Security gnaws at Gates' bottom line

The software giant said late on Thursday that companies were reluctant to sign new long-term contracts in the most recent quarter amid concern over the MSBlast worm and other security issues. The result was a sharp drop in unearned revenue - that is, money taken in by Microsoft for software deals that span future quarters.

News of the drop overshadowed better-than-expected results for the current quarter, sending Microsoft shares lower in after-hours trading. Shares were trading at $27.64 Thursday afternoon, down $1.27, or more than four per cent, from Thursday's closing price of $28.91.

Matt Rosoff, an analyst with market researcher Directions on Microsoft, said that some drop in unearned revenue was expected, given that a year ago many companies were signing deals ahead of a Microsoft-imposed deadline. However, the decline - more than $700m - was more severe than expected.

"This is the first time in Microsoft's earnings that they have really mentioned that a security problem has hurt the bottom line," Rosoff said. That, he said, could explain the increased attention CEO Steve Ballmer and others have been giving to security issues in recent weeks.

But while the security issue and its impact on this quarter's bookings is important, Rosoff said the bigger issue for Microsoft is whether it will be able to get the companies that signed up for long-term deals to renew their pacts - something that won't really become clear until next year.

Microsoft Chief Financial Officer John Connors shrugged off those concerns during a conference call with analysts, saying that the company has a strong product release schedule, which will become clearer at next week's developer conference in Los Angeles.

At the same time, Connors cautioned that the signing of such deals is heavily tied to overall corporate spending, and the company could be hurt if an expected increase in tech spending does not materialise early next year. Also, he noted that the sales force has been told to focus first on making sure customers are happy and only secondarily on signing new deals.

Security is the company's top priority, Connors said. "That could result in additional time being required to close deals," he said.

Rosoff said Microsoft will need to do a better job of articulating its plans if it expects large customers to essentially buy the company's software in advance. In particular, he noted the uncertainty around Longhorn - the next version of Windows, which might not arrive until 2006.

Microsoft has said that it has this great operating system called Longhorn, Rosoff said, "but we are not sure exactly what's going to be in it. We know there will be a wave of products around [the same time as Longhorn], but we don't know exactly when that will be."

But even as Microsoft has struggled to sign big customers, Rosoff said, the company is finally starting to see dividends from its consumer businesses - something that helps offset the impact of the security issues. MSN, for example, turned its first profit, while the company's gaming and mobile devices also showed year-over-year sales gains. The consumer PC market also showed unit gains, helping boost desktop Windows sales.

Consumer sales "are picking up just in time to make up for any declines in the business market," Rosoff said.

Ina Fried writes for CNET News.com