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.
TOO MANY TARGETS. Microsoft (MSFT), 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 (see BW Online, 1/27/06, "Microsoft's News of Many Parts"), pumping money into the company's fledgling Windows Live service that delivers software applications over the Web (see BW Online, 3/30/06, "Keeping Up with the Googles"), and increasing the pace of acquisitions. To that end, Microsoft plans to acquire Massive Inc., which sells ads inside video games, for between $200 million and $400 million, according to The Wall Street Journal.
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.
FEW EXPLANATIONS. 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. Investors weren't satisfied, and Microsoft shares dropped. The stock slid $1.71, or 6.3 percent, to $25.57 in extended trading.
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."
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 (see BW Online, 4/15/06, "Microsoft, the Value 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.
SLUGGISH GROWTH. Concerns surfaced around Microsoft's guidance for fiscal 2007 operating income. Though the company hadn't offered guidance previously, analysts expected fiscal 2007 operating income to land somewhere in the neighborhood of $21 billion. The stunner: Microsoft said operating income would be between $18.7 billion and $19.3 billion. The company also said revenue for fiscal 2007 would hit $49.5 billion to $50.5 billion, though that's roughly in line with expectations.
Microsoft's projections for operating income in the current quarter also came in below expectations. Microsoft expects $4 billion to $4.2 billion in operating income in the fiscal fourth quarter, well down from the $4.8 billion Sherlund projected. A forecast for sales of $11.5 billion to $11.7 billion for the period was largely in line with expectations.
For the third quarter, Microsoft's results were in line with results of recent periods: sluggish growth for its two monopolies, Windows and Office, and solid results from its server software business. Microsoft's Client business, comprised of sales of Windows for PCs, climbed 8% to $3.2 billion, even though the overall PC business grew 12% to 13%, by Microsoft's estimates.
STILL STRONG ELSEWHERE. The slower sales growth for Windows comes largely because the company's Windows sales are increasingly coming from computer makers, which buy the operating system at volume discounts. Revenue in the company's Information Worker group, comprised largely of Office sales, edged up 5% to $2.9 billion.
The big jumps came from Microsoft's Server and Tools and its Home and Entertainment divisions. The server software group posted its 15th straight quarter of double-digit growth, jumping 16% to $2.8 billion, benefiting largely from continued strong sales of the company's SQL Server database software. The Home and Entertainment division sales grew 85% to $1.1 billion, fueled by the November launch of Xbox 360.
Microsoft is betting that a new round of investment will spawn businesses that fuel future growth, just as SQL and Xbox are doing now. But Wall Street won't be happy until Microsoft does to more to explain exactly how.
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