Microsoft tempers outlook as sales surge

The company posted fiscal second-quarter net income of $2.28 billion, or 41 cents per share, after deducting a $660 million charge for legal issues. Without the 8 cent charge, Microsoft would have earned 49 cents per share, topping analysts' consensus estimate of 43 cents per share, according to analysts polled by First Call. The quarter ended Dec. 31.

Microsoft posted earnings of $2.62 billion, or 47 cents a share, a year earlier. Earnings also declined from the fiscal first quarter of 2002, which, excluding investment loses, added up to $2.9 billion, or 43 cents a share.

The Redmond, Wash.-based software giant reported revenue of $7.74 billion, up 18 percent from $6.55 billion a year ago, and a record high for the company.

But during a Thursday afternoon conference call with financial analysts, Microsoft Chief Financial Officer John Connors warned investors not to get overly excited about the quarter's big sales increase.

"It is too early to assume that a recovery is under way in the major economies around the world," he warned, adding that many people "must be (expecting) a booming recovery vs. a more modest recovery. We don't see a booming recovery anytime soon."

For the company's second quarter, analysts had often forecast revenue growth of about 9 percent but varied widely on earnings. Bernstein analyst Charles DiBona, for example, last week said he expected earnings of 48 cents per share. On Tuesday, UBS Warburg analyst Don Young forecast 41 cents a share, based on expected lower gross margins and increased selling expenses.

The company is undergoing several major product transitions and eventual increased reliance on services revenue. On Wednesday, Microsoft released new tools for developing applications for its .Net software-as-a-service strategy.

Higher sales of lower-margin products and the hefty investment required to launch the Xbox game console negatively affected earnings. Sales of desktop applications, which historically accounted for more than 40 percent of profits, also continued to lose momentum.

Still, sales soared past expectations owing to stronger-than-expected demand for Windows XP licenses, the Xbox game console and MSN.

Connors attributed the quarter's "record sales" in part to the launches of Windows XP, the Xbox game console and MSN 7.

"We launched two landmark products for Microsoft this quarter, and they are both off to a terrific start," he said. "The arrival of Windows XP marked a fundamentally new era in consumer and business computing, and the results speak for themselves."

Microsoft reported it sold original equipment manufacturers (OEMs) more than 17 million Windows licenses since the operating system's Oct. 25 launch. For comparison, Microsoft shipped 19 million Windows 95 licenses in 1996, the operating system's first full year of availability, according to IDC.

Scott Boggs, Microsoft's corporate controller, said that 17 million copies are equivalent to PC makers and retailers selling "two copies per second since launch."

"OEM sales of XP are more than 300 percent higher than those of Windows 98 and 200 percent higher than those of Windows Me over the same period," Young noted in his Tuesday report.

IDC analyst Roger Kay estimated that consumer PCs accounted for about 13.5 million of the Windows XP license sales, with about 2 million retail and 1.5 million commercial licenses making up the remainder. PC makers started selling Windows XP PCs on Sept. 24.

Better-than-expected holiday PC sales also helped Windows XP sales. Worldwide PC shipments dropped 6.1 percent year over year in the fourth quarter compared with a projected 9.9 percent decline, according to preliminary numbers IDC released Thursday. U.S. PC shipments declined 8.5 percent vs. a projected 16.6 percent decrease.

Though U.S. PC sales in particular were better than expected, "It's hard to tell whether XP did much of anything," IDC analyst Roger Kay said. "But they certainly caught the updraft."

Xbox sales also fared much better than expected, with Microsoft selling 1.5 million game consoles since the device's Nov. 15 launch.

"Xbox is the first step in Microsoft's long-term strategic vision for the future of home entertainment, and it too met with great success," Connors said. "We cautioned several times the operational execution for the launch would be a challenge, and it was. We executed very well to keep the channel well stocked with product."

"Microsoft avoided the 'normal' delivery problems that have plagued game console launches and delivered more console units than expected to retailers during the holiday season," Bernstein's DiBona wrote. "We also believe that Xbox experienced higher attach rates than our model assumed as a result of bundled sales of games with the consoles."

Analysts estimated that consumers bought on average three additional items, typically games selling for about $50 each, with every Xbox.

Still, analysts estimate Microsoft loses as much as $100 on every Xbox; the console sells for around $300. The company also spent $500 million for the launch, with much of that going to advertising and other promotions.

But strong Windows XP sales helped offset the earnings hit, estimated by analysts to be between 2 cents and 10 cents a share.

