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In Context: MS Software Profits Down for Three Quarters; Blame Linux?

Nov 06, 2000, 09:05 (33 Talkback[s])
(Other stories by John Wolley)

Microsoft's software profits have been in decline throughout this year, and its bottom line is being propped up only by impressive returns on its investments. Multiple trends have converged to obsolete the MS business model, but future historians are likely to credit Linux with being the catalyst that undid the MS money machine at the start of the new millennium.

by John Wolley, Linux Today

A lot of people in the Linux community don't want to hear anything about what's happening with Microsoft; but the truth is that anything remotely resembling "world domination" will only be achieved, by Linux, "over Microsoft's dead body" -- that's the way MS is playing the game.

I've been waiting for the past two years to write a story about Linux putting a serious dent in Microsoft's bottom line. If Linux is going anywhere at all, eventually it has to show up in Microsoft's revenues. I have no doubt at all that Linux is going somewhere, so I've seen it as only a matter of time before MS would put out that historic quarterly report that showed its profits shrinking -- or at least growing at a rate far enough below the 30% per year investors have come to take for granted it would send shockwaves through the financial markets. This is inevitable, if MS revenues drop much below the market's expectations -- that's the way the financial community is playing the game.

The first signs of Linux having any effect on MS financially appeared in the Times (UK) in February of '99, under the headline, "Finnish programmer costs Microsoft dear." The article speculated that an $11 billion drop in the value of Microsoft stock could be attributed to Linux -- specifically, to IBM's announcement that it would offer Linux on some of its server products.

But then, quarter after quarter through '99 and up through the quarter just ended on 30 September, Microsoft has just kept on putting out the "same old, same old" report -- the key phrase that always describes it: "beats analysts expectations." Other than an opinion in The Register about "How Linux could screw MS in Q4 2000" (the upcoming Christmas season), you really have to sift through the fine print in the trade and financial press to find any negative opinions about Microsoft's financial prospects, at least "once they get past this antitrust nuisance."

So how long will it take for Linux to impact Microsoft's bottom line? Well, a closer examination of the last three quarterly reports out of Redmond reveals it is already happening. But Microsoft being the unique organization Microsoft is, it hasn't made headlines and quite possibly never will.

The January-March, 2000 Quarter
Microsoft's fiscal year is out of synch with the calendar year -- January-March is the first quarter on the calendar, but the third quarter for MS accounting. To keep things straight, I'll just refer to MS quarterly reports by the months they cover. For the January-March, 2000, quarter, Microsoft earnings jumped to $2.39 billion, up from $1.91 billion for the same period in the previous year. This was an increase of $480 million, or 39% -- in earnings, or net profits, not just gross revenues. Same old "blows away the analysts" report, right? Look a little closer.

Most coverage of the MS results just looked at these numbers and ran with headlines like IT-Director's "Microsoft makes much money." Tony Smith of The Register took a closer look at the numbers adding up to that $2.39 billion net and pointed out $885 million "came from the sale of Microsoft investments." Let's do a little math here: MS realized $885 million in net income from its investments, but their bottom line only went up $480 million -- without the investment income, their net profits would have gone down by $405 million for the quarter, in comparison with the previous year!

I took a quick look at the MS report, but never did figure out where the $405 million in negative numbers was coming from. Since nobody in the financial press was picking up on this and making a big deal out of it, I figured there were "charge-offs" for one thing or another only accountants understand that accounted for the discrepancy. After all, if the MS net on its "core business," its software operations, were actually declining that would be really big news and somebody would pick it up.

The April-June, 2000 Quarter
The general tone of the stories on Microsoft's quarter that ended in June were decidedly less positive than what has been standard for most of the past decade. ZDNet's Larry Dignan headlined his story on the MS quarterly report, "Does Microsoft matter anymore?"

