Microsoft Takes the Long View

Third-quarter results and the '07 outlook fall short of expectations, but it's investing in growth areas.
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Updated from 5:27 p.m. EDT

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has decided to forgo profitability in favor of heavy investments in its video-game business, online advertising and other areas the company deems high growth.

But investors appeared leery of the new strategy and quickly pushed the stock down $1.75, or 6.4%, to $25.50 in after-hours trading Thursday on Instinet.

The "strategic decision," as CFO Chris Liddell calls it, explains the company's surprisingly weak bottom-line performance in the just-completed third quarter and the disappointing earnings guidance for the fourth quarter and fiscal 2007.

Late Thursday, Microsoft announced that it had earned $2.98 billion, or 31 cents a share, (excluding a legal charge of 3 cents a share) on sales of $10.9 billion.

Although that represented year-over-year revenue growth of 13% and earnings growth of 17%, it fell short of Wall Street's expectations. Analysts were looking for $11 billion on the top line and 34 cents a share on the bottom line.

The sudden bout of bottom-line blues surprised Microsoft bulls and gave skeptics like Pat Adams, chief investment officer of Choice Investment Management, more reason to stay away. "There's just no reason to be in this stock until new products ship," he says.

Microsoft, the world's largest software maker, attributed the miss to heavy spending in a number of areas, including the Xbox 360 product costs, accelerated hiring, more R&D and heavy marketing, as the company prepares for the launch of Vista, the new version of its flagship Windows operating system.

"We're willing to make those tradeoffs for growth," Liddell said during a conference call with analysts.

Surprising as the third-quarter miss was, the weak earnings guidance was simply stunning. "I'm blown away," commented Richard Williams, chief software analyst for ICAP.

EPS in the June, or fourth quarter, will be about 30 cents, the company said, compared to expectations of 34 cents. Revenue will range from $11.5 billion to $11.7 billion, the company said; Wall Street was looking for $11.6 billion.

Microsoft gave its first pass at guidance for fiscal 2007, saying EPS will range from $1.36 to $1.41 on revenue ranging from $49.5 million to $50.5 million. Analysts had forecast a profit of $1.53 a share on sales of $49.5 billion.

Goldman Sachs analyst Rick Sherlund noted during the call that the company's spending plans for 2007 appeared to be $2.4 billion higher than expected, and he asked if Microsoft was "building a

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inside of the company."

Liddell said that the company has "no Trojan horses," or secret projects, and that the money will be spent on projects that have been disclosed.

In the third quarter, the cost of revenue increase by 53% from $1.3 billion a year ago to $2 billion. Sales and marketing increased by about 14% in the quarter and R&D was up nearly 9%.

One big culprit: spending on the Xbox 360. Sales have gone up significantly, but because Microsoft loses money on every unit sold, the company's profitability suffers. Liddell said the delay of Sony's PlayStation 3 as an opportunity for Microsoft to grab share, and he forecast heavy spending on the console throughout the rest of the fiscal year, but not into 2007.

The company's Home and Entertainment segment, which makes the Xbox 360, increased revenue by 80% to $1.1 billion due to strong demand for the console. But the division's loss grew even faster, ballooning by 121% to $388 million.

The company's Client division, which sells Windows, grew by nearly 8% to $3.19 billion in sales while making a profit of $2.5 billion. The Information Worker business, which sells Office and other products, grew by 5% to $2.95 billion in sales and earned a profit of $2.1 billion.

Growth in other areas was more dynamic. Business Solutions, which runs Microsoft's fledgling enterprise applications business, grew revenue 20.7% to $216 million while narrowing its loss to $13 million from $39 million a year ago.

As the quarter ended, investors focused on the

prognosis for Vista, the next version of Microsoft's flagship Windows operating system.

Worries over Vista were eclipsed, at least temporarily, by the focus on earnings. But nothing said by Microsoft during the call indicated that the product would not ship on time.

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.