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| Five Businesses Steady into FY'08 |
| Aug. 13, 2007 |
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Online services and new business investments were among the themes at Microsoft's July 2007 Financial Analyst Meeting (FAM), an annual event in which company executives detail the past year's financial performance and outline priorities for the next several years. As in past years, executives defended the company's money-losing online and home entertainment businesses, noting that Microsoft's past investments in enterprise software helped the company expand beyond its desktop roots. However, the company promised that the Xbox business, a significant drain on profits for the last six years, would become profitable in FY'08. Enterprise Strength Fuels Newer Businesses During Microsoft's 2007 fiscal year, which ended June 30, the company's three core business segments—Client (Windows desktop OSs), Business (Office, Exchange Server, and other business software), and Server and Tools (Windows Server, SQL Server, and other infrastructure software)—each exceeded revenue expectations expressed at last year's meeting and contributed more than US$26 billion in operating profits. The big picture for these core businesses continues to look good because large organizations are renewing multiyear volume licensing agreements at record rates. According to Business Division President Jeff Raikes, renewals of Enterprise Agreements (EAs) came in above 90% in the quarter ending June 30, despite the fact that many major releases (Office 2007 in particular) came out during the year and were already covered on these organizations' existing agreements. This suggests that enterprises are interested in forthcoming products such as Windows Server 2008 and SQL Server 2008. It could also be a result of increasing licensing complexity for many new products, which makes it simpler to cover them on an EA than through other types of license purchases. The company's emerging business segments, Online (Windows Live and MSN) and Entertainment and Devices (Xbox, Windows Mobile, and other consumer products), came in at the low end or below the revenue expectations expressed last year and together lost more than US$2.5 billion. (For an FY'07 overview and FY'08 revenue predictions by business segment, see "Five Businesses: Financial Overview".) Nonetheless, Microsoft CEO Steve Ballmer, Chief Financial Officer Chris Liddell, and other executives stressed the company's ongoing commitment to these businesses, in hopes of turning Microsoft into a company with four major competencies: desktop software, enterprise software, advertising, and consumer electronics. While making this argument, Liddell detailed the FY'07 revenues and five-year compound annual growth rate for products that aren't part of Microsoft's desktop software franchise, such as Windows Server, SQL Server, and SharePoint Server, and noted that most of these product lines moved from "virtually no amount of revenue to relatively significant over the last five or so years." (For more detailed figures, see "Revenue and Growth for Selected Products".) Ballmer was more specific, naming seven areas that the company believes will offer the highest improvement in gross margins over the next three years, as follows:
Additionally, many Microsoft executives cited the company's "software plus services" strategy, by which Microsoft hopes to augment its core software offerings with online services, as a major area of focus. Microsoft has emphasized software plus services at several recent events, including the Worldwide Partner Conference in June 2007, and Chief Software Architect Ray Ozzie offered some insight into the company's plans to build an online services "platform" consisting of low-level infrastructure services. However, no new services were announced at the conference, and many important details—such as timing, pricing, and partner business models—are still absent or trickling out slowly as each product group prepares its own services for launch. Client: Price Pressure In FY'07, the launch of Vista helped the Client business segment revenue grow 14% to just under US$15.0 billion—much higher than Microsoft's predictions of 8% to 10% revenue growth, which the company offered at last year's FAM. This revenue growth was slightly ahead of Microsoft's estimates of PC unit growth during the fiscal year (11% to 13%). In FY'08, Microsoft expects this to change, with Client revenue growth coming in at 9% or 10%, and PC unit growth at 9% to 11%. Chief Operating Officer Kevin Turner explained that price pressure on sales of Windows is behind this slower growth. Specifically, sales of PCs to consumers are growing faster than sales to businesses, and sales in emerging markets are growing faster than sales in developed markets. In both cases, the faster-growing market buys lower-priced versions of Windows. Turner says that Microsoft hopes to mitigate this problem by getting more companies to cover Windows on multiyear license agreements, such as EAs. Currently, only 19% of the PCs covered by volume agreements generate annuity revenue for the Client segment. To increase this number, Microsoft is beginning to require a multiyear agreement to buy certain products, such as Vista Enterprise Edition and the Desktop Optimization Pack. (For more details on