Microsoft may already be working on Xbox's successor, HomeStation, a multipurpose entertainment hub expected later this year.

By the numbers
Despite solid results for the quarter, the company's outlook was tempered by uncertainty about the economy.

Microsoft predicted that revenue for its third fiscal quarter, ending March 31, would be in the $7.3 billion to $7.4 billion range, with earnings of $2.8 billion to $2.9 billion, or 50 cents to 51 cents a share. Analysts had expected earnings of 47 cents a share on revenue of $7.5 billion, according to First Call.

For fiscal 2002, ending June 30, Microsoft estimated revenue would fall in the $28.8 billion to $29.1 billion range, with projected earnings of $11.5 to $11.8 billion, or $1.57 to $1.60 per share. Microsoft's sales projections were slightly higher than estimates.

Microsoft also offered additional estimates about specific products.

"We expect desktop software (growth) to be up in the lower-to-mid single digits for the full fiscal year and a few points shy of that for the third quarter," Connors said. For desktop applications, such as Office, Connors predicted at best flat sales to a possible decline for the fiscal year. He also warned of a possible third-quarter revenue decline.

Sales in Asia, particularly in Japan, contributed heavily to the sales weakness. "We're forecasting the weakness in our Japanese business to continue through the remainder of fiscal 2002," Connors said.

Microsoft predicts desktop operating sales will grow in the low double digits for the fiscal year and mid-to-high single digits for the third quarter.

"We're coming off a great launch for Windows XP, with strong retail and OEM penetration," Connors said. "However, we do remain cautious about PC sales in the second half of the year and we do not anticipate the retail results we experienced in the second quarter."

Microsoft expects PC sales through the remainder of its fiscal year will remain weak, with single-digit declines.

Connors dramatically increased the forecast for the consumer software, services and devices group.

"Based on the current-quarter results, primarily for Xbox, we are raising our forecast for this segment," he said. "For the full year, this business will probably come in between $4.1 and $4.2 billion."

Microsoft's second fiscal quarter marked high and low points, with some of the biggest gains in the consumer segment.

Regionally, the South Pacific and the Americas jumped 39 percent to $3.24 billion in sales, compared with $2.33 billion a year ago and $2.43 billion in the first quarter. Strong U.S. sales bolstered the region.

Revenue for the Europe, Middle East and Africa regions declined slightly year over year, to $1.42 billion from $1.43 billion, but gained sequentially from $1.11 billion. Asia saw a 4 percent sales decrease, to $705 million from $737 million a year earlier. Revenue would have been 5 percent higher if it were not for exchange rates. In the first quarter, the region had $708 million in sales.

Revenue from PC makers and other OEMs rose 16 percent, to $2.39 billion from $2.05 billion a year earlier. OEM revenue topped $1.98 billion in the first quarter.

Desktop-application sales showed some weakness at $2.45 billion, compared with $2.49 billion a year earlier, but gained from $2.19 billion in the first quarter. The results include sales from Great Plains accounting software and Office, Microsoft's flagship productivity suite.

Sales of Windows desktop software increased 24 percent year over year, to $2.55 billion from $2.06 billion. Sales were $2.02 billion in the first quarter.

Enterprise software sales grew 4 percent year over year to $1.29 billion from $1.24 billion a year earlier; revenue topped $1.19 billion in the first quarter. "We did see lower sales across the entire enterprise segment than we anticipated," Connors said. "While we believe we gained share in the segment, demand worldwide was lighter than we expected."

Combined revenue for desktop and server software and services jumped 9 percent to $6.29 billion from $5.79 billion a year earlier and $5.4 billion in the first quarter.

Sales in the consumer software, services and devices group, which includes Internet access and online services, soared to $1.2 billion from $506 million a year earlier, largely buoyed by Xbox.

Revenue from consumer commerce investments, which includes Expedia, HomeAdvisor and CarPoint, reached $90 million, compared with $64 million a year ago. MSN now has 7.7 million subscribers.

MSN revenue grew over 40 percent year over year, although advertising sales were flat due to the weak economy. MSN eShop attracted 106 percent more shoppers than last year. Microsoft didn't say how much a rebate promotion on products bought through eShop affected traffic.

Sales in the "other" category--primarily hardware and Microsoft Press--fell to $163 million, from $188 million in the second quarter of 2001.

While a federal judge threw out a $1 billion settlement affecting more than 100 pending class-action lawsuits, the company still took a $660 million charge in the second quarter.

"Accounting rules require that we continue to recognize this as a liability until the cases are resolved," Boggs said.