Microsoft Enjoys Halo Effect

The hot video game should help earnings, but the love for small-caps may keep it range-bound.
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Strong sales of

Halo 2

, PCs and servers should help

Microsoft's

(MSFT) - Get Report

second-quarter results rise modestly above guidance and expectations, analysts say.

The launch of the

Halo 2

video game was probably the biggest news of the December quarter for the world's largest software maker, which reports results after the bell Thursday. Since its debut Nov. 9,

Halo 2

sales have shot to 6.4 million units worldwide, Microsoft said last week.

Those hefty sales could lead to stronger-than-expected results for Microsoft's Home and Entertainment division, which includes video-game and Xbox-game console sales. Microsoft had projected the division would show only a modest 1% to 3% increase in second-quarter revenue.

Indeed, Goldman Sachs analyst Rick Sherlund believes

Halo 2

results could bring the first-ever quarterly profit to the unit, given that Microsoft enjoys more than 80% to 90% margins on game-software sales. (Sherlund has an outperform rating on Microsoft, and his firm has done banking with Microsoft.)

But expecting the division to show its first-ever profit may be too optimistic, said Ola Folarin, a software analyst with PNC Advisers, who notes that Microsoft loses money on every Xbox console.

More importantly, how much can higher-than-anticipated sales of a video game impact a giant like Microsoft?

"The way I look at

it, for a company with a market cap of close to $300 billion, if there is an upside of $1 billion, how much difference will that be?" Folarin said. (PNC Advisers holds Microsoft shares.)

It's an argument that has been plaguing Microsoft for years now: The company has simply become a victim of its own success, with its two cash cows -- Windows and Office -- growing so big that the law of large numbers makes it difficult for other products to make a difference.

Unless the market loses faith in smaller-cap stocks and consequently rotates to large, "quality" names, Folarin said he expects Microsoft's stock price to remain range-bound. Shares of Microsoft have been unable to break the $30 mark since the first quarter of 2002. The stock closed Wednesday down a penny to $26.01.

One of those cash cows -- the company's Windows operating system -- is expected to benefit from PC sales more robust than Microsoft's 7% to 9% unit-growth forecast in the December quarter. Research firm IDC, for instance, estimated worldwide PC unit shipments in the quarter totaled 13.7%.

Similarly, semiconductor giant

Intel

(INTC) - Get Report

said server unit sales have remained solid, noted Sanford C. Bernstein analyst Charlie Di Bona. "We continue to see no signs that Windows is losing share on that platform," he wrote last week, adding that he expects Microsoft's server business to remain a growth driver through all of 2005. (Di Bona has an outperform rating on Microsoft, and his firm doesn't do investment banking.)

Meanwhile, Microsoft's other big profit generator, Office, is unlikely to see year-over-year revenue growth because of difficult comparisons last year, when results benefited from the release of Office 2003, noted Prudential analyst Brent Thill. (He has an overweight rating on Microsoft, and his firm doesn't do investment banking.)

Analysts overall are forecasting that Microsoft will post earnings of 33 cents a share, excluding 4 cents in stock-based compensation, on $10.55 billion in sales in the December quarter. That's above the high end of the company's guidance, which put EPS as high as 32 cents, excluding stock-based compensation, on as much as $10.5 billion in sales.

Analysts also are banking on Microsoft's full-year performance for the full fiscal year, ending June 30, to outstrip its own guidance, which the company raised three months ago. For fiscal 2005, analysts are projecting earnings of $1.26 a share, or $1.10 a share including stock-based compensation, on $39.28 billion in revenue, representing relatively modest year-over-year sales growth of 6.6%.

For the third quarter, analysts are pegging pro forma earnings at 32 cents a share on $9.66 billion in revenue.

Microsoft initially cautioned that it did not expect to benefit in 2005 from the currency rates that boosted fiscal 2004 results and created a more difficult comparison for the current fiscal year. But several analysts noted that the weak dollar means Microsoft will at least enjoy some benefit in the December quarter -- to the tune of $100 million, according to Goldman Sachs' estimate.

Another key metric drawing closer attention in recent years is Microsoft's unearned, or deferred revenue line, which tracks software sales on a subscription basis. Buying software on a subscription basis is akin to maintenance agreements in the enterprise software industry, entitling customers to free upgrades and technical support.

Last quarter, Wall Street was disappointed when

unearned revenue fell greater than expected.

For the December quarter, Microsoft has forecast that unearned revenue will be up modestly on a sequential basis. Overall, unearned revenue should become more predictable with the end of a 90-day grace period during the December quarter for business customers to renew their software subscriptions, Di Bona predicted. A large chunk of those customers signed up for subscriptions two years ago largely because of a big push by Microsoft but are not expected to renew them.

Indeed, a CIO survey by Prudential in December showing some "mixed spending intentions" for Microsoft products could mean that more customers are reluctant to enter subscription agreements because the next release of the company's flagship operating system -- called Longhorn -- is still two to three years away, Thill pointed out in a research note last week. Instead, they may be more likely to just buy new software as they need to upgrade.

However, Thill said his concerns about that trend were somewhat offset by the fact that 34% of respondents said they intend to spend more on Microsoft products in 2005, while only 2% expect to spend less. That small portion of respondents who expect to spend less is a considerable drop from the 10% who responded that way in February 2004.