Microsoft Outlook: May Come Down a Notch

Some are expecting the software kingpin to lower expectations for the quarter and beyond when it reports Thursday.
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While plenty of software makers have disappointed investors this earnings season, Wall Street is expecting

Microsoft

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to remain one of its favorite go-to names on Thursday, when the company reports third-quarter results. But analysts also are bracing for the bellwether to lower expectations for fiscal year 2003, which begins July 1.

The consensus estimate is for the Redmond, Wash., company to earn 51 cents a share on $7.3 billion in revenue in the third quarter, which ended March 31, according to Thomson Financial/First Call. That's a 16% rise in earnings and a 14% rise in revenue compared with the same period a year earlier. It includes an approximately 10 cents-a-share gain from its $800 million sale of Internet travel service

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to

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.

John McPeake, a senior enterprise software analyst with Prudential Securities, said in a note released Wednesday that he believes PC sales may be stronger than Microsoft has guided, potentially leading the company to exceed earnings estimates by 2 to 3 cents a share.

McPeake cited a report Tuesday from

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that microprocessor shipments were flat sequentially, or up 27% year over year. Based on Intel data, McPeake figures PC unit-shipment growth could be down 1% or even flat year over year. That's in contrast to Microsoft's guidance for a decline in PC units in the midsingle digits in the third and fourth quarters.

Such PC trends would bode well for Microsoft's desktop platform and desktop applications businesses, Microsoft's most profitable segments, McPeake noted. He forecasts desktop platform sales will increase 7.5% annually to $2.2 billion and desktop applications will fall 6% to $2.3 billion.

"We would be buyers of MSFT into earnings on Thursday," McPeake said in his note. McPeake, who has a buy rating on Microsoft, noted that the company is trading at roughly 30 times 2003 earnings. His firm hasn't done any banking business with Microsoft.

At least one other analyst, Rick Sherlund of Goldman Sachs, has said Microsoft's stock is richly valued. But Microsoft is trading at the lower end of its historical P/E range of the past seven years, which peaked at 84 in 1999 and dropped as low as 22 in 2000.

Charlie Di Bona, an analyst with Sanford C. Bernstein, noted that Microsoft has performed well despite the economy in part because of its release of Windows XP last year and its new pricing policy on its office software and operating system, which is driving upgrades. Customers face a July 31 deadline to bring their platform current to qualify for the new pricing program, which requires customers to pay a maintenance fee to receive the latest versions rather than buying upgrades on their own schedules.

Di Bona, who has an outperform rating on Microsoft, said he will be looking to see if Microsoft gains share in its enterprise software business, which includes its database products that compete against

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. In the second quarter, enterprise software sales rose 3.5%, compared with a year earlier, to $1.3 billion.

But "it's a weak spending environment so we're not expecting heroic numbers," Di Bona said. His firm doesn't do investing banking.

Despite all the attention on Microsoft's Xbox game console, analysts are focusing less on Microsoft's consumer product line, which accounted for 15.5% of revenue in the second quarter. The Xbox launch in Japan was marred by problems with the consoles scratching disks, while rumors have swirled about Microsoft lowering the price on its console in Europe since its launch there.

"It was never an issue until really they saturated the market with it because they're going to make all the money from the

video game software," said Alan Loewenstein, co-portfolio manager of the John Hancock Technology fund, a Microsoft shareholder.

In a note earlier this month, Goldman Sachs' Sherlund lowered his Xbox estimates by 500,000 units for the March quarter, or about $250 million to $350 million in revenue. But because Microsoft loses money on every Xbox sold, Sherlund said he doesn't expect the slower sales to lead to a material earnings shortfall. Sherlund includes Microsoft on Goldman's U.S. recommend list, and his firm has done banking business with Microsoft.

In that note, Sherlund reduced estimates for fiscal year 2003 in anticipation of the company talking down guidance.

While that's widely expected on Wall Street, investors will be listening closely to the tone of Microsoft's comments on its outlook for the next fiscal year. And, of course, no one knows exactly how much the company will take down guidance.

The consensus estimate is for Microsoft to earn $2.01 a share on $32.6 billion in fiscal year 2003, which ends in June. That's an 8% rise in earnings and 13% increase in revenue from the fiscal year 2002 consensus estimate.

Bringing fiscal year 2003 numbers down below consensus is likely to be a "mitigating factor" to upside earnings when the company announces its results, Prudential's McPeake cautioned.

But Di Bona disagreed. He believes investors are already expecting Microsoft to guide lower. "Conservatism is already priced into the market," he said.