By Matt Rosoff [bio]
Posted: Aug. 4, 2008

• Chart: Five Businesses: Financial Overview
• Illustration: Business Segment Leaders

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.

Coming off one of their best fiscal years in recent history, Microsoft executives at the company's annual Financial Analyst Meeting (FAM) expressed regret that the company's financial performance had not helped the company's stock price, primarily because of increasing expenses and strategic upheavals related to the company's online strategy. However, CEO Steve Ballmer forecast continued spending on the consumer online strategy, creating potential opportunities for partners who can supply critical technology or aid marketing. Rehabilitating Vista's image, helping customers deploy business software, and promoting its virtualization technologies will be the company's other top priorities in the year ahead.

A Great Year, Except for One Thing

Microsoft's 2008 fiscal year, which ended June 30, 2008, was outstanding financially. Revenue grew 18% to more than US$60.4 billion—remarkable growth for a company of Microsoft's size. The company saw a continuing acceleration in growth over FY'07 (15%), FY'06 (11%), and FY'05 (8%). Five percentage points ahead of Microsoft's top predictions from last year's FAM, this revenue growth translated to 21% growth in operating income and 26% growth in earnings per share, which shows that the company did a good job of keeping expenses under control.

Kicking off the July 2008 FAM, Ballmer said he "deeply care[s] about the long-term financial performance, stock price, and dividend returns on our stock." Although this is not an unusual statement for a CEO to make, Ballmer's need to say it was a subtle acknowledgment that the poor results from Microsoft's consumer online business and the appearance of disorganization in the unit has overshadowed Microsoft's outstanding performance across a broad range of other businesses. (For more information, see the chart "Five Businesses: Financial Overview". For a look at the executives in charge of Microsoft's business segments, see the illustration "Business Segment Leaders".)

Online: Spending Will Continue

The Online segment is the smallest of Microsoft's five business segments and the only one that lost money in FY'08. Online revenue grew 32% in FY'08 to US$3.21 billion, but a significant portion of that growth came from the acquisition of aQuantive early in the year. (Revenue from aQuantive was not counted in FY'07 results.) Subtracting the aQuantive revenue, growth was only 11%, which was within Microsoft's predictions for the Online segment from the 2007 FAM. In addition, the Online segment's losses nearly doubled, from US$617 million in FY'07 to US$1.23 billion in FY'08. Microsoft forecast continuing losses for the segment through FY'09, even as revenue is slated to grow between 18% and 20%.

Ballmer spoke about the Online segment in lieu of President Kevin Johnson, who announced his resignation one day before the 2008 FAM. (See "Online, Windows Chief Johnson Leaves".) During his speech, Ballmer attempted to reassure investors that the company's Online expenditures are based on a rational evaluation of long-term risk versus return, rather than an irrational attempt to beat a particular competitor—Google—at any cost. As in past years, he emphasized that the shift to online services delivered over the Internet will create massive economic opportunities in both the consumer and business markets. Left unsaid was that this shift also threatens Microsoft's business, which today is based on software running on devices inside homes and organizations, and not on hosted services delivered over the Internet.

Search Driving Spending

In explaining the company's commitment to consumer online services, Microsoft gave unusually detailed information about its Online segment. Notably, Ballmer acknowledged that Live Search expenses are responsible for the segment's losses and increasing expenses, while Windows Live and MSN are profitable. He also acknowledged that the proposed Yahoo acquisition was primarily an effort to drive more users and advertisers to Microsoft's search site.

Competing in search is essential, Ballmer argued, for several reasons:

• Search advertising is consistently more effective than any other form of online advertising because end users actively click on search advertisements instead of ignoring them
• Data collected from users during searches can be useful for targeting other types of advertisements
• Search has become the starting point for many people's computer usage, and has given Google a way to introduce applications (such as Gmail and Google Apps) that compete against Microsoft software
• Technology innovation in search has slowed, which could enable Microsoft to leapfrog Google in certain areas
• Because search requires expensive outlays for research and infrastructure, Microsoft is one of the few companies with enough resources to compete effectively in search.

Competing with Google in the next fiscal year and beyond will involve billions of dollars of additional spending, according to Ballmer and Senior Vice President Satya Nadella, who oversees Microsoft's search business and internal advertising platforms. Major plans include the following:

"Ante up." Google spends about US$2.5 billion in research and development (R&D) annually, 70% of which is on core search and advertising. Ballmer expects that Microsoft will need to spend between US$1.2 billion and US$1.5 billion per year on search R&D to equal Google's capabilities. Similarly, Google spends US$2.3 billion in capital infrastructure per year—a number that Microsoft will have to come close to matching in order to catch up.

