Microsoft posts Q1 gains, but cracks appear in licensing program

Microsoft on Thursday posted fiscal first quarter revenue of $8.22 billion in part due to a 15% increase in licensing for enterprise software servers including Windows, SQL Server and Exchange. But a significant drop in unearned revenue may reveal the beginning of problems the company is having selling its annuity licensing program to corporate customers.

Microsoft barely beat analysts’ predictions of $8.1 billion in revenue and fell short of forecasts for profits of $0.29 cents per share, according to a poll by Thomson Financial. Microsoft reported earnings per share of $0.24 cents and net income of $2.61 billion. The $8.22 billion in revenue for the first fiscal quarter ending Sept. 30 was a 6% increase over the $7.75 billion in the same quarter last year.

Despite the strong numbers, Microsoft acknowledged that its Licensing 6.0 and companion Software Assurance (SA) annuity licensing program was partly responsible for a drop of  $768 million between June 30 and Sept. 30 in unearned revenue. Also to blame were unearned revenue from multi-year licensing in prior quarters and deferral of revenue linked to technology guarantees for Office System 2003, company officials said.

Licensing 6.0 caused an outcry from customers when it was introduced in late 2001, with customers complaining that it could increase their licensing costs up to 100%. In 2002, CEO Steve Ballmer admitted the program was confusing and created some economic hardships for customers. Microsoft soon began making changes.

“I don’t think we have a crisis, I think we missed our forecast,” says John Connors, Microsoft CFO about the drop in unearned revenue. Connors said distractions due to security issues, namely the Blaster worm, kept customers, sales teams and channel partners from closing sales.

Connors said an important milestone would be converting customers to Licensing 6.0 contracts after their Upgrade Advantage (UA) accounts expire. Many customers signed UA agreements two years ago to buy time to avoid Licensing 6.0. Those UA contracts are now set to expire.

“It’s too early to see what we can do on UA renewal,” said Connors. “And I think on the sequential up or down on the unearned [revenue] we’ll just look and see how this next quarter goes and we will have more visibility into those annuity programs in the January [earnings] call.”

Connors said the multi-year nature of the licensing program doesn’t appear to be a big hurdle in customers’ minds. “Product roadmap is more important, I think, and secondly, what do corporate profits look like and what do IT budgets look like is a much bigger factor in my mind.”

Connors said Microsoft has a very good product roadmap that would become even clearer next week at the company’s annual Professional Developers Conference in Los Angeles.

Microsoft after this week’s launch of Office 2003 and Exchange 2003 has very little in terms of significant enterprise products due in the immediate future that would entice users into signing multi-year licensing agreements. Microsoft has announced an entire wave of enterprise products around its Longhorn operating system, but the product isn’t expected to launch until 2006.

Connors alluded to the fact that the company was considering further tweaks to Licensing 6.0 and SA to get customers in the fold.

“The greatest value is under the SA program. As we get that more broadly rolled out and deployed, we’ll get a lot of feedback and if we have to add more benefits to the SA program we will do that,” he said.

Microsoft did note that it had $8.25 billion of unearned revenue at the end of September  and said $2.62 billion is expected to be recognized in the second quarter of fiscal 2004, $1.95 billion in the third quarter of fiscal 2004, $1.38 billion in the fourth quarter of fiscal 2004, $665 million in the first quarter of fiscal 2005, and $1.63 billion thereafter.

While the unearned revenue question raised flags with financial analysts, Microsoft did post revenue in its servers and tools division of $1.87 billion, driven by double-digit growth of Windows, SQL Server and Exchange. Server revenue, including the sale of Client Acess Licenses, grew $214 million, up 18% over the previous year.

Sales in the company’s information worker division, which includes Office, grew by only 1% over last year to $2.29 billion. The revenue numbers do not include $137 million of revenue deferred for technology guarantees provided to purchasers of Office in the first quarter of fiscal 2004.

Microsoft is trying to alter the continuing flat revenue numbers with the release this week of Office 2003, the latest version of the productivity suite. Microsoft hopes support for XML, a revamped Outlook client and the suite’s pivotal role in Microsoft’s new collaboration strategy will help boost sales.

The company also revealed that it spent $1.61 billion, which was 19.6% of revenue, on research and development. The spending was a decrease of 6% in absolute dollar over the first quarter of 2002. The decrease was attributed to a $62 million decrease in employee-related costs, $20 million in intellectual property rights amortization, and $16 million in third party product development costs.

In Microsoft’s other business units: MSN posted advertising revenue growth of 50%; Home and Entertainment revenue grew by 20% on the back of Xbox; Mobile and Embedded Devices saw revenue of $53 million and the first release of a Windows Mobile-based Smartphone in North America, the Motorola MPx200 from AT&T Wireless.

Microsoft also said it expects revenue for the quarter ending Dec. 31 to be in the range of $9.7 billion to $9.8 billion. For the fiscal year, which ends June 30, 2004, revenue is expected to be in the range of $34.8 billion to $35.3 billion.