Original URL: http://www.theregister.co.uk/2006/04/28/microsoft_third_quarter_costs/

Microsoft costs creep up, ahead of launches

No search surprise

By Gavin Clarke

Posted in Financial News, 28th April 2006 01:56 GMT

Microsoft is keeping mum about how Windows Vista and Office 2007 will affect its coming fiscal year, but conceded investments to promote these, plus other new activities including online services, are pumping up corporate spending.

Microsoft said Thursday it expects next fiscal year's revenue to hit between $49.5bn and $50.5bn, an estimated increase of between 11 and 14 per cent over expectations for the current year. Microsoft expects to close the current fiscal year at $44.42bn, which would represent growth of 11 per cent.

The next fiscal year will, finally, see Windows Vista and Office 2007 hit both the streets and the company's bottom line. But Microsoft - which has yet to announce pricing for Windows Vista - refused to provide Wall Street with anything but the barest bones about how it expects either product will pay out during fiscal 2007. By implication, it was also keeping silent on Windows Vista's potential pricing.

Microsoft revealed these numbers while announcing financial results of its third fiscal quarter. And while Microsoft refused to be drawn on the future, the latest results do reveal the impact its Windows Vista and Office 2007 marketing ramp-up is having.

Operating expenses increased 11 per cent to $7bn for the three months to March 31, helping eat away at the company's net income, which grew 16 per cent to $2.9bn. Revenue for the quarter increased 13 per cent to $10.9m - coming in below Wall St expectations of $11bn. Operating expenses included the cost of recruitment of new marketing people to promote Windows Vista and Office 2007.

The numbers also tell of growing expenses associated with Microsoft's efforts to break into new markets occupied by the likes of Google, Yahoo!, SAP and Sony, outside of its core client, information worker, and server and tools franchises.

For the three months, the client business saw eight per cent growth, information worker five per cent, and server and tools grew 16 per cent, recording respectively $3.1bn, $3.1bn and $2.6bn in revenue and putting each safely into the operating profit zone.

However, the newer units - Microsoft Business Solutions (MBS), mobile and embedded, home and entertainment and MSN - remained loss makers even though each - except MSN - enjoyed growth that outstripped the core business. MBS grew 28 per cent, mobile was up 85 per cent and home and entertainment grew 133 per cent driven by Xbox sales.

"We have decided to add investments in a number of areas, and they do add up," chief financial officer Chris Liddell told Wall St, who was clearly concerned by the fact margins are being eroded in the face of increased spending. Liddell highlighted marketing to build and promote the Xbox 360, Windows embedded and mobile, Dynamics enterprise resource planning, and online services and MSN. "Investment today will drive future success," Liddell said.

He also promised additional investment, particularly in these newer markets. Online services will get a boost to increase the relevance of search results, to devise local and mobile search, and improve co-ordination of advertising across sites. Spending comes as MSN and AdSense unexpectedly faltered during the third quarter. Revenue from search and advertising dropped, falling from a $30m profit to $13m loss, despite MSN seeing a jump of 70% in search traffic.

Goldman Sachs analyst Rich Sherlund speculated the projected increase in costs for internet services meant Microsoft was hiding "something really big" for use against Google and Yahoo!, which Microsoft had not yet disclosed.

Liddell told Sherlund he had over-estimated his cost projections and assured Wall St. that there was: "no Trojan horse." "We see big opportunities in MSN and Windows Live. But we are not building into our guidance things we aren't talking about," Liddell said.

On gaming, Microsoft experienced increased production costs associated with delayed delivery of Xbox terminals during the third quarter. Microsoft plans additional spending during the current fourth quarter to maintain growth and help consolidate market share against Sony's Playstation. Microsoft said it now expects to ship at least five million Xbox units by the end of its fiscal year 2006 on June 30, increasing its earlier guidance of at least 4.5 million units.®