Microsoft Hits Record Revenues, But Vista Sales Forecast Lowered

Published: July 25, 2007

by Alex Woodie

Microsoft was running on all five cylinders during its last quarter, as the software giant announced a 13 percent increase in total revenues, to just under $13.4 billion for the three months ended June 30, helping the company to top $50 billion in annual revenues for the first time. Importantly for Microsoft, customers signed multi-year maintenance contracts at a feverish pace. But the company downgraded its Windows Vista sales expectations for fiscal 2008, as questions over the value of multi-year enterprise agreements continue.

The money machine that is the Redmond, Washington, software giant kept throwing off cash, as the software giant announced revenue of $13.37 billion for the fourth quarter, an increase of more than $1.5 billion compared to the fourth quarter of fiscal 2006. Net income for the quarter came in at $3.04 billion, an increase of $207 million, or about 7 percent, as operating expenses jumped by nearly $1.5 billion, to $9.3 billion, or more than 18 percent That was largely due to a $1.06 billion warranty charge to fix millions of Xbox 360 game consoles, and with taking this into consideration, the company's diluted earnings per share came in at $0.31, a three-cent improvement over last year, which helped drive the company's stock price to a 52-week high.

For the year as a whole, Microsoft recorded revenue of $51.1 billion, an increase of $6.8 billion over fiscal 2006, or 15 percent. Profit for the year topped $14 billion, a $1.5 billion increase over last year, or nearly 12 percent. "Fiscal 2007 was an excellent year from my perspective," said Microsoft's CFO, Chris Liddell. "We have healthy core businesses and are strategically investing in growth opportunities, which will build on our success and contribute to continued double-digit revenue and earnings growth in fiscal year 2008."

All of Microsoft's five business units reported an increase in revenue, a rare occurrence for the world's largest software company, which is subject to the cyclical nature of a variety of user classes. At any one time, one division or another would be in the natural trough of its revenue cycle. But not last quarter.

It was another great quarter for the company's Client business, which sells the flagship Windows client operating system. Client reported revenues of $3.8 billion, a 14 percent increase, while the Server and Tools division saw a 15 percent increase in revenues to $3.08 billion, as sales of Windows Server 2003, SQL Server 2005, and Visual Studio 2005 continued to be strong. The Microsoft Business Division, which sells everything from Office 2007 to the Dynamics suite of ERP products, reported a healthy 19 percent increase in sales to $4.63 billion--more than $150 million higher than Microsoft had expected. The Online Services Business, a perennial money loser for Microsoft, also recorded a 19 percent increase in revenue, to $690 million, as the company increased its search engine traffic and recorded higher profitability on each search. Even the Entertainment and Devices Division recorded a double-digit (10 percent) increase in revenues to $1.19 billion, on the strength of Windows Mobile 5.0 sales.

Software Assurance

While things were humming along for Microsoft last quarter, there are potential bumps in the road ahead. For a look at how Microsoft's enterprise agreements and Software Assurance programs are going, one can look at the unearned revenue portion of the statements Microsoft sends to the SEC, which function as a barometer of sorts for the health of Microsoft's multi-year contract, or "annuity," business. IT analyst group Forrester Research raised Microsoft's ire with a report issued earlier this month that found Microsoft's customers were unhappy with two- and three-year Software Assurance agreements, and that many of them were planning to not renew their contracts, or at least considering not re-signing.

According to Microsoft's fourth quarter results, that is not happening. In fact, just the opposite occurred, as the company reported $7.2 billion in unearned revenue, an increase of about $1.1 billion, or about 19 percent, compared to the amount of unearned revenue it had during the fourth quarter of June 2006. For fiscal 2007, the company reported a total of $21 billion in unearned revenue, compared to unearned revenue of about $16.4 billion for all of fiscal 2006, a difference of more than $4.5 billion, or about 28 percent. Much of that is attributed to multi-year Software Assurance maintenance contracts and other enterprise agreements with Microsoft's largest customers.

Microsoft trumped these numbers during its fourth quarter conference call. "Enterprise agreement renewal rates exceeded the high-end of our historical rate of 66 to 75 percent," said Colleen Healy general manager of investor relations at Microsoft. "This strong annuity licensing performance drove our unearned revenue balance 16 percent higher to $12.6 billion. And our contracted-but-not-billed balance drove higher on both year over year and sequentially, exceeding $10 billion at the end of June. As a result total bookings were up 15 percent, and core bookings of client, MBS, and server and tools were up over 20 percent."