Dignan didn't mention the numbers at all, but focused on the way "Microsoft has lost its luster" -- the MS conference call about its quarterlies happened to coincide with the same for "Intel, Commerce One, i2, Apple, DoubleClick and RealNetworks to name a few." And Dignan concluded many analysts opted to skip the MS conference call in favor of some of the other companies, something that would have been unthinkable up until very recently. In Dignan's view, future prospects for MS depended on .NET, and analysts weren't buying the Redmond line:

"You could listen to Microsoft drone on about its .NET strategy, but it appears to be a hosting strategy a little behind the curve. In many respects, .NET could be called .Vaporware. Microsoft is pursuing a strategy that's already applied by a host of others. Microsoft is retrofitting its tools, applications and operating systems so it can sell software as services. While Microsoft retrofits for two years, other companies are there today."

As with the previous quarter's report, The Register was one source that took a hard look at the numbers -- a very hard look. Graham Lea noted the trend towards investments propping up revenue growth, which had surfaced in the previous quarter, was continuing in a big way (italics added):

"Almost without it being noticed, Microsoft has transformed itself from a software company to an investment company. ...Microsoft's investments have been performing more profitably than its products, with the operating income showing 30 cents/share coming from products and 14 cents from investment income and interest."

Lea's analysis of the numbers continued, indicating just what a precarious financial situation MS was in (italics added):

"Revenue for the quarter was almost flat... Microsoft's ability to recognise revenue more or less as it pleases, may have been helpful here, allowing it to show this very small increase rather than a potentially headline-grabbing loss. ... Microsoft's operating income was down 13 per cent for the quarter, primarily reflecting a 10 per cent decline in the sales of MS Office and tools..."

The July-September, 2000 Quarter
The quarter just ended in September continued the trend of the previous two quarters, except that MS stock didn't get the bump that has been typical after announces its quarterly results. Apparently some analysts are getting uncomfortable with the idea of Microsoft turning into a venture capital/banking venture. The Register story on this quarter, written by John Lettice, was titled "MS beats Street, ungrateful Street beats up MS" (italics added):

"Microsoft's Q1 results comfortably 'beat the Street' - but the Street seems to be getting a mite suspicious. The company yanked earnings up from $2.19 billion a year ago to $2.21 billion, but the increase came from a surge in income from company investments... Some analysts however churlishly declined to be impressed by how effective a VC/bank Microsoft is becoming, and pointed instead to a drop in profits from operations of $12 million. ... One analyst ominously observed Microsoft was "pulling a legacy business which accounts for 70 per cent of their revenue."

Operating income -- the net MS made off its software operation -- declined again, by $12 million. And again it was the income off of MS investments, which increased by an impressive 105% (from $550 million to $1.13 billion), that allowed the Microsoft quarterly report to be anywhere in the ballpark of what the financial community has come to expect.

The Motley Fool saw the MS decline in operating income "as the result of higher operating expenses, mainly in research and development and sales and marketing." And Fool writer Richard McCaffery noted that "...margins may very well [continue to] shrink as the company faces tougher competition from Linux and the Internet."

Meanwhile, MS Has Been Boosting Prices in a Big Way
What makes these quarterly reports more ominous is that the declines in MS software income have been occurring at the same time MS has been systematically increasing its prices. As far back as November of '98, a story appeared on the AP wire with the headline, "Microsoft Software Costs Inching Up," reflecting MS tinkering with licensing to boost prices.

In October of '99, the Gartner Group warned that changes in licensing that MS had quietly announced in conjunction with the release of Windows 2000 would impose on enterprise customers a "50 per cent hike in their Microsoft budgets each year until 2002" (italics added):

"Although Microsoft pricing will remain ostensibly flat, enterprises using Microsoft software should expect to pay 50 per cent more a year as a result of changes to terms and conditions."

In February of 2000, on the same day Microsoft officially released Win2k, Gartner released another report on MS pricing. ZDNet noted that "the 'significant' new charges for Windows would affect 90 percent of large firms over the next two years, no matter what other software products they used."

The full report on the Gartner website gave the "gory details" on exactly what was going to cost more, and included some straightforward price increases: for example, client access licenses, required to allow Win2k desktop clients to connect to Win2k servers, would cost 82-122% more than with NT 4, and the upgrade of a Win9x desktop to Win2k would cost 84% more than to WinME (which MS effectively wouldn't allow anyway). But one item that Gartner flagged showed just how "innovative" MS could be when it came to figuring out new ways to extract money from its customers:

"...if an OEM ships new desktops pre-installed with Win2000 Professional and an enterprise overlays this with its own system image based on NT v.4 Workstation or Windows 9x, a UA ['Upgrade Advantage'] fee of $157 will be due for each machine overlaid."

