Microsoft reports quarterly results; listeners want to hear about Yahoo, too

Despite a disappointing performance in its Windows business, Microsoft beat Wall Street's quarterly profit expectations Thursday and issued a strong forecast for its next fiscal year.

But it was the company's pending bid for Yahoo, which reaches a critical juncture this weekend, that drew twice the usual number of analysts and investors to Microsoft's quarterly conference call.

Chief Financial Officer Chris Liddell reiterated in plain language what Microsoft has been signaling the past three weeks: "[U]nless we make progress with Yahoo towards an agreement by this weekend, we will reconsider our alternatives. ... These alternatives clearly include taking an offer to Yahoo shareholders" — a hostile takeover — "or to withdraw our proposal and focus on other opportunities both organic and inorganic."

Liddell said Microsoft has a plan for capturing more of $80 billion in online advertising spending predicted by 2010.

"With or without a Yahoo combination, Microsoft is focused on the online advertising market," he said.

That was the big issue involving Microsoft's future business. Another emerged around its current best-seller.

Microsoft's numbers for its fiscal 2008 third quarter showed sales and income from the flagship operating-system business fell more than expected compared with last year.

Broadly, the company has not yet suffered from a slowing U.S. economy, though it remains "cautious."

Liddell attributed Microsoft's resiliency to the diversity of markets, geographies and customer types its businesses cross. The Entertainment and Devices Division, for example, far exceeded Microsoft's own expectations for the quarter, selling 1.3 million Xbox 360s.

Sales remain flat

For the quarter, Microsoft had sales of $14.45 billion, flat relative to the same period a year ago. Profit was $4.39 billion, or 47 cents a share, beating the 44 cents Wall Street analysts expected on average.

Profit declined 11 percent, but the year-ago figures benefited from deferred revenue and income related to a "Technology Guarantee" program meant to spur holiday PC sales in light of the delayed launch of Windows Vista.

Also in the third quarter, Microsoft took a charge of $1.42 billion for its European Union antitrust fine. That was negated by a credit from the settlement of an Internal Revenue Service audit.

Adjusting for these accounting issues, revenue in the third quarter grew 14 percent and earnings per share increased 27 percent from a year ago.

Microsoft shares, which had gained 35 cents, a bit more than 1 percent, to $31.80 in regular trading Thursday, lost 5 percent in the after-hours market to finish at $30.19.

Underlying the quarter — which analysts described as "OK" and "not so great" — was the poor performance of the Windows business.

Client revenue of $4 billion fell 24 percent, compared with $5.3 billion in the year-ago period. Adjusting for the Technology Guarantee program, the year-over-year decline works out to about 2.2 percent.

"Elephant in room"

"This is the elephant in the room on the quarter and it's very big because it's a very important component of the model," said Brent Thill, director of software research at Citi Investment Research.

Microsoft gave several reasons for the decline, none of which had to do with the adoption rate of Windows Vista, which it said has sold 140 million licenses since launching in January 2007.

Despite those figures, Vista has suffered from an image problem and some computer users are pushing Microsoft to extend availability of its predecessor, Windows XP.

Microsoft estimated the global PC market grew 8 to 10 percent, slower than expected. Analyst firms Gartner and IDC had estimates of higher growth rates: 12.3 and 14.6 percent, respectively.

Also, sales of Windows through PC manufacturers, one of Microsoft's biggest revenue channels, grew slower than the overall hardware market, reversing a recent trend.

Colleen Healy, general manager of investor relations, cited several factors:

• PC makers had more inventory than normal at the end of Microsoft's second quarter, so they needed to purchase less from the company to meet third-quarter demand.

• Piracy, particularly in Asia, rose in the quarter.

• And, at this time last year, Windows sales were benefiting from the marketing activities around the launch of Vista, making a difficult year-over-year comparison for the business.

Sid Parakh, technology analyst with McAdams Wright Ragen, said the impact from increased piracy seemed reasonable, but that the inventory numbers were harder to explain because Microsoft should have had access to that kind of information going into the quarter.

Parakh said slower uptake of Windows Vista could factor in as well, but "not enough to raise a red flag."

Microsoft management views the deceleration in the client business as temporary. Liddell said he expects client revenue to grow between 7 and 11 percent in the current quarter, which ends June 30.

The company's forecast for the current quarter is on the low end of what analysts expect. Microsoft expects to earn 45 to 48 cents a share compared with the Wall Street consensus of 48 cents, according to First Call.

For the 2009 fiscal year, which begins July 1, Liddell issued this preliminary forecast, not including any impact from the potential acquisition of Yahoo:

Revenue will be in the range of $66.9 billion and $68 billion, up 11 to 13 percent from the expected total this year. Operating income is forecast between $26.7 billion to $27.4 billion, up 18 to 19 percent.

Online unit's loss grows

Analysts made note of the widening loss in Microsoft's Online Services Business, where it competes most directly with Google, the impetus for the Yahoo acquisition.

Revenue grew 40 percent to $843 million, though $143 million of that came through aQuantive, the Seattle digital-ad company Microsoft bought in August. The business lost $228 million on the quarter.

"Investors look at this because this is where we expect a lot of the longer-term growth come from," said Andy Miedler, an Edward Jones analyst. He said Microsoft's pursuit of Yahoo may be a distraction, particularly to this part of the company.

But Microsoft is also committed to investing heavily in developing online services, such as Internet search and the data centers that power them, resulting in short-term losses.

While analysts were pleased the Entertainment and Devices Division increased sales 68 percent to $1.58 billion, they noted that selling Xbox 360 consoles and games has a much thinner profit margin — the division had operating income of $89 million — than Microsoft's traditional software businesses.

"You don't make any money on it," Thill said.

Benjamin J. Romano: 206-464-2149 or bromano@seattletimes.com