unpredictable deferred revenue will be the hot topic after the close Thursday when the world's largest software vendor announces fiscal second-quarter results.
Deferred revenue primarily represents multiyear subscription sales to businesses, which Microsoft recognizes on its income statement in equal installments each quarter over the life of a contract. Microsoft's move to a subscription model was supposed to improve visibility and eliminate the problem of businesses declining to buy upgrades because they didn't find the new versions compelling enough. (Upgrades are included in the subscription price.)
But an unexpectedly steep $768 million decline in deferred revenue in the fiscal first quarter poked a hole in that logic and overshadowed other bright spots in the company's earnings report. It also shook up investors, who have been disappointed by the underperforming stock. Microsoft was a tech laggard last year, its shares gaining a modest 7% in 2003 on a split-adjusted basis vs. a 50% jump in the
. Microsoft shares closed Wednesday in regular trading at $28.30, higher by 20 cents.
Microsoft attributed the surprisingly steep drop in first-quarter deferred revenue to such one-time events as a sales force reorganization and a spat of virus outbreaks, among other factors. But some investors and analysts worry that customers simply don't believe Microsoft is offering enough new products and upgrades to justify renewing their subscriptions.
"Once is explainable by exogenous events, but another large decline would show you corporate customers are having a tough time swallowing
Microsoft's value proposition," said Transamerica Funds portfolio manager Chris Bonavico, who is long Microsoft. Bonavico believes Microsoft will deliver enough perks and new features to make the subscriptions worthwhile.
Microsoft has said it expects more declines in unearned revenue in the second quarter, in the range of a few hundred million dollars. Still, estimates range from down less than $200 million to a decline of as much as $500 million.
"What people are trying to figure out, basically, is Microsoft being successful transitioning customers to a subscription model and ... is the product flow from the company still compelling enough to drive that interest from customers," said Tony Ursillo, an analyst with Loomis Sayles & Co., which holds Microsoft shares.
Based on the wide range of estimates, "it's obvious that few people have their arms around where that number is going in the near term," Ursillo observed.
In addition to a dearth of new products in 2005 and 2006, Linux open-source software may be responsible for some customers' reluctance to renew their multiyear contracts with Microsoft, RBC Capital Markets analyst Sarah Mattson commented in a note last week.
Although Linux is
primarily replacing Unix, some organizations are or may consider it as an alternative to some Microsoft applications, and that's causing them to hesitate to make a multiyear commitment to Microsoft, noted Mattson, who has a sector perform rating on Microsoft. (Her firm hasn't done banking with Microsoft.)
Duane Roberts, a portfolio manager with Dana Investment in the Dallas area, believes Linux competition also could weigh on Microsoft's top line. "I think they're seeing a lot more competition from Linux than they've anticipated," Roberts said of Microsoft. "It definitely could show up in the revenue number." But Roberts doesn't go so far as to suggest the tech bellwether will miss its targets.
Microsoft's guidance calls for earnings ranging from 29 cents to 30 cents a share -- excluding an equity compensation expense of 6 cents a share -- on revenue ranging from $9.7 billion to $9.8 billion. Analysts polled by Thomson First Call are expecting Microsoft to report earnings of 30 cents a share on $9.74 billion in revenue.
But some investors believe there may even be some upside given recent signals of robust PC and consumer electronic sales during the holidays. That would translate to strong sales of Microsoft's operating system and Office as well as the Xbox video game console, which brings in about 45% of its annual sales in the December quarter.
In its first-quarter earnings call, Microsoft raised its PC forecast for fiscal year 2004 to high-single digits from low-to-mid-single-digit growth. But research firms recently declared calendar year 2003
PC growth to be in the low-double digits, suggesting some upside to Microsoft's forecast. IDC also has recently ratcheted up its 2004 PC shipment-growth forecast up to 11.4% from 10.2%, noted Friedman Ramsey Billings analyst David Hilal.
In addition, a lift in information technology spending on the corporate side should help Microsoft's server and tools division, the largest growth driver for Microsoft, Hilal said. He has an outperform rating on Microsoft and his firm hasn't done banking with Microsoft.
The improved IT environment could prompt Microsoft to raise guidance for the full year, Lehman Brothers analyst Neil Herman said in a note Wednesday. The company's current targets are EPS of $1.10 to $1.12 and $34.8 billion to $35.3 billion in revenue, representing an 8% to 10% annual revenue increase. (Herman has an overweight rating on Microsoft and his firm hasn't done banking with Microsoft.)
Indeed, some analysts and investors believe 2004 will be a
better year for Microsoft for a number of reasons. For one, the company is expected to resolve the antitrust investigation with the European Union. That, in turn, could pave the way for a higher dividend or more stock repurchases.
More immediately, a sign Thursday that Microsoft is getting its deferred revenue back under control could be the first step toward a brighter year for the software behemoth.