You can get descriptions of Microsoft's (NASDAQ:MSFT) earnings most anywhere. Some will focus on the right things, some won't. In short, Microsoft had a great quarter but says that its next quarter will be a little soft, and it predicts a strong 2005.
Wonderful. I note with some amusement that many writers are inserting "excluding stock-based compensation costs" in every sentence regarding earnings. That's all well and good, but my bemusement comes in two forms. First, I find it truly astounding that journalists generally do not bother to report the impact of stock options on company earnings for the companies that depend so deeply on them, which is a great disservice. Second, it's an expense, and a recurring one! Why back it out? Because it's not cash-based? That's extraordinarily silly.
It's just another example of the need to be extremely careful with corporate press releases, and more important, reports based on those press releases. Journalists by and large don't have time to go through financials or even think about what they're being told. They've got a slot to fill, and so if the company says "net of x," why darn it, that's what they're going to report. This is not a global statement -- for example, I think that TheWall Street Journal's Theo Francis has done an astoundingly good job covering the ongoing scandal at Marsh & McLennan (NYSE:MMC). It's just a friendly reminder that you should always think for yourself.
To Microsoft's infinite credit, its vice president for investor relations, Curt Anderson, said that it's not going to be pulling out these compensation costs anymore, since the true reflection of the business includes the cost. I wish the folks at Intel (NASDAQ:INTC), Cisco (NASDAQ:CSCO), Qualcomm (NASDAQ:QCOM), and on down the line would pay attention to this. "Break out noncash compensation? Why? It's integral to our business."
But like I said, you can read about how the company did elsewhere. I thought I'd describe one component of the report that seems to be generating some confusion -- unearned revenue -- and describe what it is and why it's an important indicator of business condition.
For the quarter, one of the things that Microsoft reported was a decrease to $7.78 billion of unearned revenue, down from $8.18 billion last quarter, a decrease of $340 million. It's a funny term -- it sounds kind of like some folks just showed up in Redmond with bags of money and said, "Here, keep this."
In actuality, unearned revenue is an outcome of the "matching principle" in accrual accounting. It happens most often with companies that have subscription or service-contract models. Under the matching principle, revenues can be taken only when the expense to provide them has been matched. So if you, customer X, sign up and pay for an annual subscription for something, even though the company has the money in hand, it doesn't "count" until it provides the service. So in a quarter, the company can count as revenue only the amount that you paid for three months of the service -- the remaining nine go into a separate account to be earned later. That's "unearned revenue." When Microsoft's model morphed from straight software to more of a service-based business, the percentage of its sales that were product-based declined, and conversely the amount people paid it for services it had not yet provided skyrocketed.
That's why people look carefully at the unearned revenue number -- it's a good sign of how much long-term business the company has taken in over the quarter. Note that unearned revenue and Microsoft's next quarter revenue and earnings guidance are all down. Do you think that this is a coincidence? It most certainly is not.
Bill Mann holds none of the companies mentioned in this article. Please view his profile for a current list of his holdings. But before you do, let us regale you with the siren song of a great newsletter product: Philip Durell's Inside Value. We're not just talking paint and rock companies -- Philip unearths some extraordinarily dynamic businesses each month. A free trial costs $10. Aw, heck, we'll even give you the free trial for nothing!
