Microsoft Posts Smaller-Than-Expected 2Q Earnings

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Juggling legal costs and the delay in the sale of its Expedia service, Microsoft posted a smaller profit amid an 18 percent surge in revenue for its second fiscal quarter that ended Dec. 30.

The software giant posted a slower but otherwise decent quarter in a dismal economic climate, registering $7.7 billion in revenue and $2.28 billion in earnings, or 41 cents per share, falling on the lower side of Wall Street expectations of between 39 cents and 45 cents per share, according to First Call. Earnings per share of 41 cents was down 6 cents from the same quarter a year ago.

The software giant took a charge of $660 million on the tentative settlement of a major class-action lawsuit, higher than the $550 million originally expected, and the company also failed to realize a gain from the planned sale of Expedia, which has not yet closed. Microsoft executives said earnings per share would have been 50 cents to 51 cents last quarter had it not lost that transaction.

On the up side, Microsoft saw solid sales of Windows XP and launched the X-box game during last quarter. According to Microsoft, Windows XP has sold 17 million copies in two months of availability, with sales to customers by PC makers 300 percent higher than that of Windows 98 and 200 percent higher than Windows ME during the same period. Executives said total PC shipments during the quarter were down 5 percent, a little more than the company expected.

Analysts said earnings were generally in line with expectations.

"Analysts had been counting on the gain from the sale of its interests in Expedia, but that did not close in the quarter," said First Call analyst Chuck Hill. "But Microsoft is doing somewhat better than other software companies because we're in the ramp-up for XP. The fundamental business comes in line with expectations."

"Earnings were down year to year and revenues are not growing fast, but Microsoft gave conservative estimates," said Drew Brousseau, a financial analyst at S.G. Cowen. "It's not a great quarter, but everybody had modest expectations. In the software industry, we're seeing companies doing in line with expectations or slightly better than the post-Sept. 11 fears. But not that great at all."

Overall, the software giant saw a modest 4 percent growth in the enterprise space last quarter, including a 2 percent growth in server platforms, particularly in Windows 2000 Advanced server, a 9 percent growth in .Net server revenue and 1 percent drop in desktop applications, executives said. Revenue in developer tools dropped 20 percent last quarter, but Microsoft expects a big turnaround in that sector this quarter with the launch of Visual Studio.Net on Feb. 13.

Microsoft CFO John Connors revised Microsoft's estimates for the second half of 2002 to mid-single-digit growth in the third and fourth quarters based on slower-than-expected PC sales, slow corporate IT spending and a weaker Japanese market. The company's estimate for revenue during the third quarter, moreover, has been revised to between $7.3 and $7.4 million.

Connors said continued deterioration in the PC market and global economy overall has led to revised estimates for the company's fiscal year to revenue of between $28.8 billion and $29.1 billion, growing 14 percent to 15 percent over fiscal year '01, and an earnings per share of between $1.57 and $1.60. Last quarter, Connors gave guidance for annual earnings per share of between $1.61 and $1.66. Legal costs for the 2002 fiscal year are expected to represent 5 percent of annual revenue.

Microsoft now expects desktop software in the lower-single-digit growth range for the rest of the year and a "few points shy" of that for the third quarter that will end in March. Desktop applications will remain flat or decline slightly for the full year with a possible decline in March, Connors said. Desktop platform growth will be up in the low double digits and mid- to high single digits for the third quarter, he noted.

Connors said enterprise platforms and services growth will stay in the low double digits for the rest of the year and high single digit growth in the third quarter. Microsoft's "services business has been on an amazing trajectory," Connors said, but slower IT spending, a weakness in the underlying Intel-based server market and a shift to annuity-based volume licensing deals affected the bottom line this quarter.

While multiyear volume licensing has grown, the annuity-based model defers revenue over a longer period because corporations pay one bill per year. "Had we not introduced those multi-year licensing agreements and [Software Assurance, we'd expect those revenues to be higher [in the second quarter," he said." "Our sales forces are seeing IT spending budgets under pressure and enthusiasm on how that will recover is lower today than in October. But we [are getting a bigger share of annuity-based licensing than a year ago."

The CFO said he expects corporate IT spending and PC shipments to continue to slow through the rest of the year, but Microsoft will hold its own. "It's too early to assume a recovery is under way in the major economies of the world," Connors said. "We don't see a booming recovery any time soon. But this is a very good quarter for Microsoft.

Asked about his thoughts on fiscal year 2003, Connors was conservative. "It appears that for Microsoft and the industry, people are expecting a strong economic recovery, but it's premature to call that."

One ASP said Microsoft's second-quarter earnings matches his expectations as well. "I'm not terribly surprised," said Dave Castellani, CEO of Mi8, a Microsoft ASP partner based in New York. "The tech sector in general is priced for perfection in my view, and what we are likely to see are lackluster results for the whole of 2002. XP sales are dependent and driven by PC sales and the next big replacement cycle looks to me like 2003-04."

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