By Matt Rosoff [Bio]
Posted: Aug. 12, 2002

• Chart: Seven Businesses: History and Expected Growth
• Illustration: Who Leads the Seven Businesses?
• Sidebar: Steve Ballmer on Business Opportunities

To better explain its business to outsiders and communicate where it sees its largest future opportunities, Microsoft will begin to report its revenues and operating profit or loss in seven core product lines. This clearer reporting method is designed to build investor confidence by revealing where Microsoft earns its money and to justify the company's investments in new business areas. It also helps Microsoft managers think about how they fit into the overall business and ensure that they are focused on generating revenue. However, although the reporting change clarifies Microsoft's areas of focus, it does not indicate any major change in how Microsoft develops, markets, or sells its products.

Ballmer Explains Seven Priorities

In Dec. 2000, spurred by Microsoft's first earnings warning in 12 years, CEO Steve Ballmer sent a memo to all Microsoft employees asking them to cut costs and focus on "serv[ing] customers well in our seven core businesses," which he outlined as productivity applications, Windows, enterprise servers and tools, MSN, small business applications, devices, and the .NET platform. (See "PC Slump Prompts New Priorities, Investment Strategies" on page 24 of the Jan. 2001 Update.)

More than a year later, in Apr. 2002, Microsoft announced it had appointed leaders to oversee seven "core businesses" which almost precisely matched the businesses in Ballmer's memo. However, there was one significant difference: instead of the .NET development platform (the success of which is difficult to measure from financial metrics alone), a new category, "Home and Entertainment," was added, to reflect Microsoft's Nov. 2001 entry into the gaming console market with Xbox. Beginning in fiscal year 2003 (FY'03), which started July 1, 2002, Microsoft will report revenues and operating income or loss for these seven businesses in quarterly filings with the Securities and Exchange Commission (SEC), which appear about one month after the company's quarterly earnings calls.

The seven businesses, in decreasing order of revenue generated in the most recent fiscal year, are as follows:

• Knowledge Worker: Office and other productivity software
• Client (Windows): all Windows client software except Windows CE
• Server and Tools: the .NET Enterprise Servers, development tools, and corporate-oriented services
• Home and Entertainment: Xbox, interactive TV, and consumer software
• MSN: all MSN services and sites
• Business Solutions Group: Great Plains and other business management software
• CE (Mobility): Windows CE and reference platforms based on it.

Speaking at the July 2002 Financial Analysts' Meeting, Ballmer and other executives explained the goals, areas of investment, and long-term opportunities for each of these business areas.

Knowledge Worker: Sell Office XP Upgrades

The Knowledge Worker business encompasses Office and earns more revenue than any other. It also includes other desktop productivity software such as Visio and Project, collaboration-oriented server software such as SharePoint Portal Server, and Client Access Licenses (CALs) for the .NET Enterprise Servers that require them, such as Windows and Exchange. (CALs are licenses for individual users to access these servers and are sold separately from the server software itself.)

The last fiscal year was tough for the Knowledge Worker business—revenues were down about 2% to just under US$10 billion, despite the recent release of Office XP. (These figures do not include revenues for the Business Solutions Group, which are sometimes lumped into Knowledge Worker. For a detailed rundown, see the chart "Seven Businesses: History and Expected Growth".)

Nonetheless, Microsoft still expects 10% revenue growth from Knowledge Worker in the coming fiscal year. According to the leader of the Knowledge Worker business, Group Vice President Jeff Raikes, stamping out piracy is an important part of this projected growth: he estimates more than 200 million users are currently using unlicensed or improperly licensed versions of Office. However, it's unlikely that better piracy prevention alone will contribute to 10% growth in Office.

Thus, Raikes also expects the introduction of the Tablet PC to inspire more businesses to upgrade to Office XP or Office 11, as earlier versions of Office will not be able to take advantage of the Tablet's unique features, such as handwriting recognition and annotations (See "Windows XP Tablet Edition Nears Delivery" on page 3 of the Sep. 2002 Update.) To reflect this, part of the marketing budget for Tablet PC will be counted against the Knowledge Worker business area, although sales will primarily count as revenues in the Client business area.

Finally, Microsoft Chief Financial Officer (CFO) John Connors noted that Knowledge Worker business's financial results would include investment costs from adding new Business Productivity Advisors to the sales force and from investing in partners who sell to small and mid-size businesses. Both of these investments are intended to spur businesses to upgrade to Office XP and make greater use of other Knowledge Worker products, servers, and services, particularly Visio and Project.

