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April 28, 2006

Microsoft 3Q earnings angst on Wall Street

Posted by David Hunter at 11:17 AM ET.

As always, it’s not nice to fool Wall Street and Microsoft shares are getting pummeled this morning as a result. It wasn’t so much that 3Q earnings were bad, as that they were at the lower end of what Wall Street expected. And it wasn’t so much the 3Q earnings, as it was the guidance for FY 2007. Jay Greene at BusinessWeek Online elucidates in Microsoft’s strange spending splurge:

Just when Microsoft investors were getting used to the company’s combination of slowing growth and expanding margins, they got a jolt on Apr. 27. The software giant released quarterly results that were largely in line with expectations. But projections for the fiscal year, which begins July 1, were another story.

Microsoft, under Chief Executive Steve Ballmer, will spend about $2 billion more in fiscal 2007 than Wall Street was expecting. “We decided to aggressively invest in a number of areas, and they do add up,” Microsoft Chief Financial Officer Chris Liddell said on a conference call.

Among those areas: speeding up production of the Xbox 360 game console, pumping money into the company’s fledgling Windows Live service that delivers software applications over the Web, and increasing the pace of acquisitions.

The sticking point, though, is that those types of investments were already factored into analysts’ models. Many were left scratching their heads, wondering how Microsoft’s new investments could add up to so much more than they calculated. “It sounds like you’re building a Google or a Yahoo inside the company,” Goldman Sachs & Co. analyst Rick Sherlund told Liddell on the call, referring to Web services, one of the areas targeted for added spending.

Liddell says the company isn’t hiding anything. “I don’t think there’s a Trojan Horse there that we don’t want to talk about, sitting below the surface,” he replied.

Analysts were disappointed by the lack of information. “Where is the money going? There wasn’t an answer,” says Charles DiBona, a Sanford C. Bernstein & Co. analyst. “It’s going into a black hole as far as anyone knows.”

It’s an interesting puzzle for the analysts, I’m sure, but models (both Microsoft’s and the analysts’) can be wrong and we’ve touched previously on the fact that in the ad-supported online services game it takes big money (in the form of people, hardware, and bricks and mortar) to make big money, so some large expenditures are going to have to be on Microsoft’s menu if they want to play.

As for the Xbox 360, it certainly is a glaring hole in Microsoft’s wallet. In 3Q, Home and Entertainment (mostly Xbox 360) had 39% of the revenue of Server and Tools, but swallowed up 49% of the S&T profits. Although it is undoubtedly too soon, one wonders exactly when the shareholders are going to get impatient for the Xbox 360 to turn the corner. To soothe potential grumblers, Microsoft’s John Porcaro reports that Business is fine, thanks for asking:

  • This quarter, we shipped 1.7 million Xbox 360 consoles, bringing our cumulative sales to date to 3.2 million consoles with 1.8 million in North America, 1.1 million in Europe and 300,000 in the rest of the world.
  • According to NPD, our life-to-date attach for software and peripherals in the U.S. through March was 4.5 and 3.0 per console respectively – higher than any other gaming console at this point in the lifecycle.
  • Despite a relatively small installed base, three of the top 10 selling video games in the US in March were for the Xbox 360 platform.
  • Attach rates on the Xbox Live service remain strong, with more than half of all Xbox 360 consoles sold connected to the service either via Silver or Gold tier memberships.
  • Because of our increased optimism and strong console shipments in Q3, we are tightening our previously announced fiscal year shipment guidance of 4.5 to 5.5 million consoles to 5.0 to 5.5 million consoles.

There’s more on the list – I just grabbed the biggies. However, while there is a whiff of largesse in the offing, the proof will be when cash starts flowing in, not out. Everyone knows the “razor and blades” analogy, but they want to be sure the customers haven’t decided to grow beards.

Finally, since the demand for cash is high, I expect there will be renewed interest in milking more cash out of the Office (aka Information Worker) and Client segments. I discussed last week how there appears to be a concerted effort to expand income from Vista by reducing piracy and raising the price per PC sold, and we just saw a new piracy reduction initiative for Office. Perhaps there will be a concerted effort to upsell Office 2007 too.

In the end, the ultimate source of Wall Street’s discomfort seems to be Microsoft acting like a growth stock. From Jay Greene’s article referenced above:

What’s behind the angst? At least part of the reason is that investors had decided to view Microsoft as a value play rather than a growth stock. So they were willing to accept slowing growth in exchange for fattening margins and rising shares. But the investment binge will curtail margin expansion at least into mid-2007.

It’s interesting to see Microsoft again making some big bets, but are they still capable of cashing them in?

Update: More analyst quotes here and here.

Update 2: A couple of commentaries: Microsoft Lost in Space and Dinosaurs like Microsoft don’t run with bulls. Ouch! On a more positive note, see Is Microsoft Preparing a Big Attack?

Filed under Advertising, Christopher Liddell, Executives, Financial, General Business, Investor Relations, Microsoft, Online Services, Windows Live, Xbox

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4 Responses to “Microsoft 3Q earnings angst on Wall Street”

  1. Microsoft launches Windows Live Shopping -- Microsoft News Tracker Says:

    [...] Exemplifing all that online services investment that has Wall Street upset, Microsoft today launched a beta of Windows Live Shopping at Today we launch the brand new Windows Live Shopping site! [...]

  2. Microsoft: Marching toward Moogle? -- Microsoft News Tracker Says:

    [...] The Wall Street angst over Microsoft’s big bet on Internet search and advertising has given rise to a good deal of examination of how well Microsoft is doing in that regard. Are they building a powerhouse competitor or a Moogle (Microsoft’s inferior copy of Google)? [...]

  3. Waiting for the Microsoft earnings report -- Microsoft News Tracker Says:

    [...] Still, any perceived shortfall will surely punish Google’s stock, which has been flat in 2006 after more than doubling in each of the last two years. One area of particular concern is how much Google is spending to maintain its much-discussed air of technological superiority. Microsoft had a little problem with that last quarter too, but another question is what will Google do when it owns the whole Web search market? That’s not an unfamiliar type of problem for Microsoft either. [...]

  4. Microsoft October spending surprise? -- Microsoft News Tracker Says:

    [...] That’s a polite way of saying that it tanked the share price which has only lately recovered during the general market run-up. Presuming this wasn’t a misquote, there’ll likely be more fireworks next week. Filed under Executives, Steve Ballmer, General Business, Financial, Microsoft [...]

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