By Matt Rosoff [bio]
Posted: Mar. 22, 2004

• Chart: 2003 Revenue by Channel

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.

Newly revealed information about Microsoft’s sales channels breaks down the revenue Microsoft receives from multiyear license agreements, OEM licenses, and one-time sales of licenses or services. The numbers, provided in recent presentations by Chief Financial Officer John Connors, provide new insight into how financial considerations may influence certain product planning decisions, the company's continuing reliance on OEMs, and why quarterly earnings results don't paint a complete picture of Microsoft's financial health, particularly in the Information Worker and Server and Tools business units.

Three Sales Methods

In a pair of Feb. 2004 speeches to financial analysts, Connors outlined the three primary ways in which customers buy Microsoft products: through volume license agreements billed annually ("annuity" purchases), through OEMs, and as one-time purchases. He also revealed how much revenue can be attributed to each sales method in Microsoft's three most important business segments:

• Client, which consists of Windows desktop OSs
• Information Worker, which includes Office, some server applications (Project Server, SharePoint Portal Server, and Live Communications Server), and the applicable Client Access Licenses (CALs) for those servers
• Server and Tools, which includes Windows Server, most server applications (including SQL and Exchange) and their CALs, developer tools, and enterprise services such as consulting and support.

(For a graphical view of these statistics, see the illustration "2003 Revenue by Channel".)

Annuity. Defined by Connors as revenue that comes from annual billings on multiyear agreements sold to businesses, such as Enterprise Agreements (EAs) or Software Assurance (SA) contracts, annuity revenues contributed 26% of Microsoft's total revenues for the year ending in Dec. 2003—the smallest of the three categories. However, the breakdown by business unit reveals that annuity revenues vary significantly across product groups. Annuity contracts made up 40% of revenues in the Information Worker business unit (probably mostly from contracts on Office) and 40% in Server and Tools (probably mostly from contracts covering CALs). Only 15% of revenues in Client came from annuity billings, the main source of which is probably enterprises purchasing upgrade licenses through their EAs.

OEM. Defined as revenue that comes from software that is sold with a PC or mobile device, OEM revenues make up 32% of Microsoft's overall revenues and a whopping 75% of revenues in the Client business unit. In addition, 20% of Information Worker revenues came from OEMs, primarily through Office sold with new PCs in Japan, according to Connors. Only 10% of Server and Tools revenue comes from OEM sales of Windows Server.

One-time licenses. Simply called "licenses" by Connors, this catch-all category includes corporate software purchases that are not billed annually, retail sales of packaged software and hardware, services (such as Microsoft Consulting and Premier Support), and MSN revenues (including consumer subscriptions). This category contributed 42% of Microsoft's overall revenues, 40% of Information Worker revenues, 50% of Server and Tools revenue, and only 10% of Client revenues.

Annuity Contracts and Release Schedules

Although multiyear contracts such as EAs and SA offer various benefits, the most significant benefit is the right to upgrade to new versions of covered products released during the period covered by these contracts. If no new versions of the covered products are released before these contracts expire, companies may question the contracts' value and not renew them.

Given that 40% of the Information Worker business unit's revenues currently come from these contracts, Microsoft has considerable financial incentive to allow no more than three years—the maximum length of a multiyear agreement—between releases of Office, thus ensuring that all purchasers of these contracts get at least one upgrade. Microsoft's current plan is to release the next version of Office concurrent with the release of the next desktop OS, code-named Longhorn, which is now expected to ship in 2006, within the three-year deadline after Office 2003. However, if Longhorn slips much further, an interim version of Office is likely in order to satisfy corporate customers that have already paid for an upgrade.

Similarly, 40% of the Server and Tools unit's revenue currently comes from multiyear contracts. A large chunk of these revenues likely come from sales of the Core CAL—a bundle of CALs for Windows Server, Exchange Server, SharePoint Portal Server, and Systems Management Server. Because CALs must be upgraded to match the server version to which they apply, Microsoft has a significant financial incentive to release a new version of these server products within three years of the previous version; otherwise, renewals of these annuity contracts, and subsequent revenues in Server and Tools, could drop off.

