It's not every week that technology stalwart
sheds 8% off its share price, as it did last week after the company reported a steep drop in deferred revenue.
Punishing the stock with its steepest one-day price decline in at least three years may have been an overreaction. But it did underscore some wrinkles in Microsoft's new subscription-payment plan, including:
Customers weren't enamored of the two-year subscription plan.
Revenue choppiness still exists, it's just moved from the top line to the unearned revenue.
Seasonality is still alive and well.
Microsoft reported its balance of unearned revenue -- what most companies call deferred revenue -- decreased $768 million to $8.2 billion on Sept. 30 from $9 billion on June 30. Street estimates and guidance called for a $200 million to $300 million drop in unearned revenue on the balance sheet. To make matters worse, Microsoft said unearned revenue probably won't start showing sequential growth again until the fourth quarter.
Investors look at unearned revenue as a measure of how well Microsoft is selling software subscriptions to business customers. Under Microsoft's subscription payment model, instituted within the past few years, customers pay Microsoft a set fee for either a two- or three-year subscription to receive upgrades. The company recognizes that revenue in installments on its income statement over the life of the contract, rather than all upfront as the company has in the past and as most software companies still do.
In a statement Tuesday, a Microsoft spokesperson reiterated the reasons cited by the company last week for the decline: strong bookings in the previous quarter, overly optimistic forecasting and security concerns.
Another problem, however, that could have led to some investor confusion is that the unearned revenue line on the balance sheet doesn't tell the whole story of Microsoft's unearned revenue. Many investors may not realize that a substantial portion of unearned revenue, for years two and three of a three-year contract, remains off the balance sheet the first year.
Microsoft indicated that off balance sheet unearned revenue remained constant -- at about $6 billion. That means Microsoft performed well when it came to signing or renewing three-year deals, but showed weakness in the two-year deals, said Sanford C. Bernstein analyst Charlie Di Bona, who has an outperform rating on Microsoft. His firm doesn't do investment banking but its parent company, Alliance Capital, holds Microsoft shares.
In addition, the drop in unearned revenue on the balance sheet was actually not entirely attributable to subscription sales declining. Nearly $200 million of it was attributable to complex accounting changes as well as results in other Microsoft businesses, including lower subscriptions from MSN, according to Di Bona.
But Matt Rosoff, an analyst with Directions on Microsoft, an independent research firm that tracks the software giant, said that the weakness in two-year subscription sales reveals some execution problems at Microsoft, which the company may never be able to fully address.
"I understand why Microsoft is trying to move to the annuity
revenue recognition to smooth out earnings," Rosoff said. But "it's my opinion that the biggest shortcoming in the plan as it stands today is that the
product road map is not sufficiently clear," he added. "I don't think that's a resolvable problem."
Customers simply may not know enough about upcoming upgrades covered by a subscription to make it seem worth paying for, Rosoff explained. And there's only so much Microsoft can do because it takes time to develop the products.
As a result, customers may just opt to forgo a subscription until the new products come out. And in the case of Office -- which makes up the bulk of the subscription revenue -- the next major upgrade does not come until Microsoft's next overhaul of its operating system, dubbed Longhorn, expected in 2006.
The difficulty of asking customers to pay for upgrades in advance may be exacerbated when Microsoft encounters major security problems, as it did this summer, Rosoff said. When Microsoft is asking a company to pay for an upgrade in advance, that company is going to look very carefully at the current generation of products and tell Microsoft to fix what it has now before being willing to pay for the next thing, he said.
Rosoff says Microsoft is partially to blame for not offering more attractive pricing and benefits with its subscriptions. Under a three-year program, customers pay 29% of the full price of a software license each year, resulting in a 13% discount. "That's not that much of a savings, and you have to pay up front," he said.
On the other hand, Microsoft has been hyping Longhorn unusually early, which may be a maneuver designed to make a case for customers to sign up for a subscription, Rosoff said.
Goldman Sachs analyst Rick Sherlund has been singing Longhorn's praises, but still expects that a whopping two-thirds of customers who signed two-year subscription agreements with Microsoft will not renew when their contracts expire, largely in the June and September quarters of next year. That would result in a 6-cent hit to his earnings-per-share estimate in fiscal year 2005, he said in a research note. (Sherlund has an outperform rating on Microsoft and his firm has done banking with the software company.)
RBC Capital analyst Sarah Mattson pointed to two consequences of fewer customers buying multiyear contracts, which led her to downgrade her rating on the stock to market perform from outperform.
"First ... Microsoft's revenues remain tied to upgrade cycles and will likely be more choppy going forward," she said. "Second, if fewer customers are locked into Microsoft contracts, switching costs to alternative operating systems and applications are lower. This leaves Microsoft a bit more vulnerable to Linux and other competitors." (Her firm hasn't done banking with Microsoft.)
Lehman Brothers analyst Neil Herman said he believes most customers, particularly larger companies, will ultimately sign up for subscriptions because they feel they have little alternative. But the subscription model seems to be moving the choppiness experienced in revenue on Microsoft's income statement to the deferred revenue line on its balance sheet, Herman said.
Herman had expected Microsoft's business to become less seasonal under the subscription model, he said. But that hasn't proven to be the case, given that the company's fourth-quarter deferred revenue number was "shockingly good" and the first quarter's was disappointing. He attributes that in part to the sales force signing deals in the fourth quarter that would have normally taken longer to complete in order to make quota at the end of the company's fiscal year.
"Eventually, we'll see smoother, more predictable movement in the deferred revenue on the balance sheet," Herman said. He has an overweight rating on Microsoft and his firm hasn't done banking with the company.
Unfortunately, more predictable movement in deferred revenue isn't unlikely to surface until next year, after the two-year deals that Microsoft signed up to the end of June 2002 come up for renewal.
The upshot is investors are going to have to monitor deferred revenue for several quarters before deciding the weak results last quarter were a one-time occurrence or larger trend.
"It makes me want to be patient with the stock and put my marginal dollars to work elsewhere," said Tony Ursillo, an analyst with Loomis, Sayles & Co., which holds Microsoft shares. "It takes an awful lot of selling to push Microsoft down 8%. A lot of people gave up on it, and they're not about to come back anytime soon."