Xbox marks the spot for Microsoft

Microsoft reported a drop in profit for its fiscal second quarter Thursday, but sales and earnings beat analyst expectations thanks to strong sales of its Xbox 360 game console during the holidays.

The company reported record quarterly revenues of $12.54 billion, up 6 percent from a year ago and ahead of the $12.09 billion expected by analysts.

The stock rose about 1.9 percent in after-hours electronic trade.

"Revenue looked pretty good," said Rich Williams, analyst with ICAP. "We already knew Xbox sold well over the holidays, and we knew they lose money on every one sold, so that wasn't a huge plus. But the deferred revenue they reported was much higher than expected at $1.64 billion - very strong."

The Redmond, Washington-based software company reported earnings of 26 cents per share, compared to the 23 cents per share expected by analysts polled by Thomson Financial. A year ago, the company earned 34 cents per share in the second quarter.

The main reason for the earnings decline was due to a program that will help customers transition to its new operating system, Vista, which Microsoft is depending on to drive growth in 2007 and in the years ahead. The scheduled date for worldwide release of Vista is January 30.

In October, Microsoft said it would offer coupons allowing customers buying a PC that runs Windows XP in the next few months to upgrade to Windows Vista once it becomes available. The company deferred $1.64 billion of revenue in the quarter due to the program.

Williams said the coupon program was a concern because it could take away from future demand for the operating system. He said the program could possibly be behind the company's decision to lower its outlook for the current quarter.

He said investors would be looking to Microsoft for crucial reads on sales of Vista and its Office software suite.

"If you go back a decade to Windows 95, the release was positive for revenue," said Microsoft CFO Chris Liddell on the earnings call. "But it was also a gradual growth. We are pleased, though, that our tech guarantee appeared to avoid any stalling of Windows XP sales in the last quarter."

He said the company had seen "encouraging signs of early demand for Office, Exchange Server 2007 and Vista."

Software was a strength for the company this quarter.

"The results show that customers are clearly ordering and and pre-ordering new software," said Walter Pritchard of Cowen and Company. "Their SQL [database] software performed really well - the strongest of their major products. Even Windows sales were strong, despite it being the quarter before Vista's release."

The server and tools division, which develops software for business databases and networks, showed strong growth - up 17 percent from the year-ago quarter to $2.85 billion.

As for its outlook, Microsoft narrowed its earnings target for this fiscal year, which ends in June. It said it expects income of between $19.3 billion and $19.7 billion, up from an estimate of $19.1 billion to $19.5 billion given in October 2006.

The company also narrowed its revenue outlook for the fiscal year. It said it now expects revenue of $50.2 billion to $50.7 billion, compared to an earlier projection of $50.0 billion to $50.9 billion.

The company's Xbox 360 gaming system proved to be a big seller during the crucial holiday season, and sales in the company's entertainment and devices division jumped 76 percent from the year-ago period. That division is now much more important to the company as a revenue driver - it makes up 24 percent of sales compared to 14 percent a year ago.

Pritchard said Microsoft's decision to lower guidance for Xbox unit sales raised some alarm with analysts.

"The quarter's numbers are pretty good, but Microsoft clouded the picture by lowering guidance for next quarter," he said. "We're not sure whether they did it because of the outlook of the business in general, or something else. It's not clear yet."

Shares of Microsoft (Charts) closed down 2.1 percent to $30.45 on Nasdaq Thursday.

Analysts quoted in this story do not owns shares of the companies mentioned and their firms have no investment banking ties with the companies.

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