Investors Pummel Microsoft; IBM Impresses

Despite strong sales of Vista, an unexpected boost in spending on online operations sent Microsoft's stock reeling in after-hours trading

Just as Microsoft allayed one set of fears with its fourth-quarter earnings results on July 17, it inflamed a new one. Wall Street headed into the report fretting that Microsoft might turn in a second straight quarter of lackluster demand for its flagship operating system software. The software giant put those concerns to rest with better-than-expected sales of Microsoft Vista. But unexpected new investment in online operations, coupled with increased costs that led Microsoft to miss its earnings target, pummeled the stock.

Redmond (Wash.)-based Microsoft (MSFT) said earnings in the period ending in June rose to 46¢ a share, falling short of its forecast by a penny. The company then reduced forecasts for 2009 earnings, in part because of plans to increase operating expenses by $500 million. Microsoft has earmarked most of that money for its online efforts. Analysts say the investment is needed, but remain dissatisfied with results of spending to date. "They've already had a lot of money built in" to capital spending plans, says Charles J. Di Bona, an analyst with Sanford C. Bernstein. "How much more can they spend?"

Microsoft has never laid out expectations for its online unit to become profitable, and Chief Financial Officer Christopher Liddell declined to do so on a conference call with analysts, investors, and the media. "It is going to be a heavy investment area," Liddell said. "I can't promise you that you'll see a massive turnaround in the short term."

IBM Wows Analysts

Liddell will probably be pressed on the issue again at Microsoft's meeting with financial analysts on July 24, where edgy analysts and investors are likely to reiterate surprise over the spending boost. Even as the company has pumped billions into the business, rival Google (GOOG) has run away with the lion's share of online advertising profits.

Liddell justified the new investments, arguing that analysts project the market to be worth $80 billion by 2012. Di Bona says that's not a good enough argument anymore. "Tell me how Microsoft makes money from these investments," the analyst says. "Show me the money."

Fourth-quarter earnings were eroded as higher-than-expected sales in the company's consulting business and Xbox division lifted expenses. What's more, Microsoft hired more workers than planned, also boosting costs.

The company also shaved a penny a share off its previous guidance for fiscal 2009, saying that earnings per share would come in between $2.12 and $2.18 a share. That's largely tied to the new online spending, and not expenses run amok, Liddell says. "I'm comfortable that there's not any lack of control in spending," Liddell said.

Nonetheless, Wall Street pounded Microsoft in after-hours trading. Shares fell about 6%, to 25.88, after rising 26¢, to 27.52, in regular trading.

In contrast to Microsoft's miss, IBM (IBM) on July 17 announced financial results that led Citigroup (C) analyst Richard Gardner to say during the company's conference call: "It's hard to find anything to question." IBM's revenues rose 13% to $26.8 billion and its per-share earnings rose 28% to $1.98. "These are truly powerful results," IBM Chief Financial Officer Mark Loughridge said on his company's conference call with analysts. "We performed better than ever." He raised the company's EPS estimate for the year by 25¢ to $8.75—which would be a 22% increase.

IBM's performance in the financial sector shows why it's doing well overall. Revenues there rose by 15%. "That's awesome, especially in light of the general woes in that business," says analyst Robert Djurdevic of Annex Research. IBM has just the right mix of high-end computers and services that struggling companies need to quickly cut costs. Mainframe computers are more energy efficient than PC servers, and thousands of applications can be run on a single mainframe—simplifying computing systems so fewer administrators are needed and there's less to go wrong.

Stellar Server Business

Not all the news from Microsoft left analysts dismayed. Perhaps the biggest bright spot for Microsoft came from Windows Vista sales, which came in weak in the previous quarter. The operating system has been widely panned as buggy and for being a memory hog, and some corporations have said they intend to skip deploying Vista and wait for the next version of Windows expected in 2010 (, 4/25/08). But strong PC sales—that Microsoft estimated to have grown 12% to 14% in the quarter—buoyed the company's so-called Client Div. There, sales grew 15%, to $4.4 billion, up from the roughly 10% growth analysts had projected.

For the quarter, Microsoft posted operating income of $5.7 billion, a 42% gain, on sales of $15.8 billion, up 18%. For the year, the company reported operating income of $22.5 billion, up 21%, on sales of $60.4 billion, an 18% jump. That's Microsoft's largest annual sales increase since 1999.

In addition to the strong Vista numbers, the software giant continues to post stellar results in its server software business. Fourth-quarter sales at its Server & Tools Div. grew 21%, to $3.7 billion, while operating income climbed 39%, to $1.4 billion. And revenue from the company's Business Div., comprised largely of sales from its Office word processing and spreadsheet franchise, grew 14% in the quarter, to $5.3 billion. The division's operating income climbed 12%. While Microsoft lost money in its Entertainment & Devices Div., home to the Xbox video game business, it posted its first-ever profitable year, with $426 million in operating income.

Yahoo Courtship

Microsoft doesn't expect the sort of sales growth it posted in fiscal 2008 to carry into the current fiscal year. The company said first-quarter sales should come in between $14.7 billion and $14.9 billion, a roughly 7% gain, with operating income between $5.9 billion to $6 billion, up about 1%. Microsoft expects economic conditions to improve in the second half of the fiscal year. Its guidance for fiscal 2009 calls for sales between $67.3 billion and $68.1 billion, up about 12%, with operating income between $26.3 billion and $26.9 billion, up roughly 18%.

Liddell declined to take questions on Microsoft's on-again, off-again courtship of online rival Yahoo (YHOO). But he reiterated previous Microsoft statements that the company continues to be interested in acquiring Yahoo's search business. And contrary to a Yahoo statement, Liddell said that Microsoft's proposal never called for a change in Yahoo's governance (, 7/14/08). That's yet another area where Liddell and other Microsoft executives should expect a grilling from analysts next week.

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