By Matt Rosoff [bio]
Posted: Nov. 25, 2002

• Chart: Finances by Business Segment

The following is the full text of an article published by Directions on Microsoft, an independent research firm focused exclusively on Microsoft strategy & technology. Each month we make one or more key articles available to non-subscribers.

In a recent filing with the U.S. Securities and Exchange Commission (SEC), Microsoft revealed new details about its business, including the fact that its desktop Windows business has operating margins of more than 80%, and that four of its seven business segments—Home & Entertainment, MSN, Business Solutions, and CE/Mobility—lose money. This information underscores the importance of Windows to the entire company and reveals how much it is willing to lose to maintain a presence in other markets. It could also affect future planning as investors, employees, and customers pressure Microsoft to spend less on unprofitable businesses.

Windows Desktop Drives Profits

Microsoft's Nov. 14 quarterly earnings filing (10-Q) covers the first quarter of Microsoft's fiscal year 2003, which ended Sept. 30, 2002. In this filing, Microsoft has for the first time broken out quarterly revenue and operating profit or loss for seven business lines as if each were an independent business, taking into account not only the cost of goods, but also other costs, such as research and development (mainly software development), sales and marketing, and depreciation of certain assets. Revenue components and costs that could not be attributed to any single business line, such as companywide administrative and marketing expenses, were accounted for separately. (For details, see the chart "Finances by Business Segment".)

In Q1'03, Microsoft's Client business, which includes desktop and some embedded versions of the Windows operating system (OS), earned US$2.48 billion in operating income on US$2.89 billion in revenues. In the same quarter a year ago, it earned US$1.71 billion on US$2.08 billion in revenues. This means that the Windows desktop is both Microsoft's biggest revenue generator and its most profitable business, with margins exceeding 80%.

This helps explain many of Microsoft's actions as part of a "protect Windows" directive, and also highlights the importance of OEMs, PC sales, and new client releases to Microsoft's overall business.

Prime Directive: Protect Windows

Because Windows is so profitable, and provides financial support for so many of Microsoft's other businesses, the company will go to almost any length to protect this business.

Thus, competitors that threaten to provide alternatives to the Windows client—such as Netscape in the past, or Sony, who has hinted at evolving its PlayStation game console into an Internet-connected computing and entertainment device—can prompt Microsoft to take extraordinary and costly action against them. Similarly, Microsoft's multi-billion dollar investment in MSN can be partly understood as a response to the threat that AOL’s network could evolve into a platform for a wide variety of application-like functions.

OEMs, PC Sales Crucial

The profitability figures demonstrate how critically Microsoft depends on PC OEMs, the channel through which Microsoft sells the vast majority of its Windows client software, and explains why the company has sometimes gone out of its way to dictate terms, reward favorites, and punish wayward OEMs.

A number of recent factors, including consolidation among OEMs, and the antitrust settlement with the U.S. Department of Justice (DoJ), which prevents Microsoft from taking certain retaliatory actions, may be tipping the balance of power. For example, large OEMs could band together to force Microsoft to bear more of the support costs of Windows, cutting into Microsoft's margins, or could promote alternatives to the Windows desktop, particularly Linux. (For more background on the shifts in the OEM space, see "OEM Landscape Changes" on page 27 of the Aug. 2002 Update.)

Relatedly, the 10-Q figures highlight the importance of PC sales to Microsoft's business. For example, if IT spending recovers in 2003 but PC sales remain stagnant or drop, then Microsoft's profits might not increase as sharply as those of enterprise-focused competitors, such as IBM, Oracle, and Sun.

Client Upgrades Take Precedence

The profitability figures also have important implications for the Windows road map: when faced with complex technical issues, Microsoft will almost never let these problems interfere with regular refreshes of the desktop client.

Earlier in 2002, for example, some Microsoft executives spoke about the next version of Windows as a unified client and server code-named Longhorn, with many new features that would have delayed its release until 2005 at the earliest. More recently, however, Microsoft has been referring to Longhorn as a client-only release, suggesting that it will be available in 2004—three years after Windows XP hit the market. This rapid release cycle means that some of the more complicated features originally suggested for Longhorn (such as support for Palladium, a hardware-based security system) could slip into a future release of Windows available in 2006 or later.

Information Worker: Expanding Beyond Office

The Information Worker business, which consists of Office and other desktop applications, is Microsoft's second-most lucrative business, with Q1'03 earnings of US$1.88 billion on revenues of US$2.39 billion. The profit margin here—between 75% and 80%—is slightly lower than Client because most sales in this category come through volume licensing agreements or retail sales, meaning that Microsoft, rather than OEMs, bears the bulk of support costs.

Microsoft is addressing external threats to this business, such as piracy (Microsoft has estimated that 150 million of the 300 million copies of Office in use are pirated), and low-cost competitors (e.g., StarOffice)—for example, the company first introduced product activation in Office XP to combat piracy.