evolving nature of multiyear license agreements, see "SA Becoming General-Purpose Subscription Service".) Turner also said that improved progress against piracy, particularly in developing countries, could help equalize revenue growth with PC unit sales growth. Despite the pricing pressure, Client remains Microsoft's most profitable business, earning operating income of US$11.6 billion in FY'07—a gross profit margin of more than 77%. Business: A Very Good Year The Business segment brightened in FY'07 with revenue growing 13% (Microsoft expected 9% to 10% growth) to US$16.4 billion and profits of US$10.8 billion. Year-over-year revenue growth approached 20% in the second half of the year after the latest versions of Office, Exchange, and SharePoint were launched. Business Division President Jeff Raikes cited several reasons for the year's success, including more than 71 million licenses of Office 2007 sold, more than US$800 million in SharePoint revenue (35% growth from the previous fiscal year), and 21% growth in "customer billings" for Dynamics products, making Dynamics a US$1 billion business for the first time. Dynamics CRM was a particular standout, adding 85,000 new seats in the fourth quarter for a total of 475,000 and increasing revenue 50% over the previous fiscal year. However, Exchange 2007 might not be selling as well as Microsoft had hoped. In his speech, Liddell noted that Exchange took in more than US$1.5 billion in revenue in FY'07. However, calculations suggest that Exchange took in roughly US$1.5 billion in FY'05 and US$1.8 billion in FY'06. (These calculations are based Microsoft's restatements of past earnings after it realigned its business segments in FY'07. That realignment moved Exchange from the Server and Tools segment to the Business segment.) Although unconfirmed by Microsoft, this revenue slowdown would match anecdotal evidence from some partners and suggests that the move to offer Exchange exclusively as a 64-bit application may be slowing its adoption. Microsoft expects Business segment revenue growth to slow slightly to 11% to 12% in FY'08 and cites the impending launch of Office Communications Server (OCS) 2007, continuing growth of Dynamics CRM, and the upcoming hosted Dynamics CRM Live service as growth drivers. The company also believes there's significant upside potential in selling Office 2007 to consumers and small businesses. Raikes said the company will increase Office sales to these customers through OEM bundling deals (particularly in emerging markets), the Office Ready PC program (which encourages retailers to install 60-day trial versions of Office and lets consumers upgrade to full licensed product online), and Office Genuine Advantage (which helps reduce the use of unlicensed and pirated copies of Office). The high rate of EA renewals in Q4'07 should also help the Business segment in FY'08, as unearned revenue from those sales is carried over to earned revenue. Specifically, unearned revenue in the Business segment stood at US$5.8 bilion, up 33% from the previous quarter and up 21% from the year-ago quarter. (The unearned revenue dip in the middle of the fiscal year is in line with normal volume licensing patterns.) It's not clear why customers apparently chose to increase their expenditures on Business Division products in their Q4'07 EA renewals, given that many of the major Business Division products (Office, Exchange, and SharePoint) had updates in FY'07 and are not expected to be updated in FY'08. One possibility: customers may have been buying the Enterprise CAL Suite, a higher-priced bundle than the Core CAL, in order to get access to the advanced features of a wide variety of products, reasoning that such purchases are simpler to manage (and in many cases less expensive) than buying individual CALs for each product. Because the Enterprise CAL Suite includes many products from the Business Division, some of the revenue from these purchases would count toward this segment. Server and Tools: No Surprises Server and Tools has consistently been Microsoft's fastest-growing business segment since the company began breaking out its results by segment in FY'03, and FY'07 was no exception: revenue grew 16% (top expectations were 15%) to US$11.2 billion. However, Server and Tools offers lower margins than Microsoft's other two core business segments; its profits came in at US$3.9 billion. Raikes, who recently took over leadership of Server and Tools, cited strength across product lines for the segment's growth, including 20% revenue growth for SQL Server, 19% growth in developer tools, and 20% growth in systems management products. The company offered no surprising predictions for FY'08, citing expectations of 14% to 15% revenue growth driven by forthcoming updates to Windows Server, SQL Server, and Visual Studio, as well as newer areas such as the System Center management products and Forefront corporate security products. As with the Business segment, Server and Tools saw a sharp increase in unearned revenue, which stood at US$3.7 billion at the end of June 2007, an increase of 29% from the previous quarter and an increase of 25% from the previous year-end. This suggests that a high proportion of customers who are buying new Windows Server 2003 and SQL Server 2005 licenses are adding Software Assurance to the purchase, which will give them upgrade rights to Windows Server 