By Matt Rosoff [bio]
Posted: Aug. 22, 2005

• Chart: Seven Businesses: FY'06 Overview

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.

In fiscal year 2006 (which began July 1, 2005), the company has particularly high hopes for SQL Server 2005 and Xbox 360, and corporate prepurchases of upgrades to the next versions of Windows and Office. Strikingly, many of the cautionary themes of past years' Financial Analyst Meetings were absent in 2005. The company spent almost no time discussing legal threats, suggesting that it believes the worst fallout from antitrust litigation is in the past, and executives predicted that Linux growth will taper off and that some Linux adoptees will switch back to Microsoft solutions. Indeed, the main challenge for Microsoft now seems to be Microsoft itself: as the company's core products become mature in their features and its traditional markets become saturated, the company must convince existing customers to upgrade or expand their purchases and must push into uncharted waters.

(For more information about Microsoft's planned push into subscription services, see "Renewed Interest in Subscription Services" on page 24 of the Sep. 2005 Update.)

Client: EAs, Emerging Markets

The Windows Client business, which includes desktop versions of Windows and is Microsoft's largest and most profitable business, posted 6% revenue growth for fiscal year 2005. This met expectations expressed at the 2004 Financial Analyst Meeting. (A comparison of FY'05 revenues with expectations, along with predictions for FY'06, can be found in the chart "Seven Businesses: FY'06 Overview".)

Revenue from OEM sales, which constitute about 80% of Client revenue, grew 10%, but the business was hurt by a decline in retail and volume licensing revenue. Client Senior Vice President Will Poole acknowledged that it had been a "substantial challenge" to get customers to cover Windows upgrades in their multiyear Enterprise Agreements (EAs) because of uncertainty about the next OS release, Windows Vista (formerly code-named Longhorn). Poole expects EA revenue to pick up as more details emerge about Vista's timing and feature set. This, along with expected PC sales growth of 7% to 8%, will drive Client revenue growth of 5% to 6% in FY'06, Microsoft said.

Looking beyond FY'06, Poole suggested that countries with emerging economies, such as Brazil, China, India, Mexico, and Southeast Asian countries, will provide a major source of growth: Microsoft expects 400 million people in these countries to buy their first computers between now and 2008. Poole highlighted some of the tactics the Client group is taking to capture more money from emerging economies, such as the following:

• Offering Windows Starter Edition, a more affordable version of the OS (although unit sales were only 100,000, less than 0.1% of Client unit sales, in FY'05)
• Reducing rampant piracy by working with local law enforcement to shut down counterfeiters, and launching Windows Genuine Advantage, which requires users to validate their copy of Windows before downloading certain add-ons
• Offering support resources, such as access to the Microsoft Knowledge Base and the ability to escalate problems to Microsoft, to help legitimate OEMs and system builders differentiate themselves from hardware vendors who use pirated software
• Engaging with telecommunications companies in emerging economies to bundle low-cost Windows PCs with Internet access; Poole suggested a reasonable price for such bundles would be US$13 to US$15 per month.

However, success in emerging economies is dependent on many factors beyond Microsoft's control, such as their governments' willingness to pass and enforce intellectual property regulations and the speed with which basic infrastructure, such as electricity and telecommunications, can be expanded to new areas.

Info Worker: Premium Editions, Servers

The Information Worker unit, which includes Office, Project, and other business productivity software, came in at the high end of expectations with 3% revenue growth.

Information Worker Group Vice President Jeff Raikes attributed the results to strong interest in Office 2003, for which more than 63 million new licenses were sold during the fiscal year. However, Microsoft's Q4'05 earnings release notes that foreign exchange benefits accounted for US$367 million in extra revenue over the fiscal year—that's more than the unit's total revenue growth of US$360 million. With stronger revenues and these foreign exchange benefits, the Information Worker unit was able to make up for a US$663 million decline in recognized unearned revenue, which occurred when an unusually large number of two-year licensing agreements expired toward the end of FY'04.

Raikes also said the unit enjoyed strong renewals of Enterprise Agreements (EAs), an assertion borne out by a spike in unearned revenue in Q4'05, when many EAs expired and were presumably renewed. This unearned revenue will help Information Worker show faster growth—5% to 6%, according to Microsoft's expectations—in the coming fiscal year.

Looking out to the late 2006 launch of the next version of Office (code-named Office 12) and beyond, Microsoft expects Information Worker growth to be driven by higher-priced premium editions of Office and other products (no further details were revealed), and new Information Worker servers and associated Client Access Licenses (CALs). "We have servers that people haven't even written rumors about yet," Raikes quipped.

The big challenge will be delivering enough value to convince customers to pay these higher prices and add these servers, rather than regarding their current Office installations as "good enough."

SQL Server, Visual Studio to Drive Server and Tools

The Server and Tools business—which includes Windows Server, server applications, and developer tools—emerged as Microsoft's main growth engine in FY'05, showing 16% (US$1.35 billion) revenue growth and 130% (US$1.84 billion) profit growth.

This success was driven by the following products:

• SQL Server, which showed revenue growth of 20%—somewhat remarkable, given that a new version is on the horizon in FY'06
• Exchange Server, which showed revenue growth of 10% and was acknowledged as the market leader in new license revenue by Gartner
• Small Business Server (SBS), which took in US$250 million and showed unit shipment growth of 40%.

In addition, Server and Tools Senior Vice President Eric Rudder noted that deployments of Active Directory (AD), an optional component of Windows Server, grew 30% among midsize businesses and enterprises. This metric is important to Microsoft because companies must first deploy AD before installing the latest versions of many Microsoft server applications, particularly Exchange.

