• Chart: Microsoft Financials for the Last Five Quarters
• Chart: Revenue by Business Segment

A strong pickup in PC sales and IT spending enabled Microsoft to post record revenues of US$10.15 billion in the second quarter of fiscal year 2004, which ended Dec. 31, 2003. The record revenues did not translate into record profits, however, as a program to buy back "underwater" employee stock options hit the bottom line, particularly in the Server and Tools business segment. Nonetheless, the strong quarter led the company to raise its guidance for FY'04. Microsoft also acknowledged uncertainty as to whether small and mid-size businesses would continue to participate in annuity licensing programs beyond this fiscal year.

(For an overview of Q2'04 financials and how they compare with previous quarters, see the chart "Microsoft Financials for the Last Five Quarters".)

Strong Revenue Growth in Core Businesses

A recovery in technology spending—sales of PCs and Intel-based servers surpassed Microsoft's forecasts in Q2'04, growing 12% and 13%, respectively—and favorable exchange rates enabled Microsoft's three largest and most profitable business segments to show revenue growth of 20% or greater from the same quarter last year.

The Client business, which includes all Windows desktop OSs, showed 21% revenue growth and 6% profit growth from the same quarter last year. This strong showing came primarily from a 27% increase in OEM license units shipped. Some of this increase in license units is attributable to the broad recovery in the PC market, but some of it is also attributable to a Q1'03 change in how Microsoft records OEM billings for Windows; as a result of this change, OEM shipments for the year-ago quarter appeared unusually low.

Information Worker showed strong revenue growth (27%) from the same quarter last year, although profits were up less than 1%. The revenue increase was spurred by the Oct. 2003 release of Office 2003, which led to significant growth in Information Worker revenue from retail (up 36% from last year) and OEM sales (up 22%).

In addition, the year-over-year revenue comparisons in both Information Worker and Client were helped by an accounting change in Q4'03 that decreased the amount of money deferred from retail and OEM sales. (For details on that accounting change, see "Deferred Revenue Changes" on page 41 of the Oct. 2003 Update.)

Server and Tools, which includes Windows Server, server applications (such as SQL and Exchange), and other products and services for enterprises, showed 21% revenue growth from last year, as revenues from server sales grew 22% and consulting and Premier Support revenues grew 29%. However, this division went from a US$234 million profit in Q2'03 to a US$204 million loss in the most recent quarter, primarily because of stock-based compensation costs of US$651 million stemming mostly from the option buyback program. The unit also hired additional employees, which pushed costs up.

Despite this change from profit to loss in Server and Tools, the strong revenue growth in Microsoft's core businesses and the general recovery of technology spending led Microsoft Chief Financial Officer John Connors to raise expectations for FY'04. The company now expects revenues of US$35.6 to US$35.9 billion for FY'04 (an increase of US$800 million from previous guidance) and diluted earnings per share of between US$0.82 and US$0.83.

Most of Microsoft's emerging businesses showed significant revenue growth from last year as well. MSN's revenues were up 19% from the previous year, due to increased sales of advertising, although the division returned to unprofitability after its first-ever profitable quarter in Q1'04. Business Solutions revenue rose 41% due to increased sales of the Navision product line and the addition of Business Contact Manager (a component of Office 2003). Mobile and Embedded Devices revenue was up 66% from the previous year thanks to strong growth in MapPoint location-based services, but losses jumped from US$75 million to US$112 million because of the one-time expense associated with the stock option buyback program.

The exception to these trends was the Home and Entertainment segment, which boasted smaller revenues compared with last year (down 5%), but also lost less money (US$394 million, compared with US$412 million). This result can be explained by the fact that, although Xbox console unit sales declined and the company lowered prices on the consoles, revenue from game sales was up US$175 million over last year. Microsoft loses money on each console but makes it up on game sales.

(For a chart showing Q2'04 and Q2'03 revenue and profit or loss by business category, see "Revenue by Business Segment".)

Buyback Cuts Profits; Unearned Picture Uncertain

Despite breaking its previous quarterly revenue record by nearly US$2 billion, Microsoft's US$1.55 billion net income was actually lower than the previous quarter's figure of US$2.61 billion. The main reason for this discrepancy is a one-time expense of US$1.48 billion from the Stock Option Transfer Program, which allowed employees to sell "underwater" options to J.P. Morgan Chase.

Unearned revenue remains an area of concern, as it dropped US$395 million from the previous quarter. The bulk of this drop (US$210 million) comes from volume licensing programs. That's because, between fall 2001 and summer 2002, many companies signed up for a program called Upgrade Advantage (UA) to upgrade their older software at a discount, which was no longer possible after that transition period. These UA payments were booked as unearned revenue, then slowly recognized over the subsequent quarters. Now, Microsoft is not taking in enough unearned revenue from new licensing agreements to keep pace with the gradual movement of these UA payments from unearned to earned.

Connors acknowledged that many of these UA customers are smaller companies that previously purchased licenses only on an as-needed basis and never before participated in an upgrade program. Thus, Microsoft does not know whether these UA customers will sign up for Software Assurance, the program that replaced UA, when their UA contracts expire. (Most UA contracts were two-year contracts that expire in calendar 2004.) If not, unearned revenue levels may not recover to their Q1'03 peak until late FY'05 or beyond. But this may not matter—with the IT industry apparently mounting a recovery, Microsoft might not need such a large store of unearned revenue to carry it through troubled times.

More information about Microsoft's Q2'04 results is at www.microsoft.com/msft. Microsoft's Q2'04 10-Q filing with the U.S. Securities and Exchange Commission, which includes profit and loss figures for each business segment, is at microsoft.shareholder.com/redesign/EdgarDetail.asp?CIK=&FID=1193125-04-16249&SID=04-00.