Software-Subscription Concerns Sink Microsoft - TheStreet

Updated from Oct. 23

Despite reporting a solid quarter, tech bellwether

Microsoft

(MSFT) - Get Report

was dropping in early trading because of indications that software subscriptions are much weaker than expected.

In recent trading, Microsoft was down $1.79, or 6.2%, to $27.12.

"The stock clearly gets slapped on concerns about the longer-term underlying strength of the business," Deutsche Banc analyst Brian Skiba. "After being put in the penalty box near-term, the stock will likely be dead money until investors can get a better idea on whether corporates will come back and commit long-term to Microsoft's desktop products through subscriptions," Skiba wrote. His company has done banking for Microsoft.

Microsoft Thursday beat first-quarter earnings estimates by 1 cent per share on better-than-expected revenue driven by strong consumer PC sales. Microsoft also said second-quarter and full-year results could come in higher than expected.

But shares of Microsoft posted a larger-than-expected decline in unearned revenue, an indicator of sales to business customers. Microsoft attributed that drop to a number of factors, including poor forecasting and distractions with the viruses that broke out during the summer.

"The consumer side is making up for the enterprise, and that's what's going on in the market right now," said Rich Parower, co-manager of the J&W Seligman Global Technology fund, which holds Microsoft shares. "Net, net, it's still Microsoft, they're still in very good shape."

The Redmond, Wash.-based software behemoth reported GAAP net income of $2.61 billion, or 24 cents a share, in the first quarter, compared with net income of $2.04 billion, or 19 cents a share, on a split-adjusted basis, in the same period a year earlier. The previous year's results include investment impairment as well as stock compensation charges

Excluding such charges as options-related expenses, Microsoft earned pro forma net income of $3.29 billion, or 30 cents a share, in the first quarter, compared with pro forma net income of $3.02 billion, or 28 cents a share on a split-adjusted basis, a year earlier. Analysts polled by Thomson First Call were expecting the company to post pro forma earnings of 29 cents a share, in line with the company's guidance for the first quarter, which ended in September.

Revenue rose 6.1% to $8.22 billion from $7.75 billion a year earlier and 1.9% from $8.07 billion in the previous quarter. Analysts' estimates pegged revenue at $8 billion for the first quarter, the midpoint of the company's targeted range of $7.9 billion to $8.1 billion.

"While corporate IT spending was slow to improve this quarter, we saw strength across all of our consumer businesses, driving higher-than-expected revenue for the company," Microsoft CFO John Connors said in a prepared statement. Robust consumer demand for personal computers during the busy back-to-school shopping season drove better-than-expected Windows revenue in the quarter, according to Microsoft.

The world's largest software maker was expected to beat estimates on greater-than-anticipated strength in the PC business. Earlier this month, research firms Gartner and IDC reported double-digit unit-shipment growth in the September quarter, and chipmaker

Intel

(INTC) - Get Report

also came out with strong quarterly results.

Microsoft concurred that PC shipments worldwide grew by percentages in the midteens during the quarter, and even higher in Japan. Connors raised Microsoft's forecast for PC unit sales to upper-single-digit growth for the fiscal year, from the company's previous outlook for mid-single-digit growth.

Looking ahead, Microsoft expects second-quarter revenue to range from $9.7 billion and $9.8 billion and second-quarter earnings to range from 29 cents to 30 cents a share, excluding an equity compensation charge of 6 cents a share. Analysts' estimates called for revenue of $9.3 billion in the December quarter and pro forma earnings of 28 cents a share.

Microsoft raised its guidance for fiscal year 2004, which ends in June. Revenue is expected to range from $34.8 billion to $35.3 billion and earnings should range from $1.10 to $1.12 a share, excluding an equity compensation charge of 24 cents a share.

Previous guidance predicted revenue would range from $34.2 billion to $34.9 billion, with earnings between $1.09 and $1.11 a share, excluding equity compensation expenses. Analyst forecasts sat at $1.11 a share in earnings on $34.7 billion in revenue for fiscal 2004.

The full-year guidance assumes a small improvement in corporate spending in the second half of the year, Connors said, noting that corporate spending has been slower to recover than consumer spending.

That trend was underscored by the decline in Microsoft's unearned revenue. Microsoft's balance of unearned revenue decreased $768 million sequentially from June 30 to $8.25 billion. Unearned revenue represents revenue received from customers paying a subscription to use Microsoft's software. Also called deferred revenue by other companies, unearned revenue is first recorded on the balance sheet when a deal is signed and then recognized on the income statement over the period of the contract.

"It is a bit disconcerting," said Standard & Poor's analyst Jonathan Rudy, who has a buy rating on the stock. "Taking a step back -- a mosaic picture -- I think people were very quick coming out of the Intel call to declare a broadbased IT spending recovery," he added. "It just seems in the enterprise, it's just not the case at this point." (His firm doesn't have an investment banking business.)

In addition to attributing the large decline in unearned revenue to IT spending, Connors cited overly optimistic forecasting, issues with the sales force and security concerns from the rash of virus outbreaks during the summer. Those security concerns diverted customers and the sales force away from closing deals, he said.

But on a conference call, Goldman Sachs software analyst Rick Sherlund suggested Microsoft may not be offering customers enough upgrades to make signing up for a subscription worthwhile. He questioned whether a customer would enter a multiyear contract if Microsoft's next big upgrade of its operating system probably will not arrive for 2 1/2 years to 3 years. Furthermore, he said, customers usually don't upgrade their software in the first year after such a release. Sherlund has an outperform rating on the stock and his firm has done banking business with Microsoft.

Connors cited other products slated to debut, including Microsoft's database product in the second half of 2004. But if Microsoft has to add more benefits, the company will do that, Connors added.

Speaking after the call, J&W Seligman's Parower said Microsoft will probably have to offer more consulting and other services to customers with subscriptions. "Everything else being equal, that could put pressure on their gross margins," he said. "I'm concerned. But if they know what the issue is -- and they do -- then I think they can do a good job managing it."

Although Microsoft cited robust consumer PC sales, the company's Client business, which is largely made up of Windows sales, grew less than 1% year over year. That was partially because of difficult year-over-year comparables because a deadline last year prompted a surge in customers signing subscription license deals.

The company's server and tools business grew almost 15%, the company's business solutions division targeting small- and medium-sized businesses climbed nearly 21%, and the still relatively tiny mobile division jumped 89% year over year.

Microsoft's MSN division posted its first quarter of operating profitability, with a drop of subscriptions offset by higher advertising revenue, the company said. And Microsoft reiterated its target of selling 14.5 million to 16 million Xboxes by the end of its fiscal year, in June.

The company's gigantic cash hoard surpassed the $50 billion mark, climbing to $51.6 billion with $3.4 billion in net cash generated from operations.

Shares of Microsoft edged up 2 cents, or 0.1%, Thursday to close at $28.91.