Earnings Show Microsoft Needs Yahoo

Lackluster quarterly results reinforce the software maker's need for growth through acquisitions and suggest it ought to raise a rebuffed takeover bid
Microsoft CEO Steve Ballmer speaks at a press conference on Mar. 3, 2008, in Hanover, Germany Sean Gallup/Getty Images

During a speech in Milan Apr. 23, Microsoft CEO Steve Ballmer said he's prepared to walk away from the company's takeover offer for Yahoo!, which has rebuffed the advances. Not so fast, Microsoft. Quarterly results reported the following day reinforce why Microsoft (MSFT) could use the growth Yahoo (YHOO) would provide.

Microsoft posted an 11% drop in profit and flat sales for the quarter ended Mar. 31. Microsoft relied on overseas operations and sales from smaller divisions to offset weakness in its flagship PC products. "It wasn't a spectacular quarter by any means," says Brent Thill, director of software research at Citigroup (C).

Profit Declines, Revenue Flat

Sales had been unusually high a year earlier, when Microsoft booked $1.6 billion in revenue from previously sold coupons for its new Windows Vista operating system and a new version of its Office productivity suite. Fiscal third-quarter profit fell to $4.41 billion, or 47¢ a share, from $4.93 billion, or 50¢ a share. Revenue was little changed at $14.45 billion, according to results released after the close of trading on Apr. 24. Analysts had expected per-share earnings of 44¢ on sales of $14.49 billion.

Excluding the benefit from the coupons, third-quarter sales would have risen 14%, Microsoft said. And the results would have been even worse if not for a 68% increase in sales in the company's Xbox division, a strong performance from the group that makes corporate server software, and the strength of Microsoft's international business, which accounts for 60% of sales.

Equally troublesome, Microsoft said this quarter's per-share profit would be 45¢ to 48¢, compared with a Wall Street consensus estimate of 48¢, says Charles Di Bona, a senior equity analyst at Sanford C. Bernstein. The earnings follow two quarters of strong gains in sales and profits.

Economic and Competitive Worries

Chief Financial Officer Chris Liddell, during an Apr. 24 conference call with investors, said Microsoft's diverse range of markets and products have kept its business healthy amid a weakening U.S. economy. Still, the results raised concern about the company's ability to continue weathering the slump, especially in light of rising competition from Google (GOOG), which controls the market for ads pegged to online searches, and is encroaching into Microsoft's markets with online software for e-mail, productivity, and other applications. What's more, investors took the results as a sign Microsoft isn't selling copies of Windows Vista as fast as the PC market is growing, and sold Microsoft shares in extended trading. The stock fell $1.58, or about 5%, after closing the day up 35¢, or about 1%, at 31.80.

Microsoft went public with a $31-a-share takeover bid for Yahoo Feb. 1 to try to close the gap with Google. But it has been unable to negotiate a deal and has threatened to take its appeal directly to shareholders if Yahoo doesn't capitulate by Apr. 26. Citigroup's Thill says Microsoft could raise its offer by $1 or $2 per share to close the deal, but adds Yahoo is holding out for perhaps $5 to $10 more. Even a combined Microsoft and Yahoo would be hard-pressed to eclipse Google in the online ad market, he says: "There's still a runaway train they're trying to catch. And they are two little trains trying to hook up."

Liddell said he's reluctant to offer more for Yahoo: "The strongest argument that we should increase our bid—simply because we can afford to—is not one that I favor." But the protracted takeover battle hasn't helped Microsoft's share price. A 30% second-quarter sales increase (BusinessWeek.com, 1/25/08) that Microsoft reported on Jan. 24 cheered investors. Since then, Microsoft shares have fallen by 4.4%, compared with a 2.7% gain for the Standard & Poor's 500-stock index.

Meanwhile, other tech-sector bellwethers have turned in upbeat reports and forecasts. Intel (INTC) shares have rallied 8.5% since Apr. 15, when the world's largest chipmaker issued a positive revenue forecast for the second quarter and predicted healthy profit margins for the year. Shares of IBM (IBM) are 3% higher after the computer concern beat expectations for first-quarter profits on Apr. 16 and raised its 2008 earnings forecast. And Apple (AAPL) shares gained 4% on Apr. 24 after the company reported a 36% increase in second-quarter profits (BusinessWeek.com, 4/24/08).

Vexing Vista Sales

Microsoft's results were hurt by slower sales of Windows Vista, introduced a little more than a year ago. Revenue in Microsoft's client division fell 24% during the quarter, to $4.03 billion. Even after accounting for the effect of the coupons last year, client revenue fell 2%. Microsoft's Chief Accounting Officer Frank Brod says the product suffered from a tough comparison to the March quarter of last year, when it launched Windows Vista. But many consumers and businesses have continued buying the older Windows XP system, and Ballmer has hinted he might extend sales past a proposed June 30 cutoff date.

The weakness in Vista sales was especially vexing given the overall strength of the PC market, analysts said. Market researcher IDC recently reported worldwide PC sales rose a stronger than usual 14.6% in the first quarter. Getting Vista and its Office 2007 suite onto as many of those machines as possible will be an engine of growth in coming quarters, and Microsoft's Brod says the sales dip was temporary.

Indeed, the 2009 fiscal year that starts on July 1 looks stronger. Microsoft said it expects $66.9 billion to $68 billion in sales, and earnings of $2.13 to $2.19 per share for the year. Analysts had expected a forecast of $66.47 billion in sales and earnings of $2.11 per share in 2009.

Compelled to Reach an Agreement?

Still, Microsoft remains weak in key areas. The online services division continues to bleed red ink. The group, which sells ads associated with Web searches and other online software, widened its loss to $228 million, compared with $171 million a year ago, though revenues grew 40%, to $843 million. Yahoo reported first-quarter sales on Apr. 22 of $1.35 billion that slightly beat Wall Street's expectations (BusinessWeek.com, 4/23/08).

Ballmer said Yahoo's results won't cause Microsoft to raise its offer. Yet the two companies may be compelled to hammer out an agreement soon. Microsoft is feeling the pressure from investors—UBS (UBS) analyst Heather Bellini wrote in an Apr. 17 research note that completing the deal is key to capturing a chunk of future online advertising revenue from Google. She noted: "Microsoft must get this acquisition right to remain relevant in the Internet age."

    Before it's here, it's on the Bloomberg Terminal.