By Matt Rosoff [bio]
Posted: Aug. 9, 2004

• Chart: Seven Businesses: FY'05 Overview
• Chart: Profits Affected by Nonrecurring Events
• Sidebar: How Much Is "A Whole Intel"

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.

Success through product and geographic segmentation, tactics to compete against Linux, and the potential for growth in emerging businesses were among the themes at Microsoft's Financial Analysts Meeting in July 2004. With few major product releases slated for fiscal year 2005 (which began July 1, 2004), spokespeople for Microsoft's seven businesses focused mostly on general opportunities and threats rather than specific products or technologies. Executives also tried to convince analysts that Microsoft is still an innovative company capable of significant profit growth.

(For a chart showing FY'04 revenue results and FY'05 revenue predictions for each business, see "Seven Businesses: FY'05 Overview".)

Client: Segmentation, Piracy Prevention

FY'04 revenue growth in the Windows Client business, Microsoft's largest and most profitable segment, nearly doubled expectations, coming in around 12%. Although profits declined slightly, this was primarily due to the effects of the Sun Microsystems settlement and a one-time program to buy back "underwater" stock options—without these events, profits would have been up about 13%. (For details on how these events affected each business unit's profit and loss, see the chart "Profits Affected by Nonrecurring Events".) The company expects Client revenue growth to slow slightly in FY'05, to 5% to 7%, as PC sales growth slows.

Senior Vice President Will Poole, who leads the Client business, said that improving Windows security remains that unit's first priority, and he highlighted the security fixes in Windows XP Service Pack 2 (SP2), which is being released in Aug. 2004. However, improving security will do little to add revenues or profits to the Client business—in fact, Chairman and Chief Software Architect Bill Gates claimed that SP2 is the costliest free upgrade Microsoft has ever released. Therefore, beyond security, the Client business is focusing on segmentation and piracy prevention for revenue growth.

Specific initiatives include the following:

Media Center. Windows XP Media Center Edition—a special-purpose version of Windows geared toward recording TV shows and working with digital media—costs more than Windows XP Home. Therefore, by increasing Media Center sales relative to overall Windows sales, the Client business can see its revenues increase more quickly than the PC run rate. To this end, Microsoft will release a new version of Windows XP Media Center Edition in late 2004 or early 2005 and will release add-ons such as Media Center Extenders (which allow users to stream digital media from a Media Center PC over a home network to a TV) to spur the market. According to Poole, Microsoft expects the Media Center installed base to grow from about 1.5 million at the end of 2004 to more than 20 million by 2008.

Starter Edition. Emerging economies where the PC penetration rate is very low present another opportunity for the Client business. To better serve these markets, Microsoft has launched pilot programs in Indonesia, Malaysia, and Thailand in which the company works with governments to distribute Windows XP Starter Edition, a lower-cost, easier-to-support version of the OS. Poole suggested that Microsoft will expand this program to other countries.

Piracy prevention. Poole cited piracy as an ongoing problem, but admitted that Microsoft cannot do much about it in countries with lax intellectual property enforcement—particularly China, where Microsoft estimates 95% of the copies of Windows in circulation are unlicensed. However, he noted that other countries, including Italy, South Korea, and Hong Kong, have cracked down on piracy in the past, and he held out hope that other countries would follow suit. Poole also noted that there are about 13 million unlicensed copies of Windows in circulation in the United States—the same absolute number as in China, albeit a much lower percentage.

Minimal Revenue Bump from "Longhorn"

Top Microsoft executives took pains to point out that the release of the next version of Windows (code-named Longhorn), expected in 2006, will probably not lead to a large bump in revenue. That's because most consumers and businesses buy a new OS only when they purchase a new PC—this is especially true given that Longhorn will probably require new hardware, making a large wave of in-place upgrades unlikely. Moreover, many other businesses pay for OS upgrades ahead of time through programs such as Enterprise Agreements.

Rather than spurring immediate profit growth, Longhorn is important because it will affect what Gates called the "competitive dynamic"—in particular, it could drive sales of other Microsoft software and propagate Microsoft's .NET platform at the expense of Java and open-source competitors.