Healy attributed these heady end-of-Q4 figures to Windows Vista and Microsoft's Software Assurance program. "Businesses are recognizing the value that Windows Vista and Software Assurance provides them, as evidenced by high renewal portion of the unearned revenue balance," she said. "We are delighted that the value proposition from our current product lineup and future roadmap beyond the recently launched flagship desktop product are resonating with customers."

Obviously, Microsoft had a great fourth quarter when it came to getting customers to sign new contracts, and renew existing agreements. It appears that many organizations signed long-term software licensing and maintenance contracts with Microsoft for Windows Vista and Office 2007 during the months of April, May, and June, which seems logical, considering it was the first full quarter that the products were available to the masses. (Although these products have been available to businesses since December, it's common for organizations to wait months, or years, before upgrading to new releases of Microsoft's client and desktop products, and perhaps all the marketing and hoopla Microsoft put into the client launches influenced corporate decision-makers, too.)

However, these good times appear to be short lived. Microsoft said it expects unearned revenue to decrease from the fourth quarter of 2007 to the first quarter of 2008. "We expect the sequential decrease to be about 10 percent due to a large amount of billings during the fourth quarter," Liddell said.

Sales of Windows Vista and Office were smoking over the last three months, but Microsoft doesn't see that continuing. In particular, sales of Windows Vista appear to be slipping a bit lower than Microsoft's initial projections. The company predicts that, a year from now, it will have nearly $800 million less in contracted but unrecorded sales of the client operating system (both Windows Vista and XP).

While Microsoft expects its unearned revenue to continue to increase from there, it will go up by only 7 to 10 percent by the end of fiscal 2008 compared to where it is now, Microsoft says. That's a hefty drop from fiscal 2007, which saw a 28 percent increase in unearned revenue from fiscal 2006.

Vista Sales Downgraded

During the conference call, Liddell poured cold water on any attempts to highlight the drop in unearned revenue as a potential red flag for Microsoft, and characterized this change as a return to "more normal" levels of enterprise agreement spending.

"People are clearly focused on Vista and Office as the big products we launched," he said. "But when we look at next year--with Visual Studio 2008, SQL Server 2008, Windows Server 2008, new business intelligence products, and CRM Live--there's a lot of different products that are appealing from a customer point of view, and staying on an annuity also helps them in an administration and cost perspective. There are lots of good reasons why we're seeing a potentially more sustainable trend from an annuity mix."

However, Liddell could not conceal the fact that Vista sales are lagging projections, despite claims about how well Vista was selling just four months ago. When Microsoft was creating its budget a year ago, it was counting on 85 percent of Windows sales for fiscal 2008 to come from Windows Vista, and 15 percent from Windows XP, Liddell said. However, continued demand for Windows XP-or perhaps less demand for Windows Vista-has surprised Microsoft, and the company had to revise Windows sales forecasts to a 78-22 mix of Vista and XP. "We tend to get paid either way, XP or Vista," he added.

PC unit sales expected to increase by 9 to 11 percent over the next 12 months, and Microsoft will clearly sell its share of Windows Vista to consumers. But the business outlook for Windows Vista is less clear.

No worries, says Liddell. "It's early days yet," he says. "We're seeing what we consider to be good customer response, but it's the next 12 to 18 months that's really going to be the time when people are going to be seriously looking to rolling it out."

Could it be that businesses are waiting for Microsoft to ship Windows Vista Service Pack 1 (SP1) before they make the jump? And if so, when would that be? Liddell's responses: "Doubt it," and "won't say," respectively.

"In terms of SP1--and clearly there will be an SP1--but at this point we're not talking about exactly when that is," he says. "We don't see it as a massive driver of uptake in its own right. It's early days yet and we're broadly happy with how we're seeing Vista adoption both from a consumer and a business point of view, and we've always expected … that the business uptake would be driven by their needs rather than that the availability of Vista per se."

Over the next year we should get an answer to the question of whether Windows Vista delivers new things that businesses "need," or whether Windows XP is simply "good enough" for business users.

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