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Monday, June 28, 2004 - Page updated at 01:11 A.M.
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Microsoft clamps down

By Kim Peterson
Seattle Times technology reporter

John Connors predicts modest growth this year.
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In the past year, Microsoft's hefty profit included $1.1 billion in customer payments that the company won't see again. The money came with no strings attached — no commissions to be paid, no rebates to be given and no other costs necessary.

In the next year, that cash will disappear as some key contracts expire. And as much as the company expects to grow, the $1.1 billion hole is going to hurt.

That's not all Microsoft faces as it begins its new fiscal year Thursday. Executives have said the company will not increase expenses, and yearly sales are expected to grow less than 10 percent for the first time. Meanwhile, shareholders are demanding an improved bottom line, and the company's $56 billion cash hoard is coming under fire.

Fiscal 2005 likely won't be the best year for Microsoft. And the company is preparing for that, in big and small ways.

It is taking out its budget scissors, looking to save $1 billion in an across-the-company drive to cut costs. It is cutting spending on travel and entertainment, and reducing some worker benefits, such as the discount at which employees can buy stock. It has eliminated some positions and is closely analyzing its marketing and sales expenses. Even catering costs have not escaped scrutiny.

And in an effort to boost sales, it is offering a number of rebates and discounts on its products.

To be sure, Microsoft's financial position is still one that other companies would love to have. But the company is moving out of its high-growth phase, an era in which it spent seemingly as easily as it earned. For four years running, its spending has grown more than its sales. Now, executives want to reverse that trend.

Penny-pinching roots

Microsoft used to be a penny-pinching company. Chairman Bill Gates flew coach for years after making his first millions.

But in more recent times, Lenny Kravitz performs at product launches and the Xbox team parties with Paris Hilton in a rented house in the Hollywood Hills. Many workers get free memberships to a posh Eastside gym, and employee meetings are at Safeco Field, where it was so cold last year that blankets were distributed.

Some of those extravagances could disappear in this next fiscal year. Microsoft says the year will be better than the last, and that it will continue improving its bottom line — which it has done every year since the dot-com crash. But to do so, it will swim against a tide of bad news, not the least of which is the $1.1 billion that it won't have in the future.

That loss of money has to do with the way Microsoft sells its software. Most consumers buy software on a license-only basis. If they want Microsoft Word, for example, they buy it at the store and receive the software and a license to use it.

But Microsoft wants businesses to pay for multiyear contracts that include regular software updates and tech support. Since the mid-1990s, it offered a program called Upgrade Advantage in which customers signed a two-year contract to upgrade software, such as a move from Windows 98 to Windows XP.

Contracts running out

Microsoft ended the program in 2002, and the remaining contracts are running out this summer. Those contracts provided Microsoft with that $1.1 billion, and because they disappear, that source of money is also gone.

The company is trying to move customers to a more expensive program, called Software Assurance, that it says has better tech support and other benefits over Upgrade Advantage. But a large percentage of customers will not make the switch.

Chief Financial Officer John Connors said in January that there are about 200,000 Upgrade Advantage contracts. After those expire, he estimated that between 10 percent and 30 percent of those customers will move to the Software Assurance program.

"It won't be 50, and if it's 10 we would be really disappointed with the way we've designed the program or we will just realize, hey, these folks are license-only customers," he told financial analysts in January, according to a transcript of the event.

The reason customers won't sign up is because of a perceived lack of value, said Alvin Park, an analyst with the Gartner research organization.

"We agree with [Connors] that it is a significant problem for Microsoft and it could be that very few people renew that Software Assurance," Park said. "We knew that there would be a lot of resistance to the new licensing models."

A fantastic 12 months

Connors said he expected revenue for the current fiscal year, which ends Wednesday, to be about $36.5 billion. Analysts with Goldman Sachs predict that the next year's revenue will reach $38.3 billion.

That's only a 5 percent increase, and far less than the double-digit revenue growth the company has traditionally seen. Part of the reason is because the company has had a fantastic 12 months in its fiscal 2004, Microsoft executives say, with major products launched in several divisions.

Another is because Microsoft benefited from fluctuations in foreign-currency exchange in ways it may not in the next year. For the first three quarters of its 2004 fiscal year, it received an $830 million benefit just because of the changing exchange rates.

