Investment loss trims Microsoft profit

For the second quarter in a row, investment losses sap what otherwise would have been solid earnings, draining $980 million from the software giant during its fiscal first quarter.

7 min read
Microsoft started off its fiscal year 2002 with strong sales, despite the malaise crippling the PC market.

But for the second quarter in a row, investment losses sapped what otherwise would have been solid earnings. Microsoft reported a $980 million investment loss, which contributed to a $1.24 billion after-tax charge.

Including the charge, the software maker reported net income for its fiscal first quarter of $1.28 billion, or 23 cents a share. Excluding investment losses, net income for the quarter was $2.9 billion.

A consensus of analysts polled by First Call had predicted earnings of 39 cents a share on that basis. The charge trimmed 20 cents off actual earnings

First-quarter revenue grew 6 percent to $6.13 billion, up from $5.77 billion a year earlier. But sequentially, Microsoft saw a modest sales decline. During the fourth quarter, the company reported revenue of $6.58 billion and earnings of $2.4 billion, or 44 cents a share, before investment losses.

"This has been a challenging period for all of us on many fronts, and we're happy to (see) our operating results for the quarter meet and in some areas exceed our expectations," Chief Financial Office John Connors told financial analysts in a conference call following the announcement. "Our revenue results for the quarter were driven primarily by continuing momentum for Windows 2000, which helped offset a weaker-than-expected PC environment."

Microsoft plowed through a tough quarter, despite record-setting declines in PC sales that battered computer makers Compaq Computer and Gateway, among others.

PC shipments collapsed in the third calendar quarter worldwide, plummeting 12 percent year over year and nearly 19 percent in the United States, according to Dataquest.

The fourth-quarter forecast is grim, even factoring in an expected boost in PC sales from the release of Microsoft's new Windows XP operating system, according to IDC. The market researcher, for example, forecast a 31 percent decline in U.S. consumer PC sales, compared with the fourth quarter of 2000.

Gartner analyst Neil MacDonald credited Microsoft's sales strength to aggressive licensing changes announced in mid-May.

"If your main business is selling desktop operating systems and applications, but PC sales are way down, you're going to scramble to find new revenue opportunities. Hence, the whole emphasis on licensing as a source of revenue," MacDonald said.

The changes, which "not coincidently went into effect Oct. 1"--a day after Microsoft closed it fiscal first quarter--raised corporate licensing fees anywhere from 33 percent to 107 percent, MacDonald said.

"Originally, Microsoft said they weren't going to extend the deadline," he added. "Now they've extended it twice, but a lot of people had to make those decisions early on. Even then, Microsoft still hasn't backed down on the changes."

Scott Boggs, Microsoft's corporate controller, dismissed any benefit from the new licensing program.

"We did see a higher than expected number of consumers sign Select and Open (licensing) agreements late in the quarter, apparently in anticipation of this new program," he said during the conference call. "However, we don't believe this resulted in a material impact on our revenue."

While Boggs noted that sales of Enterprise licensing agreements also were strong, "We only recognize a small percentage of revenue?in the quarter an agreement is signed."

Still, in response to one of many questions of volume licensing, Connors said that the programs accounted for 40 percent of revenue in fiscal year 2001.

"The percentage of the total at the end of fiscal year `01 was 39 percent, (and) at the end of the first quarter of this year it's 47 percent," Connors said.

Exceeding sales targets
Microsoft's sales increased in most categories during the first fiscal quarter compared with the same time period a year earlier. But sequentially, from the fourth quarter, revenue declined in almost every category.

Regionally, the South Pacific and the Americas accounted for $2.43 billion in sales, compared with $2.15 billion a year, up 13 percent year-over-year but down from the fourth quarter's $2.66 billion. Revenue for the Europe, Middle East and Africa region grew slightly year-over-year, to $1.11 billion from $1.09 billion but declined slightly sequentially. Asia saw a 15 percent sales decrease, to $708 million from $604 million a year earlier. Revenue would have been 9 percent higher if not for exchange rates. In the fourth quarter, the region had $777 million in sales.

Revenue from PC makers and other original equipment manufacturers (OEMs) rose 9 percent to $1.98 billion, from $1.82 billion a year earlier.

Desktop application revenue topped $2.19 billion, up 2 percent from $2.14 billion a year earlier but down from the $2.51 billion in the fourth quarter. The results include sales from Great Plains Software, an accounting-software maker Microsoft recently acquired.