In June of 2000, MS announced across-the-board price hikes on its server apps. ZDNet's Mary Jo Foley quipped, "The company's new motto, at least for its 2000-generation back-office server products: You get more, you pay more." MS justified the increases with claims of increased functionality:

"Our prices are higher across the board," acknowledged Stan Sorensen, group product manager for server applications, while speaking about changes to the price of Exchange. "But we're adding tons of new functionality."

In August, Gartner revealed the full extent of the "innovative" price hiking that had only been previewed in February: a "reimaging" charge. Reimaging is what MS enterprise customers have been doing for years: they take the PCs they buy from a hardware vendor and overwrite the vanilla Windows software that the vendor ships with a customized "image" of the operating system that has been configured for the organizations specific needs in accordance with the IT department's standards.

They've already paid for Windows and they're just overwriting it to save the time it would take to configure it the way they want on each PC. They've been doing this for years, and now MS suddenly says they have to pay an extra charge of $117 to $157 per PC, effectively just about doubling the cost of the software. Ouch!

In September a Register story reported that the reaction from Microsoft's biggest customers was so negative -- The Reg termed it a "revolt" -- that MS had amended the reimaging policy to exempt the big guys ("Select" and "Enterprise" customers, in MS licensing jargon). But Gartner calculates that the cost of the amended policy to the small and medium size businesses still affected "will net Redmond an extra $11 billion in revenue" (italics added).

Is Linux to Blame?
If Microsoft's bottom line software income is indeed in trouble (relatively speaking -- no longer growing at historic rates), what evidence is there that Linux is the cause? Well, there's virtually no hard evidence at all to make this connection, although most Linux supporters probably have a sense that it's true.

A Register story by John Lettice, posted right after the MS report for the April-June, 2000, quarter was titled "Linux server growth threatens MS revenue supply." But Lettice was referring to an IDC report that had just appeared, forecasting that "Linux server shipments will climb faster than the rest of the market, resulting in 2004 in Linux shipments of around 4.7 million, finally within spitting distance of Microsoft, at 5.7 million." So any impact on MS revenues was only a future possibility.

The problem with open source software is that it's very difficult to get hard numbers on the actual number of installs that are out there. With proprietary software, each copy licensed is recorded and feeds into the vendor company's financial statements -- counting the copies is fairly easy, as is reckoning the software's "market share" in monetary terms. It's fairly easy to see that MS isn't making as much money as it used to on its software, but we can only estimate the total number of Linux servers and desktops that are out there that represent a lost sale of Microsoft Windows.

What's even harder to do -- virtually impossible -- is to determine how many corporate IT departments are putting some part of the Win2k/Office2k upgrades they would have otherwise done by now on hold, while they evaluate Linux & open source office suites for possible use in select areas -- especially Linux & NDS vs. Win2k & Active Directory on network servers.

It's hard to counter the argument that there are multiple trends underway that are responsible for the decline in MS software profits, and that the Linux impact so far has been minimal. And I have to agree that, whatever impact Linux is having on the MS bottom line, it is having it in conjunction with these key trends (and probably a few others) that are independent of the Free Software Foundation and the open source software movement:

  • The fastest growing market now is low-cost devices, not PCs -- on a $200 product, there's no margin to pay MS $50-100 for an operating system (even if it works!).
  • Businesses are balking at the unending upgrade cycle MS depends on -- the real business gains from upgrading all your PCs just so you can upgrade to Win2k are pretty marginal, compared with the benefits of upgrading from Windows 3.x to Win95.
  • The focus of software development is shifting from the desktop to the Internet -- this environment is orders of magnitude more complex, and the cost of proprietary software development here is much higher, than what MS has been geared up for historically, and its desktop monopoly no longer gives it that much of an advantage against competitors like Sun and IBM.
  • The antitrust trial broke Microsoft's iron grip on its OEMs -- it doesn't matter what the outcome of the appeal is, MS has lost the tight control it used to have over the vendors who rely on Windows to sell their products.

