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How will Windows 7 financially impact Microsoft?

Windows 7 is slated for a release this holiday season. Here's a look at how the operating system's release is set to impact Microsoft's financial performance.

Microsoft announced on Monday that it's planning to release Windows 7 for the 2009 holiday season. The operating system was originally slated for a January 2010 release.

Now that we finally have an idea when Microsoft will be releasing Windows 7, we can project its financial impact on the company. But we need to be careful. We don't know how the market will accept Windows 7. And we still aren't sure if the enterprise market will adopt it for existing machines.

Looking at past figures, we can develop an understanding of the impact Windows launches--and especially that of Windows Vista--have had on Microsoft's financial state and project that forward.

How important is Windows to Microsoft's financial performance? Will the Windows 7 launch play an important role in Microsoft's financial performance over the long term?

Let's take a look:

The importance of Windows

Microsoft breaks its operation into five segments: client (Windows), server and tools (Windows Server), online services (Live Search and other online services), business (Office and other enterprise tools), and entertainment and devices (Xbox 360 and Zune).

Over the past five years, Microsoft's client division has accounted for approximately 30 percent of Microsoft's revenue. More importantly, it has comprised 70 percent of Microsoft's operating income--a measure of how much of a profit a company has generated before interest and taxes have been paid.

For the quarter ended March 31, 2007--two months after the launch of Windows Vista--Microsoft's total Windows revenue was $5.28 billion. Its total revenue was $14.4 billion for the quarter. Its Windows operating income was $4.3 billion for the same period. And its total operating income for all divisions was $6.6 billion.

According to Microsoft, in its 2007 annual report, which encompassed July 1, 2006, through June 30, 2007, Microsoft's Windows division generated an operating income of $11.5 billion on total operating income of $18.5 billion.

As you can see, there's no debating that Windows is extremely important to Microsoft's bottom line. Without it, the company would be profitable, but not nearly as dominant as it is. If you need more proof, a Reuters report claims that Microsoft earned 75 cents of operating profit on each dollar of Windows sales in 2007. Wow.

(I should note that these figures do not break out the total amount of revenue generated from different versions of Windows. Microsoft prefers to report client figures on total Windows sales. However, knowledge of the time tells us that client division sales figures in 2007 were overwhelmingly Windows Vista and XP sales. Today the vast majority of sales come solely from Vista.)

Financial impact today and tomorrow

We know Windows is important, but how will Windows 7 impact Microsoft's financial performance? Once again, we need to take a step back and look at the company's performance when Vista was released in 2007.

The first quarter that accounted for Vista sales showed a slight uptick in Windows revenue. According to Microsoft's March 31, 2007, filing, the company's total revenue jumped by almost $4 billion over the prior year. Over $2 billion of that gain came from the company's client division. Microsoft's operating income on Windows jumped by $1.8 billion year over year, accounting for all but $900 million of Microsoft's companywide operating-profit gain.

By June 30, 2007, the end of Microsoft's 2007 fiscal year, the company reported that it sold more than 55 million Windows Vista licenses. For the year, revenue was up more than $7 billion, compared to its 2006 fiscal year. The company enjoyed a profit of $14.07 billion--$1.5 billion more than the prior year.

OK, but was Vista a success when it launched?
Although Microsoft's revenue and profit were up when the Vista launch was accounted for in its financial statements, there's no indication that it truly helped Microsoft generate more revenue than it might have without it.

When I compared Microsoft's revenue growth between 2004 and 2005, it grew by 8 percent, year over year. Between 2005 and 2006, Microsoft witnessed 11 percent revenue growth. It achieved 15 percent growth during its 2007 fiscal year, which was the year the company released Vista. Microsoft enjoyed 18 percent revenue growth during its 2008 fiscal year.

But much of that growth cannot be attributed to the company's Windows division, which averaged 15 percent year-over-year growth from 2004 through 2008. During that period, its servers, business, and entertainment divisions grew more rapidly, accounting for the majority of Microsoft's growth in revenue.

In 2005, Microsoft generated 50 percent more profit over the prior year. Its 2006 profit figures jumped just 3 percent. Its 2007 profit jumped a respectable 12 percent. In 2008, the company generated a 26 percent change in profit.

Although it didn't significantly change Microsoft's revenue, it seems that Vista's launch did contribute heavily to Microsoft's profit gains. The company's client division saw a 13 percent jump in annual profit during its 2007 fiscal year and an 11 percent jump in its 2008 fiscal year. For the two years prior to Vista's launch, it averaged just 4 percent and 7 percent profit gains, respectively.

The bottom line on Windows

So what's the takeaway? Historically, Microsoft has enjoyed relatively steady revenue growth, regardless of the version of Windows. Dating back to XP's release in 2001, the company's revenue has not changed drastically when a new version of Windows hits store shelves.

Microsoft's business division, which includes Office and other business-oriented applications, has generally been the driver behind revenue increases for the company. In fact, it has generated more revenue than Windows for the past five years.

But it's Microsoft's profit that feels the lasting effect of Microsoft's client division. The company's profits might have grown year over year, but when a new version of Windows is released, the percentage growth has historically been almost twice as high for the fiscal year the operating system hits store shelves. After that, the company's profit growth percentage declines until another operating system is released.

The bottom line on Windows 7
Looking ahead, we should expect the same impact on Microsoft's financial statements from Windows 7. Since Vista's release, Microsoft's revenue growth has stayed relatively constant (with the exception of two revenue slides, which were the result of the recession). Its annual profits have followed historical performance--strong growth at a new Windows launch, followed by slower growth until the next Windows hits store shelves.

So when Windows 7 is released this holiday season, we shouldn't expect much. There will undoubtedly be a jump in profit. And although revenue will grow with it, I doubt that it will grow at an annual rate that is higher than the company's historical averages.

If we use history as our guide for the future, Windows 7 won't drastically change Microsoft's financial performance. After a few years, its revenue growth will probably stay constant, and its profit gains will return to their average levels.

But the beauty (or is it horror?) of business is that history can't always predict unforeseen circumstances. So keep in mind that although Microsoft's financial performance has stayed relatively uniform over the past 10 years, it might not stay that way over the next decade.

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