Microsoft Product Roadmaps

ShareTweet

Coming off a difficult year, executives at Microsoft's annual Financial Analysts Meeting (FAM) presented a cautious outlook for fiscal year (FY) 2010, which started July 1, 2009. Top priorities for FY'10 include containing costs, preserving cash, and stopping the revenue slide in the Windows client business through more aggressive pricing. Partners and customers may have a harder time finding product information and presales support as Microsoft scales back sales and marketing budgets. At the same time, Microsoft reiterated its commitment to investing in research and funding long-term opportunities like search and mobile phones.

Surviving the Reset

For the first time since becoming a public company in 1986, Microsoft's business shrank during the fiscal year: FY'09 revenue dropped 3% from the previous year to US$58.44 billion, operating income was down more than 8% to US$20.36 billion, and net income fell 18% to US$14.57 billion (net income dropped more than operating income because of foreign exchange fluctuations and losses on derivatives in FY'09). All five of the business segments Microsoft uses for financial reporting fell short of expectations expressed at last year's FAM, and only one—Server and Tools—grew during the year. (For an overview of the performance of Microsoft's business segments, see the chart "Five Businesses: Financial Overview".)

The company blamed the global economic downturn for its results. More specifically, Microsoft said it noticed a drastic fall-off in its business in fall 2008 as the global banking crisis froze credit markets and caused companies and consumers alike to slash spending. The contraction appeared to level off toward the end of Microsoft's fiscal year, but still left sales below where they were a year ago.

Microsoft CEO Steve Ballmer has referred to the spending crash in late 2008 as a "reset," and Chief Financial Officer Chris Liddell suggested that economic growth is unlikely to return to its former levels for many years, as consumers and businesses will have less access to cheap debt to fuel spending. With this cautious outlook in mind, Microsoft is taking significant steps to preserve cash and cut costs. Customers, partners, and shareholders will probably notice these changes in the following ways:

Tighter hold on cash. Leaving aside one-time expenses such as severance (in FY'09) and legal charges (which were higher in FY'08), Microsoft's operating income actually declined 12% (not just 8%) during the year. However, Liddell said that positive cash flow increased more than 45%, from US$10.4 billion to US$15.1 billion, as the company slashed capital spending (such as real estate and data centers) and acquisitions. The company's cash balance also grew from US$20.72 billion at the end of Q2 to US$31.45 billion at the end of the fiscal year, as the company put stock repurchases on hold. Liddell said the company would continue to buy shares back, but at a considerably slower pace than in recent years.

Sales and marketing squeezed. Microsoft's FY'09 operating expenses minus cost of goods sold, not including one-time charges such as severance, were only US$25.4 billion—that's US$3.5 billion less than the company forecast at the beginning of its fiscal year and only US$700 million higher than the FY'08 equivalent.

Looking at the company's income statement for FY'09, sales and marketing (S&M) expense fell 18% during the year, and the company said it reduced S&M-related headcount costs by 10% in Q4'09. (General and administrative, or G&A, expenses also fell, but the figures were skewed by a one-time legal fine imposed by the European Union in FY'08.)

At the same time, research and development (R&D) expenses shrank only 8% during the year, and both Liddell and Ballmer said the company will continue to invest strongly in R&D to ensure it doesn't miss any major growth businesses. Adding more detail to this concept, Ballmer identified seven specific business areas that Microsoft views as core to its future growth, and several other areas of investment that will serve a supporting role. (For more details, see the chart "Core and Enabling Products".)

Given these trends, if Microsoft is forced to cut costs further, those cuts are most likely to come in S&M or G&A, rather than R&D.

Client: What Went Wrong

The Windows Client segment, which consists of desktop versions of Windows, suffered a difficult year—revenue was US$14.71 billion, US$3.5 billion below expectations expressed at last year's FAM and down 11% from the previous year.

CEO Steve Ballmer, who was the acting head of the Windows Client business segment during the year, presented details about this business segment alongside his overview of the entire company. (For an illustration showing the leaders of each business segment in FY'10, see "Business Segment Leaders".)

In his presentation, Ballmer focused on OEM channel revenue, which accounts for between 80% and 85% of the revenue in this division, and which fell 14% during the year (adjusting for a one-time deferral of revenue related to an upgrade guarantee program that kicked off in Q4'09). Ballmer explained five factors that influence OEM revenue, described their effects in FY'09, and explained how Microsoft plans to respond to the factors it has power over.

