What Happens if Microsoft Warns?

UBS analyst Heather Bellini has raised the red flag, so to speak, over Microsoft's 2009 fiscal second quarter, according to a Friday report from Bloomberg. Could Microsoft really miss its forecast, as she warns? I'm not yet convinced, although the economic climate is even stormier than when Microsoft gave second quarter guidance in late October. It's too close to call, for now.

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For fiscal 2009 second quarter, Microsoft had predicted revenue between $17.3 billion and $17.8 billion, operating income between $6.1 billion to $6.4 billion and 51 cents to 53 cents earnings per share. Heather doesn't buy it. She expects $16.7 billion revenue and 48 cents earnings per share.

For fiscal 2009, Microsoft forecasted revenue between $64.9 billion and $66.4 billion, operating income between $24.4 billion and $25.5 billion and earnings per share between $2.00 and $2.10. In July, Microsoft forecast fiscal 2009 revenue between $67.3 billion and $68.1 billion, operating income between $26.3 billion and $26.9 billion and earnings per share between $2.12 and $2.18. Microsoft reduced guidance ahead because of global economic uncertainty.

For anyone trying to call Microsoft earnings, I've put together mitigating factors that are sure to affect fiscal second quarter, which ends on Dec. 31.

Annuity contracts. The 2000 recession was devastating to high-tech companies:

• The dot-com stock bubble had collapsed.
• Enterprises had just come off a big PC replacement cycle for the so-called Year 2000 crisis; many weren't buying.
• ISP discounts lead to a huge surge in consumer PC sales earlier in the year that later led to sales collapse when recession hit.
• Just about every high-tech company struggled to meet sales goals.

Microsoft applied lessons learned from the 2000 recession to software sales. In 2001, Microsoft positioned future revenue for predictability. In May, the company announced changes that would later eliminate off-the-shelf upgrades and commit many business customers to two- or three-year annuity contracts for future discounts. Today, about 40 percent of Microsoft revenue comes from volume licensing sales. For those sales with annuity contracts, Microsoft has cash in the bank. The company accounts for annuity contracts as unearned revenue, which is realized on an ongoing basis.

Microsoft ended its fiscal first quarter with $13.5 billion in unearned revenue, $13 billion of it unbilled. Microsoft typically realizes about 25 percent of each quarter's revenue from its unearned stash. Microsoft has cushion in 2008 it didn't in 2000. A Microsoft profit warning would be a chilling oracle of doom for companies that sell or service PC hardware and software. If Microsoft warns, the larger sales situation for other software developers and the company's partners will be worse than dire.

PC sales. Windows isn't the cash generator that it once was. Microsoft's client division is still hugely important, but Business and Server and Tools divisions are conjoined and together pull in an increasing share of revenue and profits. Their combined fiscal first quarter revenue was $9.15 billion, or about 61 percent of Microsoft total revenue. These two divisions also sell the most software through volume licensing and supporting "Software Assurance" annuity contracts. Many businesses can upgrade to Office 2007 without purchasing new hardware; same can be said of much Microsoft server software.

But the office-server combination can only take Microsoft so far. Even with a 4 percent year-over-year decline in fiscal second quarter, the Client division generated the most income ($3.67 billion) of any Microsoft business group. The question everybody is asking: What about calendar fourth quarter? Some people will say that earnings warnings from Dell and Intel forebode trouble. But I'm not convinced their problems are going to be Microsoft's. My reasoning:

• Microsoft is more like HP than Dell or Intel. HP performed well during third calendar quarter and, so far, has stuck to fourth-quarter guidance. HP and Microsoft have huge global reach and sell to and service customers through well-established and far reaching partner channels. Dell sells direct with some retail, and is largely contained to the United States. Intel sells ODMs and OEMs, which are highly likely to cut back orders early to avoid building up too much channel inventory. In a recession, too few is better than too many.
• In October, Microsoft CFO Chris Liddell said that sales took a dramatic downturn around Sept. 15. More than 80 percent of Client revenue comes from license sales to OEMs. Presumably, most OEMs already had placed their holiday orders by mid-September. I see more risk to Microsoft's fiscal third quarter than its second. OEMs surely have curtailed future orders—Intel's warning is evidence enough—but nominally for second quarter.
• Worldwide PC forecasts from Microsoft and industry analysts remain in the high single digits to low double digits, despite global economic turmoil. Year over year, United States will likely be flat, perhaps at best, but growth was still strong in emerging markets as recently as late October. Even with the tough economic climate, in October Microsoft predicted worldwide PC growth of 8 percent to 12 percent during fiscal 2009, which ends June 30.

