Citing continued strength in the PC and server markets, Microsoft has reported earnings that beat Wall Street expectations and a 12 per cent increase in revenue for the first quarter of its 2005 fiscal year.

The world's largest software vendor reported net income of $2.9 billion on revenue of $9.19 billion for the three-month period ended September 30. That compares to net income of $2.61 billion and revenue of $8.22 billion in the year-earlier period, the company said in a statement.

Earnings per share including an unspecified expense for stock-based compensation amounted to $0.27, beating by $0.02 Microsoft's own July forecast and the consensus estimate of analysts polled by Thomson First Call on that basis.

The 12 per cent year-over-year revenue increase was primarily driven by sales of the Windows Server operating system and other server applications as well as Office products and Windows client operating system software, Microsoft said. Small and midmarket buyers especially led improvements in IT spending, the company said.

"We've had a strong beginning to what we expect will be a very good year," Microsoft Chief Financial Officer John Connors said in a statement.

PC shipments grow

Microsoft estimated that overall PC shipments grew 10 per cent year-over-year in the quarter, 2 percentage points more than it expected. Overall server shipments were up 16 per cent, with Windows Server shipments up 18 per cent, in line with the company's expectations.

The server software business was especially strong for Microsoft, recording 19 per cent revenue growth to $2.24 billion in the first quarter with operating income up 84 per cent to $701 million.

Other parts of the company also did well, with the MSN Internet group maintaining operational profitability and increasing revenue by 10 per cent. Microsoft Home and Entertainment, the group that includes the Xbox game console business, is still loss-making but is ramping up for the November 9 release of Halo 2, a much-anticipated video game that has received1.5 million preorders.

Unexpected decline

While Microsoft is upbeat about its sales, the company did report a larger-than-expected decline in unearned revenue, which could be an indicator that customers are not buying new multiyear software contracts that include upgrades. Unearned revenue is deferred revenue for license agreements that is recognized over the life of those agreements. The amount of unearned revenue on Microsoft's balance sheet dropped $395 million in the quarter, while Microsoft had expected a maximum drop of $300 million.

Connors, on a conference call with analysts, quickly dismissed questions about the vendor's ability to persuade customers to renew their contracts or buy new plans.

"I want to caution you not to read this as an indicator of weakness in our business during the quarter," Connors said. Unearned revenue was lower because customers are taking longer to renew their multiyear licenses, but also because more customers than expected decided to buy products without contracts, especially servers, he said.

Microsoft still expects to end its 2005 fiscal year with $8.6 billion in unearned revenue on the balance sheet, compared with $7.78 billion on September 30. "We expect to complete the year with very solid bookings growth for the company overall, likely the strongest ... in the industry," Connors said.

Looking ahead

Microsoft expects revenue for its second quarter ending December 31 to be between $10.3 billion and $10.5 billion with earnings per share at $0.28, including stock-based compensation expenses.

The forecast for the current quarter is below the First Call consensus expectation of $10.64 billion in revenue. The analysts also predicted second-quarter earnings per share of $0.32, excluding charges of $0.16 for equity compensation, according to Thomson First Call.

Shares in Microsoft were down 1.6 per cent in after-hours trading at $28.10 after ending the day down 0.48 per cent at $28.56 on the Nasdaq stock exchange.

Momentum in its server business, game console market share gains and increased sales of Xbox games moved Microsoft to slightly raise its full fiscal year 2005 forecast.

The company now expects revenue for the year ending June 30, 2005, to be between $38.9 billion and $39.2 billion with earnings per share between $1.07 and $1.09. In July, the top of Microsoft's fiscal 2005 forecast was for revenue of $38.8 billion and earnings per share of $1.08.