User experience. To differentiate itself from Google, Ballmer said that Microsoft will try to improve the user experience, particularly for search queries "with commercial intent." Examples introduced so far include semantic search technology, which helps a search engine to understand natural language queries, and specialized results pages for product searches, including product pictures, reviews, and user ratings compiled from around the Web.

Disruptive business models. Because Google depends on search advertising for more than half of its revenue, Microsoft has more leeway to experiment with new business models that could draw users and advertisers to Live Search, while capturing less revenue per search in the short run. Live Search cashback (in which Microsoft offers rebates to users who buy certain products through Live Search and charges advertisers only when a user makes a purchase) is an example of this type of disruptive business model, although its financial success has yet to be demonstrated.

Marketing. Microsoft will increase spending on marketing and customer acquisition for Live Search. Some of this money will go toward distribution deals with OEMs (such as a deal with Hewlett-Packard slated to begin in 2009) and third-party Web sites. (In fall 2008, Facebook will begin using Live Search as the back end for all searches on the site, and will display Live Search advertisements in the results.) Ballmer said that Google currently spends about US$500 million per year on this type of customer acquisition, and Microsoft "may" spend the same amount. In addition, Microsoft will spend money on advertising, particularly outside the United States, where its share is even smaller than the approximately 9% share it has in the United States (according to June 2008 figures from Comscore). Google, whose search market share continues to increase, and now stands at about 60% in the United States and higher internationally, currently has no need to advertise.

Client: Changing Vista Perceptions

Revenue in Microsoft's Client segment, which consists of the Windows desktop OS, grew 13% in FY'08 to US$16.87 billion, which was well ahead of Microsoft's top expectations of 10% growth. It remains Microsoft's most profitable segment, with US$13.05 billion in operating income—an operating margin of 77%.

Bill Veghte, the senior vice president in charge of marketing and business development for Windows and consumer online services, focused on the successes of Windows Vista, although he acknowledged that Microsoft didn't have the "breadth of ecosystem support and compatibility" it needed at Vista's launch—a reference to widespread reports of incompatible drivers, as well as a lack of software that could take advantage of Vista. Without citing much evidence, Veghte suggested that these problems have been largely resolved.

For the enterprise market, Veghte said that organizational deployments of Vista had "very strong acceleration" after the release of Vista SP1 in Feb. 2008. This contrasts somewhat with remarks made by several Microsoft executives at the company's annual partner conference, who said that enterprise deployment of Windows Vista was less than expected, and that improving deployment of the OS was among their top priorities for FY'09.

Veghte also claimed that consumer adoption was strong, but admitted that Microsoft needs to improve public perception of the product in order to gain more new users. The company's solution will include a marketing campaign focused on the benefits of the OS compared with Windows XP.

Although not mentioned by Veghte, several hints suggest that this marketing campaign will focus on the retail market, and particularly on Vista PCs with specific hardware specifications that have been tested to work well with the OS. In an e-mail memo sent to employees one day before the FAM, Ballmer said that Microsoft was aware of a growing incursion into Windows sales from Apple's Macintosh computers, which often provide a better "end-to-end experience." He wrote that Microsoft was "changing the way we work with hardware vendors" to help ensure a comparable experience on Vista PCs. At FAM, Entertainment and Devices President Robbie Bach, who oversees Microsoft's relationship with retail partners, said that one of his top priorities for FY'09 was to "work with retailers to improve the shopping process when people are going to buy PCs."

In any event, Microsoft believes that its Client segment will be able to increase revenues by 9% to 10% in FY'09.

Although Veghte hardly mentioned the successor to Windows Vista, code-named Windows 7, he did say its delivery is on track for Jan. 2010, which is three years after Vista's general availability.

Business: Office 2007 Driving Growth

Microsoft's Business segment remained the company's largest in FY'08 by increasing revenues 15% in FY'08 to US$18.93 billion, which was well ahead of top expectations of 12% growth. This segment also continues to be Microsoft's second-most profitable, with US$12.36 billion in operating income—an operating margin of 65%.

