• Chart: Microsoft Financials for the Last Five Quarters
• Chart: Revenues by Product Line

Microsoft reported record quarterly revenue (US$7.75 billion) and its second-highest quarterly profit ever (US$2.73 billion) in the first quarter of fiscal year 2003, which ended Sept. 30, 2002. This growth was driven in large part by the recognition of unearned revenue from sales of multiyear licensing agreements in previous quarters.

Meanwhile, Microsoft's stash of unearned revenue continued to grow as companies raced to sign multiyear licensing agreements before a July 31 deadline, providing Microsoft with a buffer against a drop in sales the next few quarters. But this unearned revenue growth is expected to end now that the deadline has passed. The company's future results could also be negatively affected by the growing popularity of Linux in the enterprise space and by Xbox inventory and supply chain complexities.

(For an overview Q1'03 financial results and how they compare with previous quarters, see the chart "Microsoft Financials for the Last Five Quarters".)

Product Revenues Boosted by UA Signups

Revenues in the Information Worker category (renamed from "Knowledge Worker") finally broke out of a flat period: they were up 26% from the same quarter last year. This category saw big growth in unearned revenue throughout the first half of calendar year 2002 as companies raced to sign up for Upgrade Advantage (UA) for Office before that licensing program, under which customers purchased rights to upgrades for the next two years, was eliminated on July 31. Now, some of this revenue is being recognized. In addition, revenue from Project was up 40% from the same quarter a year ago thanks to a new release, but Project accounts for only a small percentage of revenue in this category.

Revenues in the Server and Tools category were up 14% from the same time last year primarily for the same reason: recognition of unearned revenue from UA agreements signed earlier. In addition, sales of SQL Server Enterprise Edition—the more expensive version of the product—were up. Chief Financial Officer John Connors noted that the increasing market share of Linux in the server space poses a growing risk in this category. Microsoft also noted that the Server and Tools category now includes Client Access Licenses (CALs) for all server products; previously, CALs for Windows Server and some .NET Enterprise Servers were counted as desktop application revenue.

Revenues in the Client (Windows desktop) category were up 33% from the same quarter last year as corporate customers bought the more expensive business versions of Windows XP and 2000 rather than the consumer versions. Revenues in this category were also bolstered by a resumption of year-over-year growth in PC sales, a trend which Microsoft believes will continue through the rest of the fiscal year: Connors reiterated his earlier prediction that PC sales would be up between 1% and 3% for FY'03 compared with FY'02.

The Home and Entertainment category, which includes Xbox, turned in only US$485 million this quarter—up slightly from last quarter's figure of US$446 million—but Connors predicted that revenues would be around US$1.5 billion in the quarter ending Dec. 30. He admitted that the Xbox business has poorer margins (the company loses money on the consoles but makes it up on the games) and more complexity in terms of inventory and supply chain than Microsoft's other business areas, and said that executing well in this holiday season would be crucial.

In this earnings call, Microsoft did not break out net income (profit or loss) or operating income. It plans to release this information in its 10-Q statement, which could be filed as late as mid-November.

(For a complete chart of revenue by category and a comparison with one year ago, see "Revenues by Product Line".)

Unearned Revenue to Drop

Microsoft's unearned revenue now stands at more than US$9.1 billion—a big increase from Q4'02's figure of US$7.7 billion, thanks mainly to heavy demand for UAs in July 2002.

This unearned revenue will provide a cushion to Microsoft's bottom line until approximately mid-2004 (which is when the last UA will expire), but Connors warned that the days of steadily increasing unearned revenue are over now that the new licensing plan is in place. Microsoft expects unearned revenue to drop in Q2'03 and again in Q3'03. An increase in Q4'03 is possible as customers are billed for the second year of EA or Select agreements they purchased in the rush to meet the deadline, but in the long run unearned revenue growth depends on Microsoft's ability to sell more enterprise agreements to small and mid-size businesses.

(For more background on what unearned revenue is and how it's counted, see "The Importance of Unearned Revenue" on page 30 of the Oct. 2002 Update.)

Detailed information about Microsoft's Q1'03 results, including an audio and scrolling text replay of the earnings call, is available at www.microsoft.com/msft/.