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| Five Businesses Head Into FY'07 | ||||
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By Matt Rosoff [bio]
The following is the full text of an article published by Directions on Microsoft, an independent research firm focused exclusively on Microsoft strategy & technology. More samples of our content, as well as a list of upcoming articles and reports are also available. Higher expenses and lower profit margins will characterize Microsoft's financial results as the company strives to extend its business beyond desktop PC and server software into online services and home entertainment. Speaking at the company's annual Financial Analyst Meeting (FAM) in July 2006, CEO Steve Ballmer insisted that Microsoft will not back down from new business areas, but he also promised greater discipline, including faster product release cycles, in its core businesses. New leaders and a reorganization from seven business segments into five are intended to help the company achieve these challenging goals. Client: New Leaders, Opportunities The Windows Client business segment, which encompasses Microsoft's desktop operating systems and earns the most profits, is in the midst of a leadership transition that will be complete by the end of FY'07 (June 30, 2007). Since last year's FAM, longtime Windows leaders Jim Allchin, Will Poole, and Brian Valentine have announced their retirements or moved to less prominent positions, while a new team centered around President Kevin Johnson and Senior Vice Presidents Steve Sinofsky and Jon DeVaan is moving into place. (For an organizational chart showing the leaders of all five business units, see "Who Leads the Five Businesses?".) The new leaders are expected to enforce a quicker release cycle for Windows versions. The next version, Windows Vista, will ship in FY'07 but has taken more than five years to complete, a situation that Ballmer vowed would never be repeated with Windows or any other major Microsoft product. Ballmer suggested that the company erred by trying to include too many major new pieces in Vista at the same time. He said that Microsoft's product development strategy would move from "integrated innovation," in which many teams try to coordinate development but risk cross-team dependencies that create delays, to "agile innovation," in which teams concentrate on their own product or feature, with integration as a secondary goal. Despite the Vista delay, FY'06 was good for the Windows Client business—revenue grew faster (9%) than Microsoft's estimate of 6% at last year's FAM. (For details of how Microsoft's seven former business segments performed financially, see the chart "Seven Businesses: Final Report Card".) Microsoft expects the same scale of revenue growth (8% to 10%) to continue through the current fiscal year. Johnson cautioned analysts not to look for a huge revenue bump from the release of Vista. In fact, despite the new OS release, the company expects PC unit sales growth to decline slightly, from about 13% in FY'06 to 8% or 9% in FY'07. Nor will retail upgrades of existing PCs compensate for the performance of the new-PC channel, as upgrades typically account for at most several hundred million in revenue—a small sum compared with the more than US$14 billion in expected revenue for the Windows Client business in FY'07. (For a chart showing the five new business segments' past performance and estimates for FY'07, see "Five Businesses: Financial Overview".) Given these predictions, Johnson identified several opportunities for the Client segment in FY'07. OEMs and overseas resellers that help Microsoft reach these goals could receive significant benefits in the form of marketing funds and other incentives. Emerging markets. Microsoft believes that PC unit sales will grow much faster in emerging economies (13% to 16%) than in developed economies (6% to 8%). That growth will be driven more by consumers (among whom PC purchases are expected to increase by as much as 22%) than by businesses. To capitalize on this demand, Microsoft will step up programs to make new PCs more affordable to individuals in emerging countries. For example, the company will expand its FlexGo program, which allows consumers to buy new PCs by buying time on prepaid cards until they own the computer outright. FlexGo will expand from its successful pilot in Brazil to China, India, Mexico, and Russia. Selling premium SKUs. Vista has several premium editions, such as Home Premium, Enterprise, and Ultimate, that Windows XP lacked. As these editions become available, Microsoft hopes the proportion of premium editions will move from 52% of Windows sales today to 54% in FY'07. Because these premium editions cost more than regular editions, this will help the Client business offset slower PC growth and the sales of lower-priced editions in developing countries. Genuine Windows. Microsoft will continue to expand its Genuine Windows program, which helps convince customers to buy legitimate rather than pirated copies of Windows. Among other efforts, Johnson noted that Microsoft has trained 8,700 OEM channel partners and 130,000 sales representatives (retailers, resellers, and