deferred revenue, a recent area of concern, should steady later this year -- but not before suffering a hit of more than $1 billion, the company's CFO said Tuesday.
"We've got a $1.1 billion hole we've got to fill going into
fiscal year 2005," CFO John Connors said Tuesday at an analyst meeting Webcast from Boston. "We definitely have a tougher hurdle going into
fiscal year 2005 than we had going into
fiscal year 2004."
About two years ago, Microsoft enjoyed a boost of about $1.1 billion to deferred revenue, which has since been flowing to the company's income statement. The boost came as a result of a deadline set for Microsoft customers to transfer to a subscription payment program or else face higher prices for upgrades, Connors explained.
The result was a big rush by customers to buy two-year contracts. However, as those contracts expire this year, only a minority of customers is expected to renew, Connors acknowledged Tuesday. That low renewal rate was reflected in the larger-than-expected $395 million decline in deferred revenue in the second quarter, as reported by Microsoft
Connors comments did nothing to alleviate concerns about the firm's declining deferred revenue, which have weighed on Microsoft's shares for the past quarter. Recently, Microsoft shares were down 23 cents, or 0.8%, to $28.57.
Connors estimated that about 30% of the two-year subscription customers -- many of which are small- and medium-sized businesses -- would renew. By contrast, about two-thirds to three-quarters of large companies who buy subscriptions typically renew, Connors said.
That's a higher renewal rate than some Wall Street analysts are projecting. Goldman Sachs analyst Rick Sherlund is now estimating that 10% to 20% of customers who signed those two-year deals will renew, in line with Sanford C. Bernstein analyst Charlie Di Bona's estimate of 15%. (Sherlund and Di Bona have outperform ratings on Microsoft; Goldman has done banking with Microsoft while Bernstein's parent company, Alliance Capital, holds Microsoft shares.)
If the percentage of two-year customers who renew doesn't reach 10%, that would mean customers aren't finding enough value in the subscriptions or they simply prefer to buy a more traditional upfront license, which doesn't entitle them to the upgrades they get with a subscription, Connors said at the meeting.
Microsoft is now assuming more customers than it previously estimated will opt for upfront licenses vs. subscriptions for the remainder of fiscal year 2004 and fiscal 2005, he noted. Record revenue surpassing $10 billion in the second quarter reflected the greater proportion of customers opting for traditional licenses over subscriptions.
Still, Connors said Microsoft prefers customers go with a subscription because they tend to be more satisfied. He didn't mention it, but subscription sales also give the company -- and investors -- more visibility, eliminate some of the reliance on upgrades to drive sales, and also eliminate the problem of customers using out-of-date versions of the software for years on end.
Connors defended the company's subscription program, saying it delivers much better technical support and other benefits. He also attacked charges that the company isn't offering enough new releases to make a subscription worthwhile, citing the new Office 2003 system, Windows Server 2003, Exchange 2003 and a new release of Microsoft's database offering due out sometime this year.
Strong PC demand and the information technology recovery will be two forces that help Microsoft fill that $1.1 billion hole, Connors said. "It does look like the IT recovery is broad and is real."
Microsoft will also be able to fill that gap with a drop in stock-based compensation. Microsoft's unique stock options exchange program with
, which allowed employees to sell certain out-of-the-money options to the banking firm, resulted in a one-time charge of $2.2 billion, or 14 cents a share, in the December quarter.
The elimination of those options means Microsoft's stock-based compensation expense will drop to about $750 million a quarter from previous estimates of $1 billion. While significant, most analysts exclude stock-based compensation charges from their estimates.
In addition to those lower stock compensation costs, Microsoft also will focus on "cost efficacy," Connors said. Focusing on containing the growth of expenses should enable the company to post good profit in fiscal-year 2005, but top-line growth will be difficult because of tough comparisons to 2004, he said. "The comps will just be a challenge going into 2005," he said.
Indeed, because of the decline in deferred revenue, some analysts have lowered their growth-rate estimates for fiscal-year 2005. "Given the loss in unearned
revenue, reported revenue growth is expected to be a more anemic 6%" in fiscal 2005, RBC Capital Markets analyst Sarah Mattson wrote in a note last week.
In the short run, the drop in unearned revenue doesn't matter because it will be offset by improvements in PC and server demand and growing IT budgets, Mattson said. "In the longer run, however, Microsoft's visibility deteriorates, its business is more dependent on upgrade cycles and the unpredictability of its business potentially grows," she said. Mattson has a sector perform rating on Microsoft and her firm hasn't done banking with the company.
With the more than $1 billion in deferred revenue cut from his model, Sherlund said in a recent note he is forecasting that Microsoft will post 8% revenue growth and 6% earnings growth in fiscal-year 2005.