For the Server and Tools business, Microsoft predicted slightly slower revenue growth of 11% to 13% in the coming fiscal year; this growth will be driven largely by the release of SQL 2005. The company also said that it hoped for revenue gains from the release of Visual Studio 2005—unusual because the company previously viewed developer tools as support for the Windows business, rather than a major revenue generator themselves. Rudder also confirmed plans for an integrated bundle of server applications (code-named Central) that is similar to SBS but targeted at midsize companies, and cited new hosted services, such as e-mail, security, and management, as engines of future growth.

MSN: All About Advertising

MSN missed revenue expectations for FY'05, growing only 3%. Although the company did not explain the shortfall, lower-than-expected traffic to MSN Search may have been to blame. According to Nielsen/NetRatings, the number of unique MSN Search users declined from 43.5 million unique users in Feb. 2004 to 40.4 million a year later. Although MSN Search launched its own algorithmic search engine in Jan. 2005 (previously, it outsourced this function), this did not have any appreciable effect on MSN Search's market share as of May 2005 (Nielsen/NetRatings).

Even with revenue falling short of expectations, MSN nearly quadrupled its profits from the previous year, due largely to cost-cutting, including decreases in stock-based compensation, and reduced operations and bandwidth costs for its Internet access business, where subscriber numbers are declining.

Despite the fairly weak revenue growth in FY'05, CEO Steve Ballmer and MSN Vice President Yusuf Mehdi emphasized MSN as an important source of growth for the entire company. Microsoft believes that the global online advertising market will grow from US$16.8 billion in FY'05 to US$28.8 billion in FY'08, and that MSN's share of that market will increase as it takes paid search revenue away from Google and Yahoo. The key to achieving this goal is the FY'06 launch of adCenter, tools for advertisers to place paid search listings on MSN Search. Previously, MSN relied on Overture (Yahoo) for this function and split much of its paid search revenue with that company.

Also, new services, such as MSN Spaces (which grew to 55 million monthly visitors in the nine months since its beta launch in Sept. 2004), and updates, such as a new Web-based e-mail interface and the ability to share files and folders online through MSN Messenger, are expected to drive new traffic and correspondingly increase advertising revenues.

At the same time, executives shied away from tying revenue growth to a corresponding growth in profits in MSN, emphasizing instead the need to invest to compete against competitors such as Google.

Home and Entertainment: Xbox 360 and IPTV

This division's revenue outpaced expectations primarily because of Halo 2, a hit Xbox game from Microsoft Game Studios that earned more than US$125 million in revenues in its first day on the market (the biggest one-day take for any entertainment property in history, including blockbuster movies).

Home and Entertainment Senior Vice President Robbie Bach predicted that revenue would grow 50% in FY'06 due to the launch of the Xbox 360 console in late 2005—well before competitors Sony and Nintendo launch their next consoles. In addition, Bach and Ballmer highlighted Microsoft's TV platform as an important source of future growth, noting sales of IPTV to telephone companies, such as British Telecom, SBC, and Verizon.

Home and Entertainment's losses are expected to increase in FY'06, as Microsoft will initially sell each Xbox 360 at a loss, although Microsoft is pricing the consoles and peripherals fairly high and offering a version without a hard drive in an effort to minimize expenses. (For more details, see "Two Versions of Xbox 360" on page 20 of the Sep. 2005 Update.) The company did not change its previous prediction of profitability for this business unit by FY'07.

Business Solutions: What's Next?

Microsoft Business Solutions (MBS) fell short of revenue expectations for the second year running, showing only 6% revenue growth. By way of comparison, Sage, which sells similar applications to the same market (mostly midsize businesses), reported 17% revenue growth for the six months ending Mar. 31, 2005 (compared with the same six-month period a year ago).

Executives spent little time talking about the division's financial performance or predicting its future results. Instead, Business Solutions Senior Vice President Doug Burgum explained how MBS products would increasingly take advantage of other Microsoft products and technologies—for example, incorporating an Outlook-like user interface, leveraging Windows SharePoint Services and the business intelligence capabilities of SQL Server, and incorporating .NET or Web services APIs to make development of vertical applications based on the MBS platform easier. Burgum also pointed to MSCRM 3.0, Great Plains 9.0, and Small Business Accounting as new products that would drive revenues in FY'06.

The company did not address lingering issues with MBS that might be affecting its market performance, such as multiple overlapping product lines and the adjustment of former Great Plains and Navision channel partners to their new roles as Microsoft partners.

Mobile and Embedded: Target Blackberry

The Mobile and Embedded unit topped revenue expectations in FY'05 due to solid sales of Windows Mobile devices, particularly Smartphones and wireless-enabled Pocket PCs—revenues from those two products increased 150% over the prior year.

Pieter Knook, the senior vice president in charge of this division, explained that the division is focused on taking market share from the popular Blackberry, a wireless e-mail device from Research in Motion (RIM), and proposed that Microsoft's mobile Exchange solution offers the following advantages:

• Carriers that want to establish mobile e-mail services for their users using Exchange and Windows Mobile devices get higher average revenue per user (ARPU) because they won't have to pay fees to connect to a RIM operations center
• Large organizations that want to set up a mobile e-mail system for employees can do it with components built into Exchange, avoiding RIM network fees and extra RIM enterprise servers
• End users will benefit from a greater choice of compatible devices with more functions, such as the ability to play Windows Media files from online music stores and connect to MSN services like Hotmail.

Excluding the MapPoint business unit, which has been moved to MSN, Microsoft expects Mobile and Embedded revenues to grow approximately 20% in FY'06, but even then, Mobile and Embedded will account for less than 1% of Microsoft's total revenue. Nonetheless, Microsoft continues to see the promise of "big numbers"—the hundreds of millions of wireless phones shipped every year—and enhancing user mobility remains an important theme across all seven of Microsoft's businesses.