• Chart: Microsoft Financials for the Last Five Quarters
• Chart: Revenue and Profit (Loss) by Business Segment
• Chart: Revenue Recognized from Licensing Transition

Strong revenue growth across six of Microsoft's business segments and a significant gain on investments were tempered by more than US$2.5 billion in legal expenses in the third quarter of fiscal year 2004, which ended Mar. 31, 2004. As a consequence, profits were the lowest they've been in eight quarters, at US$1.31 billion. Microsoft Chief Financial Officer John Connors emphasized that corporate IT spending seems to have recovered, but he was cautious about FY'05, citing the end of the unearned revenue carryover from a licensing transition in mid-2002 and the game console life cycle, among other factors.

(For an overview of Q3'04 financials and how they compare with previous quarters, see the chart "Microsoft Financials for the Last Five Quarters".)

Revenue Growth Driven by IT Recovery

Microsoft booked US$9.18 billion in revenue in Q3'04, which is 17% higher than the same quarter last year. Although this is lower than the US$10.15 in revenues collected during the previous quarter, this pattern is normal because Q2 includes the holiday season, which boosts consumer spending.

Microsoft's three core business units—Client, Information Worker, and Server and Tools—showed aggregate revenue growth of 17% over the same quarter last year, driven primarily by a broad-based recovery in IT spending.

In particular, Microsoft cited higher-than-expected server hardware sales—up about 17% over the same quarter last year, instead of the 12% that Microsoft expected—as the reason for the strong (19%) revenue growth in Server and Tools. The company noted that the number of Windows Server licenses sold was up 31% over the previous year, due mainly to the Oct. 2003 release of Windows Server 2003, and said that Small Business Server (SBS) 2003 is selling much better than its predecessor—sales are 170% of what they were after a similar time period for SBS 2002. Despite these strong sales, however, Server and Tools posted a US$635 million loss for the quarter, compared with a US$305 million profit one year ago, mainly because of US$1.22 billion in expenses associated with the Sun Microsystems legal settlement. (See "Sun Deal Signed, Litigation Ends" on page 33 of the May 2004 Update.) Looking ahead, Microsoft expects Q4'04 to show continued strength in Server and Tools, with revenues up 15% or higher from Q4'03.

The Client and Information Worker segments, meanwhile, were helped by a surge in PC sales, which were up 14% over last year. Most notably, OEM revenues for Information Worker were up 35% over the same quarter last year, helping the business segment show a 14% jump in year.profits. However, profits in the Client segment were down from the previous year because of US$700 million in expenses related to the Sun settlement. Moving forward, Microsoft expects PC shipments to continue to grow through Q4'04 and FY'05—a welcome change from recent years of flat or negative growth.

Most of Microsoft's emerging businesses also shone in Q3'04. MSN posted a record US$591 million in revenues—a profit of US$107 million—its second profitable quarter (Q1'04 was its first). This growth was driven by a 43% increase in advertising revenues; subscription revenues were down 6% from last year, although subscriber numbers rose slightly from last quarter to 8.2 million, as enough subscribers signed up for Hotmail Extra Storage and other services to make up for defections from MSN's dial-up user base. The Home and Entertainment segment also showed 17% revenue growth over last year thanks to better Xbox console sales, and cut its losses 25% from last year thanks to better margins on the consoles and third-party games. (The recent price cut to US$149 for the Xbox console didn't happen until the last week of Q3'04 and therefore had little effect on console margins.) Mobile and Embedded revenue was up 33%, driven by balanced growth across its business lines.

The only exception to the very strong quarter was Microsoft Business Solutions (MBS), which showed only 4% revenue growth from the previous year’s results, although MBS was able to cut its losses by 29% over the same time period. Connors blamed the slow revenue growth on a lack of execution in the United States, citing new staff in district positions and less effectiveness with traditional MBS partners—that is, Great Plains and Solomon resellers. Connors noted that the MBS business in the United States was keeping pace with competitors, rather than outpacing it as Microsoft had expected, but he emphasized that Navision sales are showing strong growth in Europe.

(For a chart showing Q3'04 and Q3'03 revenue and profit or loss by business category, see "Revenue and Profit (Loss) by Business Segment".)

Lawsuits, Taxes, and Unearned Revenue

The surge in IT spending did not translate into increased profits, however, as two major lawsuit settlements hit the bottom line. In addition to the Sun settlement, which cost a total of US$1.92 billion, Microsoft also set aside US$605 million for an antitrust fine levied by the European Commission. The amount will be adjusted if an appeals court lowers or eliminates that fine. (see "EU Aims to Restrict 'Future Conduct'" on page 36 of the May 2004 Update). In addition, Microsoft's tax rate was 42% (it's usually around 33%) because of the "non-deductibility" of the European Commission fine, further cutting into profits.

Investment income was a bright spot, coming in at US$1.01 billion—a welcome change from the huge impairments seen in some quarters during the last few years. Microsoft expects investment income to continue to play a significant role, coming in around US$900 million in Q4'04.

Finally, unearned revenue seems to have stabilized somewhat. Although unearned revenue dropped US$326 million from the previous quarter to US$7.53 billion, this is less than Microsoft expected it to drop, and it was driven by stronger-than-expected sales of Enterprise Agreements (EAs). Connors reiterated that the company only expects renewal rates of 10% to 30% among the customers who have Software Assurance (SA) as a result of purchasing a previous upgrade program before a July 2002 deadline. He also emphasized that the large chunk of unearned revenue that has been carried forward from this rush of sign-ups will have expired by the end of FY'04.

At the same time, Microsoft offered uncommonly detailed statistics to show that the unearned revenue carried forward from this wave of sign-ups has been a fairly small component of its overall revenue—no more than 6% of total revenue in a single quarter, and less than 3% in Q3'04. (For detailed statistics, see the chart "Revenue Recognized from Licensing Transition".) This suggests that the low expected renewal rates for these customers will have minimal effect on future earnings.

More information about Microsoft's Q3'04 results is at www.microsoft.com/msft.