But when analysts look back on the year 2000 from the vantage point of five or ten years in the future, I suspect that they'll credit Linux with being the catalyst that dramatically accelerated the impact of all the above trends on the MS bottom line. And I can imagine all sorts of sage opinions about how brilliantly Microsoft executed its transition from selling software to providing venture capital and banking services!

Related Stories -- MS Quarterly Reports:
Motley Fool: Unanswered Questions at Microsoft re Quarterly Report(Oct 23, 2000)
The Register: MS beats Street, ungrateful Street beats up MS, for Quarter ending 9/30(Oct 19, 2000)
The Register: Slow Win2k uptake, flagging Office sales dog MS Q4(Jul 19, 2000)
ZDNet UK: Does Microsoft matter anymore? [Q4 results](Jul 19, 2000)
The Register: Microsoft Q3 profits up ahead of Street expectations [via sale of MS investments](Apr 22, 2000)
CNET NEws.com: Microsoft beats earnings expectations, but sales slow [in Quarter ending 3/31](Apr 21, 2000)
IT-Director: Microsoft makes much money [in Quarter ending 12/31](Jan 21, 2000)
Wired: Surprise! Microsoft Made Piles [in Quarter ending 9/30](Oct 19, 1999)

Related Stories -- MS Price Increases:
The Register: MS reimaging sting will cost business $11bn - Gartner(Sep 27, 2000)
32BitsOnline: The Juggernaut's new license [MS reimaging charge](Aug 25, 2000)
CRN: Licensing Policy in Question -- Microsoft Select customers to pay more for Windows deployment(Aug 22, 2000)
Gartner: Microsoft Uses Windows License Compliance Confusion to Drive New Revenue(Aug 13, 2000)
Excite/ZDNet: Microsoft to hike price of server apps(Jun 17, 2000)
GartnerGroup: The Higher Licensing Cost of Upgrading to Windows 2000(Feb 20, 2000)
ZDNet/Reuters: GartnerGroup: MS to charge firms extra [for Win2k](Feb 18, 2000)
ComputerWorld/AU: Users face 50% price hike on Microsoft products - [Gartner] report(Oct 22, 1999)
AP News: Microsoft Software Costs Inching Up(Nov 15, 1998)

Related Stories -- MS, Linux & the Future:
IT Director.com: Microsoft finally guns for Linux (Oct 26, 2000)
National Post: Your choice: Microsoft or mutating penguins(Oct 25, 2000)
We Won: MS targets Linux in German advertising(Oct 22, 2000)
Smart Partner: What's MS Worried About?(Oct 20, 2000)
ZDNet: A kinder, humbler Microsoft?(Oct 20, 2000)
The xEyes/gEyes Fork: Yet Another Attempt by Microsoft to Cripple Linux?(Oct 19, 2000)
Microsoft considers apps for Linux(Oct 18, 2000)
Where is Microsoft going tomorrow?(Oct 13, 2000)
SJ Mercury/AP: Microsoft opens public testing lab(Oct 13, 2000)
National Post: Microsoft using Corel to ease into Linux, documents hint(Oct 12, 2000)
Corel Linux strategy unchanged, despite Microsoft deal(Oct 11, 2000)
TechRepublic: The duality of Microsoft's position on Linux(Sep 23, 2000)
Seattle Times: Microsoft adjusting its course after a triumphant quarter-century(Sep 03, 2000)
The Register: Linux server growth threatens MS revenue supply(Jul 25, 2000)
USA Today: Questions haunt Microsoft's future(Apr 28, 2000)
Seattle Times: Comdex '99: Microsoft rivals aim squarely for giant's soft spots(Nov 17, 1999)
The Register: Opinion: How Linux could screw MS in Q4 2000(Jul 27, 1999)
PC Week: Torvalds Q&A: Bring on Microsoft(Apr 21, 1999)
Chicago Tibune: Comdex Q&A: Linus Torvalds, on the battle against Microsoft(Apr 20, 1999)
Reuters: Microsoft Chief Sees Linux Having Limited Impact(Apr 14, 1999)
The Times (UK): Finnish programmer costs Microsoft dear(Feb 22, 1999)