Business President Steven Elop, who is taking over for Jeff Raikes when he retires in September, highlighted the success of Office 2007: Microsoft has sold more than 120 million licenses since the product's Jan. 2007 launch, which is ahead of Office 2003 at the same phase in its life cycle, and retail sales are more than twice those of Office 2003 over the same time period. Elop also noted that Dynamics passed US$1 billion in revenue and is growing by more than 20% per year. Unified Communications (Exchange and Communications Server) and SharePoint license sales are growing even faster, according to Elop, although these calculations are muddied by the inclusion of licenses for these products in various Client Access License (CAL) bundles. Regardless, the strength of Office and these server products allowed Microsoft to predict another year of between 14% and 15% revenue growth for the Business segment.

Elop gave few details about his division's plans for FY'09, and did not discuss the next version of the Office suite, code-named Office 14. However, he mentioned the impending rollout of Microsoft Online (Microsoft-hosted versions of Exchange, SharePoint, and Communications Server), and "being very aggressive" in "making sure [customers are] successful in deploying products like Office 2007 and SharePoint." The latter could have been a veiled reference to helping customers more directly with deployment—a role filled primarily by Microsoft partners today.

Server and Tools: Virtualization a Major Driver

The Server and Tools segment held its position as the fastest growing segment at Microsoft by turning in 18% revenue growth to US$13.17 billion, which was ahead of the company's top expectation of 15% growth and its sixth consecutive year of growth greater than 10%. (Prior to that, Microsoft did not break out results in these business segments.) The division also posted a healthy operating profit of US$4.59 billion, although enterprise server software has higher costs of sales than desktop software such as Windows and Office businesses and therefore provides lower operating margins of about 35%.

The company expects similar revenue growth (18% to 19%) for this segment in FY'09. This led Server and Tools Senior Vice President Bob Muglia to address an interesting question: given that IT spending is predicted to increase by only 7% in the coming year (according to market research and analysis firm IDC), how can Microsoft confidently predict that its Server and Tools segment, which sells almost exclusively to IT departments, will grow twice as fast? He gave several answers, as follows:

• Windows Server unit sales are growing faster than server hardware sales, as Windows Server takes share from proprietary Unix systems and Linux, and as virtualization allows organizations to run multiple instances of Windows Server on a single physical server
• Customers are purchasing higher-priced Enterprise and Datacenter editions of Windows Server, in part because these editions support the large-scale installations encouraged by server virtualization and offer more generous virtualization licensing terms
• SQL Server provides a lower-priced alternative to competitors such as Oracle, which recently raised prices; this will help sales in times when overall IT spending is constrained
• Forefront security products are a new market for Microsoft, and will take some share from existing security software vendors
• Microsoft's services and support revenue is growing at about 25% per year, which is considerably faster than overall IT spending; based on calculations from the company's FY'08 earnings report, this business accounted for US$2.64 billion in revenue during the fiscal year.

Entertainment and Devices: Sustained Profitability

Entertainment and Devices revenues increased 34% during FY'09, to US$8.14 billion, which was well ahead of the company's top prediction of 19% growth. It also turned in its first operating profit (US$426 million), thereby keeping a promise that Microsoft made to investors at the last two FAMs.

President Robbie Bach highlighted four priorities for this division in FY'09:

• Continued profitability, albeit with no revenue growth (Microsoft is predicting a revenue decrease of up to 4% in this segment for FY'09)
• Improving Windows Mobile to take advantage of projected growth in smart phone sales, and to counter Apple's iPhone in the consumer market (although Bach pointed out that Windows Mobile phones are outselling both the iPhone and devices from Research in Motion, such as the Blackberry)
• Trying to reach new audiences with the Xbox 360 by introducing more "casual" and family-oriented games (such as music games) and video entertainment content—a goal that Microsoft has been touting since the console's introduction in late 2005
• Supporting and integrating with Windows, including improving the Windows Media Center interface (which is counted as part of the Client segment for financial reporting purposes, but whose development team works in Bach's organization) and coordinating the division's marketing with the Vista retail campaigns.

Although this segment will probably not show margins similar to Microsoft's other profitable businesses, it is no longer a drag on earnings. More importantly, this segment's growth suggests that Microsoft can build a steadily profitable consumer-oriented business from scratch when given enough time and sufficient investment. However, it remains to be seen whether the Entertainment and Devices segment ever recoups the more than US$7 billion invested in it over the last six years.

Resources

Speech transcripts and PowerPoint slides from the 2008 FAM can be downloaded at www.microsoft.com/msft/speech/FY08/AnalystMtg2008.mspx.