Client: Sell New Windows Variants

The business area with the second-largest annual revenue is Client, which includes all desktop variants of the Windows operating system (OS), plus Windows Embedded.

With no new major client OS release planned this year, Microsoft expects revenues in the Client business to grow more slowly in fiscal year 2003 (7% to 8%) than it did the previous fiscal year (16%). Platforms Group Vice President Jim Allchin, who leads the Client business, expects much of this growth to come from organizations upgrading from standard desktops (such as Windows 95, Windows 98, Windows ME) to the higher-priced Windows XP Professional and its successors. The introduction of Windows Powered Smart Displays (Mira), a consumer product that requires Windows XP Professional, could also spur consumers to upgrade to the higher-priced OS.

Microsoft will also try to boost Client revenues by selling new types of PCs—Tablet PCs and Media Center PCs (Freestyle)—bundled with special variants of Windows XP. However, this revenue will be offset by the substantial marketing expenses for launching these new products.

Finally, Ballmer suggested that cracking down on piracy should also help boost revenues in this business area.

Server and Tools: Bigger Sales Force

The Server and Tools business includes Windows Server; most of the .NET Enterprise Servers, including Exchange and SQL Server; development tools such as Visual Studio .NET; premier support; consulting services; and Microsoft's book publishing business, MS Press.

Microsoft has big expectations for this area in the coming fiscal year, expecting revenues to grow between 13% and 18%. According to Paul Flessner, senior vice president of the .NET Enterprise Servers Division and co-leader of this business (along with Eric Rudder, the senior vice president who oversees development tools), most of this growth will come from a big expansion in the Microsoft sales force. In particular, Microsoft is adding 22% more solution sales specialists, who will encourage corporations to buy "solutions" to a general problem, such as setting up corporate intranets or connecting to multiple business partners. These solutions usually include server offerings, such as BizTalk, Commerce Server, and Content Management Server, that are not as popular or easy to sell on a standalone basis as Microsoft's two most popular servers, SQL Server and Exchange. (For more information, see "Solution Guidance Expanded" on page 13 of the Sep. 2002 Update.)

CFO Connors added that Microsoft was adding more "quota-carrying" salespeople, which could motivate the sales team to sell more servers, and mentioned in passing an "SA value program" geared toward getting business customers to buy Software Assurance, Microsoft's pay-up-front upgrade plan.

Connors also said this business area would eventually benefit from Microsoft's increased focus on "storage and security." This was probably an allusion to two server products under development: Senior Vice President Bob Muglia is heading up a storage business unit, and Senior Vice President Mike Nash a security business unit, but neither group has talked publicly about its plans.

Home and Entertainment: TV Still Opportunity

The Home and Entertainment business includes the Xbox gaming console, Xbox and PC games, consumer software, Macintosh software, Microsoft's interactive TV platform business, and sales of hardware products, such as keyboards, mice, and a forthcoming line of wireless home networking hardware.

Microsoft expects revenues in this business to grow 20% to 26% this fiscal year, primarily due to sales of Xbox consoles and games. However, Ballmer admitted that Microsoft does not expect this business area to be profitable in the short term: "We’ve been investing for a long time, and we may have to invest for a longer time." In a surprising statement, given the expensive failure of Microsoft's interactive TV business so far, Ballmer told analysts that "the biggest part of the opportunity" in Home and Entertainment is "television sets." That's because the TV business has what Ballmer calls "big numbers": there are more than a billion TV sets in use around the world, with many millions more sold every year. Microsoft’s challenge will be in developing a product or service which those billions of TV viewers will be willing to pay for.

For the current fiscal year, however, the main Home and Entertainment investments will be related to Xbox, as the company rolls out the Xbox Live gaming network and attempts to increase the number of available titles.

MSN: Focus on Cost Control

The MSN business area includes MSN Internet Access, the MSN Web portal, and other MSN-branded services such as MSN Mobile and MSN TV.

Microsoft expects MSN's revenues (not counting Expedia, which the company sold in the previous fiscal year) to grow between 18% and 22% this fiscal year. The company expects most of this growth to come from the new MSN 8 e-mail and Web browsing client for MSN Internet Access users, which it is hoping will increase the number of paying subscribers to the service, and which it might use to justify a price increase. (Microsoft has not yet revealed pricing.)

