Skip to main content

Investors looking for a little relief from the generally downbeat news on technology stocks will find it when


(MSFT) - Get Free Report

reports first-quarter earnings after the closing bell Thursday.

Most analysts expect the world's largest independent software company to hit or exceed the company's forecast of revenue in the range of $8.5 billion to $8.6 billion and diluted earnings per share of 45 cents or 46 cents for the second quarter of fiscal 2003, which ended Dec. 31. Analysts and investors will focus on the details of deferred revenue, as well as the larger question: Will a bullish performance by Microsoft signal the beginning of a recovery for the battered technology sector?

If Microsoft does hit the forecast, it will show revenue growth of about 10% year over year and earnings growth of 4 cents to 5 cents, or 7.3% to 9.7% for the same period. But compared to the September quarter, earnings will have fallen 5 cents to 6 cents a share, which is unusual, because business in the December quarter tends to be quite strong historically.

The added revenue likely will push the company's already enormous cash reserves ($40.5 billion as of the last quarter) even higher. And that is certain to bring the issue of dividends back to the table. Microsoft, a public company since 1986, has never paid a dividend, and has given no strong signal that it would reverse that policy if the president's proposal to abolish dividend taxes were approved.

Why the downturn in sequential revenue?

It's likely that deferred revenue, or "unearned revenue" in Microsoft-speak, will be down sequentially. That's because sales of Office and other major products to enterprise customers were unusually strong in the September quarter, the company indicated, because of a change in license structures that encouraged early buying.

Microsoft is moving business customers away from flat payments and toward annual licensing plans, a change that raises issues of revenue recognition likely to be discussed during a call after the earnings announcement.

Unearned revenue in the September quarter totaled $9.13 billion, up from $7.74 billion in the June quarter. Expectations on the Street are that unearned revenue will drop by $200 million to $300 million. Lehman Brothers analyst Neil Herman, who projects net earnings of 47 cents a share for the second quarter, said the drop in unearned revenue could be a good deal lower, perhaps $150 million, because of the overall strength of Microsoft's licensing activities.

The actual amount of deferred revenue will be a number to watch when results are announced. Because the issue has gotten so much attention, a big surprise on either side could well give the stock a strong shove in one direction or the other.

Sales of the company's Xbox game console in the December quarter probably dragged down earnings, because Microsoft loses at least $100 on each unit sold, according to Herman.

Also significant will be the amount of cash the company sets aside as a hedge against continuing legal difficulties. Microsoft, which earlier this month agreed to settle a California class-action suit for up to $1.1 billion, consistently cites the fear of large legal judgments as a reason to avoid paying dividends.

Beyond the PC

Last year, Microsoft restructured the company into seven lines of business -- Client, Server Platforms, Information Worker, Business Solutions, MSN, CE/Mobility and Home and Entertainment. Although about 63% of the company's revenue comes from Client (which includes Windows) and Information Worker (which includes Office), the company is pushing hard to strengthen the other five lines. The earnings announcement should include a breakdown of revenue in each segment, and investors would like to see progress in moving beyond its traditional products.

The company has had numerous product launches in the last two years, and will continue to roll out new products, including Microsoft CRM, Windows .Net Server 2003 and a new release of Microsoft's SQL server, notes Wells Fargo Securities analyst Eric Upin, who recently raised his price target from $55 to $60 a share.

Don't expect to hear that Microsoft is making money on the Xbox, says Soundview analyst Victor Raisys -- it won't for several years. But he wants to know if Microsoft is on track to deliver its estimate of an installed base of 9 million to 11 million units by the end of the fiscal year.

Still, Windows is the core of the business, and Microsoft's strategy of relentlessly pushing upgrades is key to its success. Last quarter, revenue was boosted substantially because Microsoft successfully encouraged customers to buy machines with XP professional preinstalled, instead of XP Home, a choice that netted the company an additional $48 a sale, said Herman.

And, ultimately, the company's fortunes are closely tied to the success of the PC industry, mired in the worst slump in years. An increase in sales, perhaps sparked by the need to replace the still-large base of aging Pentium II and Pentium III computers, could push the company to stronger growth during the rest of the year.

Certainly the company's guidance on the third quarter will address that issue. And a weak response will likely pull down Microsoft and other companies in the sector, in much the same way


(INTC) - Get Free Report

decision to cut capital spending hurt the market.

Plenty of question marks and reasons to fret over weak PC sales? Absolutely. But on the eve of the earnings announcement, it was difficult to find many Microsoft bears. Mark Herskovitz, senior portfolio manager for the $639 million Drefus Premier Technology Growth Fund, which holds significant amounts of Microsoft stock, said, "It's difficult to find other companies that are so secure in their core business."

None of the analysts quoted in this story works for a company that has an investment banking relationship with Microsoft.