Microsoft Feels the Heat with First Ever Revenue Decline

Economic gloom has once again descended on Microsoft, which reported disappointing fiscal third quarter results. The sales figures are yet another sign that enterprise spending is down during the recession and that many businesses are holding back major operating system and business application deployments until Windows 7 releases.

Once again, netbook sales sapped Windows Client division profits. More broadly, slower PC and server sales took their toll, too. Windows client revenue declined a stunning 16 percent year over year.

For the third fiscal quarter, ended 31March, Microsoft revenue was $13.65 billion (£9.33 billion), for 6.5 per cent year-over-year decrease. Operating income was $4.44 billion (£3.03 billion) and net income was $2.98 billion (£2.04 billion), or 33 cents a share. If not for two charges, $290 million (£198.47 million) and $420 million (£287.45 million), Microsoft would have met earnings expectations. The charges sapped 6 cents a share from earnings.

The Wall Street consensus was $14.09 billion (£9.64 billion) in revenue with earnings of 39 cents a share. In January, Microsoft refused to offer guidance, as would be typical, because of the weak economy. The previous quarter was Microsoft’s toughest since fourth quarter 2000, during the last recession. While revenue rose 2 per cent year over year in the fiscal second quarter, operating income declined 8 per cent, net income by 11 percent and earnings per share by 6 per cent year over year.

Analysts were generally bearish on Microsoft coming into the quarter, with consensus for a 17 percent growth decline. For the next quarter: 13 per cent decline and 7 per cent for the fiscal year. None of this has been good for Microsoft stock, which joined other companies in the spiral downward from September. Share price dropped to a 52-week low of $14.87 (£10.18), but rebounded to nearer $20 last week. The 52-week high, achieved about a year ago, is $32.10 (£21.98).

Windows Client division revenue and income declined in its fiscal second quarter, a trend Microsoft couldn’t reverse in third quarter. Revenue fell 16 per cent and income by 19 per cent year on year. These are staggering numbers for Microsoft and far exceed unit shipment declines for the broader PC market. The division reported report revenue of $3.4 billion (£2.33 billion) and operating income of $2.51 billion (£1.72 billion).

According to Gartner, worldwide PC shipments decline 6.5 per cent year-on-year during first calendar quarter. In the US, shipments declined 0.3 per cent year over year. Like the previous two quarters, netbook sales were strong. But the increase in shipments command a high price on average selling prices and, more importantly, margins. Mikako Kitagawa, Gartner principal analyst, predicted, “US mobile PC ASP [average selling price] likely will decline as much as 20 per cent year-over-year in first quarter 2009.”

For Microsoft, netbook sales present other problems. The majority of the portables, which analysts call mini-notebooks, ship with Windows XP Home. Retail sales reveal something of the impact: Windows XP had nearly disappeared from US retail PCs in August. By December, Windows XP Home PCs were second to Vista Home Premium, with 13.7 per cent market share, according to NPD. Microsoft loses massive margin on every netbook shipped with Windows XP Home. Original equipment manufacturers (OEMs) pay an estimated $50-$60 (£34-£44) more per copy of Vista “premium” version. Although those numbers are based on analyst estimates, as Microsoft doesn’t publicly disclose what OEMs pay for Windows.

But Windows Client numbers are telling enough. Like the previous quarter, declining PC shipments and increasing netbook sales were gravity pushing down Windows Client numbers. Microsoft reported that OEM revenues fell 19 per cent, or $637 million (£436 million), while unit shipments dropped only 6 per cent. The difference made is the continued decline of premium products, which account for only 62 per cent of Windows licences. Netbooks largely account for the shift in mix and difference between OEM revenue and licences.

Server and Tools

Servers and tools are Microsoft’s most important line of business during the economic downturn, because, in theory, it is more insulated. Annuity licensing accounts for about 65 per cent of sales, offering much greater cushion against slower hardware sales than PCs. Microsoft reported double-digit annuity licensing growth. Year-over-year revenue growth: 7 per cent. But income growth was much greater at 24 per cent.

Servers and tools revenue was $3.46 billion (£2.37 billion) and operating income was $1.34 billion (£917 million). This revenue number is simply stunning. For the first time, and in a surprising turn of fortune, servers and tools revenue topped Client. If the trend continues, servers and tools would become more important to Microsoft. Considering how much annuity licensing insulates the division from economic hills and valleys, servers and tools ascension over Client would be good for Microsoft long-term.

Microsoft attributed the 7 per cent revenue increase, or $191 million (£130.7 million), primarily to growth in client-access licenses for SQL Server, System Center and CAL suites.

Business

Like Server and Tools, Microsoft’s Business division is more insulated from the economy by annuity licensing – but to much less degree. As such, the slowing economy nipped the division, driving revenue down by 5 percent and operating income by 8 percent. Still, Business continued to be Microsoft’s most important division, reporting $4.5 billion in revenue and $2.87 billion operating income.

Business division revenues declined where they were most exposed: outside annuity licensing. Consumer revenue declined a stunning 30 per cent, or $299 million (£204.62 million). Microsoft mostly attributed the decline to weak PC sales. By comparison, business revenue increased 2 per cent, or $73 million (£49.6 million). But there are two problems with business revenue: Dynamics customer billings declined 8 per cent, and broader volume-licensing growth reflected past, rather than new, bookings.

Online Services

Microsoft’s beleaguered Online Services Group posted yet more dismal results, with revenue down 14 per cent year-on-year and operating income down a whopping 154 per cent. Online advertising revenue declined 16 per cent, spurred on by declining display ad rates. And online advertising declined by $98 million (£67.05 million) to $521 million (£356.47 million).

Entertainment and Devices

Entertainment and Devices delivered surprising results. While revenue dropped 2 per cent year-on-year, operating income was flat. These numbers are surprising because Xbox console sales grew about 30 per cent, or 1.7 million consoles sold in the quarter. But Microsoft’s Xbox typically drives up revenue while sapping operating income. For the quarter, revenue reached $1.56 billion (£1.07 billion) for an operating loss of $31 million (£21.21 million).

Microsoft’s Macintosh Business Unit is part of Entertainment and Devices. In the past Mac sales have been good to Microsoft, but not during fiscal third quarter. Mac application software sales dropped a stunning 63 per cent, in part because of the year-over-year comparison to the launch of Office 2008 and also because of declining Mac computer sales.

Joe Wilcox is editor of Microsoft Watch.