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

Strong sales of server applications and Xbox game consoles were the bright spots in the third quarter of Microsoft's fiscal year 2005, which ended Mar. 31. However, slow growth in the company's other businesses meant that total revenue grew only 5% from the previous year, to US$9.62 billion—the lowest rate of year-over-year revenue growth since the June 2000 quarter, in which Microsoft suffered its first major antitrust setback and felt the beginning of the dot-com implosion. Nonetheless, the company expects a pickup in Q4, as more than US$2.5 billion worth of multiyear contracts come up for renewal.

(For an overview of Q3'05 financials and how they compare with previous quarters, see the chart "Microsoft Financials for the Last Five Quarters".)

SQL, Exchange Drive Growth

Revenues in Q3'05 were significantly lower than the previous quarter, which is normal because of high consumer sales in the December quarter. However, rates of year-over-year revenue growth slowed in most of Microsoft's seven business units as well, suggesting a broader slowdown may be at work. Nonetheless, Microsoft was able to nearly double its profits from the same quarter last year (from US$1.32 billion to US$2.56 billion) due to much lower legal expenses. (For a chart showing Q3'05 and Q3'04 revenue and profit or loss by business segment, see "Revenue and Profit (Loss) by Business Segment".)

Core businesses. The Server and Tools business segment continues to be Microsoft's star performer, posting 12% revenue growth (to US$2.45 billion) and 34% profit growth (to US$824 million) from the previous year. SQL Server and Exchange Server were particularly strong, posting more than 15% and more than 20% annual revenue growth, respectively. In addition, consulting and support revenue grew 18% from the previous year.

However, some worrying trends emerged as well: server hardware unit shipments were up only 9% from the previous year (compared with 15% and 18% in Q2 and Q1, respectively), and Windows Server shipments matched that growth (in recent quarters, Windows Server shipments have grown slightly faster than hardware shipments). Nonetheless, Microsoft expects Server and Tools revenue growth to hit 16% or 17% in Q4, as a large number of Enterprise Agreements (EAs) are up for renewal. (EAs usually involve the sale of a Core Client Access License, or Core CAL, which counts toward Server and Tools revenue.)

Both Client and Information Worker, Microsoft's largest and most profitable business segments, showed 2% revenue growth from the same quarter last year. In Client, Microsoft blamed the slowdown on an 18% decrease in revenue from retail and commercial sales, which the company said is normal this late in the client OS lifecycle. In addition, OEM revenues grew more slowly (up 7% from last year) than OEM license sales (up 10%) because more small businesses purchased a new computer this quarter, and these businesses were more likely to choose the lower-priced Home Edition of Windows XP rather than the Professional Edition. Microsoft expects this segment to perform much better in Q4, with 8% or 9% revenue growth from the previous year.

In addition, the company noted that Windows XP Media Center Edition, a special-purpose version of the OS for home entertainment, has shipped about 600,000 copies since Jan. 2005 and 1 million since Oct. 2004; this means the OS is shipping much faster than it did during its first two years, during which it shipped only 1 million copies.

Information Worker, meanwhile, was hampered by the lack of revenue from the Licensing 6.0 transition (which was still being recognized in Q3'04). Information Worker's slight growth was attributable mostly to favorable foreign exchange rates.

Emerging businesses. Of Microsoft's emerging businesses, Home and Entertainment was the standout, with 12% revenue growth driven by a nearly 40% increase in Xbox unit sales—a surprise, given that console sales usually taper off toward the end of each console's lifecycle. However, this business unit returned into the red after a profitable Q2'05, and losses may accelerate for the next few quarters as development and marketing costs for the next Xbox increase.

The other emerging businesses remained in line with recent quarterly trends: MSN dropped slightly due to a redesign that provides less space for advertising; Business Solutions grew revenues very slowly and remained in the red, although customer acquisition rates for its core enterprise resource planning (ERP) products topped 10%; and Mobile and Embedded showed more than 30% revenue growth from last year but remains a tiny part of Microsoft's overall financial picture.

Renewals Critical for Q4 and Beyond

Microsoft noted that more than US$2.5 billion worth of EAs and Select Agreements are due for renewal in Q4—an unusually large number, which stems from the large number of organizations that signed three-year agreements prior to a licensing change in 2002. The company says that it expects EA renewal rates to be between 66% and 75%, and hinted that many of these renewals will carry higher dollar values as companies add new server products to the mix. However, if the company falls short of this renewal rate, it will have significant effects not only on Q4 results, but on FY'06 and FY'07 results, as Microsoft recognizes revenues from multiyear agreements over the lifetime of the contract.

Microsoft also reported US$496 million in investment income in Q3'05, sharply down from last year's US$1.00 billion. The drop is mainly because the company paid a US$32.6 billion special dividend in Dec. 2004 and has much less cash (US$37.6 billion) to invest.

The bottom line was also affected by US$768 million in legal expenses related to Microsoft's antitrust settlement with Gateway and pending settlements with other unnamed antitrust litigants. This is far lower than Q3'04 legal expenses of US$2.53 billion from the antitrust settlement with Sun Microsystems and antitrust fine levied by the European Union. This disparity is the main reason that Microsoft's profits nearly doubled from the previous year.

Separately, Microsoft's board of directors approved a quarterly dividend of US$0.08 per share in March. This continues the company's policy of paying quarterly dividends, which was announced in July 2004. The dividend will be paid on June 9, 2005, to all Microsoft shareholders of record on May 18.

For complete financial results, see www.microsoft.com/msft.