Microsoft Holds Steady

Investors return to waiting for more certainty on the next product cycle.
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If you follow Microsoft (MSFT) - Get Report, you're probably tired of reading about Vista, the next version of Windows.

Too bad. The long-delayed operating system will remain at the center of most things Microsoft for some time.

"This quarter was something of a nonevent," says Kyle Flynn, an analyst with TCW Asset Management, which holds shares. "The market is really holding its breath until we know what the product cycle actually looks like." And that's going to be a while. Vista will ship to some businesses next month and to consumers in late January.

Even then, it will be at least two quarters to get an accurate reading on how quickly businesses are moving to the new software. Until real results are in, handicapping Microsoft will be like trying to finish a 500-piece jigsaw puzzle with 50 pieces missing.

Take the

just-reported first quarter. Sure, the software giant beat earnings expectations by 4 cents a share. But much of the upside followed a shift in Vista and Office 2007 launch expenses from the first quarter to later in the year.

Then there's the somewhat disappointing guidance for the December quarter. Part of the reason: The company expects some buyers to put off purchases of new PCs until Vista is actually available. And that's no surprise. Even devoted Micosoftees know that upgrading a PC to a new operating system has all the fun of a root canal -- and none of the anesthetic.

But some people like to suffer, and Microsoft is catering to them by offering coupons that will allow buyers of PCs equipped with XP, the current version of Windows, to upgrade when the software is actually available. The cost: about $1.5 billion, or 11 cents a share, in deferred revenue.

But remember, that revenue is merely deferred until the third quarter, it's not lost. That point was lost on some jumping-the-gun television reporters who initially screamed that Mister Softee's December revenue guidance was way below consensus. Add back the $1.5 billion, and you'll see that it wasn't. Moreover, Microsoft actually raised full-year sales guidance a bit, although earnings guidance was two cents off the mark.

"We knew about this for a while," says Bill Gorman, a vice president with the equity research staff at PNC Wealth Management, which holds Microsoft shares. "What they did was help us quantify; I don't regard it

the earnings guidance as a problem."

Gorman's firm has a target price of $34, more bullish than the sell-side consensus of $30.57 a share, according to Thomson First Call.

Shares of Microsoft were recently up 7 cents to $28.42.

Still, it's worth noting that the PC market is slowing. Gartner analyst Charles Smulders estimates that sales will grow by about 8.5% in the December quarter, compared with 16.1% growth in the same quarter last year. So, anything Microsoft can do to boost sales in the interim is a smart move -- good for them and good for the rest of the industry.

After all, Microsoft still derives about 60% of its revenue from two desktop products -- Windows and Office. With the exception of its server business, which grew a robust 17% in the first quarter, nondesktop businesses aren't contributing much to the bottom line, though there has been some top-line improvement recently.

Paradoxically, strong sales of the Xbox 360 are expected to help the top line in December, but will hurt profitability since the company still loses money on every unit it sells. The entertainment and device division, which runs the game-console business, grew revenue by 70% in the first quarter and narrowed its loss, but isn't expected to be profitable until calendar 2008.

Deferred revenue was down about 9% in the quarter, but confused journalists notwithstanding, the market quickly realized that strong billings in the fourth quarter generally lead to weaker deferred revenue in the first. "The first quarter tends to have lighter billings, so more revenue rolls off the balance sheet in the first quarter than is added back," said Citigroup analyst Brent Thill.

It's not news that software piracy, particularly in Asia, siphons significant amounts of cash from Microsoft's pockets. The company, along with the rest of the software industry, has spent a good deal of time and money trying to fix, or at least ameliorate, the problem, and now it appears that the efforts are finally paying off.

CFO Chris Liddell mentioned this point on a conference after the announcement, but didn't quantify the effect. But some analysts did.

"We continue to believe the biggest financial lever for Microsoft is its ability to decrease operating-system piracy rates. Our analysis suggests reductions in piracy could have anywhere from a $300 million to $1.3 billion positive revenue contribution in calendar 2007," Citigroup Thill wrote in a note to clients. His company has an investment banking relationship with Microsoft.

Good news, to be sure, but on the scale of things, not tremendously important. But with Microsoft shareholders in a holding pattern until Vista hits the shelves, we'll have to be content with crumbs.