PC market growth. PC sales fell precipitously in the second half and ended up only 1% ahead of the previous fiscal year, according to Ballmer. He said that PC sales growth is largely out of Microsoft's control, acknowledging that new versions of Windows (such as the forthcoming Windows 7) do very little to spur sales of new PCs.

Hardware segment mix. This factor contributed to 10% of the overall 14% OEM revenue drop in FY'09 and reflects the fact that sales of computers with lower-priced versions of Windows are showing a higher growth rate than sales of computers with higher-priced versions of Windows. In particular, sales in emerging markets are growing faster (or shrinking more slowly) than sales in developed markets, and sales to consumers are growing faster (or shrinking more slowly) than sales to businesses. Ballmer said that Microsoft has little control over this aspect: although it can set pricing for Windows in various markets, it cannot control (for example) the fact that the Chinese economy is growing much faster than the U.S. and European economies, or that businesses are buying fewer new PCs than consumers. As part of this discussion, Ballmer lumped netbooks—inexpensive and highly portable PCs—into the broader problem of consumer sales growing faster than business sales, rather than treating them as a new or distinct part of the PC market.

Competition from Apple. Apple's "I'm a Mac" advertisements may have negatively influenced perceptions of Windows Vista and were the impetus behind a major Windows marketing campaign that began during FY'09, but Ballmer said that Apple's market share is so low that it had no impact on OEM revenues in the Client business in FY'09. Apple claims to sell a little more than 10 million Mac computers per year, while IDC statistics show that nearly 300 million x86 computers were sold during 2008. Nonetheless, Microsoft will continue the Windows branding campaign in hopes of keeping Apple from gaining market share.

Windows attach rate. This factor contributed to 1% of the overall 14% OEM revenue drop in FY'09 and refers to the number of PCs with a copy of Windows that OEMs purchased during the quarter. Two factors influence attach rate: piracy and OEM inventory fluctuations. (OEMs sometimes stock up on Windows one quarter ahead of anticipated price changes, but don't necessarily ship all the copies they purchased until future quarters.) Ballmer said that the 1% drop was caused mostly by inventory fluctuations, over which Microsoft has limited control. He also said that the company would continue its antipiracy initiatives, such as the Windows Genuine Advantage program (which requires customers to provide electronic proof that their copy of Windows is authorized before they can take certain actions, like downloading free Microsoft software), and working with governments to convince them to pass and enforce intellectual property laws. Ballmer cautioned, however, that predicting when antipiracy efforts will bear fruit is "very hard to do," as it requires a combination of education, government regulatory work, partnership with OEMs, and pricing changes.

Pricing. This factor contributed to 4% of the overall drop in OEM revenues during FY'09. Ballmer blamed the drop on a theory that lowering prices in emerging markets would lead to a corresponding drop in piracy, raising overall revenues. This theory turned out to be "wrong," said Ballmer, and Microsoft will raise prices in emerging markets in FY'10.

How Windows 7 Could Help

Somewhat surprisingly, Ballmer spent almost no time discussing the possible revenue impact of Windows 7, which comes out in Oct. 2009 (Microsoft's Q2'10). However, it should have a positive impact in several areas:

Retail. Retail sales tend to spike immediately after a new OS is released, as some consumers buy retail upgrades from the last OS. For instance, in FY'07, when Windows Vista was released, retail revenue was up 21% (US$422 million) from the previous year.

Pricing on consumer notebooks. Windows 7 gives Microsoft two distinct opportunities to increase the revenue-per-sale on portable computers sold to consumers. First, netbooks have been the fastest-growing segment of the PC market in the last two quarters. Today, Microsoft sells Windows XP Home on netbooks; with Windows 7, Microsoft can sell Windows 7 Starter Edition, for which it can charge a higher price. However, this shift may not become significant until June 2010 (the end of FY'10), the date which Microsoft has set for removing XP from the OEM channel. Second, Ballmer said that Intel and some OEMs hope to use the release of Windows 7 to promote higher-priced notebooks, known as ultralights or ultrathins, that are just as portable as netbooks but with a bigger screen and keyboard. These computers would be sold with Windows 7 Home Premium Edition, which commands a higher price than Starter Edition.