2008 and SQL Server 2008 when they are released next year. Online: Becoming an Advertising Company FY'07 was a year of slow growth and major investments for Microsoft's online business. Revenue grew only 8% (at the low end of expectations) to US$2.5 billion, while losses were up nearly nine times as much from the previous year, to US$732 million. Platform and Services President Kevin Johnson called FY'07 a "foundational year" because Microsoft made investments to capture a larger share of the online advertising business, which the company expects to grow from a US$40 billion "market opportunity" in 2007 to an US$80 billion opportunity by 2010. In FY'07, most of these investments went toward making MSN and Windows Live sites more attractive in hopes of drawing more users, as well as toward building out Microsoft's adCenter paid search platform. Johnson cited some progress in this area, noting that Live ID users (individuals who have logged into at least one Microsoft site in the past 30 days) grew 20% to 380 million, and revenue-per-search has surpassed the amount that Microsoft was earning when it outsourced its paid search platform to Yahoo's Overture. Nonetheless, a string of acquisitions and deals announced toward the end of FY'07—none of which was counted against the Online segment's earnings (acquisitions appear as cash transactions)—suggests a major strategy shift. Microsoft has been a major online publisher for more than 10 years, and Johnson noted that it's the third-biggest seller of online advertising (after Google and Yahoo). However, Microsoft is in the process of spending more than US$6 billion acquiring companies that offer a wide variety of tools and services for third-party publishers and advertisers, including the following:
Microsoft will face significant challenges integrating these businesses into the company and may face conflicts between being the third-largest seller of online advertising while providing services to other publishers and advertisers. Moreover, executives reiterated that the Online business segment would continue to lose money through FY'08 and perhaps beyond. In other words, investors were asked to have faith that Microsoft is making the right investments and is capable of turning these disparate parts into a coherent online advertising business. Entertainment and Devices: Profits at Last? The Entertainment and Devices (E&D) segment performed poorly in FY'07. Revenue grew only 28%, to US$6.1 billion, short of Microsoft's estimates of at least 31% growth—the second consecutive year in which revenue was lower than expected. The revenue miss was probably due to lower-than-expected Xbox 360 console sales: the company originally expected total shipments to equal between 13 and 15 million by the end of June 2007, but had actually shipped only 11.6 million by that point. The Xbox business also caused the E&D segment's loss to increase 47% from last year, to US$1.9 billion because Microsoft took a US$1.1 billion write-off related to defective Xbox 360 hardware. E&D President Robbie Bach gave more insight into the Xbox 360 defects, acknowledging that the problem was due to a Microsoft design flaw rather than any defective component or problem with the manufacturing process. Despite this record and a US$50 price cut on the console in Aug. 2007, Microsoft continues to predict that the Xbox business and the E&D segment as a whole will be profitable in FY'08 and will achieve "sustained profitability going forward." Bach gave several reasons for this optimism, including a game-to-console sales ratio ("attach rate") of 6.1 (a record for any game console at this stage in its lifecycle), and the forthcoming launch of Halo 3 on Sept. 25. That game's predecessor, Halo 2, took in US$125 million in revenue on the day it was launched in Nov. 2004 and led to the only profitable quarter in the history of Microsoft's Home and Entertainment segment. (That segment was renamed E&D in FY'07 after Windows Mobile and other embedded OSs were added to it.) Additionally, Xbox Live is expected to grow from 7 million users now to approximately 10 million by the end of FY'08, providing both subscription and transactional revenue; Microsoft has sold downloadable games and video worth more than US$125 million over Xbox Live since it began selling downloads in Nov. 2005. Finally, Bach noted that Microsoft's IP television (IPTV) platform for telecommunications companies, recently renamed Mediaroom, will finally begin to reach significant numbers of end users, with "subscriber growth into the millions" by the end of next fiscal year. Even if the E&D segment becomes profitable in FY'08, the businesses comprising this segment have lost more than US$7.3 billion since FY'02. To justify the company's huge investment, one or more of these businesses will have to make a significant turn in FY'08, or Microsoft could have an even harder time continuing to justify them to investors. Resources The importance of emerging markets to Microsoft's core businesses is discussed in "Emerging, Mature Markets Segmented". The aQuantive and ScreenTonic acquisitions are covered in "AQuantive Leads Online Investments" on page 43 of the June 2007 Update. The AdECN acquisition is covered in "Internet Advertising Deals". The write-off related to Xbox 360 defects is covered in "Xbox 360 Failures Acknowledged" on page 26 of the Aug. 2007 Update. |
