Microsoft Results Turn Heads

Despite reliable growth, Microsoft's unsexy stock has often failed to attract jaded investors. Its spectacular first-quarter earnings have changed that

For the last several years, Microsoft (MSFT) has made good on a promise to beat the "law of large numbers," posting consistent double-digit revenue gains even as annual sales topped $50 billion. Shareholders, though, largely yawned and the stock drifted sideways. But with its fiscal first-quarter results reported Oct. 25, Microsoft finally has their attention.

The software giant posted its fastest first-quarter revenue growth since 1999 and saw its stock soar in after-hours trading to its highest levels in five years. Revenue climbed 27%, to $13.8 billion, while operating income increased 32%, to $5.9 billion. PC purchases that exceeded expectations and record-breaking sales of the Halo 3 video game fueled results that beat analyst revenue expectations by roughly $1 billion.

Revised Expectations—Upward

What's more, Microsoft increased its guidance for the rest of the fiscal year. The company now expects to generate $58.8 billion to $59.7 billion in annual sales, up from the $56.8 billion to $57.8 billion range Microsoft projected just a quarter ago (, 7/19/07). And operating income for the fiscal year ending next June 30 should fall between $23.3 billion and $23.7 billion, up from the July guidance of $22.2 billion to $22.7 billion.

Chief Financial Officer Chris Liddell said during a conference call with analysts, investors, and journalists that only 1 point of the 4% jump in revenue guidance will come from aQuantive, the online advertising firm Microsoft bought for $5.9 billion during the quarter (, 5/18/07). The remainder will come from better-than-expected performance from Microsoft's key businesses.

That helped push Microsoft shares to levels last seen in 2002. In aftermarket trading, Microsoft stock hit $35.58, up from $31.99 before the earnings announcement. For the last few years, several analysts have told clients that Microsoft could hit such numbers, only to see the stock fall short. They've argued that the company's financial fundamentals have been strong, but investors shied away as the company remained an also-ran in key emerging markets such as Web advertising and digital music. "The only reason this thing has been trading where it has is because of the bad psychology," says Charles Di Bona, an analyst with Sanford C. Bernstein & Co., who has a price target for the stock at $37. "Maybe this is the catalyst where people start to take notice and stop being bored with the stock."

Companywide Growth

Each of the company's five business divisions showed double-digit revenue growth. That was particularly important in the Client Div., the group where Microsoft counts Windows sales. There, revenue jumped 25%, to $4.1 billion, an astonishing gain for a mature market. Microsoft estimates that PC sales grew 14% to 16% in the quarter. The larger revenue gains came as consumers went for the pricier, premium version of Windows Vista.

Microsoft's Entertainment & Device Div. got a huge bump from the Sept. 25 release of Halo 3. Microsoft rang up $330 million in sales of the game in the final week of the quarter. But Halo 3 sales, coupled with a price cut on the Xbox 360 console, also spurred sales of the console, so much so that it outsold the wildly popular Nintendo (NTDOY) Wii console during the month, according to market researcher NPD Group. Microsoft sold 1.8 million Xbox 360 consoles in the quarter, twice as many as a year ago. The division's sales went up a stunning 91%, to $1.9 billion, in the quarter.

Online Revenues Not as High

The only blemish in the quarter came from the company's Online Services Business Div., whose 25% revenue gain, to $671 million, came largely from the acquisition of aQuantive. Without aQuantive, the group's revenue would have climbed a paltry 10% in a market that's growing significantly faster. "We think it's acceptable," Liddell said. "It's not stellar. We'd like to see it higher." Microsoft expects its $240 million stake in social network Facebook (, 10/24/07) will do just that by boosting online ad revenue for the division.

Liddell pointed out that the group remains focused on building the Web business and is not yet at a point where the company expects it to turn a profit. "That isn't one of the primary drivers for the business," Liddell said.

Investors didn't even flinch at the online business numbers. And that may just be the thing that ends the long fallow period for Microsoft's stock.

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