The hot topic of
first-quarter earnings report Thursday will be the effects of a switch in the software titan's payment model that took place more than two years ago.
Specifically, Microsoft's report on unearned, or deferred, revenue at the end of the September quarter will offer some clue about the company's success in renewing contracts with business customers that began paying for software on a subscription or annuity basis -- rather than all upfront -- under two-year contracts that expired July 31.
Microsoft gave those customers a 90-day grace period to sign new contracts, which means many renewals could show up on Microsoft's deferred revenue line in the just-completed September quarter.
"This is a big contract-renewal period," said Rich Parower, portfolio manager of the
Seligman Global Technology Fund, which holds Microsoft shares. "I think this is an indicator for technology
spending for small and midsized companies," Parower added of Microsoft's unearned revenue, noting that mostly those types of companies signed the subscription contracts with Microsoft.
licensing plan introduced in 2001, Microsoft replaced several upgrade programs with a new one designed to prompt more customers to buy software on a multiyear subscription basis that entitles them to new releases and updates. The alternative was -- and still remains -- buying a license for the right to use a particular version of software in perpetuity and then paying again for an upgrade.
(Under the subscription model, Microsoft first recognizes revenue on its unearned revenue line and then moves that revenue proportionally to the income statement over the lifetime of the contract, making unearned revenue an important indicator of future revenue on the income statement. For perpetual licenses, Microsoft recognizes all of the sales at one time on the income statement.)
Microsoft has said it prefers the subscription model because it makes future revenue more predictable. However, some customers weren't upgrading as often as the company liked.
This summer, Microsoft management projected that only 10% to 30% of the customers who signed up for the two-year subscription contracts, called Upgrade Advantage, two years ago would renew their contracts. As a result, the company said unearned revenue would decline sequentially in the first quarter by $200 million to $300 million.
But several analysts believe characteristically cautious Microsoft is enjoying higher subscription-renewal rates and consequently is likely to see a smaller decline or possibly even an increase in unearned revenue in the first quarter.
unearned revenue will speak to whether the annuity licensing is being embraced or not," said First Albany analyst Mark Murphy. "We're cautiously optimistic that Microsoft can outperform there." (Murphy has a buy rating on Microsoft, and his firm hasn't done banking with the company.)
UBS analyst Heather Bellini echoed that sentiment. She estimated that contracts originally worth about $1 billion will expire in the first quarter and could experience renewal rates of more than 50%. That would translate to upside of $176 million in unearned revenue in the first quarter, implying that unearned revenue would decline only $24 million to $124 million, Bellini wrote in a note last week leading up to Microsoft earnings. (Bellini has a buy rating on Microsoft, and her firm has done investment banking with Microsoft.)
Bellini also noted that next quarter, Microsoft's unearned revenue could show year-over-year growth for the first time since June 2003, which she said could be a "significant psychological boost" for the company.
In fact, tracking year-over-year trends in unearned revenue may be more meaningful than sequential trends because of seasonality, said Sanford C. Bernstein analyst Charlie Di Bona, who rates Microsoft stock outperform.
Di Bona, who is forecasting a $150 million decline in unearned revenue, downplayed the importance of Upgrade Advantage renewals as an indicator of overall Microsoft sales, noting that the smaller businesses that initially signed up for Upgrade Advantage are not natural candidates for software subscriptions because they typically wait longer to upgrade and tend to be more cash-constrained. (Bernstein doesn't do investment banking, but its parent, Alliance Capital, holds Microsoft shares.)
Some industry onlookers are also anticipating that the world's largest software maker may shed more light on recent mixed signals about PC sales trends. "Microsoft tends to have a much more accurate prediction of PC unit growth than other companies," said Murphy, noting that, in July, Microsoft set expectations for more conservative growth than did most semiconductor firms.
More recently, chipmaker
said last week that
shipments of microprocessors were "notably less than expected" in September, a month that typically sees an acceleration in semiconductor sales. Many of Intel's peers voiced similar complaints amid a barrage of third-quarter preannouncements.
But earlier this week, research firms IDC and Gartner reported that the
PC industry posted double-digit growth in the third quarter, although both pointed out some worrying signs in the near future.
Microsoft, by contrast, projected only 6% to 8% PC unit sales growth in the September quarter. Given that such a forecast was lower than what took place, according to IDC and Gartner numbers, Microsoft may be poised to beat its first-quarter targets that are calling for earnings of 30 cents a share on revenue of $8.9 billion to $9 billion. The consensus estimate gathered by Thomson First Call forecasts that Microsoft will earn 30 cents a share on $8.99 billion in revenue.
Solid reports earlier this week from such tech giants as
also bode well for Microsoft, suggested Seligman's Parower. "I think in general what you're seeing is ... companies with big installed bases that can sell into those have generally performed well," Parower said. "Microsoft would fall into that camp."