I'm not expecting great results from the Client group, but not dismal either.

IT spending. It's down but not out. In mid-November, IDC revised its 2009 forecast for IT spending, after the bottom fell out of financial markets. IDC predicted worldwide spending to increase 2.9 percent year over year; previously, IDC forecast 5.2 percent. For the United States, 0.9 percent growth, down from an earlier forecast of 4.2 percent.

Fourth quarter is the more immediate concern, and I'm not hopeful about the United States where 533,000 jobs were lost last month—the largest number since December 1974. Factors affecting spending on Microsoft software:

• Companies laying off or closing down won't be buying new software licenses. If anything, they'll be looking to redistribute existing licenses rather than acquire new ones.
• It has been said that no one gets fired for buying Microsoft. Not so, during economic crisis when the person making the purchasing decision might be laid off next week. The "if it ain't broke, don't fix it" axiom will be the operating mandate for many IT organizations.
• The economic atomic bomb set off in the United States during the last weeks of September didn't spread fallout to global markets until early fourth quarter. Microsoft bookings may have continued well into the quarter, particularly in emerging markets.

IT spending is tracking downward for second half of Microsoft's fiscal year. If new billings are down now, what matters: When and how much the buying stopped during fourth quarter.

Credit crunch. While not widely publicized, credit problems have worsened in the last couple weeks. The spreading fallout is poised to do far more damage late-quarter than anything seen earlier. The worst credit problems had largely been contained to financial institutions, which wouldn't lend to each other and so not as much to businesses and particularly consumers. The new problem isn't borrowing but debt. Beleaguered banks are finally passing their pain onto consumers and small businesses. The pain is coming now, in November credit card statements.

Minimum payments are ballooning as some banks increase interest rates and others raise the percentage of minimum payments. A friend of mine saw his interest rate from a large and reputable national bank jump to nearly 32 percent. For many consumers and small businesses, the bad news hit their mailboxes just as the Christmas shopping season kicked off.

Most people don't give Office for Christmas, but home-based or small businesses will buy anytime. I expect these segments to curtail spending as ballooning credit payments sap profits. Consumers planning PC purchases might buy something cheaper, like a new smartphone or music player. Microsoft should see nominal impact from lower PC sales in the current quarter; more in next quarter, if too much inventory sits unsold after the holidays some OEMs would acquire fewer licenses.

Something else: Hard times mean more people will steal. Casual piracy rates are sure to eke up, as consumers and small businesses make do with less. Microsoft product activation can prevent multiple PC installations of software, but not piracy across channels, such as OEM Windows versions purchased in the aftermarket or small businesses buying Office Home and Student (Yes, even without Outlook). In these hard times, every product stolen is a lost desperately needed sale.

Conservative guidance. Chris Liddell offered muted guidance nearly a month after U.S. stocks started a period of protracted collapse and consumers and businesses pulled back spending. Microsoft tends to be more conservative than ambitious in its financial guidance. I believe that Chris left room in the model for worsening conditions. Microsoft's divisional growth guidance for fiscal second quarter:

• Client, 7-10 percent
• Server and Tools, 16-17 percent
• Business, 7-8 percent
• Online Services, 6-10 percent
• Entertainment and Devices, -5 to 1 percent

That said, conditions have worsened rather than gotten better since Microsoft offered guidance on Oct. 23. Widespread layoffs and the potential for them is causing fear among many businesses. Some IT managers would rather risk getting fired for doing nothing than spending on new technologies that looks like greater risk to the job.

Microsoft has yet to announce layoffs, which raises the question, "why?" One answer: There is no need to cut heads, to make the quarter. Another: Microsoft doesn't want to lay off among its more than 90,000 employees. Layoffs are the tried-and-true approach for cutting expenses to meet quarterly goals. If there's a Microsoft canary in the mine, layoffs will be it. That's assuming Microsoft puts shareholders before employees.

Is Heather Bellini right? You tell me? Has your company stopped or curtailed buying new Microsoft licenses since Sept. 30? Please respond in comments or by e-mail.

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