distributors) in China how to convince users to buy legitimate copies of Windows. Johnson also said that users would have to validate their copies of Vista (that is, prove electronically that they're not using pirated versions) before certain premium features can be used. Business Division: Four Business Areas The new Business Division is led by President Jeff Raikes and consists of his former Information Worker segment (Office and other productivity and collaboration applications for business), the former Microsoft Business Solutions segment (the Dynamics line of business management applications), and Exchange Server (formerly part of Server and Tools). Although the Business Division didn't exist in FY'06, Information Worker met Microsoft's estimates with 5% revenue growth, while Business Solutions beat estimates (11% to 13%) with 17% growth and turned in its first-ever profitable year. Microsoft has never publicly estimated or revealed growth rates or revenues for Exchange, but based on a comparison of old versus new business units, it appears to have captured more than US$1.8 billion in revenue in FY'06, which would make it this group's second-biggest product, after Office. Microsoft estimates 9% to 10% revenue growth for the Business Division in FY'07, as nearly all its products, including Office and Exchange, will have new versions hitting the market. Lending credence to these predictions was an unprecedented US$1.02 billion surge in total unearned revenue in the Information Worker group between Q3'06 and Q4'06—this suggests that many businesses signed or renewed multiyear license agreements in Q4 in anticipation of next year's product releases. At FAM, Raikes talked about four broad business areas in which the Business Division competes, and what Microsoft must do to succeed in each area. Resellers and systems integrators that help the Business Division achieve these goals are more likely to receive benefits such as referrals and marketing assistance. Core productivity. According to Raikes, Office faces its stiffest challenge from businesses that use older versions of Office and see no compelling reason to upgrade to the next release—a problem Microsoft often calls "good enough." Raikes categorized Office competitors such as OpenOffice, StarOffice, and IBM Workplace in the same way, saying that they "clone" older versions of Office in hopes of attracting customers who don't have an old version of Office but feel that new versions are overpriced. To continue to grow, Raikes said, this portion of the Business Division would focus on the following:
Business applications. Raikes said that the market for business management applications is growing more quickly than the market for core productivity applications, but Microsoft's share of this market is much smaller than the near-monopoly it has with Office. However, Raikes claimed that customer satisfaction with most vendors' business management products—particularly enterprise resource planning (ERP) products—is low. He also said that Microsoft's competitors, such as Intuit and Sage in the midmarket and Oracle and SAP in the enterprise market, have weaknesses that Microsoft can exploit, such as weaker channels, higher prices, requirements for expensive service contracts, and more confusing product roadmaps. Over the next three years, Microsoft will try to exploit these weaknesses. In addition, by integrating Dynamics products with Office and building them around an Office-like user interface, Microsoft will ensure that they are easy for end users to learn and use. However, Raikes skirted the most difficult challenge this group faces: how to help partners and potential customers navigate the inevitable transition from the four incompatible Dynamics ERP lines to a single ERP product. Unified communications. Raikes pointed to an enormous opportunity in this space, which encompasses e-mail, instant messaging, Voice over IP, and other IP-based communications products. Microsoft believes that the total market for unified communications products in 2009 will be US$45 billion—nearly the same amount as core productivity and business applications combined. To capitalize on this opportunity, Microsoft will focus on enabling users to have a consistent and easily manageable identity across many devices (e.g., home PC, work PC, cell phone), and support ease-of-use via integration with Office. However, Raikes acknowledged that Microsoft has yet to establish credibility in this area and believes that establishing strong partnerships is critical. As an example, he pointed to a July 2006 deal in which Nortel agreed to provide hardware and services that complement Microsoft's real-time communications products. Business intelligence. Raikes identified this as an important area of investment for the Business Division and pointed to recently announced products such as Duet, a joint effort with SAP that allows users to employ Office applications to get information out of SAP systems, and PerformancePoint Server 2007, a forthcoming server product for analyzing financial data (essentially a follow-up version to Business Scorecard Manager). Finally, Raikes touched on the importance of online