Accounting Changes

Finally, Client revenue will gain two accounting-related boosts in FY'10.

First, US$276 million revenue from Q4'09 has been deferred to Q2'10 to account for the Windows 7 Upgrade Option Program, under which customers who purchase Windows Vista between June 26, 2009, and Feb. 2010 get a free upgrade to Windows 7.

Second, Microsoft is moving revenue from Windows Live, a set of popular online services (such as Hotmail and Messenger) and their associated desktop clients, from the Online segment to the Client segment. According to pro forma statements that Microsoft released with its Q4'09 results, Windows Live accounted for approximately US$588 million in revenue and about US$400 million in operating losses. (The operating loss figure is impossible to calculate precisely because Microsoft also reallocated some corporate expenses across all five business segments.)

Business: Banking on Annuity Revenue

The Microsoft Business Division segment, which includes Office, unified communications (including Exchange and Communications Server), Dynamics, and other business software, missed FY'09 revenue prediction by about US$2.6 billion, coming in at US$18.89 billion, down very slightly from last year. At last year's FAM, the company predicted growth of 14% to 15%.

Business Division President Steven Elop broke the division's revenue into the following three segments:

Consumer. Revenue from sales of Office and other software to consumers makes up 20% of this segment's revenue and was down 30% from the previous year. Elop blamed the fall on declining PC sales to consumers, which were down 20%, not including netbooks (which generally cannot run Office), and on price cuts on consumer versions of Office. He claimed that attach rates of Office to new PCs sold remained relatively stable, suggesting that Microsoft isn't yet seeing competitive online offerings, such as Google Apps, replace Office in the consumer market (although they may be contributing to price pressure).

Nonannuity business. Revenue from one-time sales to businesses—mostly smaller businesses purchasing Office on volume license agreements without an upgrade and maintenance subscription (such as Software Assurance)—makes up 20% of revenue in this segment and was down 35% from the previous year. Here, declining PC shipments (which were down 20%) and declining sales of Office to small businesses created the shortfall. However, Elop claimed that pricing remained stable in this segment.

Annuity business. Annuity revenue is recognized revenue from multiyear license agreements, such as Enterprise Agreements and Software Assurance, that were signed during previous periods. (Microsoft books revenue from multiyear agreements as unearned and then gradually recognizes it over the course of the payment term.) This component makes up 65% of the revenue in the Business segment and was up about 5% in FY'09, according to Elop. However, Elop did not mention that the total balance of unearned revenue—representing money that's been paid by customers but not yet recognized—in this segment was approximately flat between the end of FY'08 and the end of FY'09. This suggests that sales of multiyear contracts were flat or down during the year, and annuity revenue may not serve as a bulwark against declines in the other parts of this business in FY'10 and beyond.

What's Next?

Elop and other speakers mentioned the forthcoming Office 2010 suite, which is expected to emerge in the second half of FY'10, but suggested that associated server products, such as Exchange and SharePoint 2010, would be equally important.

Elop also insisted that the browser-based Web editions of Office 2010, which will be offered to consumers at no charge, would add to revenue. Instead of cannibalizing some sales of low-end editions of Office, Microsoft believes these Web editions will be used primarily by customers who use unlicensed copies of Office today. With Office Web, Microsoft will have the opportunity to capture some advertising revenue from these customers and convert some of them to a full version of the suite, Elop reasoned.

Server and Tools: Growing Despite the Economy

Server and Tools, which includes Windows Server, SQL Server, other infrastructure software, and development tools, was the only one of Microsoft's five business segments to grow during FY'09. Revenues increased 8% to US$14.13 billion, although this was still about US$2.2 billion short of expectations stated at last year's FAM.

Server and Tools President Bob Muglia put a positive spin on the year's results, noting that this revenue growth came even as server hardware sales fell 15% during the year. More specifically, Muglia claimed the following:

• About 20% of sales of Windows Server and SQL Server are the higher-priced Enterprise and Datacenter editions
• In situations where Microsoft's sales force saw Windows Server Hyper-V going head to head against VMware products, Hyper-V won 70% of those sales
• SQL Server market share grew 1%, while Oracle's market share shrank 1%
• System Center revenue was up 30% and is now a US$1 billion annual business.

