Ballmer Talks Up "Big Bold Bets" In Wake of Big Stock Drop

Published: May 3, 2006

by Alex Woodie

Microsoft experienced strong revenue growth in many aspects of its business, and posted solid profits for its third quarter. But a recent increase in spending--including accelerated hiring of programmers to work on the forthcoming Windows Vista, "Longhorn" Server, and Exchange 12 releases--sent Wall Street into a tizzy, and Microsoft's stock dropped 11 percent as a result. To calm the nervous Nellies, Microsoft chief executive Steve Ballmer took to his computer and wrote a 2,000-word letter describing the need to take "big bold bets" to create great products.

Normally, you would think a company that posted double-digit increases in revenue and profits would be congratulated. It's a slam dunk for blue chip companies in mature markets, right? But Microsoft's meteoric rise to dominance of the computer industry in the late 1990s served to set a very high bar for its future results. While it has unquestionably improved the computer experiences of hundreds of millions of people over the past six years, in Wall Street's eyes, Microsoft hasn't lived up to those lofty expectations set during the bubble years, which is reflected in its mostly flat stock price since 2001.

Microsoft, it would seem, can't even buy a break these days. During the company's third quarter of fiscal year 2006, which ended March 31, overall revenue increased by nearly $1.3 billion, or 13 percent, to $10.9 billion, compared to the same period in fiscal 2005. Net income growth was even stronger, with a 16 percent rise, or $414 million, to $2.98 billion, which translates into $0.29 per share after legal charges of three cents are subtracted. However, these numbers came in below the expectations of both Microsoft and Wall Street analysts.

Several of Microsoft's businesses are flourishing. The Server and Tools unit, in particular, is experiencing very strong growth. Revenues in this unit--which makes and sells the Windows Server System, including SQL Server, and development tools like Visual Studio--increased 16 percent to $2.8 billion, while its operating income increased 30 percent to $1.0 billion. The highlight of this unit continues to be SQL Server 2005, where sales increased 30 percent compared to the third quarter 2005and surpassed Microsoft's forecast. In fact, Microsoft raised its fourth quarter Server and Tools revenues forecast due to the continued demand for the database--one of the few bright spots in Microsoft's recent financial news.

Microsoft's Client segment, which sells the Windows XP operating systems, also posted a solid 8 percent increase in revenue, to nearly $3.2 billion--a healthy performance for a business that has been showing its age. Information Worker, which sells the Office line of software, and which is the third cornerstone of Microsoft's profit-making engine, increased revenues by just 5 percent. When you consider that more than 70 percent of the revenue these two businesses bring in goes straight into the profit can, any increase in sales is more than welcomed.

Microsoft benefited from strong demand for PCs and servers during the quarter. "PC hardware and server market growth remains robust," said Colleen Healy, general manager of investor relations at Microsoft. Most markets around the world showed solid demand, but it was the Europe, Middle East, and Africa (EMEA) markets and emerging markets in South America and Asia that show the strongest demand, she says.

Rounding out the bright spots, Microsoft Business Solutions, the unit that sells the Dynamics line of ERP and CRM software, continued to grow, posting a 21 percent increase in revenue, to $216 million, for the quarter. The Mobile and Embedded Devices unit also saw a solid, 46 percent jump--from $61 million to $89 million. However, it should be kept in mind that industry forecasts see softer demand for mobile devices in the years to come.

Now for the less-than-bright spots. The MSN division continues to be a source of concern for Microsoft, as it fights market leader Google for online advertising dollars. Revenue in this division decreased 3 percent to $561 million, $26 million less than what Microsoft spent in operating costs. Highlights of this division included five new beta releases of Live products--one new product every 20 days--which could pave the way for future growth here.

Revenue for the Home and Entertainment segment jumped 85 percent, to $1.0 billion, which would have been a good thing, except that Microsoft miscalculated demand for its Xbox 360 gaming console, which led it to shell out some extra money for things like expedited shipping and getting a third manufacturing partner on board at the last minute. This unit lost $388 million last quarter because of those unbudgeted costs.

