MSFT-Channeling a Strong Quarter

We believe MSFT is poised to deliver strong Dec Q results relative to top- and bottom-line consensus expectations of $17.24 billion and $0.58, respectively, on the heels of improving PC unit sales data, what we expect was a strong benefit from channel inventory build, and less piracy around the Windows 7 launch.

• Improving PC sales to help Windows revenue. We are raising our Windows division revenue and overall EPS estimates for the Dec Q, the remainder of F10, and F11 to reflect anticipated channel inventory build along with Gartner's preliminary PC unit shipments for the Dec Q and Gartner's latest PC unit forecasts for the remainder of F10 and F11.

• Channel inventory build should boost revenue around the Windows 7 launch. Channel inventory build in preparation for the launch likely had a meaningful impact (it did with the Vista launch) on Dec Q results as MSFT sells to (versus through) the channel.

• Less initial piracy around the launch likely helping too. MSFT likely also saw a Dec Q benefit from an initial reduction in piracy; a phenomenon that could persist into the Mar Q before software pirates circumvent Windows 7's security measures and begin selling illegitimate copies of the new OS.

• Expectations appear very attainable. Despite improving PC sales trends and positive chatter around the Windows 7 launch, Dec Q expectations appear very attainable, implying a y/y organic cc revenue decline of 6.3%, a deterioration from Sep’s organic cc decline of 2.9%.

• Model changes. For the Dec Q, we are raising our revenue estimate to $19.2B from $18.4B driven entirely by our Windows revenue revisions, which we now forecast at $6.8B vs. $6.0B prior. On the bottom line, we've raised our EPS estimate to $0.62 from $0.56. Further detail is provided within.

• So why not upgrade the stock? Despite our view that the Dec Q is likely to come in very strong relative to current expectations, sending MSFT shares higher near term, we are maintaining our Neutral rating and $30 PT at this time. We believe MSFT shares are benefiting from the same hype they enjoyed around previous OS releases. Once the hype dies down, the shares are
likely to come down as they’ve done in the past. At that point, MSFT still must contend with several challenging secular issues facing the company. In addition, expectations for a corp. PC refresh cycle are likely overblown.

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