services, such as Office Live and Live Meeting, to the Business Division, but he emphasized that the group will focus on software-plus-services rather than on services that replace existing software. Server and Tools: Windows, SQL Drive Growth The Server and Tools segment, which is led by Senior Vice President Bob Muglia (reporting to President Kevin Johnson), continues to be the main engine of Microsoft's revenue growth, posting 15% growth in FY'06. Even with the removal of Exchange Server from this segment, Microsoft expects growth to continue in the same range in FY'07, driven mainly by SQL Server, which posted 30% revenue growth in FY'06, and by the continuing trend of enterprises moving from proprietary Unix-based hardware and software to Intel-based servers. At FAM, Muglia outlined how the Server and Tools segment will continue its strong growth. Resellers and systems integrators, particularly those with an enterprise focus, that help Microsoft reach these goals could receive referrals and marketing assistance from the company. Windows Server will gain new footholds in three places where it now fares poorly against Linux: Web servers, high-performance computing, and security or edge servers. Muglia vowed that Windows Longhorn Server, expected in late 2007, would "eliminate all remaining deficiencies" against Apache/Linux Web servers, while high-performance computing will be enabled by the release of Windows Compute Cluster Edition in summer 2006. It will take longer (up to two years) for Microsoft to show results in security or edge servers, but this initiative will be aided by the acquisition of Whale Communications and new Microsoft-sponsored training programs for OEMs on Windows-based appliances. More powerful (and expensive) versions of SQL Server will close a gap in Microsoft's revenue compared with competitors. Although SQL Server has 41% of the database market in terms of units, its share of revenue trails well behind at 20%. New security-related products under the Forefront brand, including a forthcoming antivirus desktop client for enterprises, will hit the market in FY'07. The Systems Center brand of management products will benefit as well-established players in the Unix world fall prey to the continuing shift to Intel-based servers. Virtualization will be critical in this business area, and Muglia vowed that the company would "own" the virtualization space. BizTalk Server can take market share from IBM in the business integration space. Higher-priced versions of developer tools, such as Visual Studio Team Server, will parlay Microsoft's dominance in the developer tools market into a reliable revenue stream. Online Services: In Transition The new Online Services segment, formerly called MSN, is in the midst of a major transition: The group is redesigning and rebranding many MSN services as Windows Live, creating new services, and—most important from a revenue perspective—building new advertising platforms for paid search (in which advertisers bid for placement in search results) and syndicated advertising (in which Microsoft places advertisements on third-party sites and splits the advertising revenue with those sites). As part of this transition, MSN leaders such as David Cole and Yusuf Mehdi have moved into new roles, replaced by a leadership team including President Kevin Johnson, Senior Vice Presidents Steve Sinofsky (who is also overseeing part of the Windows Client business) and Steve Berkowitz (former CEO of number-four search engine Ask.com), and Vice President Blake Irving (whose former role at MSN has been expanded). This transition was costly in FY'06, as the MSN business unit showed a 3% decrease in revenue and its first loss since FY'03. Microsoft expects growth to resume in the second half of FY'07, for a total of 7% to 11% revenue growth over the course of the year. However, the Online segment's losses will continue, and the company gave no timeline for its return to profitability. This is particularly striking given the strong finances of online competitors such as Google, whose year-over-year revenues increased 70% and profits more than doubled in the June 2006 quarter. Despite this discouraging financial picture, several Microsoft executives at FAM reiterated the company's commitment to online services. CEO Steve Ballmer said that Microsoft would not get out of online services or acquire a major competitor, such as Yahoo, but would continue to invest until it becomes a growing and profitable business. Chief Technology Officer Ray Ozzie spoke at length about how online services could erode Microsoft's traditional software business models and said the company must compete aggressively online to survive this shift. In his overview of the Online segment, Johnson noted that only 5% of total advertising budgets are spent online, even though users spend 15% to 20% of their media-consumption time online. Microsoft believes this inequality will eventually correct itself, leading to a huge increase in online advertising expenditures. To capture some of this growth, however, Microsoft believes it must improve the quality of its online services and its ability to deliver targeted advertisements to viewers. Johnson