On the other hand, SQL Server is less frequently covered in annuity contracts (it is not part of the Core CAL), so a delay between SQL Server releases is less likely to impact renewal rates for these contracts. Likewise, because only 15% of Client revenues come from annuity contracts, EA renewal rates are less likely to be affected by delays in Longhorn.

Recently announced schedule changes make sense when viewed in this light. For instance, the company recently announced slipping release dates for both Longhorn and the next version of SQL Server (code-named Yukon) and has revealed no plans to release interim versions of these products. At the same time, Microsoft has hinted that a new version of Windows Server will ship in 2005—less than three years after Windows Server 2003—even if that server cannot incorporate the technology planned for Longhorn. Similarly, although the next version of Exchange (code-named Kodiak) was supposed to be based on Yukon technology, Microsoft might ship an interim version if the Yukon dependency would cause Exchange to miss the fall 2006 deadline—three years after Exchange 2003 was released.

Other Implications

The newly revealed statistics offer some other insights into Microsoft's financial situation as well:

Healthy PC sales important. Despite a decade-long effort to diversify into new businesses, Microsoft's health is still largely reliant on PC sales—75% of its largest and most profitable business (Client) comes through the OEM channel, as does 20% of its second-most-important business (Information Worker). Some annuity sales also track PC sales as well, since organizations with EAs must buy new licenses and upgrade rights for any new PCs that they add to their overall PC count.

This underscores the importance of keeping PC sales strong between new releases of Windows. Among other tactics, Microsoft has introduced new form factors (such as the Tablet PC and Media Center PC) and promoted advanced digital media scenarios, which require PCs with more processing power, memory, and hard drive space. But if Longhorn slips further into the future, this task could become increasingly difficult.

Quarterly earnings don't tell the whole story. When Microsoft sells an annuity contract, the company usually bills the customer for only the first year of that contract. Of this first-year billing, a small portion is immediately reflected as revenue; the rest is booked as unearned revenue, then recognized over the course of the year. Subsequent years of the contract are not reflected in Microsoft's financial statements until they are billed to the customer.

Because 40% of revenues in Information Worker and Server and Tools come from annuity contracts, Microsoft's quarterly earnings statements provide only a partial view of the health of these segments—spikes or dips in sales may not show up for a year or more. Therefore, other sources of data, including Microsoft's 10-Q filings (which break down unearned revenue in more detail) and sales statistics from external sources should be consulted before making any assumptions about the popularity of a particular product, for instance.

Serious About Subscriptions?

In addition to the new statistics, Connors also reiterated Microsoft's interest in moving more customers to a subscription-type model for buying software—a concept that other executives have in the past called "software as a service." This would help Microsoft financially by evening out its revenue stream and making the company less reliant on selling major upgrades every several years.

However, Connors also acknowledged that the company would have to make some major shifts to accomplish this, such as focusing research and development on small incremental upgrades rather than major product revisions, and improving technologies (such as Systems Management Server and the Software Update Service) to make deploying this stream of upgrades easier. The notion of many incremental upgrades also complicates the goal, expressed by Chief Software Architect Bill Gates and others, of offering "integrated innovation" among Microsoft's many different product lines—if products have multiple interdependencies, upgrades must be coordinated and tested against many other products, leading to higher development costs.

Meanwhile, only between 10% and 30% of customers who purchased upgrade rights on older software in 2002 are expected to renew in 2004, suggesting that many smaller customers prefer one-time license purchases rather than the SA annuity approach. (For a discussion of the issues around SA renewal, see "Software Assurance Approaching Critical Deadline" in the Apr. 2004 issue of Update .)

As Connors said, "The first premise is that we will take what the market gives. . . . If customers want to buy license[s], we want to make it super easy to do that, so that they can buy as many as they want without it being an annuity program." For the near future, then, software as a service remains a speculative long-term goal.

Resources

Transcripts of Connors's Feb. 2004 speeches to financial analysts are at www.microsoft.com/msft/speech.mspx.

For an overview of Microsoft's last earnings report, see "Q2'04 Record Revenues Offset by One-Time Expense" on page 27 of the Mar. 2004 Update.