Earnings Preview: Microsoft (MSFT)

Microsoft Corporation (MSFT) will report fourth quarter results on July 22, 2010. We expect the company to gain from strong business fundamentals, although growth will be tempered by currency issues related to the ongoing European crisis.

Third Quarter Highlights

Microsoft’s third quarter earnings beat the Zacks Consensus by 3 cents on revenues that were more or less in line. Management mentioned increasing demand from both consumer and enterprise segments, with the small and medium business segments returning.

Overall margins continued to respond positively to recent restructuring actions that have lowered the cost structure. As a result, earnings came in at 45 cents a share, or 7.14% over the Zacks Consensus estimate. Despite the seasonal softness, it was another record cash flow quarter for Microsoft.

Management did not provide guidance, as is normal for Microsoft. Analysts also did not alter expectations for the upcoming quarter, following the earnings release.

Agreement of Analysts

However, there have been a few revisions over the past 30 days. While analysts largely agreed on the company’s performance in the current quarter, 5 analysts nudged up their estimates for the June quarter and fiscal year 2010, with little impact on average expectations. We see just one downward revision for the June quarter and 2 for fiscal 2010. However, the fiscal 2011 story looks different, with 3 analysts lowering estimates for the year and 3 moving in the opposite direction.

Magnitude of Estimate Revisions

Over the same 30-day period, there have been no changes to the average estimate for the June or September quarters, while the estimates for fiscal years 2010 and 2011 have both gone up by a penny.

We expect Microsoft to report another strong quarter. However, a study of the pros and cons of investment in Microsoft shares seems in order at this point.

Pros – The many positive catalysts as stated by analysts include the continued adoption of Windows 7 at consumer and enterprise customers, recent optimism of market research firms IDC and Gartner regarding PC shipments and continued technology deployment at data centers. Microsoft is expected to be a major beneficiary of cloud computing adoption and new product cycles are expected to drive robust growth going forward.

Cons – The major risk facing the company is currency-related. With such a large market share, Microsoft will very likely be impacted by the economic crisis in Europe. This has prompted the few downward revisions.

Our Recommendation

While we concede that currency-related risks remain, we are optimistic about the macro trends that should remain positive for the company. We believe the currency problem is a near-term issue and will not be sufficient to override the strength in underlying demand.

Additionally, we note that the company has a history of positive earnings surprises, with the four-quarter average beat at 19.2%. Therefore, another beat this quarter cannot be ruled out, although we expect it to be small going by the trend.

The increased caution regarding the European crisis has pushed the Zacks Rank to #3, which translates into a short-term Hold recommendation. However, our long-term Outperform view remains intact as of now and we continue to believe that longer-term investors would gain from accumulating the shares.

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