was elusive about exactly how Microsoft will accomplish this, but the company's online strategy seems to boil down to three tactics: Guide users from popular online services that generate little advertising revenue (such as Mail, Messenger, and Spaces), as well as from popular Microsoft software (such as Windows and Office) to less-popular Microsoft services that have a proven advertising business model (particularly Search). Build systems for small and midsize businesses to participate in paid search advertising (AdCenter) and syndicated advertising (AdExpert) while trying to leapfrog competitors' offerings with technological advances such as better user tracking and demographic targeting Increase MSN's brand advertising (e.g., banners, sponsored pages) business by investing in new content on the MSN.com site and capturing big advertisers—Ballmer noted that he's spending more time talking to advertisers than to large enterprise customers. In a tacit acknowledgment that investors will not tolerate poor performance indefinitely, Johnson also explained the metrics by which Microsoft will judge its online businesses. For example, communications services—and their executives—will be judged on the number of non-duplicate users they garner and the time users spend on each service, while Windows Live Search will be judged on query volume, price-per-click, and revenue-per-search. One metric not highlighted, however, was profitability. Entertainment and Devices: Spend Now, Earn Later? The new Entertainment and Devices (E&D) segment, led by Robbie Bach, combines his former Home and Entertainment segment (Xbox and games, TV platforms, and other consumer products) with the Mobile and Embedded segment (Windows Mobile and CE) led by Pieter Knook. Home and Entertainment missed Microsoft's estimates for FY'06, with 36% revenue growth versus expectations of greater than 50%; that business segment has lost nearly US$5 billion since Microsoft began reporting its financial results in FY'02. Although the Mobile and Embedded segment became profitable in FY'06, it's such a small business—US$2 million in earnings on US$377 million in revenue for FY'06—that it will do little to bolster the new E&D segment's results. Speaking at FAM, Bach gave a rundown of each of the major businesses that comprise the E&D Division. Xbox. Because Microsoft sells each Xbox game console at a loss, in hopes that future game sales will generate net profits, Bach predicted that the Xbox business would continue to lose money through FY'07, finally becoming profitable in FY'08 (one year later than Microsoft has predicted in the past). The entire E&D Division will also move into the black in FY'08, Bach said. Bach also predicted that by the end of 2006, the Xbox 360 would have a lead of 10 million units over Sony's PlayStation 3 and Nintendo's Wii consoles, both of which are scheduled for release in fall 2006. This is an important advantage because the first console with a 10 million user base typically builds an unassailable lead for that generation of consoles, as game developers create more exclusive games for it and retailers devote more space to it. Entertainment. Bach noted that FY'07 should see the first widespread deployment of Microsoft's IPTV solution by AT&T (in the United States), BT (in the United Kingdom) and Deutsche Telekom (in Germany), adding a new source of revenue. However, he warned that the new Zune line of portable audio/video devices and online services would be a multiyear investment running into the hundreds of millions of dollars. Bach said this portion of E&D would remain a money-loser through FY'08 and gave no timeline for profitability. Bach also alluded to the importance of this business in establishing "connected entertainment" scenarios in which users can transfer content among a number of devices—ideally, all running Microsoft software. Communication. Microsoft shipped more than six million Windows Mobile devices in FY'06, and Bach predicted that this portion of the business would continue growing and earning profits, citing "takebacks" from Research In Motion's Blackberry in the enterprise as well as strong "engagement" from mobile operators and handset makers (such as HTC, Motorola, Palm, and Samsung). Productivity. The fourth business, consumer hardware (keyboards and mice) and software (e.g., Encarta, Money, Works) has been profitable for many years, and Bach said this profitability will continue. Of Microsoft's five businesses, the company gave the weakest justification for E&D: The company didn't explain the Home and Entertainment segment's revenue shortfall in FY'06 and provided no market projections or spending details for any components of this business. Nor did executives explain why Microsoft—a company whose greatest strength and core experience is software—believes it must delve deeper into the hardware business. Rather, Microsoft continues to ask investors to have a little more patience for an uncertain payoff in FY'08 or beyond. Resources Transcripts and slide decks from Microsoft executive speeches at FAM are available at www.microsoft.com/msft/speech/FY06/AnalystMtg2006.mspx.
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