Q4/07 Earnings

I'm tied up today and don't expect to post much on earnings this time around. The Xbox charge will blow earnings for both the quarter and the year, so that pretty much negates any anticipation for a "blowout". That said, Ballmer's recent public comments have had a certain unmistakable swagger. So expect the rest of the business to have done quite well. No doubt the company - and analysts with buy recommendations and/or investment banking relationships - will do their best to present the results in that light. Specifically, look for numerous references to "excluding the charge, EPS would have been...". While there's some merit to that wrt understanding how the rest of the business did, the reality is that rightly or wrongly (it's clearly wrongly btw) Xbox is part of MSFT's overall business now. In fact it's a significant part, especially for top line revenue and revenue growth. So excluding that charge is a bit like saying "the date went really well except for the part where I got drunk, spilled a glass of red wine all over her new dress, and she slapped me in the face".

The major focus, of course, will be on anything that gives a sense of how Vista is doing (answer: not nearly as well as it should be, all company rhetoric aside) and of course guidance for the year. Again, listening to the swagger coming out of Ballmer, Witts (who incidentally rivals Liddell for B-O-R-I-N-G) and others at the recent partner meeting, they seem to be very optimistic about FY08 - at least for now. So I don't anticipate any negative change to previous guidance. There's even a chance they could raise it slightly.

WRT the stock, it has suddenly reversed course and been surprising strong after tracking near perfectly against my earlier $28's downside forecast. Not sure what to make of that, except possibly that those comments coming out of the partner meeting caused the street to jump the gun and buy heading into earnings. Hopefully, there are enough positives on the conference call - or at least absence of negatives - that we avoid a post earnings selloff like INTC experienced. Of course, INTC had nicely outperformed the NASDAQ on the year heading into that, whereas MSFT - even given the recent strength, and in this, its major new product year - is still lagging it by more than 6%. So we'll see.

Pre-earnings:

• Microsoft Xbox Repairs May Cut Fourth-Quarter Gain (Update1) [I like the "may" part]
• Microsoft Q4 earnings preview, Xbox could hit revenue [ditto "could"; It's 7-8 cents after-tax people]
• All eyes look to Vista as Microsoft reports
• Microsoft earnings today: Xbox 360, Windows Vista

Post-earnings and conference call:

So,

• PC growth was stronger than expected (by a full 1%)
• Foreign exchange helped revenue (by a full 2%)
• "Each business grew revenue at double-digit rates at the high-end of our guidance"
• The Windows premium mix did better than expected (up 17% to 72%)
• MBD revenue was up 19% versus guidance of 13-14%
• Enterprise agreement renewals exceeded the historic range of 66-76%
• Dynamics bookings were up 24% (not great vs Salesforce.com, but better than normal)
• They sold 400K less Xbox consoles (thereby avoiding the loss per unit * 400K)
• 243M shares were bought back on the Q for $7B+ (thereby boosting EPS)
• Headcount growth came in lighter than usual (again, should have helped income even though it's still excessive at ~10%)

And...

MSFT only managed to meet street expectations on EPS. Huh? Hey, I only report the stuff. I guess Ballmer's swagger was reserved for top line results only - part of a disturbing trend. BTW, notice how the earnings "caption" always gives away the plot? Last Q, for example, when earnings for a beat were there, the caption was "Microsoft Reports Record Profits". This Q, when it's just a meet, the caption is "Microsoft's Annual Revenue Surpasses $50B".

To determine why EPS weren't higher I reviewed the financials. FWIW, the first thing I always do is take MSFT's efforts to make growth of revenue vs earnings less easy to compare, and rearrange it so that it's clear cut. That yields a table that looks like this:

At first glance - and ignoring the usual losers - the issue would appear to be Client (see red highlight). That failure of earnings growth to match revenue growth is a real concern. But it's been one for a while, and includes such macro items as an increasing percentage of sales coming from emerging markets (where Windows sells for less). Indeed, Client revenue growth (at least) was actually within forecast (14% vs guidance of 14-15%). It's actually Server & Tools that came in light on revenue versus guidance (15% vs the 16-17% forecast). Additionally, they only matched on earnings growth (versus exceeding it as they have on some previous occasions). According to Liddell, some of the top line issue may have been a result of stronger than expected EA renewals. Whether that played any part in the bottom line impact is unclear. Finally, you have MBD coming in way above plan on revenue (19% vs guidance of 13-14%), but only matching that growth on earnings (it too has done better than that in some previous quarters). Bottom line, who knows? It's a $100M-$300M earnings mystery wrapped in an enigma - or maybe I'm just too tired to analyze it further. On the all-important Vista issue, it's clear from comments that adoption is behind expectation. Liddell's actual euphemism was something along the lines of "we're broadly happy with Vista adoption". But in the Q&A, he was forced to concede that MSFT took down expectations for next year from 85% Vista/15% XP to just 78% Vista. What did Ballmer say again? Oh right, "Vista will be great - bet on it". He must have meant "eventually". Rounding things out we have the pre-announced Xbox loss, which came in at $.08 (the high end of the previously given range of course). That took total losses in E&D for just the past two years to a whopping $3.176B. Yup, that's a "strong business" alright. Finally, Online continues to be a financial sinkhole and will lose money again next year (Xbox business plan redux?). Forecast revenue growth of 10-13% for Online in FY08 is also a joke compared to GOOG, YHOO, or the market as a whole.

So overall, revenue came in roughly as I expected. However, bottom line results were weaker (I expected 1-2 cents upside). Guidance for next year is in line with what I anticipated (i.e. a slight increase), which ultimately is good. But the implicit confirmation about Vista sluggishness, combined with the lack of margin and earnings acceleration next year - and guidance to continue hemorrhaging in Online, will likely take the wind out of the sails of the extra bullishness that had been building following management's recent upbeat comments. Some analysts may still take their estimates up slightly following the call (assuming that MSFT was just being conservative as usual). But I doubt we'll see anything like what followed IBM's strong results. BTW, IBM stock has now handily outperformed MSFT over 1, 3, 5 and 10 years. So much for MSFT being the "new IBM" - we should be so lucky.

For its part, MSFT is down in AH trading. Although exactly how much is subject to some debate (NASDAQ reporting last trade @ $30.90, down .61 from the close; MSNmoney and YHOO say $30.83, down .68). It will likely open weak tomorrow as a result (despite the MM's best efforts). It could have been worse though. Just look at GOOG in AH - down $39.06 according to MSNmoney (and it was down forty-something at one point). That should also hurt the market tomorrow.

Update:

• For Microsoft, Meeting Expectations Apparently Not Enough

"For people who think Microsoft is still a growth story, it's disappointing. It's a mature company in a mature industry with declining prices," Chowdhry added. "For people who think Microsoft is a value company, what they delivered today was quite good."