Microsoft Report Mixed

The software giant beats earnings estimates, but the first-quarter sales outlook is light.
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Updated from 5:38 p.m. EDT

In a report laden with confusing charges,

Microsoft

(MSFT) - Get Report

on Thursday beat the consensus estimate for fourth-quarter earnings by 2 cents on sales that fell just short of expectations.

The software giant raised guidance for fiscal 2006 to reflect a raft of new product launches, but its outlook for first-quarter sales fell short of analyst expectations.

Investors appeared to be responding more to the light first-quarter estimates as they sent shares down 61 cents, or 2.3%, to $25.83 in recent after-hours trading after closing up 25 cents, or 0.1%, to $26.44.

"I characterize the results of the quarter as good," said Tony Ursillo, an analyst with Loomis, Sayles & Co., which holds Microsoft shares. "But this next year may continue to be a year of investment."

However, at least one other analyst argued that the market response to Microsoft's results doesn't make sense.

"I think the market is reacting the way it is because it's confused," said Sanford C. Bernstein analyst Charlie Di Bona, who has an outperform rating on Microsoft. "If you're buying this company for Q1 '06, you're buying the wrong kind of stock." (His firm doesn't do investment banking, but its parent, Alliance Capital, owns Microsoft shares.)

The world's largest software maker earned $3.70 billion, or 34 cents a share, in the fourth quarter. But that number included several pieces not factored into analysts' estimates: a stock-based compensation charge of 3 cents a share, legal charges of 5 cents a share and tax benefits of 9 cents a share.

Excluding charges and the tax benefit, Microsoft delivered pro forma net income of 33 cents a share in the second quarter. That exceeded the consensus estimate gathered by Thomson First Call calling for 31 cents a share and the company's guidance of 30 cents to 31 cents a share excluding stock and other charges.

A year ago, Microsoft posted fourth-quarter net income of $2.69 billion, or 25 cents a share, including stock-based compensation charges of 5 cents a share and tax benefit of 2 cents a share.

Fourth-quarter revenue rose 9% to $10.16 billion from $9.29 billion a year earlier. That fell slightly short of the consensus estimate of $10.17 billion for the fourth quarter but within the company's targeted range of $10.1 billion to $10.2 billion.

Looking forward, Microsoft said it expects to earn 29 cents to 31 cents a share, including stock compensation, on revenue of $9.7 billion to $9.8 billion in the first quarter of fiscal 2006, which began July 1. Analysts' estimates currently call for first-quarter earnings of 30 cents a share including stock charges and 34 cents a share excluding stock-based compensation on $9.92 billion in revenue.

Di Bona argued that the slight difference between the company's first-quarter sales guidance and the consensus estimate -- a 1% to 2% difference -- was hardly enough to warrant the stock selloff. "You're looking for something to complain about," he said. "This was a very strong quarter and they upped guidance" for the full year.

Indeed, the Redmond, Wash.-based company raised its outlook for fiscal 2006. Microsoft said it expects to earn $1.27 a share to $1.32 a share including stock charges on sales between $43.7 billion and $44.5 billion, representing 10% to 12% growth.

Previously, Microsoft said it expects to earn $1.26 to $1.30 a share, including stock charges projected at 13 cents a share, on $43.3 billion to $44.1 billion in revenue in fiscal '06.

On his first conference call as CFO, Chris Liddell refused to give an estimate for stock-based compensation for fiscal 2006 despite repeated questions from analysts. He argued the charge is a "true expense" of the company's business and should be included in analyst and investor models. But for now, analysts are excluding the expense from their estimates provided to Thomson First Call, which has resulted in some confusion after the company released its results.

Analysts have estimated stock charges of 13 cents a share for fiscal 2006, which would bring Microsoft's targets to a range of $1.40 to $1.45 a share.

