UPDATE 26 January 2006 6:35 pm ET
Redmond (WA) - Microsoft today reported record revenues of 11.84 billion and a profit of $3.65 billion for the fiscal quarter ended on Dec. 31, 2005. While client software remains the cash cow of the company, the Xbox 360 revealed its first impact: the company shipped 1.5 million units and was hit by a $293 million loss in its Home and Entertainment division.
Once again, Microsoft posted a solid revenue and profit increase, 9% and 5%, respectively over the results of Q4 2004 (fiscal Q2 2005). The core businesses of Microsoft, especially its client as well as its server and tools group continue to provide the foundation for the firm's operation, as they finished the quarter with an operating income of a combined $3.73 billion - which is 80% of Microsoft's total operating income of $4.66 billion.
The Client business remains the most profitable unit with earnings of $2.64 billion (and sales of $3.46 billion), while the server group brought in a profit of $1.1 billion ($2.91 billion of sales).
The Home and Entertainment group, which is responsible for the Xbox 360, was expected to post a significant loss due to the launch of the new console and a number of games. However, shipments appear are behind Microsoft's ambitious goals to sell between 2.75 and 3 million units in the first days. Considering the fact that the holiday season is long over and that Microsoft shipped just about 50% of its 90 day forecast in the first 40 days after launch, the original target may not be realistic anymore. And even the goal to sell a total of 5.5 million Xbox 360 devices in fiscal 2006, which ends on June 30, may be in jeopardy.
According to Microsoft's SEC filing, revenues of the Home and Entertainment group climbed from $1.37 billion in Q4 of 2004 to $1.55 billion in Q4 of 2005. The $300 million of sales the company achieved with the launch of Halo 2 in the 2004 quarter was partially offset by the launch of the new game console, which enabled the company to increase its Xbox sales by $125 million. However, since the Xbox 360 is losing money on a per-unit basis, last year's profits of $55 million turned into a $293 million loss this time.
The company expects operating expenses and operating loss to continue to increase "as a result of Xbox 360 launch-related activities and Xbox 360 console costs,"
The best strategy to get an Xbox 360
Full analysis follows after the jump...
A dazzling performance, except in the traditional dazzling department
Analysis by Scott M. Fulton, III
By anyone's estimates, Microsoft continues to be a tremendously healthy company. During the conference call this afternoon, Wolfgang had a laugh with me, Skype-ing over to my desktop a copy of the headline posted on MarketWatch: "Microsoft in Black." The headline may as well have read, "Life Goes On." What color would you expect it to be?
The general feeling of bliss was leveraged somewhat, at certain points in today's conference call, for generous use in obscuring perhaps the company's sole point of embarrassment this past quarter: Microsoft's ability to ship Xbox 360 consoles is not only out of sync with customer demand, it's below its own sales goals.
So the company found itself tweaking its numbers just a bit, but only the near-term numbers for now. "We've lowered our estimate of Xbox 360 console sales in the first 90 days from launch, from 2.75 - 3 million units, to 2.5 million units, due to supply constraints," chief financial officer Chris Liddell reported. "Even so, we estimate consumers will spend over $1.5 billion in total retail value on Xbox 360 consoles, games, and peripherals, in these 90 days, which is indicative of the health and magnitude of the Xbox 360 launch. As you know, we're bringing on a third manufacturing partner, Celestica, next month, to help in meeting strong consumer demand for the Xbox 360 console. For that reason, we are not adjusting our previously announced fiscal year console sales guidance of 4.5 - 5.5 million consoles [by the end of June]."
Liddell brushed past questions regarding estimates that one more manufacturer added to the mix would not help Microsoft meet even its adjusted targets, and certainly not its five-million-by-June figure. Liddell told a Goldman Sachs analyst that the company's problems responding to customer demand is "nothing that we think is systematic," and nothing significant going forward. Estimates from outside Microsoft, of Xbox 360 sales thus far, have ranged as low as 800,000 units for the US.
Liddell quoted figures from NPD Funworld stating that for every Xbox 360 console sold, customers purchase three or four pieces of software to go with it, for what the industry calls "software attach." With software such a profitable industry, a Merrill Lynch analyst asked, why doesn't the company raise its guidance estimates for revenue from the Home & Entertainment segment for fiscal '06? The problem, responded Liddell, is that the corresponding dropoff in original Xbox sales ("Xbox 1") offset gains for the company; and besides, he implied, a new Xbox 360 customer picks up the three or four titles that he would have purchased anyway had he bought Xbox 1 instead.
Besides, Colleen Healy, Microsoft's senior director of investor relations, said, the company remains "super-thrilled with the attach rate." That said, however, she doesn't want to forecast future console sales too aggressively.
Revenue growth for the company's MSN division was flat, but that was to be expected, and that is to be expected going forth to June, as the company continues to make investments in Windows Live. While Microsoft continues to build its next-generation AdCenter advertising model for MSN, currently, only 20% of ads served on MSN come through AdCenter, Liddell reported. He expects the bulk of MSN's advertising to become AdCenter-supported by this spring.
The two amazing stories this quarter come from unexpected sources: SQL Server 2005 had a much higher than projected acceptance rate, which led to 20% revenue growth year-over-year for that product alone. And the star of the day, as PBS' Paul Kangas would say, goes to Microsoft CRM, the customer relationship management program whose revenue growth, Liddell reported, is in the triple-digits.
But 80% of the company's business isn't even related to anything I just mentioned. It's attached to the PC industry, which continues to grow at a rate Microsoft estimates at 14-15% annually, which is above everyone's dire expectations from two years ago, and should provide the company with a sea of black ink and neutral-sounding headlines from MarketWatch for quite some time to come.