A blockbuster quarter for Microsoft, but clouds are on the horizon

Updated Feb. 1, 2010 at 7:00 a.m.

A blockbuster quarter for Microsoft, but clouds are on the horizon

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Editor’s note: Allan Krans is a senior analyst with Technology Business Research.

By Allan Krans, special to LTW

HAMPTON, N.H. - The consumer is solidifying Microsoft’s core business.

A wave of new consumer PC purchases during the holiday season produced a blockbuster quarter for Microsoft Windows, regardless of whether the $1.7 billion in Windows 7 pre-buying is included or excluded. The additional $1.7 in Windows 7 coupon revenue was the icing on the cake this quarter, as revenue in the Windows division increased by 30.7%, to $5.2 billion without that added benefit.

(See report on earnings by clicking here.)

Driven by a 20% increase in consumer PC shipments during the quarter, the strength in the Windows Division was able to offset widespread weakness in the other divisions to propel Microsoft (Nasdaq: MSFT) to total revenue growth of 14.4%.

Celebration Will Be Short-Lived

For a company constantly grappling with fear, uncertainty and doubt, the record revenue and operating profit during 4Q09 should provide a brief respite. In spite of all the questions surrounding netbooks, Apple, and Linux, the introduction of Windows 7 is thus far a resounding success. However, Microsoft will not bask in the glory of its results for long, as the fundamental challenges facing the company’s business remain unchanged. Consumers supported Microsoft’s business during 4Q09, but a majority of Microsoft’s revenue is derived from corporate customers, which are a much tougher audience to please. With Windows 7, for instance, consumers have limited ability to choose operating systems, as most are pre-loaded onto PCs. Business customers carefully control operating system purchases and use stringent buying criteria when making decisions.

On top of the typical customer evaluation period that follows a new operating system introduction, Microsoft is grappling with the lasting effects of an economic slowdown that continues to persist in the form of conservative corporate IT purchasing. Even the typically stellar Server & Tools segment continues to limp along, reporting single-digit revenue growth for the second consecutive quarter. Now that the initial consumer rush to purchase Windows 7 has passed, Microsoft will move onto the much harder task of demonstrating the value of its new product lines to business customers with tight purse strings.

Critical Cloud Releases Are on the Docket

In addition to completing a number of critically important product releases in its traditional software portfolio, 4Q09 and 2010 will include multiple product releases that will form the baseline for Microsoft’s cloud services strategy. During 4Q09 Microsoft released its Azure cloud services platform, which is now commercially available, and Microsoft will begin charging for the services on February 1st.

On the operating side Microsoft made an important symbolic move, merging the Windows Live business with the Client Division to create the new Windows and Windows Live segment, which includes both the traditional OS and Azure offerings. The next critical pillar of Microsoft’s cloud services strategy will come in June 2010, when the company releases Office 2010, and its web companion Office Web Applications.

Cloud Brings Both Opportunity and Threats

Despite the critical implications for Microsoft; cloud also poses significant risk to Microsoft’s existing financial model. Cloud offerings may be a growth driver for Microsoft, but will not come close to approaching the 50 percent-plus operating margins produced in its core businesses. However, even though cloud poses the threat of margin erosion, the alternative for Microsoft is to see revenue and profit dollars move from its coffers to competitors such as Google and Amazon.

Microsoft is making the best of growing customer demand for cloud solutions, and will leverage the trend to capture more customer IT spending dollars (as it replaces hardware and middleware systems) and to capture new customers, particularly in cost-sensitive emerging economies. Microsoft will combat lower cloud margins by focusing on revenue volume, producing lower margins but higher operating income dollars. With a large traditional business to protect, Microsoft is taking a measured approach to its cloud strategy, moving only as fast as customer demand and focusing on software-plus-services rather than the complete cloud transition promoted by Salesforce.com or NetSuite.

While this strategy is intended to preserve Microsoft’s financials, it also matches customer consumption patterns, most of which will consist of a mixture of onsite and cloud-based. The functionality and pricing of Microsoft cloud offerings will play a role in its cloud performance, but partner buy-in will be the critical success factor. With partners currently accounting for 95 percent of Microsoft’s revenue, the success of software plus services will be driven by partners.

Tags: Microsoft, Opinion Analysis, Windows, Apple

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