Microsoft's full-year earnings guidance falls around analyst expectations of $1.42 a share excluding stock charges. But to complicate matters further, Microsoft lowered its estimated tax rate to 32% from 33%. That yields a benefit of about 2 cents a share to earnings not calculated by analysts, Ursillo noted.

Adding that 2 cents to the consensus estimate brings it to the high end of Microsoft's range, suggesting analysts might be overly optimistic about 2006 earnings, Ursillo noted, although he still expects Microsoft's results to probably get to the high end of its earnings target.

"The bottom line is investors may not see as much leverage this year in the model as they would have liked," Ursillo said. "But I think that happens in fiscal 2007."

On the top line, meanwhile, the high-end of Microsoft's outlook is considerably higher -- by about $700 million -- than the consensus estimate of $43.79 billion.

"Fiscal year 2006 will be the start of a multiyear product cycle and improving revenue growth," Liddell said.

In an interview late Thursday, Chief Accounting Officer Scott Di Valerio cited the launch of Xbox 360, the next-generation video-game console, in time for the holiday season and added that the company also expects "good overall growth" from Microsoft's Information Worker and Client divisions -- the company's two cash cows. (However, Xbox will be a drag on earnings because Microsoft will lose money on every console it sells.)

Microsoft execs reiterated that the company is still on schedule for the Xbox 360 launch, as well as the debut of a new database product this fall and a much-anticipated new version of Windows in the second half of next year.

"It's taking a look at the strength of the businesses across the stack and even taking into account that we expect a little slower PC market growth than what we're seeing," Di Valerio said of the 2006 outlook. "We have some good launches coming into the first half of fiscal '06, and taking a look at the overall IT spend and the economy, we think those numbers are going to come out."

Slightly stronger-than-expected PC sales helped drive a 10% jump in sales in the Client division, which represents sales of the Windows operating system, to $3.034 billion in the June quarter and a 7% jump in operating income to $2.175 billion.

Microsoft had forecast 10% to 12% PC growth in the quarter, but research firm Gartner recently estimated that the

actual growth rate was closer to 15%.

Gartner, however, also cautioned that such growth cannot continue indefinitely and predicted a more difficult environment in the second half of this year. Additionally, Windows sales could also slow down as customers hold off making purchases as they await the release of a new version, dubbed Longhorn, by the end of next year.

Liddell said Microsoft is projecting PC unit growth of 7% to 9% in fiscal 2006 and 9% to 10% in the first quarter.

Microsoft's other money-maker, Information Worker, which includes sales of the Office software suite, delivered sales of $2.909 billion, a modest 3% increase from a year ago. But the division's operating income actually declined 1% to $1.997 billion, primarily due to sales and marking costs associated with Microsoft's "New Era" ad campaign, as well as other costs.

Microsoft's Server and Tools division continued to show strength, with a 16% jump in sales in the fourth quarter to $2.682 billion and a 32% climb in operating income to $800 million.

Microsoft's Home and Entertainment Unit, including Xbox sales, also showed a big sales boost -- by 22% to $610 million. Its operating loss, meanwhile, shrank to $179 million from $340 million a year earlier.

On the flipside, Microsoft's online unit, MSN, registered a 1% decline in sales to $582 million, although its operating income soared 259% to $104 million.

The company's Business Solutions, representing sales of business applications, posted an 11% jump in sales from a year earlier to $247 million, but its operating loss grew to $76 million from $70 million a year ago.

Unearned, or deferred, revenue -- a key measure of how many business customers are renewing their contracts to buy Microsoft software on a subscription basis -- ballooned to $9.167 billion from $7.941 billion in the March quarter. That was higher than the $8.8 billion balance projected by Microsoft, which the company had bumped up from $8.6 billion.

The fourth quarter is typically a heavy period for contract renewals.

On another front, Microsoft accelerated its share buyback program during the fourth quarter, spending $4.31 billion to repurchase shares during the quarter. The company ended the quarter with $37.75 billion in cash and short-term investments on its balance sheet.