Vice President Yusuf Mehdi, who leads the MSN business, also said that MSN's "number one" priority is "profitable customer acquisition," which it will achieve by cutting back on the generous but expensive promotions it has used in the past.

Notably absent at the Financial Analysts' Meeting were the demonstrations of prototype services seen in past years, such as productivity-oriented services based on the .NET My Services technology. Today, MSN appears to be less interested in developing new services from scratch; instead, it is reusing technology developed elsewhere within the company.

(For more details on MSN 8 and the MSN business, see "MSN Refocuses on Client Software" on page 24 of the Sep. 2002 Update.)

Business Solutions Group: Fragmented Market

The Business Solutions Group (BSG) was created in Apr. 2001 after Microsoft acquired accounting and financial management software company Great Plains. This group now includes Navision, a Danish business software company acquired in July 2002, and forthcoming business management products such as MSCRM Server, a tool for businesses to manage their sales forces and customer service representatives.

Microsoft expects the BSG's revenues to nearly double this fiscal year, but most of this growth will come from Navision, which had revenues of 380 million Danish kroner (US$46.6 million) in its last quarter as an independent company. Microsoft believes the costs related to the acquisition will amount to US$1.4 billion this fiscal year.

Long-term, Microsoft has high hopes for the BSG because, as Ballmer points out, the market for business management software for small and mid-size companies is "fragmented," rather than served by one or a few dominant companies. Ballmer says the company has placed a "fundamental bet" that it can end this fragmentation and become a dominant player. (The Server and Tools segment would also benefit by getting more small and mid-size companies to buy SQL and Exchange, two products which they don't often buy today.)

To meet this goal, Microsoft will increase this year’s research and development budget for the BSG. It is particularly focused on the .NET Business Framework, a set of platform technologies on which ISVs can build vertical business management software that runs on Windows and the .NET Enterprise Servers. Microsoft will also increase its investment in BSG channel partners (for example, in training and incentives) to help them sell more BSG products.

CE: Massive Upside Potential

The seventh business unit, CE, includes the Windows CE operating system and the mobile device reference platforms that are based on it, such as Pocket PC and Smartphone. However, this unit does not include CE-based operating systems for TV set-top boxes, which are counted in Home and Entertainment, or Windows Embedded, which is counted in Client.

Although CE generated only US$60 million out of Microsoft's total US$28.4 billion in revenues last fiscal year, the company remains interested in this business area because, once again, it has a lot of "big numbers," particularly in the wireless space: Ballmer estimates that 450 million wireless handsets will be sold worldwide in the next 12 months, and added, "You don’t have to envision getting much revenue per device for that to look like a pretty interesting business." Microsoft hopes that this year's rollout of the Smartphone 2002 operating system for data-enabled wireless phones will kick off a long upward trend in the CE business area.

Change in Reporting, Not Strategy

The fact that Microsoft is reporting its financial results for seven business units does not mean that the company is changing its product development, marketing, or sales strategies. The biggest evidence of this is the fact that the seven businesses have not yet been reflected in the company's organizational structure. Without organizational changes, changes in product strategy are extremely unlikely—for example, senior Microsoft executives who were not named as "leaders" of the seven businesses still control immense budgets and headcount, and Ballmer continues to exercise considerable direct influence as well. (For details, see the chart "Who Leads the Seven Businesses?".)

Rather, the new reporting method is a way of aligning investor expectations with employee priorities, and of satisfying investors (particularly the large institutional investors, such as banks, who own 61% of the company's outstanding shares) who are requesting more detailed financial reporting in the wake of recent accounting scandals at other companies. It also helps Microsoft justify investing its nearly US$40 billion cash hoard in long-term bets, such as mobile devices, game consoles, and interactive TV, rather than using it for other purposes such as paying a dividend to shareholders.

As Steve Ballmer explained to financial analysts, "We like businesses that have some large number"—particularly a large number of potential new customers. (See "Steve Ballmer on Business Opportunities".) Each of the seven businesses meets this requirement.

Resources

For historical Microsoft financial statements, see www.microsoft.com/msft/history.htm. Note that the statements currently on this Web site include the Business Solutions Group as part of Knowledge Worker and include CE as part of Client.