But the biggest threat to this segment is earlier versions of Office. The release of Office XP in May 2001 (Q4'01) had no appreciable effect on revenues in this category, suggesting that most companies were satisfied with earlier versions and found few compelling reasons to upgrade. (Revenues spiked in Q1'03, but this was primarily due to an approaching licensing deadline—for more background, see "First Quarter Sees Record Revenue" on page 29 of the Nov. 2002 Update.)

The combination of high profitability and stagnation in this business segment explains the new Information Worker initiative. In particular, the company has broadened its focus beyond the Office suite to include new applications, such as OneNote and XDocs, and is targeting a larger market, including employees who don’t currently use a PC or sit at a desk. The company has created a new product group and added new sales force positions to help implement this initiative. (For details, see "Information Worker Focus of New Client Plans" on page 26 of the Oct. 2002 Update.)

Servers Drive Many Big Initiatives

The Server Platforms (or Servers and Tools) segment includes a wide variety of enterprise products, including Windows Server, the .NET Enterprise Servers (such as SQL and Exchange), Client Access Licenses (CALs) for these servers, development tools, and enterprise services such as consulting and support.

This category has much lower margins (between 25% and 35%) than Client and Information Worker, and costs more to operate (about US$1 billion per quarter) than those other two business segments combined. This is mainly because Microsoft sells far fewer units of server software than it does of PC software, and because server sales are more complex, raising the cost of sales. In addition, the company cannot rely as heavily on the low-cost OEM channel to move server products, and services (consulting, in particular) offer much lower margins than software.

Many of Microsoft's big initiatives in the last several years are intended to increase revenues and profits in the Server Platforms segment. For example, the company's relentless promotional drumbeat for Web services and its inclusion of XML support in many products (not only servers but also development tools and desktop applications) are designed to position its server platform as the best solution for enterprise application integration and data-sharing between companies. The Trustworthy Computing initiative is, in large part, designed to convince enterprises that Microsoft server products are secure and reliable enough for their datacenters. The Microsoft Solution Offerings (MSOs) allow partners to accomplish more pre-sales engineering work with less help from Microsoft—reducing Microsoft's cost of sales—and increase the average number of server products per sale.

The acquisition of Great Plains and Navision, which together cost more than US$2 billion and the subsequent formation of Microsoft Business Solutions (MBS) could also increase profits in this segment by expanding the market for Windows Server and SQL Server (required by most MBS products) to small and mid-size businesses. But this strategy could also backfire: Microsoft relies heavily on ISVs to build solutions that run on its server platforms, and some of these ISVs sell products that compete with MBS solutions. ISVs could hedge their support for Microsoft platforms if they see the company moving into competition with them.

Other Businesses Not Profitable

Combined, Microsoft's four other business segments lost US$375 million on revenues of US$1.16 billion in Q1'03. This makes public a fact that many outsiders have long suspected: without the company's immensely profitable desktop OS and application businesses, forays into new areas would be unsustainable.

The example of MSN is particularly instructive for companies that suddenly find Microsoft competing in their markets. In Q1'02 and Q1'03, costs for MSN were stable at approximately US$630 million, while losses narrowed from US$199 million to US$97 million. Although costs were probably not as high in the early days of MSN, it's safe to assume that Microsoft has, over the last seven years, invested several billion dollars in its ISP and Web portal businesses. Many competitors have gone out of business after spending—and losing—far less.

The message is clear for competitors in areas where Microsoft is a recent entrant or minority player, such as Nintendo and Sony in the console gaming space, Palm in the handheld computing space, Liberate in the enhanced TV space, and Symbian in the wireless phone space: once Microsoft identifies a business as strategically important, it can outspend competitors for many years to remain active and to ensure that no competitor becomes dominant enough to drive standards.

Similarly, enterprise ISVs who hoped to expand downward into the mid-size business space should realize that MBS "only" lost US$68 million in Q1'03. (Great Plains and Navision were both profitable when Microsoft bought them, but this division includes other initiatives such as bCentral and the forthcoming Customer Relationship Management Server.) Microsoft can afford to lose this amount for many years to become the dominant player in this market.

How the Revelations Could Hurt

Although helpful to investors—particularly the institutional investors that hold more than 60% of Microsoft's publicly available shares—the company's decision to reveal these numbers could cause the company some pain as well:

• Investors might question why Microsoft continues to invest in unprofitable businesses, and increase demands for the company to pay some of its US$40.5 billion in cash as a dividend.
• Employees in profitable business segments might complain more loudly about the disparity between their contribution to the company's bottom line and the resources they're allocated. Meanwhile, employees in less profitable segments might question their commitment to a business that loses millions of dollars each year.
• Corporate customers, increasingly concerned about security and reliability, might press Microsoft to plow more of the profits from Windows into improving the security and reliability of Windows, rather than into new business areas.

Resources

Microsoft's 10-Q filing is available in HTML format at www.sec.gov/Archives/edgar/data/789019/000103221002001614/d10q.htm, and as a Word document at www.microsoft.com/msft/sec/FY03/10Q03_1.doc.