Muglia cited several growth drivers for the next few years, including management (System Center), virtualization (driving sales of Windows Server, particularly high-end editions), security (Forefront), business intelligence, and data warehousing (both key features of SQL Server).

In speaking about revenue growth opportunities, Muglia did not mention SQL Server's core database management functions, suggesting that Microsoft will continue to lead by selling SQL Server as a tool to analyze data that may be stored in other systems. He also neglected to mention development tools, suggesting that Microsoft does not see the high-priced Visual Studio Team System as a significant source of revenue growth.

Entertainment and Devices: Xbox OK, Mobile Not

The Entertainment and Devices segment, which includes the Xbox, mobile and embedded OSs, and other consumer-oriented hardware and software, came closer to meeting Microsoft's expectations from FAM 2008 than any other business segment: revenue dropped 6%, to US$7.75 billion, while Microsoft expected minimum revenue of US$7.88 billion (a decline of 4%). Equally important, this business was profitable for the second consecutive year, meeting Microsoft's commitment of continued profitability, although it earned only US$169 million.

Entertainment and Devices President Robbie Bach highlighted the performance of the Xbox business, noting that console sales grew 30%—Microsoft's best unit growth rate since it entered the game console business—to 11.2 million, while Xbox Live subscribers grew 75% to 20 million (although an undisclosed portion of subscribers, perhaps as many as 50%, use the free version of the service). Bach noted that Entertainment and Devices revenue was hurt by console price cuts, lower game sales, and slowing PC sales (which affected sales of keyboards and mice).

Bach and Ballmer both acknowledged that Microsoft needs to improve its performance in the mobile space, admitting that Windows Mobile lost market share in FY'10, primarily to Apple's iPhone and Research In Motion's BlackBerry family of devices. The speakers focused on the Windows Mobile 6.5 device platform and its associated back-end services, such as the MyPhone data backup service, but that will be a relatively minor upgrade. Windows Mobile 7, which will be accompanied by significant new consumer features, will probably not emerge in the second half of calendar year 2010, after FY'10 ends.

In a minor accounting note, Microsoft said that revenue from mobile services, such as Bing for Mobile and Windows Live for Mobile, will be counted in this segment rather than in Online as in past years. Based on pro forma numbers presented in Microsoft's Q4'09 earnings call, these services had revenues of approximately US$71 million in FY'09.

Online: All About Search

The Online segment, which includes Microsoft's consumer online services, as well as products and services for advertisers and publishers, missed FY'09 revenue estimates expressed at last year's FAM by US$700 million: instead of revenue growing 18% to 20%, it shrank 4% to US$3.09 billion, while losses nearly doubled from US$1.22 billion to US$2.25 billion.

Online Services President Qi Lu, who joined Microsoft in late 2008 after leading search and search-advertising development at Yahoo, highlighted the company's search strategy and deal with Yahoo, which was announced the day before the meeting. (For more details on that deal, see "Yahoo Ad Deal Struck".) Lu reiterated Microsoft's three-part search strategy, which the company has talked about before, as follows:

• Make the necessary infrastructure and research investments to equal Google on core relevance
• Differentiate search results from Google's by displaying more targeted information in results for specific types of searches—for instance, presenting lowest airfares and price prediction data on the search results page, rather than forcing users to click through to another site
• Try to come up with major "game-changing" innovations—for example, the cashback program, under which Microsoft offers rebates to consumers who buy products online after finding them via Bing.

Lu and Ballmer explained how the Yahoo deal could increase Microsoft's revenue per search and the usefulness of its search engine, by giving the company more data about user habits.

Executives spent no time talking about Microsoft's display advertising business or the advertising tools and services gained in the US$6 billion acquisition of aQuantive in 2007. Several top executives from that acquisition, including aQuantive founder Brian McAndrews, have left Microsoft, and the company appears to be consolidating or jettisoning assets from that acquisition—in spring 2009, it combined aQuantive's DrivePM advertising network with the Direct Response network used on Microsoft and partner sites, and in July it sold the Razorfish advertising agency to agency conglomerate Publicis (see "Razorfish Sold").

Given that search advertising is proving to be the most resilient type of advertising in the current downturn—Microsoft's search advertising revenue actually increased in FY'09, and Google is still showing slight growth—Microsoft's other ad-related businesses could be targeted for further cutbacks or spin-offs as the company looks to contain costs.