Updated from April 18

Microsoft

(MSFT) - Get Report

was bouncing back from Thursday night's hammering after it was upgraded by Merrill Lynch. The software maker's stock plunged almost $3 Thursday night after it missed third-quarter revenue estimates and took down guidance for the fourth quarter and fiscal 2003. The company also scaled back its rosy projections for Xbox sales in this fiscal year.

Merrill raised Microsoft to buy from market perform, saying it is one of the few large-cap stocks likely to do well when the software sector recovers. At the same time, Merrill cut its 2002 earnings estimate to $1.84 from $1.88 and its 2003 estimate to $1.92 from $1.95.

The stock retraced some ground after the upgrade and was down only 79 cents to $55.60 on Instinet.

There was confusion Thursday night about the company's earnings performance as its bottom line included both gains and charges; it was unclear whether analysts' estimates incorporated them. But, after crunching the numbers, analysts said Microsoft appears to have beaten expectations.

Shares of Microsoft fell 26 cents, or 0.5%, to close regular trading at $56.37. After its announcement, shares sank $2.90, or 5.1%, to $53.73, but then rebounded to $54.92 in recent trading as investors made sense of the earnings confusion.

"While we look forward to slightly improved PC growth rates for the next quarter, our expectations for enterprise IT spending levels continue to be quite modest," CFO John Connors said in a press release.

For the third quarter ended in March, the world's largest software maker posted net income of $2.74 billion, or 49 cents a share. That figure includes a 15-cent gain from Microsoft's $847 million sale of Internet travel service

Expedia

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to

USA Networks

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, and a 14-cent charge for investment writedowns.

The Redmond, Wash., company said revenue rose 13% to $7.25 billion. A year ago the company earned 44 cents a share on revenue of $6.40 billion. Wall Street had been expecting Microsoft to earn 51 cents a share on $7.34 billion in revenue, according to Thomson Financial/First Call.

Analysts had expected Microsoft to gain 10 cents a share from Expedia, but Microsoft ended up gaining 15 cents. Charlie Di Bona, an analyst with Sanford Bernstein, said that to compare Microsoft's numbers accurately to those of First Call, you must add back the 14-cent impairment and subtract the 5 cents from Expedia. That brings Microsoft's earnings to 58 cents a share -- well above Wall Street estimates. Di Bona has an outperform rating on Microsoft. "I don't think anybody knew about the impairment charge," he said.

But Thomson Financial/First Call research analyst Ken Perkins said he'd be less likely to rework the consensus to incorporate Expedia, suggesting that investors compare the consensus earnings estimate with either Microsoft's reported 49 cents a share or rework Microsoft's number to 63 cents a share, by adding the 14 cents of impairment that no one expected. Of course, if Microsoft's number is reworked to 63 cents a share, than the company handily beat the consensus estimate.

On a postclose conference call, Microsoft said the impairment charge was related to its investment in

AT&T

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. The company said its operating income per share beat guidance by 6 cents a share; its Expedia sale led to 7 cents more a share than expected, but that was offset by the 14-cent-a-share impairment.

Jim Moore, managing director at Deutsche Bank Securities, who estimated earnings would come in at 50 cents a share, described the quarter as "in line with expectations." He called Connors' comments about the PC industry "encouraging. The operational side looks fine," he said. Moore has a long-term buy rating on Microsoft, and his firm has done banking business with the software company.

Going Forward

As expected, Microsoft also offered conservative guidance for the fourth quarter, which ends June 30, and for fiscal year 2003.

Microsoft said it expects fourth-quarter revenue to range from $7 billion to $7.1 billion and earnings per share to range from 41 cents to 42 cents a share. That brings fiscal-year 2002 revenue to a range of $28.1 billion to $28.2 billion and earnings per share of $1.54 to $1.55 a share, including investment impairments and the Expedia gain.

Wall Street was expecting the company to earn 44 cents a share on $7.65 billion in revenue in the fourth quarter and earnings of $1.87 a share on $28.9 billion in revenue, according to Thomson Financial/First Call. The full-year number does not include the impairment charge from the third quarter.

For fiscal-year 2003, Microsoft said revenue will range from $31.5 billion to $32.4 billion and earnings will range from $1.89 to $1.92 per share.

The consensus estimate is for Microsoft to earn $2.01 a share on $32.64 billion in fiscal-year 2003.

"I don't think it's a huge surprise to Wall Street that they brought their fiscal '03 number down, and I think it's probably in the range of where people thought it may go," Moore said. "They also have some decent numbers here on the quarter."

Connors said PC shipments were perhaps a little better than expected in the third quarter. He expects PC shipments to be flat to down slightly in the fourth quarter, and the PC market to grow in the slow single-digit percentages in fiscal year 2003, compared with a low single-digit decline in fiscal year 2002.

But Connors backtracked from Microsoft's goal of selling between 4.5 million and 6 million Xbox game consoles by the end of June. Connors said on the conference call that Xbox shipments are expected to reach only 3.5 million to 4 million, largely due to difficulty breaking into the Japanese market dominated by

Sony

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.

The company's launch in Japan last quarter was marred by consoles scratching disks. On Thursday, Microsoft announced it would slash the price of the console in Europe to spur sales. By the close of fiscal-year 2003, Connors said Microsoft expects to sell 9 million to 11 million consoles.