What happened with the Xbox last quarter could be seen as a symbol for what MSFT is going through as a whole. While gamers seem to be adopting the Xbox "platform," Microsoft seems to have difficulty keeping costs in line. The same thing is going on with development of the next line of products, namely Windows Vista, Windows Server "Longhorn," and Exchange 12, which Microsoft formally christened Exchange Server 2007 last week, as well as its MSN unit.

Despite the fact that, during the third quarter, Microsoft delayed the release of Windows Vista, from late 2006 to early 2007--and also delayed, by proxy, the release of Windows Server Longhorn, which is due to follow Vista by 12 months--Microsoft had to accelerate the hiring of programmers to work on these projects, among others.

Chris Liddell, Microsoft's chief financial officer, said the 11 percent increase in operating expenses during the quarter--from $6.3 billion during 3Q05 to $7.0 billion last quarter--was "higher than expected." He said the company has increased hiring within the enterprise and SMB sales forces, and that the company continues to "hire aggressively" in support of R&D for Longhorn Server, Exchange 12, and Communication Services. Some of the spending was also targeted on "building upon our strong position in display advertising and for improved search" in the MSN unit, he added.

The increased spending hasn't been confined to the last three months. Spending is up more than 10 percent over the past nine months, which corresponds to about $1.8 billion above and beyond fiscal year 2005's pace. While reigning in spending had been a key priority a year ago, now it appears the priority is getting product out onto the market, no matter what the cost.

During the conference call, Liddell outlined three key elements of Microsoft's strategy to aggressively pursue key markets. Number one: "We will experience high product cost for Xbox. We're making strategic choices to maximize production, which will cost income growth in the short term." Number two: The company will increase spending on marketing, partner readiness, and sales force hiring. "Efforts will continue in the fourth quarter and into 2007," he said. Number three: There are plans for hiring more programmers and service providers. "We intend to quicken the pace of development in businesses where we can drive growth and market share." These areas include services, unified communication and collaboration, security, business intelligence, and high performance computing. "We also expect to ramp up acquisitions," particularly in competing with online services, such as local and mobile search, he added.

As a result of this increased spending, Microsoft had to lower its guidance for net income for fiscal year 2006, from the $17.9 to $18.3 billion range it was forecasting just three months ago to the $16.6 to $16.86 billion range it is saying now. Revenue projections predictions for fiscal year 2006 stayed at around $44 billion, in large part because of the current wave of increased corporate IT spending, and strong consumer spending, among developing markets in particular.

This has Wall Street worried. Following Thursday's earnings release, numerous brokerage houses lowered their guidance on Microsoft. That helped to send the company's stock plunging, from around $27.30 before the announcement to about $24.10 on Friday, where it has stayed. That corresponds with a decrease in market capitalization of about $33 billion, to "just" $247 billion. More than 600 million shares changed hands, the biggest single day of trading in more than 10 years for the 30-year-old company, reflecting widespread disappointment and fear.

After the market closed Friday, CEO Ballmer wrote a lengthy e-mail to Microsoft employees. "There has been a very strong reaction to our revenue and earnings figures," he writes. "I want to provide some context for what we announced yesterday and let you know why I believe more strongly than ever that Microsoft is well positioned for sustained, robust growth in the years ahead."

Microsoft is on the cusp of "the next wave of blockbuster releases," including Windows Vista, Office 2007, and Exchange Server 2007 (funny, he didn't mention Longhorn Server). "New offerings in enterprise search, unified communication, business intelligence and collaboration will make Microsoft a leader in developing solutions for businesses of all sizes, in every corner of the globe," he writes.

Ballmer scoffed at the investors and analysts who hammered his company's stock--and decreased his own net worth by more than $1.5 billion, although he didn't mention that in the e-mail. "I've never been more confident that we are making the right investments," he wrote. "Throughout our history, Microsoft has won by making big, bold bets."

The company is definitely making another big bold bet right now, and we'll see if it pays off.