Microsoft's Coming Revenue Trade-Off

Microsoft sales and earnings projections for the next few quarters signal that the company is willing to sacrifice profit for long term growth.

For fiscal 2007, starting July 1, 2006, the company expects revenue in the range of $49.5 billion to $50.5 billion; operating income between $18.7 billion and $19.3 billion and diluted earnings per share somewhere between $1.36 and $1.41.

Those numbers puzzled analysts. The consensus had been for earnings of $1.53 per share on revenue of $49.5 billion, and they wanted to know where that money was going.

On Thursday evening's third-quarter earnings call, Microsoft CFO Chris Liddell summarized those expectations and sparked questions.

"The revenues looks good…but your expenses are more than $2.4 billion more than I estimated....There's something really big here. It sounds like you're building a Google or a Yahoo and Ray Ozzie has said this is really expensive. It looks like you're ramping up your online business and the decision is to take the benefits of next year's product cycle to gear up for a battle in the online market," said Rick Sherlund, partner with Goldman Sachs as he tried to suss out specifics.

Ozzie is the Microsoft CTO charged with building the company's nascent software-as-a-service effort.

Liddell said there was no smoking gun. "In terms of the $2.4 billion, I wouldn't come up with that number. I'd characterize this as a broad-based approach across multiple fronts. I don't think there's any Trojan horse we haven't talked about …. We are not building into our guidance things we're not talking about."

In her follow-up query, UBS Warburg analyst Heather Bellini said it appeared that over the next few years Microsoft would see accelerated revenue from launches but was willing to sacrifice earnings growth to reinvest in other projects.

Liddell would not comment beyond next year's guidance but "clearly from our point of view, we've made a strategic decision relative to next year where we're willing to make that trade off to get ahead and also in the third and fourth quarters as well. I don't want to extrapolate to '08 or '09."

This news worried Wall Street. In a research note published after the call, Sherlund wrote that the company's spending outlook "is quite surprising."

Management disclosed "plans to accelerate spending by roughly $2 billion more than expected in fiscal (June) 2007. This effectively takes the wind out of the sails of investor sentiment at a time when investors were beginning to warm up to prospects for accelerating earnings momentum...from Vista and Office 2007 product launches in January," Sherlund wrote.

In other tidbits from the call, Microsoft expects revenue for its upcoming fourth quarter to fall in the $11.5 billion to $11.7 billion range, representing 13 percent to 15 percent growth over the year-ago period.

Liddell said the company expected client revenue growth in the 7 percent to 8 percent range, and raised guidance on the already robust server and tools unit, which he now expects to hit 17 percent to 18 percent growth.

For the third quarter that ended March 31, that group saw 16 percent growth, with SQL Server 2005 a standout, logging 30 percent growth in sales over last year.

The Information Worker unit, including the Office franchise, is expected to grow in the 5 percent to 6 percent range for the fourth quarter, and Microsoft Business Solutions expects business to grow 11 percent to 13 percent for the quarter ending June 30.

For the full fiscal year, the company expects revenue to be between $44 billion and $44.2 billion, representing year over year growth of 11 percent, Liddell told press and analysts on Thursday's earnings call.

In highlights for the recently-closed third quarter, Liddell said the closely watched Microsoft Business Solutions unit posted earnings of $216 million, up 21 percent from $179 million for the year-ago period. Liddell cited 28 percent growh in license revenue, especially in ERP.

MBS reported a profit last quarter, slightly ahead of schedule.

Liddell also said several times that sales of multiyear licenses were up. The company saw "strong renewals on Enterprise Agreements and both Select and Open annuity deals for the quarter were very strong relative to non-annuity deals," he said.

Increasing uptake on these multi-year subscriptions has been a top priority for Microsoft, which viewed bought-but-undeployed licenses as a time-bomb as it prepared its Vista and Office 2007 launches.

The company acknowledged last month that both the new Vista Windows client and Office would not be generally available--outside EAs--until early 2007.

For the third quarter overall, the company posted a net profit of $2.98 billion, or 29 cents per share, compared to $2.56 billion, or 23 cents per diluted share, a year earlier. Revenue rose 13 percent to $10.9 billion.

Excluding legal charges, Microsoft earned 32 cents a share. Analysts, on average, had forecast net earnings per share of 33 cents per share on revenue of $11.04 billion, according to Reuters Estimates.

Analysts expect PC demand to soften in the coming quarters ahead of the upgrades.

Additional reporting from Reuters was used in this story.

This story was updated Friday with details from Goldman Sachs' research note.