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Microsoft (Nasdaq: MSFT) 
said strong demand for new products, including the Xbox 360 gaming console, drove a 13 percent jump in revenue for its third quarter, but its earnings and outlook fell short of Wall Street expectations and the company's stock took a pounding as a result.
Income for the quarter was US$2.98 billion, up 16 percent, but fell short of analyst targets on a per-share basis, at 31 cents versus the consensus of 33 cents. Revenue came in at $10.9 billion, a 13 percent increase over sales of $9.62 billion a year earlier, but below third party forecasts of $11.04 billion.
Showing Confidence
The outlook from Microsoft also fell short, with the company saying it expected earnings of 30 cents per share, versus analysts' forecast of 34 cents, though the revenue forecast was in the range expected by analysts.
"We are pleased with the increasing pace of revenue growth throughout this fiscal year," Chief Financial Officer Chris Liddell said. "We are now accelerating our investments in the business to drive future growth, which is reflected in our financial guidance. We believe next fiscal year will deliver even stronger double-digit revenue growth than this year."
Microsoft also said it continued to aggressively buy up its own shares in the quarter, scooping up $4.9 billion worth of the stock during the third quarter alone, a move Liddell said was evidence of the company's "confidence in the future."
Investors appeared more willing to focus on the bad news, however. Shares of the Redmond, Wash.-based software maker were down nearly 11 percent in morning trading Friday to $24.48, within a few pennies of the stock's 52-week low.
Analysts were equally disappointed, with four houses -- CIBC World Markets, Morgan Stanley, Canaccord Adams and Lehman Brothers -- all downgrading the stock following the report.
Good News, Bad News
Liddell said one reason the company guided lower on earnings is that it plans to invest heavily in new product development, pumping money into its main Windows line to beef up security and functionality in the upcoming Vista release and investing in the MSN portal and Windows Live Web services businesses in order to compete with the likes of Google (Nasdaq: GOOG) and Yahoo (Nasdaq: YHOO) .
Microsoft said several of its business lines saw revenue increases driven by new product releases, including the Home and Entertainment unit, which got a boost from the Xbox 360 and helped drive revenue up 80 percent over the year before.
Overall sales were lower than expected, however, with Microsoft citing lower sales of the original Xbox as one reason as gamers waited for more units of the new console to be ready. Meanwhile, strong sales of the Xbox don't necessarily help the company's bottom line, as the machines are sold at a loss. That bottom-line drain was especially true in the third quarter, as Microsoft paid extra to have more of the units manufactured faster to meet demand.
The Business Solutions unit also grew rapidly, expanding by 21 percent as customers bought more Microsoft Dynamics business management applications. The Server and Tools business line also grew, with the SQL Server line of products up by 30 percent.
"Enterprise customers are increasingly selecting SQL Server to run their mission-critical applications," said Kevin Johnson, the unit's co-president.
Changing Landscape
Making the earnings miss more remarkable for some observers was the fact that it came when many companies were meeting or beating forecasts and when reports were suggesting the economy was expanding more than previously believed.
"This effectively takes the wind out of the sails of investor sentiment at a time when investors were beginning to warm up to the prospects for accelerating earnings momentum," Goldman Sachs analyst Rick Sherlund said in a research note. Sherlund added that the amount of profits being diverted into development are significant enough that Microsoft could be "growing a Yahoo or Google" inside the company.
The earnings announcement came as Microsoft has a full agenda on other fronts. Its Windows Vista consumer release is being delayed, the firm announced recently, and it remains locked in an epic battle with European antitrust regulators. It has also launched an aggressive "People Ready Business" advertising campaign designed to raise the profile of its enterprise application line of products.
"Microsoft still has work to do on articulating how its products are evolving to deliver truly new and exciting capabilities," Gartner (NYSE: IT) analyst David Mitchell Smith told the E-Commerce Times. "So far, they haven't done enough to sufficiently develop the idea of how its new products are different from the software it's been selling for 20 years."
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