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

Microsoft announced a two-for-one stock split and will begin paying annual dividends to shareholders on Mar. 7, 2003. The announcements coincided with the company's earnings report for the second quarter (ending Dec. 31, 2002) of its 2003 fiscal year, a quarter that saw a record US$8.54 billion in revenues. However, profit was down slightly from the previous quarter and has remained flat over the last two years. Given this trend and the likelihood of a challenging FY'04, the dividend and split are primarily meant to increase the stock's appeal to investors.

(For an overview of Q2'03 financial results and how they compare with previous quarters, see the chart "Microsoft Financials for the Last Five Quarters".)

Increasing Investor Appeal

The two-for-one split will be applicable to all shareholders who own stock on Jan. 27, 2003; the stock price will be cut in half on Feb. 18. Microsoft has split its stock eight times before, but only when the price of shares was US$90 or higher. (It was trading at US$55.35 when this split was announced.)

In addition, all shareholders who own the stock at the close of business on Feb. 21 will receive a dividend of US$0.08 per share on Mar. 7. The dividend—Microsoft's first ever—will amount to about US$850 million of Microsoft's US$43.4 billion in cash and short-term investments, and will be the first in a planned series of annual dividends.

According to Chief Financial Officer John Connors, the company chose to pay the dividend now in part because its legal situation is beginning to stabilize—a federal judge approved an antitrust settlement with the U.S. Department of Justice in Nov. 2002, and a proposed settlement was reached with California consumers in a class-action antitrust suit in Jan. 2003. (See "Antitrust Fallout Continues; Sendo Sues".) Connors suggested that the company will pay larger dividends in the future, calling this first payout a "starter dividend."

However, both the split and the dividend are primarily designed to increase the appeal of Microsoft shares to investors. Although the company's revenue has continued to rise fairly steadily, net income dropped 6% from the previous quarter and has been flat for the last two years—in fact, the company's profit was lower in Q2'03 (US$2.55 billion) than in the same quarter two years ago (US$2.62 billion).

Moreover, Connors admitted that it would be "pretty tough" for FY'04 revenues to show much growth over FY'03, citing the following reasons:

• A switch in licensing practices caused many businesses to renew their license agreements or purchase software upgrades before prices went up, boosting sales in FY'03
• Xbox—a huge revenue-gainer, if not yet profitable—was a new product in some markets in FY'03
• Softness in the global economy continues, and there is no indication of a major recovery in IT spending or PC sales.

Given these factors, the company is concerned that a high share price relative to other technology bellwethers, such as Intel, Oracle, and SAP, could keep investors away. The stock split will cut the price of Microsoft shares in half.

Instituting an annual dividend further sweetens the pot and signals to the investment community that Microsoft, while enjoying reliable cash flow and huge cash reserves, is unlikely to see the high growth that typified it and other technology companies in the 1990s.

Client Revenue Flat, Xbox on Track

Product revenues in the Client category, which includes Windows desktops, were down very slightly compared with the same quarter last year. This is primarily because last year's sales were boosted by the major marketing campaign that went with the Windows XP launch, and because some multinational OEMs had accumulated inventory left over from Q1'03 and therefore bought fewer licenses in Q2'03. The holiday season also saw a greater percentage of sales come from consumers buying the less expensive Windows XP Home Edition, rather than businesses buying more expensive Professional desktops.

The following categories also showed notable results:

• Server Platforms showed 12% revenue growth despite continuing weakness in corporate IT spending. This is due in part to the growth of Intel-based ervers versus Unix-based servers, and in part to a big boost in unearned revenue in this category earlier in calendar year 2002; this unearned revenue is now being carried forward. (For background on how unearned revenue is counted, see "The Importance of Unearned Revenue" on page 30 of the Oct. 2002 Update.)
• Home and Entertainment showed revenue growth of 35% over last year, mainly because Xbox is available in Europe this year. The company has now sold more than 8 million Xbox units—about 5.4 million in North America, 1.8 million in Europe, and 800,000 in the Asia-Pacific region—and is on track for its low-end goal of 9 million by the end of the fiscal year on June 30. However, the business model for Xbox relies on game sales for profitability; the company loses money on each console, so console sales help only revenue, not profits. The company also sold more than 250,000 Xbox Live starter kits in Q2'03, which is more than twice the number expected.
• Microsoft Business Solutions (MBS) boasted record revenues of US$135 million, compared with US$105 million last quarter. Connors credited a new financing program for MBS customers for the growth, and said that the category would post about US$500 million in revenues for the fiscal year.

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

Microsoft will break out profit or loss for Q2'03 in each category in its 10-Q filing with the U.S. Securities and Exchange Commission, which will probably be filed in mid-February.

Detailed information about Microsoft's Q2'03 results and financial history is available at www.microsoft.com/msft.