business PC growth would outpace consumer PC growth.

Other than the company's second-quarter guidance, the other blemish in Microsoft's report was the higher-than-expected decline in unearned revenue -- a key measure of how many business customers are renewing their contracts to buy Microsoft software on a subscription basis. Unearned, or deferred, revenue fell $395 million from the end of June to $7.78 billion on Sept. 30.

That decline was bigger than Microsoft's forecast, which called for a drop of $200 million to $300 million. Indeed, some Wall Street analysts were even forecasting an increase because they expected Microsoft to renew more subscription contracts than its estimates. The company had said it expected to be able to renew 10% to 30% of two-year subscription contracts.

In his introductory remarks on the conference call, Connors cautioned investors not to read that decline as weakness in the quarter -- only to be followed with numerous questions about it from analysts. "I do believe investors have become overly focused on unearned rev and have missed the bigger picture," Connors said, noting that given the volume of contracts Microsoft signs, delays can lead to a big swing in unearned revenue.

Connors said unearned revenue fell more than expected because of a shift in more business through manufacturers, more upfront license sales and business customers taking longer than anticipated to renew subscription contracts. One factor contributing to the delays is the tendency by Microsoft to try to sell those customers more software products when they renew, Connors said.

Despite that higher-than-expected drop, Microsoft is standing by its target for unearned revenue shooting back up to $8.6 billion by the end of the fiscal year in June. "That should tell you we don't believe the health of annuity license business has deteriorated," Anderson said in a telephone interview, referring to the company's subscription, or annuity, sales.

However, Loomis Sayles' Ursillo was not comforted by such assurances. "There are a number of things going on that didn't allow Microsoft to make its target this quarter, and it sounds like there are a number of assumptions going into the estimation of reaching $8.6 billion. But based on the discussion on the call, I think there is a range of outcomes that can happen," Ursillo said.

When a customer signs a subscription contract, Microsoft recognizes a portion of it on the unearned revenue line of its balance sheet and the moves that revenue to the income statement over the lifetime of the contract. But to complicate matters, for longer-term contracts, part of the contract initially remains off the balance sheet because Microsoft has yet to send a bill for it, making it difficult to get a clear picture of total sales -- or bookings -- registered by Microsoft during a quarter.

Taking into account that portion of sales that remains off the balance sheet, Connors said: "Our aggregate bookings volumes are very, very healthy ... outperforming the rest of the commercial software industry."

Connors forecast that unearned revenue should rise modestly in the December quarter and said the renewal rate for customers whose two-year subscription contracts recently expired has been falling at the high end of the company's forecasted range of 10% to 30%.

In the first quarter, Microsoft's Information Worker unit -- a cash cow representing sales of its Office software suite -- posted a 13.6% increase in revenue from a year ago to $2.24 billion. Microsoft's other cash cow, its Client or Windows operating system unit, posted a 6.6% year-over-year jump in revenue to $2.99 billion.

Server and Tools, one of Microsoft's faster-growing divisions, saw sales jump nearly 19% from a year earlier to $2.24 billion, while its operating income climbed a whopping 84% to $701 million, from $381 million a year earlier.

Microsoft's online unit, MSN, registered a 10% increase in revenue to $540 million and recorded operating income of $77 million, a 35% increase from the year-earlier quarter.