"That's a benefit that we don't expect to see recurring in the next year," said Curt Anderson, senior director of investor relations.

But growth is also slowing because Microsoft doesn't have many blockbuster product releases for consumers or businesses scheduled in the next year.

For the holiday season, it will likely debut an online music store and its Portable Media Center handheld video player, but it's not at all clear that these new products will sell well at the beginning.

In the first half of next year, Microsoft has said it will ship the next updates of its SQL Server database and its Visual Studio developer tools. But the fiscal year will likely be over by the time the SQL Server sales ramp up, and Visual Studio isn't a big moneymaker for the company anyway.

Computers being replaced

So for the next 12 months, the company will have to count on the industrywide uptick in technology sales for some of its growth, analysts say.

"That's the reason why John Connors is predicting relatively slow growth this year," said Matt Rosoff, an analyst with the Kirkland-based Directions on Microsoft consulting company. "It's really about the [information technology] recovery."

According to Gartner, worldwide computer shipments will climb to 186.4 million units in 2004, a 13.6 percent increase from 2003. The growth is mainly attributable to computers being replaced, Gartner said, adding that it expects nearly 100 million PCs to be replaced this year and 120 million more next year.

Combined, those replacements surpass the dramatic hardware upgrades seen during the height of the Y2K frenzy in 1998 and 1999.

Analysts acknowledge that Microsoft is going to take a hit this year. But some say revenue and earnings-per-share growth should pick up in 2006 and 2007, and that this next year is a victim of some anomalies.

"There are a few one-time issues, rather than a dramatic slowdown in the core business," said Brad Reback, an analyst with CIBC World Markets.

Pleasing shareholders

Microsoft's shareholders may not have much to be pleased about these days. The company's share price has not been above $30 in the past year, and its annual dividend of 16 cents a share is paltry compared with other companies that make up the Dow Jones industrial average.

Recently, in its internal and public comments, Microsoft has been more vocal about increasing shareholder value. When it announced some employee-benefit cuts last month, it said the move would "increase the long-term value" of the company.

"As employees and shareholders, this benefits all of us," said the announcement, which was delivered via e-mail by Ken DiPietro, corporate vice president of human resources. But hundreds of employees found it hard to see the upside of the cuts — estimated to save the company at least $80 million a year — and vented their frustrations in an informal internal Internet poll.

The benefit cuts are part of the $1 billion cost-saving drive across the company. Some departments, such as human resources, are undergoing a restructuring to improve efficiency, and nearly everyone is being pushed to spend less.

Microsoft is promoting its Live Meeting Web conferencing software internally, asking employees to hold meetings online instead of in person. The company has said it can save more than $200 million just by reducing spending on travel and entertainment, computer upgrades and catering.

The cuts have been especially jarring for some employees because Microsoft has more than $56 billion in the bank. But the company has said that the money belongs to shareholders, and it should either be invested in new opportunities or returned to them.

It is also holding on to the money in case it needs it to settle lawsuits.

Analysts have said they are expecting Microsoft to return some of the money to shareholders in the form of a larger dividend. That could be announced next month at Microsoft's annual financial-analysts meeting or in its fourth-quarter earnings release.

Offering new rebates

The savings push isn't new at Microsoft. The company said it's been able to save nearly $1.5 billion since 2001, and nearly $300 million of that came from the Xbox division, which re-engineered the way the video-game consoles are produced.

On top of the cuts, Microsoft is hoping to boost sales by offering new rebates and discounts for its products, analysts say. It is giving rebates of up to $15,000 for small-business customers that want to upgrade to Windows XP, for example, and $75 for each copy of Office Small Business Edition 2003.

Many of the rebates are targeted at small businesses — an area Microsoft has said it will focus on in the future.

It is rare for the company to discount products other than at the beginning or the end of their lifespan, and the rebates could signal that Microsoft is getting as creative with sales opportunities as it is with cost cuts.

"Anytime you can show the world that you're going to hold operating expenses flat and continue to grow revenue is important for shareholders," Anderson said. "That generates real value for shareholders."

Kim Peterson: 206-464-2360 or kpeterson@seattletimes.com

Copyright © 2004 The Seattle Times Company

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