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The rising cost of business: Is Microsoft planning something big?

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The rising cost of business: Is Microsoft planning something big?

Redmond (WA) – Analysts dissecting the numbers from today’s fiscal third quarter earnings report from Microsoft noticed a trend within the trend: The cost of revenue – what Microsoft paid in order to earn what it did – rose a staggering 49% over the same quarter in 2005. And while the company’s guidance for the fourth quarter promised continued double-digit earnings growth, some analysts were noting a widening gap between what Microsoft expects to reap and what it expects to earn.

One Merrill Lynch analyst in particular – who apparently works for a company that knows how to do the math – worked out the fourth quarter guidance figures, and determined that Microsoft must be planning to spend up to $2.4 billion more than the firm had accounted for. His math may be off on occasion, the analyst conceded, but certainly not two-point-four-billion dollars off. If Merrill Lynch effectively accounted for every segment of the company, and Microsoft’s estimates for expenditures were that much higher…what is it they’re spending the money on?

Granted, the cost of doing business is rising for everyone, not just Microsoft. And the company is feeling some strain from having spent more than it expected to shore up its premiere of Xbox 360, whose launch last November sputtered due to lack of supply. There were aggressive investments being made in MSN as well, whose earnings declined 3% year-over-year for this quarter, and are expected to decline by another 5% next quarter. Those investments included the hiring of former Ask.com CEO Steve Berkowitz to lead marketing and other management duties for MSN. But unless Berkowitz is just a pseudonym for Katie Couric, analysts’ questions implied today, it’s doubtful he’s being paid over $2 billion a year.

Today, Microsoft announced operating income for its fiscal third quarter of $3.89 billion (after legal expenses), on revenue of $10.9 billion. Revenue was up 13% year-over-year, but income was up only 5%. It’s not a loss, by any means, and Microsoft is still a healthy company. But you can see the gap.

Revenue is actually down in all departments over the fiscal second quarter, when Microsoft reported a record $11.84 billion in revenue – but that drop was expected. Both commercial and retail licensing of Windows declined by a combined total of 6%, which contributed to the quarter-to-quarter revenue drop in the Client division. This is where the Vista delay makes its mark. But casting a far more serious shadow than that is the 3% year-over-year decline in revenue for the MSN division, which Microsoft had predicted would come in flat during its last quarter’s guidance.

Two steps forward, one step back, for Xbox 360

Meanwhile, the unpredicted and unexpected growth of SQL Server continues, contributing to a 16% year-over-year growth in the Server and Tools division, along with an unexpected surge in sales for Windows Server 2003 R2.

But even the “star of the day” news carried a Barry Bonds-size asterisk along with it: Growth in the Home and Entertainment division was 85% year-over-year, with $1.06 billion of revenue versus $1.56 billion during the holiday season. Of course, Xbox 360 was the reason for that success. Microsoft shipped another 1.7 million Xbox 360 consoles in the fiscal third quarter, up from 1.5 million in the previous quarter.

If you’re a keen financial analyst, you already found another gap: Microsoft sold more Xbox 360s in the previous quarter, not less, than during Christmas, by about 200,000 units. But it earned half a billion less in cash.

Perhaps Microsoft’s excuse for delaying Vista past December – that March is really the new Christmas – actually applies to the gaming division. “Consumer demand for Xbox 360 consoles remains very strong,” reported Colleen Healy, Microsoft’s general manager for investor relations. “Console supply increased throughout the quarter, due to improving component supplies, and the addition of Celestica to Wistron and Flextronics in manufacturing. As a result, Q3 shipments of 1.7 million consoles were heavily weighted to the month of March.

“Attachments remain at record levels,” Healy added, “although revenue in the quarter was slightly below forecast, due to the back-end nature of the console sales.” The attach rate – the number of extra parts consumers purchase – for accessories up through March, according to NPD figures Healy cited, was 4.5 games and 3 peripherals per console sold, “higher than any other gaming console at this point in its life cycle,” she boasted.

If Healy’s statement can be interpreted as a prediction, then the payoff for the surge in Xbox 360 sales in March – which came as a result of increased supply, thanks to Celestica – will actually come a little later, when revenues from “attachments” are tallied…even though, as NPD will point out, those attached items are purchased on the same day as the new consoles.

“While revenue increased 13% during the quarter,” Healy continued, “cost of revenue increased 49%, due primarily to Xbox 360 console volumes.” Unit shipments became strong toward March, she said, but the costs of shipping consoles simply increased tremendously.