Information Worker: Slow Year Ahead

Coming off the launch of Office 2003 in FY'04, which saw 17% revenue growth and 10% profit growth, Microsoft's expectations for its second-largest business unit are fairly modest—only 1% to 2% revenue growth for FY'05.

Office Senior Vice President Steven Sinofsky cited the importance of product segmentation in the last fiscal year: the lower-priced Student and Teacher Edition of Office 2003 sold extremely well in the retail channel, and the inclusion of Business Contact Manager may have helped OEM sales of the Small Business Edition.

Sinofsky also cited the importance of geographic segmentation in conquering overseas markets, citing the English Writing Assistant, an add-on to the Chinese version of Office that provides Web-based guidance on English vocabulary, grammar, and usage; and a forthcoming Japanese product called Office Interconnect, which will let users update their contact information in a virtual "business card," then automatically push this update to the user's contacts.

Finally, Sinofsky noted the importance of selling products outside the core Office suite, including servers such as Project Server, Live Communications Server, and SharePoint Portal Server, and noted that these products have a longer ramp-up time than the Office suite.

Server and Tools: Linux Threat Addressed

FY'04 was a strong year for the Server and Tools business segment, as revenues grew 19%—considerably faster than the high-end expectation of 12%. (Profits were down significantly, but without the Sun settlement and option buyback program, they would have grown by 76%.) The company continues to expect solid results in FY'05, with revenue growth around 8% or 9%.

Server and Tools Senior Vice President Eric Rudder credited the strength of old standbys SQL Server (revenues grew 20%) and Exchange Server (which had sales in excess of US$1 billion for the first time) for the year's results, but he also noted the growth of systems management products, such as Systems Management Server (SMS) and Microsoft Operations Manager (MOM), which together contributed about US$300 million in revenues.

Looking forward, Rudder cited the importance of Visual Studio .NET 2005 and SQL Server 2005 as "anchor products"—that is, they are meant to provide a solid platform on which Microsoft, ISVs, and corporate developers can build applications, which will spur continuing Windows platform growth. Rudder also highlighted the importance of business intelligence tools such as SQL Server Reporting Services and listed forthcoming Windows Server releases, including new 64-bit editions with better 32-bit compatibility, an edition for high-performance computing, and Windows Server 2003 Release 2 (R2), which will incorporate functionality currently offered by add-ons (such as Rights Management Services).

This business segment faces a significant threat from Linux, and Sales Group Vice President Kevin Johnson spent considerable time explaining the pitch that Microsoft makes to customers considering Linux. In its "Get the Facts" campaign, the company highlights the following advantages of its platform:

• Lower total cost of ownership and, in some cases, lower upfront costs (based on data from both Microsoft-commissioned and independent studies)
• A more coherent systems-management story, with products such as SMS and MOM and the forthcoming Dynamic Systems Initiative
• Indemnification against any intellectual property judgments affecting Microsoft products—a reference to emerging concerns over patent claims on technology in Linux.

MSN: All About Advertising

Microsoft expected MSN revenues to shrink in FY'04 as dial-up subscribers continued leaving the service for broadband access from other providers. However, the division beat its revenue expectations handily, increasing revenues 13% and turning its first-ever profit thanks to a 43% increase in advertising revenues, internal cost-cutting, and the end of expensive customer acquisition and retention programs for MSN's dial-up ISP business.

MSN Senior Vice President Yusuf Mehdi highlighted the importance of advertising for future growth, noting that advertisers spend only about 1% to 2% of their budget online, while consumers spend about 12% of their time online. Mehdi predicted that overall online advertising expenditures could triple to more than US$20 billion in the next four years. He said MSN could grow faster than the market by supporting advances such as new media formats and personalized advertising, and because MSN has a strong international presence, with 18 localized versions of its sites and services.

Mehdi also discussed an MSN search initiative and demonstrated a forthcoming tool that will let users search their hard drives, information in Outlook (including text in e-mail attachments), and the Internet. Although this tool will be free to consumers and therefore won't contribute directly to Microsoft's bottom line, it could draw more users into viewing paid search results from advertisers—a major component of MSN's overall advertising revenue. Mehdi also noted the importance of e-commerce in FY'05, but he did not demonstrate the much-anticipated MSN Music store.

