Legal Charges Hit Microsoft’s Q3 Profit

UPDATED: Bills from Microsoft’s recent settlements hit the world’s largest software company’s bottom line during its third fiscal quarter as profits tumbled close to 39 percent from the same time last year.

But overall, sales were strong, as Microsoft benefited from an unexpected surge in computer sales.

For the quarter that ended March 31, 2004, Microsoft’s net income was $1.31 billion (12 cents per share), a drop of 38.8 percent from its profit of $2.14 billion (20 cents per share), in the same time last year.

Revenue rose by 17 percent to $9.18 billion, largely due to ongoing strength in computer sales.

“Our results this quarter demonstrate that we are in the midst of a
corporate recovery,” Microsoft CFO John Connors told analysts during a conference call,
adding that consumer spending on PCs is expected to slow. The company is
looking for an overall growth rate of 10 percent in PC sales across sectors.

The 17 percent year-over-year increase in revenue cheered analysts, but
the number fell short of last quarter, when the company took in a whopping
$10.15 billion, even as its operating income took a $2.17 billion hit from
the cost of a change in stock compensation.

This year’s costs included stock- based compensation expense of $748
million and legal charges of $2.53 billion (pre-tax) for
its settlement with Sun Microsystems and the EU’s $590
million fine.

Next quarter, revenue will be worse, the company said — although its
expected $8.9 to $9 billion isn’t bubkis by any means. Operating income is
expected to be in the range of $2.8 billion and $2.9 billion, including
stock-based compensation expenses of approximately $750 million, which will knock 5 cents off earnings per share.

“This company continues to exhibit that its growth is slowing,” Melanie
Hollands, president of hedge fund Koala Capital, told “Revenues are weaker on both a year-over-year and
a sequential basis. It also seems that next quarter revenues could be
sequentially weaker, if current guidance is any indication.”

But there was plenty of good news in the earnings release. Sales were up, with
the Client, Information Worker and Server and Tools businesses growing a
combined 17 percent; Servers and Tools grew 19 percent.

The company said that worldwide retail license sales of Office 2003 since its launch in October 2003 were double those of Office XP over the same timeframe.

MSN reported another profitable quarter, with revenue growth of 16
percent over last year, thanks to ad sales, which grew 43 percent last

Making lemonade out of lemons, Connors said the majority of
users who have not upgraded to Windows XP or Windows Server 2003 represent a
great opportunity. While not commenting directly on the mysterious XP
Reloaded, largely viewed as an interim release of Windows because of delays in Longhorn, the next version, Connors called it “an incredible opportunity to get consumers to
understand the value of XP, from the improved security and digital media and
entertainment perspectives.”

Microsoft’s aggressive push for XP this year
and the beginning of 2005 will be reflected in the company’s numbers, he

Connors surprised analysts on the conference call with a look at the 2005
picture. Revenue is expected to be between $37.8 billion and $38.2 billion,
with operating income of $15.9 billion and $16.3 billion, and diluted
earnings per share ranging from $1.16 to $1.18, including stock-based
compensation expense of approximately $0.15.

According to Connors, while its guidance to analysts is that operating
income will be flat this year and next, the company expects a 2 percent
improvement in its operating margins. “While 2005 has tough revenue
comparables,” he said, “our absolute results should be quite good.”

Connors refused to divulge details of Microsoft’s plans for its huge cash
surplus, leaving the discussion for the July analyst meeting. Investors have
been calling for a larger dividend to no avail.

“There’s just no excuse for ‘lazy’ balance sheet cash like this,” said
Hollands, “particularly considering the low percentage returns this cash has
been generating during the last couple of years.” However, she told, “should the company choose to increase its dividend
again, it would be yet another admission that it is now a value, not a
growth company.”

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