The payoff, Chris Liddell promised, will come in the next quarter, as revenue for the Home and Entertainment divisions is expected to increase at an unheard-of annual rate of between 85% and 110%. But believe it or not, that’s not as high as it could have been. “This reflects a reduction in the implied revenue balance we gave you in January,” he said, “due primarily to lower expectations for the Xbox 1 business.” The rate of consumer migration to the next generation of consoles, he explained later, is higher than the company expected, which means the drop-off in sales for the original Xbox is actually costing Microsoft some money.

This may not be good news for Sony, whose forthcoming PlayStation 3 is expected to carry a price tag of around $500, while PlayStation 2 prices descend to the $129 mark. Sony’s big price gap – larger than between Xbox 360 and Xbox 1 – may mean the company will have to depend on continuing demand for PS2 while the PS3 leans toward the high-end customer, making slower inroads toward the mainstream. If increased PS3 demand translates into plummeting PS2 demand, the way Xbox 360 has impacted Xbox 1 – to the tune of maybe hundreds of millions in lost revenue – then Sony’s price strategy may come back to haunt it.

Talking more about what we’re not talking about

Meanwhile, analysts continue to tally the cost of Microsoft’s business – including the amount it’s reinvesting in Xbox 360 supplies, and in shoring up MSN’s lagging advertising revenues – and even with the notable rises, something’s still not adding up. 

What is Microsoft up to? Is it, asked the Merrill analyst, staking a few billion bucks to make MSN topple Google in the search and services arena? Granted, that’s the type of question to which no one genuinely expects a Microsoft executive to respond with, “Why, sure!” What’s interesting, and what’s informative, is the way the Microsoft executive does not say no.

“Relative to the starting base of fiscal year ’06, I would characterize it as being a broad-based approach across multiple fronts,” Microsoft’s CFO Chris Liddell responded. “I don’t think there’s any Trojan horse there that we haven’t talked about, that is sitting below the surface, that we don’t want to talk about. I would say to the extent that there is a difference between your expectations of where we’re coming in, I would list the sort of twelve to fifteen things that I mentioned before, and we would be accelerating the pace in virtually all of those, relative to, possibly, your expectations. So there are some big numbers there, that is certainly true. And there’s certainly some big potential spending and opportunities that we foresee in the MSN and Windows Live area, so that’s certainly true. But we’re not building into our guidance things that we’re not talking about.”

In other words, there’s a general cost of doing business, and that continues to rise. The tide rises for all boats simultaneously, and that’s a big number of boats. But if the tide seems to be rising larger, and there appear to be more boats on the water now than before, then if there were a difference to be measured, Microsoft’s not going to talk about it. Notice that’s not a “no.”

The company has intentionally chosen, Liddell said, to make a strategic trade-off, and re-invest some of its earnings, as a way of shoring up its position for a better chance at monetization later. Meaning, if we re-invest in businesses now, the payoff will eventually come. Is this a strategy that will continue over the next few years, Liddell was asked, where the company is willing to sacrifice earnings growth, so that it continues to lag below revenue growth? While Liddell refused to give guidance into 2008 and beyond, he did admit, “Clearly, from our point of view, we have made a strategic decision, with respect to next year, that given the set of opportunities and the revenue growth potential that we see, we’re willing to make that tradeoff next year…and not only next year, but to get ahead of it, if you like, in the third and fourth quarter as well.”

The question may still be hanging in the air, but it’s hanging rather heavily: Is there a big strategic investment that the company is planning for? Other analysts tried to whittle the numbers down, to see if there were some expenditures they missed. Is the company really planning to fork over that €2 billion per day fine the European Commission keeps threatening? While not really saying no, CFO Chris Liddell said Microsoft’s not reserving any more for legal expenditures than it usually would. Is the company planning to issue vouchers to customers, good for discounts toward future purchases of the delayed Windows Vista? If so, that could be considered a cash write-off. That’s a possibility, Liddell conceded, but something which Microsoft hasn’t decided on yet, and with nine months to make that decision, he said, that’s plenty of time to think it over. Does the fact that Microsoft projects lesser growth in the PC market per year – only 10% for next year, versus as much as 17% a few years ago – play a role in its valuation? Yes, conceded Liddell, but not a very large one.

So if the Merrill Lynch analyst is correct, that leaves a possible increase in the cost of business that’s ironically just as big as one of those huge barriers-to-entry that Microsoft used to be so good at constructing. Pay no attention, the financial wizards seem to be saying, to that four-legged animal behind the curtain.