Color On Quarter: Microsoft (NASDAQ:MSFT)

Plenty of firms commenting Microsoft (NASDAQ:MSFT) after the software giant reported its result last night.

- Merril Lynch says bears likely to focus on weaknesses in Xbox and Online. Xbox 360 met Q2 expectations of 4.4mn consoles, but lowered H2 guidance to 1.6mn consoles versus 2.6-4.6mn. In firm's view, this was likely done to balance retail supply with demand. Lower shipments could boost EPS in the short-term. Online was impacted by the transition to AdCentre, and will take time to work out.

Firm says Vista - core to FY07 investment thesis - is working. Client growth in Q2 of 9% y/y (adjusted for coupon program) was in-line with PC growth of 8-10%, indicating that Microsoft's SKU strategy is benefiting ASP's. Microsoft raised guidance for full-year Client revenue from 9-10% to 11-12% due to an expected full-year premium mix of 60%. In firm's view, a higher mix and good uptake of Vista could result in $800mn-$1bn revenue upside on an annual basis.

According to the firm, overhang for FY08 will be margin leverage. Management likely to talk about this on 2/15/07 meeting with investors in NY and on 3Q07 earnings call. Firm's view is that Microsoft is unlikely to make significant investments that would dilute margins. In a worst case scenario, MSFT could double or even triple Online opex of $400mn and keep margins flat because one-time launch expenses for Vista and Office will go away by the end of FY07. They think there could be upside of $0.10-0.15 to FY08 consensus EPS of $1.67, both from incremental Vista and Office 2007 revenue and lower opex.

- First Albany outlining positives and negatives:

Positives: 1) MSFT exceeded both revenue and EPS consensus estimates; 2) management indicated that December sales demonstrated encouraging signs of early adopter demand for Windows Vista, Office 2007, and Exchange Server 2007; 3) bookings grew 21% Y/Y, matching a multiyear high ; 4) Xbox 360 attach rates remain at record levels, while "Gears of War" sold >2.7M units within its first 8 weeks of release; 5) MSFT raised its premium mix expectations for 2H:07 to 60% from its previous estimate of 52%-54%; 6) SQL Server database grew >30% despite a tough comparison.

Negatives: 1) despite strong Entertainment (Xbox) results, MSFT reduced Entertainment guidance, probably reflecting a drive toward lower inventory levels; 2) despite a return to growth in Online Services (MSN), MSFT reduced guidance for Online Services, citing a slower expected growth rate in search queries and page views.

- JP Morgan notes that unearned came in at $11.9B in line with our target and ahead of cons. at $11.5B--and is a key positive data point on early Office traction as well as the burgeoning Client enterprise upgrade cycle. Along this line, Client unearned increased 35%+ YoY net undelivered elements and tech guarantee impact.

Q3 guidance of $13.7-14B/$0.45-0.46 is modestly below firm's $14B/ $0.45 est. and reflects higher deferrals, but they expected MSFT would be conservative. Q3 includes launch costs for Vista which will be largely one time in nature--and firm believes the co. is being cautious around early Vista and Office activity. They also believe that the EandD target of (15%)-(25%) YoY could prove to be too low.

MSFT has taken some of the upside off the table by raising guidance for Vista premium mix to 60%, raising Client rev. growth targets to 11-12% from 9-10% and reflecting some of the Office bookings strength by raising MBD targets to 10-11% growth from 8-9%. However, firm still believes 1) there is further upside in SandT on the SQL cycle, 2) MBD guidance reflects little ASP improvement which we should see, and 3) the Vista enterprise upgrade cycle could surprise.

Notablecalls: In otherwise strong results/guidance, Xbox guidance cut was the only negative surprise. However, I don't think this will be enough to spoil the party.