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Microsoft Tests Its Mettle

A pessimistic market could use some good news from the software giant.
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SAN FRANCISCO -- Conservative expectations surround Microsoft (MSFT) - Get Free Report for its first fiscal quarter, making it possible for the company to narrowly beat the Street when it reports earnings Thursday.

But with

tech stocks

seemingly headed toward another multi-year low, the optimism might end there.

Fort Pitt Capital analyst Kim Caughey expects the company to meet or beat analysts' profit estimates of 47 cents a share by one or two cents. Fort Pitt owns 407,000 shares, and Caughey holds Microsoft shares personally.

But she'll be looking even more closely at Microsoft's comments about its server and tools group, which "is a great indicator of whether a wide swath of businesses are still buying software," she says.

Because many customers pay for server software on a subscription basis, Caughey wants to make sure "they're still paying subscriptions and re-upping

contracts at the same rate they have in the past."

In July, Microsoft projected year-over-year revenue growth of 19% to 20% for its server group, implying first-quarter revenue of $3.45 billion. The group generated 16% revenue growth during the same period last year.

Its Vista and Office client software business is projected to grow 6% to 7% in the first quarter -- tepid compared with 25% growth for that business in the same quarter of last year.

But even that conservative projection

might be optimistic



(DELL) - Get Free Report

has since said its PC sales have slowed. And "channel checks" indicate that notebook shipments were much weaker in early September, according to American Technology Research analysts. Donovan Gow cut his client software growth prediction Tuesday by a point to 6%. "Microsoft has set the bar very low for itself, particularly on client," he wrote.

Caughey also wants to see Microsoft's projections for Xbox sales in the holiday season. The company recently slashed the console's prices, making one model available at $199, an $80 price cut.

Caughey says she was excited to hear that the Xbox recently moved up to the No. 2 position in the small-but-important Japanese market, surpassing both of



PlayStation models. In Japan, "Xbox's lack of quality perceptions has finally been overcome, and that's kind of exciting," she says.

Even so, revenue in the entertainment and devices business, which includes


, is expected to be down 23% to 26% during the first quarter on a tough year-over-year comparison. Last year's first quarter included the release of

Halo 3

, its top-selling game franchise, which also spurred sales of the gaming console.

In Microsoft's online business, Caughey says she will be looking for results from Microsoft's latest initiatives intended to drive market share in search and advertising at the MSN and properties, especially in light of




third-quarter performance


However, Caughey doesn't expect Microsoft to comment further on the potential for

merger talks

with Yahoo! In recent weeks, CEO

Steve Ballmer

mused publicly that negotiations could be revived given recent declines in Yahoo!'s share price. Headquarters quickly issued a denial that talks would begin again.

Yet speculation lingers, especially given the 64% drop in Yahoo!'s third-quarter profit and its subsequent plans to lay off 10% of its work force. After Microsoft launched a hostile bid for the company in February, Yahoo!'s board adopted provisions that would have made it very costly for an acquirer to lay off any Yahoo! employee.

Caughey still believes buying Yahoo! would be a good business move, as long as Microsoft doesn't overpay.

One question hanging over any forecast from Microsoft is how far out ahead of the sector the company is willing to go in tempering 2009 expectations. As the banking sector collapsed and markets began to expect a recession, Microsoft shares began to sink. They've fallen 19% to $21.53 since the company's fourth-quarter results were released in July.

Even with sell-side software analysts finally trimming their 2009 estimates, the Street is still expecting the sector to generate calendar 2009 revenue growth of 9.8%, Friedman Billings Ramsey software analysts wrote in a note Wednesday. "We believe 5% to 8% is most realistic."

FBR expects more consensus estimate cuts in the sector. "If it takes multiple revisions to get expectations accurately 'dialed in,' we think that provides an unfriendly scenario for the group to trade higher." The firm makes a market in shares of Microsoft.