• Sidebar: Big Dividend, Buyback Announced
• Chart: Microsoft Financials for the Last Five Quarters
• Chart: Revenue and Profit (Loss) By Business Segment
• Chart: Why Expenses Have Been Rising

Profits reached a record US$2.69 billion in the fourth quarter of Microsoft's 2004 fiscal year, which ended June 30—a record profit for the company since it began counting stock-based employee compensation as an expense. The strong quarter was driven by growth in PC and server shipments, particularly to businesses, and stronger-than-expected sales of multiyear licenses to large customers. (For an overview of Q4'04 financials and how they compare with previous quarters, see the chart "Microsoft Financials for the Last Five Quarters".)

Microsoft Chief Financial Officer John Connors expects strong corporate IT spending to continue at least through the first half of FY'05, and he raised Microsoft's revenue guidance for the fiscal year to between US$38.4 and US$38.8 billion. However, in Dec. 2005, Microsoft will return about US$32 billion in cash to investors in the form of a one-time payment, reducing the earnings it receives from its cash and short-term investments. As a result of this and other factors, including the lack of a new Office release and the likely end of a foreign-currency benefit, Connors expects profits to grow only 5% in the coming fiscal year. (For details of Microsoft's cash disbursement plan, see "Big Dividend, Buyback Announced".)

Hardware, Enterprise Sales Drive Growth

Of Microsoft's seven business units, Information Worker showed the strongest quarterly improvement over the previous year, with revenues up 23% and profits up 33%. Most of the increase is due to strong sales of Office 2003 through volume licensing (particularly Enterprise Agreements), as well as in retail and Japanese OEM channels. Comparisons with last year, however, can be misleading, since a year ago many customers were delaying purchases of Office while waiting for the Oct. 2003 launch of Office 2003. Connors cautioned that revenue growth in this segment will slow to 1% or 2% for FY'05 as unearned revenue from a summer 2002 licensing transition will no longer be carried forward, because there is no Office launch planned for the coming fiscal year, and because Information Worker particularly benefited from foreign exchange rates (which contributed 5% of its overall revenue in Q4'04), a trend that Connors expects to end in FY'05.

(For a chart showing Q4'04 and Q4'03 revenue and profit or loss by business segment, see "Revenue and Profit (Loss) by Business Segment".)

Microsoft's other two core businesses—Server and Tools, and Client—also showed strong results, primarily because of a pickup in hardware sales to businesses. Server and Tools revenue grew 20% over the year-ago quarter, thanks to 13% unit growth in server hardware shipments; Windows-based servers outpaced the rest of the server OS market, with unit shipments growing 18%. Strong sales of SQL Server and the Core Client Access License (a bundled license giving corporate users access to multiple Microsoft server products) also helped. The company expects Server and Tools revenue growth to slow only slightly in FY'05 (to between 13% and 15%), as Windows continues to outpace Unix and compete effectively with Linux in the server market.

Client, meanwhile, showed 9% revenue growth over the year-ago quarter, as PC shipments were up 12%, and the proportion of higher-priced Professional versions of Windows (including Tablet and Media Center) grew from 62% to 64%. Microsoft expects Client revenue growth to slow slightly in FY'05, as sales in major markets slow (piracy rates in emerging economies limit revenue growth from those countries) and the mix of Professional versions of Windows remains constant.

MSN showed its third profitable quarter out of the last four, earning US$35 million on revenues of US$588 million, mostly due to strong advertising revenues. The quarter's results meant that MSN showed its first annual profit (US$121 million on US$2.22 billion in revenues) since its founding in 1995. In addition, although MSN dial-up subscriber numbers have dropped drastically since the end of the last fiscal year (from 6.5 million to 4.3 million), the company has more than made up the loss by signing up Hotmail Extra Storage and MSN Premium and Plus customers. As a result, the total number of MSN subscribers increased from 8.6 million at the end of FY'03 to 8.8 million now.

The company's other emerging businesses remain in the red, with Home and Entertainment losses increasing to US$339 million (up 38%) because of lower prices on the Xbox console. However, Microsoft reached its FY'04 goal for Xbox unit shipments, selling 15.5 million units worldwide (10.1 million in the United States, 3.9 million in Europe, and 1.5 million in the Asia-Pacific region), and expects to have shipped more than 20 million by this time next year. Company executives reiterated that Home and Entertainment remains a long-term investment and gave no timeline for profitability.

Microsoft Business Solutions showed 9% revenue growth over last year thanks to stronger sales of Navision and Axapta products, particularly in the United States, but the company is no longer predicting profitability for that division by FY'05.

Mobile and Embedded revenues grew 58% to US$70 million in Q4'04, but Microsoft is only predicting 21% growth for all of FY'05, as the main component of revenue growth in FY'04 was the acquisition of Vicinity Corporation (which provides mapping and location services) and its existing customers.

Investment Income to Drop

Connors lowered FY'05 earnings guidance from his April prediction of between US$1.16 and US$1.18 a share to between US$1.05 and US$1.08 per share. The main reason for this change is a significant reduction in Microsoft's investment portfolio. First and foremost, the company will have US$32 billion less in cash and short-term investments after its one-time payment to investors in Dec. 2004. Other contributing factors include a shift to more liquid but lower-yield investments (in preparation for the December payout), and other shifts to account for expected higher interest rates. In addition, Connors noted that FY'04 earnings benefited from favorable foreign exchange rates to the tune of US$1.1 billion, a trend that he does not expect to continue through FY'05.

Unearned revenue, an important indicator of Microsoft's sales of multiyear licenses, grew US$651 million from last quarter to US$8.18 billion. This result was due to a wave of companies signing or renewing Enterprise Agreements, particularly in June. Microsoft expects unearned revenue to drop in Q1'05, as fewer than 30% of customers with expiring Upgrade Advantage agreements are expected to convert to Software Assurance or Enterprise Agreements. However, now that this transition is over, Microsoft expects unearned revenue to adhere more closely to traditional seasonal patterns, rising sequentially in Q2 and Q4 and dropping in Q1 and Q3. Overall, the company expects to have about US$8.6 billion in unearned revenue by the end of FY'05.

Connors also reiterated that Microsoft is "very focused" on managing costs, which have grown faster than revenues over the last two fiscal years. Much of this cost growth was a result of expenses, particularly legal settlements, outside the day-to-day costs of doing business. (For details, see the chart "Why Expenses Have Been Rising".) Nonetheless, Connors vowed that Microsoft will work harder to constrain regular costs in FY’05. Specifically, he said that costs, excluding legal settlements and stock program changes, would grow US$250 million in FY'05, whereas the company expects revenues to grow at least US$1.6 billion. This cost containment is particularly important given that revenue growth in some core businesses (notably Information Worker) and investment income is expected to slow substantially in FY'05.

More information about Microsoft's Q4'04 and FY'04 results is at www.microsoft.com/msft.