Home and Entertainment: Aiming for Sony

Although revenues and sales figures for Xbox met the company's expectations in FY'04, this continues to be Microsoft's most expensive business unit, amassing losses of more than US$1 billion in each of the last three years—primarily due to the fact that Microsoft loses money on each Xbox console sold. Chief Financial Officer John Connors was very conservative in his predictions for this business, suggesting that it would probably be the last to become profitable—perhaps by FY'07.

Bryan Lee, the head of finance for this business division, spent little time discussing results, but noted that industrywide video game revenues in the last six years have grown 60%, to US$10 billion annually, putting gaming on par with the movie or recorded music businesses. He noted that Microsoft has progressed in establishing partnerships and building well-known game franchises such as Halo in less than three years and said that the Xbox team was "laser-focused" on beating Sony in the next generation of consoles, which are expected to emerge in 2005 or 2006.

Business Solutions: Right Focus

At the 2003 Financial Analyst Meeting, Microsoft Business Solutions (MBS) Senior Vice President Doug Burgum predicted that his business unit would begin turning a profit by FY'05. However, MBS was the only segment not to live up to Microsoft's revenue expectations in FY'04, turning in only US$667 million against a low-end expectation of US$700 million, and Connors suggested FY'06 or later as a more reasonable time frame for MBS profitability.

This year, Burgum tried to reassure analysts that MBS was on the right track, explaining that vendors squarely focused on small and mid-size businesses—including MBS, Intuit, Sage, and Salesforce.com—had their best-ever revenues in 2003 and 2004, whereas enterprise vendors attempting to move downmarket (such as Oracle, PeopleSoft, and Siebel) are well below their peaks. In contrast with past years, Burgum steered clear of discussing MBS's long-term platform plans, such as the .NET Business Framework and Project Green, instead noting that all four of MBS's enterprise resource planning (ERP) product lines—Axapta, Great Plains, Navision, and Solomon—have major releases scheduled for FY'05. Burgum also dismissed concerns that having four ERP brands was confusing, comparing MBS to "any car manufacturer, any consumer goods company that puts out multiple brands in a category with different flavors and different niches."

Mobile and Embedded: Big Opportunity

Microsoft's smallest business unit, with FY ’04 revenues of US$247 million, is also its fastest-growing unit, with FY'04 revenues growing 58% and FY'05 revenue growth expected at more than 20%.

Mobile and Embedded Senior Vice President Pieter Knook stuck to familiar themes, reiterating the enormous opportunity (1.4 billion mobile and embedded devices are shipped every year) and suggesting that his group could leverage work done in other parts of Microsoft to address evolutions in the mobile and embedded industry, such as the following:

• IT professionals' demand for better security
• Developers' demands for a consistent development environment and platform
• The move toward 32-bit embedded processors
• User demand for digital media on mobile devices.

Goal: Growth and Value

Over the last several years, as Microsoft's profits and share price have remained relatively flat and its dividend payments have increased, culminating with a US$32 billion one-time payout planned for Dec. 2004, many financial advisors have come to think of Microsoft as a blue-chip company—stable and flush with cash but not particularly interesting, quick-to-market, or capable of rapid profit growth.

Microsoft executives tried to counter this impression, most notably by repeating the mantra of "innovation" (mentioned almost 100 times during the day—by way of comparison, once-common buzzword ".NET" only rated about 30 mentions). More to the point, Connors suggested that all seven businesses could be profitable by FY'07, which would eliminate more than US$2 billion in losses from the company's bottom line, and Ballmer suggested that operating profits could grow by as much as US$8 billion by the end of FY'08. (For further discussion of future profits, see "How Much Is 'A Whole Intel'?".)

To reach these goals, Microsoft will need to do more than create and sell innovative new products and unlock new markets, such as developing countries and small to mid-size businesses. Executives acknowledged that the company must also better control unusual expenses, such as legal settlements and losses on strategic investments, and avoid ills often associated with large companies, such as bureaucracy and attrition.