Microsoft Earnings Preview: Kinect Up, Windows DownMicrosoft Earnings Preview: Kinect Up, Windows Down

Microsoft is expected to report a sharp decline in Windows revenues when it states quarterly earning on Thursday, the latest sign that tablets powered by alternate operating systems are taking a big bite out of the traditional PC market.

But it's predicted the software vendor will report solid growth in other areas, including servers, search, office software, and entertainment devices such as the Kinect hands-free system for Xbox.

Overall, Wall Street analysts expect Microsoft to post EPS of 68 cents per share when it reports after the bell, compared to 74 cents per share a year ago. Total revenue is expected to increase slightly, from $19.02 billion to $19.15 billion.

Analysts at Goldman Sachs predict Windows sales in Microsoft's fiscal second quarter, which runs from September through December and includes the key holiday shopping period, to come in at $5.25 billion, down 27% from the same period a year ago. Market watchers at Caris & Company expect a 25% drop in Windows sales.

The falloff isn't as sharp as it appears at first glance. Windows revenues in Microsoft's fiscal second quarter of 2009 were unusually high because they included not only sales that occurred during that period, but also sales from the first quarter. Microsoft didn't count a good portion of Windows sales in Q1 FY2009 because of a program that allowed consumers to upgrade for free from Windows Vista to Windows 7, which shipped Oct. 22nd 2009.

Still, a longer view shows that Windows sales have effectively stalled as shipments of Apple's iPad and Google-Android powered slates increase at geometric rates.

Windows sales for the first half of Microsoft's current fiscal year should, based on actual results for the first quarter and estimates for the second quarter, come in at about $10.09 billion. Windows sales for the first half of Microsoft's 2009 fiscal year, a period that evens out the impact of the Windows 7 upgrade program, were about $10.06 billion.

That means Windows sales have likely grown less than 1% in the first six months of Microsoft's current fiscal year—despite the fact that the company claims enterprises are now widely embracing Windows 7 as they transition off XP. If that's true, then Microsoft must be seeing a significant falloff in Windows revenues from sales of licenses to consumer PC makers (OEMs), which account for about 80% of total Windows sales.

Windows faces tablet headwinds

Goldman Sachs' Bill Shope believe this is, in fact, what's happening as shoppers reject PCs in favor of tablets in large numbers. "Our bearish view on PC units is driven by cyclical headwinds and our belief that tablets will be cannibalistic to traditional notebooks and netbooks," Shope said in a recent research report.

Astonishingly, Shope believes PC makers will lose one out of three sales to tablets this year, and very few of those tablets will be running Windows. Microsoft recently said it won't truly aim for the tablet market until it ships a version of Windows 8 geared to run on ARM's mobile processors. That most likely won't happen until early 2012.

Microsoft's second quarter report won't be all bad news, however. Caris' Sandeep Aggarwal believes the report will confirm what most already suspect—that the Kinect hands-free motion control system for Xbox 360 is a blockbuster hit. "Kinect sales breaking all expectations," Aggarwal declared in a research note last week. As a result, he expects Microsoft's Entertainment and Devices unit to post a 57% year-over-year increase in revenues, to $3.77 billion.

Aggarwal also expects the Server & Tools group to see a 7% increase in revenues, to $4.2 billion, on the strength of a rebound in IT spending, Online Services to grow 19%, to $689 million, as Microsoft's search alliance with Yahoo ramps up, and he sees a 9% increase in sales, to $5.28 billion, at the Microsoft Business Division as Office 2010 gains traction in the business market.

Microsoft shares were up 1.12%, to $28.77, in afternoon trading Wednesday.