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Microsoft Marks Time

The software giant could please investors by keeping Vista on its revised schedule.
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CFO Chris Liddell reports his company's third-quarter earnings Thursday afternoon, investors are going to be listening hard for the word they least want to hear -- "delay."

Microsoft bulls are counting on Vista, the oft-delayed new version of the company's flagship Windows operating system, to breathe life into the stock. "We want them to say the dates we're looking at now are firm," says Alan Lowenstein, senior vice president of American Fund Advisers, which has a position in the stock.

Another delay, investors say, would be bad news indeed. Earlier this year, Microsoft said it wouldn't quite make the end-of-year deadline it set for itself to launch Vista. Instead, it

scheduled a staged rollout, with business-oriented versions of the operating systems going to market late this year, while consumer versions will appear in early 2007.

"A lot of investors are hanging their hats on the Vista cycle," says Daniel Morgan, portfolio manager for Synovus Investment Advisors, which owns shares of Microsoft. "You can talk about the Xbox, and MSN and SQL Server, but the reality is that 65% of

Microsoft's profits are determined by the PC business."

Vista aside, Microsoft's third quarter looks fairly routine. Most analysts are looking for an in-line quarter, with the possibility of a modest upside bonus. That means the stock is unlikely to break out of its nearly 18-month trading range of $24 to $28 in the immediate future; real gains, say the bulls, are to be expected after Vista and other new products, such as the latest version of Office, begin clicking with corporate and consumer buyers.

But until then, there's no particular catalyst for the stock. Indeed, Goldman Sachs analyst Rick Sherlund says "anticipation of Vista may be a damper on revenue and earning growth rates in the first half of fiscal 2007."

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That's because some buyers are loath to purchase an existing product when a new one could make it obsolete in the near future.

In any case, sales of consumer PCs have outpaced business computers all year and that shift has been a drag on Microsoft's "client" line of business all year, since it makes much less on software installed on home PCs, Sherlund notes. The client group typically contributes about 30% of the company's revenue. Goldman Sachs has an investment banking relationship with Microsoft.

Like Sherlund, Sanford W. Bernstein analyst Charles Di Bona expects a quarter in line with Thomson First Call expectations of a profit of 33 cents a share on sales of a bit more than $11 billion.

But it might be too soon to expect Microsoft to update the Vista schedule, according to Loomis Sayles software analyst Tony Ursillo. His pick for most important item on the earnings call is the company's preliminary guidance for fiscal 2007, which he expects to be "conservative, since the company is missing the holiday window for Vista and Office, and



will compete against the Xbox with a new offering during the year." His company owns shares of Microsoft.

If Microsoft does live up to expectations for 2007, it won't be acting like the dog some people call it. First Call's consensus for the year is for EPS of $1.53, compared with the $1.32 estimate for fiscal 2006. Sales, meanwhile, are expected to rise from an estimated $44.3 billion in 2006 to $49.5 billion in 2007, an increase of nearly 16%.

Guidance for the fourth quarter ending in June is expected to match consensus of a 34-cent-a-share profit on sales of $11.6 billion.

The emphasis on Vista and Office does tend to obscure a number of other areas key to future growth for Microsoft. Server and tools, for example, has been growing solidly, propelled recently by the early success of SQL 2005. Sherlund, for example, believes the segment grew by 17% in the March quarter, and expects it to represent 26% of revenue.

The company's business solutions arm is still relatively small, accounting for just 2% of revenue, but Microsoft has been pouring money into it and is moving quickly to integrate a fistful of separate applications into a unified business suite ultimately capable of competing with


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The company's Xbox video-game device falls under the company's home and entertainment division, which is generally unprofitable, and contributes about 10% of total revenue. Sherlund says Microsoft still loses money on each console sold, and he doesn't expect that the Xbox -- despite estimated sales of 1.6 million units in the March quarter -- will make a contribution to earnings.

But Bernstein's Di Bona says the delay of Sony's new PlayStation 3 gives Microsoft a chance to gain market share in the space. He quotes data from market researcher NPD showing that on average each Xbox 360 owner also has purchased four games and three additional peripherals (such as hard drives or joy sticks) for the system. "We believe that stronger-than-expected demand for the very profitable games and peripherals will continue to offset much of the high cost of the hardware," Di Bona says. His company does not have an investment banking business.