two cash cows -- Office and Windows -- may help the world's largest software maker beat Wall Street estimates when it reports fiscal first-quarter results today.
But to drive future growth, Microsoft's prospects lie elsewhere -- and not necessarily in sexy markets like video games. Instead, analysts point to servers, applications for small- and medium-sized businesses, and telecom as the most likely growth prospects for the tech bellwether.
Microsoft has said first-quarter earnings would total 29 cents a share, excluding a 6-cents-a-share stock compensation expense, on $7.9 billion to $8.1 billion in revenue. The consensus estimate on Wall Street also sits at 29 cents a share, with revenue expected to hit $8.1 billion. Still, that represents year-over-year revenue growth of a diminutive 4.4%.
But stronger-than-expected PC shipments may boost Microsoft's Windows business in particular, helping the company beat expectations, analysts say. Last week, research firms Gartner and IDC both reported a
surge in demand for personal computers, with shipments growing between about 14% and 15% annually in the quarter ending in September. That news came on the heels of strong reports from PC chipmaker
and PC maker
Microsoft, which relies on PC sales to generate about one-third of its quarterly revenue, assumed PC sales would grow in the more muted low-single-digit percentages in the September quarter. Prudential analyst Brent Thill said in a note that upside from stronger PC shipments could amount to as much as 7 cents a share to earnings. He has an overweight rating on the stock and his firm doesn't do investment banking.
Stronger PC sales also could prompt Microsoft to raise its overall 2004 forecast, which currently sits at $1.09 to $1.11 in earnings per share, excluding stock options expenses and $34.2 billion to $34.9 billion in revenue. Wall Street analysts are forecasting Microsoft will earn $1.11 a share on $34.72 billion in revenue in fiscal 2004, representing 8% year-over-year revenue growth.
In addition to strong PC sales, Microsoft's server platforms business could supply some upside in the first quarter, Lehman Brothers analyst Neil Herman said in a note last week. Herman, who has an overweight rating on Microsoft, said the company's estimate for 10% to 15% year-over-year growth in the server business is conservative. The company's sometimes-overlooked server business earned $2.5 billion in operating income on $7.1 billion in revenue in fiscal year 2003, accounting for 22% of total sales and nearly 19% of total operating income.
Microsoft wants server sales to reach the same level of its two cash cows, said Matt Rosoff, an analyst with Directions on Microsoft, an independent research firm that tracks the software company. Microsoft's clients business, primarily made up of the operating system, booked $10.4 billion in sales in fiscal 2003, while its information worker business, primarily made up of Office, posted $9.2 billion in revenue.
The server and tools business comprises about 30 or 40 applications that run on the server, including Windows' server; its SQL server database product, which competes against
at the low end; and its email Exchange server.
"The biggest challenge," says Banc of America Securities analyst Bob Austrian, "is having Microsoft shift its focus as an institution toward the server to the possible peril of the desktop." Austrian has a buy rating on Microsoft and his firm has an investment banking relationship with the company.
The new version of Office is not expected to be an immediate big sales booster. Office upgrades are "no longer seismic events," Goldman Sachs analyst Rick Sherlund said in a recent research note. That's because a large bulk of the revenue for Microsoft Office comes from business customers who automatically receive the upgrades as part of a subscription-pricing scheme launched by Microsoft over the past couple of years. Sherlund has an outperform rating on Microsoft and his firm has done banking with the company.
How well-received the pricing system is will be tested in the next couple of quarters as the first group of customers to switch comes up for renewal. Microsoft's guidance for unearned revenue in the second quarter will provide some hint at what sort of renewal rates the company is expecting.
Sherlund noted that some customers may opt against renewing Office to wait for the next new version of Microsoft's other cash cow -- its operating system -- which is not due out until 2006. That release, dubbed Longhorn, could "trigger the largest upgrade opportunity Microsoft has ever experienced," as it represents the next major platform of computing from the software giant, Sherlund said.
In the meantime, Microsoft is also setting its sights on another market -- applications serving small- and medium-sized businesses, which the company calls business solutions. Microsoft would like sales from its business solutions division to almost double to $1 billion this fiscal year from $567 million in fiscal year 2003, and reach $10 billion by the end of the decade, Rosoff said.
After the small- and medium-sized business market, Rosoff points to Microsoft's mobile and embedded devices business as having some "pretty" long-term growth prospects. In fiscal 2003, that business accounted for only $156 million in revenue and posted an operating loss of $157 million.
But Microsoft's mobile business has been slow to take off and faces stiff competition from other giants such as
. Microsoft only this week announced the sale of the first Microsoft-powered cell phone in the U.S.
The wild cards in Microsoft's future are MSN and its home and entertainment business, made up primarily of the Xbox video-game console, Rosoff says. Because Microsoft loses money on every Xbox sold, Microsoft's home and entertainment division posted an operating loss of $924 million in fiscal year 2003 on $2.75 billion in revenue.
The current generation of Xbox consoles should break even in 2005, Rosoff said, but then it will be time for the next generation to debut and likely continue bleeding money. For Microsoft, Xbox is a 20-year business and defensive play to prevent Sony from taking over a combined home entertainment and office market, Rosoff said.
Meanwhile, Microsoft seems to be focusing more on making MSN profitable, Rosoff said. Its losses have shrunk by more than half to $299 million in fiscal year 2003 from $641 million in 2002. Rosoff said he believes Microsoft views MSN as a vehicle to sell services to consumers, but the company has yet to find a killer app to sell that way.
Indeed, MSN and Xbox could be more important to Microsoft's future as drivers of earnings rather than revenue, said Banc of America's Austrian. "They need to really reduce the losses in these areas, and if they succeed, that could be the biggest driver of improved earnings," he said.
There is likely to come a time, however, when investors want to see more results from the money-losing businesses. "Talking about share with Xbox is nice, and some of the new contracts in the mobility
space are nice, but these growth opportunities have really been a drag," said Standard & Poor's software analyst Jonathan Rudy, who has a buy rating on Microsoft. He doesn't own shares and his firm doesn't do investment banking.