Microsoft's Xbox Factor


There's little doubt that Microsoft's soon-to-be-released Xbox 360 game console will be a hot seller this holiday season -- but just how hot was called into question on Oct. 27, when Microsoft (MSFT) released fiscal first-quarter results.

Sales in the current quarter will come in about $300 million lighter than Wall Street analysts expected, the company said. The culprit, say analysts, is lower-than-expected shipments of the next-generation Xbox console, due out Nov. 22.

GO FIGURE. Analysts had expected between 2 million to 2.5 million consoles to ship in the quarter. But after checking with retailers and other Microsoft partners, Goldman Sachs analyst Rick Sherlund says he believes that figure will be between 1.5 million to 1.7 million.

For Sherlund and others, the reason for the possible shortfall wasn't immediately clear. And Microsoft executives, who have never offered guidance about Xbox shipments, didn't provide any clues on a conference call after results were released. "I'm not sure why they're not shipping more," Sherlund says.

Microsoft did say that it expects to ship 4.5 million to 5.5 million consoles by the end of the fiscal year. Microsoft has a lot riding on the success of the Xbox, and the outlook -- however upbeat -- wasn't cheery enough to boost its shares. The stock slumped in extended trading.

DECLINING ADS. Analysts looking for a silver lining in Microsoft's results didn't find it in MSN's first-quarter performance. Microsoft's giant Web business posted a 1% revenue gain, to $564 million. As was the case in the last several quarters, higher advertising sales were offset by declining revenue from the unit's Internet access business.

And particularly worrisome for analysts is a decline in MSN's search ad revenue. Though Microsoft didn't break out the number, Sanford C. Bernstein analyst Charles DiBona estimates that those sales fell by a percentage in the midteens. By contrast, Google's (GOOG) ad revenue climbed 14%, and Yahoo!'s (YHOO) was up 6%.

"As a competitor, you'd like to suck a little oxygen out of their bubble," DiBona says of Microsoft's efforts to do battle with Google. "That's not happening." Microsoft Chief Financial Officer Chris Liddell says the company recognizes the issue, sayiong: "It's something we're going to have to address in the future."

BUYBACK'S BOUNTY. Still, some investors may have taken comfort from overall first-quarter results, which were largely in line with expectations. Operating income climbed 16%, to $4.05 billion, on sales of $9.74 billion, a 6% gain.

The three horses that deliver Microsoft's revenue -- the Windows operating system for PCs, the Office productivity application, and its server software products -- all hit earlier guidance. Windows and Office benefited from strong back-to-school sales, and SQL Server, a database program, led the server software.

Another possible buoy for the stock: Microsoft separately announced plans to rev up its already aggressive stock-repurchase plan. In July, 2004, Microsoft said it would buy $30 billion of its stock over four years. It has already bought $11 billion worth. Liddell says it now plans to complete the buyback by the end of next year.

DOUBLE-DIGIT GROWTH? With Microsoft's cash holdings soaring past $40 billion, some analysts had hoped the company would increase its dividend. While Liddell said the dividend issue is separate from the stock buyback, most analysts took it as a sign that Microsoft doesn't plan to increase its dividend at least until next year.

Looking forward, executives believe business conditions will remain stable through this fiscal year. In the current quarter, it anticipates that PC sales will grow 10% to 12% and will climb 9% to 11% for the fiscal year.

For Microsoft, that means sales growth remains on track to hit double digits in the fiscal year. The last fiscal year was Microsoft's first-ever year of single-digit sales growth. It anticipates sales of $43.7 to $44.5 billion in the year, a 10% gain. For the quarter, it expects sales to grow 10% to 11%, reaching to between $11.9 billion and $12 billion.

WAITING AND HOPING. Operating income will grow 22% to 26% to between $17.9 billion and $18.4 billion for the year. Microsoft anticipates operating income in the current quarter to come in between $4.6 billion and $4.7 billion, vs. the $4.7 billion it posted in the year-earlier period.

With its shares slumping in recent weeks, Microsoft could have used a solid quarter to bump up expectations in advance of its Nov. 9 annual meeting. Instead, shareholders will have to settle for a goosed buyback and hopes that a big flow of new products will lift the stock in the coming year.

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