Sales of the Office business software package declined slightly during the quarter, buoyed by Microsoft's new licensing program. "While Office revenue from corporate licenses continued to be strong, the retail market was quite weak," Boggs said.

Sales of Windows desktop software topped $2.02 billion, up 7 percent year over year, but declined slightly from $2.04 billion in the fourth quarter.

Enterprise software sales grew 15 percent year over year to $1.19 billion from $1.04 billion a year earlier, but declined from the fourth quarter's $1.29 billion. SQL Server sales grew 48 percent from the same period a year earlier "and is now our fourth-largest business," Boggs said. Exchange 2000 sales increased about 50 percent.

Combined revenue for desktop and server software and services declined from the fourth quarter's $5.84 billion but rose 7 percent to $5.4 billion from $5.07 billion a year earlier.

Sales in the consumer software, services and devices group, which includes Internet access and online services, grew 5 percent year over year to $501 million but declined sequentially from $509 million. Revenue from consumer commerce investments, which includes Expedia, HomeAdvisor and Carpoint, reached $94 million, compared with $63 million a year ago. MSN access and advertising revenue grew 22 percent in the quarter. MSN now has 7 million subscribers, with 40 percent of those gained in the quarter switching from AOL.

Sales in the "other" category--primarily hardware and Microsoft Press--fell to $129 million, from $165 million in the fiscal first quarter of 2000.

As expected, Microsoft reset expectations for its fiscal second quarter and the remainder of fiscal 2002. Microsoft projected sales of $7.1 billion to $7.3 billion in the second quarter, with earnings of $2.8 billion to $2.9 billion, or 49 cents to 50 cents a share.

For the year, Microsoft now expects between $28.4 and $29.1 billion in revenue, down from earlier guidance of $28.8 billion and $29.5 billion. Earnings are expected to be $12 billion to $12.4 billion, or $1.61 to $1.66 cents a share. Earlier guidance put earnings per share between $1.91 and $1.95.

Deciphering the Xbox files
While Windows XP is expected to be important to second-quarter results, analysts remain cautious because of the hostile PC sales market.

For that reason, no other single product is likely to impact Microsoft's second fiscal quarter more than the new Xbox video game console, say analysts. But potential manufacturing problems with contractor Flextronics could complicate the launch of the highly anticipated game console.

"Microsoft delayed the launch date...There have been rumors of manufacturing problems, and they're not saying how many units they're going to launch," said IDC analyst Schelley Olhava. "All of these raise a red flag."

Last month, Microsoft pushed back the Xbox launch by one week, to Nov. 15, without explanation.

Microsoft's decision this week to award Flextronics rival Selectron a $1 billion contract for quality control and repair services for Xbox also could signal trouble ahead.

"Repair services?" Olhava asked. "This is a game console, not a PC. You aren't going to send it back to the company for repair because it's DOA. You want a new one. You want to just plug it into your TV."

One possible scenario is that Solectron was hired to solve problems at the Guadalajara, Mexico, factory where Flextronics is assembling Xbox consoles for North American delivery. Or Solectron could be inspecting units before they are shipped to retailers.

Launching Xbox successfully means more than just Microsoft making a successful entrance into the game console market. Merrill Lynch analyst Henry Blodgett expects Microsoft to sell Xbox at a loss of about $100 per unit. With $500 million in promotion and other factors, he forecasts Xbox sapping as much as 10 cents per share from Microsoft's quarterly earnings.

The company must sell a large volume of Xbox consoles quickly to bring in revenue from high-margin games.

But Prudential Securities analyst John McPeake in a Thursday research note said he thinks "these assumptions are likely conservative, and that Microsoft may initially be able to generate more Xbox revenue and profits than we previously thought."

Assuming more software sold with each console, he predicts a gross profit of $60 million to $65 million, or a penny a share. McPeake also predicted Microsoft would try to create publicity and demand for Xbox through an artificial shortage.

"Microsoft may be planning this type of strategy by withholding Xbox consoles in the first month of release, only to later provide the full number of planned consoles," he wrote.

"For the December quarter, we are looking for revenue in the range of $800 to $850 million," Connors said. "We expect to sell between 1 (million) and 1.5 million consoles during the holiday season, and we are looking to exit fiscal (2002) with 4.5 (million) to 6 million console units worldwide."

Xbox will launch with about 15 game titles, he added.