Xbox marks the sore spot
Microsoft's lower-than-expected earnings are due in part to the cost of making the gaming console, and more research expenses could hurt future results.
By Amanda Cantrell, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) - The Xbox giveth, and the Xbox taketh away.

Microsoft (Research) on Thursday reported a quarterly profit increase of 16 percent and a sales gain of 13 percent on strong sales of its Xbox 360 gaming console and business software, but its earnings and sales fell short of Wall Street analysts' expectations and it revealed that its expected operating income for the coming fiscal year will be about $2 billion shy of what analysts had estimated.

Microsoft's stock tumbled more than 8 percent in pre-market trading.

Despite the strong top line growth, the company said its cost of revenue rose 49 percent, due largely to strong Xbox 360 sales and the costs associated with producing each gaming console. Microsoft still loses money on each Xbox it sells.

Microsoft's chief financial officer Chris Liddell blamed the difference on rising costs that will continue to climb, in part because of a strategic decision to ship as many Xboxes as it can now in order to build its user base and take advantage of rival Sony's decision to delay the latest version of its PlayStation console. The company had trouble meeting demand for the Xbox 360 when it launched last year.

Liddell said the company will also increase its costs, including spending more on research and development, marketing for new products and investment in its MSN Internet division.

"We have decided to aggressively invest next year in a number of areas, and (costs) do add up," said Liddell.

But analysts listening to the quarterly conference call were sharply critical of the cost increases.

"It was shocking," said Brendan Barnicle, an analyst with Pacific Crest Securities. "They gave this guidance, but the stock didn't go down much right away because no one believed it could be that far off. The expenses are wildly higher than anyone had expected."

One analyst on the call said that it looked as if Microsoft may be "building a Google or a Yahoo!" within the company.

Liddell responded that the company is not building a "Trojan horse" inside the company.

"I would characterize this as being a broad based approach across multiple fronts," he said.

Microsoft also issued a weaker than expected forecast for the current quarter, and shares slid 6.4 percent in after-hours trading. The No. 1 software maker's net income rose to $2.98 billion from $2.56 billion a year earlier.

The company said it expects earnings of 30 cents a share for the current quarter, well below analysts' expectations of 34 cents a share. The company expects sales in the range of $11.5 billion to $11.7 billion. The mid point of that range is in line with analyst expectations.

Microsoft posted net income per share of 29 cents, including a charge for legal expenses, up from 23 cents in the year-earlier quarter, which included a 5 cent legal charge. The company's operating earnings of 31 cents per share fell short of Wall Street analyst expectations of 33 cents a share.

The company reported sales of $10.9 billion, just short of Wall Street analysts' forecasts of $11 billion, but up from $9.6 billion in the year-earlier quarter.

"They kind of blew this quarter, but their outlook is still good," said Toan Tran, equity strategist at Morningstar.

"Obviously it is a disappointment for the quarter," said Mike Morcos, a portfolio manager at Old Second National Bank, whose firm owns shares of Microsoft. "The next quarter may be a little challenging as well, as consumers wait for new software to come out. But I think that going out a few quarters, Microsoft is going to look very attractively priced. It has a lot of revenue and earnings drivers that will finally move the stock out of the range it's in."

A vista to 2007

Analysts and investors have been hoping the launch of the company's newest operating system, Windows Vista, and the newest version of its Microsoft Office software will be the catalyst that finally perks up Microsoft's stock, which has been stuck in a rut for more than three years. Vista is expected to hit the shelves for business users later this year. During the third quarter, Microsoft announced it is delaying the launch of Vista for consumers until 2007.

Strong sales of its server software contributed to the sales gains, along with the Xbox. Sales in the company's server division grew 21 percent in the quarter, while revenue in the home entertainment division, which makes Xboxes, grew 80 percent. Microsoft shipped 1.7 million Xboxes in the quarter.

Microsoft also gave its first forecast for the coming year, saying it expects sales for fiscal 2007 in the range of $49.5 billion to $50.5 billion and earnings per share in the range of $1.36 to $1.41. While the sales forecast is upbeat - analysts had been expecting $49.5 billion - the earnings forecast falls well below analysts' expectations of $1.53 per share.

"We are now accelerating our investments in the business to drive future growth, which is reflected in our financial guidance," said Liddell in a statement. "We believe next fiscal year will deliver even stronger double-digit (percentage) revenue growth than this year."

He announced the company accelerated its buyback program, buying $4.9 billion in stock during the quarter.

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Barnicle does not own shares of Microsoft, and his firm does not do banking business with the company. Tran does not own shares of Microsoft, and his firm does not do investment banking. Top of page

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.